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CSS Industries – A Gift Wrapped Opportunity?

June 07, 2011 | About:
Nathan Tedford

Nathan Tedford

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CSS Industries – A Gift Wrapped Opportunity? - June Value Contest Submission

Corporate Overview:

From the 2011 10-K: “CSS Industries is a consumers products company primarily engaged in the design, manufacture, procurement, distribution, and sale of seasonal and all occasion social expression products principally to mass market retailers. These seasonal and all occasion products include decorative ribbons and bows, boxed greeting cards, gift tags, gift wrap, gift bags, gift boxes, gift card holders, decorative tissue paper, decorations, classroom exchange Valentines, floral accessories, Halloween masks, costumes, make-up and novelties, Easter egg dyes and novelties, craft and educational products, stickers, memory books, stationary, journals, notecards, infant and wedding photo albums, scrapbooks, and other gift items that commemorate life’s celebrations.”

Headquartered in Philadelphia, Penn., CSS Industries (CSS) competes in the above markets primarily within North America. Based on the product mix that they sell, their operating results are highly seasonal with 59% of their sales attributable to holiday products in general (Christmas, Halloween, Valentine’s Day, & Easter) and 46% attributable to Christmas alone. Due to the seasonality of the business, the company typically records operating losses in their first and fourth quarter (from January to June) with the bulk of their operating profits and cash flow coming in the second and third quarters.

Sustainability of Market Share

CSS operates in what I would consider a highly competitive industry. Though branding can help when it comes to influencing consumer choices, I believe design, manufacturing quality, relationships with key vendors and price have a larger impact on consumer choice than branding in this space. If a competitor were to significantly surpass CSS’s offerings in one or all of these measures, CSS’s operating results could suffer.

That being said, CSS has historically been very successfully operated in this highly competitive environment. Based on their operating results, I consider them to be well-adapted in meeting consumer demand in this space and in satisfying their key relationships with retailers. Given their operating history I have no reason to believe that they will not be able to continue to adapt and perform in this space in the future. However, as with any company, there are potential risks, the most important of which I will discuss below.

Fundamentals - Assets

Throughout the year, CSS uses revolving debt facilities to fund operations during the first, second, and third quarters. Outstanding debt on these facilities is then paid off after the Christmas season as operating cash flow becomes positive in the third and fourth quarters. As the cash-to-debt ratio and enterprise value fluctuates throughout the year, only year-end results from 10-Ks have been reported herein as they take into account the business performance over an entire business “cycle” (one year).

Examining their most recent balance sheet, CSS is in a very strong financial position. The company has no long term debt outstanding and a significant net cash balance. Both their Z-score of 5.94 and their F-score of 8 are above average and confirm their strong financial position.

To determine the attractiveness of CSS from an asset standpoint, Table 1 presents some of the key balance sheet metrics for this stock.

Table 1: Balance Sheet Valuation Ratios

Net Cash per Share: $5.18
Net Current Asset Value per Share: $14.49
Book Value per Share: $24.21
Tangible Book Value per Share: $19.21
Price Per Share: $18.00


As can be seen from the above table, CSS is trading below both its book value and tangible book value and approximately 25% above its net current asset value. As an added bonus, just under 30% of the share price is in cash on the balance sheet as of year end.

Looking into the future, CSS currently maintains a defined contribution pension plan for its employees which does not expose it to significant long-term unfunded pension liabilities. However, they do have obligations related to a historical post-retirement medical benefit plan that was in effect for employees at a company acquired in 2002. After the acquisition this plan was frozen and is currently operated on an unfunded basis with the total benefit obligation of the plan reflected as a long-term liability on the balance sheet. Annual expenses related to the plan have averaged $60,000 over the last three years which represents less than 0.2% of their average annual operating cash flow. As such, unfunded retirement liabilities are not considered to be a material factor in this investment thesis.

