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Shutterfly's Kodak Buy May be Picture Perfect (Update 1)

Updated to include CEO comments, largest shareholders and share prices

NEW YORK (TheStreet) - Shutterfly's (SFLY) $23.8 million deal to buy the customer accounts of Eastman Kodak's (EK) Gallery may be a profit turning point for the company, while thwarting the likes of Apple (AAPL) in entering the online photo sharing business.

The purchase removes a large competitor in the online photo-sharing market and may help to ease pricing pressures, creating a key long-term upside for Shutterfly and its online peers, according to analysts.

Late on Thursday, Shutterfly announced a "stalking horse" bid for the U.S. and Canadian customer accounts of Kodak's Gallery photo sharing business, pushing shares up over 16%. Shutterfly won't take on the Kodak brand or any of its operating assets or liabilities, and the deal also needs to be approved by a bankruptcy judge after a bidding process, which is expected later in March.

If Shutterfly can close the Kodak Gallery customer account buy, analysts say it will be a long-term jolt to the company's earnings that may be the catalyst to push shares in the direction of 2011 highs, after a second half stock swoon.

"We view this as a prudent use of capital to further consolidate share and potentially mitigate industry pricing pressure," writes Janney Capital Markets analyst Shawn Milne in a note reacting to the deal. Milne estimates that the Kodak Gallery generates roughly $75 million in revenue, which when added to Shutterfly's earnings, will boose earnings per share by up to 15 cents in 2012. Though Milne likes the deal and rates the company a "buy" with a $30 a share price target, he expects the company's EPS to fall to $1.02 in 2012 from $1.15 in 2011.

Kodak Gallery lets users store and share their digital images, customize photobooks, cards and albums. Overall the business has 75 million users and meshes strongly with Shutterfly's photobook, cards and photo sharing businesses. But with the prominence of networks like Facebook, a surge in low priced competitors and the use of daily deals promotions, Shutterfly and others saw margins fall on pricing pressures that are expected to persist in 2012.

Shutterfly competes primarily against Hewlett Packard's (HP) Snapfish, Kodak Gallery, VistaPrint (VPRT) and American Greetings (AM). The key to Shutterfly's acquisition is eliminating a large industry player, which may benefit pricing going forward.

"For Shutterfly to eliminate of one of the few scale players in the industry for the proposed price of only $24 million appears to underscore the company's dominance within the industry and the financial weakness of its competitors," writes Mitch Bartlett of Craig Hallum Capital in a note. While the deal may help on pricing and show that other players are struggling to grow, it may also remove the threat of a new entrant like Amazon (AMZN) or Apple (AAPL) that could add an even greater hit.

By making the move, Shutterfly removes "the threat of a new or larger competitior (e.g. AMZN, AAPL) entering the space through the Kodak Gallery assets," adds Bartlett. He believes that pricing pressure in digital photos may moderate in 2012, representing an unexpected catalyst that makes Shutterfly a "buy" with a price target of $32 a share.

Shutterfly carries its photosharing capabilities on the Apple iPhone and iPad, in addition to other smart devices that run on Google (GOOG) and Microsoft (MSFT) software.

The deal pushed Shutterfly shares up over 16% to $31.27 in Friday afternoon trading, adding roughly $150 million in market value, pushing 2012 gains to nearly 40%. Still shares are roughy 25% in the last 12 months, after the company's shares were halved in the second half of 2011 on falling profits.

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For large institutional shareholders, the deal boost makes recent share purchases look well timed. Wells Capital Management, the largest shutterfly shareholder with a 14% stake nearly doubled its holding in the quarter ended on Dec. 31, according to regulatory filings. Meanwhile, Wellington Management made a similar sized share boost, putting its stake at 13.9% and Columbia Wanger upped its stake by 25%.

Shutterfly is expected to see its profits fall to $11 million from $14 million, even as revenue grows 22% to $561 million, according to consensus estimates of analysts polled by Bloomberg, who give the company a price target of $31.80. Eleven analysts rate shares a "buy," while 2 put out "hold" ratings.

One source of an earnings drain in 2011 was the company's use of daily deals sites like Groupon (GRPN) and Amazon's (AMZN) Livingsocial; however, Chief Executive Jeffrey Housenbold said in a recent Morgan Stanley conference that he's identified a new daily deals strategy, as seen in Shutterfly's fourth quarter earnings.

In the first three quarters of 2011 Shutterfly reported losses, which turned in the fourth quarter, bolstered by a more targeted and analytics-based use of deals sites like Groupon and Livingsocial. [What] changed in the fourth quarter, was the growth and pervasiveness in the daily deal category," said Housenbold of Shutterfly's continued, but changing use of the sites.

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