Sep 27, 2011
Operator
Good day, and welcome to the American Greetings Corporation Second Quarter fiscal 2012 Earnings Conference Call. Today's conference is being recorded.
At this time, I would like to turn the conference over to Mr. Gregory Steinberg.
Please go ahead, sir.
Gregory M. Steinberg
Thank you, Mindy. Good morning, everyone, and welcome to our second quarter conference call.
I'm Greg Steinberg, the company's Treasurer and Director of Investor Relations. 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 2012 this morning. If you not yet have our first quarter press release, you can find a copy within the Investors section of the American Greetings' website at 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 like more information on our risks involving forward-looking statements, please see our annual report or our SEC filings.
Previous earnings releases as well as our 10-Qs, 10-Ks and annual report 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?
Zev Weiss
Thank you, Greg, and good morning, everyone. I am very pleased with our innovative new products and revenue growth this quarter, which resulted in market share gains both domestically and internationally.
Let me share a few comments on our ongoing product leadership initiative and our outlook for the balance of fiscal year 2012. And then I'll turn it over to Steve to walk you through our financials for the quarter.
Our team continues to develop great new products that help consumers express themselves, as well as connect with each other and celebrate life's special moments. We have developed some exciting new greeting cards for consumers to enjoy this fall season.
We have cards for Halloween featuring clever humor, hot design trend and consumer favorite icons designed to appeal to kids and Gen Y. We've also created a collection of cards that include warm casual language with an emphasis on the fun spirit of the holiday so that consumers can make more meaningful connections.
We're also looking for ways to mutually benefit consumers and our retail partners. A recent example of this is a new line of decals and skins that we introduced this summer for cellular phones, laptops, lockers, dorm rooms and anywhere consumers want to add their own personal style.
We leveraged our creativity to develop a variety of designs and styles, and particularly at younger consumers. This is a great time to bring these products to market both in advance of the school year and a time when there are no major card-sending holidays.
These are just a few examples of how we continue to execute product innovation and drive interest and excitement in the category. This strategy supports our retail partner strategies, strengthens our industry-leading portfolio of products and helps consumers connect with each other in a meaningful way.
As part of the strategy, we have and will continue to study societal and consumer trends and further improve our products' ability to help consumers meet their relationship needs. Based on our findings and market opportunities, at times, we may choose to increase our expenses and investments to support our product leadership.
We also strive to continuously make our organization more efficient. While this is an ongoing focus for many years, as we look forward, we expect this effort to be supported by additional investments in both capital and expenses as part of our multiyear systems refresh project.
These investments in our foundational systems and processes will better enable us to continue to execute our product leadership strategy. As we have discussed in the past, the 3 key elements of our IT strategy are: one, replacing the systems; two, driving efficiencies within the business; and three, adding new capabilities.
We are currently in the early phase of this effort. There are still uncertainty about the ultimate timing and size of the spend.
While we still have many decisions to make, we may make more investments in the second half of this fiscal year to support the project. This will mean an addition to the capital we had anticipated at the beginning of the year.
During our first quarter conference call, we had shared our expectations on revenue and cash flow for the fiscal year. At that time, we expected our revenues for fiscal year 2012 to increase about 5% compared to the prior year, and our full year cash flow from operating activities less capital expenditures to be between $80 million and $100 million.
And we had expected our capital expenditures to be between $45 million and $50 million. As we look at the balance of this year, in addition to the seasonality of our business typically encounters, we are more cautious than we were at the beginning of the year about the global economy and the effect that it's having on the consumer.
We now estimate that our revenue will increase around 3% compared to the prior year. Also, as we shared, there are many decisions regarding incremental capital expenditures that we will still need to make during the remainder of the year as part of our multiyear systems refresh project.
As a result of potentially higher than originally forecasted capital expenditures, we are more likely to be around the low end of our previous cash flow guidance. While we could experience volatility during the second half of the year, we remain steadfast in our investments to continue our product leadership and remain focused on our longer-term goals, and believe that we are well positioned to succeed.
I will now turn the call over to Steve to walk through our financials for the quarter. Steve?
Stephen J. Smith
Thank you, Zev. I have 3 components to my prepared remarks today.
I will start with a few brief comments on the consolidated results this quarter, move to a review of our reported segments, and then cover a few key components of our financials. After those 3 components, we will open the line for questions.
