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AMERICAN GREETINGS CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) This Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited consolidated financial statements. This discussion and analysis, and other statements made in this Report, contain forward-looking statements, see "Factors That May Affect Future Results" at the end of this discussion and analysis for a description of the uncertainties, risks and assumptions associated with these statements. Unless otherwise indicated or the context otherwise requires, the "Corporation," "we," "our," "us" and "American Greetings" are used in this Report to refer to the businesses of American Greetings Corporation and its consolidated subsidiaries. Overview Second Quarter Transactions On July 1, 2014, we sold our current world headquarters location and entered into an operating lease arrangement with the new owner of the building. We expect to remain in our current location until the completion of our new world headquarters, which we anticipate will occur in calendar year 2016. Net of transaction costs, we received $13.5 million cash from the sale, and recorded a non-cash loss on disposal of $15.5 million during our second fiscal quarter, of which $13.3 million was recorded within the North American Social Expression segment and $2.2 million was recorded within the Unallocated segment. On August 29, 2014, we completed the sale of our wholly-owned display fixtures business, A.G. Industries, Inc. (dba AGI In-Store "AGI In-Store"), to Rock-Tenn Company for $73.7 million in cash, subject to closing date working capital adjustments. We recognized a gain of $38.8 million from the sale, which was recorded within the Unallocated segment. Second Quarter Results of Operations Total revenue for the current year second quarter was $432.4 million, an increase of $12.0 million or 2.9% compared to the prior year period. This improvement was primarily the result of increased sales of greeting cards, higher sales of gift wrap and party goods and the impact of favorable foreign currency movements. These improvements were partially offset by lower revenues from our fixtures business and decreased sales of other ancillary products. Second quarter operating income was $43.5 million, an increase of $36.4 million compared to the prior period. The improvement was driven by the gain of $38.8 million in connection with the sale of AGI In-Store and costs and fees related to the prior year going private transaction of $22.3 million that did not recur in the current year quarter. These improvements were partially offset by the non-cash loss on disposal of $15.5 million related to the sale of the current world headquarters location. Net of the above items, operating income decreased from the prior year primarily due to lower earnings in our display fixtures business, which is reported in the Non-reportable segment. In addition, improved earnings, net of the loss on sale of the headquarters, in our North American Social Expression Products segment was offset by lower earnings in our Retail Operations segment. The current year six months includes the unfavorable impact of approximately $5 million related to scan-based trading ("SBT") implementations, which was approximately $2 million higher than the prior year. 21-------------------------------------------------------------------------------- Table of Contents Results of Operations Three months ended August 29, 2014 and August 30, 2013 Net income was $22.8 million in the second quarter compared to a net loss of $5.2 million in the prior year period. Our results for the three months ended August 29, 2014 and August 30, 2013 are summarized below: % Total % Total (Dollars in thousands) 2014 Revenue 2013 Revenue Net sales $ 427,090 98.8% $ 413,667 98.4% Other revenue 5,335 1.2% 6,754 1.6% Total revenue 432,425 100.0% 420,421 100.0% Material, labor and other production costs 180,109 41.7% 176,674 42.0% Selling, distribution and marketing expenses 165,834 38.3% 155,007 36.9% Administrative and general expenses 66,850 15.5% 82,684 19.7% Other operating income - net (23,828 ) (5.5% ) (961 ) (0.3% ) Operating income 43,460 10.0% 7,017 1.7% Interest expense 9,255 2.1% 5,433 1.3% Interest income (30 ) (0.0% ) (73 ) (0.0% ) Other non-operating income - net (272 ) (0.1% ) (4,025 ) (1.0% ) Income before income tax expense 34,507 8.0% 5,682 1.4% Income tax expense 11,667 2.7% 10,903 2.6% Net income (loss) $ 22,840 5.3% $ (5,221 ) (1.2% ) For the three months ended August 29, 2014, consolidated net sales were $427.1 million, up from $413.7 million in the prior year second quarter. This 3.2%, or $13.4 million, increase was driven by higher sales of greeting cards of approximately $16 million, increased sales of gift packaging and party goods of approximately $3 million and the favorable impact of foreign currency of approximately $10 million. These increases were partially offset by lower sales in our fixtures business of approximately $11 million, decreased sales of other ancillary products of approximately $4 million and the unfavorable impact of SBT implementations of approximately $1 million. Other revenue, primarily royalty revenue from our Strawberry Shortcake and Care Bears properties, decreased $1.4 million during the three months ended August 29, 2014. Wholesale Unit and Pricing Analysis for Greeting Cards Unit and pricing comparatives (on a sales less returns basis), excluding intercompany eliminations, for the three months ended August 29, 2014 and August 30, 2013 are summarized below: Increase (Decrease) From the Prior Year Everyday Cards Seasonal Cards Total Greeting Cards 2014 2013 2014 2013 2014 2013 Unit volume 1.1% (3.8% ) (3.8% ) (0.7% ) 0.1% (3.2% ) Selling prices 4.2% 2.3% 13.0% (5.3% ) 5.9% 0.8% Overall increase / (decrease) 5.3% (1.6% ) 8.7% (6.0% ) 6.0% (2.5% ) 22 -------------------------------------------------------------------------------- Table of Contents During the second quarter, combined everyday and seasonal greeting card sales less returns increased 6.0% compared to the prior year quarter, including increases in selling prices of 5.9% and unit volume of 0.1%. The overall increase in