We are lowering our recommendation on the shares of Shutterfly Inc. (SFLY) to Neutral.

Shutterfly’s fourth quarter earnings of 88 cents per share were well ahead of the Zacks Consensus Estimate of 70 cents, driven primarily by better-than-expected growth in revenue. Net revenues were up 22% from the prior-year quarter to $131.1 million.

For full year 2009, Shutterfly earned $5.9 million or 22 cents per share, up from $3.7 million or 14 cents per share a year ago. Revenues were up 15% to $246.4 million.

For the first quarter, Shutterfly expects net revenues in the range of $40.0 million to $42.0 million, an 11% to 17% increase from the prior-year quarter. The company expects to post a loss of 12 cents to 15 cents per share, excluding one-time items. On a GAAP basis, the loss would range from 23 cents to 27 cents per share.

Shutterfly’s business is highly seasonal, with a large proportion of net revenues, net income and operating cash flows being generated during the fourth quarter every year. The company usually reports a loss in the first three quarters.

Increased usage of digital cameras combined with accessibility of high-speed Internet provides significant expansion potential for the company. Product innovation, focus on developing a successful commercial printing business, strategic partnerships with retailers and opportunistic acquisition also augur well. However, these positives are already reflected in the current valuation, leaving limited room for above market gains.

On the downside, we see a continuation of pricing pressure in its printing business. Also, a weak economy and rising unemployment will negatively impact the company’s profitability as consumers’ discretionary spending is expected to be restricted in the near term. Therefore we have downgraded our recommendation to Neutral.

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