ITEM 1.
BUSINESS.
Overview
We are an Internet-based social expression and personal publishing service that enables consumers to share, print and preserve their memories by leveraging our technology, manufacturing, web-design and merchandising capabilities. Our primary focus is on helping consumers manage their memories through the powerful medium of photography.
We provide a full range of personalized photo-based products and services that make it easy, convenient and fun for consumers to upload, edit, enhance, organize, find, share, create, print and preserve their memories in a creative and thoughtful manner.
Consumers use our products and services to stay connected to their friends and family, to organize their memories in a single location, to tell stories and to preserve their memories for themselves and their children. Our customers purchase physical products both for their own personal use and for giving thoughtful and personalized gifts
such as photo books, calendars, greeting cards, stationery and other photo-based products and merchandise.
We currently generate the majority of our revenues by producing and selling professionally-bound photo books, personalized calendars, greeting cards and stationery, other photo-based merchandise and high-quality prints ranging in size from wallet-s
ized to jumbo-sized 20Ч30
enlargements. We currently manufacture these items in our Charlotte, North Carolina manufacturing facility. In January 2009, we ceased operations in our Hayward, California facility and expect to begin operations in a new manufac
turing and production facility in Phoenix, Arizona by the second quarter of 2009. By controlling the production process in our own manufacturing facilities, we are able to produce high-quality products, innovate rapidly, maintain a favorable cost
structure and ensure timely shipment to customers, even during peak periods of demand. Additionally, we sell a variety of photo-based merchandise that is currently manufactured for us by third parties, such as calendars, mugs, mouse pads, coasters, tote bags, desk organizers, puzzles, playing cards, multi-media DVDs, magnets and keepsake boxes, notebooks, notepads, address labels and stickers. We generate substantially all of our revenue from sales originating in the United States and our sales
cycle has historically been highly seasonal as we generate more than 50% of our revenue during our fiscal fourth quarter.
Our high-quality products and services and the compelling online experience we create for our customers, combined with our focus on continuous innovation, have earned us numerous third-party accolades and, more importantly, have allowed us to establish a premium brand. We realize the benefits of a premium brand through high customer loyalty,
low customer acquisition costs and premium pricing.
Our customers are a central part of our business model. They generate most of the content on our service by uploading their photos and storing their memories. In addition, they share their photos electronically with their friends and families, extending and endorsing our brand and creating a sense of community. Finally, by giving Shutterfly-branded
products to colleagues, friends and loved ones throughout the year, customers reinforce the Shutterfly brand. Through these various activities, our customers create a viral network of new users and customers.
In addition to driving lower customer acquisition costs through viral marketing, our customers provide input on new features, functionalities and products. Close, frequent customer interactions, coupled with significant investments in sophisticated integrated marketing programs, enable us to fine-tune and tailor our promotions and website
presentation to specific customer segments. Consequently, customers are presented with a highly personalized Shutterfly shopping experience, which helps foster a unique and deep relationship with our brand.
Our corporation was formed in 1999, and we have experienced rapid growth since launching our service in December 1999. During fiscal year 2008, we fulfilled more than 7.5 million orders, to more than 2.7 million customers, at an average order value of more than $28 per order.
In June 2005, we completed the acquisition of Memory Matrix, Inc., a Nevada engineering firm dedicated to improving the consumer digital photography experience, in exchange for 109,302 shares of common stock. In June 2007, for $1.6 million, we acquired certain assets and liabilities of CustomAbility, LLC, a New Jersey publishing
company that produced customized children’s books under the brand name
Make It About Me
. On January 4, 2008, for $10.0 million in cash and stock consideration of approximately $4.0 million, we acquired Nexo Systems, a privately held on-line sharing and group services company based in Palo Alto, California.
Vision and Mission
Our vision is to make the world a better place by helping people share life’s joy. Our mission is to build an unrivaled service that enables deeper, more personal relationships between our customers and those who matter most in their lives.
We believe that people have an intrinsic desire for social expression, as they wish to capture and share their experiences and pass them on to future generations. Today, with the evolution of digital cameras and technology, millions of people around the world are capturing their memories from vacations, weddings, birthdays,
anniversaries, graduations, family reunions and holidays and communicating in deeper, more meaningful ways. Our products and services make sharing, printing and preserving those memories easy, convenient and fun, and allow for our customers to be more thoughtful and creative with their memories.
Historically, preserving photos and creating original, thoughtful compilations of memories was a difficult, expensive, manual, time-consuming and often inconvenient process for consumers. As a result of these constraints, the desire for easy, convenient, versatile, affordable and trusted online photo services has emerged.
Until the widespread adoption of the Internet and digital cameras, there were significant inefficiencies and quality limitations associated with capturing, developing, processing, storing, editing and sharing images. Photos had to be stored in physical form and were vulnerable to deterioration, destruction or loss. Most people chose the
limited option of storing their 4x6 prints in shoeboxes or simple photo albums because photography-related markets — including film processing, photo printing and scrapbooking — either did not exist or were not well-integrated. In particular, convenient options for photo production, storage and sharing were very limited; consumers had to settle for ordering duplicate 4x6 prints from either mail-order or local processing labs with varied capabilities and often poor quality control. Furthermore,
the “shoebox” approach created significant difficulties for consumers in organizing their photos and limited their ability to be thoughtful and creative with their memories. The photo-related industries had not found a way to capitalize on the public’s need to preserve memories across generations in a secure, convenient, creative and engaging manner.
Internet and digital photo-based technology enables consumers to create an archive of memories that extends beyond photos to include highly personalized, more engaging products and services that can be protected and preserved for future generations. We believe that the key forces driving the expansion of the market for these products and
services are:
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Proliferation of digital cameras and penetration of
high-speed connectivity.
The growing use of digital cameras, largely driven by price decreases, has increased the demand for online photo-printing services. High-bandwidth,
high-speed Internet access has spurred the integration of the Internet into daily life and provides consumers with improved performance and speed for sharing information, especially large files sizes such as digital images. According to InfoTrends, in 2008, U.S. digital camera unit sales reached approximately 37 million units, approximately 90 million U.S. households will have broadband by 2013, up from 64 million in 2008, and the number of U.S. households that have both a digital camera and Internet access
is expected to grow to more than 90 million households by 2013.
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Increasing convenience and quality of online photo
services.
Online photo services provide multiple advantages over at-home printing. Although at-home photo printing is instantaneous, it requires an investment
in a printer, photo paper and ink, resulting in a much higher cost per print. The quality rendered from at-home printers is usually inferior compared to commercially produced prints. In addition, at-home printers are less capable of producing products that require binding and / or finishing, such as photo books, calendars and folded greeting cards. In contrast, online photo services conveniently provide a wide variety of customized, high-quality photo-based products delivered directly to consumers’
doorsteps.
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Growing consumer desire to find easy, convenient ways to
generate personalized content.
Consumers are interested in creating highly customized and personalized photo-based products and merchandise to preserve their
precious memories, express their creativity and make gift giving more personal and thoughtful. Improvements in software and photo editing tools have enabled consumers to modify their photos quickly and easily using a personal computer. Consumers are now able to create digital compilations of memories that were previously only possible through a physical and more time-consuming process.
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Participation in online communities.
Consumers have become increasingly comfortable using the Internet as a forum for sharing and publishing information in open or permission-based networks. Many of the most popular online communities include user-generated, rich-media
content such as photos and videos to communicate more powerfully than the written word. Additionally, busy consumers continue to leverage these online communities to keep in touch with distant friends and family, share event photos taken by multiple cameras, in a single location, and even promote a business or hobby.
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Addressable Markets
Digital cameras, digital image processing and the Internet have dramatically changed the photo-related services market, and have created entirely new ways for consumers to capture, edit, enhance, organize, find, share, create, print and preserve images. In particular, the range and quality of printed photos, photo-based products, photo-based
merchandise and ancillary products have expanded and improved significantly, while associated production costs and the time required to create this output have dramatically decreased. Consequently, companies like Shutterfly are now addressing a wide variety of consumer needs and multiple, large markets in ways not possible with earlier technology.
We currently address several adjacent markets related to consumers’ desire to be thoughtful and creative with their memories. These include, but are not limited to:
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Photo-based merchandise.
Photo-based merchandise is a substantial market opportunity that includes any product that can be customized with the imprint of a digital image. Photo-based merchandise includes, but is not limited to, photo calendars, photo greeting cards and
photo books. InfoTrends estimates that revenue from U.S. online net-to-mail sales of non-print products (photo gifts and merchandise) will grow from less than $350 million in 2007 to more than $1 billion in 2012.
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Greeting cards and stationery.
According to the Greeting Card Association’s website, U.S. consumers purchase approximately 7 billion greeting cards each year, generating nearly $7.5 billion in retail sales. More than 90 percent of all U.S. households
buy greeting cards, with the average household purchasing 30 individual cards per year. The Greeting Card Association also reports that nine out of ten Americans say they look forward to receiving personal letters and greeting cards because cards allow them to keep in touch with friends and family and make them feel they are important to someone else.
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Scrapbooks.
According to a 2007 survey by Creating Keepsakes, the addressable markets for the US scrapbook industry was approximately $2.87 billion in 2007 up from $2.55 billion in 2004. Additionally, approximately 82% of scrapbookers have at least a college degree
and spend almost four hours a week assembling their memories into scrapbooks.
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Calendars.
A 2002 guide published by the Calendar Marketing Association estimated that 500 million calendars are produced annually in the United States and that approximately 98% of American households have at least one calendar.
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Photo prints
. InfoTrends estimates that nearly 20 billion digital photo prints were made in the U.S. in 2008, generating revenue of approximately $5 billion. Total revenue from prints is expected to decline by approximately 10% by 2013.
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We generally characterize our products as either “personalized products and services” or “prints”. Our personalized products and services revenues are derived from sales of photo books, greeting cards, calendars, and ancillary products such as photo-based merchandise, and the related shipping revenue from these
sales. Also included in personalized products and services revenue is our sponsorship and advertising programs and our commercial print services. Our print revenues are derived from sales of photo prints and the related shipping revenue. In 2008, 2007 and 2006, our personalized products and services revenues represented approximately 61%, 56% and 51% of our total net revenues, respectively, and our print revenues represented approximately 39%, 44% and 49% of our total net revenues,
respectively.
The addressable market for our products and services includes every person who enjoys the memories created by digital photographic devices such as cameras, camera cell phones or camcorders. Although photofinishing products and services are purchased by a broad consumer base, we believe that women, in particular, play a key role in many
photo-based purchasing decisions. The U.S. Census Bureau reports that there were approximately 55 million women age 25-44 in 2006. We believe that securing the loyalty of this core consumer base represents a sizable market opportunity.
Value for Our Customers
Creating value for our customers is the basis for our success. Our tag line is “Tell Your Story,” and we offer customers easy, convenient and fun ways to tell their stories by:
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sharing and preserving memories for family, friends and themselves;
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organizing all of their photos in a safe and easily accessible location;
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maintaining emotional connections with friends and family, despite being time-constrained, through thoughtful and personal photo-based communications and gifts; and
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achieving satisfaction and self-expression through creativity and telling stories through photos and personalized photo-based products and services.
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Broad offering.
We offer a wide variety of premium products to customers, including prints and photo-based products that include, but are not limited to, photo books, greeting cards, calendars, mugs, mouse pads, photo albums and scrapbooking products and accessories.
In addition, we provide a number of valuable tools and services, such as the ability to create personalized and secure Share Sites for families and groups, to upload and edit photos online, share photos with friends and family and store an unlimited number of photos on our system at no cost. With many creative options from which to choose, we enable customers to become engaged in the Shutterfly experience and feel a sense of pride in their creations.
