The Sky-High Valuations of Shutter Stocks

Two of the most remarkable runs in the current market are Shutterfly and Shutterstock . Not only do the companies deal in photo books and digital images that appear to offer nothing proprietary, but the stocks also trade as if the companies are leading a revolutionary change.

Investors naturally get excited about the brand recognition possibilities and the cloud services offered to consumers to create irreplaceable lifetime products. The question is if the services offer any sort of moat that prevents competition from easily replicating the products. The hope from investors is that once consumers join the service, they won't stray to other websites.

Another interesting dynamic is that investors are evidently willing to overlook the tough margins suggestive of heavy competition, yet other related stocks such as CafePress and Vistaprint are clearly affected by the difficult business climate.

Good to be a "shutter" stock
Initially, it's easy to understand why investors are getting exited over the shutter stocks. The online and cloud-based offerings allow unlimited consumers to purchase from the site, making Shutterfly the social site for creating photo books. The theory is that consumers will flock to the site in similar ways as Facebook or Twitter, photos will be shared, and products will be ordered over and over. Once consumers upload photos, they'll continuously return to the site and Shutterfly will draw massive numbers of repeat customers.

If one searches the internet for a photo book, Mixbook and Blurb, along with Walgreen, quickly pop to the top of the results. Does Shutterfly offer any advantage over these competitors other than spending massively on marketing? After all, the company spent more than 60% of the gross profit on sales and marketing in the last quarter.

While first-mover advantage and size will make a difference, ultimately the differentiating factor will be pricing and product offerings. In that essence, the ability to drive attractive margins could be severely hampered by the ease of setting up a new competitor via cloud services that require limited capital investments.

Weak margins tell the story
Both Shutterfly and Shutterstock offer investors profitable companies , but neither one is able to expand margins due to what must be intensive pricing pressure from competitors.. Even more concerning is that revenue growth isn't that spectacular for either stock, yet both stocks trade at massive earnings multiples.

Shutterfly saw a decline in its gross margin from 49% last Q2 to 46% for the current year Q2. This drop, combined with higher operating expenses, led to a larger loss from operations.

Shutterstock provides digital images for commercial use, such as the recent collaboration with Facebook, which allows advertisers to access the images for creating ads on the leading social network. The company has a solid gross margin at 62%, but the numbers have stalled. The good news is that it is generating higher income from operations, with the operating margin hitting over 19% from slightly more than 15% in Q2 last year.

Are T-shirts or business cards any different?
Both Vistaprint and CafePress have been hit with the reality that the ease of selling these products on the internet also makes it extremely easy for competition to pop up. Even with these companies offering services that provide a level of brand recognition over new entrants into the market, neither company has the ability to charge a premium price and remain in business.

While Vistaprint is solidly profitable and a dominant player in the online-marketing products space, investors are only willing to award the company with a $1.8 billion market value, even with the gross margin higher than Shutterfly and Shutterstock. While the gross margin has been stable at around 64%, the need to spend on operating expenses has kept net income in check.

CafePress has faced even more pressure, with the stock sitting near all-time lows. The online provider of custom t-shirts is struggling to generate enough growth to increase profits. In the latest quarter, the gross profit margin dropped to 38.7%, compared to 41.5% in the second quarter of 2012. As a consequence, the company lost money this year after making a profit last year.

Bottom line
. Unfortunately, the story probably won't end well for Shutterfly and Shutterstock. These stocks won't be the Pets.com of this decade, but the valuations are too far out of whack with the long-term earnings potential in a highly competitive market. Current investors might not see positive returns from these levels after strong stock gains this year.

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The article The Sky-High Valuations of Shutter Stocks originally appeared on Fool.com.

Mark Holder and Stone Fox Capital Advisors, LLC have no positions in any stocks mentioned. The Motley Fool recommends Vistaprint. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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