Last fall I wrote about American Greetings Corporation (NYSE: AM), a designer, manufacturer and wholesaler of greeting cards and other gift-related accessories (gift wrap, party goods, etc). I concluded that the company’s dual class share structure had led to a number of wasteful acquisitions:
With AM, I see a company that generates significant free cash flows but lacks the focus to use these free cash flows in the most efficient manner. This makes it ripe for an acquisition by a more focused acquirer (LBO shops should take note of its significant free cash flows and mature industry). If not for the dual class share structure, AM would be a perfect target for an activist hedge fund. Unfortunately, there is no evidence the former will happen and the latter cannot happen until they change their share structure (a highly unlikely event). Translation: an investor today is likely to witness continued lackluster returns as the industry continues to contract, and further shareholder capital wasted on acquisitions as management attempts to transform itself into a technology company. For this reason, I ignore the value I see in the company’s real estate and free cash flows.
AM was a rare example of a highly acquisitive company that had seen revenues actually decline annually for most of the decade. Unfortunately, despite this track record the company continues to channel its strong free cash flows toward further acquisitions rather than return it to shareholders. The current entrenched leadership is simply too large of an obstacle for future shareholder returns.
Recently I stumbled upon one of AM’s smaller competitors, CSS Industries (NYSE: CSS). Like AM, CSS enjoys strong free cash flows which have averaged around $35 million annually for the last decade. This compares favourably to the company’s current market cap of just $185 million (for a yield of ~19%), and unlike AM, CSS operates with almost no leverage (current D/E is just 0.018x!) and a net cash position, which contributes to a strong CROIC consistently in the high teens.
Additionally, CSS is taking some important steps now as part of its restructuring of its underperforming gift wrap division which will lead to significantly improved performance in the future. The major thrust of this restructuring is a transition to offshore manufacturing. While the company will incur some charges now ($10.3 million, of which just $7.1 million in cash costs with the remainder non-cash), the annual savings will be dramatic.
For example, in 2011 the company closed it largest leased manufacturing plant, laying off as many as 650 unionized employees. This location was 1.0 million square feet and although the company does not break out rent on a property-by-property basis, we can find some clues in this listing, which reports asking rent of $1.85 p.s.f. Now, CSS may have been paying a higher figure (for example, it could have signed its lease in a lessor’s market, whereas today the economy and relatively abundance of vacancies would suggest a lessee’s market), but for conservatism let’s assume $1.85 p.s.f. is close to what the company paid. This translates to $1.85 million in pre-tax savings, and this doesn’t even account for CAM and Taxes (the $1.85 would almost certainly be triple net). Furthermore, transitioning 650 unionized employees offshore should lead to significant savings. Assume $15,000 per employee (on average, more for full time, and less for seasonal employees) in net savings (reducing labour expense, but increasing COGS as production is shifted to third party suppliers) which I think is pretty conservative, and this would be a further $9.75 million pre-tax. At a 35% tax rate, this flows $7.5 million to earnings, or $0.78 per share.
So there are a number of things to like about CSS: low debt, strong free cash flows, and big savings available in the restructuring. But this isn’t the whole story. As I mentioned in my AM write-up, this industry as a whole is in decline. While the market share leader, Hallmark Cards, is private, we see from the financial results of AM and CSS that sales have been in decline since before the recession began. Declining industry revenues leads to heightened competition and often desperate moves such as AM’s acquisition binge as it tries to transform itself into a digital content business. Additionally, about 1/4 of CSS’ sales are to Wal-Mart and another 12% to Target; the loss of either of these customers to Hallmark or AM would be disastrous for CSS which is less capable of competing on price with its significantly larger competitors.
In the end, I am not interested in the smallest (by far) player in a declining industry, especially where there is high customer concentration. What do you think of CSS?