American Greetings Corporation F2Q09 (Qtr End 08/29/08) Earnings Call Transcript

Sep.26.08 | About: American Greetings (AM-OLD)

American Greetings Corporation (NYSE:AM-OLD)

F2Q09 Earnings Call

September 26, 2008 9:00 am ET

Executives

Gregory M. Steinberg - Treasurer and Director of Investor Relations

Zev Weiss - Chief Executive Officer, Director

Jeffrey M. Weiss - President, Chief Operating Officer, Director

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

Analysts

Jeffery Stein - Soleil-Stein Research LLC

[Will Bate - Bate Capital]

[Robert Hayley - Gadelli]

Mike Hughes - Delaware Investments

Operator

Welcome to the American Greetings second quarter 2009 earnings conference call. (Operator Instructions) I’d now like to turn the call over to Greg Steinberg.

Gregory M. Steinberg

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 2009 this morning.

If you do not yet have our second quarter press release, you can find a copy within the Investors 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 10Qs, 10Ks and annual RevPAR are available on the Investors section of the American Greetings website.

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

Zev Weiss

This morning we will share with you our fiscal 2009 second quarter results. I will briefly comment on our performance this quarter and then share some comments on capital deployment in our second half outlook.

Similar to the first quarter we experienced mixed results in the second quarter. While encouraged that revenues were up, we are disappointed with the incremental costs necessary to generate that revenue. Given current economic conditions the revenue increase is commendable. Revenues were up as a result of improved card sales in North America partially offset by a slight decrease in our retail segment.

Over the last couple of years many of you are aware that we have focused our resources on constantly developing fresh new products especially in our North American cards. This emphasis on creativity in our product helps consumers connect in a way that is authentic to them. I believe the changes we have made the last couple of years are showing up in our revenues.

Operationally we had lower yielding sales meaning we generated less income as a percentage of net sales. The lower yield was driven by more costly content and lower sell-through. As an example, we sold more cards with higher content related costs such as music, lights and embellishments. We also shipped more products into retail with the expectation of increasing point of sale productivity. While sales did increase, the level of productivity improvement was not quite what we had anticipated. The lower-than-expected sell-through resulted in increased costs within our supply chain. We are working very hard to improve our sell-through in order to improve margins in future periods.

In previous quarters we discussed the rollout of the new Canadian card line which as many of you may remember was a project to convert our Canadian cards from a dual currency pricing of both Canadian and US dollars to a single Canadian dollar price on the back of each card. I’m pleased to share with you that the project is essentially complete and it did not have a material impact in our second quarter.

Now let me turn to our sources and uses of capital, and in particular how we have recently deployed the capital in the corporation. First let me address a likely source of capital, namely the sale of our Strawberry Shortcake and Care Bear properties to Cookie Jar. The agreement we have with Cookie Jar has an anticipated closing date of September 30. However with the recent disruptions in the financial markets it is likely that the transaction will not close on September 30. We still anticipate closing the transaction by the end of the year.

The use of the proceeds will be consistent with our approach to financial policy as it has in the past meaning we will continue to compare growth options with the opportunity to repurchase our own shares.

Switching from our sources to our uses of capital, many of you know that in the second half of last fiscal year we acquired two digital photo companies as a way to expand our current product offering of online social expressions into the adjacent area of online photo sharing and photo personalized products. During the first half of this fiscal year we continued to work on integrating our digital photo acquisitions in order to prepare for the upcoming holidays. Last quarter we shared with you that we have completed the back office integration. We now have a team focused on enhancing the usability of the website and developing an improved product offering. The team has already added more selection to personalized greeting cards, calendars and photo books that are enhanced by digital photos. In addition there are now products including photo personalized jewelry and ornaments.

Consistent with our strategy to enhance our core product lines, during the quarter we purchased a majority of the distressed first lien debt of another social expression company, Recycled Paper Greetings, for $44 million. Recycled Paper Greetings is seeking to restructure its balance sheet and as such we cannot comment further on the investment at this time.

The last area of capital deployment is our share repurchase program. In January of this calendar year we announced a $100 million share repurchase program. During the second fiscal quarter we purchased about 3.1 million of our shares for $46 million. Over the last three and a half years we have completed five separate share repurchase programs and now have reduced our diluted share count by 42%.

