Sunday, January 15, 2006

Factory Card -- Where's the Party?

Factory Card & Party Outlet (FCPO-$7.69) based in Naperville, Illinois, is a chain of company-owned stores offering an extensive selection of party supplies (invitations, party favors, candles, and piƱatas), greeting cards, giftwrap, balloons, everyday and seasonal merchandise and other special occasion merchandise at everyday value prices. As of October 29, 2005, the Company operated 189 Company-owned retail stores in 20 states, pricipally in the midwest and the eastern seaboard. The Company's primary card supplier is Rhode Island-based Paramount Cards. FCPO filed for bankruptcy in 1999 and emerged in April 2002.

The share price of FCPO has plummeted almost 32% in the last year, for the Company has missed sales targets and experienced negative comparable store sales of 1.3% in the first-nine months of FY '05. Because of underperforming business trends, management performed an impairment review of each store in the third quarter ended October 29, 2005, resulting in a pre-tax charge of $200,000 (related to fixed asset impairment). No impairment charges were incurred in fiscal 2004.

On January 13, 2006, Cramer, Rosenthal & McGlynn (CRM LLC), a limited liability company that provides investment management services, and is one of the largest institutional holders of FCPO, filed a Form 13D. CRM LLC is noticeably upset with FCPO management, given that their 159,000 shares, or 5.07% stake, has lost 28.7%, or approximately $493,000 in aggregate value.

In the 13D filing, CRM LLC publicly stated their belief that the Company's stock trades at a distressed valuation as a result of a number of factors. These include, but are not limited to, (1)inadequate management, (2) misguided and failed sales growth strategies, and, (3) poor corporate governance. Ergot, CRM LLC is lobbying for extraordinary action, such as changes in Company management, changes in the Company's board of directors or retention of an investment banker to consider strategic alternatives, including a sale of the Company, which may be required in order to realize the Company's 'intrinsic value.'

The 10Q Detective decided to step into the fray and see if there was merit to CRM's concerns:

Management's strategies to increase sales in the past quarters has been wholly unsuccessful. One example CRM cited was management's determination to make a "strategic commitment" to the Halloween selling season in 2005 and the significant investments made to that end. FCRO made a substantial investment in store payroll and advertising with the anticipation of a larger and quicker ramp up to the Halloween season.

For the quarter ended October 29, 2005, net sales did increase 4.7 percent to $56.2 million. However, the Company still bled red ink, for the net loss in the third quarter of 2005 was $1.2
million, or a share-net losss of $0.39, compared to reported net income of $472,000, or $0.14 per fully diluted share, last year. The increase was attributed to an increased store count coupled with a modest 1.0% increase in comparable store sales.

Operating performance was negatively affected by higher store occupancy costs; net increases in advertising expense directly rated to FCPO's attempt to drive customer counts through use of a direct mail program; Internet advertising as well as billboards in the third quarter of fiscal 2005; and, an impairment charge related to fixed assets at under-performing stores.

The Company purportedly showed that cash flow from operations generated $4.0 million. If, however, you subtract an increase of $7.5 million in accounts payable and a $2.5 million increase in accrued expenses, operations would have used approximately $6.0 million!

FCPO's business is highly seasonal, with operating results varying from quarter to quarter. Historically, the Company experiences higher sales during the second and fourth fiscal quarters due to increased demand by customers for products attributable to special occasions and the holiday seasons during these selling months. Unfortunately, as CRM LLC has brought to light, management cannot seem to sustain top-line growth. On January 5, 2006, FCPO
announced that net sales for the critical December 2005 holiday month fell 0.6 percent, compared with the five-week period ended last year. And the more important performance metric--comparable store sales (for the same period) decreased 2.8 percent.

For the nine months ended October 29, 2005, corporate spent $4.5 million on investment activities. Significant expenditures incurred in the current year include new store openings, computer equipment and software, store remodelings, the rollout of a private label program, and warehouse equipment for a distribution center.

