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American Greetings Corporation (NYSE:AM-OLD)

F3Q09 Earnings Call

December 23, 2008 9:00 am ET

Executives

Greg Steinberg - Treasurer and Director of Investor Relations

Zev Weiss – CEO

Steve Smith – CFO

Analysts

Jeff Stein – Soleil Securities

Carla Casella – JP Morgan

Alan Fournier – Pennant Capital

Charlie Carter – Suntrust

Operator

(Operator Instructions) Welcome to the American Greetings Third Quarter 2009 Earnings Conference Call. I’ll now turn the call over to Greg Steinberg, Treasurer and Director of Investor Relations.

Greg Steinberg

Joining me today on our conference call are Zev Weiss, our CEO and Steve Smith, our CFO. We released our earnings for the quarter fiscal 2009 this morning. If you do not yet have our third quarter press release, you can find a copy within the Investors section of the American Greetings website at investors.AmericanGreetings.com.

As you may expect, some of our comments today include statements about projections for the future. Those projections involve risks and uncertainties that could cause actual results to differ materially from the forward looking statements. We cannot guarantee the accuracy of any forecasts or estimates and we do not plan to update any forward looking statements.

If you would like more information on our risks involved in forward looking statements, please see our annual report or our SEC filings, previous earnings releases as well as our 10-Qs, 10-Ks and annual report are available on the Investors section of the American Greetings website.

We will now proceed with comments from both our CEO and CFO followed by a question and answer session.

Zev Weiss

This morning we will share with you our fiscal 2009 third quarter results. I will briefly discuss a few of the major items that impacted our financial results this quarter, share some comments on capital deployment and lastly I will discuss the impact of the economic environment on our full year earnings outlook.

Before I talk about our overall performance I’d like to discuss a few issues that had a material impact on our third quarter financials. As a result of the recent deterioration in the global economy certain indicators arose during the third quarter, prompting us to review the value of our goodwill and certain other long lived assets. As a result of this review, our third quarter results include asset impairments of approximately $247 million.

Earlier this year we talked about our desire to decrease costs. We worked hard on several projects throughout the year. In addition, on December 9, we announced the elimination of about 275 positions as part of our cost reduction effort. The position elimination was a very difficult decision but necessary to ensure we remain competitive in this challenging economic environment.

We are assisting the affected associates with severance and out placement service. As a result of the severance, we have recognized a charge in the third quarter of about $7 million and expect an additional charge in our fourth quarter also related to the positions eliminated on December 9. We truly appreciate the hard work and dedication these associates have provided and thank them for their efforts.

Our results have been impacted by the downturn in the economy. With decreased foot traffic at retail we saw a decline in revenues for the first time in several quarters. In addition, our margins were also depressed. While our total revenues were down I was pleased that the sales performance within our everyday greeting cards in North America was essentially flat versus a year ago. This is an encouraging sign in the current environment.

The consolidated revenue decline was driven primarily by reductions in our gift packaging products. Over the past few years we decided not to pursue low margin business that would have been pursued in the past years. In addition, we have seen continued softness in demand for seasonal gift wrap.

Operationally the earnings were down from last year. We continue to experience lower yielding sales as a result of mix shift towards lower margin product and increased distribution costs. This deterioration of margins is a continuance of what we spoke about the last two quarters.

You may recall that in the second half of last fiscal year we acquired two digital photo companies as a way to expand our current product offering of online social expressions into the adjacent area of online photo sharing and photo personalized products. Last quarter we talked about an answer to the usability of the website and improvements to the product offering.

Although we worked hard to launch these new products and improve the website the difficult economic conditions have hurt us as third party advertising on our website has been lower than we anticipated and consumers have not purchased as many of the photo personalized products as we expected.

Now let me turn to our sources and uses of capital. First let me address our anticipated sale of a portion of our intellectual property assets, namely our Care Bears and Strawberry Shortcake properties. As it currently stands that specific transaction is delayed as the buyers was able to obtain financing to complete the transaction. Under the terms of the agreement, we now have the right to solicit offers from other parties. As you would expect we are currently exercising these rights. Our goal is to complete the sale this fiscal year.

