Description

Investment Thesis

American Greetings (NYSE:AM) is not seeking to go private to make long-term strategic investments due to a steep secular decline in greeting card demand. AM is not Dell. The Greeting Card Duopoly (AM + Hallmark = 85% share) is proving to be more resilient than newspapers in the digital age. Rather, the relatives of the founding family (9% owners) of AM, who already control the company through a super voting B class, aim to reap the value of a several hidden assets by attempting a buyout during a period of intentionally depressed trailing earnings. While the growth prospects are tepid, gross margins are stable and AM enjoys tremendous brand equity in a business with very high barriers to entry.  The 10-year average trailing EBITDA for AM is $216m, implying a current price of 4.3X EV/EBITDA based on the $19.00 bid. However, the 13yr trailing average valuation at 5.5X EV/EBITDA is 28% higher than the current offer. FY 2013 reported EPS of $1.47 implies an offer price of 13X EPS, but when adjusted for one-time costs voluntarily incurred, the adjusted EPS is ~$2.49 per share, or 7.6X EPS. Despite increasing buyout offers from the family, the deal has languished and AM is beginning to lap these impacts and reported Q1 EPS last week of $1.04 vs. $0.20 y/y triggering another 4% increase in the offer price. In terms of hidden assets, early signs of success with 400 refreshed Clintons stores, that AM recently took over, seems to have precipitated the buyout offer. Another hidden asset is the intent to invest $150-200m in a new headquarters being built in a successful 1.9m sq ft. mixed-use development 37% owned by the Weiss family. The AM headquarter headcount has been in gradual decline over the past several years suggesting the new property will be an excellent real estate asset going forward. Next, AM announced a new 1,000 store customer with unknown economics. Finally, Koch Industries ~25% equity stake suggest that its Georgia Pacific subsidiary is likely to create synergies around paper costs which could prove helpful in competitive bids with Hallmark for big-box distribution. At least one 6% shareholder (Tower View) has publicly indicated they are voting against the deal. If other major holders follow and the majority of the minority vote fails on August 7th, I believe that Koch and/or the Weiss family will be willing to add debt/equity and increase the offer to at least $24, or >26% upside to the current bid.  

Description of Business / Company Background

AM operates predominantly in a single industry: the design, manufacture and sale of everyday and seasonal greeting cards and other social expression products in North America (78% sales) and International (22%) in the United Kingdom, Australia and New Zealand. AM designs cards with an in-house team of designers or licenses creative content from other artists. AM manufactures the vast majority of its products in the Southeastern U.S. in 4.7m sq ft of its 6 wholly owned plants only 0.1m of which is  leased.  They also own 4 distribution warehouses. Their primary manufacturing method is direct to plate printing. A small proportion of product requires hand finishing. Finished greeting cards can coast 20-40 cents to manufacture and sell for $3.00 retail.  In addition, their subsidiary, AG Interactive, Inc., distributes social expression products, including electronic greetings and a broad range of graphics and digital services and products, through a variety of electronic channels, including Web sites, Internet portals, instant messaging services and electronic mobile devices. They also engage in design and character licensing and manufacture custom display fixtures for owned products and products of others.

AM is the 2^nd largest ($1.7b rev.) social expression products business to private co Hallmark ($4b rev.) in what is a long-standing U.S. duopoly. Jacob Sapirstein founded AM in 1906. His son Irving Stone (he changed his surname) was CEO until 1987, and was succeeded by his son-in-law Morry Weiss. Morry is now Chairman and his sons Zev Weiss (CEO) and Jeff Weiss (President) run the business today. The Weiss family (Zev, Jeffrey, Gary and Elie) collectively hold 81.6% of all Class B shares (10 votes each) with 3,046,387 B shares as of 11/25/12.