selling price was driven by both everyday and seasonal greeting cards in our North American Social Expression Products segment and everyday greeting cards in our International Social Expression Products segment. Everyday card sales less returns for the second quarter increased 5.3% due to increases in selling prices of 4.2% and improvement in unit volume of 1.1%. The selling price increase was driven by general price increases and favorable product mix within the core product line, which more than offset the continued unfavorable shift to a higher proportion of value cards. The unit volume improvement was primarily driven by additional distribution to new customers in our North American Social Expression Products segment. Seasonal card sales less returns increased 8.7% during the second quarter, including a 13.0% increase in selling prices and a decrease in unit volume of 3.8%. Since the second quarter has the fewest holidays, the change in selling prices and unit volume appear large on a percentage basis compared to other quarters. The increase in selling prices was driven by our Father's Day, Graduation and Fall programs in our North American Social Expression Products segment. The unit volume decline was driven by our Graduation and Fall programs in our North American Social Expression Products segment. Expense Overview Material, labor and other production costs ("MLOPC") for the three months ended August 29, 2014 were $180.1 million, compared to $176.7 million in the prior year three months. As a percentage of total revenue, these costs were 41.7% in the current period compared to 42.0% for the three months ended August 30, 2013. The $3.4 million dollar increase was primarily due to the impact of higher sales and unfavorable product mix in the current year second quarter as well as the unfavorable impact of foreign currency translation of approximately $5 million. Partially offsetting these increases were lower product manufacturing expenses and the favorable impact of higher absorption of production and product related costs associated with inventory growth during the current year quarter that was greater than in the prior year quarter. The additional inventory growth in the current year is associated with a new party goods product launch and the timing of the pre-holiday seasonal inventory build. Selling, distribution and marketing ("SDM") expenses for the three months ended August 29, 2014 were $165.8 million, increasing $10.8 million from $155.0 million in the prior year second quarter. As a percentage of total revenue, these costs were 38.3% in the current period compared to 36.9% for the prior year period. The dollar increase in the current year second quarter was driven by higher supply chain costs of approximately $2 million, higher retail store expenses of approximately $2 million and the unfavorable impact of foreign currency translation of approximately $6 million. Administrative and general expenses were $66.9 million for the three months ended August 29, 2014, a decrease of $15.8 million from $82.7 million for the three months ended August 30, 2013. This decrease was driven primarily by prior year costs and fees related to taking the Corporation private of approximately $22 million that did not recur in the current year. The decrease was partially offset by higher costs in the current year of approximately $2 million related to a long-term incentive program that we established in the third quarter of the prior year as a replacement to our prior stock-based compensation programs, higher technology costs of approximately $3 million and the unfavorable impact of foreign currency translation of approximately $1 million. Other operating income - net was $23.8 million for the three months ended August 29, 2014 compared to $1.0 million for the prior year second quarter. The increase was driven primarily by the gain on the sale of AGI In-Store of $38.8 million, partially offset by a non-cash loss recorded upon the sale of our current world headquarters location of $15.5 million, both of which occurred in the current year second quarter. Other non-operating income - net for the three months ended August 29, 2014 was $0.3 million, decreasing $3.7 million from $4.0 million in the prior year second quarter. The decrease was driven primarily by a gain of approximately $3.3 million in the prior year second quarter related to the Corporation's investment in Party City Holdings, Inc. ("Party City") that did not recur in the current year period. 23 -------------------------------------------------------------------------------- Table of Contents The effective tax rate was 33.8% and 191.9% for the three months ended August 29, 2014 and August 30, 2013, respectively. The lower than statutory rate in the current period is due primarily to the favorable settlement of state audits. The higher than statutory rate in the prior period was due primarily to the recording of an $8.0 million valuation allowance against certain net operating loss and foreign tax credit carryforwards which we believed at the time would expire unused as a result of the going private transaction. Results of Operations Six months ended August 29, 2014 and August 30, 2013 Net income was $66.6 million in the six months ended August 29, 2014 compared to $28.2 million in the prior year six months. Our results for the six months ended August 29, 2014 and August 30, 2013 are summarized below: % Total % Total (Dollars in thousands) 2014 Revenue 2013 Revenue Net sales $ 924,364 98.8% $ 904,212 98.5% Other revenue 11,645 1.2% 13,512 1.5% Total revenue 936,009 100.0% 917,724 100.0% Material, labor and other production costs 380,895 40.7% 380,511 41.5% Selling, distribution and marketing expenses 338,093 36.1% 325,346 35.5% Administrative and general expenses 136,145 14.5% 153,764 16.8% Other operating income - net (25,796 ) (2.7% ) (4,279 ) (0.6% ) Operating income 106,672 11.4% 62,382 6.8% Interest expense 18,249 1.9% 9,745 1.1% Interest income (141 ) (0.0% ) (193 ) (0.0% ) Other non-operating income - net (1,379 ) (0.1% ) (5,398 ) (0.6% ) Income before income tax expense 89,943 9.6% 58,228 6.3% Income tax expense 23,364 2.5% 30,056 3.2% Net income $ 66,579 7.1% $ 