UPDATE: Ancora's Letter to Shutterfly Chair Philip Marineau

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Philip Marineau Shutterfly, Inc. 2800 Bridge Parkway Redwood City, CA 94065 Dear Philip: Ancora Advisors LLC is a shareholder of Shutterfly Inc. and we have publicly shared our views on compensation and capital allocation leading up to and shortly after the most recent annual meeting. Since that time, we have held off on any public communication to provide Shutterfly's board of directors time to digest and respond to a dissident shareholder (Marathon Partners) winning two seats on the Company's board and the resounding vote by shareholders against the Company's executive compensation plan. We had hoped these seemingly clear messages of dissatisfaction by the Company's shareholders would incite the changes necessary to maximize shareholder value and avoid another year of shareholder acrimony. Unfortunately, the persistent inaction by the board and the responses of Shutterfly's CEO to a question asked during the Company's 2Q'15 earnings call leaves us with little expectation that the board will heed the owners of the Company and implement changes to the issues Marathon addressed in its proxy contest. Specifically, Mr. Housenbold was asked the following question, "What changes should we expect following the recent proxy vote?" Mr. Housenbold replied that there were essentially no planned changes within three topics to which shareholders clearly voted for transformation based on Marathon's proxy materials – corporate strategy, capital allocation and compensation. Mr. Housenbold commented on the call:  Corporate Strategy: "while we are open to good ideas from anywhere, from shareholders, from customers, from partners, from employees, we believe as we said consistently throughout the proxy process, we believe we have the right strategy, the right vision, the market leadership, the right platform and the right set of execution and imperatives to be able to fulfill the Shutterfly 3.0 vision. So, I don't see any changes in the corporate strategy"  Capital Allocation: "we have been very consistent in saying that we are going to return excess capital to shareholders in a tax efficient way, coupled with remaining flexibility on the balance sheet to do smart accretive acquisitions and not to lever up the Company too far, given changes in macroeconomic and financial markets that could create a distressed situation. So, I don't believe there's any changes to our capital allocation strategy either"  Compensation: "We made meaningful changes in CEO compensation during the proxy process. And our comp committee, along with our outside advisors, are doing a holistic bottoms-up review, which will be discussed at the board level over the next few months. We need to be competitive. You've heard a number of Internet companies in the Valley cite challenges from unicorns and the hiring market, particularly in technology and marketing, so we need to be competitive. Our preference is to have additional shares in the pool to align shareholders' and employees' interests and create upside and retentive value. But absent of additional shares in the pool, as we said during the process, we would have to default to cash, not our choice. So after this bottoms-up analysis, we will be coming back to shareholders with a new proposal for additional shares in the pool" Though not entirely surprised, we view these responses as obtuse when considering the results of the latest annual meeting. Mr. Housenbold specifically dismissed the need for change in corporate strategy and capital allocation, and refers to "meaningful changes" in compensation made during the proxy contest, which we find somewhat amusing given the overwhelming vote against the compensation plan that included these changes. It is also clear that the status quo strategy which Mr. Housenbold refers to is not working for shareholders, as evidenced by the performance of Shutterfly's stock price. Regardless of their investment time horizon, investors are likely to be frustrated with strategy given the near, medium, and long term performance of the stock relative to the market. SFLY performance vs. relevant indices 1-year 2-year 5-year Nasdaq (27.6%) (54.6%) (51.0%) Russell 2000 (25.7%) (35.2%) (18.6%) S&P 500 (21.8%) (45.6%) (22.3%) (as of 10/9/15) If Shutterfly's board continues to blatantly ignore the demands of its shareholders, it is hard for us to envision a scenario where the Company does not face another proxy contest in 2016, particularly in light of the share price underperformance outlined in the table above. We have shared some of our views on the three topics Mr. Housenbold discussed on the most recent conference call below. We would hope that you and the rest of the board would begin to strongly consider our and other shareholders' input when considering how to drive the Company forward from years of subpar shareholder returns. Corporate Strategy One of the points of contention that we believe is top of mind for investors regarding the Company's corporate strategy is the inconsistent message from management on requiring significant incremental investment versus harvesting previous investments. Below are a number of quotes that highlight the poor communication from the Company's management team to investors:  February 2014: "(we) anticipate the trend of significant investments in our scale and