Exceptional quality and service.
We have built strong relationships with our customers who trust us to preserve and protect their memories in a central storage repository. We enable customers to enhance, share and make projects with their photos at their convenience.
Our focus on ease of use, image quality, design selection, secure photo storage, high-quality products and first-rate packaging has established Shutterfly as a premium brand. Our customers have come to expect the best quality and service from us. This trust is maintained by fast, consistent fulfillment times, responsive customer service and continuous innovation.
Customer-focused approach.
The entire Shutterfly customer experience reflects our customer-centered approach. Membership is free and offers customers the ability to upload, edit, store and share an unlimited number of photos. Membership is not required to view shared
pictures, which can be viewed with a simple click. We conveniently mail orders to our customers’ homes or offices, directly to a gift recipient or allow customers to pick up at local Target stores. We also offer a year-round direct-mail greeting card service where customers upload their electronic address books to Shutterfly and we mail their cards and party invitations on their behalf. We take special care to focus on our customers’ requests for new features and functionality, products and services.
The Shutterfly Solution
We have developed a portfolio of products and services along with specialized manufacturing capabilities that allow us to offer consumers an easy, convenient and fun way to enjoy, share and preserve their memories. We satisfy traditional consumer needs — by introducing consumers to new forms of communication and creative expression
through our website features and functionality, photo prints, and personalized photo-based products and services. We also provide photo printing, storing and sharing. We believe that many people are intimidated by the process of creating photo-based products or merchandise or fear that it will take too much work. We believe that we have removed much of the difficulty and intimidation of the process and have made it easy and enjoyable. In addition to these consumer benefits, we believe that our business model
is supported by the following characteristics:
Viral network effect.
We benefit from a viral network in several ways. When our existing customers upload and share their personal memories through photos, they are providing compelling user-generated content that attracts their friends and family to our website, thus
enlarging our network of users and potential customers. This implicit endorsement, coupled with user-friendly policies, such as not requiring share recipients to register to view pictures, reinforces our trusted brand and leads to lower customer acquisition costs. In addition, as our customers create and give thoughtful and unique physical gifts such as greeting cards, calendars and photo books, these products create numerous opportunities for potential customers to interact with our brand. Many of our customers
also use our website to create community-oriented products such as a photo book celebrating a school play or a yearbook for their children’s soccer team, and they often proactively introduce and sell these items to larger groups of potential new customers. As our products and services delight our customers, they often become enthusiastic evangelists for Shutterfly and introduce our products and services to their friends and family through word-of-mouth referrals and endorsements.
Attractive target demographics reflected in our loyal customer base.
Our customers have described themselves as being interested in maintaining personal connections with friends and family, wanting to tell stories, wishing to preserve their memories for themselves and
their children and wanting an offering that is intuitive and easy to use. As a result, we believe that they are looking for an easy and convenient way to be both thoughtful and creative with their memories. Our customers use our website to share, enhance and preserve memories from vacations, holidays and family events and to create gifts for events such as birthdays, weddings, anniversaries, Halloween, Hanukkah, Christmas, Valentine’s Day, Easter, Mother’s Day and Father’s Day. We believe that
our customer loyalty is also aided by high switching costs. If a customer were to leave Shutterfly, he or she would have to spend significant time uploading and organizing photos on a new service.
Premium pricing.
We believe that we are able to maintain premium pricing for many of our products because of our market position and the loyal customer base we have created. We believe that our market position and loyal customer base exist because we have differentiated
ourselves in the marketplace by delivering high-quality products, outstanding customer service, an intuitive and easy user experience and continuous innovation across our products and services.
Deep understanding of our customers.
Customer insights are an important source of new product and service innovation for us, and we continually strive to understand our customers’ needs in order to improve customer satisfaction. We invest significant time and resources
to understand and address the needs of our customers through market research, focus groups, customer surveys, usability testing, customer response to promotions and customer service interactions. We believe a coordinated focus on understanding the customer allows us take measures to increase customer loyalty, consumer awareness of Shutterfly, customer satisfaction and repeat purchases.
Vertical integration and superior technology.
We derived approximately 79% of our net revenues in 2008, from products we manufactured in our Hayward, California and Charlotte, North Carolina facilities. Our vertically integrated and highly technical manufacturing approach
provides quality control, agility in rolling out new products and ability to secure capacity at critical peak demand periods. We believe that vertical integration provides us with quality, cost, flexibility and innovation advantages, including:
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greater consistency and quality of output;
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increased ability to control and optimize costs for raw materials and production;
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fully-automated image processing and print scheduling;
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more flexibility to provide rapid, responsive order fulfillment and processing;
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assured high-quality capacity, even during peak demand such as the fourth quarter holiday season;
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additional insights into new and existing photo products and production processes;
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rapid prototyping, testing and refinement of new products and services; and
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the ability to address customer inquiries quickly.
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We have devoted more than eight years to developing our proprietary software, technology and production systems that we believe give us an advantage over our competitors. It is our intention to continue investing in and protecting our proprietary technology, platforms and processes that help us differentiate ourselves from the competition,
innovate, and control costs.
Our Growth Strategy
Our goal is to grow our business, build a premium lifestyle brand and become the leading online provider of products and services dedicated to improving the sharing and preservation of personal memories through social expression and personal publishing. We believe the combination of our focus, our dedication to customers and the benefits
we derive from our vertically integrated production facilities will allow us to profitably capture a significant share of our addressable markets. In addition to strong consumer trends supporting our business — such as the proliferation of digital cameras, higher broadband penetration and greater adoption of Internet related e-commerce and communication services — we believe our growth will be supported by the following initiatives:
Expand product and service offerings.
We will continue to innovate to increase the breadth and depth of our products and services, including prints, photo-based merchandise and ancillary products. During 2008, we launched Shutterfly Gallery and Share Sites which we believe
will enhance awareness of our products and services along with providing ease of use. We also added new premium designer stationery, notebooks, notepads, address labels, stickers and calendar posters to our product base.
Expand customer base.
We intend to expand our customer base and continue to promote the Shutterfly brand. We will leverage existing channels, which include word-of-mouth referrals from existing customers, print advertising, catalogs, online advertising, search engine
marketing and complementary alliances with other companies such as Sony, David’s Bridal and Delta Airlines. We’ve also expanded our customer base through our offerings at Target stores, including in-store placements and ad circulars which complement our retail sales and “print-to-Target” offerings. The launch of our Share platform continues to expand our customer base as users create personalized sites and share them with their friends and family.
Increase sales to existing customers.
We intend to increase both average order value and repeat orders per customer by expanding our products and services, tailoring our offerings to encourage additional purchases for different holidays and life events and increasing
our cross-selling and up-selling activities.
Develop new lines of business.
We intend to continue to leverage our existing systems and capabilities to develop additional adjacent product offerings. In 2008, we announced a strategic relationship with CK Media Scrapbooking, the industry’s largest
print publisher, and the introduction of two new designer scrapbooks. We increased our involvement in sponsorship and advertising initiatives. Companies such as Sony, ABC, AT&T, Universal Music and Proctor & Gamble now advertise on our website. And we also intend to expand on our commercial print initiative. During 2008, we entered into a strategic relationship with Group O, a leading provider of marketing services, to provide commercial print services. We intend to continue
to incubate and grow this initiative during 2009.
International expansion.
In future years, we intend to develop additional business opportunities through international expansion, targeting consumers in key geographies where digital camera penetration is high and where Internet usage and e-commerce are widespread.
Products and Services
Using the Shutterfly service is easy, convenient and fun. Our website is designed to be simple, uncluttered and inviting, and we work continuously to enhance the customer experience of the website, while also improving ease of use. If consumers decide to either upload pictures or purchase products, they register on the website
and begin the following process:
Upload.
Customers can upload digital photos from their computer to our website using our Flash-based uploader that enables pictures to be uploaded in the background while they continue to browse through the Shutterfly site, or use Shutterfly Studio, our photo organization
software. We also make it easy to upload from other popular photo software including Adobe Photoshop Elements, Apple iPhoto, and Google Picasa. There are no limits to photo file sizes and the upload processes are accelerated by multi-threading, which enables photos to be uploaded simultaneously. Unlike some competitive services, we do not compress image files as part of the upload process, which we believe preserves quality and photo resolution.
Organize and find.
Customers initially upload their photos into user-defined albums. We offer multiple ways to further organize and find pictures. For example, customers can automatically sort photos within albums by upload date, photo titles or original filenames. We’ve
recently enhanced the website to enable customers to drag and drop pictures to arrange them within albums. Additionally, customers with many albums can organize them into folders for different themes, occasions, or time periods. Customers can also use our “favorites” function to tag their favorite photos with a star rating system on both the website and within Shutterfly Studio.
View and enhance.
Once photos have been uploaded to Shutterfly, customers can choose to view their photos in a variety of ways, including photo slideshows. To improve picture quality, customers also have access to our free online editing and image enhancement tools.
In addition to cropping and red-eye removal, we offer a variety of creative options, such as saturating photos with additional color or changing color shots to black-and-white or sepia. Customers are also able to choose from a wide variety of photo borders. We offer free customized back printing on photos and the option to add captions to many of our products. Customers can view and enhance their photos online or on their desktop via Shutterfly Studio, which easily integrates with our website. Shutterfly Studio
provides advanced viewing and editing capabilities such as full screen slideshows, cropping, red-, blue- and green-eye removal, sharpening, auto adjustments and captioning.
Create.
We enable customers to create a variety of personalized products from their photos, including prints in wallet, 4×6, 5×7, 8×10, 11×14, 16×20 and 20×30 sizes, greeting cards, stationery cards (“designer cards”), calendars,
photo books and other photo-based products and merchandise. Our highly-interactive, design-it-yourself “creation paths” help even first-time customers make professional-looking, high-quality prints and products. Customers can easily design each product by following simple step-by-step instructions and using intuitive features, such as dragging and dropping an image into a template. Our technology then generates an image of the customer’s product on screen so that customers can make any desired
design choices or changes and then view the final product to ensure satisfaction before purchase. Customers can also save in-process projects and return to them at a more convenient time to finish and purchase.
Product enhancements during 2008 include:
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launched Shutterfly Gallery, a community site where photo book customers can post their books, share their stories and inspire other Shutterfly customers with new ways to tell their stories;
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launched our “Storyboard” feature which makes it easier and faster for customers to create their photo books;
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launched a host of new content and designs for photo books including new themed books for Mothers’ Day, Fathers’ Day, Halloween and Christmas and eight new digital scrapbooks in association with Creating Keepsakes (CK) Media;
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added new leather and padded photo book cover options on our square photo books;
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launched premium designer stationery for baby announcements, baby shower invitations, party invitations, graduation and holiday; and
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expanded our product line by adding notebooks, notepads, address labels, stickers and calendar posters.
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Share.
We enable our customers to share memories and stay connected with friends and family in several different ways. Customers can e-mail friends, family and colleagues a link to an individual album that can be viewed as a slideshow of images. In order to
view those images, e-mail recipients simply click on the URL link in the e-mail and view images immediately without the need to register with Shutterfly. Recipients can then order prints or save them into their own album. Similarly, customers can share their photo books electronically by sending an e-mail to friends and family with a link to a photo book project, thereby improving the ease of photo book development and collaboration, and sharing of personalized content. We recently enhanced our
photo book sharing to enable customers to post their photo books onto a variety of social networking and blogging websites including Facebook, MySpace, Blogger, WordPress, LiveJournal, or to embed it on another website as a photo book widget. We also sponsor seasonal and topical photo contests that promote sharing of photos by our customers. To save our customers time, we offer an easy way to copy names, e-mail addresses and mailing addresses from various software such as Outlook, Outlook Express,
Entourage, Palm and Eudora into their Shutterfly address book.
