American Greetings Corporation 10-Q
Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended August 31, 2005
OR
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                                          to                                         
Commission file number 1-13859
AMERICAN GREETINGS CORPORATION
(Exact name of registrant as specified in its charter)
     
Ohio   34-0065325
     
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer Identification No.)
     
One American Road, Cleveland, Ohio   44144
 
(Address of principal executive offices)   (Zip Code)
(216) 252-7300
 
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes þ No o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
As of October 4, 2005, the number of shares outstanding of each of the issuer’s classes of common stock was:
             
 
  Class A Common   61,496,467    
 
  Class B Common   4,221,126    
 
 

 


AMERICAN GREETINGS CORPORATION
INDEX
         
 
       
       
 
       
     
 
     
     
 
     
     
 
     
     
 
     
     
 
     
     
 
     
     
 
     
     
 
     
     
 
     
     
 
     
     
 
     
     
 
     
EXHIBITS
     
 Exhibit 10.1 Executive Deferred Comp Plan
 Exhibit 10.2 Amendment 1 to Executive Deferred Comp Plan
 Exhibit 10.3 Amendment 2 to Executive Deferred Comp Plan
 Exhibit 10.4 Amendment 3 to Executive Deferred Comp Plan
 Exhibit 10.5 Form of Agreement for Deferred Comp benefits
 Exhibit 10.6 Form of Agrmt Under Amend 3 to Exec Deferred Comp
 Exhibit 10.7 Performance Share Grant Agreement/Zev Weiss
 Exhibit 10.8 Performance Share Grant Agreement/Jeffrey Weiss
 Exhibit 31(a) Section 302 Certification of CEO
 Exhibit 31(b) Section 302 Certification of CFO
 Exhibit 32 Section 906 Certification of CEO and CFO

 


Table of Contents

PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
AMERICAN GREETINGS CORPORATION
CONDENSED CONSOLIDATED STATEMENT OF INCOME
(Thousands of dollars except share and per share amounts)
                                 
    (Unaudited)  
    Three Months Ended     Six Months Ended  
    August 31,     August 31,  
    2005     2004     2005     2004  
Net sales
  $ 387,556     $ 392,084     $ 830,832     $ 825,625  
 
                               
Costs and expenses:
                               
Material, labor and other production costs
    176,316       186,717       356,789       368,332  
Selling, distribution and marketing
    147,328       146,303       302,602       292,955  
Administrative and general
    58,970       57,505       122,098       121,642  
Interest expense
    8,587       9,163       18,269       61,857  
Other income — net
    (11,932 )     (17,230 )     (20,303 )     (33,576 )
 
                       
Total costs and expenses
    379,269       382,458       779,455       811,210  
 
                       
 
                               
Income from continuing operations before income tax expense
    8,287       9,626       51,377       14,415  
Income tax expense
    5,046       3,726       21,722       5,579  
 
                       
 
                               
Income from continuing operations
    3,241       5,900       29,655       8,836  
 
                               
Income from discontinued operations, net of tax
          1,010             2,312  
 
                       
 
                               
Net income
  $ 3,241     $ 6,910     $ 29,655     $ 11,148  
 
                       
 
                               
Earnings per share — basic:
                               
Income from continuing operations
  $ 0.05     $ 0.09     $ 0.44     $ 0.13  
Income from discontinued operations
          0.01             0.03  
 
                       
Net income
  $ 0.05     $ 0.10     $ 0.44     $ 0.16  
 
                       
 
                               
Earnings per share — assuming dilution:
                               
Income from continuing operations
  $ 0.05     $ 0.09     $ 0.41     $ 0.13  
Income from discontinued operations
          0.01             0.03  
 
                       
Net income
  $ 0.05     $ 0.10     $ 0.41     $ 0.16  
 
                       
 
                               
Average number of common shares outstanding
    67,101,944       68,418,773       67,848,865       68,209,732  
 
                               
Average number of common shares outstanding — assuming dilution
    67,913,912       69,265,799       81,240,972       69,057,063  
 
                               
Dividends declared per share
  $ 0.08     $     $ 0.16     $  
See notes to condensed consolidated financial statements (unaudited).

