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American Greetings Corporation (NYSE:AM-OLD)

F3Q08 Earnings Call

December 20, 2007 9:00 am ET

Executives

Gregory M. Steinberg – Treasurer & Director of Investor Relations

Zev Weiss – Chief Executive Officer & Director

Stephen J. Smith – Chief Financial Officer & Senior Vice President

Analysts

Jeffrey S. Stein – KeyBanc Capital Markets, Inc.

Kathleen Reed – Stanford Financial

Brian M. Delaney – EnTrust Capital

Dax Vlassis – Gates Capital Management

Operator

Good day and welcome to the American Greetings third quarter 2008 earnings conference call. (Operator Instructions) I would like to turn the call over to Mr. Greg Steinberg. Please go ahead sir.

Gregory M. Steinberg

Good morning everyone and welcome to our third quarter conference call. I’m Greg Steinberg the company’s treasurer and joining me today on the call are Zev Weiss our CEO and Seven Smith or CFO. We released our earnings for the third quarter fiscal 2008 this morning. If you do not yet have our third quarter press release you can find a copy within the investor’s section of the American Greetings website atinvenstors.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 risk involved in forward-looking statements please see our annual report or our SEC filings. Previous earnings releases as well as our 10Qs, 10Ks 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. Zev?

Zev Weiss

Good morning everyone. I am pleased to share with you today our fiscal 2008 third quarter results. During the third quarter we continued to see improved performance at retail as a result of our card initiatives. We realized improved gross margins as we continued to effectively manage our supply chain costs and we announced two acquisitions in the digital photo space.

I will comment on three broad topics today. Our strategic card initiatives, our capital deployment including our recently announced acquisitions and our full year outlook. I am pleased with our card performance in North America this quarter. The positive performance we experienced during the first half of this year has continued into our third quarter in many of the doors that we reset over the past 18 months. The consumers and the retailers response to our strategic card initiatives was strong during the first half of the year and continues to be positive. I am pleased with the overall feedback we have received as many of the retailers have been delighted by the improved product appeal and consumers are responding as well. We continue tracking towards the return hurdles we had hoped for and each successive quarter showing improvement in consumer response.

Our ongoing consumer research continues to provide us with insights that are being reflected in our products. While consumer based research is not new we’ve pushed the application of the research to the next level. We’ve dug deeper, conducting additional testing, looked at generational shopping habits and examined the overall card shopping experience. Now, key learning’s and best practices are being integrated into our product lines and being delivered to our customers through their retail experience.

To give you an example of how this consumer based research is being delivered at retail let me explain how we are adjusting just one line of cards; humor cards. Funny cards continue to be a staple in our card line. Our newest cards reflect photo humor, real life situations and distinguish between what women think is funny and what men think is funny. We have and will continue to leverage the insights we’ve gained from our research into our future card programs.

Let me take a step back from the consumer research and share with you some perspective on the overall investment in scanned based trading and the strategic card initiative. Two years ago we expected the investment to be approximately $100 million over a two year period. We now see that total tracking towards $110 to $115 million. As a result we are expecting the impact this fiscal year to include an incremental $10 to $15 million investment over the $36 million we originally anticipated. The expected increase is being driven entirely by scanned based trading conversions.

We experienced a delay in scanned based trading conversions during the third quarter versus our internal expectations driven primarily by the effort to properly coordinate the technical aspects with our retail partners. While the scanned based trading technology is new for many of them our teams are working together to finalize the data exchange required. As a result we expect to see a meaningful scanned based trading impact in our fourth fiscal quarter. However, if the technology exchange is not completed during the fourth quarter we expect that some of the expenses associated with scanned based trading will occur in the first quarter of next fiscal year rather than this year’s fourth quarter.

Now I’m going to shift gears from a review of our card initiatives to an update on our several capital deployment activities. These activities have included our recently announced acquisitions, our information systems refresh effort and the share repurchase program.