In 2008, we acquired Nexo Systems and with the integration of its technology and team, we launched our new sharing platform called Shutterfly Share Sites. Shutterfly Share Sites enable customers to create personalized, secure websites for sports teams, school activities, clubs and other tight-knit social networks. With
Share Sites, customers can post and share photos, videos, journals, calendars, forums, polls, and widgets all in one place. Customers can personalize the look of the site by choosing from dozens of backgrounds and layouts and by creating their own personalized URL address. To ensure the privacy of Share Sites, we offer users the choice of making sites open or members only and allow for optional password protection.
We also launched Shutterfly Gallery, our community sharing platform, allowing customers to post their photo books, share their thoughts and perspectives on storytelling, add photo books to their favorites list, rate and comment on other photo books, and share interesting Gallery projects with friends and family with the “Email
a Friend” feature. When a customer finds a photo book they particularly like, they also have the ability to “make one like this” which uses the design and layout of that book as a template for a new book using their own photos, captions, and titles.
Order and ship.
We provide convenient ordering and flexible shipping options. To order a product after it is created, the customer adds it to his or her shopping cart and completes the billing and shipping information. Shipping addresses can be typed in or easily added
directly from a customer’s Shutterfly address book. When a picture or product is being ordered, we flag photos of poor quality, usually due to low resolution, to alert customers of potential quality issues. This helps ensure that a customer does not order an out-of-focus or poor quality picture. Customers can ship single orders to multiple recipients. We also offer several different shipping options, such as next-day, two-day or regular service. Standard turn-around times from the time an order is placed
to the time it is shipped are one business day for most print orders and two business days for other photo-based products manufactured by Shutterfly. For our photo-based merchandise manufactured on our behalf by third parties, turn-around times vary, but generally range from two to five days from the time we receive the order and transmit it to our manufacturer. We also offer premium services for addressing, stamping and mailing greeting cards directly to recipients.
Archive.
We provide customers with unlimited storage of their photos, collections and projects at no cost to the customer. Customers can also order a copy of their photos on a DVD for an extra fee.
Marketing, Advertising and Promotion
We use a variety of integrated marketing programs, including advertising, direct marketing technologies, channels, methods and strategic alliances to attract and retain our customers. These methods include direct marketing over the Internet, e-mail marketing to prospects and existing customers, search engine marketing, and traditional
direct marketing mailings such as postcards and seasonal catalogs. In addition, because many of our products are either shared over the Internet or given as gifts, the appearance of our brand on the products and packaging provides ongoing distribution as well as viral advertising.
We place targeted advertisements on websites and in publications, contract for targeted e-mail marketing services and contract for advertising placement on leading search engines. We also maintain an affiliate program under which we pay program participants for referral sales generated from hyperlinks to our website from the affiliate’s
website and in promotional materials.
We maintain alliances with complementary companies. For example, we have co-marketing and promotion arrangements with companies such as Delta Airlines SkyMiles, David’s Bridal, and Proctor and Gamble. In 2007, we began a relationship with Target Corporation where we provided our customers the ability to order their 4x6
prints online and pick them up at select local Target store in as little as an hour. We also offer an in-store suite of prepaid products including photo books, adventure books, photo gifts, and gift cards. Customers may purchase these products at select Target stores and redeem them online at Shutterfly.com.
In addition, from time to time we create co-branded versions of our website. In general, these arrangements involve payment of a commission to or revenue sharing with these companies for sales of our products and services generated through these websites.
Technology and Production Systems
We use a combination of proprietary and third-party technology, including the following:
Customer relationship management, or CRM, system.
Our integrated CRM system is composed of various tools designed to convert first-time customers into repeat buyers. We seek to increase average order sizes by expanding customer awareness, providing targeted, segmented
offers to customers and encouraging cross- and up-selling. The system uses a variety of data, including website usage patterns, order size, order frequency, products purchased, seasonality factors, image upload and share usage, as well as customer satisfaction information. This data is continually updated and refreshed in a data warehouse, from which different customer segments are identified and modified on a continuing basis for targeted marketing communications.
By using this deep customer intelligence and ongoing analysis, we are able to offer customers a more personalized website experience and to target them with specific website promotions, discounts, specialized e-mail and direct mail offers. Our promotion engine generates special offers that are account specific and applied automatically
at checkout. In 2008, we introduced our “promotion code at checkout” functionality that allows us to run multiple offers at any given time that are targeted to specific customer profiles.
We are also able to dynamically assign visitors to test and control groups who are shown different versions of our service. This form of A-B testing enables us to continuously optimize products, pricing, promotions and user interaction with our website.
Website system.
We have designed our website system to be highly available, secure and cost-effective. We can scale to increasing numbers of customers by adding relatively inexpensive industry-standard computers and servers. We have a strong commitment to our privacy
policy, and we utilize technologies such as firewalls, encryption technology for secure transmission of personal information between customers’ computers and our website system and intrusion detection systems.
Image archive.
We store our customers’ images in our image archive. Once a customer uploads a photo to our website, it is copied to multiple redundant systems, including an off-site copy. We continue to expand our storage capacity to meet increasing customer demand.
Our innovative storage architecture provides low storage costs, facilitates the safe, secure archiving of customers’ images and delivers the speed and performance required to enable customers to access, enhance and edit their images in real-time.
When we store and archive a customer’s image, we do not alter or reduce resolution of the original image (for example, we do not reduce the data file size), which preserves the quality and integrity of the image. This approach also lets customers enhance the image using a duplicate, while giving them the ability to recall the original
at any time.
Render farm.
Once a customer orders a photo or any photo-based product or photo-based merchandise, our render farm technology performs fully automated image processing on the image prior to production. The customer’s original uploaded image is retrieved from the
image archive, and automatic algorithms enhance the color, contrast and sharpness of the image. The render farm also performs customer-requested edits such as crop, borders, customized back-printing and red-eye removal.
To ensure that output is of consistent quality, we apply our proprietary ColorSure technology during this render stage. ColorSure creates an automated mapping of the image’s specific attributes to the printer’s specific print calibrations and attributes, prior to production. For example, this technology allows a 4x6 print
to look the same as a photo printed on an enlargement or in a photo book, even if they are ordered at separate times.
Production system.
We operate our own production facility in Charlotte, North Carolina. In January 2009, we closed our Hayward, California facility and we are configuring a new facility in Phoenix, Arizona that is expected to begin operations in the second
quarter of 2009. Our automated production system controls our production processes, including order management and pick, pack and ship operations. Using proprietary algorithms, the production system analyzes tens of thousands of orders daily and automates the workflow into our high-volume silver halide photofinishing machines and our state-of-the-art digital offset presses.
Competition
The market for digital photography products and services is large, evolving and intensely competitive, and we expect competition to increase in the future. We face intense competition from a wide range of companies, including the following:
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online digital photography services companies such as Kodak EasyShare Gallery (formerly known as Ofoto), Snapfish, which is a service of Hewlett-Packard, American Greetings’ Photoworks and Webshots brands, and others;
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“Big Box” retailers such as Wal-Mart, Costco and others that are seeking to offer low cost digital photography products and services. These competitors provide in-store fulfillment and self-service kiosks for printing, which may, among other strategies, offer their customers heavily discounted in-store products and services
that compete directly with our offerings;
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drug stores such as Walgreens, CVS and others that offer in-store pick-up from Internet orders;
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regional photography companies such as Ritz Camera that have established brands and customer bases in existing photography markets;
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Internet portals and search engines such as Yahoo!, AOL, and Google that offer broad-reaching digital photography and related products and services to their large user bases;
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home printing service providers such as Hewlett-Packard, Epson, Canon, and Fuji that are seeking to expand their printer and ink businesses by gaining market share in the emerging digital photography marketplace;
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photo-related software companies such as Apple, Microsoft and Corel;
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social media companies that host images such as MySpace, Facebook and Hi5; and
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specialized companies in the photo book and stationery business such as Hallmark, American Greetings, Tiny Prints, Picaboo and Blurb.
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brand recognition and trust;
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quality of products and services;
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breadth of products and services;
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user affinity and loyalty;
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We believe that we compete favorably with respect to many of these factors, particularly customer trust and loyalty, quality and breadth of products and services, and customer service. Many of our competitors promote their products on the basis of low prices or the convenience of same-day availability for digital photos printed in
drugstores or other retail outlets. As a general matter, we currently plan to distinguish ourselves from such competitors principally on the basis of product quality and innovation, rather than price or same-day delivery.
The level of competition in our industry has been consistently high since our inception in 1999, and is likely to increase as current competitors improve their offerings and as new participants enter the market or as industry consolidation further develops. These competitors have or could develop a variety of competitive advantages over
us, including significantly longer operating histories; larger and broader customer bases; greater brand recognition; greater financial, research and development and distribution resources; and greater ability to acquire, invest in or partner with traditional and online competitors. Well-funded new entrants may choose to prioritize growing their market share and brand awareness instead of profitability. We may be unable to compete successfully against current and future competitors, and competitive pressures
could harm our business and prospects.
Intellectual Property
Protecting our intellectual property rights is part of our strategy for continued growth and competitive differentiation. We seek to protect our proprietary rights through a combination of patent, copyright, trade secret and trademark law. We enter into confidentiality and proprietary rights agreements with our employees, consultants and
business partners, and control access to and distribution of our proprietary information. In 2008, we entered into two licensing arrangements with two different third parties for certain of our patented technology. Under the terms of the licenses, we received initial payments in 2008 and expect to receive additional payments in 2009 and 2010. We seek to enter into other similar arrangements with third parties who seek to use our patented technology.
As of December 31, 2008, we had 28 issued patents, which expire at various dates between 2019 and 2027, and more than 20 patent applications pending in the United States. Our issued patents and patent applications relate generally to the user interface for our website, our computer network infrastructure and software, personalized
photo-related products and automated workflow and digital printing. We intend to pursue corresponding patent coverage in additional countries to the extent we believe such coverage is appropriate and cost efficient. However, we cannot be certain that any of our pending or any future applications will be granted. In addition, third parties could bring invalidity, co-inventorship or similar claims with respect to any of our currently issued patents or any patents that may be issued to us in the future.
We have in the past received claims, and in the future a third party may claim that we have infringed its patent rights. This can result in litigation and/or require us to enter into a license agreement with a third party. For example, effective May 1, 2005, Shutterfly entered into a settlement and license agreement to resolve litigation
with respect to alleged infringement of certain processes under U.S. patents relating to uploading, storing, sharing, accessing, downloading and/or requesting or obtaining digital images or prints of digital images or merchandise to which such images are applied. Under the terms of the agreement, Shutterfly paid $2.0 million for a license to certain patents, including a non-exclusive, fully-paid up, royalty-free, worldwide license to the patents underlying the litigation, and a mutual release of claims
and obtained a royalty-bearing license for certain other private label activities for an addtional $2.0 million.
