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American Greetings (NYSE:AM-OLD)

Q2 2013 Earnings Call

September 28, 2012 9:00 am ET

Executives

Gregory M. Steinberg - Director of Investor Relations and Treasurer

Stephen J. Smith - Chief Financial Officer and Senior Vice President

Analysts

Carla Casella - JP Morgan Chase & Co, Research Division

Michael Schechter

Jeffrey S. Stein - Northcoast Research

Victor B. Anthony - Topeka Capital Markets Inc., Research Division

Operator

Good day, and welcome to the American Greetings Corporation Second Quarter Fiscal 2013 Earnings Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Gregory Steinberg, Treasurer and Executive Director of Investor Relations. Please go ahead, sir.

Gregory M. Steinberg

Thank you, Cynthia. Good morning, everyone, and welcome to our second quarter conference call. Joining me today on the call is Steve Smith, our CFO. We released our earnings for the second quarter fiscal 2013 this morning. If you do not yet have our second quarter press release, you can find a copy within the Investors section of American Greetings' website at investors.americangreetings.com.

As you may expect, some of our comments today may 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 SEC filings. Previous earnings releases as well as our 10-Qs, 10-Ks and our annual report are available on the Investors section of the American Greetings website.

We will now proceed with comments from our CFO, followed by a question-and-answer session. Steve?

Stephen J. Smith

Thanks, Greg. In light of a purchase proposal that was announced on Wednesday, this conference call will have a slightly modified format. First, Zev Weiss, our CEO, will not be participating in today's call. Second, I will not be discussing the proposal that was announced Wednesday. Third, I will be restricting my remarks and the answers to questions during the question-and-answer period for the second quarter and first fiscal half, and we'll not be commenting on the balance of the fiscal year, either with regard to the company's performance or with regard to investments or uses of capital.

I have 3 components to my prepared remarks today. I will start with comments on how the Clinton's transaction impacted our consolidated results this quarter, then move to a review of our reported segments, and finally, I will touch on a few key components of our financials. We will then open the line for questions, again, focusing on the year-to-date performance only.

I would like to first start with comments on how the recent acquisition of certain assets of Clinton Cards is impacting our financial results. As you likely know, during the first fiscal quarter, we acquired the senior secured debt of Clinton Cards and incurred bad debt and other related expenses as Clinton Cards filed for administration.

During the second fiscal quarter, we acquired certain assets from Clinton Cards for about $37 million, which included approximately 400 stores and related overhead as well as the Clinton Cards brand.

If you cut through the financial noise associated with the Clinton's transaction, that is, if you put aside the Clinton's effect, within our core business, our revenue and operating margin are tracking slightly ahead of our internal expectations due to a combination of sales running ahead of internal plans as well as expenses, especially overhead, being carefully managed.

Since the acquisition of the Clinton's assets, our strategy to improve the operations has included reevaluating the overall product offering within the stores, remodeling a handful of stores, remerchandising the card assortment, aggressively renegotiating leases and reducing overhead costs. We are encouraged with the progress so far as well as the preliminary results, although we are in the early days of our journey. We still expect fiscal 2013 to be year of transition for these stores as we work to turn around their performance.

In addition to turning around this business, forecasting its performance at this time is also difficult as it is a highly seasonal business, and the ultimate number of stores that we will own and operate has not been finalized.

You will see that within this quarter's financials, we've added a new segment called Retail Operations. This segment represents the ongoing activities of those U.K.-based stores, which we are branding Clinton's. You will also see that within the International Social Expression product segment, we've added a line for inter-segment items to account for the inter-segment sales and profits from our wholesale business in the U.K. to those retail stores in the U.K.

During our second fiscal quarter, the Clinton's acquisition impacted both the operating and nonoperating sections of our income statement. In addition, those impacts were both transactional and operational. In order to aid your understanding of the effect Clinton is having on our financial statements, we have included a supplemental exhibit to our earnings release. The supplemental exhibit outlines some of the more significant effects of the Clinton's, both during the quarter and year-to-date periods. Let me take a few minutes and verbally explain those effects.

We recognized a net increase in revenue of about $26 million, which was comprised of both the $40 million of revenue from the new Retail Operations segment and the eliminations associated with the inter-segment revenue, the revenue from our U.K. Wholesale business that I just mentioned, of $14 million.