Our consolidated revenue was up $26 million or 7.6% from last year's second quarter revenue of $343 million. Included in our $369 million of revenue was a benefit from foreign exchange of about $9 million versus the prior year's second quarter.
Holding aside the impact from FX, revenue was up 5%, driven by increased domestic and international greeting cards sales. Our operating income was $30 million compared to $24 million in the prior year's second quarter.
During last year's second quarter, we recognized about $5 million of cost associated with the Papyrus and Recycled Paper Greetings integrations. This year, our 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.
Holding aside integration costs and the gain from the intellectual property sale, our operating income was down about $4 million quarter-on-quarter. I'll now review our reported segments and how they differ from the prior year's results.
Our North American segments revenues of $263 million were up about $11 million compared to the prior year's second quarter. About $2 million of the increase was due to a benefit from foreign exchange.
The remainder of the increase was driven by an increase in sales of everyday greeting cards. Our North American segments earnings of $26 million were down about $3 million versus the prior year.
Last year, we had about $5 million of expense associated with the integration of Recycled Paper Greetings and Papyrus in the second quarter that did not repeat. This year, we incurred $3 million of additional expense within our part-time merchandising group, supporting additional store roll-outs and revenue growth, about $2 million of incremental bad debt expense and about $3 million of additional scrap.
Switching now to our International segment. Revenues were about $76 million, which is an increase of about $21 million versus the prior year or greater than a 35% revenue increase quarter-on-quarter.
The increase was driven roughly equally by 3 items: about 1/3 was organic revenue growth; roughly another third was from the recently acquired Watermark business; and the last third was favorable foreign exchange. Segment earnings of $2 million, up about $1 million compared to the prior year as a result of the revenue increase.
The recently acquired Watermark business is performing in line with our expectations both operationally and financially in the second quarter. Our AG Interactive segments revenue of $60 million were down about $2 million lower than the prior year.
Revenue -- a reduction in revenues was driven by lower advertising and the effect of winding down our PhotoWorks website. Earnings for the segment were up $2 million versus the prior year's second quarter due to back-office savings, which were enabled in part due to the changes at PhotoWorks.
Let me shift from the segment announcement to briefly comment on the status of our licensing performance. Licensing revenue, which is reported on our income statement as other revenue, was about $9 million for the second quarter, which was roughly flat compared to the prior year's second quarter.
Licensing expenses were about $6 million, which is down about $1 million compared to the last year's comparable quarter. So for the second quarter, the company's net licensing effort or revenue less expense was up $1 million compared to the prior year's second quarter.
Let me now move to the third 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 up about $12 million compared to last year's second quarter.
The primary driver of increase in MLOPC was increased revenue. We also experienced unfavorable foreign exchange of about $4 million and $3 million of additional scrap.
Selling, distribution and marketing expenses were up about $13 million versus the prior year's second quarter. Approximately $10 million of the increase was the combination of a cost associated with additional store roll-outs and increased revenue, along with about $3 million of unfavorable foreign exchange.
Administrative and general expenses were down about $1 million versus the prior year's second quarter. Last year, we had $5 million of expenses associated with the integration of Recycled Paper Greetings and Papyrus that did not repeat.
This year, our back-office costs were up about $2 million as a result of the Watermark acquisition. We recognized about $1.5 million of additional bad debt expense, and we absorbed about $1 million of unfavorable foreign exchange.
Other operating income was up $4.2 million versus the prior year's second quarter. The increase was due to a gain on the sale of a couple of minor character properties within our intellectual property portfolio.
The next item is taxes. Our effective tax rate for the quarter was 42%.
The higher than statutory rate in the current period is due to an increase in accruals associated with anticipated settlements related to open audits. We currently expect our effective tax rate to be in the upper-30% range for this fiscal year.
Let's now shift gears and review the income statement to a brief look at a couple of items in our balance sheet and cash flow statements. As we have recently experienced some sales growth, both our accounts receivable and inventory have also grown.
While we will continue to focus on tightly managing our working capital, it is reasonable to expect working capital used during periods of sales growth rather than working capital sourced. On our balance sheet, accounts receivable were about $22 million higher than the prior year.
Slightly more than 1/2 of the increase was driven by higher sales and the timing of receipts from certain retail partners, while the other 1/2 of the increase in receivables was driven by the combination of receivables associated with the Watermark acquisition and about $4 million of foreign exchange. Inventory increased by $59 million compared to the prior year.