Our primary brand is “Shutterfly.” We hold registrations for the Shutterfly service mark in our major markets of the United States and Canada, as well as in the European Community, Mexico, Japan, Australia and New Zealand. We also hold “Shutterfly.com” Internet domain registrations in the United States, Mexico,
Australia and New Zealand, and a “Shutterfly and Design” trademark, “Shutterfly Express”, “Shutterfly Collections” and “Postcards by Shutterfly” service mark registrations in the United States. An additional application for the Shutterfly mark is pending in Brazil. We also hold a registration for the “VividPics” service mark in the United States and Mexico, and have pending applications for additional marks, including “Shutterfly Studio”,
a “Shutterfly Studio and Design” trademark, “Your pictures and more”, “Marking it personal”, and “Memory Vault”. We also own the trademark to our tagline, “Tell Your Story.”
These brand registrations are a critical component of our marketing programs. If we lose the ability to use our Shutterfly mark in a particular country or our domain name, we could be forced to either incur significant additional expenses to market our products within that country or elect not to sell products in that country. In addition,
regulations governing domain names and laws protecting trademarks and similar proprietary rights could change in ways that block or interfere with our ability to use our current brand and to acquire or maintain the domain names that utilize the name Shutterfly in all of the countries in which we currently or intend to conduct business.
Government Regulation
The legal environment of the Internet is evolving rapidly in the United States and elsewhere. The manner in which existing laws and regulations will be applied to the Internet in general, and how they will relate to our business in particular, is unclear in many cases. Accordingly, we often cannot be certain how existing laws will apply
in the online context, including with respect to such topics as privacy, defamation, pricing, credit card fraud, advertising, taxation, sweepstakes, promotions, content regulation, quality of products and services and intellectual property ownership and infringement. In particular, legal issues relating to the liability of providers of online services for activities of their users are currently unsettled both within the United States and abroad.
Numerous laws have been adopted at the national and state level in the United States that could have an impact on our business. These laws include the following:
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The CAN-SPAM Act of 2003 and similar laws adopted by a number of states. These laws are intended to regulate unsolicited commercial e-mails, create criminal penalties for unmarked sexually-oriented material and e-mails containing fraudulent headers and control other abusive online marketing practices.
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The Communications Decency Act, which gives statutory protection to online service providers who distribute third-party content.
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The Digital Millennium Copyright Act, which is intended to reduce the liability of online service providers for listing or linking to third-party websites that include materials that infringe copyrights or other rights of others.
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The Children’s Online Privacy Protection Act and the Prosecutorial Remedies and Other Tools to End Exploitation of Children Today Act of 2003, which are intended to restrict the distribution of certain materials deemed harmful to children and impose additional restrictions on the ability of online services to collect user information
from minors. In addition, the Protection of Children From Sexual Predators Act of 1998 requires online service providers to report evidence of violations of federal child pornography laws under certain circumstances.
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Statutes adopted in the State of California require online services to report certain breaches of the security of personal data, and to report to California consumers when their personal data might be disclosed to direct marketers.
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To resolve some of the remaining legal uncertainty, we expect new laws and regulations to be adopted over time that will be directly applicable to the Internet and to our activities. Any existing or new legislation applicable to Shutterfly could expose us to substantial liability, including significant expenses necessary to comply with
such laws and regulations, and could dampen the growth in the use of the Internet in general.
We post on our website our privacy policies and practices concerning the use and disclosure of user data. Any failure by us to comply with our posted privacy policies, Federal Trade Commission requirements or other privacy-related laws and regulations could result in proceedings by governmental or regulatory bodies that could potentially
harm our business, results of operations and financial condition. In this regard, there are a large number of legislative proposals before the United States Congress and various state legislative bodies regarding privacy issues related to our business. It is not possible to predict whether or when such legislation may be adopted, and certain proposals, if adopted, could harm our business through a decrease in user registrations and revenues. These decreases could be caused by, among other possible provisions,
the required use of disclaimers or other requirements before users can utilize our services.
Due to the global nature of the Internet, it is possible that the governments of other states and foreign countries might attempt to regulate its transmissions or prosecute us for violations of their laws. We might unintentionally violate such laws, such laws may be modified and new laws may be enacted in the future. Any such developments
could harm our business, operating results and financial condition. We may be subject to legal liability for our online services. The law relating to the liability of providers of these online services for activities of their users is currently unsettled both within the United States and abroad. Claims may be threatened against us for aiding and abetting, defamation, negligence, copyright or trademark infringement, or other theories based on the nature and content of information to which we provide links or that
may be posted online.
Employees
As of December 31, 2008, we had 514 full time employees. Approximately 127 employees were engaged in engineering, 235 in photo lab operations, 70 in sales and marketing, 18 in customer service and 64 in general and administrative functions. During the peak holiday season, we hire contract workers on a temporary basis from third-party
outsourcing firms. For example, during our peak production day in the fourth quarter of 2008, we used approximately 640 temporary workers to assist in our production and fulfillment operations during high-demand periods. None of our employees are represented by a labor union or are covered by a collective bargaining agreement. We have never experienced any employment-related work stoppages and consider our employee relations to be good.
Available Information
Our Internet website is located at http://www.shutterfly.com. The information on our website is not a part of this annual report. We make available free of charge on our website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant
to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. Our SEC reports can be accessed through the investor relations section of our Internet website.
The public may also read and copy any materials we file with the Securities and Exchange Commission at the Securities and Exchange Commission’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the Securities and Exchange Commission
at 1-800-SEC-0330. The Securities and Exchange Commission also maintains an Internet website that contains reports, proxy and information statements and other information regarding issuers that file electronically with the Securities and Exchange Commission. The Securities and Exchange Commission’s Internet website is located at http://www.sec.gov.
ITEM 1A. RISK FACTORS
Our net revenues, operating results and cash requirements are affected by the seasonal nature of our business.
Our business is highly seasonal, with a high proportion of our net revenues, net income and operating cash flows generated during the fourth quarter. For example, we generated approximately 50% of our net revenues for 2008 in the fourth quarter of 2008, and the net income that we generated during the fourth quarter of 2008 was necessary
for us to achieve profitability on an annual basis for 2008. In addition, we incur significant additional expenses in the period leading up to the fourth quarter holiday season including expenses related to the hiring and training of temporary workers to meet our seasonal needs, additional inventory and equipment purchases and increased advertising. If we are unable to accurately forecast and respond to consumer demand for our products during the fourth quarter, our financial results, reputation and brand will
suffer and the market price of our common stock would likely decline.
We also base our operating expense budgets on expected net revenue trends. A portion of our expenses, such as office, lab facility, and various equipment leases and various personnel costs, are largely fixed and are based on our expectations of our peak levels of operations. We may be unable to adjust spending quickly enough to offset
any unexpected revenue shortfall. Accordingly, any shortfall in net revenues may cause significant variation in operating results in any quarter.
In addition, our operations and financial performance depend on general economic conditions. The U.S. economy recently experienced, and could continue to experience, an economic downturn due to the crisis in credit markets, slower economic activity, concerns about inflation, increased energy costs, decreased consumer confidence,
high consumer debt levels and unemployment rates and other adverse business conditions. Such fluctuations in the U.S. economy could cause, among others, deterioration and continued decline in consumer spending and increase in the cost of labor and materials. As a result, given the combination of the current economic conditions, very low consumer sentiment and limited discretionary funds, the economic slowdown could exacerbate the seasonal decline in sales that we typically see in the
first three quarters of the calendar year.
Our limited operating history makes it difficult to assess the exact impact of the seasonal factors on our business or the extent to which our business is susceptible to cyclical fluctuations in the U.S. economy. In addition, our historically rapid growth may have overshadowed whatever seasonal or cyclical factors might have influenced
our business to date. Seasonal or cyclical variations in our business may become more pronounced over time and may harm our future operating results.
Economic trends could adversely affect our financial performance.
We are subject to macro-economic fluctuations in the U.S. economy. Recent macro-economic issues involving the broader financial markets, including the housing and credit system and the liquidity issues in the auction rate securities that we have invested
in have negatively impacted the economy and our financial performance.
Weak economic conditions and declines in consumer spending and consumption have harmed and may further harm our operating results. Purchases of our products are often discretionary. If the economic climate does not improve or continues to deteriorate,
customers or potential customers could further delay, reduce or forego their purchases of our products and services, which could impact our business in a number of ways, including lower prices for our products and services and reduced sales. In addition, the current economic conditions may lead to price increases by our suppliers or increase our operating expenses due to, among others, higher costs of labor, energy, equipment and facilities. Economic downturns may also lead to restructuring
actions and associated expenses. Due to reduced consumer spending and increased competitive pressures in the current economic environment, we may not be able to pass these increased costs to our customers. The resulting increased expenses and/or reduced income would negatively impact our operating results.
If the negative macro-economic conditions persist, or if the economy enters a prolonged period of decelerating growth, our results of operations may be further harmed.
If we are unable to meet our production requirements, our net revenues and results of operations would be harmed.
We believe that we must continue to grow our current production capability to meet our projected net revenue targets. We anticipate that total capital expenditures will range between 11% to 12% of our expected calendar year 2009 net revenues. A portion of those capital expenditures will be used to add manufacturing capacity
during 2009. During 2007, we opened a new manufacturing and production plant in Charlotte, North Carolina, and in July 2008, we announced that we will be closing our Hayward, California production facility in early 2009 and expect to begin operations in a new manufacturing and production facility in Phoenix, Arizona by the second quarter of 2009. Operational difficulties, such as a significant interruption in the operation or opening of any of our plants could delay production or shipment
of our products. Our inability to meet our production requirements could lead to customer dissatisfaction and damage to our reputation and brand, which would result in reduced net revenues. Moreover, if the costs of meeting production requirements, including capital expenditures, were to exceed our expectations, our results of operations would be harmed.
There could be unforeseen construction, scheduling, engineering, cost or other problems with the build-out of the facility of our new Phoenix manufacturing and production plant, which could cause the operation commencement date to differ significantly from initial expectations. Any significant delay in the commencement of operations
at the new plant could cause a delay in our production requirements and harm our business, financial condition and results of operations. The new plant could also experience other operational disruptions, including telecommunications system problems, disruptions in transitioning fulfillment orders and problems or increased expenses associated with operating the new plant, which could harm our business, financial condition and results of operations.
In addition, we face significant production risks at peak holiday seasons, including the risks of obtaining sufficient qualified seasonal production personnel. A majority of our workforce during the fourth quarter of 2008 was seasonal, temporary personnel. We have had difficulties in the past finding a sufficient number of qualified seasonal
employees, and our failure to obtain qualified seasonal production personnel at any of our production plants could harm our operations.
Our quarterly financial results may fluctuate, which may lead to volatility in our stock price.
Our future revenues and operating results may vary significantly from quarter-to-quarter due to a number of factors, many of which are difficult for us to predict and control. Factors that could cause our quarterly operating results to fluctuate include:
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general economic conditions, including recession and economic slowdown in the U.S. and worldwide and higher inflation, as well as those economic conditions specific to the Internet and ecommerce industries;
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demand for our products and services, including seasonal demand;
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our pricing and marketing strategies and those of our competitors;
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our ability to attract visitors to our website and convert those visitors into customers;
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our ability to retain customers and encourage repeat purchases;
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our ability to sustain our profit margins, and our ability to diversify our product offerings and sell to consumers photo-based products such as photo books, calendars and cards;
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the costs of customer acquisition;
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our ability to manage our production and fulfillment operations;
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the costs to produce our prints and photo-based products and merchandise and to provide our services;
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the costs of expanding or enhancing our technology or website;
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a significant increase in returns and credits, beyond our estimated allowances, for customers who are not satisfied with our products;
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declines or disruptions to the travel industry;
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variations in weather, particularly heavy rain and snow which tend to depress travel and picture taking;
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volatility in our stock price, which may lead to higher stock-based compensation expense;
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consumer preferences for digital photography services;
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improvements to the quality, cost and convenience of desktop printing of digital pictures and products; and
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macroeconomic and geopolitical events such as recession, inflation, war, threat of war or terrorist actions.