AM has been sporadically active on the acquisition front. In 1956, they acquired Canadian company Carlton Cards which is the brand they use today in Target stores. AM created some of the first licensed characters including Holly Hobbie, Strawberry Shortcake, and Care Bears, the latter two of which still generate ~$25m+ annual royalties. In 1996, they launched their own website with electronic greeting cards. In 2000, they acquired Gibson which was the 2^nd largest publicly held greeting card company and brought in relationships in the deep discount dollar store channels. In 2004, they acquired DesignWare to obtain a more diversified base of products and party goods. In 2009, they acquired Recycled Paper Greetings and Papyrus brands at which time AM exited card retailing and turned over its 314 stores to Dominique Schurman (Papyrus founder). In 2011, they acquired Cardstore.com to allow people to create personalized greeting cards. In 2012, AM re-entered retailing when Clinton Cards, one of the largest U.K. greeting card retailers, was put into administration by its primary debt holder, AM. Schurman is currently refreshing this brand with the new name, Clintons, and 400 of the 700 stores remain open.

AM’s five largest customer comprise 42% of total revenue, including Walmart (14%) and Target(14%).

Background of Buy Out

On 9/26/12, a few days prior to the Q2 earnings call, the Weiss family offered $17.18 per share, a 22% premium for about 29.3m A shares and 2.9m B shares in an all debt deal. The stock also had 51% short interest at the time. They raised the offer by 2% to $17.50 per share on 1/17/13 to “meaningfully enhance our price to avoid back-and-forth debate.” They further stated “We do not intend to further increase the price of our offer.” The stock has generally traded below the offer price. On 4/1/13, the offer was raised to $18.20 with the inclusion of Koch Industries committing $240m for non-voting preferred stock. On 7/3/13, the offer was raised again to $19.00 with an approval of additional debt financing to $600m. The definitive proxy was filed 7/10/13 and special meeting date of 8/7/13 to vote on the merger.

A slide deck recently prepared by AM is found here: http://www.sec.gov/Archives/edgar/data/5133/000119312513294329/d570742ddefa14a.htm

TowerView’s presentation to ISS on 7/18/13 throws light on the flawed valuation analysis and suggest the current bid is actually putting a ceiling on AM shares were it being traded today without the bid: http://www.sec.gov/Archives/edgar/data/5133/000114036113028407/ex99_1.htm

The Special Committee members are Dr. Scott S. Cowen (chair), William E. MacDonald, III, Michael J. Merriman, Jr. and Jeffrey D. Dunn. The Special Committee has retained Peter J. Solomon Company as financial advisor and Sullivan & Cromwell LLP as legal counsel. The board is generally composed of long-time family friends and Mr. Merriman was CFO at AM in 2005-2006. Conflicts abound.

Current Themes in Social Expression

AM’s short interest was 51% at the time of the offer. Conventional wisdom says the Internet is supplanting all forms of print communication such as books, newspapers, and magazines. Facebook is supposed to kill greeting cards. Industry level data is difficult to parse due to product mix issues related to Hallmark’s declining retail store footprint. The Greeting Card Association reports 6.5b greeting cards per year with 80% being purchased by women, typically age 45-50. 80% of American adults purchase greeting cards each year for multiple occasions including birthdays, holidays, weddings, anniversaries and others. The U.K. is the most productive greeting card market in the world in terms of cards/person/year. The last significant innovation in greeting cards was the introduction of audio cards in 2007. This encouraged new, younger customers who had not purchased greeting cards before to visit the aisle.

While some consumers feel gouged paying $3-$5 for a single-use or keepsake card, most special occasions are in fact “special” and many card senders don’t want to assume the social risk of giving someone a cheap card. Unlike most gifts, the value of the greeting card is written on the back of the card so frugality does not go unnoticed. This is the main impediment to the e-Card which is viewed as “cheap” and only marginally more special than a Facebook ping. While e-Cards and other electronic methods may be increasing (especially for lower value social network type “friends”), they do not appear to be substituting for more valuable relationships. AM has several industry leading electronic card products. AM is a leader in online greeting cards, online personalized greeting cards (upload a photo), eCards (email delivery), and even print-your-own cards.  AM’s major Internet and wireless brands include AmericanGreetings.com, BlueMountain.com, Egreetings.com, and Cardstore.com. Aggregate revenues for this segment are reported as AG Interactive. Revenue growth in this segment has been tepid and has never exceeded 5% of total sales.

While AM claims the greeting card industry unit volume is shrinking by 2-4% annually in its buyout presentation intended to dissuade investors, AM’s actual wholesale unit and pricing for greeting cards (shown below) have remained stable over time.  