Fundamentals – Cash Generation

To get an idea of the sustainability and quality of the CSS’s operating results over the last 10 years, Table 2 presents some of their key financial ratios and operating metrics as calculated from their historical 10-Ks.

Table 2: Historical Operating Performance

FY Gross Margin FCF Margin FCF / share Real FCF / share Real EBIT / share
2002 27.1% 8.3% $3.60 $4.46 $4.50
2003 26.3% 10.7% $5.85 $7.08 $5.43
2004 26.6% 7.0% $3.89 $4.63 $6.08
2005 25.9% 5.6% $3.07 $3.56 $5.90
2006 24.0% 3.4% $1.86 $2.10 $4.18
2007 25.7% 9.4% $5.14 $5.66 $4.42
2008 27.6% 6.7% $3.43 $3.63 $4.34
2009 26.2% 2.9% $1.42 $1.46 $3.01
2010 24.7% 9.9% $4.54 $4.59 -$3.02*
2011 25.4% 6.4% $2.97 $2.97 $1.04**
Ave. 25.9% 7.0% $3.58 $4.01 $3.59
* Negative earnings due to goodwill impairment charge

** Impacted by announced restructuring charges (discussed below)


From Table 2, CSS has produced positive free cash flow in each of the past 10 years with an inflation adjusted average annual free cash flow of $4.01 per share. Using this 10-year average and a recent price of $18.00, CSS is trading at a free cash flow yield of over 20% which is extremely high for a consistently profitable company. In order to justify this free cash flow yield, investors have to assume that the free cash flow generation capabilities of CSS will collapse over the coming years very quickly.

In my view, the largest perceived risk associated with CSS is that investors feel that foreign competition will be able to enter their competitive space and undercut them on price with comparable quality. However, I think this risk is largely overblown. CSS currently sources materials related to 56% of their sales from foreign suppliers. In addition, they have recently announced that they will close their gift-wrap manufacturing facility in the United States by the end of 2011 and transition that portion of the business to foreign suppliers as well.

To coincide with this announcement, CSS recorded a non-cash pre-tax tangible asset impairment charge of $11 million which represents the full impairment of the tangible assets associated with this facility. CSS also expects to incur pre-tax charges of $10 million in fiscal year 2012 related to this restructuring. Due to these impairment charges, CSS’s reportable earnings and EBIT for 2011 were impacted. Furthermore, their 2012 results will also be impacted. However, as this restructuring should help to ensure that CSS remains competitive within their market segment, this restructuring should only help their operating results going forward. This also presents us with an opportunity, as the “normal” earnings power of the business is currently hidden behind these one-time restructuring charges.

Fundamentals – Operating Metrics

To further examine the sustainability of CSS’s business, a Dupont-style analysis has been completed with results for each of the components presented below. In these calculations, the effect of one-time charges has been included.

Table 3: Historical Operating Performance

FY Profit Margin Asset Turnover RoA Leverage Ratio RoE Cash Conversion Cash RoE RoC
2002 5.1% 1.42 7.2% 127% 9.2% 163% 14.9% 16.9%
2003 3.2% 1.52 4.9% 158% 7.7% 334% 25.8% 18.0%
2004 5.5% 1.46 8.1% 148% 12.0% 127% 15.2% 18.2%
2005 5.7% 1.61 9.2% 154% 14.2% 97% 13.8% 21.4%
2006 4.2% 1.57 6.5% 143% 9.4% 83% 7.8% 15.2%
2007 4.5% 1.55 7.0% 131% 9.1% 209% 19.2% 15.5%
2008 5.1% 1.44 7.3% 131% 9.7% 131% 12.7% 20.9%
2009 3.5% 1.50 5.3% 124% 6.6% 81% 5.3% 16.4%
2010 -5.3% 1.59 -8.4% 120% -10.2% -186% 19.0% -15.5%
2011 1.2% 1.57 2.0% 121% 2.4% 515% 12.3% 5.2%
Ave. 3.3% 1.52 4.9% 136% 7.0% 155% 14.6% 13.2%


From Table 3, CSS has averaged a cash return on equity of 14.6% over the last 10 years. As CSS is currently trading slightly below tangible book, the anticipated cash return on equity at this price is over 15% per year assuming that CSS continues to perform in line with their historical averages. The trend in reduced operating leverage that has been evident from 2003 onwards has a potential to reduce the predicted return by a few percentage point, but as CSS has tended to grow by acquisition in the past, there is a chance that they will re-leverage at some time in the future.