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Based on the factors cited above, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance. It is possible that in one or more future quarters, our operating results may be below the expectations of public market analysts and investors. In that event, the trading price
of our common stock may decline.
We have incurred operating losses in the past and may not be able to sustain profitability in the future.
We have periodically experienced operating losses since our inception in 1999. In particular, we make investments in our business that generally result in operating losses in each of the first three quarters of our fiscal year. This typically has enabled us to generate the majority of our net revenue during the fourth quarter and to achieve
profitability for the full fiscal year. If we are unable to produce our products and provide our services at commercially reasonable costs, if customer demand and revenues decline or if our expenses exceed our expectations, we may not be able to sustain or increase profitability on a quarterly or annual basis.
We have a limited public company operating history, which makes it difficult to evaluate our business and prospects for the future.
We became a public company in September 2006, and we have only a limited public operating history on which investors can base an evaluation of our business and future prospects. We face many risks, uncertainties, expenses and difficulties. To address these risks and uncertainties, we must do the following:
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maintain and increase the size of our customer base;
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maintain and enhance our brand;
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maintain and grow our website and customer operations;
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enhance and expand our products and services;
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successfully execute our business and marketing strategy;
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continue to develop and upgrade our technology and information processing systems;
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continue to enhance our service to meet the needs of a changing market;
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provide superior customer service;
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respond to competitive developments; and
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attract, integrate, retain and motivate qualified personnel.
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We may be unable to accomplish one or more of these requirements, which could cause our business to suffer. Accomplishing one or more of these requirements might be very expensive, which could harm our financial results.
If we are not able to reliably meet our data storage and management requirements, customer satisfaction and our reputation could be harmed.
As a part of our current business model, we offer our customers free unlimited online storage and sharing of photographs and, as a result, must store and manage multiple petabytes of data. This policy results in immense system requirements and substantial ongoing technological challenges, both of which are expected to continue to increase
over time. If we are not able to reliably meet these data storage and management requirements, we could have disruptions in services which could impair customer satisfaction and our reputation and lead to reduced net revenues and increased expenses. Moreover, if the cost of meeting these data storage and management requirements exceeds our expectations, our results of operations would be harmed.
Our data storage system could suffer damage or interruption from human error, fire, flood, power loss, telecommunications failure, break-ins, terrorist attacks, acts of war and similar events. In addition, our primary storage facilities are located near a major fault line, increasing our susceptibility to the risk that an earthquake could
significantly harm our data storage system. If we experience disruption to our redundant systems located at our data storage center, such disruption could result in the deletion or corruption of customer stored images. For example, in 2007, we experienced a loss of a small number of customer images due to an isolated server failure.
Interruptions to our website, information technology systems, print production processes or customer service operations could damage our reputation and brand and substantially harm our business and results of operations.
The satisfactory performance, reliability and availability of our website, information technology systems, printing production processes and customer service operations are critical to our reputation, and our ability to attract and retain customers and maintain adequate customer satisfaction. We currently conduct periodic site maintenance
several times a quarter that sometimes requires us to take the website down. The scheduled down times are planned at non-peak hours, typically at midnight. Any interruptions that result in the unavailability of our website or reduced order fulfillment performance or customer service could result in negative publicity, damage our reputation and brand and cause our business and results of operations to suffer. For example, in the second quarter of 2008, we experienced website performance issues in conjunction
with a large release of additional website functionality which impacted our key metrics and revenue. This risk is heightened in the fourth quarter, as we experience significantly increased traffic to our website during the holiday season. Any interruption that occurs during such time would have a disproportionately negative impact than if it occurred during a different quarter.
We depend in part on third parties to implement and maintain certain aspects of our communications and printing systems. Therefore many of the causes of system interruptions or interruptions in the production process may be outside of our control. As a result, we may not be able to remedy such interruptions in a timely manner, or at all.
Our business interruption insurance policies do not address all potential causes of business interruptions that we may experience, and any proceeds we may receive from these policies in the event of a business interruption may not fully compensate us for the revenues we may lose.
We may have difficulty managing our growth and expanding our operations successfully.
We have grown from 431 employees as of December 31, 2007 to 514 employees as of December 31, 2008. We have website operations, offices and customer support centers in Redwood City, California and Mesa, Arizona, and production facilities in Charlotte, North Carolina, Hayward, California (through early 2009), and a new facility in Phoenix,
Arizona that is expected to be operational by the second quarter of 2009. Our growth has placed, and will continue to place, a strain on our administrative and operational infrastructure. Our ability to manage our operations and growth will require us to continue to refine our operational, financial and management controls, human resource policies and reporting systems.
If we are unable to manage future expansion, we may not be able to implement improvements to our controls, policies and systems in an efficient or timely manner and may discover deficiencies in existing systems and controls. Our ability to provide a high-quality customer experience could be compromised, which would damage our reputation
and brand and substantially harm our business and results of operations.
We recently implemented a new enterprise resource planning system ("ERP") as part of our strategy to provide scale in our operations. The ERP system is complex and could have flaws that could negatively impact our business and operations. Moreover, our internal processes may not be entirely compatible with the ERP system, which
may require additional resources to ensure compatibility.
Competitive pricing pressures, particularly with respect to 4Ч6 print pricing and shipping, may harm our business and results of operations.
Demand for our products and services is sensitive to price, especially in times of economic slowdown and consumer conservatism. Many external factors, including our production and personnel costs, consumer sentiment and our competitors’ pricing and marketing strategies, can significantly impact our pricing strategies. If we fail
to meet our customers’ price expectations, we could lose customers, which would harm our business and results of operations.
Changes in our pricing strategies have had, and may co
ntinue to have, a significant impact on our net revenues and net income. From time to time, we have made changes to our pricing structure for 4Ч6 prints in order to remain competitive. In December 2007,
one of our competitors lowered its list prices on 4Ч6 prints from $0.12 to $0.09. During the third quarter of 2008, we lowered the list price of 4x6 prints from $0.19 to $0.15. We expect to continue to test other pricing, promotion and bundled service offerings, however, a significant drop in our 4Ч6 pric
es, without a corresponding increase in volume, or decreases in volume as a result of competitive pressures would
negatively impact our net revenues and could adversely affect our gross margins and overall profitability.
We generate a significant portion of our net revenues from the fees we collect from shipping our products. For example, these fees represented approximately 17%, 19% and 20% of our net revenues in 2008, 2007 and 2006 respectively. We offer discounted or free shipping, with a minimum purchase requirement, during promotional
periods to attract and retain customers. If free shipping offers extend beyond a limited number of occasions, are not based upon a minimum purchase requirement or become commonplace, our net revenues and results of operations would be negatively impacted. In addition, we occasionally offer free or discounted products and services to attract and retain customers. In the future, if we increase these offers to respond to actions taken by our competitors, our results of operations may be harmed.
We face intense competition from a range of competitors and may be unsuccessful in competing against current and future competitors.
The digital photography products and services industries are intensely competitive, and we expect competition to increase in the future as current competitors improve their offerings and as new participants enter the market or as industry consolidation further develops. Competition may result in pricing pressures, reduced profit margins
or loss of market share, any of which could substantially harm our business and results of operations. We face intense competition from a wide range of companies, including the following:
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Online digital photography services companies such as Kodak EasyShare Gallery (formerly known as Ofoto), Snapfish, which is a service of Hewlett-Packard, American Greetings’ Photoworks and Webshots brands, and others;
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“Big Box” retailers such as Wal-Mart, Costco and others that are seeking to offer low cost digital photography products and services, such as in-store fulfillment and self-service kiosks for printing; these competitors may, among other strategies, offer their customers heavily discounted in-store products and services that
compete directly with our offerings;
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Drug stores such as Walgreens, CVS and others that offer in-store pick-up from Internet orders;
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Regional photography companies such as Ritz Camera that have established brands and customer bases in existing photography markets;
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Internet portals and search engines such as Yahoo!, AOL, Google that offer broad-reaching digital photography and related products and services to their large user bases;
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Home printing service providers such as Hewlett-Packard, Epson, Canon, and Kodak that are seeking to expand their printer and ink businesses by gaining market share in the emerging digital photography marketplace; and
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Photo-related software companies such as Apple, Microsoft and Corel;
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Social media companies that host images such as MySpace, Facebook and Hi5; and
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Specialized companies in the photo book and stationery business such as Hallmark, American Greetings, Tiny Prints, Picaboo and Blurb.
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Many of our competitors have significantly longer operating histories, larger and broader customer bases, greater brand and name recognition and greater financial, research and development and distribution resources, and operate in more geographic areas than we do. Well-funded competitors may be better able to withstand economic downturns
and associated periods of reduced customer spending and increased pricing pressures. The numerous choices for digital photography services can cause confusion for consumers, and may cause them to select a competitor with greater name recognition. Some competitors are able to devote substantially more resources to website and systems development or to investments or partnerships with traditional and online competitors. Competitors that are well-funded, particularly new entrants may choose to prioritize
growing their market share and brand awareness instead of profitability. Competitors and new entrants in the digital photography products and services industries may develop new products, technologies or capabilities that could render obsolete or less competitive many of the products, services and content that we offer. We may be unable to compete successfully against current and future competitors, and competitive pressures could harm our business and prospects.
If we are unable to adequately control the costs associated with operating our business, our results of operations will suffer.
The primary costs in operating our business are related to producing and shipping products, acquiring customers, compensating our personnel, acquiring equipment and technology and leasing facilities. If we are unable to keep these costs aligned with the level of revenues that we generate, our results of operations would be harmed. Controlling
our business costs is challenging because many of the factors that impact these costs are beyond our control. For example, the costs to produce prints, such as the costs of photographic print paper, could increase due to a shortage of silver or an increase in worldwide energy prices. In addition, we may become subject to increased costs by the third-party shippers that deliver our products to our customers, and we may be unable to pass along any increases in shipping costs to our customers. The costs
of online advertising and keyword search could also increase significantly due to increased competition, which would increase our customer acquisition costs.
We invest in securities that are subject to market risk and the recent issues in the financial markets could adversely affect the value of our assets.
At December 31, 2008, $52.3 million par value of our marketable securities portfolio was invested in AAA rated investments in auction-rate debt securities ("ARS"). ARS investments are long-term variable rate bonds tied to short-term interest rates. After the initial issuance of the securities, the interest rate on the securities
is reset periodically, at intervals established at the time of issuance (primarily every twenty eight days), based on market demand for a reset period. Auction rate securities are bought and sold in the marketplace through a competitive bidding process often referred to as a “Dutch auction.” If there is insufficient interest in the securities at the time of an auction, the auction may not be completed and the rates may be reset to predetermined “penalty” or “maximum” rates.
From the inception of these investments in ARS in January 2008 through February 2009, due to the recent uncertainties in the credit markets, all scheduled auctions have failed. Consequently, the investments are not currently liquid and we will not be able to access these funds until a future auction of these investments is successful,
the securities are called by the issuer or a buyer is found outside of the auction process. As a result, we have classified the entire balance of ARS as non-current investments on our consolidated balance sheet. At the time of the initial investment and through the date of this report, all of these auction rate securities remain AAA rated. The assets underlying each security are student loans and 90% of the principal amounts are guaranteed by the Federal Family Education Loan Program (“FFELP”).