28,172 3.1% For the six months ended August 29, 2014, consolidated net sales were $924.4 million, up from $904.2 million in the prior year six months. This 2.2%, or $20.2 million, increase was driven by higher sales of greeting cards of approximately $26 million, increased sales of gift packaging and party goods of approximately $1 million and the favorable impact of foreign currency of approximately $17 million. These increases were partially offset by lower sales in our fixtures business of approximately $15 million, decreased sales of other ancillary products of approximately $7 million and the unfavorable impact of SBT implementations of approximately $2 million. Other revenue, primarily royalty revenue from our Strawberry Shortcake and Care Bears properties, decreased $1.9 million in the six months ended August 29, 2014 compared to the same period in the prior year. 24-------------------------------------------------------------------------------- Table of Contents Wholesale Unit and Pricing Analysis for Greeting Cards Unit and pricing comparatives (on a sales less returns basis), excluding intercompany eliminations, for the six months ended August 29, 2014 and August 30, 2013 are summarized below: Increase (Decrease) From the Prior Year Everyday Cards Seasonal Cards Total Greeting Cards 2014 2013 2014 2013 2014 2013 Unit volume (1.4 %) 0.8 % 4.2 % 2.1 % 0.1 % 1.1 % Selling prices 4.9 % 2.7 % 2.0 % (0.2 %) 4.1 % 1.9 % Overall increase / (decrease) 3.4 % 3.5 % 6.3 % 1.9 % 4.2 % 3.0 % During the six months ended August 29, 2014, combined everyday and seasonal greeting card sales less returns increased 4.2% compared to the prior year six months. The overall increase was primarily driven by increases in selling prices from our everyday and seasonal greeting cards in our North American Social Expression Products segment and everyday greeting cards in our International Social Expression Products segment. Everyday card sales less returns were up 3.4% compared to the prior year six months, as a result of increases in selling prices of 4.9%, partially offset by a decline in unit volume of 1.4%. The increase in selling prices was driven by general price increases and favorable product mix within the core product line, which more than offset the continued unfavorable shift to a higher proportion of value cards. The unit volume decline was primarily driven by soft sales within our International Social Expression Products segment. Seasonal card sales less returns increased 6.3%, with unit volume growth of 4.2% and selling price increases of 2.0%. The increase in unit volume was attributable to our Mother's Day program in both our North American Social Expression Products and International Social Expression Products segments and our Easter program within our North American Social Expression Products segment. The increase in selling prices was driven by our Father's Day, Graduation and Fall programs in our North American Social Expression Products segment. Expense Overview MLOPC for the six months ended August 29, 2014 were $380.9 million, an increase of $0.4 million from $380.5 million for the comparable period in the prior year. As a percentage of total revenue, these costs were 40.7% in the current period compared to 41.5% for the six months ended August 30, 2013. The dollar increase was primarily due to the impact of higher sales and unfavorable product mix in the current year six months as well as the unfavorable impact of foreign currency translation of approximately $9 million. Partially offsetting these increases were lower product display material costs, lower product manufacturing expenses and the favorable impact of higher absorption of production and product related costs associated with inventory growth during the current year first half that was greater than in the prior year period. The additional inventory growth in the current year is associated with a new party goods product launch and the timing of the pre-holiday seasonal inventory build. SDM expenses for the six months ended August 29, 2014 were $338.1 million, increasing $12.8 million from $325.3 million for the comparable period in the prior year. As a percentage of total revenue, these costs were 36.1% in the current period compared to 35.5% for the prior year period. The increase was primarily driven by higher supply chain costs of approximately $4 million, increased retail store expenses of approximately $1 million and the unfavorable impact of foreign currency translation of approximately $10 million. Partially offsetting these increases were lower sales, marketing and product management expenses of approximately $2 million. Administrative and general expenses were $136.1 million for the six months ended August 29, 2014, a decrease of $17.7 million from $153.8 million in the prior year period. This decrease was driven primarily by prior year costs and fees related to taking the Corporation private of approximately $26 million that did not recur in the current year and lower stock-based compensation expense of approximately $2 million. The decrease was partially offset by higher costs in the current year of approximately $4 million related to a long-term incentive program that we established in the third quarter of the prior year as a replacement to our prior stock-based compensation programs, 25-------------------------------------------------------------------------------- Table of Contents higher technology costs of approximately $4 million and the unfavorable impact of foreign currency translation of approximately $2 million. Other operating income - net was $25.8 million for the six months ended August 29, 2014 compared to $4.3 million for the prior year six month period. The increase was driven primarily by the gain on the sale of AGI In-Store of $38.8 million, partially offset by a non-cash loss recorded upon sale of our current world headquarters location of $15.5 million, both of which occurred in the current year second quarter. In addition, in both the current year and prior year six month periods, based on updated estimated recovery information provided in connection with the Clinton Cards bankruptcy administration, we recorded an impairment