Let me now turn to uses of capital. Last quarter we announced the purchase of a majority of the distressed first lien debt of another social expressions company, Recycled Paper Greetings, for $44 million. Recycled Paper Greetings is continuing to work to restructure its balance sheet and we have ongoing discussions. Those discussions include the possibility of purchasing them. However, we believe they are investigating a variety of alternatives; therefore we cannot be certain of the outcome at this time.

Another use of capital has been our share repurchase program. In January of this calendar year we announced a $100 million share repurchase program. During the third fiscal quarter we purchased about 300,000 of our shares for about $5 million, completing that $100 million program. Over the last four year we have reduced our diluted share count by 45%. We will continue to assess growth options versus the opportunity to purchase our shares. I should also note that earlier this month we announced a quarterly dividend of $0.12 a share.

Finally, I’d like to talk about our outlook for the full year. Our previous full year guidance of $1.60 to $1.85 of diluted earnings per share and about $60 to $80 million of cash flow from operating activities less capital expenditures is no longer appropriate. There are a number of factors we considered as we have looked at the balance of the year.

From a macro perspective general economic conditions are putting significant pressure on our sales both domestic and international and cutting into our earnings performance more that we previously anticipated. Retail traffic is materially down which affects both our sales through the mass channel as well as our sales through the specialty retail channel. On the internet side of the business our online advertising sales have dropped meaningfully in the last quarter.

As a result of the rapid changes in the economy and the resulting variability to our earnings together with the potential for additional retail store closures and possible adjustments to third quarter estimated goodwill impairment charges in the fourth quarter accurately forecasting future earnings even in the near term earnings is very difficult. As a result of the difficulty in assessing these variables we are currently unable to provide definitive earnings guidance for the balance of this year.

Now let me turn the call over to Steve who will provide a detailed review of the quarter and then we will take your questions.

Steve Smith

I have three components to my prepared remarks today. I will start with comments on several major items that impacted our consolidated results this quarter then I will share a review of our reported segment, finally, a quick walk through a few key components of our financials. We will then open the line for questions.

Overall, our consolidated revenues were down $32 million from last years third quarter or 6.5%. Included in our $454 million of revenue was the adverse impact from foreign exchange of $19 million over the prior years third quarter. Holding aside the foreign exchange impact revenue was down about $13 million which is about 2.6%. However, our operating loss of $222 million was about $264 million lower than the operating income of $42 million in the prior years third quarter.

Goodwill and other asset impairments of $247 million and a severance charge of $7 million drove most of the decrease in operating income. The decrease in operating income was partially offset by lower variable compensation expense of $11 million. Holding aside these three items operating income was about $20 million lower than prior. The remainder of the shortfall is best explained at the segment level.

As Zev mentioned the recent deterioration in the global economy caused us to accelerate the process to review the value of goodwill and other long lived assets. We have completed the preliminary assessment of the goodwill testing and as a result we’ve recorded and estimated impairment of goodwill in both our international and AG interactive segments.

Within our international segment we recorded a charge of $82 million. Within our AG interactive segment we recorded a charge of $150 million for goodwill and $11 million for other intangible assets. These charges represent the majority of the goodwill that was previously recorded in these two segments. While we believe the estimate is reasonable and appropriate, as we conclude the testing over the next few months that it’s possible that we can make an adjustment during the fourth fiscal quarter to these impairment charges.

During the quarter we also reviewed certain assets within our retail segment and concluded that an impairment has occurred. As a result, we recorded an impairment charge for certain long live assets of about $4 million. We are evaluating the retail store base given the significant and recent deterioration of foot traffic in our stores. During the fourth quarter we will be deciding if further store closures are appropriate especially in the US market.

Let me pause here and walk you through at a very high level the charges of this quarter to help you understand our operating performance during the period. I have five components to my verbal bridge. First, we reported an operating loss of $222 million which equates to a loss per share of $4.25. Second, the primary reason for that operating loss is due to the fact that during the quarter we recorded goodwill and other intangible asset impairment charges of $243 million which if carried crudely through to the EPS equates to $4.46.