I should also note that today we announced a quarterly dividend of $0.12 a share.

Finally, I’d like to switch gears from the comments on our sources and uses of capital to a few comments on our second half. Our full-year guidance of $1.60 to $1.85 of diluted earnings per share and about $60 million to $80 million cash flow from operating activities less capital expenditures is still appropriate. However I would like to repeat my comments from last quarter and add a few more thoughts.

First, you are aware that we are a seasonal business and with a significant concentration of earnings in our second fiscal half. Second, year-to-date we’ve experience increased manufacturing and distribution costs. We have increased our effort around mitigating the increased cost structure. However the increasingly difficult economic conditions are adding additional risks to our second half performance and could place us near the lower end of our earnings guidance.

Before I turn the call over to Steve Smith, I’d like to take a moment to recognize the contributions of Steve Hardis who retired from our Board of Directors in June. Steve Hardis had served on our Board since 1999 and served as the Chairman of the Audit Committee and a member of several committees including the Executive Committee. Steve’s experience and insight provided valued guidance in many areas. We will miss Steve Hardis’ wisdom and counsel and we wish him well in the future.

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

Stephen J. Smith

I have three components to my prepared remarks for today. I will start with a few summary comments on our earnings this quarter, then I will share a brief review of our reported segments, and finally a quick walk-through of a few key components of our financials. We will then open the call for questions.

Overall our second quarter consolidated revenue was up $8 million from last year’s second quarter or about 2%. Included in our $386 million of net revenue was a benefit from foreign exchange of $1 million over the prior year’s second quarter. So holding aside the foreign exchange impact, revenue was up $7 million still about 2%.

However, our second quarter operating income was about $9.5 million lower than the prior year’s second quarter. The decrease in operating income was driven primarily by lower yielding sales in our North American social expressions segment. The lower yield is a result of a general mix shift towards cards with more content such as music and therefore lower margins. Lower yield also means higher distribution costs and increased scrap and returns. These costs are a continuation of some of the costs we discussed with you last quarter.

To offset some of these increased costs we are working on productivity improvement projects. The projects include streamlining back office functions and reducing our overall supply chain costs.

Now I’ll shift to the second component of my prepared marks, which will be a review of our reported segments.

Our North American social expressions product segment’s revenues were up about $3 million versus the prior year’s second quarter. Our every day and seasonal cards drove this revenue increase. The increase was partially offset by lower revenues from gift packaging and party goods product lines. Our North American social expressions product segment’s earnings were down $7 million versus the prior year. The decrease was driven primarily by lower yielding sales including higher content and higher distribution costs.

Switching now to our international social expressions product segment, revenues were $63 million which is essentially flat with the prior year. Segment earnings were down about $4 million quarter-on-quarter. This was driven primarily by costs associated with an effort to consolidate our brands within the UK as part of our focus on long-term efficiency and cost reduction.

Moving from the social expressions segment to our retail segment, revenues were about $38 million which is down about $2 million compared to the prior year’s second quarter. This was driven by reduced mall traffic which resulted in a decline in same-store sales of 2.4% during the quarter. However, through cost reduction we were able to keep segment earnings essentially flat versus the prior year.

We ended the quarter with 412 doors, down 17 doors compared to the second quarter of last year. We will continue to evaluate our store base and close stores when it makes economic sense. Based on our current forecast we still expect to close approximately 25 to 30 stores this fiscal year but that target could change depending on store performance and lease renewal rates.

For the quarter our AG interactive segment’s revenues of $21 million were up $4 million versus the prior year. This revenue increase was solely a result of our recent photo acquisitions. Segment earnings were down about $2 million also a result of the photo acquisitions. The earnings decline in this segment due to the acquisitions was in line with the internal plan we set at the end of our last fiscal year. The $2 million decline includes about $1 million of amortization of intangibles associated with the photo acquisitions.

Let me now explain the status of our licensing performance. Licensing revenue for the quarter which is reported as other revenue was about $13 million which is up about $1 million versus the prior year. Licensing expenses were almost $12 million which is up about $2 million versus last year. So for the quarter the company’s net licensing effort, that is revenues less expenses, was about $1 million which is down $1 million from the prior year’s second quarter. The change was principally driven by the ongoing investments to support existing properties and to develop new properties.