Where are the purported operating efficiencies from the Company's bragged about 300,000 square-foot distribution center? Gross profit was 35.8% for the third quarter of fiscal 2005 compared to 36.3% last year. This purported leverage of freight and distribution costs continued to be offset by higher store occupancy costs and the expenses of new, 'innovative' product roll-outs. While management was disappointed with these results, they still believe that this performance is not indicative of FCPO's future potential.

To unlock this future potential and to improve logistic efficiencies, corporate also recently installed a state-of-the-art 'Demand-Chain' replenishment system; revamped its entire greeting card category; enhanced its database marketing capabilities; and, launched an E-Commerce site. The 10Q Detective agrees with CRM LLC, for management is constantly cooking up new merchandising schemes in its kitchen, but the birthday cake always seems to taste stale: "We are well positioned for the graduation season and look forward to the full implementation of our new line of greeting cards from Premier Greetings in early May."--[Gary Rada, CEO, commenting on last year's results/BusinessWire, April 2005]

Sadly, CRM LLC is probably correct, too, that the current initiatives will not go far enough to position FCPO to improve future financial results. According to industry sources, the market for party and special occasion merchandise, comprised of party supplies, greeting cards, gift-wrap, and related items, was estimated at $14 billion in sales in 2003. And, as the highly fragmented market demonstrates, barriers to entry are low, and consumers purchasing party-related products embrace passive loyalty among party supply stores, designated departments in drug stores, general mass merchandisers like Wal-Mart and Target, supermarkets and department stores of local, regional and national chains.

Major chain competitors in the Company's markets include Party City, Hallmark Cards, and iParty. Recently, FCPO has also started to compete with internet and catalog businesses with similar merchandise and product offerings. Hence with all these comers crashing the paper party, the 10Q Detective is skeptical that FCPO can contain competitive pricing ressures. Too, continued costs to update older stores, salary expenses, costs of targeted ad campaigns, and [no-doubt] coming inventory writedowns from misread consumer demand, will expand future SG&A expenses.

CRM is also rallying against the conflicts of corporate governance, for the interests of management and the board are not aligned with those of the stockholders. According to CRM, actions taken by the board indicate a blatant disregard for the interests of stockholders, to whom they owe fiduciary duties. CRM alleges in its filing that salaries paid to senior management are not justified--having increased over the past three years--despite a quantifiable record of uneven quarterly operating histories. Looking at 8K-SEC filings through December 2005, the 10Q Detective was able to ascertain that the salaries of the top three executives (Rada-CEO/ Gower-Sr. VP/ Misch-CFO) --excluding bonus', incentive stock options, and understated severance packages--totaled $1.06 million for the current FY ended January 2006. Pro-rating for the first nine-months, the aggregate payroll of $817,500 contributed 13.45% to total SG&A expenses!

In light of all these disclosures, the best strategic alternative that CRM proffers to unlock shareholder value would be an outright sale of the Company. Looking at a recent comparative--a good example would be the acquisition of Party City Corporation by AAH Holdings. Completed
in December 2005, shareholders received $17.50 per share in cash for each share of common stock outstanding, without interest, for total consideration of approximately $364 million. Park City went quietly for 4x sales multiple. FCPO, with margins contracting and top-line growth stagnant, however, could never command that type of valuation. Currently, with a ROE of (10.8%) and a P/S ratio of 0.16x [reflecting this abysmal operating history], FCPO would be lucky to roll off the table for its enterprise value of $38.12 million, or approximately $12.00 per share.

Three years removed from bankruptcy, FCPO's business dream remains--to become the premier specialty retailer of greeting cards and party supplies in the United States through merchandising innovation, value orientation and controlled growth. We applaud FCPO for trying to control inventory costs. Still, despite the size and scope of its merchandise offerings, we doubt that corporate can do much about its variable costs. FCPO has an erratic history of cash flow, and the 10Q Detective believes that the only way FCPO can unlock its potential value is either growth through acquisitions, or by letting itself be acquired. That said, however, this is one party we'd prefer not to go to...."wife has the flu"--pass!

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