About 1/3 of the increase was driven by our need to build card and fixture inventory for expanded customer relationships. About 20% of the increase was due to a combination of the inventory associated with the Watermark transaction and approximately $4 million of foreign exchange.
The remaining portion of the increase is a combination of a more normalized level of inventory, as well as inventory beyond planned levels of approximately $15 million. While we had expected inventory to be higher this year to support the sales growth, it has been running higher than our own expectations.
As a result, we are very focused on this area, and our team has increased its effort on bringing down -- inventory down to a more appropriate level. Shifting to our cash flow statement.
One item I would like to mention is accounts payable and other liabilities, which was $46 million less of a use compared to the prior year's second quarter. As we shared previously, we had accrued additional variable compensation 2 years ago in fiscal 2010 due to the better-than-anticipated performance that year.
The accrued variable compensation expense from fiscal 2010 was paid during the first quarter of fiscal 2011. That pattern was not repeated during the most recent 2 fiscal years.
So that concludes our prepared comments for today. I would now like to turn the call over to the operator to handle our question-and-answer period.
Mindy?
Operator
[Operator Instructions] We'll take our first question from Jeff Stein of Ticonderoga Securities.
Jeffrey S. Stein
Question on the top line, first of all, top line outlook. Is the reforecasted 3%, is that based upon what you're currently seeing now in your business?
Or is it just the concern that what you might see based on what's going on in the economy?
Zev Weiss
I think it's a little bit of both. I think if you look at the first 6 months of the year and compare it to some of the heightened expectations that we had at the beginning of the year, traffic might be a little bit softer than we anticipated.
We're still very pleased with what we're seeing, it just may not be as high as we originally thought.
Jeffrey S. Stein
Are there any -- is it channel-specific, or would you call it more broad-based?
Zev Weiss
I think it's broad based, and we actually talked about it in the past, when you look at sort of the retail performance and the foot traffic that you're seeing in retailers, you'll see a strong consistency with what you're seeing in our results.
Jeffrey S. Stein
Got it. Got it.
And could you address the issue of inventories? You mentioned, I think Steve mentioned that inventories are about $50 million higher than you'd like them to be.
Could you talk about, one, how it got that way; and number two, is this inventory that you would expect the sell-through? And will you be able to just your manufacturing to kind of normalize it?
Or is there some markdown risk associated with this?
Zev Weiss
The reason behind it is there's been a lot of account activity going on. And whenever that happens, you want to make sure that you’re doing everything you can to take care of your customers.
And that was what we did. And the inventory that was recently built, and is very usable.
And I think we've got good plans in place to be able to get it back in line.
Jeffrey S. Stein
Okay. So you don't see this at this time as a risk, at least that portion of it, as a risk to earnings in the back half of the year?
Zev Weiss
I don't see it as earnings issue. I think it's a balance sheet, cash flow, and there's work that we got to do ahead of us from a cash flow perspective, but I think we've got good plans in place to be able to address it.
Jeffrey S. Stein
Okay. Can you talk a little bit, Zev, about the financing for the headquarters?
You guys did file an 8-K earlier this week. And I'm just kind of wondering a couple of things.
One, I know this is a long-term project that you've committed to, but given the recent weakness that we're beginning to see in the economy, it sounds to me like you're also planning to step up your capital expenditures a bit in the back half of the year. I guess is this the right time to be pushing full speed ahead with these initiatives?
Zev Weiss
Well, as you said, Jeff, this is a very -- we got long-term projects, we've got very long-term projects. And this is a very long-term project.
And when you look at the overall economics of what we're doing and the benefits that we're going to have to the associates and you compare it to the economics and the benefit you have remaining where you are, this is the right thing to do. And it's the right thing to do, I think, now.
It's also the right thing to do for the very long term of the business.
Jeffrey S. Stein
Okay. Can you talk about the various pieces of financing, and kind of how you get to where you hope to be in terms of how you expect this to be financed?
It sounds to me like you've got a $65 million loan commitment at a very attractive rate. You've got some tax benefits.
I'm wondering maybe you or Steve can address the issue of what the present value of those tax benefits is, and over what period of time you would expect to realize them? And then maybe kind of what you expect to do to kind of fill in the gap between the $65 million that's committed and what you will need to complete the project perhaps from the other sources?
Zev Weiss
Let me speak in some general terms, and I'll let Steve if he wants to jump in on perhaps some of the more specifics. We shared that there's $93.5 million of overall financing that we're picking up from a number of different places, government-type financing.