We incurred a total of about $60 million in operating losses during the quarter relating to the combination of the Clinton's operations, the inter-segment eliminations and the transaction costs associated with the acquisition. These losses appear in 3 areas of our segment reporting.

First, the new Retail segment incurred an operating loss of $5 million. Second, the inter-segment profit of $7 million must be eliminated from our International Social Expressions products segment. And third, we incurred about $4 million of additional transaction-related costs during the quarter, which appear on the unallocated section of our segment reporting.

Below the operating income line, but related to Clinton's acquisitions, we recognized an additional $2 million impairment of the senior secured debt owed to us by Clinton Cards. When we include this impairment within the activities reported in operating income for the second quarter related to Clinton's, then the pretax loss from Clinton's activities, both operational and transactional, was approximately $19 million in the quarter.

Switching gears from a review of the several ways Clinton's has impacted our quarter to a consolidated review of our performance, let me start with revenues.

Our consolidated revenue increased about $24 million from last year's second quarter of $370 million to $394 million in this year's second quarter. This year was negatively affected by about $3 million of foreign exchange compared to the prior year's second quarter. So holding aside the FX, revenue was up about $27 million or 7%.

In addition, scan-based trading negatively impacted revenue by about $4 million compared to the prior year. Holding aside the impact of both foreign exchange and scan-based trading, revenue was up about $31 million at just over 8%. The revenue increase of $31 million was primarily driven by the acquisition of Clinton Cards, which contributed net incremental revenue of about $26 million. Holding aside the impact of the foreign exchange, scan-based trading and Clinton's, revenue was up about $5 million or approximately 1%.

Switching from a review of revenue to a review earnings are operating loss of $2 million in this year's second quarter as compared to $30 million of operating income in the prior year second quarter. Last year's operating income benefited from a gain of about $5 million due to the sale of a couple of minor characters in our intellectual property portfolio. This year's operating income was negatively impacted by both the $60 million drag due to Clinton's that I just described, as well as a roughly $3 million drag compared to last year due to scan-based trading conversions.

Holding aside the effect of both Clinton's and scan-based trading, our operating income was down about $8 million quarter-on-quarter. The primary drivers of this decrease year-on-year were: increased expenses related to our systems refresh project; increased to marketing expenses; and lower earnings within our fixtures business and our licensing unit, and both units appear in our nonreportable segment.

I'll now review our reported segments and how they differ from the prior year's results. Our North American segments revenues of $266 million were up about $2 million compared to the prior year second quarter. The increase was driven by increased sales of seasonal greeting cards, which were partially offset by about $2 million from scan-based trading conversions.

Our North American segment's earnings of $20 million were down about $5 million versus the prior year. The decline was driven by incremental expenses associated with our systems refresh project, increased marketing costs primarily related to Cardstore and the negative effect of scan-based trading conversions.

Within our international segment, revenues were about $61 million, a decrease of about $15 million versus the prior year. The decrease was driven almost entirely by the fact that sales from our legacy wholesale business to our newly acquired retail business, Clinton's, were eliminated from the consolidated results as inter-segment sales. The inter-segment sales eliminations accounted for $14 million of the $15 million revenue decline.

Within the international segment, we reported a loss of $7 million this year, which includes $7 million of inter-segment profit related to Clinton's that is now eliminated for consolidation purposes. Holding aside the effect of Clinton's, segment income was down about $2 million versus prior. The $2 million decline was driven primarily by the effect of scan-based trading conversions.

Our AG Interactive segment's revenues of $16 million and segment earnings of $4.6 million were both flat compared to the prior year's second quarter.

Let me shift from the segment analysis to briefly comment on the status for our licensing business. Licensing revenue for the quarter, which is reported on our income statement as other revenue, was about $7 million, which is down almost $2 million compared to the prior year. Licensing expenses were almost $6 million, which is down about $600,000 compared to the last year. So for the second quarter, the company's net licensing effort, or revenues less expenses, was about $1 million lower than the prior year second quarter.

