Fructivore Investments

I have previously expressed an optimistic view on American Greetings (AM), based on its attractive price/free cash flow. Last Wednesday, American Greetings announced earnings that were substantially down from one year ago, and the stock was punished by nearly 10%, although it has recovered somewhat since then. Now, Ben Graham reminds us not to place too much weight on the results of a single quarter or even a single year; nonetheless, nonetheless, it may still be worthwhile to examine the results of a quarter for signs that the company can no longer produce the desired performance. If, however, the company can continue to produce results, the market’s overreaction may create profitable opportunities.

American Greetings reported a decline in revenues of 3.8%, or about $13.6 million; however, it explains this away as the result of the sale of their party goods division, without which sales would have declined by a mere 1%, which I think of as a trivial difference. More significant is the decline in reported earnings from $23.1 million to $8.5 million. Prior to the announced results, American Greetings had a market capitalization of over $800 million, so if we take the $8.5 million as fully representative of their earnings power, annualize it, and then apply a multiple of 10x, we get $340 million. This is a slight gap.

American Greetings’ management first cites that these earnings contain $5.2 million in expenses to integrate two recent acquisitions, while last year’s earnings for the quarter were increased by $7.9 million in insurance benefits. I consider both of these to be nonrecurring. Removing them serves to considerably narrow the gap between the two years. A second issue is that the firm’s tax rate for the latest quarter was the unusually high figure of 49.9%. If we remove the integration costs and apply a kosher 35% tax rate, we get $14.4 million, which is much closer (although it is still not the $20 million that would produce our $800 million market capitalization).

However, we are leaving out on our favorite adjustment, that of subtracting capital expenditures and adding back in depreciation. This measure improves estimated free cash flow to approximately $17 million, which is very close to our target. American Greetings’ management also understands the importance of free cash flow; their metric they cite in the announcement and earnings call is cash flow from operations minus capital expenditures, and they claim that they have produced $75 million out of their target $120 million for the year. Much of that amount comes from changes in working capital and is therefore not likely to be recurring, but for the first half of the year, earnings as modified above plus depreciation minus capital expenditures still comes in at $51 million, which is actually an improvement over last year.

So, although I would have liked the $17 million estimated free cash flow for the quarter to have been closer to the $20 million I had in mind, it is clear that overall performance has not degraded. So, absent further declines, American Greetings is still attractively priced, and the 10% drop seems to me to be more the effect of market participants seeing a large GAAP earnings decline and not digging any further into the numbers.

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Investing by grocca