operational infrastructure will moderate in 2015" – Brian Regan, CFO  July 2014: "we think that the margins will expand in 2015 from an EBITDA standpoint relative to 2014" – Jeff Housenbold, CEO  October 2014: "We haven't given a long-term model because things change and it's just been our consistent policy. But what we have said in the past is, we think EBITDA margins return to a two handle; we think that capex drops back between 7% and 8%, and we think we can drive top-line growth and increase profitability. So I believe EBITDA and free cash flow will grow at a quicker clip than revenue will over the next three to four years" – Jeff Housenbold, CEO  February 2015: "We expect that our GAAP operating income will range from approximately $0.5 million to $7.5 million and that our full-year 2015 adjusted EBITDA margin will range from 17.5% to 18.1% of net revenues" (implying margins down YoY) – Brian Regan, CFO  July 2015: "We didn't make any specific commitments to 2016 margins except for our reiterating our belief that the investments we're making in technology and manufacturing will allow us to reduce our cost structure and gain additional scale and scope economies, and that the margin should expand in 2016" – Jeff Housenbold, CEO Throughout 2014, management repeatedly pledged showing returns on previous investments via expanding EBITDA margins in 2015, but then reneged on those promises when issuing 2015 guidance in February. Initial discussions around 2016 margins are following a similar pattern to last year, and given the lack of management credibility, we are not surprised that investors are hesitant to take the Company at its word for these claims. While investment in both the consumer and enterprise platforms is certainly necessary and we are encouraged by the opportunity created by this investment to penetrate the enterprise market and expand the Company's industry leading share through product improvement in the consumer business, management needs to be held accountable for delivering returns on these investments. We believe this can be achieved through the establishment and publishing of longer term financial targets (beyond 1 year guidance), and the tying of executive compensation to delivering on these stated longer term goals. During the first quarter 2014 conference call, Mr. Housenbold boasted about his ability to expand margins if he so chose:  "So too early to give you guidance exactly where it falls out (for 2015), but we could make this a mid-20's EBITDA margin model if we wanted to cut back on investments" While we acknowledge the response was prior to the Groovebook acquisition and the increase in the mix of enterprise revenues, both of which will weigh on near term margins, there needs to be some accountability for management's claims to shareholders. Applying 22% EBITDA margins (well below levels management indicated they could achieve) to consensus 2016 revenues would imply that Shutterfly would be currently trading at just over 6x 2016 Adjusted EBITDA (~8.5x if treating stock compensation as a cash expense). As exemplified by the current valuation, investors do not have faith in the current corporate strategy to drive shareholder returns. Better communication of the long term strategy of the Company and visibility into the financial impact of that strategy are steps in the right direction for restoring management credibility. However, only when the Company actually hits these targets will investors truly regain faith in management. To this end, we believe a portion of the long-term incentive compensation for executives should be tied to these longer term targets to ensure management is properly focused on achieving the Company's stated goals. Capital Allocation We concur with Mr. Housenbold that capital should be returned to shareholders tax efficiently and that the Company should not take on excessive leverage. Through conversation with CFO Brian Regan, we also acknowledge that the Company must maintain a minimum cash balance to manage large 4Q/1Q working cap swings and to preserve long term balance sheet flexibility to address the 2018 maturity of the convertible notes. While taking these points into consideration, we still believe the Company has an opportunity to drive significant FCF / share accretion through adding modest leverage and pursuing more aggressive buybacks. We also believe there should be an extremely high bar for acquisitions given the current Shutterfly valuation, and that the Company should carefully consider the accretion to FCF / share of any deal versus repurchasing additional shares. Barring any strategic transactions or other unforeseen events, the Company should be in a net cash position at the close of 2015, assuming the completion of the ASR and a continuation of share repurchases in the back half at a similar pace to the first half of the year (excluding the cash allocated to the ASR). We believe that the Company has an untapped asset in its balance sheet that should be put to use, particularly in light of the recent pullback in the stock price. In July, we sent an analysis to Mr. Regan which indicated that targeting a conservative net leverage level of ~1.5x (a minimum cash adjustment for working capital in our analysis results in actual levels below 1.0x) at the end of 2016 and 2017 by using cash on hand and modestly tapping the Company's credit facility to buy back stock would