Now let me move to the third part of my comments today, a review of several of the key components of our financial statements. The company's manufacturing labor and other production costs were about $19 million compared to last year's second quarter. About $9 million or 1/2 of the increase is directly related to Clinton's. The remaining increase is primarily a combination of higher product costs and a change in sales mix. In addition, there was approximately $1 million related to product display materials.

Our selling, distribution and marketing expenses increased by $22.5 million versus the prior year's second quarter. About $25 million of the increase was driven by the acquisition of Clinton's, and about $3 million of increase was related to incremental marketing expenses. These increases were only partially offset by about $3 million of lower costs in our field service organization versus last year.

In the prior year, we incurred additional expenses in the field service organization related to expanding distribution into new retailer doors, and those additional expenses did not repeat this year.

The administrative and general expenses were up about $10 million versus the prior year second quarter. The increase was driven by about $4 million of transaction costs related to Clinton's, about $4 million of increased operating expenses associated with Clinton's, and about $3 million of additional expenses related to our systems refresh project.

Other operating income was $800,000 this year compared to other operating income of $5 million in the prior year's second quarter. The roughly $4 million variance is primarily the result of a gain last year on the sale of a couple of minor character properties within our intellectual property portfolio that did not repeat this year.

Our nonoperating expense was about $250,000 this year. However, there are 2 offsetting items that I should point out. As I previously mentioned, we recognized about $2 million of expense associated with Clinton Cards. However, offsetting this nonoperating expense was a gain of $3 million due to the sale of a portion of an investment we made in the company that acquired our party goods manufacturing operations.

Let's now shift gears from a review of the income statement to a brief look at our balance sheet and cash flow. Before I review some of the specific accounts, I should mention that the purchase price allocation for Clinton's is preliminary and subject to revision, as evaluation work is still being conducted.

Accounts receivable decreased $14 million compared to last year. The decline was the result of the Clinton's transaction and the fact that our wholesale business is no longer -- no longer have accounts receivable due to it from the Clinton's Card company. Inventories increased by about $27 million compared to the prior year. About $24 million of the increase is also due to the acquisition of the Clinton's stores.

Accounts payable increased about $17 million compared to the prior year. About 1/3 of the increase is due to the acquisition of Clinton Cards, while the remainder is due to ordinary timing of payments.

The last item I will address is capital expenditures on our statement of cash flows. This year, we have invested about $46 million in the first half of the fiscal year compared to about $30 million last year, an increase of $16 million. The increase in capital expenditures is being driven exclusively by the investment in our systems refresh project.

That concludes our prepared comments for today. Before we take questions, let me repeat the parameters we are setting for the Q&A period. I will be restricting my responses and we will be restricting our responses to the second quarter and fiscal first half. And we will not be commenting on the balance of the fiscal year, either with regard to the company's performance or with regard to investments or uses of capital. We will also not be commenting on the proposal that was announced on Wednesday. With those parameters in place, Cynthia, please open the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] We will take our first question from Carla Casella with JPMorgan.

Carla Casella - JP Morgan Chase & Co, Research Division

This is Carla Casella from JPMorgan. I was wondering if you could just talk about the business environment, both in the U.S. and Europe, and whether you've seen any slowdown? We've heard a number of retailers and consumer product companies talk about a slowdown in Europe around the back to school timeframe. I'm wondering if you're seeing the same thing.

Stephen J. Smith

Well, Carla, the things that you're reading and seeing, we're seeing as well. The international environment is a bit difficult for us to parse, particularly in Europe because of the Clinton's transaction and the noise it's created in our financials. So not much more to add beyond what you've already read.

Carla Casella - JP Morgan Chase & Co, Research Division

Okay, great. And then have you fleshed out any more of your timing or magnitude of your headquarters investment?

Stephen J. Smith

The project through the end of the fiscal quarter was running on time and on budget. We're not commenting beyond that at this time.

Carla Casella - JP Morgan Chase & Co, Research Division

Okay. And then just one of the housekeeping. There's another $55 million of debt on the balance sheet. Is that all Clinton Cards? And where would that rank in terms of seniority and/or priority in the capital structure? Is that secured debt? Is it -- at an operating company level at Clinton?

