Zev Weiss – Chief Executive Officer
Steve Smith – Chief Financial Officer
Gregory Steinberg – Director Investor Relations
Jeff Stein - Soleil Securities
American Greetings Corporation (AM-OLD) F2Q10 Earnings Call September 24, 2009 9:00 AM ET
Welcome to the American Greetings Corporation fiscal second quarter 2010 earnings conference call. Today’s conference is being recorded. At this time I would like to turn the conference over to Mr. Gregory Steinberg. Please go ahead sir.
Good morning everyone and welcome to our second quarter conference call. I’m Greg Steinberg, the company’s treasurer and I help manage our Investor Relations. Joining me today on the call are Zev Weiss, our CEO; Jeff Weiss, our COO and Steve Smith, our CFO.
We released our earnings for the second quarter fiscal 2010 this morning. If you do not yet have our second quarter press release, you can find a copy within the investor section of the American Greetings website at www.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 investor 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.
Thank you Greg and good morning everyone. Today I’ll cover three topics. First I will share my thoughts on our fiscal 2010 second quarter including some of our new product offering. Second, I’ll provide a brief update on the integration of Recycled Paper Greetings and Papyrus, and finally, I’ll share a few directional comments on our outlook for the balance of fiscal year 2010. Steve will then present more details behind our second quarter financial results.
I’m thrilled with our quarterly performance as our $0.59 of earnings per share is a record level for us in the second quarter. In addition, our year to date cash flow from operations, less capital expenditures of almost $70 million has exceeded our expectations. I believe that the strategic investments we have made over the last several years to enhance our leadership position in a greeting card category have contributed to the improvements in our performance. We’ve devoted more time and effort needed to develop new products so that consumers can find unique and fresh offerings that resonate with them when they shop the greeting cards aisle. While we are constantly introducing fresh and new products, I’m particularly excited about the innovative ways we have found to utilize technology in our greeting cards. Over the past couple of years, we have added music to greeting cards, but that was only the beginning.
We have now expanded our use of technology to encompass additional formats to further engage the consumer. Specifically, we have developed greeting cards that we affectionately refer to as Talking Heads. This patent-pending product encourages the consumer to pull down a flap that looks like a person’s chin and hear a humorous message.
We have also introduced recordable reading cards that allow the consumer to personalize the greeting card by adding their own voice message, and we recently rolled out greeting cards with a combination of light, sound, and action all packed into a single card. These light, sound, and action greeting cards are multi-century as they feature high-quality audio-synchronized with light and small motions to engage multiple senses and really wow the card recipient. These examples of leadership and innovation are all in addition to the recent companies we added to our portfolio. The acquisitions are Recycled Paper Greetings and Papyrus. RPG and Papyrus complement our leadership in innovation with leadership in humour and elegant design.
In addition to the innovation with our core greeting card product, we have also been busy within our AG Interactive Online businesses.
We introduced an application for the iPhone where users can browse, personalize, and send electronic greeting cards or e-cards to anyone with an e-mail address. This app recently became one of the top ten entertainment offerings on iTunes, an amazement accomplishment given the tens of thousand of applications currently in circulation.
Another example of innovation within our AG Interactive segment is a unique service on our website that give shopper’s the ability to send high-quality e-cards directly to Facebook accounts. Obviously, we have introduced many new products across multiple media and distribution channels. More importantly, we have enhanced our focus on developing fresh new products and look forward to sharing them with consumers to help them express, connect, and celebrate life’s special moments.
Switching gears from innovation to integration, last quarter, I spoke about our acquisitions of Recycled Paper Greetings or RPG and Papyrus. Recall that these best in class product lines are an integral part of our strategy to satisfy the full range of consumer needs. We intend to keep RPG and Papyrus separate in order to protect what makes their products unique while looking to leverage the scale of the broader organization.
We have assembled teams who have been working on the integration plan including the identification of savings opportunities. We have sharpened our pencil on both the integration cost as well as the future run rate contribution to earnings. Our preliminary estimate of one-time cash cost is currently about $20 million of which a few million is expected to spent this fiscal year with the balance paid over the subsequent twelve months.
Regarding the future contribution, last quarter we said we expected to realize an annual run rate contribution to operating income from the two acquisitions of at least $15 million. As we have crystallized our integration plan, I’m pleased to share that we now believe that we can achieve a run rate contribution to operating income of $15 to $20 million annually. We expect the integration to occur over the next 18 months.
During our last quarterly call, we shared with you some thoughts about our outlook for this fiscal year. We previously estimated cash flow from operations less capital expenditures could exceed $70 million. Given our very strong performance year to date and our outlook for the balance of the fiscal year, we now expect our full year cash flow from operations less capital expenditures to exceed $125 million. The $125 million includes the projected benefits from working capital, deferred cost, and taxes as well as this year’s anticipated cash cost associated with the two integration efforts. In addition, we now expect our capital expenditures to be around $35 million.
