Shutterfly Operating Margins Will Likely Normalize

The 60% net income decline Shutterfly (SFLY) experienced from last year is primarily the result of higher operating costs. The results have some investors worried, which may be warranted given its rich valuation. With that said, it may be beneficial for foolish investors interested in Shutterfly to take a closer look at historical operating margins and technology investments.

Operating margins
Shutterfly's operating margins have been volatile over the past five years; ranging from 2.8% to 8.1%.

Source: SEC 2013 10K Filing page 35

While some investors are worried about the lackluster performance in 2013, the five year sample size clearly shows that the operating margin drop is nothing too out-of-the ordinary. The reason for the volatility has been the operating expenses.

Operating expenses
Shutterfly's operating expenses consist of technology and development, sales and marketing, and general and administrative expenses. Shutterfly anticipates 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 in future fiscal years.

Source: SEC 2013 10K filing page 43

Technology and development expense increased $23.2 million, or 27% YOY reflecting a strategic focus to increase the rate of innovation in product and services offerings, generate greater differentiation from competitors, and improve long-term operating efficiency. As a percentage of net revenues, technology and development expense increased to 14% in 2013 from 13% in 2012. The increase in technology and development expense was primarily due to an increase of $14.4 million in personnel and related costs, reflecting additional hires during 2013.

In 2013, Shutterfly introduced a photobook creation app for the iPad, making it possible to create digital and physical photo books with enhanced multimedia features. Also in 2013, Shutterfly launched the beta version of an enhanced cloud service called "ThisLife", where consumers can now gather and organize photos and videos from across devices, cloud services and social networks. The increase in technology costs, and specifically the IPad app and cloud service should help with competing in the shifting environment.

Sales and marketing expense consists of marketing programs, personnel expenses for customer acquisition, product marketing, and business development. Sales and marketing expense increased $41.2 million, or 28%, in 2013 compared to 2012. As a percentage of net revenues, total sales and marketing expense increased to 24% in 2013 from 23% in 2012. The increase in sales and marketing expense was primarily due to an increase of $20.2 million related to direct response, expanded online and performance marketing campaigns, and brand advertising. I expect the increase in marketing expenses will aid future sales growth, especially as product awareness of its new technology investments increases.

General and administrative expense includes general corporate costs, including rent for corporate offices, insurance, depreciation on information technology equipment, and legal and accounting fees. General and administrative expense increased $22.5 million, or 32%, in 2013 compared to 2012. As a percentage of net revenues, general and administrative expense increased to 12% in 2013 from 11% in 2012. The increase in general and administrative expense is primarily due to an increase in stock-based compensation of $6.4 million as a result of increased headcount. It may be beneficial for foolish investors to review stock based compensation for future fiscal years to grasp future expectations.

 Shutterfly's increased spending in technology, sales, and administrative costs are vital for the company to compete in today's tech-savvy environment. The operating expenses should decrease as a percentage of operating income once the projects are completed. The 2013 operating margin of 2.8% will likely normalize to the 5-year average of 4.8 if the company is able to execute on it's current investments.

Foolish takeaway
Although the 2013 decrease in operating margins have made investors question the viability of Shutterfly's stock, it should not cause too much concern. For the company to compete effectively, it has beefed up its spending in technology and hiring. Foolish investors should look for an evening out of operating costs in the future as sales continue to grow.