Gregory M. Steinberg

Hi, Carla. It's Greg Steinberg. The incremental $55 million is actually borrowings under our senior secured revolver. And so, it's senior in the structure and it's under that particular facility. It's not specifically or directly related to the Clinton's business.

Operator

We'll take our next question from Andrew Brooke [ph] with Morgan Stanley.

Unknown Analyst

So it appears that management team is very bullish on the long-term prospects for the company. With that said, what was the thought process you underwent as you weight the option of acquiring Clinton Cards, which is effectively the first foray you've made into retail versus investing further capital in Cardstore.com and your other e-commerce efforts?

Stephen J. Smith

The transaction with regard to Clinton's cards was driven by a long-term relationship that we've had with that group that is over -- is decades old. The environment that permitted the transaction was one where Clinton Cards needed a long-term capital to support a business model that had the brand that we believed in. And so we invested in that brand and those stores, and we hope that that's a good long-term investment.

Operator

[Operator Instructions] We will go next to Michael Schechter with Mentor Partners.

Michael Schechter

A couple of quick questions. What was the total systems refresh cost running through the balance sheet?

Stephen J. Smith

In the year-to-date period, $60 million was spent against the capital expenditures in the year-to-date period, Michael.

Michael Schechter

That's CapEx. But how much through the income statement?

Stephen J. Smith

We have that -- I think it was just over $3 million of systems refresh expense in the quarter. I don't know if we have it year-to-date with us, Michael, we'll look while we're sitting here.

Michael Schechter

Great. And same thing with the marketing cost for the -- extra marketing cost you've been building.

Stephen J. Smith

Greg, maybe you'll have that one?

Gregory M. Steinberg

Sure. In the quarter, it's about $3 million, bringing the year-to-date number to about $7 million for the marketing costs.

Michael Schechter

Okay, so that's, I guess, on a 12-month basis, about $22 million?

Gregory M. Steinberg

That's about right. Rounding both last year's figure and this year's figure.

Michael Schechter

So is this something that will continue?

Stephen J. Smith

Well, we haven't -- we have set the parameters where we won't comment about the future. And so I can't answer that question directly, Michael, I'm sorry.

Michael Schechter

Are you generating revenues from the prior marketing expenses?

Stephen J. Smith

We are generating revenues. As we've said last quarter in our conference call, the revenues are very small.

Michael Schechter

Okay. The fixture business, which you said was down, what's the -- what was going on there? How big was the delta year-over-year?

Stephen J. Smith

The -- we don't comment within segments, but the business is small to begin with. Some of their external customers are paring back their purchase of our wire fixtures for their stores. And it's hard to tell whether that's a continuing trend or not. It's only been during this particular quarter of first half.

Michael Schechter

Is it in -- if we look at your business in, like, 3 layers: the high end, the mid and sort of the dollar stores, is it one particular segment? Is it across-the-board? Is it one customer?

Stephen J. Smith

It's multiple customers within the fixtures business that are driving that deterioration.

Michael Schechter

Is it in one particular layer?

Stephen J. Smith

No.

Michael Schechter

Okay. And last, looking at the segment eliminations, is it fair to look at the revenue $15 million of revenue, $16 million of revenue, $7 million of -- or $14 million and $7 million, is that margin correct?

Stephen J. Smith

I guess, it would be correct for that inter-segment report, yes.

Michael Schechter

So if Clinton Cards were owned by a third-party or deconsolidated off the income statement, you'd be running a 50% margin on the sales to Clinton. Is that logical on a marginal sale basis?

Stephen J. Smith

So what you're seeing in our segment are just cost of goods, none of the other costs associated with doing business. So I think what you're concluding is a gross margin, not a full margin.

Michael Schechter

Okay. And is it fair to look at this and say -- and I know you can't talk going forward, but this would be sort of an annual run rate where this -- we'll see this elimination continually. And if we went backwards, you'd see a $28 million elimination?

Stephen J. Smith

Right. So it's hard to look forward, as we mentioned, this is a very seasonal business. I think there's 2 issues with answering your question that may make it complex in your question, Michael. First, we haven't resolved the full number of stores. And two, it's seasonal and we're still learning the seasonal pattern of this business.

Michael Schechter

Well I assume it's seasonal into Christmas and the spring holidays, which would make it even greater than $28 million on a trailing basis.