CSS’s historical return on tangible capital is 13.2% which I consider to be average. However, this number also includes the effects of the large goodwill writedown in 2010 and the impact of restructuring charges in 2011. Excluding these events, the “normalized” RoC is approximately 18%. In either case, the RoC values indicated that CSS should be worth at least tangible book value, as it is able to provide a return greater than the long-term after-tax return of the market.

Risks

In addition to the risk of foreign competition, CSS also faces the potential of margin compression due to demands placed on them from their largest customers. As CSS derives 24% of its sales from Walmart (WMT) and its affiliates and 12% of its sales from Target (TGT), this is a concern. However, as they have managed to maintain a relatively steady gross margin over the last 10 years, I do not see this as a real risk moving forward.

In my opinion, the primary risk to CSS’s business performance is the sensitivity of CSS to the state of the US economy. As a significant majority of CSS’s sales come from the US, if there is another downturn in consumer spending, operating results could suffer until the recovery is complete. Examining the historical FCF numbers in Table 2, CSS generated significantly less FCF in 2009 than in any of the other ten years reported. However, they did manage to remain profitable. In any case, I see this as more of a short-term risk than a long-term risk which is partially mitigated by the solid asset backing present on the balance sheet.

Shareholder Relations and Ownership

CSS pays a regular quarterly dividend of $0.15 resulting in a current yield of approximately 3.3%. The dividend is also well covered with a payout ratio of 20% based on the FCF generated in the 2011 fiscal year. In addition to the dividend, CSS has bought back a number of its shares in the open market from time to time. Though no share repurchases were completed in 2010 or 2011, they have been buying back shares on an infrequent basis since 2004, with a large repurchase in 2009. They also currently have an active share repurchase agreement with a remaining authorization. Given the recent cash built up on the balance sheet, I would not be surprised to see an increased dividend, buyback, or acquisition over the next few years.

Summary

CSS seems to present a good opportunity for medium to long-term capital gains while minimizing the potential for permanent capital losses. At a share price of $18.00 CSS trades below its tangible book value and approximately 25% above its NCAV. This type of asset backing should provide a solid foundation against a permanent loss of capital while invested this stock.

Based on CSS’s “normal” FCF and EBIT generation capabilities, I expect the intrinsic value of CSS to lie somewhere between $40 and $65 per share after assigning typical market multiples and accounting for the excess cash present on the balance sheet at the end of the 2011 FY. As the restructuring charges incurred due to the closure of one of their US manufacturing facilities will impact their 2012 results, I expect that “normal” earnings reports in 2013 and beyond should provide a tailwind to help CSS reach its intrinsic value.

Disclaimer:

The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question. The investing methodology outlined in this article assumes that a stock will perform in the future as it has in the past. This is generally not true. It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation.

Full Disclosure: Long CSS.


Rating: 3.1/5 (15 votes)

Comments

matt83
Matt83 - 3 years ago
Nathan

CSS recently popped up on my radar as well. I'm still struggling on whether or not the facts warrant a position in the security. I have a few comments on the article submission.

