Quarterly Report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

Form 10-Q

(Mark One)
x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the quarterly period ended September 30, 2009
or
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the transition period from to

Commission file number 001-33031

SHUTTERFLY, INC.

(Exact Name of Registrant as Specified in Its Charter)

Delaware	94-3330068
( State or Other Jurisdiction of Incorporation or Organization)	(IRS Employer Identification No.)

2800 Bridge Parkway Redwood City, California	94065
(Address of Principal Executive Offices)	(Zip Code)

Registrant’s Telephone Number, Including Area Code

(650) 610-5200

Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T ( § 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes o No o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “accelerated filer,” “large accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated Filer o Accelerated Filer x

Non-accelerated Filer o Smaller reporting company o

(Do not check if a smaller reporting company)

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class	Outstanding at October 28, 2009
Common stock, $0.0001 par value per share	25,673,740 shares

EXPLANATORY NOTE REGARDING RESTATEMENT OF OUR CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

This quarterly report contains the restated condensed consolidated statements of operations for the three and nine months ended September 30, 2008 and condensed consolidated statements of cash flows for the nine months ended September 30, 2008. See Note 9 of Notes to Condensed Consolidated Financial Statements appearing in Part I Item 1 of this quarterly report.

TABLE OF CONTENTS

	Page Number
PART I — FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Consolidated Balance Sheets	3
Consolidated Statements of Operations	4
Consolidated Statements of Cash Flows	5
Notes to Consolidated Financial Statements	6
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	19
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	32
ITEM 4. CONTROLS AND PROCEDURES	32
PART II — OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS	34
ITEM 1A. RISK FACTORS	34
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	49
ITEM 3. DEFAULTS UPON SENIOR SECURITIES	49
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	49
ITEM 5. OTHER INFORMATION	49
ITEM 6. EXHIBITS	49
SIGNATURES	50
INDEX TO EXHIBITS
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Item 1. Condensed Consolidated Financial Statements

SHUTTERFLY, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except par value amounts)

(Unaudited)

	September 30,			December 31,
	2009			2008

ASSETS
Current assets:
Cash and cash equivalents	$	63,250		$	88,164
Short-term investments		48,375			-
Accounts receivable, net		3,607			5,992
Inventories		3,316			3,610
Deferred tax asset, current portion		1,030			1,194
Prepaid expenses and other current assets		15,703			4,749
Total current assets		135,281			103,709
Long-term investments		-			52,250
Property and equipment, net		43,217			48,108
Goodwill and intangible assets, net		13,872			14,547
Deferred tax asset, net of current portion		11,759			12,266
Other assets		4,719			2,417
Total assets	$	208,848		$	233,297

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	6,265		$	11,214
Accrued liabilities		11,451			24,802
Deferred revenue		8,916			9,461
Total current liabilities		26,632			45,477
Other liabilities		1,621			1,018
Total liabilities		28,253			46,495

Stockholders' equity
Common stock, $0.0001 par value; 100,000 shares authorized; 25,651 and
25,138 shares issued and outstanding on September 30, 2009 and
December 31, 2008, respectively		3			2
Additional paid-in-capital		215,926			203,902
Accumulated deficit		(35,334	)		(17,102	)
Total stockholders' equity		180,595			186,802
Total liabilities and stockholders' equity	$	208,848		$	233,297

The accompanying notes are an integral part of these condensed consolidated financial statements.

SHUTTERFLY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
				(As restated)						(As restated)
Net revenues	$	40,495		$	35,953		$	115,365		$	105,738
Cost of net revenues (1)		21,420			18,451			61,161			53,777
Gross profit		19,075			17,502			54,204			51,961
Operating expenses (1):
Technology and development		11,390			9,689			33,347			28,796
Sales and marketing		9,377			10,138			26,075			26,936
General and administrative		7,363			6,901			22,642			22,299
Total operating expenses		28,130			26,728			82,064			78,031
Loss from operations		(9,055	)		(9,226	)		(27,860	)		(26,070	)
Interest expense		(22	)		(100	)		(136	)		(185	)
Interest and other income, net		74			455			681			2,514
Loss before income taxes		(9,003	)		(8,871	)		(27,315	)		(23,741	)
Benefit from income taxes		2,657			6,071			9,083			13,032
Net loss	$	(6,346	)	$	(2,800	)	$	(18,232	)	$	(10,709	)


Net loss per share - basic and diluted	$	(0.25	)	$	(0.11	)	$	(0.72	)	$	(0.43	)

Weighted-average shares outstanding - basic and diluted		25,517			25,067			25,303			25,020


(1) Stock-based compensation is allocated as follows:

Cost of net revenues	$	119		$	109		$	297		$	301
Technology and development		1,077			654			2,292			1,693
Sales and marketing		955			696			2,428			1,733
General and administrative		2,005			1,216			4,778			3,327

The accompanying notes are an integral part of these condensed consolidated financial statements.

SHUTTERFLY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	Nine Months Ended
	September 30,
	2009			2008
				(As restated)
Cash flows from operating activities:
Net loss	$	(18,232	)	$	(10,709	)
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		18,844			17,463
Amortization of intangible assets		1,491			1,370
Stock-based compensation		9,795			7,054
Loss on disposal of property and equipment		79			308
Deferred income taxes		703			(10,123	)
Changes in operating assets and liabilities:
Accounts receivable, net		2,389			1,336
Inventories		294			1,518
Prepaid expenses and other current assets		(10,700	)		(3,553	)
Other assets		(2,421	)		352
Accounts payable		(5,083	)		(2,757	)
Accrued and other liabilities		(14,737	)		(6,087	)
Deferred revenue		(546	)		468
Net cash used in operating activities		(18,124	)		(3,360	)

Cash flows from investing activities:
Acquisition of business and intangibles, net of cash acquired		(796	)		(10,098	)
Purchases of property and equipment		(8,272	)		(16,760	)
Capitalization of software and website development costs		(3,032	)		(3,239	)
Proceeds from sale of short term investments		-			3,002
Proceeds from sale of equipment		-			6
Purchase of auction rate securities		-			(52,250	)
Proceeds from the sale of auction rate securities		3,875			-
Net cash used in investing activities		(8,225	)		(79,339	)

Cash flows from financing activities:
Principal payments of capital lease obligations		(90	)		(378	)
Proceeds from issuance of common stock upon exercise of stock options		2,139			1,130
Shares withheld for payment of employee's withholding tax liability		(1,041	)		-
Tax benefit of stock options recorded in additional paid-in capital		427			-
Net cash provided by financing activities		1,435			752

Net increase in cash and cash equivalents		(24,914	)		(81,947	)
Cash and cash equivalents, beginning of period		88,164			122,582
Cash and cash equivalents, end of period	$	63,250		$	40,635

Supplemental schedule of non-cash investing activities
Net change in accrued purchases of property and equipment	$	1,524			-
Escrow liability from acquisition of business		150			-

The accompanying notes are an integral part of these condensed consolidated financial statements.

SHUTTERFLY, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1 — The Company and Summary of Significant Accounting Policies

Shutterfly, Inc., (the “Company”) was incorporated in the state of Delaware and began its services in December 1999. The Company is an Internet-based social expression and personal publishing service that enables customers to share, print and preserve their memories by leveraging a technology-based platform and manufacturing processes. The Company provides customers a full range of products and services to organize and archive digital images and videos; share pictures; order prints and create an assortment of personalized items such as stationery cards, calendars, and photo books. The Company is headquartered in Redwood City, California.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and, accordingly, do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The accompanying unaudited condensed consolidated financial statements include the accounts of Shutterfly, Inc. and its wholly-owned subsidiary. In the opinion of management, all adjustments, consisting primarily of normal recurring accruals, considered necessary for a fair statement of the Company’s results of operations for the interim periods reported and of its financial condition as of the date of the interim balance sheet have been included. Operating results for the three and nine months ended September 30, 2009, are not necessarily indicative of the results that may be expected for the year ending December 31, 2009, or for any other period.