Now let me move from the segment analysis to the third component of my comments this morning, a review of a few key components of our financial statements.

The company’s manufacturing, labor and other production costs were up $7 million compared to last year’s second quarter. This increase was driven by a mix shift toward lower margin products, including products with higher content related costs such as royalties, music and other embellishments, and higher scrap related costs. We see these increased content costs being a part of our future business model and are taking action to try to mitigate some of these expenses.

Selling, distribution and marketing costs were up $10 million versus the prior year’s second quarter. We incurred higher freight and distribution related costs in the quarter as we shift more pieces into the field and incur the supply chain costs associated with those activities. We also had increased costs that I mentioned a few minutes ago related to both the photo acquisitions and to the brand consolidation costs in our international segment.

The administrative and general expenses were up less than $1 million versus the prior year’s second quarter. While we were able to reduce some of our corporate overhead expense, this reduction was partially offset by increased information technology related costs.

Moving down the income statement, the next item I will address is taxes. Our effective tax rate was 2.9% this quarter. During the quarter we recognized a tax benefit from what is known as a return to provision adjustment, which was related to intercompany transactions. Well what does that mean? A return to provision adjustment is made in conjunction with the preparation of the corporate tax return. This adjustment balances the tax provision on the company’s books which was estimated at year end with the amounts of the actual tax return which is prepared months later.

Since the second fiscal quarter had seasonally low pre-tax income, discreet items or changes to tax assets and reserves have a more significant impact on the corporation’s quarterly effective tax rate. As a result of this item that benefited taxes this quarter and additional tax planning efforts that we currently anticipate will be completed this fiscal year, we expect a lower tax rate than the rate we had initially planned. If these anticipated items occur, our full-year tax rate could be around 30%.

Now let me shift gears from a review of the income statement to looking briefly at our balance sheet and our cash flow statements.

On our balance sheet our net deferred costs decreased almost $42 million from about $363 million a year ago to about $321 million at the end of the second quarter. The four line items of deferred costs on our balance sheet at the end of the second quarter were: Prepaid expenses of $103 million, other assets of $309 million, other current liabilities of $63 million, and other liabilities of $28 million.

The second item on our balance sheet that I would like to review is inventory. Inventory was about $13 million higher than the prior year. This increase was caused by three main factors including an extended offering of technology cards, the new Canadian line, and more scan-based trading inventory versus a year ago as more accounts are now under the scan-based trading model.

The last item on our balance sheet I would like to address is related to our debt. Two years ago when we refinanced our debt we tendered for the full $300 million of our 6.1% senior notes. A small portion, about $23 million, was not tendered at that time. We repurchased the remaining $23 million of senior notes during the second quarter.

Moving on now to our cash flow statement, let us look at capital expenditures for a moment. The company spent about $29 million during the six-month period through August which is above the prior year’s six-month investment of $14 million. About 2/3 of the increase is related to new machinery and equipment for our plants in order to make them more efficient especially in light of increased raw material costs and higher energy prices. An additional reason for the increase in capital expenditures was due to the start of a multi-year investment into information technology. For the full year we still expect to spend $50 million to $70 million on capital expenditures.

So that concludes our prepared comments for today.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Jeffery Stein - Soleil-Stein Research LLC.

Jeffery Stein - Soleil-Stein Research LLC

You maintained the guidance at $160 million to $180 million but you also adjusted your estimated tax rate, so I’m just curious, I presume you’ve incorporated your new tax planning into your forecast and therefore it almost sounds like you’re saying you expect operating income to be below where you originally thought it might be.

Zev Weiss

Jeff, you are correct. We are taking into account the tax rate into that number.

Jeffery Stein - Soleil-Stein Research LLC

Secondly, and this kind of went right by me. You mentioned something about an investment you’ve now made in Recycled Paper and I’m wondering if you could possibly elaborate on it a little bit just from a high level, why the interest in Recycled Paper? Are they a bankrupt company or just trying to restructure their debt and what got them into this position in the first place?