3


Table of Contents

AMERICAN GREETINGS CORPORATION
CONDENSED CONSOLIDATED STATEMENT OF FINANCIAL POSITION
(Thousands of dollars)
                         
    (Unaudited)     (Note 1)     (Unaudited)  
    August 31, 2005     February 28, 2005     August 31, 2004  
ASSETS
                       
 
                       
Current assets
                       
Cash and cash equivalents
  $ 163,807     $ 250,267     $ 152,763  
Short-term investments
    208,750       208,740        
Trade accounts receivable, net
    172,020       188,987       232,054  
Inventories
    296,133       222,874       308,977  
Deferred and refundable income taxes
    176,265       193,497       152,143  
Assets of businesses held for sale
                40,390  
Prepaid expenses and other
    219,244       204,253       218,931  
 
                 
Total current assets
    1,236,219       1,268,618       1,105,258  
 
                       
Goodwill
    260,276       270,057       231,886  
Other assets
    603,757       644,140       628,619  
 
                       
Property, plant and equipment — at cost
    976,308       995,281       992,348  
Less accumulated depreciation
    657,361       653,889       652,049  
 
                 
Property, plant and equipment — net
    318,947       341,392       340,299  
 
                 
 
  $ 2,419,199     $ 2,524,207     $ 2,306,062  
 
                 
LIABILITIES AND SHAREHOLDERS’ EQUITY
                       
 
                       
Current liabilities
                       
Accounts payable
  $ 132,978     $ 143,041     $ 150,513  
Accrued liabilities
    118,980       118,090       101,951  
Accrued compensation and benefits
    76,933       96,789       65,891  
Income taxes
    21,462       38,777       15,012  
Liabilities of businesses held for sale
                4,462  
Other current liabilities
    116,564       79,549       68,201  
 
                 
Total current liabilities
    466,917       476,246       406,030  
 
                       
Long-term debt
    476,222       486,099       483,876  
Other liabilities
    121,467       137,868       105,480  
Deferred income taxes
    37,077       37,214       27,427  
 
                       
Shareholders’ Equity
                 
Common shares — Class A
    62,170       64,867       64,022  
Common shares — Class B
    4,221       4,160       4,603  
Capital in excess of par value
    391,174       368,777       348,474  
Treasury stock
    (536,249 )     (445,618 )     (435,107 )
Accumulated other comprehensive income
    12,853       29,039       10,325  
Retained earnings
    1,383,347       1,365,555       1,290,932  
 
                 
Total shareholders’ equity
    1,317,516       1,386,780       1,283,249  
 
                 
 
  $ 2,419,199     $ 2,524,207     $ 2,306,062  
 
                 
See notes to condensed consolidated financial statements (unaudited).

4


Table of Contents

AMERICAN GREETINGS CORPORATION
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(Thousands of dollars)
                 
    (Unaudited)  
    Six Months Ended  
    August 31,  
    2005     2004  
OPERATING ACTIVITIES:
               
Net income
  $ 29,655     $ 11,148  
Income from discontinued operations
          2,312  
 
           
Income from continuing operations
    29,655       8,836  
Adjustments to reconcile to net cash provided by operating activities:
               
Gain on sale of investment
          (3,095 )
Loss on sale of fixed assets
    1,628       1,127  
Loss on extinguishment of debt
    863       39,056  
Depreciation and amortization
    28,426       28,321  
Deferred income taxes
    25,773       (5,787 )
Other non-cash charges
    1,749       1,038  
Changes in operating assets and liabilities, net of acquisitions:
               
Decrease (increase) in trade accounts receivable
    11,685       (238 )
Increase in inventories
    (75,697 )     (72,229 )
(Increase) decrease in other current assets
    (17,865 )     8,590  
Decrease in deferred costs — net
    52,774       71,006  
(Decrease) increase in accounts payable and other liabilities
    (29,901 )     2,358  
Other — net
    4,580       2,672  
 
           
Cash Provided by Operating Activities
    33,670       81,655  
 
               
INVESTING ACTIVITIES:
               
Proceeds from sale of short-term investments
    1,070,480        
Purchases of short-term investments
    (1,070,490 )      
Property, plant and equipment additions
    (18,780 )     (15,019 )
Proceeds from sale of fixed assets
    7,369       115  
Cash payments for business acquisitions
          (3,894 )
Investment in corporate owned life insurance
    (2,219 )     (2,861 )
Other — net
    (5,893 )     19,783  
 
           
Cash Used by Investing Activities
    (19,533 )     (1,876 )
 
               
FINANCING ACTIVITIES:
               
Reduction of long-term debt
    (10,782 )     (216,417 )
Sale of stock under benefit plans
    21,302       18,739  
Purchase of treasury shares
    (98,026 )     (9,363 )
Dividends to shareholders
    (10,906 )      
 
           
Cash Used by Financing Activities
    (98,412 )     (207,041 )
 
               
CASH USED BY DISCONTINUED OPERATIONS
          (2,789 )
 
               
EFFECT OF EXCHANGE RATE CHANGES ON CASH
    (2,185 )     (2,636 )
 
           
DECREASE IN CASH AND CASH EQUIVALENTS
    (86,460 )     (132,687 )
 
               
Cash and Cash Equivalents at Beginning of Year
    250,267       285,450  
 
           
Cash and Cash Equivalents at End of Period
  $ 163,807     $ 152,763  
 
           
See notes to condensed consolidated financial statements (unaudited).