The December 31, 2008, condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. These unaudited interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes for the year ended December 31, 2008, included in the Company’s Annual Report on Form 10-K/A.

Subsequent Events Evaluation

Management has reviewed and evaluated material subsequent events from the balance sheet date of September 30, 2009, through the financial statements issue date of October 30, 2009. All appropriate subsequent event disclosures have been made in the notes to our unaudited condensed consolidated financial statements.

Principles of Consolidation

The accompanying condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary. All intercompany transactions and balances have been eliminated.

Fair Value

The Company records its financial assets and liabilities at fair value. The accounting standard for fair value provides a framework for measuring fair value, clarifies the definition of fair value and expands disclosures regarding fair value measurements. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the reporting date. The accounting standard establishes a three-tier hierarchy, which prioritizes the inputs used in the valuation methodologies in measuring fair value:

Level 1 – Quoted prices in active markets for identical assets or liabilities

Level 2 – Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3 – Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

Income Taxes

The Company accounts for income taxes under the liability method. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities and net operating loss and credit carryforwards using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.

The Company accounts for uncertain tax positions in accordance with the respective authoritative guidance. The application of income tax law is inherently complex. Laws and regulations in this area are voluminous and are often ambiguous. The Company is required to make subjective assumptions and judgments regarding its income tax exposures. Interpretations and guidance surrounding income tax laws and regulations change over time. As such, changes in the Company’s subjective assumptions and judgments can materially affect amounts recognized in the consolidated balance sheets and statements of operations.

The Company’s policy is to recognize interest and /or penalties related to all tax positions in income tax expense. To the extent that accrued interest and penalties do not ultimately become payable, amounts accrued will be reduced and reflected as a reduction of the overall income tax provision in the period that such determination is made. No interest or penalties were accrued as of December 31, 2008 or September 30, 2009.

At September 30, 2009, the Company had $12.1 million and $10.3 million of federal and state net operating losses, respectively, associated with windfall tax benefits that will be recorded as additional paid-in capital when realized. A tax windfall is created when the tax deduction associated with stock options exercised and vesting of restricted stock units exceeds the recognized stock-based compensation expense. The Company is subject to taxation in California and other jurisdictions in the United States.

Comprehensive Loss

Comprehensive loss consists of certain changes in equity that are excluded from net loss. Specifically, unrealized gains and losses on available for sale marketable securities are included in comprehensive loss.

The components of comprehensive loss were as follows (in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2009			2008			2009			2008
				(As restated)						(As restated)
Unrealized loss in investments, net of tax	$	--		$	(904	)	$	--		$	(3,127	)
Net loss		(6,346	)		(2,800	)		(18,232	)		(10,709	)
Total comprehensive loss	$	(6,346	)	$	(3,704	)	$	(18,232	)	$	(13,836	)

Unrealized loss in investments for the three and nine months ended September 30, 2008 is net of tax benefit of $487 and $1,684, respectively.

Recent Accounting Pronouncements

In February 2008, the FASB issued an accounting standard update that delayed the effective date of fair value measurements accounting for all non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until the beginning of the first quarter of fiscal 2009. These include goodwill and other non-amortizable intangible assets. The Company adopted this accounting standard update effective January 1, 2009. The adoption of this update to non-financial assets and liabilities, as codified in ASC 820-10 (formerly FSP 157-2, “ Effective Date of FASB Statement No. 157 ”), did not have any impact on the Company’s condensed consolidated financial statements.

Effective January 1, 2009, the Company adopted a new accounting standard update regarding business combinations. As codified under ASC 805 (formerly SFAS No. 141 revised 2007, “ Business Combinations ”), this update requires an entity to recognize the assets acquired, liabilities assumed, contractual contingencies, and contingent consideration at their fair value on the acquisition date. It further requires that acquisition-related costs be recognized separately from the acquisition and expensed as incurred; that restructuring costs generally be expensed in periods subsequent to the acquisition date; and that changes in accounting for deferred tax asset valuation allowances and acquired income tax uncertainties after the measurement period be recognized as a component of provision for taxes. In addition, acquired in-process research and development is capitalized as an intangible asset and amortized over its estimated useful life. With the adoption of this accounting standard update, any tax related adjustments associated with acquisitions that closed prior to January 1, 2009 will be recorded through income tax expense, whereas the previous accounting treatment would require any adjustment to be recognized through the purchase price. This accounting standard update applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The adoption of these accounting updates did not have any impact on the Company’s condensed consolidated financial statements.

Effective January 1, 2009, the Company adopted an accounting standard which establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary, as codified in ASC 810-10 (formerly SFAS No. 160, Accounting and Reporting on Non-controlling Interest in Consolidated Financial Statements, an Amendment of ARB 51 ”). This accounting standard states that accounting and reporting for minority interests are to be recharacterized as noncontrolling interests and classified as a component of equity. The calculation of earnings per share continues to be based on income amounts attributable to the parent. The adoption of these accounting updates did not have any impact on the Company’s condensed consolidated financial statements.

Effective January 1, 2009, the Company adopted an accounting standard update regarding the determination of the useful life of intangible assets. As codified in ASC 350-30-35 (formerly FSP No. 142-3, “ Determination of the Useful Life of Intangible Assets ”), this update amends the factors considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under intangibles accounting. It also requires a consistent approach between the useful life of a recognized intangible asset under prior business combination accounting and the period of expected cash flows used to measure the fair value of an asset under the new business combinations accounting (as currently codified under ASC 850). The update also requires enhanced disclosures when an intangible asset’s expected future cash flows are affected by an entity’s intent and/or ability to renew or extend the arrangement. The adoption of these accounting updates did not have any impact on the Company’s condensed consolidated financial statements.

Effective January 1, 2009, the Company adopted a new accounting standard update from the Emerging Issues Task Force (“EITF”) consensus regarding the accounting of defensive intangible assets. This update, as codified in ASC 350-30 (formerly EITF No. 08-7, “ Accounting for Defensive Intangible Assets ”), clarifies accounting for defensive intangible assets subsequent to initial measurement. It applies to acquired intangible assets which an entity has no intention of actively using, or intends to discontinue use of, the intangible asset but holds it to prevent others from obtaining access to it (i.e., a defensive intangible asset). Under this update, a consensus was reached that an acquired defensive asset should be accounted for as a separate unit of accounting (i.e., an asset separate from other assets of the acquirer); and the useful life assigned to an acquired defensive asset should be based on the period during which the asset would diminish in value. The adoption of these accounting updates did not have any impact on the Company’s condensed consolidated financial statements.

Effective April 1, 2009, the Company adopted a new accounting standard for subsequent events, as codified in ASC 855-10 (formerly SFAS No. 165, Subsequent Events ). The update modifies the names of the two types of subsequent events either as recognized subsequent events (previously referred to in practice as Type I subsequent events) or non-recognized subsequent events (previously referred to in practice as Type II subsequent events). In addition, the standard modifies the definition of subsequent events to refer to events or transactions that occur after the balance sheet date, but before the financial statements are issued (for public entities) or available to be issued (for nonpublic entities). It also requires the disclosure of the date through which subsequent events have been evaluated. The update did not result in significant changes in the practice of subsequent event disclosures, and therefore the adoption did not have any impact on the Company’s consolidated financial statements.