AM’s unit/price changes over the last 10 years are shown below:

2013       2012       2011       2010       2009       2008       2007       2006       2005       2004

Unit volume change      0.3%       8.5%       -2.1%      7.0%           2.2%       8.8%       -10.3%    -1.6%       -2.6%        0.9%

Selling Prices                1.0%       -2.8%       1.4%       0.4%          -2.7%      -5.2%       5.1%        2.2%       -1.4%       -1.4%

Overall inc/dec              1.3%       5.5%       -0.7%      7.5%           -0.5%      3.1%      -5.7%        0.5%        -4.0%       -0.6%

Near term threats to a stable or increasing consumption of greeting cards are few. Some industry contacts have suggested that new store designs in big box chains anticipate moving greeting cards away from “action alley” or the high traffic passageways where customers can be encouraged to make impulse purchases of products such as greeting cards. Walgreens and CVS are reducing the space allocation from 140 ft. to 106 ft. Although this would impair sales to some degree as AM’s 5 largest big-box customers comprised 42% of sales, the impact would be small as most customers are likely to seek out greeting cards to support the social custom of giving a card.

Growth in value cards ($1.00) growth won’t kill AM - In the 1990’s, AM focused on mass retailers while Hallmark focused on corporate owned and licensed stores. As traffic trends shifted towards one-stop-shopping outlets, large retailers eventually demanded more margin on what they knew to be a very high margin product and forced AM and Hallmark to more aggressively compete for long term contracts and required them to offer more elaborate store sets, provide fixtures, and card replenishment services.  Around the same time, the rise of the dollar stores led to Hallmark and AM selling much cheaper value cards into those categories. Today, these cards are 25% of sales. As Zev Weiss was quoted:  “Not only were the dollar stores taking share from a unit perspective; they also caused other retailers to decide that they could no longer sell cards at $2.50, if the competition was selling cards at fifty cents.” I surveyed Walmart, Target, CVS, Walgreens, Publix (southern grocery chain), Kroger, The Fresh Market (southern grocery chain), Party City, Hallmark Gold Crown and FREDS (dollar store) and in no instance was the value card more than 10% of the overall cards presented. AM and Hallmark still retain significant control over fixtures and product mix in all of the chain stores where they have distribution. Value cards tend to all be on the same card stock, the same white envelope, and the same stock photography. They look cheap.  In addition to the low variety, they are only offered in one size. Value cards lack embellishments (i.e. glitter, ribbon, etc.) that make cards seem special and add cost. Importantly, value cards are typically not available for key holidays such as Valentines and Mother’s Day.

Stand alone greeting card shops are in the U.S. are in secular decline- AM closed 60 stores in 2009.  Hallmark’s corporate and licensed stores have been in a rapid state of decline from a peak of 5,500. According to its website, Hallmark operates about 2,800 stores in the U.S., in addition to its greeting card and gift product operations. About 380 of those stores are corporate-operated, with the rest independently owned and operated.  Hallmark has been closing about 200 Gold Crown stores per year for several years and the store count is down to 2,400. Hallmark owns about 400 stores and they lose money on their retail model every year. The stores are very nice, have high investment in payroll (25%). The stores that used to do $750/yr and now selling $500k. They are attempting to renegotiate more rent reductions. On message boards, many of these Hallmark licensees complain their foot traffic has migrated to big-box stores where people are already doing a bulk of their shopping. Plus, they complain about having very high fixture costs which they are required to do in order to comply with the terms of the Hallmark license. The migration of invitation and stationary sales to online channels has also been a significant headwind for traditional greeting card retailers.

Significant Barriers To Entry For All Other Greeting Card Publishers

There are about 3,000 other greeting card publishers in the U.S. which sell to about 15% of the overall market not penetrated by Hallmark and American Greetings. Their cards are principally sold in boutique gift shops. Based on my store visits, larger retailers will occasionally have a line of boutique, regional cards but it not often. Additionally, there are dozens of websites for electronic greeting cards, self-printable downloadable cards, as well as personalized card printing services.

For printed cards, an important barrier to entry is the high SKU count expectation for retailers. There is a desire to have the right image, right message, and right price and average SKU counts can be 2,000 cards for a complete line of cards which cover all special occasions and all categories of buyers (i.e. husbands, wives, grandparents, etc.). Managing the supply chain and having these cards available at the right time of year to be retailed is a tremendous design and logistical challenge. Hallmark had a display in my local Walmart for 60 St. Patrick’s Day themed cards for a minor holiday that only generates about 7m units in sales according to the Greeting Card Association. AM produces 50,000 SKU’s each year.