Stephen J. Smith

It could. We also have timing that relates to profits within the consolidated group because of moneys put into inventory. And so it's complex.

Michael Schechter

And you're still outsourcing some of the management to, I guess, Schurmann it was?

Stephen J. Smith

We are.

Michael Schechter

And just last on the headquarters, what's the spending been this year, to date, on a operating income basis and a CapEx basis?

Stephen J. Smith

Very small, less than a couple of million dollars, possibly less than a million. I don't have the figure in front of me.

Michael Schechter

So that really hasn't ramped up yet?

Stephen J. Smith

Correct.

Operator

We will take our next question from Jeff Stein with Northcoast Research.

Jeffrey S. Stein - Northcoast Research

Just one question relating to your share buyback. Wondering if the stock that you bought back during the quarter was under a 10b5-1 program? And if you could talk about the timing of when those purchases occurred.

Gregory M. Steinberg

Jeff, it's Greg. Generally, we don't get in the specifics on how we purchase shares and the timing of when we do it. So I prefer not to get into the real specifics. You've seen us over the past number of years use a variety of methods to repurchase shares. Some have been 10b5-1s. And so, I think, we should leave it at that for the historical share repurchases.

Operator

[Operator Instructions] We'll go next to Victor Anthony with Topeka Capital Markets.

Victor B. Anthony - Topeka Capital Markets Inc., Research Division

I just have 2 questions, mainly on the on online components of your business. So in the licensing agreement with the Snapfish, help me understand how this does not compete with Cardstore? And if it does, what are you communicating about the Cardstore assets? And overall, can you just help us understand your overall commitments to the online social expressions space. That's the first one.

Stephen J. Smith

So, Victor, rather than having them be competitors, we see them as complementary. We look at using our intellectual property in multiple media, in multiple channels. This is yet -- Cardstore is yet another channel distribution of our intellectual property, including any character properties we would own or license from others.

Victor B. Anthony - Topeka Capital Markets Inc., Research Division

Okay. So what's your overall commitment, I guess, to the overall social expressions space. Is that -- should we expect significant incremental investment there? Or given everything else you have going on, is it -- is it get pushed to the wayside?

Stephen J. Smith

Let me clarify. We are extremely committed to that social expressions space that is our business. If you're speaking directly to the electronic social expressions, we would hope over time to be the leader in that space as well.

Victor B. Anthony - Topeka Capital Markets Inc., Research Division

Okay. So what are your plans for the holiday season in terms of promotion? And how do you see a similar -- or do see a similar or more intense competitive environment to last year?

Stephen J. Smith

Well, we're not commenting about the future. The competitive environment is intense.

Victor B. Anthony - Topeka Capital Markets Inc., Research Division

Okay, all right. So my last question is really on comments you made on your last conference call, where you downplayed your long-term value of the bulk card business. We -- so you said, you're go-forward strategies to incorporate both the bulk and one-to-one. So I just wanted to get a sense of how big is the bulk card business today on Cardstore? And how big do you think it becomes in the future?

Stephen J. Smith

The bulk card business is small relative with the overall consolidated group as well as to the segment, the North American segment, which it fits. So we haven't broken out the level of revenue for you historically. We expect, because of its sheer size as an nascent business, to take some time before it becomes reportable. So the best I can answer is it's growing. We're investing in it. And without speaking to the future, we've been investing in it relatively aggressively in the recent past.

Operator

We'll go next to Kevin Vice [ph] with PrinceRidge.

Unknown Analyst

A question on -- I think, you said that your gross margins were down because of mix. Is that within the wholesale business, or because of the mix to retail?

Stephen J. Smith

Our mix and our business is affected in multiple ways. We were speaking to the MLOPC element of our financial statement, the mix we were speaking to was a combination of types of units sold and the cost of those units sold.

Unknown Analyst

Okay, so that would be within the wholesale card -- or wholesale card business?

Stephen J. Smith

Yes, it would be within the wholesale, the North American business, yes.

Unknown Analyst

Okay. So is that trade down, do you think, from end customers? Or is there some other element to it that your selling more expensive cards that you're maybe not getting the pricing for?