result in FCF / share accretion of nearly 20% by 2017. At the current stock price, the accretion is now even more attractive, delivering FCF / share of over $5 in 2017 (with what we believe to be conservative revenue growth and EBITDA margin expansion assumptions). We believe the modest use of the balance sheet in this case provides the Company significant flexibility to deal with the seasonal working capital swings, invest in growth, manage the 2018 convertible maturity, and continue to pursue strategic acquisitions. Mr. Housenbold often cites the hundreds of deals the Company analyzes on an ongoing basis. We believe the most attractive deal in front of the Company today is repurchasing its own stock. Not only should every deal the Company looks at be weighed against using that capital for buybacks, but we also believe the board should strongly consider putting the balance sheet asset to further use to repurchase stock more aggressively or even tender for shares at these levels, both of which are extremely accretive for shareholders over the next few years as the Company benefits from EBITDA margin expansion and a reduction of capital intensity. We have included an updated version of the analysis we sent Mr. Regan at the end of the letter. Compensation While compensation issues at Shutterfly have been discussed at length during the Marathon proxy contest and in our previous letters, we find it deeply disturbing that Mr. Housenbold noted on the last conference call, "We made meaningful changes in CEO compensation during the proxy process." We would like to reiterate a portion of the conclusion by ISS after assessing Shutterfly's compensation practices (emphasis is ours):  May 2015: "CEO pay, however, hews closer to the trend in revenue growth than the trend in shareholder returns, resulting in what is a troublingly large multiple of total pay to even the median of the company's own pay peers, let alone a more representative selection. At some point – this may be that point – shareholders need ask the hard question the board appears to be ignoring: what, exactly, is the value proposition that justifies this expense?" ISS points out another egregious trend, noting that stock compensation rose to 59% of 2014 adjusted EBITDA from just 30% in 2008, exemplifying how the relative cost to shareholders has risen dramatically. Given the overwhelming vote by shareholders in June against the compensation plan (26,651,987 against to 7,467,750 for), we thought that the message for dramatic overhaul to compensation had been delivered. We believe shareholders will require that the bottoms-up analysis that the Company is undertaking and subsequent proposal provide the transformation in executive compensation demanded at the annual meeting, and we hope the proposal would include some of the elements we have previously discussed, including:  TSR / relative TSR based performance triggers for PBRSUs (versus EBITDA triggers)  Use of out of the money options instead of RSUs  Longer dated vesting schedules  Metrics that tie to long term operating targets, which include the cost of stock compensation to shareholders such as EBITDA less capex per share (un-adjusted) From 2011-2014, Mr. Housenbold has been paid over $50m in total compensation (which would have eclipsed $62m through 2015 had the board's incentive compensation passed). During that time, he has sold nearly $90m of Shutterfly stock and, after the failure of the sale process, was given excessive and off-cycle stock grants that provided no functional method for ensuring he remains with the Company in the medium to long term or drive shareholder value, which appeared abnormal to us. Since the beginning of 2011, Mr. Housenbold has prospered handsomely, yet investors have seen the value of their shares appreciate by only 12.2% in nearly 5 years, implying a 2.4% IRR. We struggle to find any way that the legacy compensation plans have instilled an owner's mentality among senior management, and we would urge you to keep this in mind when considering the next plan that you present to shareholders. Finally, Mr. Housenbold indicated that if no plan was passed by shareholders, the Company would default to cash compensation without shares available in the pool. Should the Shutterfly board and shareholders remain at impasse on executive comp, we encourage the board to consider the precedent at WebMD Health Corp. In order to add shares to the pool to ensure retention of key non-executive employees, the WebMD board recently proposed excluding executive officers and members of the board from grant eligibility for the new shares available. We believe a similar compromise could prove tenable as a bridge to finding a long term executive compensation solution acceptable to shareholders. Conclusion We strongly recommend that you and your fellow board members view the outcome of June's annual meeting as a shareholder mandate for change. The Company's owners have unquestionably spoken. If the board is unwilling to implement meaningful changes to its current corporate strategy, capital allocation plans, and compensation policies, then we believe another active proxy season is inevitable come 2016. Sincerely, Fred DiSanto Chief Executive Officer and Executive Chairman Ancora Advisors LLC James Chadwick Portfolio Manager Ancora Advisors LLC cc. Shutterfly Board of Directors
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