Effective April 1, 2009, the Company adopted three accounting standard updates which were intended to provide additional application guidance and enhanced disclosures regarding fair value measurements and impairments of securities. They also provide additional guidelines for estimating fair value in accordance with fair value accounting. The first update, as codified in ASC 820-10-65 (formerly FASB Staff Positions (“FSP”) No. 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly ), provides additional guidelines for estimating fair value in accordance with fair value accounting. The second accounting update, as codified in ASC 320-10-65 (formerly FSP No. 115-2, Recognition and Presentation of Other-Than-Temporary Impairments) , changes accounting requirements for other-than-temporary-impairment (OTTI) for debt securities by replacing the current requirement that a holder have the positive intent and ability to hold an impaired security to recovery in order to conclude an impairment was temporary with a requirement that an entity conclude it does not intend to sell an impaired security and it will not be required to sell the security before the recovery of its amortized cost basis. The third accounting update, as codified in ASC 825-10-65 (formerly Accounting Principles Board (“APB”) Opinion No. 28-1, Interim Disclosures about Fair Value of Financial Instruments) , increases the frequency of fair value disclosures. These updates were effective for fiscal years and interim periods ended after June 15, 2009. The adoption of these accounting updates did not have any impact on the Company’s condensed consolidated financial statements.

Effective July 1, 2009, the Company adopted The “FASB Accounting Standards Codification” and the Hierarchy of Generally Accepted Accounting Principles (ASC 105), (formerly SFAS No. 168, The “FASB Accounting Standards Codification” and the Hierarchy of Generally Accepted Accounting Principles ). This standard establishes only two levels of U.S. generally accepted accounting principles (“GAAP”), authoritative and nonauthoritative. The Financial Accounting Standard Board (“FASB”) Accounting Standards Codification (the “Codification”) became the source of authoritative, nongovernmental GAAP, except for rules and interpretive releases of the SEC, which are sources of authoritative GAAP for SEC registrants. All other non-grandfathered, non-SEC accounting literature not included in the Codification became nonauthoritative. The Company began using the new guidelines and numbering system prescribed by the Codification when referring to GAAP in the third quarter of fiscal 2009. As the Codification was not intended to change or alter existing GAAP, it did not have any impact on the Company’s condensed consolidated financial statements.

Note 2 — Stock-Based Compensation

Stock Option Activity

A summary of the Company’s stock option activity for the three and nine months ended September 30, 2009 is as follows (in thousands):

	Number of Options Outstanding			Weighted Average Exercise Price		Weighted Average Contractual Term (Years)		Aggregate Intrinsic Value
Balances, December 31, 2008		5,529		$	13.41
Granted		14			7.83
Exercised		(14	)		4.18
Forfeited, cancelled or expired		(272	)		13.44
Balances, March 31, 2009		5,257		$	13.42		7.2	$	6,928
Granted		39			11.57
Exercised		(128	)		6.33
Forfeited, cancelled or expired		(213	)		17.60
Balances, June 30, 2009		4,955		$	13.43		7.0	$	17,197
Granted		42			14.28
Exercised		(187	)		6.68
Forfeited, cancelled or expired		(31	)		16.96
Balances, September 30, 2009		4,779		$	13.67		6.8	$	23,558
Options vested and expected to vest at September 30, 2009		4,461		$	13.32		6.7	$	22,949
Options vested at September 30, 2009		3,487		$	11.92		6.3	$	21,042

During the three months ended September 30, 2009, the Company granted options to purchase an aggregate of 42,000 shares of common stock with an estimated weighted-average grant-date fair value of $6.47 per share. The total intrinsic value of options exercised during the three months ended September 30, 2009, was $1,696,000. Net cash proceeds from the exercise of stock options were $1,270,000 for the three months ended September 30, 2009.

Valuation of Stock Options

The Company estimated the fair value of each option award on the date of grant using the Black-Scholes option-pricing model and the assumptions noted in the following table. Expected volatility is based on the historical and implied volatility of a peer group of publicly traded entities. The expected term of options gives consideration to historical exercises, post-vesting cancellations and the options’ contractual term. The risk-free rate for the expected term of the option is based on the U.S. Treasury Constant Maturity at the time of grant. The assumptions used to value options granted during the three and nine months ended September 30, 2009 and September 30, 2008, were as follows:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2009			2008			2009			2008
Dividend yield		—			—			—			—
Annual risk free rate of return		2.5	%		2.9	%		2.3	%		2.6	%
Expected volatility		51.9	%		48.8	%		56.2	%		50.4	%
Expected term (years)		4.6			4.7			4.6			4.4

Employee stock-based compensation expense recognized in the three and nine months ended September 30, 2009, was calculated based on awards ultimately expected to vest and has been reduced for estimated forfeitures. Accounting standards require forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

Restricted Stock Units

The Company grants restricted stock units (“RSUs”) to its employees under the provisions of the 2006 Equity Incentive Plan. The cost of RSUs is determined using the fair value of our common stock on the date of grant. RSUs typically vest and become exercisable annually, based on a two, three or four year total vesting term. Compensation cost is amortized on a straight-line basis over the requisite service period.

Restricted Stock Unit Activity

A summary of the Company’s restricted stock unit activity for the three and nine months ended September 30, 2009, is as follows (in thousands):

	Number of Units Outstanding		Weighted Average Grant Date Fair Value
Balances, December 31, 2008		958	$	12.11
Granted		865		7.95
Vested		(18)		20.15
Forfeited, cancelled or expired		(103)		14.28
Balances, March 31, 2009		1,702	$	9.78
Granted		350		12.99
Vested		(193)		15.21
Forfeited, cancelled or expired		(24)		12.73
Balances, June 30, 2009		1,835	$	9.78
Granted		111		13.65
Vested		(49)		15.02
Forfeited, cancelled or expired		(17)		9.75
Balances, September 30, 2009		1,880	$	9.89

Included in the RSU grants for the three months ended September 30, 2009, are 66,000 RSUs that have both performance and service vesting criteria (“PBRSU”). The performance criteria is tied to the Company’s financial performance for the three months ended September 30, 2009 and the vesting period is three years. Compensation cost associated with these PBRSUs is recognized based on whether or not satisfaction of the performance criteria is probable. As of September 30, 2009, the performance criteria for the fiscal quarter were met and the associated stock based compensation was recognized.

In connection with the acquisition of TinyPictures, Inc. on September 10, 2009, the Company granted PBRSUs to existing TinyPictures employees. Vesting of these awards are contingent on achieving certain performance milestones and continued employment. The Company will begin recognizing stock based compensation in the period in which achievement of each milestone is deemed probable. As of September 30, 2009, no stock-based compensation has been recognized associated with these PBRSUs.

Inducement Awards

In the nine months period ended September 30, 2009, the Company granted inducement awards of restricted stock units to an executive. These inducement grants were approved by the Company’s Board of Directors and were not issued under a shareholder approved plan. A total of 200,000 restricted stock units were granted under this nonqualified agreement. These grants vest over a three year period beginning on the grant date.

At September 30, 2009, the Company had $23,130,000 of total unrecognized compensation expense, net of estimated forfeitures, related to stock options and stock awards that will be recognized over a weighted-average period of approximately two years.

