American Greetings Corporation (NYSE: AM) designs, manufactures and sells greeting cards and other stationery as well as gift wrap, party goods and giftware. The company has been actively working to grow its digital content business, which includes websites such as eGreetings.com, Cardstore.com, and WebShots.com. The company’s shares have declined ~25% in recent months, despite both top and bottom line year over year growth. It is now trading at less than 90% of book value, and a P/E less than 8x, warranting a closer look.
First, let’s look at its historical performance.
(Click charts to expand)
Here we see that the company has generated relatively lackluster returns over the last decade, hovering in the single digits on a variety of metrics. This is an indicator of the company’s lack of competitive moat and the highly competitive nature of its industry. The greeting card industry is highly competitive, with (according to the company) more than 3,000 companies fighting for a relatively fixed (or, most likely, declining) number of sales. The company discloses information about its customers, and we see that the number of occasions that people exchange greeting cards has declined from approximately ten per year around 2006, to just seven this year, and that the total number of cards purchased each year has also declined. If this trend continues, we can expect competition in the industry to intensify, which would further erode returns. All else equal, it is better to look for companies in less competitive industries, or industries where a dominant position (AM is the second largest company in its industry) is associated with stronger returns.
Before we write the company off as a poor steward of shareholder capital, it is interesting to note that the company’s CROIC, which is based on cash rather than accrual earnings, has been consistently above its earnings-based measures. Further, its CROIC has been relatively robust, in the high teens to low 20s. Sometimes companies have a great deal of non-cash expenses (like depreciation), which artificially reduce earnings-based returns metrics. Let’s take a look at its cash flows.
The yellow line in this chart (on the right axis) confirms that the company’s free cash flow is consistently well above net income (ignore the volatility in the quarterly data). Additionally, we see that the company has relatively low capital demands (the difference between cash flows from operations and free cash flows) and that free cash flow has been relatively consistent, though declining. Last year, the company generated $143 million in free cash flow, as compared with a market cap of just $712 million, indicating a trailing free cash flow yield of ~20%. This is quite impressive, though the negative trend beginning in 2005 is worrisome.
Here we see revenue also declining beginning around 2004/2005. The bulk of this revenue decline is due to declining unit volumes, offset in part by increased selling prices. Part of the decline is also due to the sale of the company’s retail division (which included 341 locations) in 2009 to Schurman Fine Papers, which now licenses AM’s brands. Licensing revenue will be less than the retail revenue, but profitability will be significantly higher, likely accounting for the jump in margins in 2010 and 2011.
AM is quite acquisitive, with business purchases nearly every year for the last decade. This appears to be an attempt by the company to transition into more of an online services company, in order to compensate for the declines in its core industry. One would expect these acquisitions to turn up in increasing revenue but as we see, this has not occurred. The company has spent $187 million in the last seven years, with little to show for it. This is a red flag, and tends to reveal a company focused on the wrong metrics rather than focusing on shareholder value.
Speaking of red flags, there is another related to revenue: customer concentration. The company’s top five customers account for ~40% of revenue, though the top two customers, Wal-Mart (NYSE:WMT) and Target (NYSE:TGT), account for nearly 30% alone. As discussed in many places, customer concentration is a major threat that subjects the company to the risk of significant revenue disruption should major customers find other suppliers, and also acts as an ongoing drag on margins, as major customers are able to exercise significant negotiating power.
Inventories: Understated Value
The company uses LIFO accounting, which understates the carrying value of inventory. The company reports its LIFO reserve to be $78 million as of the last 10-K, which adds about 10% to the company’s reported book value.
Real Estate: Hidden Value?
The company has significant real estate holdings, which are likely worth far more than their carrying value. The company’s owned real estate amounts to 8,930,500 square feet of space. This is held on the books at $187,431,000 gross of depreciation, or around (I am forced to make some assumptions here) $110 million net of depreciation (the figure included on the balance sheet in total assets). This represents around $12.50 per square foot, which is far below the reproduction cost of these properties. The short story is that this is an old company (in operation since 1906) with a significant amount of accumulated depreciation and a low cost basis on many of its buildings. The actual reproduction cost of its owned property could easily be $50 psf, representing significant potential value in the company’s real estate.
Other Assets: A Red Flag
The company has an alarmingly high soft asset account “Other Assets” which makes up 27% of total assets, up from 23% in 2007. The notes to the financial statements suggest that “Other Assets” includes certain deferred costs and a variety of partial ownership interests in different companies. Greater transparency would help the user of these financial statements.
Shareholders: Far From Equal
AM has a dual class share structure. These classes are identical in all respects except for voting; Class A shares carry one vote while Class B shares carry ten votes. The Class B shares are controlled by the Weiss family, either via direct ownership or indirectly through the brothers’ role in administering the Irving I Stone Oversight Trust.
I am wary of companies where parties with a minority economic interest have a majority voting interest. This both reduces the number of potential value-unlocking catalysts, and increases the likelihood of self-dealing. It appears to me that the compensation packages are quite high for a company with such lackluster returns (both in terms of fundamental performance and stock price performance). Moreover, the non-employee board members are generously (overly?) compensated, suggesting it is unlikely there will be a push for change from within the boardroom. From my perspective, it appears this company is run for insiders rather than shareholders.
It is worth noting that the company was involved in a derivative action related to accusations of options backdating, suggesting that my fears of self-dealing are not just theoretical.
With AM, I see a company that generates significant free cash flows but lacks the focus to use these free cash flows in the most efficient manner. This makes it ripe for an acquisition by a more focused acquirer (LBO shops should take note of its significant free cash flows and mature industry). If not for the dual class share structure, AM would be a perfect target for an activist hedge fund. Unfortunately, there is no evidence the former will happen and the latter cannot happen until they change their share structure (a highly unlikely event). Translation: an investor today is likely to witness continued lackluster returns as the industry continues to contract, and further shareholder capital wasted on acquisitions as management attempts to transform itself into a technology company. For this reason, I ignore the value I see in the company’s real estate and free cash flows.
What do you think of American Greetings?
Disclosure: No position