During the third quarter we announced the acquisition of WebShop and the intent to acquire PhotoWorks two Internet based digital photo sharing businesses. WebShops is one of the largest online photo sharing sites on the Internet with more than 7 million unique visitors monthly. PhotoWorks is a leading online personal publishing company that allows consumers to use their digital images to create quality photo personalized products like greeting cards, calendars and photo books. The acquisition of WebShops has given us access to many more potential online customers. PhotoWorks offers production capabilities that position us for a comprehensive photo strategy bringing together both digital and physical products. The acquisition of PhotoWorks is expected to close in mid to late January, 2008.

While we have a lot of integration to accomplish over the next year our strategy to bring together the strengths of both sites then leverage the users across all of our websites. By having consumers using all of our sites we will also have the intentional collateral benefit of enhancing our online advertising model. Further into the future we will explore ways to leverage our own retail stores and bring the conversions of digital photos and physical products to our retail partners.

That is our vision. Now let me speak about the near term realities. Additional costs will be incurred to reposition the two acquired sites and their brands. We are currently working through our plans on how to reposition offerings and the specific investments that we will make in the future and have not reached a conclusion on the band around these costs. Again, the PhotoWorks transaction is not expected to close until later in our fourth quarter.

As you may recall earlier this year we provided a wider band than typical for us for our capital expenditures this year due to our expected increased spending on information systems. We have made a few decisions in this area of spending as we focus in on three strategic components of investing in information technology. One, replacing outdated systems; two, driving efficiencies within the business; and three, adding new capabilities. We will roll out these three strategic components in a serious of phases or waves over a seven to ten year period. Some of the cash outflow will be expenses immediately and some will end up on our balance sheet and be expensed at a later date.

You may have noted that our capital expenditures year-to-date are higher than the prior year. While there are several pluses and minuses in how we deployed this capital versus last year one of the larger incremental items was the selection and purchase of our first large piece of the software and that expenditure is reflected in our year-to-date capital expenditures. We expect to provide additional clarity regarding next year’s investment on information systems in the spring.

Shifting to our share repurchase activity during the third fiscal quarter the company purchased approximately 1.7 million shares of its Class-A common stock for about $41 million under the $100 million share repurchase program we launched this past April.

My last topic is our guidance for this fiscal year. We are still on target to meet our projected earnings per share goal of $1.35 to $1.55 and about $125 million of cash flow from operating activities less capital expenditures. With upside to these estimates depending on several items. There are a couple of major factors that could impact the first quarter. The first is the [inaudible] of the strength or weakness of the holiday season. The seasonality of Christmas is a risk to our performance every year and face this risk both domestically and internationally. However, given changes in consumer buying patterns both domestically and internationally it has become even more difficult to predict Christmas performance for many of our business units. T

The second major factor affecting this year’s performance is the pace of the roll out of our card initiatives. We have a significant amount of activity planned for the fourth quarter. Most of which is already underway. These activities include both scanned based trading conversions and various programs still to be rolled out for our strategic card initiatives. Our ability to execute all these items during the remainder of the fourth quarter is key to our full year performance and our ability to stay within the estimates. Note worthy is the fact that failure to execute all of the planned activities would mean lower expenses than expected and would represent upside to our estimates.

As you look at the remainder of our fiscal year the risks and opportunities ahead of us lead us to a view that our original guidance remains unchanged a $1.35 to $1.55 of diluted earnings per share. Now, let me turn the call over to Steve who will provide a detailed review of the quarter and then we’ll take your questions. Steve?

Stephen J. Smith

Today I will have three sections to my prepared remarks. First, a few comments on our consolidated revenues. Second, a brief review of our business segments. Third, a walk through of some key components of our financials for the third fiscal quarter. We will then open up the line for questions.

Our reported revenues were down $35 million from last years third quarter or 6.8%. Revenues benefited from both foreign exchange and lower spending on our strategic card initiatives. These benefits were almost completely offset but a loss of revenue due to the candle product line divestiture last year. The revenue benefit from exchange was $13 million over the prior year’s third quarter. We also had a $3 million benefit versus the prior year as our strategic card and scanned based training initiatives had less activity than last y ear’s third quarter. However the candle product line divestiture reduced our sales to $14 million versus last year. These three items when netted together increased revenues by $2 million. So, cutting through all the noise and holding aside foreign exchange, differences in initiative timing and the effect of divestitures our revenues were down $37 million compared to the prior year’s third quarter or about 7%.