Note 3 — Net Loss Per Share

Basic net loss per share is computed by dividing the net loss attributable to common shares for the period by the weighted average number of common shares outstanding during the period, reduced by the weighted average unvested common shares subject to repurchase by the Company.

Diluted net loss per share attributed to common shares is computed by dividing the net loss attributable to common shares for the period by the weighted average number of common and potential common shares outstanding during the period, if the effect of each class of potential common shares is dilutive. Potential common shares include restricted common stock, common stock subject to repurchase rights, and incremental shares of common stock issuable upon the exercise of stock options and settlement of RSUs.

A summary of the net loss per share for the three and nine months ended September 30, 2009 and 2008, is as follows (in thousands):

	Three Months						Nine Months
	Ended September 30,						Ended September 30,
	2009			2008			2009			2008
					(as restated)						(as restated)
Historical net loss per share:
Numerator
Net loss	$	(6,346	)	$	(2,800	)	$	(18,232	)	$	(10,709	)

Denominator
Weighted-average common shares outstanding		25,517			25,067			25,303			25,022
Less: Weighted-average unvested common shares subject to repurchase		—			—			—			(2	)

Denominator for basic and diluted net loss per share		25,517			25,067			25,303			25,020

Net loss per share — basic and diluted	$	(0.25	)	$	(0.11	)	$	(0.72	)	$	(0.43	)

The following weighted-average outstanding options, common stock subject to repurchase and restricted stock units were excluded from the computation of diluted net loss per common share for the periods presented because including them would have had an anti-dilutive effect (in thousands):

	Three Months				Nine Months
	Ended September 30,				Ended September 30,
	2009		2008		2009		2008
Options to purchase common stock, common stock subject to repurchase and restricted stock units		6,698		6,443		6,790		6,108

Note 4 — Fair Value Measurement

The following table represents the Company’s fair value hierarchy for its financial assets (cash equivalents and investments) as of September 30, 2009 (in thousands):

	September 30, 2009
	Fair Value		Level 1		Level 2		Level 3
Cash equivalents:
Money market funds	$	60,491	$	60,491	$	—	$	—
Short-term investments:
Auction rate securities		42,030		—		—		42,030
Rights on ARS securities		6,345		—		—		6,345
Total financial assets	$	108,866	$	60,491	$	—	$	48,375

Level 3 assets consist of auction rate securities (“ARS”) with an auction reset feature whose underlying assets are student loans that are substantially backed by the federal government. Because the auctions for these securities have continued to fail since February 2008, these investments are not currently trading and therefore do not have a readily determinable market value. Accordingly, the estimated fair value of the ARS no longer approximates par value. The Company’s ARS investments are held by UBS AG ("UBS"), one of the Company’s investment providers. In November 2008, the Company accepted an offer (the “Right”) from UBS entitling the Company to sell at par value ARS purchased from UBS (approximately $48.4 million, par value) at anytime during a two-year period from June 30, 2010 through July 2, 2012. Although the Company expects to sell its ARS under the Right, if the Right is not exercised before July 2, 2012, it will expire and UBS will have no further rights or obligation to buy the Company’s ARS. 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 Right. UBS has disclaimed any assurance that it will have sufficient financial resources to satisfy its obligations under the Right. The Company has valued the ARS and Right using a discounted cash flow model based on Level 3 assumptions. The assumptions used in valuing the ARS and the Right include estimates of, based on data available as of September 30, 2009, interest rates, timing and amount of cash flows, credit and liquidity premiums, expected holding periods of the ARS, loan rates per the UBS Right and bearer risk associated with UBS’s financial ability to repurchase the ARS beginning June 30, 2010.

During the nine months ended September 30, 2009 the Company liquidated $3.9 million (at par value) ARS investments that were called by the issuers. The Company intends to exercise the UBS Right on June 30, 2010, and as a result, has classified these ARS investments and the Right as short-term investments as of September 30, 2009.

The following table provides a summary of changes in fair value of the Company’s ARS investments and the Right which are both Level 3 assets as of September 30, 2009 (in thousands):

	Rights		ARS
Balance at December 31, 2008	$	9,013	$	43,237
Sale of auction rate securities		-		(3,875)
Unrealized gain/(loss) included in earnings		(2,668)		2,668
Balance at September 30, 2009	$	6,345	$	42,030

Note 5 — Balance Sheet Components

Prepaid Expenses and Other Current Assets

	September 30, 2009		December 31, 2008
	(in thousands)
Intra-period deferred tax asset	$	10,213	$	-
Prepaid service contracts - current portion		2,718		2,818
Other prepaid expenses and current assets		2,772		1,931
	$	15,703	$	4,749

Property and Equipment

	September 30, 2009			December 31, 2008
	(in thousands)
Computer and other equipment	$	81,715		$	78,299
Software		7,158			7,450
Leasehold improvements		6,848			8,933
Furniture and fixtures		2,862			2,609
Capitalized software and website development costs		16,290			12,622
		114,873			109,913
Less: Accumulated depreciation and amortization		( 71,656	)		(61,805	)
Net property and equipment	$	43,217		$	48,108

Property and equipment includes $1,212,000 and $3,356,000 of equipment under capital leases at September 30, 2009 and December 31, 2008, respectively. Accumulated depreciation of assets under capital leases totaled $1,197,000 and $3,010,000 at September 30, 2009 and December 31, 2008, respectively.

Depreciation and amortization expense totaled $6,301,000 and $6,226,000 for the three months ended September 30, 2009 and 2008, respectively. Depreciation and amortization expense totaled $18,844,000 and $17,463,000 for the nine months ended September 30, 2009 and 2008, respectively.

During the nine months ended September 30, 2009, the Company retired $8,910,000 of fully depreciated property and equipment, primarily building leasehold improvements and equipment associated with the closure of the Company's Hayward production facility.

Accrued Liabilities

	September 30, 2009		December 31, 2008
	(in thousands)
Accrued compensation	$	2,743	$	4,110
Accrued marketing expenses		2,456		6,697
Accrued purchases		2,119		952
Accrued sales taxes		1,051		5,923
Accrued production facility expenses		972		2,677
Accrued consultant expenses		738		1,439
Accrued other		1,372		3,004
	$	11,451	$	24,802

Note 6 — Restructuring

In July 2008, the Company announced that effective in early 2009, it would close its Hayward production facility and begin operations at a new manufacturing facility to be located in Phoenix, Arizona. At the time of the decision, the Company recorded approximately $80,000 in contractual lease termination costs. The Company completed its closure of the Hayward facility in the first quarter of fiscal 2009. The Company paid a total of $827,000 in severance costs, which was recognized ratably over the period from the severance communication date in July 2008 through March 31, 2009. The Company recorded an additional restructuring accrual as of March 31, 2009, for rent and related costs for the remainder of the leases associated with the Hayward facility. As of September 30, 2009, the Company made all rent payments associated with the leases and no outstanding restructuring accrual exists.

Accrued liabilities related to restructuring actions consist of (in thousands):

	Facility Closure Costs		Workforce Reduction Costs		Total
Balance, December 31, 2008	$	80	$	633	$	713
Restructuring charges		271		194		465
Payments		(351)		(827)		(1,178)
Balance, September 30, 2009	$	—	$	—	$	—

Note 7 — Commitments and Contingencies

Indemnifications

In the normal course of business, the Company enters into contracts and agreements that contain a variety of representations and warranties and provide for general indemnifications. The Company’s exposure under these agreements is unknown because it involves future claims that may be made against the Company, but have not yet been made. To date, the Company has not paid any claims or been required to defend any action related to its indemnification obligations. However, the Company may record charges in the future as a result of these indemnification obligations.