Third, our retail segment impaired fixed assets of $4 million which equated to roughly $0.06 of EPS drag in the quarter. Fourth, the severance charge of $7 million due to the reduction in force we announced on December 9 is associated with about $0.10 of EPS drag for this quarter. Fifth and finally, the reversal of variable compensation expenses such as bonuses of $11 million gave a lift to EPS of roughly $0.17. If you wanted to look at operating income holding aside these items you would see operating income of about $21 million which equates to about $0.20 of earnings per share.

Now I’ll shift to the second component of my prepared remarks which will be a review of our reported segments. Our North American social expression segments revenues were down about $18 million versus the prior year’s third quarter. The revenue decrease was the result of lower sales in our gift packaging lines. Our North American segments earnings were down $16 million versus the prior year. The decrease was driven by a combination of lower revenues and lower yielding sales including higher content and higher distribution costs.

Switching now to our international social expression segment revenues were $89 million which is up $2 million versus the prior year. The increase was driven solely by the business that we acquired during the first quarter of this year. Segment earnings were down about $91 million quarter on quarter. The single largest factor was the goodwill impairment of $82 million I mentioned earlier.

However, at the segment level there was also about $5 million of foreign exchange impact associated with the goodwill. The remaining earnings decline of $4 million was driven primarily by charges taken as a result of the bankruptcy of one major customer.

Moving from the social expression segments to the retail segment revenues were about $40 million which is down about $1 million compared to the prior years third quarter. Same store sales declined 6.8% during the quarter with the majority of the impact coming during the last month of the quarter. Segment earnings were down $4 million versus the prior year. This decline was driven by an asset impairment of $4 million. While we did have meaningful markdowns in the quarter, this was offset by lower rent expense.

We ended the quarter with 415 doors down 14 doors compared to the third quarter last year. Earlier this year we had forecast closing approximately 25 to 30 stores this fiscal year. Based on our recent performance we now expect to close approximately 60 stores this year. However, even that figure could be increased as we are actively considering a much larger door closure.

As we are actively negotiating with landlords on lease renewal rates we will determine the appropriate number of store doors to close, if any, based in part on the outcome of those negotiations during the fourth fiscal quarter. We will have an update on our store closure decisions in April.

For the quarter our AG interactive segments revenues of $21 million were up $2 million versus the prior year. This revenue increase was the result of our recent photo acquisitions. In addition, we had increased subscription revenue that was offset by lower advertising revenue in our online business unit. Segment earnings were down about $163 million. As I mentioned earlier, this segment recognized goodwill and intangible asset impairments of $161 million. The remaining earnings decline of about $2 million was primarily the result of the photo product line drag on segments performance.

Let me pause here and explain the status of our licensing performance. Licensing revenue for the quarter which was reported in our income statement as other revenue was about $10 million which is down about $1 million versus the prior year. Licensing expenses were about $9 million compared to $10 million in the prior year. For the third quarter the company’s net licensing effort or revenues less expenses was flat with the prior years third quarter at about $1 million.

Now let me move from the segment analysis to the third component of my comments, a review of several of the key components of our financial statements. First, the company’s manufacturing labor and other production costs or MLOPC was flat compared to last years third quarter. While our MLOPC benefited from lower net sales we incurred higher content related costs, higher scrap related costs and about $2 million of severance.

Selling, distribution and marketing costs were also flat versus the prior years third quarter. While our selling, distribution and marketing costs benefited from lower net sales and fewer stores within our retail segment they were offset by severance of $3 million and the asset impairment of $4 million associated with the retail stores. In addition, we incurred higher freight and distribution related costs in the quarter.

The administrative and general expenses were down $10 million versus the prior years third quarter. This decline was driven by a reversal of variable compensation expense of $11 million. Approximately $2 million of severance charges were included in this line item in the quarter.

Moving down the income statement the next item I will address is taxes. Our effective tax rate was 15.5% for the third fiscal quarter. The difference between the statutory rate and the effective rate was related to the goodwill impairment charges. Of the $232 million of impairment charges only a portion is deductible for tax purposes.

Let’s now shift gears from a review of the income statement to take brief look at our balance sheet and then at our cash flow statement. On our balance sheet our net deferred cost decreased about $37 million from $363 million a year ago to about $326 million at the end of the third quarter. The four line items of deferred costs on our balance sheet at the end of the third quarter were:

Prepaid expense $120 million

Other assets $295 million

Other current liabilities $ 61 million

Other liabilities $ 28 million

In absolute terms the deferred cost asset is down over $400 million or 55% from the peak it reached about five years ago.