Some economists have gone on record as saying the recession is over, but we believe it is yet to be seen, so it is not clear what effect the recession is going to have on the second half of our fiscal year, but it is clearly possible that it could dampen demand. Remember, we have a seasonal business where the second half of the fiscal year as our two biggest holidays, Christmas and Valentine’s Day, but we have a lot of work ahead of us. I would like to take a moment and recognize the efforts of our associates. We couldn’t have achieved our current results without their teamwork and commitment.
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.
I have three components to my prepared remarks today. I will start with some comments on a few large items that impacted our consolidated results this quarter. Then, I will share a review of our reported segments. Finally, a quick walk through a few key components of our financials. We will then open the line for questions.
Our consolidated revenue of $356 million was down about $29 million or 7.6% from last year’s second quarter revenue of $386 million. However, included in our reported revenue this quarter was the adverse impact from foreign exchange of $14 million versus the prior year’s second quarter. So, holding aside the foreign exchange impact, revenue is down about $15 million or 4%. About $4 million of the $15 million decline was the result of the net revenue lost due to the combination of the divestiture of the retail business offset by the revenue pickup from the Recycled Paper and Papyrus acquisitions.
Holding aside the impact of foreign exchange and the net impact of the acquired and sold businesses, revenue is down $11 million or about 3%. Our operating income of $38 million was $34 million higher than the operating income of $4 million in the prior year’s second quarter. However, this year’s operating income included a benefit of $7 million associated with a legacy corporate owned life insurance program.
Focusing on operating income and holding aside the insurance benefit, our operating income improved about $27 million versus prior. This positive variance of $27 million is mostly within the North American Social Expression businesses and is therefore best explained at the segment level.
So, let me now shift the second component of my prepared remarks which will be review of the reported segments and how they differ from the prior year’s results. Note that we no longer have a retail operation segment as we divested this business during the first fiscal quarter. For your information, in a prior’s second quarter, the retail operation segment reported revenues of about $35 million and a segment loss of approximately $7 million.
Our North American segment’s revenues of $267 million were up near $24 million or about 10% versus the prior year. The revenue increase was driven by the benefit of $30 million of RPG and Papyrus revenues which we did not have last year. Holding aside the benefit from the acquired companies, revenues were down about $6 million or 2.6%.
During this quarter, we had lower sales from non-card product lines particularly within our gift packaging product line. Our North American segments’ earnings were up $20 million versus the prior year. The improvement was driven by a combination of improved yield and the realization of cost reduction initiatives put in place near the end of our last fiscal year.
Improved yield means that we reduced excess volumes in the system by producing a more precise mix of what consumers desire, and as a result, the company yielded sourcing and manufacturing efficiencies. We expect many of these improvements to continue through the balance of the year, although content-related costs many fluctuate as we develop the innovative new products that is described.
Switching now to our international segment, revenues were about $46 million, which is an increase of $2 million versus the prior year. This increase was driven primarily by improvement in our non-card product sales. Segment earnings were up $3 million quarter on quarter driven by lower expense due to the cost reduction initiatives implemented during the prior fiscal year and less bad debt expense. However, we remain cautious about the general economic conditions in the UK which may put pressure on our international performance for at least the balance of this fiscal year.
Let me know move from the social expression segments to our interactive segment. Revenues were $18 million, which is down about $2 million versus the prior year as advertising revenue continues to be depressed. Segment earnings were up about $1 million. The improvement is related to the cost reduction efforts taken late last year along with less intangible asset amortization as there was an impairment of intangible assets in this segment during the last fiscal year.
I am now going to shift from the analysis of our segments to briefly comment on the status of our licensing performance. Licensing revenue for the quarter, which is reported on our income statement within other revenue, was about $8 million or down about $5 million versus the prior year. Licensing expenses were $7 million this year compared to almost $12 million last year, so for the second quarter, the company’s net licensing effort or revenues less expenses was relatively flat compared to the prior year’s second quarter.
Now, let me move to the third part of my comments today or review of several of the key components of our financial statements. The company’s manufacturing labor and other production costs or MLOPC were down about $17 million compared to last year’s second quarter. While nearly one third of our MLOPC improvement was from foreign exchange, we also benefited from efficiencies as a result of improved yield, specifically lower volumes and lower scrap costs compared to last year.
As we discussed last quarter, our supply chain continues to operate more efficiently as we reduced excess volumes in the system. Selling, distribution, and marketing costs were down about $37 million versus the prior year second quarter. In this line item, you plainly see how the portfolio changes since February have altered our financial statements.
About 40% of the reduction in SD&M was the result of the combination of exiting our retail store operations partially offset by the acquisitions of RPG and Papyrus. Another 25% was related to improved yield and cost reduction efforts. About 20% was associated with favorable foreign exchange and finally about 10% was related to the reduced expenses within the licensing effort that I mentioned a few moments ago.