Line of Credit

On June 29, 2009, the Company entered into a line of credit facility (the “Facility”) with Silicon Valley Bank. The Facility is a $20.0 million 364-day revolving line of credit, and is collateralized by substantially all of the assets of the Company. The Facility is unsecured and contains certain financial and non-financial covenants. As of September 30, 2009, the Company was in compliance with these covenants. The Company will use amounts borrowed under the Facility, if any, to finance the Company’s working capital needs and for general corporate purposes, including future acquisitions. As of September 30, 2009, the Company has not drawn on the line of credit. The Company incurred $82,000 of Facility origination costs which have been capitalized within prepaid expenses and will be amortized over the 12 month term of the Facility.

Contingencies

From time to time, the Company may have certain contingent liabilities that arise in the ordinary course of its business activities. The Company accrues contingent liabilities when it is probable that future expenditures will be made and such expenditures can be reasonably estimated.

Legal Matters

On or about June 18, 2007, Fotomedia Technologies, LLC (“Fotomedia”) filed suit in the United States District Court for the Eastern District of Texas, against the Company and several other defendants alleging infringement of U.S. Patent Nos. 6,018,774; 6,542,936 B1; and 6,871,231 B2. Fotomedia sought unspecified damages, costs, interest and attorneys’ fees, and a permanent injunction. The court issued a claim construction order on July 21, 2009. Fotomedia and the Company subsequently entered into a settlement agreement and the claims between the parties were dismissed with prejudice on August 20, 2009.

On June 25, 2009, Soverain Software LLC filed a complaint for alleged patent infringement against the Company and seventeen other defendants in Soverain Software LLC. v J.C.Penny Corp. et.al., Civ. No. 6:09-CV-274, in the Eastern District of Texas, Tyler Division. The Complaint asserts infringement of U.S. Patent nos. 5,715,314 and 5,909,492, which claim network sales systems including, among other things, a buyer computer and a shopping cart computer, and U.S. Patent no. 7,272,639, which claims, among other things, a method of processing service requests from a client to a server system through a network using session identifiers. The Complaint asserts that the Company directly or indirectly infringes the patents without providing any details concerning the alleged infringement, and it seeks unspecified damages and injunctive relief. The plaintiff has indicated that it is prepared to offer a license to the patents but the terms of any such license have not been disclosed. The Company has answered the Complaint and asserted affirmative defenses and counterclaims for a declaration of non-infringement, invalidity and unenforceability. The initial Scheduling Conference is set for November 2, 2009.

In addition to the above cases, from time to time, the Company may be involved in various legal proceedings arising in the ordinary course of business. In all cases, at each reporting period, the Company evaluates whether or not a potential loss amount or a potential range of loss is probable and reasonably estimable under the provisions of the authoritative guidance that addresses accounting for contingencies. In such cases, the Company accrues for the amount, or if a range, the Company accrues the low end of the range as a component of legal expense.

Note 8 — Acquisition

On September 10, 2009, the Company acquired all of the outstanding common shares and securities convertible into common shares of TinyPictures, Inc. (“TinyPictures”) for a total aggregate purchase price of $1.3 million. The Company also granted $1.3 million in contingent consideration in the form of performance-based restricted stock units (“PBRSUs”) to continuing employees. Vesting of the PBRSUs are contingent on achieving certain performance milestones and continued employment. TinyPictures develops applications that enable users to share videos and images to others across mobile networks and social networking platforms. The acquisition was accounted for as a non-taxable purchase transaction and, accordingly, the purchase price has been allocated to the tangible assets, liabilities assumed, and identifiable intangible assets acquired based on their estimated fair values on the acquisition date. The excess of the purchase price over the aggregate fair values was recorded as goodwill. Stock based compensation associated with the PBRSUs will be recognized when the achievement of the performance milestones are deemed probable.

The total purchase price of $1.3 million was reduced for total negative working capital of $0.3 million, resulting in an adjusted purchase price of $1.0 million. Of that amount , $0.1 million was allocated to in-process research and development having an indefinite life and $51,000 was allocated to core technology and user base which will be amortized over their estimated useful lives of one to three years. The Company also recorded a deferred tax asset of $0.6 million which relates to the net operating loss carry-forwards from TinyPictures. The remaining excess purchase price of approximately $0.5 million was allocated to goodwill which represents the knowledge and experience of the assembled workforce and future technology. The results of operations for TinyPictures have been included in the condensed consolidated statement of operations for the period subsequent to the acquisition date. Acquisition-related costs were included in general and administrative expenses in the Company’s condensed consolidated statement of operations for the three and nine months ended September 30, 2009.

The following table provides a summary of the activity of the Company’s goodwill and intangible asset balances, including additions from the TinyPictures acquisition (in thousands):

	December 31, 2008		Additions		Accumulated Amortization			September 30, 2009
Purchased technology	$	8,450	$	128	$	(3,379	)	$	5,199
Customer relationships		990		25		(689	)		326
Licenses and other		256		-		(177	)		79
Total intangible assets	$	9,696	$	153	$	(4,245	)	$	5,604

Goodwill	$	7,724	$	544		-		$	8,268

The following table presents the pro forma statements of operations obtained by combining the historical consolidated statements of operations of the Company and TinyPictures for the three and nine months ended September 30, 2009 and 2008, giving effect to the merger as if it occurred on January 1, 2009 and 2008, respectively (in thousands, except per share data):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2009			2008			2009			2008
Pro forma revenue	$	40,496		$	35,953		$	115,385		$	105,740
Pro forma operating loss		(9,412	)		(10,231	)		(29,487	)		(29,070	)
Pro forma net loss		(6,703	)		(3,798	)		(19,857	)		(13,747	)

Pro forma basic and diluted net loss per share	$	(0.27	)	$	(0.15	)	$	(0.78	)	$	(0.54	)

Note 9 — Restatement

Subsequent to the issuance of its condensed consolidated financial statements for the three and nine months ended September 30, 2008, the Company identified an error in the calculation of its stock-based compensation expense. Since 2006, the Company has licensed software from a third-party to automate the administration of its employee equity programs and calculate its stock based compensation expense. The third-party published a technical bulletin that identified a change to its most current software version to correct computational errors in determining stock-based compensation expense. Subsequently, in 2009 the Company identified that the version of the software it used to calculate stock-based compensation contained the same error and that it had incorrectly calculated stock-based compensation expense by continuing to apply a weighted average forfeiture rate to the vested portion of stock option awards until the grant’s final vest date, rather than reflecting actual forfeitures as awards vest. The net effect of the error was an understatement of stock-based compensation expense in certain periods prior to the grant’s final vest date. Correction of the financial statement errors will result in changes to the timing of stock-based compensation expense over the vesting period of the awards during the relevant periods, but will not change the total stock-based compensation expense calculated for any grant. As stock-based compensation is a non-cash item, there as no impact to net cash provided or used by operations for the three and nine months of September 30, 2008.

