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Shutterfly: A Perfect Picture?



A version of this column first appeared in the weekend edition of The Wall Street Journal.

SAN DIEGO (MarketWatch) -- When Silicon Valley venture capitalist and entrepreneur Jim Clark resigned as chairman and quit the board of Shutterfly Inc. earlier this year, one of the reasons he gave was that as a "technologist" he believed there was "little that I can offer to guide what has become a manufacturing company."

Clark, the company's largest holder, hasn't yet sold any shares. But his departure, and the "manufacturing" comment, may have been more significant than the picture-perfect performance of Shutterfly's stock (SFLY) would suggest. Since going public a year ago, Shutterfly's shares have more than doubled as a pure play on the boom in digital cameras.

The company calls itself "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." That is a touchy-feely way of saying it processes digital photos for consumers with the hopes of also selling them such things as photo books, personalized photo greeting cards and scrapbooks.

It has been a growing business, and an idea whose time has clearly come. It also is one with plenty of competition from the likes of the Kodak Gallery from Eastman Kodak Co., (EK) Snapfish a unit of Hewlett Packard Co. (HPQ) and Flickr, which is owned by Yahoo Inc. (YHOO) As you might guess, that means there also is plenty of price competition in the space, as well as in the burgeoning photo-book sector, where industry originator MyPublisher Inc. recently won kudos from PC Magazine, which preferred MyPublisher over the others.

The businesses is so competitive that a recent partnership between Shutterfly and Target Corp. (TGT) sounds impressive until you head to Target's Web site, where customers have their choice of placing orders through Shutterfly or Kodak.

Which gets us back to Clark's departure and his "manufacturing" comments and why they may be relevant: A hefty and increasing chunk of Shutterfly's revenue doesn't come from products, but instead from the amount Shutterfly charges for shipping. If you are like me, you probably assumed that when you buy something online the cost of shipping is merely a pass-through from FedEx Corp. (FDX) , United Parcel Service Inc., (UPS) DHL International Ltd. (555200) or the U.S. Postal Service.

But at Shutterfly, those shipping fees also are a profit center; the company is currently only profitable in its fourth quarter. "We do make money on it," says Judith McGarry, director of investor relations. While not disclosing just how profitable it is, Shutterfly does acknowledge that shipping is a "significant" revenue generator that for the first nine months of 2006 generated 23% of sales before ending the year at 20%, up from 19% the year before. That compares with 5.3% at Amazon.com Inc. (AMZN) , which unlike Shutterfly also discloses shipping costs.

Amazon's disclosures show that shipping is a money loser, thanks largely to free shipping. Not only doesn't Shutterfly disclose shipping costs, but as of its first quarter, it stopped disclosing quarterly shipping revenue, instead preferring to do so at year's end. The reason, McGarry says, is that there is too much fluctuation, in part because of rising postal costs and the way shipping is allocated back to specific products.

Not surprisingly, Shutterfly fans don't mention shipping as an issue. Instead, analysts such as Youssef Squali of Jefferies & Co. and Brad Manuilow of American Technology Research highlight in their reports about how the company plans to expand with new products and line extensions.

Sounds great on paper, but at 83 times this year's expected per-share earnings and 57 times 2008, Shutterfly trades more like the kind of technology company that Clark prefers rather than a manufacturing company. And not just any manufacturing company, but one that gets nearly a quarter of its sales and an unknown portion of profits from something as nebulous and potentially unpredictable as shipping, which isn't even a product and as of the past year appears to have growing influence on the company's financial performance.

McGarry counters that "it's not clear that shipping is going to rise as a percent of revenue." And besides, she says, "We don't think that's a meaningful way to view the business." Which might mean it really is.

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