In 2005, AM evaluated outsourcing manufacturing to China but elected against it order to achieve maximum responsiveness to market opportunities and believed that China-based printers were not accustomed to greeting cards manufacturing. Greeting card manufacturing in China is extremely complicated primarily because the product is less common in the culture. My conversations with other independent publishers also confirmed these logistical challenges given the lead time requirements. Cards are typically gang printed where multiple designs are arranged on the same large sheet of paper that share common stock and finishing requirements. This maximizes press time and greatly increases printing efficiencies and economies of scale. Various mid-size greeting card publishers (Leanin’ Tree, Designer Greetings, Legacy Publishing Group) are unlikely to gain big-box distribution and threaten the dominance of AM and Hallmark as they simply lack economies of scale to be competitive on price with an undifferentiated product. AM has protected its market share through occasional acquisitions as they did with Papyrus and Recycled Greetings.

Beginning in 2002, AM’s larger customers operated under a scan-based trading (“SBT”) arrangement where the AM owns the product delivered to its retail customers until the product is sold by the retailer to the ultimate consumer, at which time AM recognizes revenue for both everyday and seasonal products. This provides AM real-time insights about which products are selling and informs AM’s staff about how to refresh inventory and reset displays in large stores. Large retailers do not touch the greeting card aisle. The entire store set is managed by AM/Hallmark as a store-within-a-store. Retailers have grown accustomed to this level of service that is exceedingly difficult for new and smaller publishers to replicate. Even boutique store operators do not enjoy managing their small greeting card inventories.

Long Run Cash Generation of Greeting Cards

Over the last 12 years, average FCF yield as a percent of market capitalization has been 10%. Management has spent $1,016m buying back stock, reducing the share count by 51%, all while paying $265m in cumulative dividends over that 12 year period for an average yield of 2.4%.

They have perpetuated this cash generation despite several important disruptions in their model:

1. 2009 credit crisis where there was a marked and sticky shift to value cards.
2. Steady march of electronic communication over the last 20 years.
3. Increasing globalization of supply chains with digital printers.
4. Retail shift to big-box away from greeting card stores.

AM product mix has evolved gradually over the years towards increasing sales of everyday and seasonal greeting cards and less gift packaging and “other” (not shown).  

2013       2012       2011       2010       2009       2008       2007       2006       2005       2004

Everyday Greeting Cards        49%        50%        48%           48%        43%        41%        38%           38%        36%        38%

Seasonal Greeting Cards        25%        25%        24%           23%        22%        22%        21%            22%        20%        19%  

Gift Packaging                         14%        14%        14%           14%        14%        15%        16%            16%        17%        17%

Everyday greeting cards continue to be the predominant product and have had an increasing contribution since 2005 from its nadir. Seasonal greeting cards have flattened due primarily in part to competitive threats from Shutterfly, TinyPrints, and VistaPrint in the photo cards space which has been a strong consumer trend for the past several years that has competed for mindshare over traditional boxed Christmas cards.

The core “Social Expressions” segment which includes both North American and International segments have had positive operating earnings over the 12 year cycle. These data are adjusted for goodwill impairments of $27m (2012), $290m (2009), and $43m (2006). The record low reported operating margin of 9.6% for 2013 is primarily the result of $24m of losses in the International segment due to the Clinton Cards transaction. Adjusted for this impact, operating margin in 2013 was 11.2%. 

2013       2012       2011       2010       2009       2008       2007       2006       2005       2004

Social Expression Earnings(m)     147          197           230            249          289         197         141             291         274         318

Operating Margin                         9.6%       12.5%       16.1%      16.9%       21.7%     14.0%     9.9%        18.6%     17.8%     19.9%  

Despite a constant margin squeeze from big box retailers that play Hallmark and AM against each other around the renewal of multi-year distribution agreements, these margins have been managed. Generally, AM and Hallmark and have protected margins with declines in headcount. Hallmark has the largest creative design staff in the world with 500. Hallmark has eliminated positions for the past 10 years. Their Kansas City office used to be 7,000 people and now is down to 3,500. Hallmark has been forced to invest in the category to maintain their footprint in the stores. Hallmark is the generally the industry innovator and AM is the low-cost follower.