A second item on our balance sheet that I would like to review is inventory. Inventory is about $7 million higher than the prior year. This increase was caused by an enhanced offering in technology cards and more scanned based trading inventory than in the prior year as more accounts are now under scanned based trading as a model.

Moving to our cash flow statement let us look at capital expenditures for a moment. The company spent about $44 million during the nine month period through November which is about $7 million above the prior year nine month investment of $37 million. The increase is primarily related to new machinery and equipment for our plants in order to make them more efficient.

That concludes our prepared comments for today. I would now like to turn the call over to the operator to handle our question and answer period.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jeff Stein – Soleil Securities

Jeff Stein – Soleil Securities

Can you talk a little bit about financial covenants? In the 10-K you allude to the leverage covenant and interest coverage but there’s no numbers and I’m wondering where you guys are at trailing 12 months relative to the covenants in your revolver?

Steve Smith

We have two covenants, one is a leverage ratio and one is interest coverage. We’ve passed both for the past quarter, the preliminary work that we’ve done.

Jeff Stein – Soleil Securities

Can you tell us what the tests are for leverage and interest?

Steve Smith

Yes, they’re public. Rather than get into the details here we’d be glad to go offline and do that with you. The bottom line is its net debt to EBITDA and then EBITDA to interest coverage.

Jeff Stein – Soleil Securities

In terms of the numbers themselves is the interest coverage 3.2%.

Steve Smith

I prefer not to get into that over the line.

Jeff Stein – Soleil Securities

Can you talk a little bit about the affect of technology cards on your gross margin during the quarter?

Zev Weiss

Speaking to it in general we continue to see sales in technology cards, both cards that are music based but also evolving and do other products as well. I think we’re doing a better job getting arms around how we distribute this to make sure that we’re at least optimizing sales and profits in the distribution. I also think we’re doing a better job on the sourcing side. I know that for going forward I’m sure all that has yet impacted the third quarter numbers.

Jeff Stein – Soleil Securities

Have you been making progress in terms of getting the scrappage rate down on the year on year basis?

Zev Weiss

Yes, I believe we’re doing a much better job in the way we’re distributing the product to do a better job on the scrap rate. Obviously Christmas is going to be an important holiday for that so we’ll see how that goes. We’ll know probably in a week or so.

Jeff Stein – Soleil Securities

On the pending sale of Care Bears and Strawberry Shortcake, if you do not sell the business to Cookie Jar how does that affect the relationship between the two companies because I think if I’m correct there was some litigation and will that be an issue if the deal does not go through?

Zev Weiss

It’s hard to say. It’s probably not right to get into all the details. If it doesn’t go through it remains to be seen as to what’s going to happen.

Jeff Stein – Soleil Securities

Are we correct and assuming that you are committed to moving forward with the sale of that business if it is not to Cookie Jar Entertainment.

Zev Weiss

That’s correct.

Operator

Your next question comes from Carla Casella – JP Morgan

Carla Casella – JP Morgan

A couple of clarifications on the retail impairments of $3.9 million, what line item is that included in?

Steve Smith

Let me give you the detail on that. On the retail the $4 million is in our sales, distribution and marketing line for the quarter.

Carla Casella – JP Morgan

What about the severance?

Steve Smith

The severance is spread out amongst three different line items. Of the $7 million a little more than $1 million is in our MLOPC, a little more than $3 million is in our sales, distribution and marketing, and just over $2 million is in administration and general.

Carla Casella – JP Morgan

Your short term borrowings were significantly higher than last year; do you still expect to pay that down? What was the timeframe you would expect that to come back down to?

Steve Smith

We haven’t forecast the end of the year’s cash balance or cash flow. The historical pattern is for us to be collecting a significant amount of cash here in the fourth fiscal quarter including the month of December which in fact is happening now. We can’t come to a specific figure for you.

Carla Casella – JP Morgan

Do you have to bring that down to zero, is that written in the agreement?

Steve Smith

There’s no cleanup required.