recovery related to the senior secured debt of Clinton Cards that we acquired in May 2012 and subsequently impaired. The recovery was $3.4 million for the six months ended August 29, 2014 and $2.4 million for six months ended August 30, 2013. The current year recovery represents the final amount of a full recovery of the impairment. The income related to the impairment recovery in the current year first quarter was partially offset by other expenses of $2.1 million related to the Clinton Cards bankruptcy administration. Other non-operating income - net for the six months ended August 29, 2014 was $1.4 million, decreasing $4.0 million from $5.4 million in the prior year second quarter. The decrease was driven primarily by a gain of approximately $3.3 million in the prior year second quarter related to the Corporation's investment in Party City that did not recur in the current year period. The effective tax rate was 26.0% and 51.6% for the six months ended August 29, 2014 and August 30, 2013, respectively. The lower than statutory rate in the current period is due to both the recording of a net $3.1 million federal tax refund and related interest attributable to fiscal 2000 and the error corrections identified in the current year first quarter and recorded in accordance with Accounting Standards Codification ("ASC") Topic 250, Accounting Changes and Error Corrections. The net impact of the error corrections was a reduction to income tax expense of $4.1 million. During the first quarter of fiscal 2015, we identified and corrected errors in the accounting for income taxes that related primarily to the year ended February 28, 2014. These errors primarily related to our failure to consider all sources of available taxable income when assessing the need for a valuation allowance against certain deferred tax assets and the recognition of a liability for an uncertain tax position. These errors were the result of the significant complexity created as a result of the going private transaction in fiscal 2014. See Note 1, "Basis of Presentation," to the Consolidated Financial Statements for further information. The higher than statutory rate in the prior period was due primarily to the recording of an $8.0 million valuation allowance against certain net operating loss and foreign tax credit carryforwards which we believed at the time would expire unused as a result of the going private transaction. Segment Information Our operations are organized and managed according to a number of factors, including product categories, geographic locations and channels of distribution. Our North American Social Expression Products and International Social Expression Products segments primarily design, manufacture and sell greeting cards and other related products through various channels of distribution, with mass retailers as the primary channel. As permitted under ASC Topic 280 ("ASC 280"), "Segment Reporting," certain operating segments have been aggregated into the International Social Expression Products segment. The aggregated operating divisions have similar economic characteristics, products, production processes, types of customers and distribution methods. At August 29, 2014, we operated 402 card and gift retail stores in the United Kingdom ("UK") through our Retail Operations segment. These stores sell products purchased from the International Social Expression Products segment as well as products purchased from other vendors. The AG Interactive segment 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 and electronic mobile devices. The Non-reportable segment primarily includes licensing activities and the design, manufacture and sales of display fixtures. The display fixtures business was sold on the last day of the quarter ended August 29, 2014. See Note 4, "Dispositions," to the Consolidated Financial Statements for further information. Segment results are reported using actual foreign exchange rates for the periods presented. Refer to Note 18, "Business Segment Information," to the Consolidated Financial Statements for further information and a 26-------------------------------------------------------------------------------- Table of Contents reconciliation of total segment revenue to consolidated "Total revenue" and total segment earnings (loss) before tax to consolidated "Income before income tax expense." North American Social Expression Products Segment Three Months Ended August % Six Months Ended August % (Dollars in thousands) 29, 2014 30, 2013 Change 29, 2014 30, 2013 Change Total revenue $ 276,990 $ 261,694 5.8% $ 606,047 $ 589,981 2.7% Segment earnings 27,830 35,045 (20.6% ) 97,194 101,392 (4.1% ) Total revenue of our North American Social Expression Products segment increased $15.3 million for the three months ended August 29, 2014 and increased $16.1 million for the six months ended August 29, 2014 compared to the prior year periods. The increase during the current quarter was primarily driven by higher sales of greeting cards of approximately $18 million and higher sales of gift packaging and party goods of approximately $3 million. These increases for the current quarter were partially offset by lower sales of other ancillary products of approximately $4 million and the unfavorable impacts of foreign currency translation and SBT implementations of approximately $1 million each. The increase in total revenue for the six months ended August 29, 2014 was primarily driven by higher sales of greeting cards of approximately $24 million and higher sales of gift packaging and party goods of approximately $1 million. These increases for the six month period were partially offset by lower sales of other ancillary products of approximately $4 million and the unfavorable impacts of foreign currency translation and SBT implementations of approximately $3 million and $2 million, respectively. Segment earnings decreased $7.2 million in the current three months compared to the three months ended August 30, 2013. The decrease was driven primarily by a non-cash loss related to the sale of our current world headquarters location, of which approximately $13 million of the total loss of $15.5 million was recorded within the North American