The following is a summary of the significant effects of the restatement:

	Three Months Ended									Nine Months Ended
	September 30, 2008									September 30, 2008
	As Previously Reported			Adjustments			As Restated			As Previously Reported			Adjustments			As Restated

Net revenues	$	35,953		$	-		$	35,953		$	105,738		$	-		$	105,738
Cost of net revenues (1)		18,430			21			18,451			53,739			38			53,777
Gross profit		17,523			(21	)		17,502			51,999			(38	)		51,961
Operating expenses (1):
Technology and development		9,645			44			9,689			28,642			154			28,796
Sales and marketing		10,087			51			10,138			26,762			174			26,936
General and administrative		6,772			129			6,901			21,946			353			22,299
Total operating expenses		26,504			224			26,728			77,350			681			78,031
Loss from operations		(8,981	)		(245	)		(9,226	)		(25,351	)		(719	)		(26,070	)
Interest expense		(100	)		-			(100	)		(185	)		-			(185	)
Interest and other income, net		455			-			455			2,514			-			2,514
Loss before income taxes		(8,626	)		(245	)		(8,871	)		(23,022	)		(719	)		(23,741	)
Benefit from income taxes		5,915			156			6,071			12,655			377			13,032
Net loss	$	(2,711	)	$	(89	)	$	(2,800	)	$	(10,367	)	$	(342	)	$	(10,709	)


Net loss per share - basic and diluted	$	(0.11	)	$	(0.00	)	$	(0.11	)	$	(0.41	)	$	(0.02	)	$	(0.43	)

Weighted-average shares outstanding - basic and diluted		25,067			-			25,067			25,020			-			25,020


(1) Stock-based compensation is allocated as follows:

Cost of net revenues	$	88		$	21		$	109		$	263		$	38		$	301
Technology and development		610			44			654			1,539			154			1,693
Sales and marketing		645			51			696			1,559			174			1,733
General and administrative		1,087			129			1,216			2,974			353			3,327
	$	2,430		$	245		$	2,675		$	6,335		$	719		$	7,054

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This document, including the following Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that are based upon our current expectations. These forward-looking statements include statements related to our expectations regarding the seasonality of our business, the decline in average selling prices for prints, revenue trends, average order value, number of orders, number of customers, operating expenses as a percentage of net revenues, the effect of capital expenditures on our results of operations , effective tax rates, realization of deferred tax assets, the sufficiency of our cash and cash equivalents balances and cash generated from operations for the next twelve months and our ability to grow our personalized products and services as a percentage of our total revenues, as well as other statements regarding our future operations, financial condition and prospects and business strategies. In some cases, you can identify forward-looking statements by terminology such as “project,” “believe,” “anticipate,” “plan,” “expect,” “estimate,” “intend,” “continue,” “should,” “would,” “could,” “potentially,” “will,” or “may,” or the negative of these terms or other comparable terminology. Forward-looking statements involve risks and uncertainties. Our actual results and the timing of events could differ materially from those anticipated in our forward-looking statements as a result of many factors, including but not limited to, the seasonality of our business, whether we are able to expand our customer base and increase our product and service offering, competition in our marketplace and the other risks set forth below under “Risk Factors” in Part II, Item 1A of this report. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. We assume no obligation to update any of the forward-looking statements after the date of this report or to conform these forward-looking statements to actual results.

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 photos. 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 net revenues by producing and selling professionally-bound photo books, greeting cards and stationery, personalized calendars, other photo-based merchandise and high-quality prints ranging in size from wallet to jumbo-sized 20x30 enlargements. We currently manufacture these items in our Charlotte, North Carolina and Phoenix, Arizona manufacturing facilities. Our new manufacturing and production facility in Phoenix, Arizona began operations in April 2009, and replaced our Hayward, California facility, which ceased operations in January 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 periods of peak 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, keepsake boxes, notebooks, notepads, address labels and stickers.

Our high-quality products and services and the compelling online experience we create for our customers, together 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 believe that 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 operations and financial performance depend on general economic conditions. The U.S. economy continues to experience, an economic downturn due to slower economic activity, concerns about inflation, decreased consumer confidence, high consumer debt levels and higher unemployment rates and other adverse business conditions. Such fluctuations in the U.S. economy could cause, among other things, 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 and could negatively effect sales in the fourth quarter, which has historically been the source of a substantial portion of our revenues. Throughout this period we intend to focus on actions that are within our control and initiatives that are intended to increase revenue, earnings, free cash flow and long-term shareholder value.

Basis of Presentation

Net Revenues. We generate revenues primarily from the printing and shipping of photo-based products, such as photo books, cards and stationery, calendars, photo prints, and photo-based merchandise, such as mugs, mouse pads and magnets. Revenues are recorded net of estimated returns, promotions redeemed by customers and other discounts. Customers place orders through our website and pay primarily using credit cards.

Our personalized products and services revenues are derived from the sale of photo-based products, photo-based merchandise and ancillary products and services, and the related shipping revenues. Revenue from advertising displayed on our website and referral fees are also included in personalized products and services revenue. We believe our products and services are differentiated from other traditional photo processors by our high quality production and numerous form factors and templates, which are key to attracting and retaining customers. We also provide commercial print services which is a component of our net revenues.

Our business is subject to seasonal fluctuations. In particular, we generate a substantial portion of our revenues during the holiday season in the calendar fourth quarter. We also typically experience increases in net revenues during other shopping-related seasonal events, such as Easter, Mother’s Day, Father’s Day, and Halloween. We generally experience lower net revenues during the first, second and third calendar quarters and have incurred and may continue to incur losses in these quarters. Due to the relatively short lead time required to fulfill product orders, usually one to three business days, order backlog is not material to our business.

To further understand net revenue trends, we monitor several key metrics including:

Total Customers. We closely monitor total customers as a key indicator of demand. Total customers include the number of transacting customers in a given period. We seek to expand our customer base by empowering our existing customers with sharing and collaboration services (such as Shutterfly Gallery and Shutterfly Share Sites), and by conducting integrated marketing and advertising programs. Total customers have increased on an annual basis for each year since inception and while we expect this trend to continue, the number of customers is dependent on whether we are successful in executing our strategy in addition to the conditions of the overall economic environment.

Average Order Value. Average order value is net revenues, excluding revenues from our commercial print initiative, for a given period divided by the total number of customer orders recorded during that same period. We seek to increase average order value as a means of increasing net revenues. Average order value has increased on an annual basis for each year since 2000, and we anticipate that this trend will continue in the future as consumers shift from prints into personalized products and services.

Total Number of Orders. We closely monitor total number of orders as a leading indicator of net revenue trends. We recognize the net revenues associated with an order when the products have been shipped and all other revenue recognition criteria have been met. Orders are typically processed and shipped within two business days after a customer places an order. Total number of orders has increased on an annual basis for each year since 2000, and while we anticipate this trend to continue in the future, the number of orders is dependent on whether we are successful in executing our strategy, the conditions of the overall economic environment and a continued increase in consumer trends towards photo-based products.

Personalized Products and Services Revenues as Percentage of Net Revenues. We continue to innovate and improve our personalized products and services and expect the net revenues from these products and services to increase as percentage of net revenues as we continue to diversify our product offerings. Personalized products and services as a percentage of total net revenue was 51% in 2006, 56% in 2007 and 61% in 2008. In addition, as a percentage of total net revenues, revenues from 4x6 prints have been declining; from 28% in 2006, to 22% in 2007, and to 19% in 2008.

We believe the analysis of these metrics provides us with important information on our overall net revenue trends and operating results. Fluctuations in these metrics are not unusual and no single factor is determinative of our net revenues and operating results.