Operator

Your next question comes from Alan Fournier – Pennant Capital

Alan Fournier – Pennant Capital

Could you go through what I’ll call plan ‘B’ is in terms of dealing with short term maturities if the asset sales are not consummated?

Steve Smith

First of all let’s talk about the maturity profile of our different financing instruments. We don’t have anything that’s significant that matures until really 2011. We have an asset backed securitization structure which rolls pretty much every year that’s in the neighborhood of a little less than $100 million. The revolver facility that we have with a group of banks doesn’t mature until 2011. Beyond that the $200 million in senior notes does not mature until 2016. From a liquidity perspective there is a significant amount of time until they mature.

The un-drawn component of our facilities of about $740 million is about $266 million at the end of the last fiscal quarter.

Alan Fournier – Pennant Capital

I thought they were about $248 million of short term maturities.

Steve Smith

No, that’s current portion of long term debt doesn’t mean that they mature. That’s the amount drawn under the revolver and asset backed securitization.

Operator

Your next question comes from Charlie Carter – Suntrust

Charlie Carter – Suntrust

Following up the higher content at higher tech cards remind me in the last quarter what percentage of your overall gift cards sales did the higher content cards represent this quarter?

Zev Weiss

You asked gift cards but you probably mean overall cards, right?

Charlie Carter – Suntrust

Sure.

Zev Weiss

I don’t have the exact number. It’s definitely less than 10%.

Charlie Carter – Suntrust

With the negative mix shift how much of that is the scrappage and how much of it is a structural difference in how you’re able to price those and what the ultimate gross margin could be on those cards relative to just your plain vanilla gift cards that you’re selling?

Zev Weiss

I think what you’re referring to is probably two different issues. One of them as to do with the percentage of cards that are technology related that are either music and/or other things like lights. Depending on the product there is different flexibility around the pricing and how new and how different the product is and that gives you more ability to make sure that you can get the pricing that you need to make the margins.

The other has to do with making sure that our yields, which means really the amount of scrap that we may have in all of our product, whether it’s our everyday product or a seasonal product. I would consider that more within our reach to get, a little bit more structural but within the company’s own reach. That’s something that we’ve been working on for the past six months. I think we’ll be seeing benefits of that in the very near term.

Charlie Carter – Suntrust

If you had to say we’ve got this of the mix shift that’s happening within that segment of the business would you say most of its scrappage related or most of it’s a structural change in the way that or how much that pricing that product can garner in the marketplace.

Zev Weiss

A lot of it is scrap related, its both, it’s related to technology product and to our other products as well. A lot of what we’re trying to do on both products is to make sure that what we ship out actually sells through the register so that we’re not actually taking scrap on it.

Operator

Your next question comes from Jeff Stein – Soleil Securities

Jeff Stein – Soleil Securities

I’m wondering what the remaining goodwill on your balance sheet relates to? Can you talk a little bit about the number of stores where you have lease renewals to negotiate in 2009?

Steve Smith

The goodwill that remains is in the North American social expressions segment. On the retail card stores could you refine that question for me?

Jeff Stein – Soleil Securities

How many leases come up for renewal in 2009?

Steve Smith

I don’t have the figure in front of me. Something in the order magnitude of 50 to 100 would be the number out of the 415 that we have in North America.

Jeff Stein – Soleil Securities

On Recycled Paper Greetings does the weakness that we’ve seen in the economy incrementally since you made this investment or the impairment charge that you took would either of those events either impair your ability or affect your interest in pursuing a combination with the company?

Zev Weiss

There’s not much I can say to comment on Recycled right now. Unfortunately getting to your answer would lead into commenting on it. At this point there’s nothing really more we can say about it.

Operator

Having no other questions at this time I’d like to turn the call back to Mr. Steinberg for any additional or closing comments.

Greg Steinberg

That does conclude the question and answer portion of our conference call today. We look forward to speaking with you again at our fourth quarter earnings release which is anticipated to occur in mid to late April. We thank you for joining us this morning.

Operator

That does conclude today’s call. Thank you for your participation have a good day.

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Source: American Greetings Corporation F3Q09 (Qtr End 11/28/08) Earnings Call Transcript
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