In the long run, gross margins and EBIT have been very well managed. The 340bp in de-leverage in selling, distribution and marketing and 110bp in administration and general is discussed below.

2013       2012       2011       2010       2009       2008       2007       2006       2005       2004

Gross Margin                                55.6%      55.4%     56.4%       55.5%      50.8%    54.9%     52.6%     54.8%    52.4%    53.3%

Selling, distribution, & marketing  35.5%      32.1%     30.9%       32.0%      37.6%     35.9%      36.0%       33.7%     34.4%     32.5%  

Administration & general              16.2%      15.1%     16.6%      17.2%       13.7%     14.3%      14.5%       13.1%     13.3%     11.2%  

EBIT Margin                                   5.1%         9.0%      11.2%       8.7%       -15.4%      7.4%        5.1%        8.6%        9.9%     12.6%  

Setting up the Buyout

FY 2013 earnings and cash flow faced a series of one-time impacts intended to depress the stock price and make the buyout offer appear attractive to investors.

1)       Clinton Cards Acquisition – The consolidated negative EBIT impact was $32m for the year or $0.55ps assuming a 42% tax rate. This was primarily driven by one-time transaction and integration costs of $43m.

2)       IT Refresh Projects – For the 2013, there was $9m in expense and $50m in Capex for a total of $59m related to a one-time IT project. $24m was of total cost was incurred prior to 2013 and $70m of additional expense remains for this project in FY 2014-2015. While this project is likely a necessary long-run investment to protect margins, it appears that 38% of the total anticipated investment was taken in 2013.

3)       Aggressive Marketing Spend for Cardstore.com - $7m of additional marketing expense was incurred in 2013. Management is not disclosing the impact that this is having on sales but at least within the entire AG Interactive segment, of which Cardstore.com is a component, total revenue was down 6.4%. Either management is very enthusiastic about selling cards online or this is an easy way to make a current period “investment” that can be reversed in the future.  

4)       New World Headquarters – $8m in CapEx and $4m in expense for a total of $12m.

5)       Going Private Administrative Expenses - $7m one-time expenses

Taken together, these one-time expenses reduced EPS by $1.02 for FY 2013 and added $58m in CapEx.  

Hidden Assets, Not Control Premium, Are Primary Benefits of Going Private

1)       Clintons retail turnaround seems to be going better than expected- The initial buyout offer from the family came only 4 months after AM placed Clinton Cards into administration. Clinton Cards was a 5% customer before administration and I believe that AM management liked what they saw after looking under the hood. While AM historically did not make money on its retail operations that it subsequently sold to Schurman Retail Group for $6m in exchange for paying $18m for the Papyrus label, the U.K greeting card market is the strongest in the world on a per capita basis.  AM reported $14m contribution to incremental earnings excluding one-time integration costs. Dominique Schurman, who is regarded as the best greeting card retailer today, is the CEO of the Clinton Cards (now rebranded Clintons). She stated on an interview with SkyNews (http://www.dailymotion.com/video/xxccs2_clinton-cards-future-feat-dominique-schurman-chief-executive_news#.Ue0R1I1wqX9) that sales were up by 10% for the 70 stores that AM had already refreshed. She also commented that the supply chain systems being used at Clintons were very substandard and will clearly benefit from the AM IT refresh project nearing completion. As AM will be capturing both the wholesale and retail margins, the EBIT margin could be as high as 20%, or double the margin of the current AM wholesale business. AM provided almost no guidance about sales trends and claim that they are not aware of sales trends at Clintons since they just took over the business so they won’t comment. However, that is clearly an evasive answer as they were the largest supplier of Clintons for dozens of years before they loaned it an excessive inventory of cards, at which point AM bought $56m in their debt from their banker and then promptly called the loans and took it over. Founded in 1968, Clintons had 700 stores at the time of administration, several of which were in very high rent areas and have since been closed. AM is in the final states of renegotiating all of the leases (just as they did for the Papyrus takeover) and will refresh all 400 stores over a 2-3 year period.