Cost of Net Revenues. Cost of net revenues consists primarily of direct materials (the majority of which consists of paper, ink, and photo book covers), payroll and related expenses for direct labor, shipping charges, packaging supplies, distribution and fulfillment activities, rent for production facilities, depreciation of production equipment, and third-party costs for photo-based merchandise. Cost of net revenues also includes payroll and related expenses for personnel engaged in customer service. In addition, cost of revenues includes any third-party software or patents licensed, as well as the amortization of acquired developed technology and capitalized website development costs. Cost of net revenues also includes certain costs associated with the closure of our Hayward manufacturing and production facility.

Operating Expenses. Operating expenses consist of technology and development, sales and marketing, and general and administrative expenses. We anticipate that each of the following categories of operating expenses will increase in absolute dollar amounts, but remain relatively consistent as a percentage of net revenues.

Technology and development expense consists primarily of personnel and related costs for employees and contractors engaged in the development and ongoing maintenance of our website, infrastructure and software. These expenses include depreciation of the computer and network hardware used to run our website and store the customer data, as well as amortization of purchased software. Technology and development expense also includes co-location and bandwidth costs.

Sales and marketing expense consists of costs incurred for marketing programs and personnel and related expenses for our customer acquisition, product marketing, business development and public relations activities. Our marketing efforts consist of various online and offline media programs, such as e-mail and direct mail promotions, the purchase of keyword search terms and various strategic alliances. We depend on these efforts to attract customers to our service.

General and administrative expense includes general corporate costs, including rent for our corporate offices, insurance, depreciation on information technology equipment and legal and accounting fees. In addition, general and administrative expense includes personnel expenses of employees involved in executive, finance, accounting, human resources, information technology and legal roles. Third-party payment processor and credit card fees are also included in general and administrative expense and have historically fluctuated based on revenues during the period. All of the payments we have received from our intellectual property license agreements have been included as an offset to general and administrative expense. In the nine month period ending September 30, 2009, we received annual payments from two different multi-million dollar cross-licensing agreements. We expect to recognize a final payment due under one of the agreements when it is received in the first quarter of fiscal year 2010.

Interest Expense. Interest expense consists of interest costs recognized under our capital lease obligations as well as costs associated with our line of credit facility.

Interest and other income, net . Interest and other income, net consists of the interest earned on our cash and investment accounts as well as gains/losses on our trading securities and the Right from UBS entitling us to sell at par value auction-rate securities purchased from UBS (approximately $48.4 million, par value) at anytime during a two-year period from June 30, 2010 through July 2, 2012.

Income Taxes. Historically, we have only been subject to taxation in the United States because we only operate within the United States.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our critical accounting policies and estimates. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies and estimates are discussed in our Annual Report on Form 10-K-/A for the fiscal year ended December 31, 2008.

Results of Operations

The following table presents the components of our income statement as a percentage of net revenues:

	Three Months						Nine Months
	Ended September 30,						Ended September 30,
	2009			2008			2009			2008
				(as restated)						(as restated)
Net revenues		100	%		100	%		100	%		100	%
Cost of revenues		53	%		51	%		53	%		51	%

Gross profit		47	%		49	%		47	%		49	%
Operating expenses:
Technology and development		28	%		27	%		29	%		27	%
Sales and marketing		23	%		28	%		23	%		25	%
General and administrative		18	%		19	%		20	%		21	%

Loss from operations		(22)	%		(25)	%		(25)	%		(24)	%
Interest expense		0	%		0	%		0	%		0	%
Interest and other income, net		0	%		0	%		1	%		2	%

Loss before income taxes		(22)	%		(25)	%		(24)	%		(22)	%
Benefit from income taxes		6	%		17	%		8	%		12	%

Net loss		(16)	%		(8)	%		(16)	%		(10)	%

Comparison of the Three Month Period Ended September 30, 2009 and 2008

	Three Months Ended September 30,
	2009				2008				$ Change		% Change
	(in thousands)
					(as restated)
Net revenues		$	40,495			$	35,953			4,542		13	%
Cost of net revenues			21,420				18,451			2,969		16	%
Percentage of net revenues			53	%			51	%
Gross profit			19,075				17,502			1,573		9	%

Net revenues increased $4.5 million, or 13%, for the three months ended September 30, 2009, as compared to the same period in 2008. Revenue growth was attributable to an increase in personalized products and services revenues and revenue from our commercial print initiative, offset by a decrease in print revenue. Personalized products and services (“PPS”) revenues increased $5.5 million, or 28%, to $24.9 million for the three months ended September 30, 2009 as compared to the same period in 2008. The increase in PPS is primarily a result of increased sales of photo books and stationery cards. PPS represented 61% of revenue compared to 54% in the same period in 2008. Revenue from our commercial print initiative totaled $1.2 million, and represented 3% of our total net revenues. Print revenue decreased $0.9 million, or 6%, to $15.6 million for the three months ended September 30, 2009, as compared to the same period in 2008. Print revenue represented 39% of revenue compared to 46% in the same period in 2008. The decrease in overall print revenue is primarily due to a lower average sales price for 4x6 prints which is a result of our price change in September 2008 offset partially by continued stable growth in unit volumes. In the third quarter of 2009, 4x6 print revenues represented 24% of total net revenues versus 29% in the third quarter of 2008.

Excluding commercial print revenues, net revenue increases were also the result of year-over-year increases in all of our key metrics: customers, orders and average order value, as noted below:

	Three Months Ended September 30,
	2009			2008			$ Change			% Change
	(in thousands, except AOV amounts)
Customers			982			916			65		7	%
Orders			1,705			1,656			49		3	%
Average order value		$	23.03		$	21.71		$	1.32		6	%

Cost of net revenues increased $3.0 million, or 16%, for the three months ended September 30, 2009 as compared to the same period in 2008. As a percentage of net revenues, cost of net revenues increased from 51% to 53% for the same comparable period, which decreased gross margin from 49% in the third quarter of 2008 to 47% in the third quarter of 2009. The decrease in our gross margin percentage is primarily due to cost increases from the transition of our Hayward manufacturing facility to our new Phoenix manufacturing facility and higher equipment rental expenses compared to the same period in 2008. However, these factors were partially offset by favorable improvements from product mix and continued savings in shipping and materials costs due to operational efficiencies and negotiated cost reductions.

	Three Months Ended September 30,
	2009			2008			$ Change		% Change
	(in thousands)
				(as restated)
Technology and development	$	11,390		$	9,689		$	1,701		18	%
Percentage of net revenues		28	%		27	%
Sales and marketing		9,377			10,138			(761)		(8)	%
Percentage of net revenues		23	%		28	%
General and administrative		7,363			6,901			462		7	%
Percentage of net revenues		18	%		19	%

Our technology and development expense increased $1.7 million, or 18%, for the three months ended September 30, 2009, as compared to the same period in 2008. As a percentage of revenue, this expense increased slightly from 27% to 28% for the same comparable period. The increase in technology and development expense was primarily due to an increase of $0.7 million in third party hosting and connectivity costs compared to the same period in 2008. Depreciation expense also increased by $0.1 million as we continued to invest in our website infrastructure hardware to support our continued revenue growth. Personnel and related costs for employees and consultants involved with website development and website infrastructure support teams increased by $0.4 million. For the three months ended September 30, 2009, we capitalized $1.5 million in eligible costs, which includes $0.4 million of stock based compensation, associated with software developed or obtained for internal use, compared to $1.3 million in the same period in the prior year.