Social Expression Products segment, higher supply chain costs of approximately $3 million, increased technology costs of approximately $3 million and higher costs in the current year of approximately $1 million related to a long-term incentive program that we established in the third quarter of the prior year as a replacement to our prior stock-based compensation programs. These unfavorable variances were partially offset by the impact of higher revenues in the current year second quarter. Segment earnings decreased $4.2 million in the six month period ended August 30, 2014 compared to the prior year period. The decrease was driven primarily by a non-cash loss related to the sale of our current world headquarters location, of which approximately $13 million of the total loss of $15.5 million was recorded within the North American Social Expression Products segment, higher supply chain costs of approximately $5 million, increased technology costs of approximately $4 million and higher costs in the current year of approximately $3 million related to a long-term incentive program that we established in the third quarter of the prior year as a replacement to our prior stock-based compensation programs. These unfavorable variances were partially offset by the impact of higher revenues and favorable product mix in the current year six month period. International Social Expression Products Segment Three Months Ended August % Six Months Ended August % (Dollars in thousands) 29, 2014 30, 2013 Change 29, 2014 30, 2013 Change Total revenue $ 57,217 $ 54,635 4.7% $ 122,191 $ 114,344 6.9% Segment earnings 564 684 (17.5% ) 2,016 1,014 98.8% Total revenue of our International Social Expression Products segment increased $2.6 million and $7.8 million for the three and six months ended August 29, 2014, respectively, compared to the prior year periods. The increases were primarily due to the favorable impact of foreign currency translation of approximately $5 million and $7 million for the current year three and six month periods, respectively. Greeting card sales for the three months ended August 29, 2014 decreased by approximately $2 million compared to the prior year quarter while card sales 27 -------------------------------------------------------------------------------- Table of Contents for the six month period remained flat compared to the prior year. The current year six month period included the favorable impact of fewer SBT implementations of approximately $1 million. Segment earnings remained flat year-over-year for the three months ended August 29, 2014 and August 30, 2013. The impact on earnings from decreased greeting card sales as well as increased scrap expense of approximately $2 million was offset by favorable product mix. Segment earnings increased $1.0 million in the six months ended August 29, 2014, compared to the six months ended August 30, 2013. The increased earnings were primarily driven by slightly lower year-over-year supply chain and general and administrative costs. Retail Operations Segment Three Months Ended August % Six Months Ended August % (Dollars in thousands) 29, 2014 30, 2013 Change 29, 2014 30, 2013 Change Total revenue $ 69,741 $ 62,732 11.2% $ 148,905 $ 137,450 8.3% Segment loss (14,563 ) (8,984 ) (62.1% ) (18,603 ) (12,436 ) (49.6% ) Total revenue of our Retail Operations segment increased $7.0 million and $11.5 million for the three and six months ended August 29, 2014, respectively, compared to the prior year periods. The increases were driven by the impact of favorable foreign exchange translation of approximately $7 million and $13 million for the three and six month periods, respectively. During the three and six month periods ended August 29, 2014, net sales at stores open one year or more were down approximately 0.5% and 2.1%, respectively, compared to the same periods in the prior year. Segment earnings decreased $5.6 million and $6.2 million in the three and six months ended August 29, 2014, respectively, compared to the prior year periods. The lower segment earnings were the result of lower gross margins driven by promotional pricing activities and higher store operating costs. AG Interactive Segment Three Months Ended August % Six Months Ended August % (Dollars in thousands) 29, 2014 30, 2013 Change 29, 2014 30, 2013 Change Total revenue $ 14,445 $ 14,504 (0.4% ) $ 28,944 $ 29,204 (0.9% ) Segment earnings 5,964 3,165 88.4% 11,376 6,478 75.6% Total revenue of AG Interactive decreased slightly for both the three and six months ended August 29, 2014. This decrease in revenue was driven primarily by slightly lower advertising revenue compared to the prior year. At the end of the second quarter of fiscal 2015, AG Interactive had approximately 3.6 million online paid subscriptions compared to 3.7 million at the end of the same period in the prior year. Segment earnings increased $2.8 million and $4.9 million for the three and six months ended August 29, 2014 primarily due to cost savings initiatives initiated in the prior year. Non-reportable Segment Three Months Ended August % Six Months Ended August % (Dollars in thousands) 29, 2014 30, 2013 Change 29, 2014 30, 2013 Change Total revenue $ 14,032 $ 26,856 (47.8% ) $ 29,922 $ 46,745 (36.0% ) Segment (loss) earnings (1,306 ) 10,059 (113.0% ) 2,709 17,441 (84.5% ) 28 -------------------------------------------------------------------------------- Table of Contents Total revenue from our Non-reportable segment decreased $12.8 million and $16.8 million for the three and six months ended August 29, 2014, respectively, compared to the prior year periods. This decrease in revenue was driven primarily by our fixtures business, where, during the first quarter of the prior year, we obtained a contract to supply fixtures to a large consumer electronics company. This contract, which was completed during the second quarter of the prior year, contributed approximately $26 million of revenue in the prior year six month period, including approximately $16 million in the prior year second quarter, and did not recur in the first half of the current year. This decrease in revenue was partially offset by other fixtures business revenue growth. Segment earnings