Despite the earnings jump reported by American Greetings (NYSE:AM), I'm a little cautious about declaring the quarter a victory. When life gives you lemons, you make lemonade. In the accounting world, you can either recognize the culinary and nutritional benefits of that lemonade over the time frame in which you drink it, or you can declare the lemonade a one-time gain and book all of the benefits up front.
For the third quarter, American Greetings' sales fell 7%, but net income increased 385% to $49.7 million. Of this increase, $20 million was related to a one-time gain linked to retailer consolidation. When retailers such as Safeway (NYSE:SWY) and SUPERVALU (NYSE:SVU) consolidate stores, they have to renegotiate their contract with American Greetings. According to management, these contract renegotiations created $20 million in future benefits for the company. In the fourth quarter, the company will receive a $60 million cash inflow, and in the future variable costs will decrease cash flow.
In such situations, management usually has the choice of booking gains up front or recognizing the gains over the life of the benefit. Although I don't know the specific details of the renegotiated contracts and therefore refrain from passing judgment on the decision to book the $20 million gain, I nevertheless just don't like to see upfront gains. I prefer to see the gains booked over the life of the benefit. American Greetings' North American social expression segment, which earned $86.7 million and accounts for the bulk of the company's profits, would have been down $16.4 million from the prior year without the gain.
Accounting debates aside, American Greetings seems to have been dealt a tough set of cards but is dealing with the situation. The company has been favoring profitability over growth, and has cut some business in gift wrapping and closed some underperforming stores; it had 496 stores at the end of the quarter. The company has also embarked on changes designed to improve profitability through supply-chain efficiency and shifting the sales mix to higher-margin goods.
The company continues to buy shares hand over fist, with a target of having 56 million shares outstanding (it now has 59 million) when the fiscal year closes, down a whopping 30% from 78.7 million shares a year ago. This magnitude of share buybacks indicates management thinks the company is wildly undervalued, which signals that investors who think that this company can stabilize and continue to milk free cash flow might want to take a closer look.
- Here's some more bearish commentary on American Greetings.
- And some slightly more optimistic analysis.
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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates comments, concerns, and complaints. The Motley Fool has a disclosure policy.