Moving to our segments the North American social expression segment revenues were down $37 million versus the prior year’s third quarter. About $14 million of that 37 or 40% of the lower revenue was the result of the candle product line divestiture. Holding aside this strategic decision this segment’s revenues were down $23 million or 7%. Of the $23 million $20 million relates to two product lines where we are sacrificing low margin revenue in order to increase returns. I will speak to this trade off in just a moment. The remaining $3 million in revenue decline was caused by roughly $6 million related to timing of terms with a retail partner partially offset by $3 million of benefit of lower spending on strategic card initiatives.

As I just mentioned $20 million of the decreased revenue is related to two product lines those being packaging and party goods. In both of these areas our results this year have been generally in line with our internal plan as we have consciously accepted the trade off of lower sales for higher margins. This trade off has been especially prominent in the promotional gift wrap piece of our gift packaging business. The decreases in gift packaging and party goods were driven by a few items. First, the focus has been to improve the overall annual return within the product line and as a result we did not pursue or we walked away from traditionally low margin business that would have been pursued in past years. Second, with respect to the gift packaging we have seen continued softness in demand for gift wrap over the past few years as consumers are purchasing more gift cards which are of course not wrapped like a traditional present.

Our North American social expression segment’s earnings were $50 million which is down $38 million versus the prior year. However, last year’s results included a $20 million pre-tax gain in the quarter as a result of retailer consolidation and the effect the consolidations had on several long term supply agreements between the company and the affected retailers. Separately, this year’s earnings benefited from $4 million of lower spending with the strategic card and scanned based trading initiatives. So, taking into account the $20 million gain in the prior year’s quarter and the $4 million earnings benefit from lower initiative spending this quarter segment earnings were down $22 million. The lower earnings were driven by three factors. First, a reduction in verbal margin due to lower sales accounted for about 50% of the decline. The negative impact of term timing as an issue with the retailer partner accounted for 30% of the decline and various manufacturing, merchandising and distribution cost were the balance.

Switching to our international social expression segment revenues were off about 2% or $2 million. Despite lower revenues segment earnings improved $4 million quarter-on-quarter. About one half of the earnings improvement came from our Australian business and the other half from our European business. Our Australian business improved their gross margin in the quarter while our European business benefited from lower distribution costs.

Our retail store segment increased same store sales by 4.6% this quarter. Total revenues for this segment were down almost $3 million as a result of 67 fewer doors compared to a year ago. Segment earnings declined a bit less than $1 million versus last year’s third quarter primarily driven by higher payroll related costs. This segment again benefited from the performance of juvenile gifting products. While our store count remains at 429 doors we will continue to evaluate our stores and close them when it makes economic sense. Based on our current forecasts we still expect to close approximately 25 stores this entire fiscal year and we have closed seven year-to-date.

For the quarter or AG interactive segments revenues were down $3 million versus the prior year. The decline in revenue is the result of exiting our mobile ring tone product line last year. Segment earnings were $2 million which is flat versus a year ago. While we realized some savings from exiting the ring tone business last year it was offset by investment in the traditional online business.

While we generally don’t spend much time commenting on our non-reportable segment during our conference calls let me at least mention that the revenues in this segment were down about $4 million quarter-on-quarter with the decline driven by lower third party sales in our fixtures business.

Let me pause here and explain the status of our licensing business. Licensing revenue for the quarter which is reported as other revenue was about $11 million which is essentially flat with the prior year. Licensing expenses were about $10 million which is up about $1 million versus last year. So, for the third quarter the company’s net licensing effort revenues less expenses was about $700,000 which was down about $1.5 million from the prior year’s third quarter.

Now, let me move to the third of my three topics this morning a review of our key financial statement items. The company’s manufacturing, labor and other production costs or MLOPC were down $22 million and improved 100 basis points compared to last year’s third quarter. Lower sales volume drove a $17 million favorable variance. In addition, favorable product mix added $12 million to the reduction as we benefited from a higher percentage of card products and the divestiture of lower margin candle product lines last year. Partially offsetting these two items was approximately $5 million of unfavorable foreign exchange.