decreased $11.4 million and $14.7 million for the three and six months ended August 29, 2014 compared to the prior year periods. This decrease was primarily driven by the display fixtures business, due to lower sales volume, unfavorable product mix and higher operating costs. As noted above, the display fixtures business was sold on August 29, 2014. Unallocated Items Centrally incurred and managed costs are not allocated back to the operating segments. The unallocated items include interest expense for centrally-incurred debt, domestic profit-sharing expense, and for the three and six months ended August 30, 2013, stock-based compensation expense. Unallocated items also included costs associated with corporate operations such as the senior management, corporate finance, legal and insurance programs. Three Months Ended August Six Months Ended August (Dollars in thousands) 29, 2014 30, 2013 29, 2014 30, 2013 Interest expense $ (9,255 ) $ (5,433 ) $ (18,249 ) $ (9,745 ) Profit-sharing expense (1,389 ) (484 ) (5,468 ) (4,465 ) Stock-based compensation expense - (11,121 ) - (13,596 ) Corporate overhead expense 26,662 (17,249 ) 18,968 (27,855 ) Total Unallocated $ 16,018 $ (34,287 ) $ (4,749 ) $ (55,661 ) For the three and six month periods ended August 30, 2013, stock-based compensation in the table above includes non-cash stock-based compensation prior to closing of the going private transaction and the impact of the settlement of stock options and the cancellation or modification of outstanding restricted stock units and performance shares concurrent with the closing of the going private transaction, a portion of which was non-cash. There is no stock-based compensation subsequent to the closing of the going private transaction as these plans were converted into cash compensation plans. During the current year second quarter, we sold our world headquarters location and incurred a non-cash loss on disposal of $15.5 million, of which $2.2 million was recorded within the Unallocated segment. See Note 4, "Dispositions," to the Consolidated Financial Statements for further information. For both the three and six month periods ended August 29, 2014, "Corporate overhead expense" included the gain on sale of AGI In-Store of $38.8 million. See Note 4, "Dispositions," to the Consolidated Financial Statements for further information. For the three and six month periods ended August 30, 2013, "Corporate overhead expense" included non-recurring costs related to the going private transaction of approximately $12.6 million and $17.2 million, respectively. For both the three and six month periods ended August 30, 2013, "Corporate overhead expense" included a gain totaling $3.3 million related to a cash distribution on its minority investment in the common stock of Party City. Liquidity and Capital Resources The seasonal nature of our business precludes a useful comparison of the current period and the fiscal year-end financial statements; therefore, a Consolidated Statement of Financial Position as of August 30, 2013, has been included. 29-------------------------------------------------------------------------------- Table of Contents Operating Activities Operating activities used $28.3 million of cash during the six months ended August 29, 2014, compared to providing $34.1 million in the prior year period. Accounts receivable provided $0.1 million of cash during the six months ended August 29, 2014, compared to providing $9.5 million of cash during the prior year period. The year-over-year decrease in cash flow of approximately $9 million occurred primarily within our North American Social Expression Products and International Social Expression Products segments due primarily to the timing of collections from, or credits issued to, certain customers occurring in a different pattern in the current year period compared to the prior year period. Inventory used $76.6 million of cash during the six months ended August 29, 2014, compared to $49.6 million in the prior year six months. Historically, the first half of our fiscal year is a period of inventory build, and thus a use of cash, in preparation for the fall and winter seasonal holidays. In addition to the normal seasonal inventory build, the current year includes an inventory increase related to a new party goods product launch and inventory growth in our Retail Operations segment to align inventory to more normalized levels. Other current assets used $2.4 million of cash during the six months ended August 29, 2014, compared to providing $16.1 million during the prior year six months. The variance between years is due to the change in the balance of prepaid rents in our Retail Operations segment, primarily driven by year-over-year timing differences. Deferred costs - net generally represents payments under agreements with retailers net of the related amortization of those payments. During the six months ended August 29, 2014, amortization exceeded payments by $22.0 million. During the six months ended August 30, 2013, amortization exceeded payments by $24.4 million. See Note 10, "Deferred Costs," to the Consolidated Financial Statements for further detail of deferred costs related to customer agreements. Accounts payable and other liabilities used $39.4 million of cash during the six months ended August 29, 2014, compared to using $39.7 million in the prior year period. Investing Activities Investing activities provided $47.8 million of cash during the six months ended August 29, 2014, compared to using $14.6 million in the prior year period. The current year includes proceeds received from the sale of AGI In-Store and the sale of our current world headquarters of $73.7 million and $13.5 million, respectively. See Note 4, "Dispositions," to the Consolidated Financial Statements for further information. In addition, the current year includes proceeds received from H L & L Property Company, an indirect affiliate of American Greetings ("H L & L") of $9.9 million related to the sale of certain assets previously purchased by us related to the new world headquarters. Partially offsetting these cash inflows was cash paid for capital expenditures of $50.2 million during the current year six