The administrative and general expenses were down $8.7 million versus the prior year second quarter. This reduction was principally due to the $7 million insurance benefit I mentioned earlier. The balance was driven by favorable foreign exchange.
Moving down the income statement, the next item I will address is taxes. Our effective tax rate for the quarter was 32.2%. The lower than statutory effective tax rate was do the $7 million insurance benefit which is non-taxable.
Let me now shift gears from a review of the income statement to take a brief look at some components of our balance sheet. On our balance sheet, accounts receivable were about $15 million higher than the prior year. The increase is primarily related to the acquisitions of RPG and Papyrus. Despite the fact that the acquired and sold businesses were almost revenue neutral because their businesses were wholesale business models while the divested business was a retail operation, our balance sheet will carry more AR going forward.
Inventories decreased by $52 million compared to the prior year. While our accounts receivable increased due to the transactions, our inventory decreased due to the transactions. As the business sold was a retail business, we eliminated a much higher inventory position than we acquired with RPG and Papyrus. Just over 40% of the inventory reduction was the result of the sale of our retail store operations, only partially offset by the acquisitions of RPG and Papyrus. The balance of the decrease versus last year is the result of more efficient inventory management across almost all of our product lines.
Our net deferred cost decreased $26 million from $320 million a year ago to $295 million at the end of the second quarter. The four line items of deferred cost on our balance sheet at the end of the second quarter were prepaid expenses of $96 million, other assets of $254 million, other current liabilities of $53 million, and other liabilities of $2 million.
The last item I would like to comment on is accounts payable. Accounts payable were down about $29 million at the end of the quarter compared to the prior year. About one half of the reduction is a result of lower spending. About $4 million was the net effect of the sale of our retail store operations, partially offset by the acquisitions of RPG and Papyrus. The balance is simply timing of some of our payments.
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.
(Operator Instructions) Your first question comes from the line of Jeff Stein with Soleil Securities.
Jeff Stein – Soleil Securities
First of all, if you could just talk a little bit about where the upside is coming from relative to your internal forecast because clearly in the first quarter, you had great improvement gross margin, not quite as good in Q2, I guess probably because of the Canadian issue you had in Q1 last year, but it seems that on the selling, distribution, and marketing line there is some geography issues with regard to the disposal of retail and acquisition of RPG and Papyrus, but away from that, where is the upside relative to expectations, and then if you can also address the issue on your free cash flow revised guidance, is most of the improvement that you’re seeing relative to where you thought, is it mainly net income related or are there also some working capital and tax issues that had not been contemplated previously?
Jeff, I would say that when you look at the performance relative to expectations, I think it would be pretty much what you’re probably thinking. In terms of sales, it’s a bit better than we expected, and if you look it from a year over year perspective, they’re hanging in there very nicely, and in this environment, that’s pretty good especially given some of the things we were seeing towards the end of last year, so I think we are very pleased with that, and we think that a combination of product work that we are doing in our core lines as well as the innovation products is really helping us on a topline basis, and then from a bottom line perspective which is probably what’s generating the impact, it is the cost savings some of which when you think that perhaps things are going to be a bit softer, you really watch your cost, and when the revenues come through just fine, you get the extra benefit of the gross margin, but if you’re watching your fixed cost as well, you get basically a double benefit, and I think that’s what’s going on. The group is doing really a great job on the product side, and they are watching their costs really hard, and the combination of the two is the having the effect on the earnings, and I think that’s a big part of what’s driving the cash flow. There is some benefit. Obviously, you look at what’s happening year to date, we’re hoping that there will be some benefit on the balance sheet side and on the tax side, but the net income is clearly going to help the free cash flow as well.
Jeff Stein – Soleil Securities
Would it be fair to say that of the $50 million bump that you are providing from a guidance standpoint and cash flow, most of that will be net income related?
A large portion of it is Jeff. Not all of it. There are some tax benefits to the upside. We’d rather not comment on the specifics behind taxes and working capital and deferred cost, but net income clearly is a significant boost to free cash flow. We’re picking up a bit from taxes.
Jeff Stein – Soleil Securities
Steve, where do you see the tax rate for the year?
We haven’t forecasted publicly. There is a combination of different activities for tax planning. They are still in the works. It is likely to be lower than our statutory tax rate of about 38.5%, but we don’t want to predict the exact figure.
And at this time with no further questions in the queue, I’d like to turn the conference over to Gregory Steinberg for any additional or closing remarks.
Well, that does conclude the question and answer portion of our conference call today. We look forward to seeing you or speaking with you again at our third quarter conference call which is expected to occur in late December. We thank you for joining us this morning, and that does conclude today’s call.
This concludes today’s conference, we appreciate your participation.
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