Selling, distribution and marketing costs were up $2 million versus the prior year’s third quarter. Foreign exchange was a $4.5 million negative variance and that variance was partially offset by $2 million of lower expenses as a result of closure of retail stores in the prior year. The administrative and general expenses were down about $5 million quarter-on-quarter due to a continued effort to lower corporate overhead costs. Other operating income was down $20 million versus the prior year. Last year’s results included a $20 million gain as a result of retailer consolidation and the effect the consolidations had on several long term supply agreements between the company and the affected retailers.

Continuing down the income statement other non-operating income increased $4.7 million which was almost completely driven by foreign exchange gain. For the quarter interest expense was down $2 million from last year. This decrease is a result of lower debt levels during the quarter compared to the prior year. Our quarterly tax rate was 33.7%. However, due to the discreet items of the first quarter we are still expecting our tax rate for fiscal 2008 to be in the high 30s.

Now let me shift gears from a review of the income statement to three major items found in our financial statements: deferred costs on balance sheet, capital expenditures on the cash flow statements; and our average share count. On our balance sheet you will see that our net deferred costs were essentially flat compared to the prior sequential quarter at $363 million and down $45 million from the prior year’s third quarter end. The four line items of deferred costs on our balance sheet at the end of this year’s third quarter were: one, prepared expense of $135 million; two, other assets of $314 million; three, other current liabilities of about $57 million; and four, other liabilities of $29 million.

On our cash flow statement let us look at capital expenditures for a moment. The company spent just over $37 million so far this year which is $8 million more than the prior year’s investment of almost $30 million. We expect to spend $50 to $60 million on capital expenditures this year due in part to our increased spend for information systems some of which already occurred during the third quarter.

One final note on our share count; based on our actual share repurchases year-to-date and assuming we complete the $100 million share repurchase program during the fourth fiscal quarter I would expect that our full year average shares outstanding will be about 55 million shares.

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

Question-and-Answer Session

Operator

(Operator Instructions) Well go first to Jeff Stein with KeyBanc Capital Markets.

Jeffrey S. Stein – KeyBanc Capital Markets, Inc.

First, it sounds to me like the potential swing factor in the fourth quarter is more expense related than revenue related. Would that be correct?

Zev Weiss

There clearly is on the revenue side the seasonal component for both Christmas and Valentines Day affect us. But, I think if you just looked at the bottom line impact of both I think I would agree with that. Not having looked through the numbers, I think that sounds right.

Jeffrey S. Stein – KeyBanc Capital Markets, Inc.

Can you just quantify the aggregated amount of scanned based trading activity that you would expect to occur in the fourth quarter that would potentially swing or hold between fourth quarter or first quarter.

Stephen J. Smith

While we don’t forecast specific line items let me aggregate scanned based trading and our card initiative together and for that you would see that we have spent year-to-date in the order of magnitude around $19 million. What we’ve said for the year is that we could spend $36 to up to the high 40s in expense for the year. So, all of that roughly $20, $25 to $30 million would occur in the fourth fiscal quarter.

Jeffrey S. Stein – KeyBanc Capital Markets, Inc.

You talked about the fact that you’re continuing to see good results in the reset doors. I’m wondering given all the noise that’s going on with currency, with switch to scanned based trading and all and lost doors year-over-year, on a comp store basis what kind of performance are you seeing in the reset doors relative to let’s say non-reset doors?

Zev Weiss

I’m not going to get into all the details of that. I can tell you that in general the trends that we had been seeing which were positive trends have continued and so we’ve been very pleased with it.

Jeffrey S. Stein – KeyBanc Capital Markets, Inc.

Does this have any implications for spending on strategic card initiatives for next year?

Zev Weiss

I would expect that there would be some spending but, we’re still working through our plans for next year and we’re still trying to iron out all the details to see exactly what we’re going to do.

Jeffrey S. Stein – KeyBanc Capital Markets, Inc.

I know you’re not quite ready yet to comment on the impact that you might incur for integrated WebShops and PhotoWorks but would you put that number in the material range?

Stephen J. Smith

For the fourth quarter we could tell you that we expect it to be a few pennies of drag on earnings. I’m not sure if you would consider that material or not. In the next fiscal year because we haven’t yet closed on the PhotoWorks transaction as you know we’re going through a tender offer process. We would yet know what the total impact both acquisitions will be next fiscal year. As we get into – as we close that transaction hopefully in late January then we’ll offer more guidance on that specific business area in April.