Some of that is related to the state. Some of that is related to the city.
Some of that is upfront, and some of that is in the form of a loan. And some of it is paid out over time.
And so it's not -- the $93.5 million is not the full investment value benefit. On top of that, as you mentioned, we announced earlier in the week $65 million of financing that we're picking up as well.
And that's all in the form of a note. So when we look at those 2 that comprises of significant part of what we estimate the cost to be.
And I'm not sure if we want get into all the details right now on the components of the $93.5 million because there are quite a few.
Stephen J. Smith
Let me comment just generally, Zev, that of our total estimated cost of the entire project, Jeff, roughly half of it on an MTD basis is funding sources outside of American Greetings.
Jeffrey S. Stein
Got it. Okay.
And, Steve, can you address the -- maybe an updated look at CapEx for the current fiscal year? It sounded to me in your prepared comments like you're planning to accelerate some spending into this year, and maybe quantify what that might be?
Stephen J. Smith
Sure. As we said, we are still thinking through some of the decisions around CapEx for the second half.
So why not pass the baton to Zev for further comment.
Zev Weiss
Yes. I think the variability right now in CapEx is related to the IT refresh project.
And there's a number of decisions that are in front of us over the next couple of months where we may accelerate some of that CapEx into this fiscal year. And we haven't made those calls yet.
Jeffrey S. Stein
And with the acceleration of the CapEx, I guess, as you define CapEx, some of it -- does any of it -- would any of it flow through the P&L and perhaps cause some variability to earnings? Or is this all capitalized?
Stephen J. Smith
Almost all capitalized. Yes, in future years, it would, but in this fiscal given the timing within the year.
Operator
[Operator Instructions] We'll take our next question from Michael Schechter of Mentor Partners.
Michael Schecter
I want to go back to the headquarters, because the 8-K talks about $150 million to $200 million of CapEx. And I realized you're talking about sources of financing outside of American Greetings, but at the end of the day, a $65 million note is on our balance sheet.
And while I understand the benefits to the associates, I'm trying to understand spending anywhere from 12% to 24% of our equity market cap for headquarters. And can you walk through how it works, how it's financed and how the return on investment is versus buying back stock or doing something like that and the savings you may get out of the new headquarters?
Zev Weiss
Let me touch on sort of the return on investment, not to get into the sort of a spreadsheet on it. Let me just tell you the thinking on it, because I think we walked through in general at least how the financing pieces come together.
And that is if you look at the building that we are in, it's roughly, let’s say, 50- to 60-year-old building with significant deferred cost and deferred maintenance. And when you look at the spend that's ahead of us to maintain a 1.7 million square foot building, that is extremely old, and for the most part, build originally to be a distribution center, not to house offices, and you compare that to -- and by the way, look at the ongoing cost of maintaining that facility, compare that to the net cost for the company to build and then the ongoing cost of the maintenance.
Aside from the fact that there's benefits for the associates, I don't mean that piece of it, this is the right thing for the company to do.
Michael Schecter
Does it make more sense to lease a building? I mean, you were putting up, it looks like, 25% of our capital to build the building.
Now it may, given where we are, we may have to do something, it sounds like, but I'm trying to understand deploying 20% of our equity into a freestanding real estate asset, and we’re a greeting cards notional company, not a real estate play.
Zev Weiss
Michael, it may, and I don't think the idea of how you would finance the building from a long-term perspective is something we're working through our thinking right now. But it's definitely something worth considering.
Michael Schecter
But you're starting to build this within the next 3 to 6 months, I assume?
Zev Weiss
No, we're really in the early stages right now of the design.
Michael Schecter
Okay. So when do you think you'll start breaking ground and have to really commit to financing it?
Zev Weiss
I don't know the answer to that. I think we got to get through the design phase and then start through.
When we get through some of the hurdles in the design phase, we'll start to figure out exactly when we would break ground.
Operator
[Operator Instructions] And at this time, there are no other questions in the queue. I'll turn the call back over to Gregory Steinberg for any additional or closing comments.
Gregory M. Steinberg
Thank you, Mindy. That does conclude the question-and-answer portion of today's conference call.
We look forward to speaking with you again at our Fiscal Year 2012 Third Quarter Conference Call, which will occur in December. We thank you for joining us this morning.
Operator
This does conclude today's conference. We thank you for your participation.