Our sales and marketing expense decreased $0.8 million, or 8%, for the three months ended September 30, 2009 as compared to the same period in 2008. As a percentage of net revenues, sales and marketing expense for the three months ended September 30, 2009 decreased from 28% to 23% for the same comparable period. The decrease in sales and marketing expense is primarily due to a decrease of $1.4 million in customer acquisition costs reflecting greater emphasis on promotional offers and product trials and a reduction in external marketing spend. Overall decrease is offset by an increase of $0.3 million in personnel and related costs primarily due to a slight increase in headcount. In addition, stock base compensation increased by $0.3 million compared to the same period in the prior year.

Our general and administrative expense increased $0.5 million, or 7%, for the three months ended September 30, 2009 as compared to the same period in 2008. As a percentage of net revenues, general and administrative expense decreased from 19% to 18% as compared to the same comparable period. The overall fluctuation in general and administrative expense is primarily due to an increase of $0.8 million in stock based compensation offset by a continued decrease in professional services costs of $0.2 million.

	Three Months Ended September 30,
	2009		2008		$ Change		% Change
	(in thousands)
Interest expense	$	(22)	$	(100)	$	(78)		(78)	%
Interest and other income, net		74		455		(381)		(84)	%

Interest expense decreased by $78,000 or 78% for the three months ended September 30, 2009, as compared to the same periods in 2008, due to the expiration of the line of credit with JP Morgan in April 2009. We completed a replacement facility in June 29, 2009 and incurred lower origination costs resulting in a decrease in amortization expense as compared to the same period in the prior year.

Interest and other income, net decreased by $0.4 million or 84% for the three months ended September 30, 2009, as compared to the same period in 2008. The decrease is primarily due to an overall lower yield on our investment portfolio relative to our investment balances in the comparable prior year period. During the three months ended September 30, 2009, we recorded a $0.9 million mark-to-market gain on our auction-rate securities that have been classified as trading securities which was entirely offset by a $0.9 million loss on the UBS Right.

	Three Months Ended September 30,
	2009			2008
	(in thousands)
				(as restated)
Income tax benefit	$	2,657		$	6,071
Effective tax rate		30	%		68	%

The benefit for income taxes was $2.7 million for the three months ended September 30, 2009, compared to the benefit of $6.0 million for the same period in 2008. The decrease in our effective tax rate was primarily the result of the inclusion of federal research and development credits in the three months ended September 30, 2009, compared to same period in the prior year. The Federal Research and Development credit was extended retroactively to January 1, 2008 and prospectively to December 31, 2009 as a result of the Tax Extenders and Alternative Minimum Tax Relief Act of 2008 which was signed into law on October 3, 2008.

As of September 30, 2009, we had approximately $12.1 million of federal and $31 million of state net operating loss carryforwards available to reduce future taxable income. These net operating loss carryforwards begin to expire in 2021 and 2014 for federal and state tax purposes, respectively.

	Three Months Ended September 30,
	2009			2008			% Change
	(in thousands)
				(as restated)
Loss before income taxes	$	(9,003	)	$	(8,871	)		1	%
Net loss		(6,346	)		(2,800	)		127	%

Net loss increased by $3.5 million, or 127% for the three months ended September 30, 2009 as compared to the same period in 2008.

Comparison of the Nine Month Period Ended September 30, 2009 and 2008

	Nine Months Ended September 30,
	2009			2008			$ Change		% Change
	(in thousands)
				(as restated)
Net revenues	$	115,365		$	105,738		$	9,627		9	%
Cost of net revenues		61,161			53,777			7,384		14	%
Percentage of net revenues		53	%		51	%
Gross profit		54,204			51,961			2,243		4	%

Net revenues increased $9.6 million, or 9% for the nine months ended September 30, 2009 as compared to the same period in 2008. Revenue growth was attributable to the increase in personalized products and services revenues and revenues from our commercial print initiative, offset by a decrease in print revenue. PPS increased $13.6 million, or 24%, to $71.1 million for the nine months ended September 30, 2009 as compared to the same period in 2008. The increase in PPS is primarily a result of increased sales of photo books, stationery cards and calendars. PPS made up 62% of net revenues for the nine months ended September 30, 2009, up from 54% for the same period in 2008. Revenue from our commercial print initiative totaled $2.6 million, and represented 2% of our total net revenues. Print revenue decreased $4.0 million, or 8%, to $44.3 million for the nine months ended September 30, 2009 as compared to the same period in 2008. The decrease in overall print revenue is primarily due to a lower average sales price for 4x6 prints which is a result of our price change in September 2008. The decrease in overall print revenue is also attributable to decreased sales volume of photo card and large format print sizes.

Cost of net revenues increased $7.4 million, or 14%, for the nine months ended September 30, 2009 as compared to the same period in 2008. As a percentage of net revenues, cost of net revenues increased from 51% to 53% for the same comparable period, which decreased gross margin from 49% to 47% for the nine months ended September 30, 2008 and 2009, respectively. The decrease in our gross margin percentage is primarily due to the cost increases from the closure and transition of our Hayward manufacturing facility to our new Phoenix manufacturing facility, an increase in manufacturing headcount, and higher equipment rental expenses compared to the same period in 2008. However, these factors were partially offset by favorable improvements from product mix and continued savings in shipping and materials costs due to operational efficiencies and negotiated cost reductions.

	Nine Months Ended September 30,
	2009			2008			$ Change		% Change
	(in thousands)
				(as restated)
Technology and development	$	33,347		$	28,796		$	4,551		16	%
Percentage of net revenues		29	%		27	%
Sales and marketing		26,075			26,936			(861)		(3)	%
Percentage of net revenues		23	%		25	%
General and administrative		22,642			22,299			343		2	%
Percentage of net revenues		20	%		21	%

Our technology and development expense increased $4.6 million, or 16%, for the nine months ended September 30, 2009 as compared to the same period in 2008. As a percentage of revenue, technology and development expense for the nine months ended September 30, 2009 increased from 27% to 29% for the same comparable period. The increase in technology and development expense was primarily due to an increase of $2.2 million in third party hosting and connectivity costs and an increase in depreciation expense of $0.7 million compared to the same period in 2008. Personnel and related costs for employees and consultants involved with website development and website infrastructure support teams increased by $1.6 million. For the nine months ended September 30, 2009, we capitalized $4.2 million in eligible costs, which includes $1.2 million of stock based compensation, associated with software developed or obtained for internal use, compared to $3.6 million in the same period in the prior year.

Our sales and marketing expense decreased $0.9, or 3%, for the nine months ended September 30, 2009 as compared to the same period in 2008. This expense decreased as a percentage of net revenues from 25% to 23% for the same comparable period. The decrease in sales and marketing expense is primarily due to a decrease of $2.5 million in customer acquisition costs reflecting greater emphasis on promotional offers and product trials and a reduction in external marketing spend. Overall decrease is offset by an increase in personnel and related costs for employees and consultants of $0.9 million and an increase in stock based compensation of $0.7 million compared to the same period in the prior year.

Our general and administrative expense increased $0.3 million, or 2%, for the nine months ended September 30, 2009 as compared to the same period in 2008. This expense decreased as a percentage of net revenues from 21% to 20%. The increase in general and administrative expense is primarily due to increases in facility costs of $0.7 million, depreciation of $0.3 million, and stock-based compensation of $1.5 million. These increases were offset by a $1.7 million decrease in consulting and other professional service costs as a result of a decrease in contractor headcount, as well as decreases in Sarbanes-Oxley related audit expenditures, and ERP costs in the prior year period that did not recur in the current period.

	Nine Months Ended September 30,
	2009		2008		$ Change		% Change
	(in thousands)
Interest expense	$	(136)	$	(185)	$	49