month period. In the prior year period, the cash usage was primarily driven by $32.0 million of cash paid for capital expenditures. The prior year also included the receipt of a cash distribution of $12.1 million related to our investment in Party City. Financing Activities Financing activities used $38.7 million of cash during the current year six months, compared to $56.7 million in the prior year six month period. During the current year, this use of cash was primarily driven by cash dividend payments of $24.2 million. In addition, we made payments in the aggregate of $10.0 million on our term loan and made repayments, net of borrowings, under our revolving credit facility of $4.5 million. The primary use of cash in the prior year was in connection with activities related to the going private transaction. These activities included borrowings under our new credit agreement, net of repayments and debt issuance costs, which provided cash of $285.4 million, the contribution from Century Intermediate Holding Company ("CIHC"), our parent and sole shareholder, which provided cash of $240.0 million and payment of cash of $568.3 million to 30-------------------------------------------------------------------------------- Table of Contents complete the going private transaction and cancel outstanding shares. In addition, prior to the going private transaction, we paid cash dividends of $9.6 million. Credit Sources Substantial credit sources are available to us. In total, we had available sources of credit of approximately $630 million at August 29, 2014, which included $330 million outstanding on our term loan facility, a $250 million revolving credit facility and a $50 million accounts receivable securitization facility, of which $272.3 million in the aggregate was unused as of August 29, 2014. Borrowings under the accounts receivable securitization facility are limited based on our eligible receivables outstanding. At August 29, 2014, we had no borrowings outstanding under our revolving credit facility and we had no borrowings outstanding under our accounts receivable securitization facility. We had, in the aggregate, $27.7 million outstanding under letters of credit, which reduced the total credit availability thereunder as of August 29, 2014. Please refer to the discussion of our borrowing arrangements as disclosed in the "Credit Sources" section under Part II, Item 7 of our Annual Report on Form 10-K for the year ended February 28, 2014 for further information. At August 29, 2014, we were in compliance with our financial covenants under the borrowing agreements described above. Capital Deployment and Investments On February 10, 2014, Century Intermediate Holding Company 2 ("CIHC2"), an indirect parent of American Greetings, issued $285 million aggregate principal amount of 9.75%/10.50% Senior PIK Toggle Notes due 2019 (the "PIK Notes"). Excluding the first and last interest payment periods, which must be paid in cash, CIHC2 may elect to either accrue or pay cash interest on the PIK Notes. The PIK Notes carry a cash interest rate of 9.75%. Prior to the payment of interest by CIHC2, it is expected that we will provide CIHC2 with the cash flow for CHIC2 to pay interest on the PIK Notes. Assuming interest is paid regularly in cash, rather than accrued, the annual cash required to pay the interest is expected to be approximately $27.8 million while the entire issuance of PIK Notes are outstanding. For further information, refer to the discussion of the PIK Notes as disclosed in "Transactions with Parent Companies and Other Affiliated Companies" in Note 18, "Related Party Information," to the Consolidated Financial Statements under Part II, Item 18 of our Annual Report on Form 10-K for the fiscal year ended February 28, 2014. Throughout fiscal 2015 and thereafter, we will continue to consider all options for capital deployment including growth opportunities, acquisitions and other investments in third parties, expanding customer relationships, expenditures or investments related to our current product leadership initiatives or other future strategic initiatives, capital expenditures, the information technology systems refresh project, paying down debt, paying dividends and, as appropriate, preserving cash. Our future operating cash flow and borrowing availability under our credit agreement and our accounts receivable securitization facility are expected to meet these and other currently anticipated funding requirements. The seasonal nature of our business results in peak working capital requirements that may be financed through short-term borrowings when cash on hand is insufficient. Over roughly the next five or six years, we expect to allocate resources, including capital, to refresh our information technology systems by modernizing our systems, redesigning and deploying new processes, and evolving new organization structures, all of which are intended to drive efficiencies within the business and add new capabilities. Amounts that we spend could be material in any fiscal year and over the life of the project. The total amount spent through fiscal 2014 on this project was approximately $109 million. During the six months ended August 29, 2014, we spent approximately $9 million, including capital of approximately $6 million and expense of approximately $3 million, on these information technology systems. We currently expect to spend a total of at least an additional $150 million on these information technology systems over the remaining life of the project, the majority of which we expect will be capital expenditures. We believe these investments are important to our business, helping us drive further efficiencies and add new capabilities; however, there can be no assurance that we will not spend more or less than $150 million over the remaining life of the project, or that we will achieve the anticipated efficiencies or any cost savings. 