Operator

(Operator Instructions) We’ll go next to Kathleen Reed with Stanford Financial.

Kathleen Reed – Stanford Financial

Can you give us an overall qualifications statement to what you’re seeing in terms of the holiday season so far? How it compares to prior years? If there are other trends other than the prevalence of gift cards that you’re really seeing? If you’re seeing increased traffic across the nation? Just some more qualification. It’s kind of confusing messages we’re hearing from some other companies.

Zev Weiss

Obviously we hear a lot of the same things that you hear that’s being reported publicly. Given that there’s so much that happens at the end of the holiday and it’s literally happening day-by-day as we speak I just would prefer not to comment on it at all. We’ll hear more about it when we get together again for the next call. I just think there’s so much – as you know the holiday’s been happening later and later every year and it really does come down to that last three to 10 days.

Kathleen Reed – Stanford Financial

With that said can you give us any – on your third quarter then just how actual cards did seasonal versus everyday? Were seasonal cards down year-over-year? What kind of growth are we seeing in cards?

Stephen J. Smith

We can speak to some of the data. As you know we generally generate that information for the Q which comes out for us right at the beginning of the new calendar year. So while we’re still crunching some of the details behind it I would share that the seasonal cards and everyday cards were very close to our plan and the plan was for them to be roughly at flat for this quarter, third quarter.

Kathleen Reed – Stanford Financial

So, flat year-over-year?

Stephen J. Smith

Correct.

Kathleen Reed – Stanford Financial

I think when you were going through your comments just in terms of your gross margin improvement in the quarter you said that lower sales helped you with that. Did I hear that right?

Stephen J. Smith

Lower revenues were about two thirds of the reason for the lower MLOPC in the quarter.

Kathleen Reed – Stanford Financial

On a dollar basis?

Stephen J. Smith

On a dollar basis.

Kathleen Reed – Stanford Financial

So, on the gross margin improvement though?

Stephen J. Smith

Right. So, of the 100 basis point improvement 60 basis points is related to lower revenues. 50 was related to the improved quality or mix as I called it and then that ends to 110 and the other 10 basis point offset was foreign exchange.

Kathleen Reed – Stanford Financial

I’ll ask that question a different way later. Zev, when you were speaking about the positive trends you were seeing from the card program that you were – I think you said they were either meeting your hurdle or getting towards your hurdle. Are we seeing actually some positive pricing trends from that card program?

Zev Weiss

The first year that we did the roll out just because the way the cards mixed in the everyday section it wasn’t that we intended necessarily to drive pricing but some of the mix drove pricing. This year as we’ve comped that we’re on the second year of it – its much more unit based than it is pricing based.

Kathleen Reed – Stanford Financial

Just to again clarify the fact that your guidance may come in at the high end of your guidance. Did you say that if spending on the scanned based trading gets rolled into the first quarter of 09 you would be higher than your $1.55? Or, that would be one of the reasons why you would come in at the higher end of the $1.35 to $1.55?

Stephen J. Smith

I would say yes to those two parts of your question. Yes, the SBT to the extend it rolls into the fourth quarter will cause us to have less spending and therefore have us higher in the fourth quarter and that is the reason we would be at the higher end.

Kathleen Reed – Stanford Financial

On the segment results the interactive segment I thought we had anniversary’d the divestiture of the shut down of the ring tone business back in the summer. So, I’m a little bit confused why that’s still a drag.

Gregory M. Steinberg

The wind down of the ring tones business happened over a couple quarter periods so it was actually spread primarily across the third and fourth quarter a year ago. So, some of it was anniversary’d – there’s pieces of it in the second quarter and as we went through processes to shut down offices and some of those operations it was spread out over a couple of quarter periods.

Kathleen Reed – Stanford Financial

Are we done with that now?

Gregory M. Steinberg

At the end of this fiscal year we’ll have fully lapped it from last year.

Kathleen Reed – Stanford Financial

So even fourth quarter will the problem.

Gregory M. Steinberg

I would expect it to be smaller in the fourth quarter.