2)       New World Headquarters – AM intends to spend $175m for a new 700,000 sq ft. world headquarters to be located in Crocker Park in west Cleveland, a development 37% owned by the Weiss family.  Stark Enterprises developed Crocker Park with the Weiss family and is described as follows: “a diverse mixed-use town center, was built in 2004 and includes 800,000 sq. ft. of retail, 500,000 sq. ft. of residential units and 100,000 sq. ft. of Class A office space (totaling 1.4 million sq. ft). Today, 99 percent of the existing retail space is leased, 98 percent of the office space is occupied and Crocker Park’s 216-unit apartment complex is filled to capacity.” Thus, AM will now be the anchor employer in the development. The family had threatened to move AM to Chicago and negotiated $2.5m cash from Ohio,  $54m in bonds to improve public infrastructure in and around Crocker Park, and a 15 year Ohio Job Retention Tax Credit of 75% bringing the total package to about $90m. It was nice of Ohio taxpayers to contribute to the Weiss family real estate ambitions from a thinly veiled threat to move 1,750 jobs away from Cleveland.  The reality is that AM’s headquarters has been in a perpetual state of layoffs for many years and the company aims to downsize from its current facility of 1.7m sq ft. Certainly AM’s designers are enthused about the new office space while Stark and the Weiss family can contemplate the next phase for Crocker Park. For shareholders, this project has the effect of negatively impacting the DCF performed by Peter J. Solomon Co, the financial advisor to the special committee. Moreover, it precludes investors from the future value of the real estate asset which can be easily subleased as the company reduces headcount over time and allows its creative team to telecommute or increasing its creative outsourcing effort.

3)       Koch Industries Synergies –  The ability of AM to partner with Koch’s Georgia Pacific should not be discounted. When paper pulp prices when up very high in 2007 and 2008, it had a very negative impact on greeting card margins. These prices increases led to lots of consolidation by several large printers. The company reports that pulp prices are a risk factor since “paper is a significant expense in the production of our greeting cards”. Since value cards ($1.00 or less) are about 25% of industry sales (and growing), paper is an increasing proportion of COGS. In the long run, AM is likely to benefit from having a strategic and equity partner involved in paper manufacturing and paper innovation. AM and Hallmark compete for big box distribution. In AM’s investor presentation release 7/18/13, AM argues “As a private company, AM will be subject to less commercial negotiating stress, and be better able to optimize its retail partner negotiations much like its largest competitor (Hallmark).”  Although this argument is somewhat strained logic, it does validate the margin pressures in the business and suggest that AM will win share through a potential strategic partnership with Georgia Pacific. Since Koch positions itself as being as BRK alternative, there may be a reputational case for Koch not wanting to be involved in a deal that could be perceived as hostile or unfair to existing shareholders. Being a 25% non-voting preferred equity holder, Koch’s intent with AM is unclear although it would seem to fit their style more if they were an eventually 100% holder of AM as they learn more about the business.

4)       Significant New Customer-  The most recently updated proxy included an additional 4.2% increase in revenue as a function of “a contract to distribute greeting cards in over 1,000 stores of a major national retailer”. However, management indicated that “the relationship would require substantial investment in the early years and has a negative NPV over the first five years” and only if renewed after 5 years would results in a positive NPV.  Given the way management has downplayed the prospects for AM, it is very difficult to have any reliance on the real significance of this new customer. However, they also increased the gross profit for AM by 7.9% in association with the revenue increase which highlights the operating leverage from the additional distribution.

Conclusion – AM is a high quality business with durable cash flows and a positive outlook. So positive, prior to the buyout announcement, the family was executing a $325m investment in a new world headquarters and IT refresh. At least one 6% shareholder (TowerView) has publicly indicated they are voting against the deal and I believe others will follow. Koch and/or the Weiss family will be willing to add debt/equity and increase the offer to at least $24, or >26% upside to the current bid. 

Catalysts –

• Risk of majority of minority vote failing likely to encourage rebid in advance of improving earnings for balance of FY 2014.
• Comps will continue to look favorable as AM laps the Clinton Cards 1X expenses.

Risks –

• Koch equity commitment is withdrawn due to failure to agree on higher valuation.
• Management incurs hidden costs to depress current period earnings.
• Rapidly rising interest rates may prevent additional use of leverage.

Catalyst