31-------------------------------------------------------------------------------- Table of Contents In May 2011, we announced plans to relocate our world headquarters to the Crocker Park mixed use development in Westlake, Ohio, which offers a vibrant urban setting, with retail stores and restaurants, offices and apartments. After putting the project on hold pending the outcome of the going private transaction, we announced plans in October 2013 to resume the project and on March 26, 2014, we purchased the land on which the new world headquarters will be built. We are leasing a portion of the real property to H L & L, which will build the new world headquarters on the site. We have also entered into an operating lease with H L & L for the use of the new world headquarters building, which we expect to be ready for occupancy in calendar year 2016. Further details of the relocation undertaking are provided in Note 18, "Related Party Information," to the Consolidated Financial Statements under Part II, Item 18 of our Annual Report on Form 10-K for the fiscal year ended February 28, 2014 and Note 17, "Related Party Information," to the Consolidated Financial Statements of this Form 10-Q. During the quarter ended August 29, 2014, we paid cash dividends in the aggregate amount of $24.2 million to CIHC, our parent and sole shareholder, $14.3 million of which was for the purpose of paying interest on the PIK Notes. In addition, H L & L paid to us $9.9 million to acquire certain assets previously purchased by us related to the new world headquarters project. Contractual Purchase Obligations In connection with the sale of AGI In-Store, effective August 29, 2014, we entered into a long-term supply agreement whereby we are committed to purchase a significant portion of our North American display fixtures requirements from Rock-Tenn Company. The supply agreement has an initial term of five years. The Corporation is committed to purchase $180 million of display fixture related products, accessories and/or services over the initial term of the agreement. Critical Accounting Policies Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Please refer to the discussion of our Critical Accounting Policies under Part II, Item 7 of our Annual Report on Form 10-K for the year ended February 28, 2014. Factors That May Affect Future Results Certain statements in this report may constitute forward-looking statements within the meaning of the Federal securities laws. These statements can be identified by the fact that they do not relate strictly to historic or current facts. They use such words as "anticipate," "estimate," "expect," "project," "intend," "plan," "believe" and other words and terms of similar meaning in connection with any discussion of future operating or financial performance. These forward-looking statements are based on currently available information, but are subject to a variety of uncertainties, unknown risks and other factors concerning our operations and business environment, which are difficult to predict and may be beyond our control. Important factors that could cause actual results to differ materially from those suggested by these forward-looking statements, and that could adversely affect our future financial performance, include, but are not limited to, the following: • a weak retail environment and general economic conditions; • the loss of one or more retail customers and/or retail consolidations, acquisitions and bankruptcies, including the possibility of resulting adverse changes to retail contract terms; • competitive terms of sale offered to customers, including costs and other terms associated with new and expanded customer relationships; • the ability of Clinton Cards to achieve the anticipated revenue and operating profits, including risks associated with leasing substantial amounts of space for its retail stores; • the timing and impact of expenses incurred and investments made to support new retail or product 32 -------------------------------------------------------------------------------- Table of Contents strategies, as well as new product introductions and achieving the desired benefits from those investments; • unanticipated expenses we may be required to incur relating to our world headquarters project; • our ability to qualify for state and local incentives offered to assist us in the development of a new world headquarters; • the timing of investments in, together with the ability to successfully implement or achieve the desired benefits and cost savings associated with, any information systems refresh we may implement; • our inability to remediate the material weakness related to our internal control over the accounting for income taxes; • the timing and impact of converting customers to a scan-based trading model; • Schurman Fine Papers' ability to successfully operate its retail operations and satisfy its obligations to us; • consumer demand for social expression products generally, shifts in consumer shopping behavior, and consumer acceptance of products as priced and marketed, including the success of advertising and marketing efforts, such as our online efforts through Cardstore.com; • the impact and availability of technology, including social media, on product sales; • escalation in the cost of providing employee health care; • the ability to comply with our debt covenants; • our ability to adequately maintain the security of our electronic and other confidential information; • fluctuations in the value of currencies in major areas where we operate, including the U.S. Dollar, Euro, UK Pound Sterling and Canadian Dollar; and • the outcome of any legal claims, known or unknown. The risks and uncertainties identified above are not the only risks we face. Additional risks and uncertainties not presently known to us or that we believe to be immaterial also may adversely affect us. Should any known or unknown risks or uncertainties develop into actual events, or underlying assumptions prove inaccurate, these developments could have material adverse effects on our business, financial condition and results of operations. For further information concerning the risks we face and issues that could materially affect our financial performance related to forward-looking statements, refer to our periodic filings with the Securities and Exchange Commission, including the "Risk Factors" section included in Part I, Item 1A of our Annual Report on Form 10-K for the fiscal year ended February 28, 2014. |