At lunch on a recent afternoon in Silicon Valley, Shutterfly CEO Jeffrey Housenbold is remarkably upbeat, considering the miserable year the overall photo business is having.

Almost any way you slice it, people are making fewer glossy prints in a rough economy. The numbers are off for at-home printing (down 2%), photo-counter printing (down 6%) and kiosk printing (down 12%), according to the Photo Marketing Association. The only big growth category? The under-the-table printing that people do for free at work. (That’s up 42%.)

Fortunately for Housenbold the photo recession hasn’t hit online photo finishers like Shutterfly as hard as some other parts of the industry. In fact, Shutterfly and rivals like Eastman Kodak’s (EK) Kodak Gallery and Hewlett-Packard’s (HPQ) Snapfish are still growing – partly because they’ve embraced ideas like photo books, social networks and smartphones to push their business beyond the old-fashioned glossy print.

The expansion beyond prints isn’t new, but it’s accelerating.

Though photo sites have offered items like custom books, and stationery for nearly a decade, those items have recently become a major driver of sales. A few years ago, Shutterfly got 80% of its revenue selling prints. Last year it was just 39%.

“The 4×6 print has evolved,” Housenbold says. “Now it’s a photo book.”

Say goodbye to that box of unsorted photos

It should come as no surprise that 4×6 prints aren’t exciting anymore. They’re commodities that sites often sell for little or no profit in hopes of attracting new customers. Plus, though they have long been a mainstay of family photo albums and shoeboxes, loose prints are a pain to manage and store; bound photo books are far easier to handle, and far more profitable.

That sea change is critically important for Redwood City-based Shutterfly. Unlike some of its rivals, which are subsidiaries of large companies with healthy war chests, Shutterfly is a standalone public company. If its business depended on simply selling 4×6 prints cheaper than the competition, it wouldn’t stand a chance.

As more complicated items like photo books gain popularity, Housenbold and his team are under pressure to dream up new ways to attract customers and entice them to spend more money – a challenge that the former eBay executive relishes.

One way to do that is to make photo books less intimidating. Surveys show that most people who start making one abandon the process before it’s printed – a simpler process could be worth millions in added sales.

With that in mind, Housenbold challenged his engineers to invent a way for consumers to make a photo book in less than 5 minutes for less than $15. They came up with Simple Path, a service that automatically lays out digital photos on photo book templates, saving customers the hassle of organizing a book themselves.

It’s an approach that analysts applaud. “The core consumer is likely to be a time-starved mom who may even get a guilty conscience about not printing,” says Liz Cutting, imaging analyst at NPD Group. “If you can make it easy, you will be her savior.”

Web-only albums?

Housenbold is also chasing customers who might not want to print at all – at least, not yet. In this age of cell phone cameras and social networks, there are more and more of those: The percentage of camera owners who don’t bother printing rose from 19% in 2007 to 24% last year, Cutting says. (NPD is readying this year’s survey, and she wouldn’t be surprised to see the percentage of non-printers rise again.)

To hook those customers, Shutterfly has embraced social networking. New closed groups on the site allow people to share photos with a specific circle of acquaintances – say, a Little League team or an elementary school class – rather than share everything with everyone. Housenbold says the feature is proving to be an effective way to attract customers who might otherwise use a competitor’s service.

Housenbold has some other plans to attract younger users who are likely to avoid printing and simply upload their photos to Facebook. He says Shutterfly will soon experiment with simple gifts young people can send each other in the mail, and might even dive into the market for “virtual goods” – digital items that people can buy and exchange in social networks.

But in the short term, he’s focused on the last three months of the year, Shutterfly’s make-or-break season. Not only does Shutterfly do more than half of its annual sales in the fourth quarter, it does more than a third in the three weeks after Thanksgiving, as people use the service for holiday cards and photo book gifts.

Lately Housenbold seems to be feeling optimistic. The last time Shutterfly reported earnings, he said to expect full-year sales of between $205 million and $220 million, a sunnier outlook than he gave three months earlier. Can he hit those numbers? We’ll see – but the photo industry could certainly use the good news.