Typically, the fair value of ARS investments approximates par value due to the frequent resets through the auction process. While we continue to earn interest on our ARS investments at the contractual rate, these investments are not currently trading and therefore do not have a readily determinable market value. Accordingly, the estimated
fair value of the ARS investments no longer approximates par value.
At December 31, 2008, we utilized a discounted cash flow approach to determine the Level 3 valuation for the ARS investments. This analysis indicated a fair value of $43.3 million. The assumptions used in preparing the discounted cash flow model include estimates for interest rates, timing and amount of cash flows, credit and liquidity
premiums, and expected holding periods of the ARS. These assumptions are volatile and subject to change as the underlying sources of these assumptions and market conditions change. They represent our estimates given available data as of December 31, 2008. Based on this assessment of fair value, as of December 31, 2008 we determined there was a decline in fair value of our ARS investments of $9.0 million.
In November 2008, we accepted an offer (the “Rights”) from UBS AG (“UBS”), one of our investment advisors, entitling us to sell at par value auction-rate securities originally purchased from UBS (approximately $52.3 million, par value) at anytime during a two-year period from June 30, 2010 through July 2, 2012. In
accepting the Rights, we also granted UBS the authority to sell or auction the ARS at par at any time up until the expiration date of the offer and released UBS from any claims relating to the marketing and sale of ARS. Although we expect to sell our ARS under the Rights, if the Rights are not exercised before July 2, 2012, it will expire and UBS will have no further rights or obligation to buy our ARS. The Rights represent a contractual agreement between us and UBS that will
rank senior to UBS' ordinary shares. Throughout the period from acceptance of the offer until the Rights are redeemed or UBS sells the securities, ARS will continue to accrue interest as determined by the auction process or the terms outlined in the prospectus of the ARS if the auction process fails. UBS’s obligations under the Right are not secured by its assets and do not require UBS to obtain any financing to support its performance obligations under the Rights. UBS has disclaimed
any assurance that it will have sufficient financial resources to satisfy its obligations under the Rights.
The Rights represents a firm agreement in accordance with FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities”, (SFAS 133), which defines a firm agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics: a) the agreement specifies
all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction, and b) the agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable. The enforceability of the Rights resulted in the recognition of a separate freestanding asset and was accounted for separately from the ARS investment. As of December 31, 2008, we recorded $9.0 million as the fair value of the Rights, classified
as long-term investment on the consolidated balance sheet as of December 31, 2008, with a corresponding credit to interest and other income, net, in the consolidated statement of income for the year ended December 31, 2008. The Rights does not meet the definition of a derivative instrument under SFAS 133. Therefore, we elected to measure the Rights at fair value under SFAS 159, which permits an entity to elect the fair value option for recognized financial assets, in order to match the changes
in the fair value of the ARS. We valued the Rights as the difference between the fair value and the original Par value of the ARS, adjusted for bearer risk, if any, associated with UBS’s financial ability to repurchase the ARS beginning June 30, 2010.
Prior to accepting the UBS offer, we recorded our ARS as available-for-sale investments, and therefore recorded resulting unrealized gains or losses, net of tax, in accumulated other comprehensive income in stockholders’ equity. In connection with the acceptance of the UBS offer in November 2008, resulting in a right to
require UBS to purchase the ARS at par value beginning on June 30, 2010, we have reclassified our ARS subject to the Rights and held by UBS from available-for-sale to trading in accordance with FASB Statement No. 115, “
Accounting for Certain Investments in Debt and Equity Securities”
(SFAS 115). The transfer to trading securities reflects our intent to exercise the Rights during the period June 30, 2010 to July
3, 2012. Prior to our agreement with UBS, our intent was to hold the ARS until the earlier of anticipated recovery in market value or maturity. At December 31, 2008, we recorded an other than temporary impairment loss on our auction rate securities of $9.0 million in interest and other income, net, which had previously been recognized as a component of other comprehensive income, net of tax. Any future gains or losses resulting from changes in the fair value of the ARS will be
recognized in earnings.
The loss of key personnel and an inability to attract and retain additional personnel could affect our ability to successfully grow our business.
We are highly dependent upon the continued service and performance of our senior management team and key technical, marketing and production personnel. The loss of these key employees, each of whom is “at will” and may terminate his or her employment relationship with us at any time, may significantly delay or prevent
the achievement of our business objectives.
We believe that our future success will also depend in part on our continued ability to identify, hire, train and motivate qualified personnel. We face intense competition for qualified individuals from numerous technology, marketing, financial services, manufacturing and e-commerce companies. In addition, competition for qualified personnel
is particularly intense in the San Francisco Bay Area, where our headquarters are located. We may be unable to attract and retain suitably qualified individuals who are capable of meeting our growing operational and managerial requirements, or we may be required to pay increased compensation in order to do so. Our failure to attract and retain qualified personnel could impair our ability to implement our business plan.
In 2006, the Board authorized three automatic annual increases to our stock option pool. Each annual increase is limited to a) 4.62% of common stock issued and outstanding on the December 31 immediately prior to the date of increase or b) a lesser number as determined by the Board. After the last annual
increase in January 2010, the provision will expire. In order to attract key personnel, in 2007 and in 2008, the Board authorized 515,000 additional inducement stock option grants and restricted stock awards to supplement our option pool. Inducement stock options and awards are granted to certain employees upon hire, which do not require shareholder approval. In the future, attracting key personnel may require a level of option grants in excess of the amount available in our option
pool. Accordingly the Board may authorize additional inducement grants which could further dilute existing shareholders.
If we are unable to attract customers in a cost-effective manner, or if we were to become subject to e-mail blacklisting, traffic to our website would be reduced and our business and results of operations would be harmed.
Our success depends on our ability to attract customers in a cost-effective manner. We rely on a variety of methods to bring visitors to our website and promote our products, including paying fees to third parties who drive new customers to our website, purchasing search results from online search engines, e-mail and direct mail. We pay
providers of online services, search engines, directories and other website and e-commerce businesses to provide content, advertising banners and other links that direct customers to our website. We also use e-mail and direct mail to offer free products and services to attract customers, and we offer substantial pricing discounts to encourage repeat purchases. Our methods of attracting customers, including acquiring customer lists from third parties, can involve substantial costs, regardless of whether we acquire
new customers. Even if we are successful in acquiring and retaining customers, the cost involved in these efforts impacts our results of operations. Customer lists are typically recorded as intangible assets and may be subject to impairment charges if the fair value of that list exceeds its carrying value. These potential impairment charges could harm our results from operations. If we are unable to enhance or maintain the methods we use to reach consumers, if the costs of attracting customers
using these methods significantly increase, or if we are unable to develop new cost-effective means to obtain customers, our ability to attract new customers would be harmed, traffic to our website would be reduced and our business and results of operations would be harmed.
In addition, various private entities attempt to regulate the use of e-mail for commercial solicitation. These entities often advocate standards of conduct or practice that significantly exceed current legal requirements and classify certain e-mail solicitations that comply with current legal requirements as unsolicited bulk e-mails, or
“spam.” In addition, we have noted unauthorized “spammers” utilize our domain name to solicit spam. Some of these entities maintain blacklists of companies and individuals, and the websites, Internet service providers and Internet protocol addresses associated with those entities or individuals that do not adhere to what the blacklisting entity believes are appropriate standards of conduct or practices for commercial e-mail solicitations. If a company’s Internet protocol addresses
are listed by a blacklisting entity, e-mails sent from those addresses may be blocked if they are sent to any Internet domain or Internet address that subscribes to the blacklisting entity’s service or purchases its blacklist. From time to time we are blacklisted, sometimes without our knowledge, which could impair our ability to market our products and services, communicate with our customers and otherwise operate our business.
We may not succeed in promoting, strengthening and continuing to establish the Shutterfly brand, which would prevent us from acquiring new customers and increasing revenues.
A component of our business strategy is the continued promotion and strengthening of the Shutterfly brand. Due to the competitive nature of the digital photography products and services markets, if we are unable to successfully promote the Shutterfly brand, we may fail to substantially increase our net revenues. Customer awareness of and
the perceived value of our brand will depend largely on the success of our marketing efforts and our ability to provide a consistent, high-quality customer experience. To promote our brand, we have incurred, and will continue to incur, substantial expense related to advertising and other marketing efforts.
Our ability to provide a high-quality customer experience also depends, in large part, on external factors over which we may have little or no control, including the reliability and performance of our suppliers and third-party Internet and communication infrastructure providers. For example, some of our products, such as select photo-based
merchandise, are produced and shipped to customers by our third-party vendors, and we rely on these vendors to properly inspect and ship these products. In addition, we rely on third-party shippers, including the U.S. Postal Service and United Parcel Service, to deliver our products to customers. Strikes or other service interruptions affecting these shippers could impair our ability to deliver merchandise on a timely basis. Our products are also subject to damage during delivery and handling by our third-party
shippers. Our failure to provide customers with high-quality products in a timely manner for any reason could substantially harm our reputation and our efforts to develop Shutterfly as a trusted brand. The failure of our brand promotion activities could adversely affect our ability to attract new customers and maintain customer relationships, which would substantially harm our business and results of operations.
Purchasers of digital photography products and services may not choose to shop online, which would harm our net revenues and results of operations.
The online market for digital photography products and services is less developed than the online market for other consumer products. If this market does not gain widespread acceptance, our business may suffer. Our success will depend in part on our ability to attract customers who have historically used traditional retail photography
services or who have produced photographs and other products using self-service alternatives, such as printing at home. Furthermore, we may have to incur significantly higher and more sustained advertising and promotional expenditures or reduce the prices of our products and services in order to attract additional online consumers to our website and convert them into purchasing customers. Specific factors that could prevent prospective customers from purchasing from us include:
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the inability to physically handle and examine product samples;
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delivery time associated with Internet orders;
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concerns about the security of online transactions and the privacy of personal information;
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delayed shipments or shipments of incorrect or damaged products; and
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inconvenience associated with returning or exchanging purchased items.
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If purchasers of digital photography products and services do not choose to shop online, our net revenues and results of operations would be harmed.
If affordable broadband access does not become widely available to consumers, our revenue growth will likely suffer.
Because our business currently involves consumers uploading and downloading large data files, we are highly dependent upon the availability of affordable broadband access to consumers. Many areas of the country still do not have broadband access, and the cost of broadband access may be too expensive for many potential customers. To the
extent that broadband access is not available or not adopted by consumers due to cost, our revenue growth would likely suffer.
If either facility where our computer and communications hardware is located fails or if our production facilities fail, our business and results of operations would be harmed.
Our ability to successfully receive and fulfill orders and to provide high-quality customer service depends in part on the efficient and uninterrupted operation of our computer and communications systems. Substantially all of the computer hardware necessary to operate our website is located at two third-party hosting facilities in Santa
Clara, California, and our production facilities are located in Charlotte, North Carolina, Hayward, California (through early 2009), and a new facility in Phoenix, Arizona that is expected to be operational in the second quarter of 2009. Our systems and operations could suffer damage or interruption from human error, fire, flood, power loss, insufficient power availability, telecommunications failure, break-ins, terrorist attacks, acts of war and similar events. In addition, Santa Clara is located near a major
fault line increasing our susceptibility to the risk that an earthquake could significantly harm the operations of these facilities. We maintain business interruption insurance, however, this insurance may be insufficient to compensate us for losses that may occur, particularly from interruption due to an earthquake which is not covered under our current policy. We do not presently have redundant systems in multiple locations. In addition, the impact of any of these disasters on our business may be
exacerbated by the fact that we are still in the process of developing our formal disaster recovery plan and we do not have a final plan in place.