Stephen J. Smith

I think it's yes and yes. We're seeing demand pull that is of higher quality cards. And we're seeing also demand pull of some units that are value.

Unknown Analyst

Okay. Do you think over time you can -- you'll be able to get the pricing on those higher item or higher cost items?

Stephen J. Smith

We have historically not spoken to pricing strategy. We believe our customer pull is appropriate across all of the different levels of competition.

Unknown Analyst

Okay. On the retail stores, can you say what percentage of the store you're providing product for? And maybe what your long-term target would be?

Stephen J. Smith

We haven't historically commented and we don't wish to today. Just sure of that mix percentage that we supply into the retail store operations.

Unknown Analyst

Okay. Could you say maybe just directionally, do you think it will be going up over time?

Stephen J. Smith

Hard to say at this point. As we mentioned in our prepared remarks, that we're looking at the merchandising mix within the stores, and that it hasn't yet stabilized.

Unknown Analyst

Okay. I was thinking about the elimination. And obviously that, that would go away once the product sold through, unless you're planning on selling more product internally.

Stephen J. Smith

Well, we would hope that, that channel would grow. And we will continue to grow with it.

Unknown Analyst

Okay, great. And then can you say on a trailing basis what your consolidated cash flow is as defined by the Indenture, the bond Indenture?

Stephen J. Smith

We don't have that with us today.

Unknown Analyst

Could I follow-up on that then?

Stephen J. Smith

Possibly, we'll have to check with others to see whether that's appropriate off-line or not.

Unknown Analyst

Okay. And then, lastly, I was just wondering if you're in a position to say, to sort of update from the year-end percentage of voting shares that's owned by the family?

Stephen J. Smith

I don't have anything beyond which was filed in the 13B filing recently.

Operator

[Operator Instructions] And we will take a follow-up question from Carla Casella with JPMorgan.

Carla Casella - JP Morgan Chase & Co, Research Division

I have one follow-up on just gross margins. I think you had talked a while back about some movement in gross margins, across business cards specific and looking at the different channels. I think you said there's not much difference in gross margin by distribution channel, meaning, whether it's sold through specialty store versus a dollar store, versus a drugstore. But can you tell us what you're seeing in terms of margin trends? Are consumers changing the card purchases into cards that either a lower or higher? And how are some of your initiatives working to improve the gross margin on the paper card business?

Stephen J. Smith

I can help, Carla, I can't answer the entire question. We don't typically speak to margin within the segment. We are seeing growth in the higher priced product. Look, the innovative product that we're introducing commands a greater price than average. And we're seeing consumers enjoy that product and pull-through at a greater rate than historically.

Carla Casella - JP Morgan Chase & Co, Research Division

Okay, that's great. And I think you had talked also about doing some more private label or less product that needed to be licensed. Is there still any opportunity there?

Stephen J. Smith

Our licensing business, it goes through peaks and troughs, and we hope it will continue to grow. It's a cycle that's multi-year, not within a given year.

Carla Casella - JP Morgan Chase & Co, Research Division

Okay, great. And then just looking at some of the add backs for EBITDA, I'm still a little bit confused in terms of what from the Clinton will be ongoing versus what is truly one-time.

Stephen J. Smith

So let's speak to what happened rather than what might be the future. In the quarter, as we shared in the transcript and if you look at the segment results, we would speak to the inter-segment and retail operations, both $7 million of operating drag associated within inter-segment items as well as the operating loss of $5 million in the quarter. That type of performance will continue to the extent that business continues. The items that are transaction-related relate to $4 million of transaction expense in this quarter. And Greg, do you have the year-to-date of transaction expense, please?

Gregory M. Steinberg

Sure. That's about $6 million on a year-to-date basis.

Carla Casella - JP Morgan Chase & Co, Research Division

Okay. That will go away?

Gregory M. Steinberg

I would not typically repeat.

Operator

[Operator Instructions] And gentlemen, it does appear we have no further questions. Mr. Steinberg, I'll turn the conference back over to you for any closing comments.

Gregory M. Steinberg

Thank you, Cynthia. That concludes today's question-and-answer session as well as today's conference call. We do thank you for joining us this morning.

Operator

Once again, ladies and gentlemen, this will conclude today's conference call. We thank you for your participation.

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