Operator

(Operator Instructions) We’ll go to Brian Delaney with EnTrust.

Brian M. Delaney – EnTrust Capital

I’m sorry if I missed it. In the other non-operating income line the $4.5 million what was that again?

Stephen J. Smith

That’s foreign exchange.

Brian M. Delaney – EnTrust Capital

All of it is in there because the foreign – that’s the total net impact of it?

Stephen J. Smith

Well, the foreign exchange that is in that line item is $4.5 million. The next effect for us across the entire P&L spectrum is a net effect to us of $2.7 million positive EBITDA.

Operator

We’ll go next to Dax Vlassis with Gates Capital Management.

Dax Vlassis – Gates Capital Management

I was wondering what percentage of the business is currently based on scanned based trading for the segments it’s applicable to?

Zev Weiss

It’s still under a third.

Dax Vlassis – Gates Capital Management

Under a third. How does that compare to let’s say a year or two years ago?

Stephen J. Smith

It’s creeping up Dax in the neighborhood of three to four percentage points per year if you look out over the last few years. But, it’s very much lumpy in that some of these contracts get signed occur within a quarter and you see a step up where all three or four percentage points might occur in that particular quarter.

Dax Vlassis – Gates Capital Management

Where do you expect that to go with the current plans that you have for scanned based trading?

Zev Weiss

It’s very difficult to predict something like that because this is sort of one component of an overall negotiation and it’s difficult to say how that’s going to play out. So even on say a short term basis let’s say a 12 month period it’s very hard to say exactly how that will play out. I can’t give you an exact number on it. There’s lots of different scenarios but it depends on how things play out.

Dax Vlassis – Gates Capital Management

What about your cap ex ongoing? I know you’re going to spend $55 to $60 would you expect a similar number next year and the year after that?

Stephen J. Smith

We haven’t forecast next year yet Dax. Historically we’ve been running in that range but as we mentioned in the last two calls we anticipate incremental spending on system refresh and we haven’t yet shared how much that could be for next fiscal year.

Dax Vlassis – Gates Capital Management

I’m just saying if I’m looking going forward would you expect the next few years to be above $60 million?

Stephen J. Smith

Again, we haven’t forecast out the next few years publicly. In April we may do that.

Dax Vlassis – Gates Capital Management

Did you say your comps for retail were up 4.6?

Stephen J. Smith

Yes we did.

Dax Vlassis – Gates Capital Management

Is WebShops profitable?

Stephen J. Smith

The business in this quarter had less than a $1 million drag on EBITDA so no it was not.

Dax Vlassis – Gates Capital Management

I just mean the business that you bought at it stands was it profitable?

Stephen J. Smith

It’s slightly negative on a consolidated basis annually.

Dax Vlassis – Gates Capital Management

Just so I understand the scanned based trading. For this quarter did I hear it right it was approximately $8 million?

Stephen J. Smith

For this quarter, yes $8 million on the pre-tax line.

Dax Vlassis – Gates Capital Management

For strategic card or just scanned based trading?

Stephen J. Smith

A combination of both was $8 million roughly split equally for the quarter.

Dax Vlassis – Gates Capital Management

For the full year you’d expect to spend somewhere, if everything goes as planned, around high 40s?

Stephen J. Smith

It will be in a band because we’re not sure which contracts could be executed from a technical perspective so it will be a band from the low 30s to the high 40s maybe a tad above.

Dax Vlassis – Gates Capital Management

Would most of the incremental spending be in scanned based trading in the fourth quarter?

Stephen J. Smith

Yes.

Dax Vlassis – Gates Capital Management

Would you expect that to be 50/50 at year end if everything goes as planned?

Stephen J. Smith

50/50 between the card initiative and the scanned based trading? No. It will be more heavily weighted toward the scanned based trading initiative.

Operator

With no further question in the queue I’d like to turn the conference back over to Greg Steinburg for any additional or closing remarks.

Gregory M. Steinberg

That concludes 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 April. We thank you for joining us this morning and Happy Holidays.

Operator

That does conclude our conference call today. We appreciate your participation. You may disconnect at this time.

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Source: American Greetings F3Q08 (Quarter End 11/30/07) Earnings Call Transcript
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