One of the things you noted and did not account for in some of your metrics is the seasonality of the business. Employing fiscal year-end (3-31) balances is somewhat misleading given that 74.2% and 76.4% of sales occur during the quarters ending Sept and Dec for the last two years. A similar relation exists historically. For example, during fiscal 2011, cash (Q1-Q4) stood at $2.8mm, $2.1mm, $4.2mm, and $50.4mm. Cash is unusually high due to the collection of A/R so it's not true cash. Invested capital also balloons with seasonal borrowings given the inventory build-up surrounding Q2 and Q3 sales. I used average invested capital for my ROIC computation and came up with slightly different figures. Same applies to ROA and ROE.

Also, at current levels of profitability, they are destroying incremental invested capital. After-tax ROIC (on tangible capital) has come down from a respectable 10.5% in '07 and 11.9% in '08 to 8.4% ('09), 4.7% ('10), and 6.9% ('11). Top-line growth has been negative and SG&A has remained level, thereby compressing ROIC. The only way CSS is "bailed out" is through higher sales. This is a bet on a mean reversion in consumer spending. Not to say that this isn't a valid assumption because equities are priced as though consumers fell off a cliff. It's just something to be aware of.

-Matt

Adib Motiwala
Adib Motiwala - 3 years ago
Matt,

Your analysis is spot on. EBITDA margins have been shrinking since 06/07. Management has not been able to cut SGA. I assume those are fixed costs and if sales recover then margins should recover. However, with flat sales over the years and low and seasonal profits, my confidence is low on this kind of business.

On the positive side, it appears cheap on most metrics. I note that the EV equals last four years of FCF so payback is 4 years on this investment.

Interesting to see how things progress.

matt83
Matt83 - 3 years ago
Adib -

The way I initially viewed a prospective investment in CSS is akin to a call option. I computed the ratio of average market cap to average tangible book value historically and it provides a good deal of comfort in the floor value. I can't agree with the upside Nathan alluded to. Here's my math on possible valuation.

TTM FCF ~ $30mm capitalized @ 10% and a net debt adjustment reflecting (again) average cash and debt balances gives a share price of $29.71. FCF peaked around $50mm in '07, but that is only due to a run off in inventory specific to that year. '08 FCF (with similar net income) amounts to a FCF of $36mm. The details are

2007

Net Income $23.9mm + Non-Cash Adjustments $13.6 + Working Cap Adjustments $17.9mm

2008

Net Income $25.4mm + Non-Cash Adjustments $19.5 + Working Cap Adjustments $(3.2mm)

So the FCF is borrowed from the year after (or prior if we want to get into semantics). The $40 price target implies about $40mm +/- in FCF, whereas the $65 target implies a record breaking and unreachable $65mm +/- in FCF. I am comfortable with a $30mm run rate under the assumption that sales don't continue to bleed. Anything more is a bit of a stretch.

In this environment it is a potentially interesting asymmetric bet.
EngineeringIncome
EngineeringIncome - 3 years ago
Hi Matt,

Thanks for the comment. The reason that I did not account for the seasonality of the business is that I don't think the fact that CSS is a seasonable business should be held against it. The way I think of it, if we had a business identical to CSS, but which earned its income equally throughout the year, there would be no need for the use of the revolving credit lines and its profitability and operating metrics would be as stated. The penalty that CSS pays for their seasonal business is reflected in the interest expense associated with the use of their revolving credit facilities (which reduces net income and OCF). I don’t really think of CSS’s revolving credit lines as ‘true’ invested capital as they are a simply a way to cope with the seasonal nature of the business. The fact that the business is seasonal also does not take away from the fact that the business has a relatively reliable and profitable track record.

Regarding the cash on the balance sheet, while I agree that the cash fluctuates significantly on a quarter to quarter basis, the long term ‘trend’ in the company’s net cash (or debt) position only becomes evident at the end of each annual business ‘cycle’. Looking at the historical balance sheets, the recent trend has been to eliminate long-term debt and increase cash.

I agree that their return on tangible capital has been severely impacted by the recession and that this is largely a mean reversion bet. That being said, with the current price and asset backing I do think that it’s a relative safe, and potentially rewarding one.

Nathan

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