Zev Weiss

Jeff, I really can’t share anything beyond what we shared in the prepared remarks. Again, for the reason that we shared which is they’re in the middle of seeking to restructure their own balance sheet, we just don’t think it’d be appropriate to get into it any more.

Jeffery Stein - Soleil-Stein Research LLC

So at this point you are a creditor of Recycled Paper having purchased $44 million of their debt?

Zev Weiss

We’ve purchased a majority of their first lien debt and the cash cost of that has been $44 million.

Jeffery Stein - Soleil-Stein Research LLC

Can you tell us at what discount you have purchased that? What is the face value of that debt?

Zev Weiss

Again, for the reason I shared before, I think it’s a good question, it’s the right question to ask. It’s just given where they’re at and what they’re in the middle of trying to accomplish with their own balance sheet, we just don’t think it’s appropriate to comment anymore.

Jeffery Stein - Soleil-Stein Research LLC

Understand. And on the licensing side, in your opinion and I don’t know what the balance sheet of Cookie Jar looks like, but is it possible that that transaction could be in jeopardy?

Zev Weiss

I think it’s very reasonable to assume we’re going to close that transaction this year.

Operator

Our next question comes from [Will Bate - Bate Capital].

[Will Bate - Bate Capital]

A quick question on the Strawberry Shortcake. Could you add a little bit more color to timing and how the process will look the next few months?

Zev Weiss

I think it’s probably not appropriate for us to get into the details of that just because we’re right in the middle of it. Again I would just reiterate what we shared before, which is we feel confident that it will close by the end of the year.

[Will Bate - Bate Capital]

What’s delaying it? I missed that if you addressed that earlier.

Zev Weiss

It’s just what’s going on right now in the capital markets is affecting a lot of folks who are in the middle of transactions. And those overall market issues are affecting this transaction as I’m sure it’s affecting a lot of folks.

[Will Bate - Bate Capital]

Do you expect the Recycled Paper transaction to be a future use of capital?

Zev Weiss

Again given where they’re at, because they’re in the middle of their own restructuring of their own balance sheet, we just don’t want to get into any more details on it. Again we’re not trying to be difficult. We just think it’s not appropriate at this moment.

Operator

Our next question comes from [Robert Hayley - Gadelli].

[Robert Hayley - Gadelli]

A question on the Strawberry Shortcake transaction. You expect it to close at the end of this year; do you mean calendar year or your fiscal year?

Zev Weiss

I’d say fiscal year.

[Robert Hayley - Gadelli]

Could you just talk about generally what sort of financial impact you would expect to see from that transaction on your margin structure in the short term and then in the longer term?

Zev Weiss

I think specifically you’re asking, given that we have an overall properties business and that we’re selling two of the larger properties but we still have a number of other properties, some classic properties and some newer ones, what do we expect the run rate to be? Is that it? It’s too early for us to comment on that because we haven’t gotten through the transaction yet. Clearly we will have a different operating structure but what that will exactly look like, we’re still working on. We’ll be prepared to talk about that when the transaction closes.

[Robert Hayley - Gadelli]

So is it safe to assume that might be something that will evolve then post-transaction?

Zev Weiss

Yes. Clearly our operating model will be different given that the properties business will not have two of its largest assets in it. So we’re going to significantly have to adjust that model but what that exactly looks like, we are not prepared to talk about. It will look different.

[Robert Hayley - Gadelli]

Could you talk about the debt on your balance sheet? It looks like you took on some short-term debt in the quarter. And what drove that?

Stephen J. Smith

It’s part of our normal working capital cycle. The historical pattern has been for us to go from trough to peak borrowings that swing between $125 million to $150 million on average. And that’s what you’re seeing in this fiscal quarter.

[Robert Hayley - Gadelli]

Any general comments on retail foot traffic? Any door closure impact to your business you’ve seen?

Zev Weiss

I think what you read about in the press in terms of major retailers comp store sales; I think we would see very consistently in our results and what we’re seeing as well. I don’t think we’re seeing anything that is inconsistent with what you’re reading about in the press.

Operator

Our next question comes from Jeffery Stein - Soleil-Stein Research LLC.

