Shutterstock Inc (NYSE:SSTK) Danger Zone

Shutterstock SSTK

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The adage ‘content is king’ is true more so now than perhaps ever before. Media companies crave unique content, individuals can create content easier than ever before, and consumers can access content through a multitude of outlets. However, not all content is created equal. Original content, whether it be videos, images, or both, while costly, can be highly profitable. On the flip side, redistributing others’ content is not only undifferentiated, but also not a winning business strategy. This firm’s content redistribution platform, coupled with declining profits and overvalued stock price land Shutterstock (SSTK: $55/share) in the Danger Zone.

Revenue Growth Hides Profit Decline

Shutterstock’s economic earnings, the true cash flows of the business, have declined from $34 million in 2012 to $23 million in 2015, or -12% compounded annually. This decline comes despite revenue growing from $170 million in 2012 to $425 million in 2015, or 36% compounded annually. Figure 1 highlights the disconnect between revenue and cash flows. See the reconciliation of Shutterstock’s GAAP net income to economic earnings here.

Figure 1: SSTK’s Profits Decline Despite Revenue Growth

NewConstructs_SSTK_RevenueVsEconEarnings_2016-08-01

Sources: New Constructs, LLC and company filings

Such impressive revenue growth doesn’t seem so impressive when one realizes it’s a byproduct of unsustainable spending. Since 2012, while revenue has grown 36% compounded annually, R&D, sales and marketing, and G&A expenses have grown 36%, 33%, and 42% compounded annually respectively. Cost of revenues has grown 39% compounded annually over the same time. Essentially, revenue growth fails to outpace the cost to grow that revenue, which is not a sustainable long-term strategy.

Over the past three years, Shutterstock has generated cumulative -$48 million in free cash flow. Additionally, the company’s return on invested capital (ROIC), which was once an astounding 899%, has fallen to 34% over the last twelve months.

Executive Compensation Won’t Fix Issues

Shutterstock’s CEO receives only $1 in base salary, a fact that taken at face value would seem like a quality compensation plan. However, no one works for free. In lieu of salary, SSTK’s CEO was granted stock options that are only exercisable if SSTK trades at or above a set target price. Incentivizing executives solely with stock price can have damaging effects, as business decisions can be made only to drive stock price appreciation with little regard to the long-term economic success of the business.

In fact, in a 2015 study, the number one reason cited as to why companies misrepresent earnings was to influence stock price. The larger takeaway from the study was that 20% of companies misrepresent earnings in one way or another. Create an incentive that can be achieved throughaccounting tricks and loopholes, and humans will exploit it. Apart from the CEO, other executives receive annual bonuses for the achievement of revenue and adjusted EBITDA goals. As seen in Figures 1 and 2, revenue and adjusted EBITDA do not accurately measure shareholder value creation. In fact, each of these metrics is rising while economic earnings are in decline. The best way to create shareholder value, and align executives with the best interest of shareholders, is to tie performance bonuses to ROIC because there is a clear correlation between ROIC and shareholder value. Until changes are made to the executive incentives at SSTK, expect further shareholder value destruction.

Non-GAAP Metrics Soar While Profits Decline

Investors need to understand there are inherent risks when analyzing and relying on non-GAAP metrics. For proof, look no further than Shutterstock’s use of non-GAAP. Here are expenses SSTK has removed when calculating its non-GAAP metrics, including adjusted EBITDA and non-GAAP net income:

  1. Write off of property & equipment
  2. Non-cash equity based compensation
  3. Acquisition related amortization expense

These costs have a material impact on results, particularly equity based compensation, which is a real cost of business. In 2015, SSTK removed $18 million net of tax (96% of GAAP net income) in equity-based compensation to calculate its non-GAAP net income. By removing this large expense, along with others, Shutterstock reports non-GAAP metrics that are much improved from economic earnings, and also trending upwards while economic earnings decline. Adjusted EBITDA grew from $35 million in 2012 to $85 million in 2015, or 34% compounded annually. Over this same time, non-GAAP net income grew 16% compounded annually while economic earnings declined 12% compounded annually, per Figure 2.

Figure 2: SSTK’s Misleading Non-GAAP Metrics

NewConstructs_SSTK_Non-GAAPvsEconEarnings_2016-08-01

Sources: New Constructs, LLC and company filings

Content Delivery Does Not Provide High Margins

Similar to video content providers like Netflix or Hulu, Shutterstock faces competition from a litany of different outlets. A non-exhaustive list of online image distributors includes iStockPhoto, owned by Getty Images, Fotolia, owned by Adobe (ADBE) Dreamstime, or 123rf. Getty Images and Corbis Corporation are staples of the traditional stock image providers. Further fragmenting the market, image hosting sites such as Flickr, owned by Yahoo (recently acquired by Verizon (VZ)), Photobucket, or even Facebook (FB) offer images for licensing. This list does not include traditional photographers that may be hired for a specific client request.

A content distribution platform provides few barriers to entry, as seen in the numerous competitors, and, apart from pricing, provides little opportunity for differentiation. Such commoditization of content would not be a problem if Shutterstock already had greater profitability than that of its competition, However, it does not. When comparing margins with Adobe, we see that the benefits of selling an actual product (Adobe’s Creative Suite) reveal themselves in superior margins. Apart from ADBE, the companies in Figure 3 may not seem like direct competition, but each of them offers images for license through a captive service. The high profitability of each illustrates the uphill battle facing Shutterstock, particularly in regards to pricing power.

Figure 3: Shutterstock’s Margins Lag Larger Competition

NewConstructs_SSTK_ROICcomparison_2016-08-01

Sources: New Constructs, LLC and company filings 

Bull Hopes Rest On Differentiated Content Delivery Platform

The largest bull case around SSTK revolves around its ability to continually grow its content library, attract more users, and ultimately be the leading stock image provider on the web. Once it reaches this scale, bulls would argue that the company could cease the massive spending that is currently ongoing, and become highly profitable.

The biggest issue with this argument, and any bull case around Shutterstock, is that adding undifferentiated content is a process that only stops if you can provide unique, original content. A middle man content delivery platform will not ever generate significant profits. If this situation sounds similar, its because we’ve long been alerting investors to the downfalls of this business strategy at Netflix. Without costly original content, Shutterstock is reliant upon other entities (photographers) to populate its main service being provided (stock images). A content delivery platform is not particularly hard to create, as noted by the many different online image services.

Without exclusive rights to images, Shutterstock has no “leg up” on other image providers either. Content creators are free to submit their work across numerous platforms which

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