Capacity constraints and system failures could prevent access to our website, which could harm our reputation and negatively affect our net revenues.
Our business requires that we have adequate capacity in our computer systems to cope with the high volume of visits to our website. As our operations grow in size and scope, we will need to improve and upgrade our computer systems and network infrastructure to ensure reliable access to our website, in order to offer customers enhanced
and new products, services, capacity, features and functionality. The expansion of our systems and infrastructure may require us to commit substantial financial, operational and technical resources before the volume of our business increases, with no assurance that our net revenues will increase.
Our ability to provide high-quality products and service depends on the efficient and uninterrupted operation of our computer and communications systems. If our systems cannot be expanded in a timely manner to cope with increased website traffic, we could experience disruptions in service, slower response times, lower customer satisfaction,
and delays in the introduction of new products and services. Any of these problems could harm our reputation and cause our net revenues to decline.
Our technology, infrastructure and processes may contain undetected errors or design faults that could result in decreased production, limited capacity or reduced demand.
Our technology, infrastructure and processes may contain undetected errors or design faults. These errors or design faults may cause our website to fail and result in loss of, or delay in, market acceptance of our products and services. If we experience a delay in a website release that results in customer dissatisfaction during the period
required to correct errors and design faults, we would lose revenue. In the future, we may encounter scalability limitations, in current or future technology releases, or delays in the commercial release of any future version of our technology, infrastructure and processes that could seriously harm our business.
We currently depend on third party suppliers for our photographic print paper, printing machines and other supplies, which expose us to risks if these suppliers fail to perform under our agreements with them.
We h
ave historically relied on an exclusive supply relationship with Fuji Photo Film U.S.A. to supply all of our photographic paper for silver halide print production, such as 4Ч6 prints. We have an agreement with Fuji that expires in April 2010. If that agre
ement
is not renewed before it expires, or if Fuji fails to perform in accordance with the terms of our agreement and if we are unable to secure a paper supply from a different source in a timely manner, we would likely fail to meet customer expectations, which could result in negative publicity, damage our reputation and brand and harm our business and results of operations. We purchase other photo-based supplies from third parties on a purchase order basis, and, as a result, these parties could increase their prices,
reallocate supply to others, including our competitors, or choose to terminate their relationship with us. In addition, we purchase or rent the machines used to produce certain of our photo-based products from Hewlett-Packard, which is one of our primary competitors in the area of online digital photography services. This competition may influence their willingness to provide us with additional products or services. If we were required to switch vendors of machines for photo-based products, we may incur delays
and incremental costs, which could harm our operating results.
We currently outsource some of our production of photo-based products to third parties, which exposes us to risks if these parties fail to perform under our agreements with them.
We currently outsource the production of some of our print and photo-based products to third parties. If these parties fail to perform in accordance with the terms of our agreements and if we are unable to secure another outsource partner in a timely manner, we would likely fail to meet customer expectations, which could result in negative
publicity, damage our reputation and brand and harm our business and results of operations.
If we are unable to develop, market and sell new products and services that address additional market opportunities, our results of operations may suffer. In addition, we may need to expand beyond our current customer demographic to grow our business.
Al
though historically we have focused our business on consumer markets for silver halide prints, such as 4x6 prints, and photo-based products, such as photo books and calendars, we intend to address, and demand may shift to, new products and services. In add
ition, we believe
we may need to address additional markets and expand our customer demographic in order to further grow our business. We may not successfully expand our existing services or create new products and services, address new market segments or develop a significantly broader customer base. Any failure to address additional market opportunities could result in loss of market share, which would harm our business, financial condition and results of operations.
We may undertake acquisitions to expand our business, which may pose risks to our business and dilute the ownership of our existing stockholders.
A key component of our business strategy includes strengthening our competitive position and refining the customer experience on our website through internal development. However, from time to time, we may selectively pursue acquisitions of businesses, like our June 2007 acquisition of Make it About Me! (“MIAM”), our January
2008 acquisition of Nexo and other technologies or services. Integrating any newly acquired businesses, technologies or services is likely to be expensive and time consuming. To finance any acquisition, it may be necessary for us to raise additional funds through public or private financings. Additional funds may not be available on terms that are favorable to us, and, in the case of equity financings, would result in dilution to our stockholders. Also, the value of our stock may be insufficient to attract acquisition
candidates. If we do complete any acquisitions, we may be unable to operate the acquired businesses profitably or otherwise implement our strategy successfully. If we are unable to integrate any newly acquired entities, technologies or services effectively, our business and results of operations will suffer. The time and expense associated with finding suitable and compatible businesses, technologies or services could also disrupt our ongoing business and divert our management’s attention.
Future acquisitions by us could also result in large and immediate write-offs or assumptions of debt and contingent liabilities, any of which could substantially harm our business and results of operations.
Our net revenues and results of operations are affected by the level of vacation and other travel by our customers, and any declines or disruptions in the travel industry could harm our business.
Because vacation and other travel is one of the primary occasions in which our customers utilize their digital cameras, our net revenues and results of operations are affected by the level of vacation and other travel by our customers. Accordingly, downturns or weaknesses in the travel industry could harm our business. Travel expenditures
are sensitive to business and personal discretionary spending levels and tend to decline during general economic downturns such as those currently being experienced in the U.S. and worldwide. Events or weakness in the travel industry that could negatively affect the travel industry include price escalation in the airline industry or other travel-related industries, airline or other travel related strikes, safety concerns, including terrorist activities, inclement weather and airline bankruptcies or liquidations.
In addition, high gasoline prices may lead to reduced travel in the United States. Any decrease in vacation or travel could harm our net revenues and results of operations.
Failure to adequately protect our intellectual property could substantially harm our business and results of operations.
We rely on a combination of patent, trademark, trade secret and copyright law and contractual restrictions to protect our intellectual property. These protective measures afford only limited protection. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our website features and functionalities
or to obtain and use information that we consider proprietary, such as the technology used to operate our website, our production operations and our trademarks.
As of December 31, 2008, we had 28 patents issued and more than 20 patent applications pending in the United States. We intend to pursue corresponding patent coverage in other countries to the extent we believe such coverage is appropriate and cost efficient. We cannot ensure that any of our pending applications will be granted. In addition,
third parties have in the past and could in the future bring infringement, invalidity, co-inventorship or similar claims with respect to any of our currently issued patents or any patents that may be issued to us in the future. Any such claims, whether or not successful, could be extremely costly, could damage our reputation and brand and substantially harm our business and results of operations.
Our primary brand is “Shutterfly.” We hold registrations for the Shutterfly service mark in our major markets of the United States and Canada, as well as in the European Community, Mexico, Japan, Australia and New Zealand. An additional application for the Shutterfly mark is pending in Brazil. Our competitors may adopt names
similar to ours, thereby impeding our ability to build brand identity and possibly leading to customer confusion. In addition, there could be potential trade name or trademark infringement claims brought by owners of marks that are similar to Shutterfly or one of our other marks. The Shutterfly brand is a critical component of our marketing programs. If we lose the ability to use the Shutterfly service mark in any particular market, we could be forced to either incur significant additional marketing expenses
within that market, or elect not to sell products in that market. Any claims or customer confusion related to our marks could damage our reputation and brand and substantially harm our business and results of operations.
If we become involved in intellectual property litigation or other proceedings related to a determination of rights, we could incur substantial costs, expenses or liability, lose our exclusive rights or be required to stop certain of our business activities.
Third parties may sue us for infringing their intellectual property rights. In June 2007, we were sued by FotoMedia Technologies, LLC alleging patent infringement. In February 2008, we were also sued by Parallel Networks, also alleging patent infringement. Likewise, we may need to resort to litigation to enforce
our intellectual property rights or to determine the scope and validity of third-party proprietary rights.
The cost to us of any litigation or other proceeding relating to intellectual property rights, whether or not initiated by us and even if resolved in our favor, could be substantial, and the litigation would divert our management’s efforts from growing our business. Some of our competitors may be able to sustain the costs of complex
intellectual property litigation more effectively than we can because they have substantially greater resources. Uncertainties resulting from the initiation and continuation of any litigation could limit our ability to continue our operations.
Alternatively, we may be required to, or decide to, enter into a license with a third party. For example, in May 2005, we entered into a settlement and license agreement to resolve litigation brought by a third party with respect to our alleged infringement of its patents. Under the terms of the agreement, we agreed to pay the third party
a total of $2.0 million in exchange for a license to its patents, and we also obtained a royalty-bearing license for certain other private label activities for an additional $2.0 million. Any future license required under any other party’s patents may not be made available on commercially acceptable terms, if at all. In addition, such licenses are likely to be non-exclusive and, therefore, our competitors may have access to the same technology licensed to us. If we fail to obtain a required license and
are unable to design around a patent, we may be unable to effectively conduct certain of our business activities, which could limit our ability to generate revenues and harm our results of operations and possibly prevent us from generating revenues sufficient to sustain our operations.
The inability to acquire or maintain domain names for our website could substantially harm our business and results of operations.
We currently are the registrant of the Internet domain name for our website, Shutterfly.com, as well as various related domain names. Domain names generally are regulated by Internet regulatory bodies and are controlled also by trademark and other related laws. The regulations governing domain names could change in ways that block or interfere
with our ability to use relevant domains. Also, we might not be able to prevent third parties from registering or retaining domain names that interfere with our consumer communications, or infringe or otherwise decrease the value of our trademarks and other proprietary rights. Regulatory bodies also may establish additional generic or country-code top-level domains or modify the requirements for holding domain names. As a result, we might not be able to acquire or maintain the domain names that utilize the name
Shutterfly in all of the countries in which we currently or intend to conduct business. This could substantially harm our business and results of operations.
We may be subject to past or future liabilities for collection of sales and use taxes, and the payment of corporate level taxes.
Our policies concerning the collection of sales and use taxes and the payment of certain corporate level taxes have been based upon decisions of the U.S. Supreme Court that determine when a taxpayer is deemed to have nexus with a state sufficient to impose tax obligations under the Commerce Clause of the U.S. Constitution. Those Supreme
Court decisions require that the taxpayer be physically present before a state can require the collection of sales and use taxes. States are currently attempting to expand the definition of what constitutes physical presence for sales and use taxes. At the same time, the standard governing the imposition of other taxes, for instance, corporate income taxes, is less established and a number of state courts have recently concluded that the Commerce Clause definition of nexus should be expanded to include
either “physical” or “economic” presence (essentially marketing activities) which is a broader definition than is used for sales and use tax.
In reliance upon the U.S. Supreme Court’s decisions, we have continued to collect sales and use taxes in California, Nevada, Pennsylvania, North Carolina, New York, New Jersey, Arizona and Minneapolis where we have employees and/or property. Starting in June 2007, we also began collecting sales and use taxes in other states
where we have implemented joint sales efforts with Target Corporation.
While we believe the U.S. Supreme Court decisions support our policies concerning the collection and payment of taxes, tax authorities could disagree with our interpretations. If sustained, those authorities might seek to impose past as well as future liability for taxes and/or penalties. Such impositions could also impose significant
administrative burdens and decrease our future sales. Moreover, the U.S. Congress has been considering various initiatives that could limit or supersede the U.S. Supreme Court’s position regarding sales and use taxes.
Our effective tax rate may be subject to fluctuation from federal and state audits, and disqualifying dispositions of stock options.
Future tax audits by taxing agencies for the open tax years could lead to fluctuations in our effective tax rate because the taxing authority may disagree with certain assumptions we have made regarding appropriate credits and deductions in filing our tax returns.