Jeffery Stein - Soleil-Stein Research LLC

I’m wondering if you can provide any update on the study you’ve been conducting regarding possible consolidation of two manufacturing plants?

Zev Weiss

We haven’t announced anything on that. Just to give the background, we’ve announced that we’re looking at two plants, one of them in Michigan and one in Tennessee, and we shared that in the fall we were going to be able to react to that. And we have not announced anything yet and I don’t think we want to do that on this call. We’re not ready to do that yet.

Jeffery Stein - Soleil-Stein Research LLC

There have been a few retail bankruptcies announced recently, Mervyns being one, and wondering if any of the recent bankruptcies have affected you in terms of receivable exposure?

Stephen J. Smith

We prefer not to comment on specific accounts Jeff, but we have taken into account some of the recent activities and we’re well reserved for those that are public.

Jeffery Stein - Soleil-Stein Research LLC

During the quarter your other non-operating income increased almost double. I’m wondering what the reason for that was? [Inaudible] income?

Stephen J. Smith

Other non-operating income was more foreign exchange Jeff. We had about $1.2 million of fx incremental quarter-on-quarter.

Operator

Our next question comes from Mike Hughes - Delaware Investments.

Mike Hughes - Delaware Investments

Two questions for you. The $210 million of debt that’s due within a year, can you just review the composition of that, just all the revolver? And the second question, the operating cash flow is pretty weak in the quarter and I think most of that’s related to drawing down AP and other liabilities. Can you just address that too?

Stephen J. Smith

The $210 million is our current portion of long-term debt. It doesn’t mean that it’s necessarily due. As was asked earlier, the borrowings are driven by working capital cycle. In addition the investment that Zev previously mentioned in Recycled Paper Greetings, the working capital cycle will play out through January or February where cash will start coming into the company starting in mid-November.

As it relates to operating cash flow of the quarter, it’s actually pretty much close to plan for us if you adjust for again a couple of factors, one of which is we’re a bit heavy in inventory this particular quarter. We mentioned earlier in the call how we had a change in a Canadian product line. Some of that is rippling through our system as well as we have additional accounts on scan-based trading. A little bit of increased inventory there. And finally some additional carry of what we call tech cards. Those are all weighing against us on operating cash flow for this fiscal quarter.

Mike Hughes - Delaware Investments

If I look at the cash flow statement provided in the press release for the six months ended 08 versus 07, one of the big deltas is the accounts payable and other liabilities. That’s a use of about $70 million this year versus $23 million last year. So what’s going on with that line item? And back on my debt question, what is the actual composition of that? Is that all the revolver, the $210 million?

Stephen J. Smith

Let me answer the first question and then I’ll get to your second one. First of all, within accounts payable and other liabilities the accounts payable balance is pretty much flat with prior year. If you look at our DPOs, they’re flat. What’s happening within that account are two things. First, there’s a change in taxes payable that’s accounting for the bulk of the delta really a change-on-change versus prior’s cash flow. And secondly, just due to the cutoff this year of our fiscal quarter on August 29 there was some timing of compensation payments, basically salaries to our employees that were carried differently due to the month-end cutoff.

As it relates to the components of the borrowings, we have both a revolver and our asset-backed securitization being utilized this quarter.

Operator

Our next question comes from [Will Bate - Bate Capital].

[Will Bate - Bate Capital]

You do read a lot about some of the larger retailers but you don’t hear too much about the independents. Can you guys sort of speak to the foot traffic and financial health you’re seeing at some of your mom-and-pop and independent chain customers?

Zev Weiss

As you know and I know many others know, for us we’re primarily a large mass retail company and the independents for us is a very small of our overall business. Truthfully I haven’t seen a whole lot one way or the other but it doesn’t affect us in a large way.

[Will Bate - Bate Capital]

Would you say it more or less tracks the performance from a comp store sales perspective of the larger guys?

Zev Weiss

I haven’t seen anything that is inconsistent with the larger guys, but again it’s a really small part of our business.

Operator

At this time we have no other questions.

Gregory M. Steinberg

That does conclude the question and answer portion of our conference call today. We look forward to speaking with you again at our third quarter earnings release which is anticipated to occur in late December. And we thank you for joining us this morning. Here ends today’s call.

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