Under current stock option tax regulations, we are entitled to a stock option compensation tax deduction when employees exercise and sell their incentive stock options within a two year period for a taxable gain. Our current effective tax rate estimate does not incorporate this deduction as the extent of the deduction, based on employee
option disposition activity is not currently determinable. These disqualifying dispositions could lead to future fluctuations in our effective tax rate for any given quarter or year.
Government regulation of the Internet and e-commerce is evolving, and unfavorable changes or failure by us to comply with these regulations could substantially harm our business and results of operations.
We are subject to general business regulations and laws as well as regulations and laws specifically governing the Internet and e-commerce. Existing and future laws and regulations may impede the growth of the Internet or other online services. These regulations and laws may cover taxation, restrictions on imports and exports, customs,
tariffs, user privacy, data protection, pricing, content, copyrights, distribution, electronic contracts and other communications, consumer protection, the provision of online payment services, broadband residential Internet access and the characteristics and quality of products and services. It is not clear how existing laws governing issues such as property use and ownership, sales and other taxes, libel and personal privacy apply to the Internet and e-commerce as the vast majority of these laws were adopted
prior to the advent of the Internet and do not contemplate or address the unique issues raised by the Internet or e-commerce. Those laws that do reference the Internet are only beginning to be interpreted by the courts and their applicability and reach are therefore uncertain. For example, the Digital Millennium Copyright Act, or DMCA, is intended, in part, to limit the liability of eligible online service providers for including (or for listing or linking to third-party websites that include) materials that
infringe copyrights or other rights of others. Portions of the Communications Decency Act, or CDA, are intended to provide statutory protections to online service providers who distribute third-party content. We rely on the protections provided by both the DMCA and CDA in conducting our business. Any changes in these laws or judicial interpretations narrowing their protections will subject us to greater risk of liability and may increase our costs of compliance with these regulations or limit our ability to operate
certain lines of business. The Children’s Online Protection Act and the Children’s Online Privacy Protection Act are intended to restrict the distribution of certain materials deemed harmful to children and impose additional restrictions on the ability of online services to collect user information from minors. In addition, the Protection of Children From Sexual Predators Act of 1998 requires online service providers to report evidence of violations of federal child pornography laws under certain
circumstances. The costs of compliance with these regulations may increase in the future as a result of changes in the regulations or the interpretation of them. Further, any failures on our part to comply with these regulations may subject us to significant liabilities. Those current and future laws and regulations or unfavorable resolution of these issues may substantially harm our business and results of operations.
Legislation regarding copyright protection or content interdiction could impose complex and costly constraints on our business model.
Because of our focus on automation and high volumes, our operations do not involve, for the vast majority of our sales, any human-based review of content. Although our website’s terms of use specifically require customers to represent that they have the right and authority to reproduce the content they provide and that the content
is in full compliance with all relevant laws and regulations, we do not have the ability to determine the accuracy of these representations on a case-by-case basis. There is a risk that a customer may supply an image or other content that is the property of another party used without permission, that infringes the copyright or trademark of another party, or that would be considered to be defamatory, pornographic, hateful, racist, scandalous, obscene or otherwise offensive, objectionable or illegal under the laws
or court decisions of the jurisdiction where that customer lives. There is, therefore, a risk that customers may intentionally or inadvertently order and receive products from us that are in violation of the rights of another party or a law or regulation of a particular jurisdiction. If we should become legally obligated in the future to perform manual screening and review for all orders destined for a jurisdiction, we will encounter increased production costs or may cease accepting orders for shipment to that
jurisdiction. That could substantially harm our business and results of operations.
Our practice of offering free products and services could be subject to judicial or regulatory challenge.
We regularly offer free products and free shipping as an inducement for customers to try our products. Although we believe that we conspicuously and clearly communicate all details and conditions of these offers — for example, that customers are required to pay shipping, handling and/or processing charges to take advantage of the
free product offer — we may be subject to claims from individuals or governmental regulators that our free offers are misleading or do not comply with applicable legislation. These claims may be expensive to defend and could divert management’s time and attention. If we become subject to such claims in the future, or are required or elect to curtail or eliminate our use of free offers, our results of operations may be harmed.
Any failure by us to protect the confidential information of our customers and networks against security breaches and the risks associated with credit card fraud could damage our reputation and brand and substantially harm our business and results of operations.
A significant prerequisite to online commerce and communications is the secure transmission of confidential information over public networks. Our failure to prevent security breaches could damage our reputation and brand and substantially harm our business and results of operations. For example, a majority of our sales are billed to our
customers’ credit card accounts directly, orders are shipped to a customer’s address, and customers log on using their e-mail address. We rely on encryption and authentication technology licensed from third parties to effect the secure transmission of confidential information, including credit card numbers. Advances in computer capabilities, new discoveries in the field of cryptography or other developments may result in a compromise or breach of the technology used by us to protect customer transaction
data. In addition, any party who is able to illicitly obtain a user’s password could access the user’s transaction data, personal information or stored images. Any compromise of our security could damage our reputation and brand and expose us to a risk of loss or litigation and possible liability, which would substantially harm our business and results of operations. In addition, anyone who is able to circumvent our security measures could misappropriate proprietary information or cause interruptions
in our operations. We may need to devote significant resources to protect against security breaches or to address problems caused by breaches.
In addition, under current credit card practices, we are liable for fraudulent credit card transactions because we do not obtain a cardholder’s signature. We do not currently carry insurance against this risk. To date, we have experienced minimal losses from credit card fraud, but we continue to face the risk of significant losses
from this type of fraud. Our failure to adequately control fraudulent credit card transactions could damage our reputation and brand and substantially harm our business and results of operations.
Changes in regulations or user concerns regarding privacy and protection of user data could harm our business.
Federal, state and international laws and regulations may govern the collection, use, sharing and security of data that we receive from our customers. In addition, we have and post on our website our own privacy policies and practices concerning the collection, use and disclosure of customer data. Any failure, or perceived failure, by
us to comply with our posted privacy policies or with any data-related consent orders, Federal Trade Commission requirements or other federal, state or international privacy-related laws and regulations could result in proceedings or actions against us by governmental entities or others, which could potentially harm our business. Further, failure or perceived failure to comply with our policies or applicable requirements related to the collection, use or security of personal information or other privacy-related
matters could damage our reputation and result in a loss of customers.
International expansion will require management attention and resources and may be unsuccessful, which could harm our future business development and existing domestic operations.
To date, we have conducted limited international operations, but we intend to expand into international markets in order to grow our business. These expansion plans will require significant management attention and resources and may be unsuccessful. We have limited experience adapting our products to conform to local cultures, standards
and policies. We may have to compete with local companies which understand the local market better than we do. In addition, to achieve satisfactory performance for consumers in international locations it may be necessary to locate physical facilities, such as production facilities, in the foreign market. We do not have experience establishing such facilities overseas. We may not be successful in expanding into any international markets or in generating revenues from foreign operations. In addition, different
privacy, censorship and liability standards and regulations and different intellectual property laws in foreign countries may cause our business to be harmed.
The success of our business depends on continued consumer adoption of digital photography
Our growth is highly dependent upon the continued adoption by consumers of digital photography. The digital photography market is rapidly evolving, characterized by changing technologies, intense price competition, additional competitors, evolving industry standards, frequent new service announcements and changing consumer demands and
behaviors. To the extent that consumer adoption of digital photography does not continue to grow as expected, our revenue growth would likely suffer. Moreover, we face significant risks that, if the market for digital photography evolves in ways that we are not able to address due to changing technologies or consumer behaviors, pricing pressures, or otherwise, our current products and services may become less attractive, which would likely result in the loss of customers, as well as lower net revenues and/or
increased expenses.
Maintaining and improving our financial controls and the requirements of being a public company may strain our resources, divert management’s attention and affect our ability to attract and retain qualified board members.
As a public company, we are subject to the reporting requirements of the Securities Exchange Act of 1934, the Sarbanes-Oxley Act of 2002 and the rules and regulations of The NASDAQ Stock Market. Additional or new regulatory requirements may be adopted in the future. The requirements of existing and potential future rules and
regulations will likely continue to increase our legal, accounting and financial compliance costs, make some activities more difficult, time-consuming or costly and may also place undue strain on our personnel, systems and resources.
The Sarbanes-Oxley Act requires, among other things, that we maintain effective disclosure controls and procedures and effective internal control over financial reporting. Significant resources and management oversight are required to design, document, test, implement and monitor internal control over relevant processes and to, remediate
any deficiencies. As a result, management’s attention may be diverted from other business concerns, which could harm our business, financial condition and results of operations. These efforts also involve substantial accounting related costs. In addition, if we are unable to continue to meet these requirements, we may not be able to remain listed on The NASDAQ Global Market.
Under the Sarbanes-Oxley Act and the rules and regulations of The NASDAQ Stock Market, we are required to maintain a board of directors with a majority of independent directors. These rules and regulations may make it more difficult and more expensive for us to maintain directors’ and officers’ liability insurance, and we may
be required to accept reduced coverage or incur substantially higher costs to maintain coverage. If we are unable to maintain adequate directors’ and officers’ insurance, our ability to recruit and retain qualified directors and officers, especially those directors who may be considered independent for purposes of NASDAQ rules, will be significantly curtailed.
Our stock price may be volatile or may decline regardless of our operating performance.
The market price of our common stock may fluctuate significantly in response to numerous factors, many of which are beyond our control. In particular, the stock market as a whole recently has experienced extreme price and volume fluctuations that have affected the market price of many technology companies in ways that may have
been unrelated to those companies’ operating performance. Factors that could cause our stock price to fluctuate include:
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Economic downturns and market conditions or trends in our industry or the macro-economy as a whole;
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price and volume fluctuations in the overall stock market;
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changes in operating performance and stock market valuations of other technology companies generally, or those in our industry in particular;
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the financial projections we may provide to the public, any changes in these projections or our failure to meet these projections;
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changes in financial estimates by any securities analysts who follow our company, our failure to meet these estimates or failure of those analysts to initiate or maintain coverage of our stock;
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ratings downgrades by any securities analysts who follow our company;
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the public’s response to our press releases or other public announcements, including our filings with the SEC;
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announcements by us or our competitors of significant technical innovations, acquisitions, strategic partnerships, joint ventures or capital commitments;
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introduction of technologies or product enhancements that reduce the need for our products;
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impairment or loss in value of our investments in auction rate securities;
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the loss of key personnel;
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lawsuits threatened or filed against us;
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future sales of our common stock by our executive officers, directors and significant stockholders; and
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other events or factors, including those resulting from war, incidents of terrorism or responses to these events.
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Some provisions in our restated certificate of incorporation and restated bylaws and Delaware law may deter third parties from acquiring us.
Our restated certificate of incorporation and restated bylaws contain provisions that may make the acquisition of our company more difficult without the approval of our board of directors, including the following:
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our board is classified into three classes of directors, each with staggered three-year terms;
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only our chairman, our chief executive officer, our president, or a majority of our board of directors is authorized to call a special meeting of stockholders;
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our stockholders may take action only at a meeting of stockholders and not by written consent;
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vacancies on our board of directors may be filled only by our board of directors and not by stockholders;
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our certificate of incorporation authorizes undesignated preferred stock, the terms of which may be established and shares of which may be issued without stockholder approval; and
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advance notice procedures apply for stockholders to nominate candidates for election as directors or to bring matters before an annual meeting of stockholders.
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These anti-takeover defenses could discourage, delay or prevent a transaction involving a change in control of our company. These provisions could also discourage proxy contests and make it more difficult for stockholders to elect directors of their choosing and to cause us to take other corporate actions they desire.