5


Table of Contents

AMERICAN GREETINGS CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Three and Six Months Ended August 31, 2005 and 2004
Note 1 – Basis of Presentation
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary to fairly present financial position, results of operations and cash flows for the period have been included.
The Corporation’s fiscal year ends on February 28 or 29. References to a particular year refer to the fiscal year ending in February of that year. For example, 2005 refers to the year ended February 28, 2005. For 2005, the Corporation’s subsidiary, AG Interactive, was consolidated on a two-month lag corresponding with its fiscal year-end of December 31. For 2006, AG Interactive has changed its fiscal year-end to coincide with the Corporation’s fiscal year-end. As a result, the six months ended August 31, 2005 includes eight months of AG Interactive’s operations. The additional two months of activity generated revenues of approximately $11 million for the six month period ended August 31, 2005, but had no significant impact on segment earnings.
These interim financial statements should be read in conjunction with the financial statements and notes thereto included in the Annual Report on Form 10-K for the year ended February 28, 2005 of American Greetings Corporation (the “Corporation”), from which the Condensed Consolidated Statement of Financial Position at February 28, 2005, presented herein, has been derived. Certain amounts in the prior year financial statements have been reclassified to conform to the 2006 presentation.
Note 2 – Seasonal Nature of Business
A significant portion of the Corporation’s business is seasonal in nature. Therefore, the results of operations for interim periods are not necessarily indicative of the results for the fiscal year taken as a whole.

6


Table of Contents

Note 3 — Recent Accounting Pronouncements
In November 2004, the Financial Accounting Standards Board (the “FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 151 (“SFAS 151”), “Inventory Costs — an amendment of ARB No. 43, Chapter 4.” SFAS 151 seeks to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage) in the determination of inventory carrying costs. The statement requires such costs to be treated as a current period expense. SFAS 151 also establishes the concept of “normal capacity” and requires the allocation of fixed production overhead to inventory based on the normal capacity of the production facilities. Any unallocated overhead would be treated as a current period expense in the period incurred. This statement is effective for fiscal years beginning after July 15, 2005. The Corporation does not believe that the adoption of SFAS 151 will have a significant impact on the Corporation’s consolidated financial statements.
In December 2004, the FASB issued SFAS No. 123 (revised 2004) (“SFAS 123(R)”), “Share-Based Payment.” SFAS 123(R) requires that compensation cost relating to share-based payment transactions be recognized in financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued. SFAS 123(R) eliminates the alternative to use the intrinsic value method of accounting in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” The Corporation is in the process of evaluating the impact that the adoption of this statement will have on the consolidated financial statements. It is, however, expected to reduce consolidated net income. This statement was originally effective for the first interim or annual period beginning after June 15, 2005. In April 2005, the Securities and Exchange Commission amended the compliance date of SFAS 123(R) through an amendment of Regulation S-X. The new effective date for the Corporation is March 1, 2006. Refer to Note 12 for the Corporation’s current accounting for stock-based compensation.
Note 4 — Other Income — Net
                                 
    Three Months Ended     Six Months Ended  
    August 31,     August 31,  
(In thousands)   2005     2004     2005     2004  
 
                       
Royalty revenue
  $ (9,481 )   $ (1,408 )   $ (15,160 )   $ (11,891 )
Foreign exchange (gain) loss
    (720 )     (112 )     519       (417 )
Interest income
    (2,694 )     (1,530 )     (5,334 )     (2,236 )
Gain on sale of investment
          (5 )           (3,095 )
Other
    963       (14,175 )     (328 )     (15,937 )
 
                       
 
  $ (11,932 )   $ (17,230 )   $ (20,303 )   $ (33,576 )
 
                       
During the three months ended August 31, 2004, other included a $10.0 million one-time receipt related to licensing activities. Other includes, among other things, gains and losses on asset disposals and rental income. Proceeds of $19.1 million received from the sale of an investment in the prior year are included in “Other — net” investing activities in the Condensed Consolidated Statement of Cash Flows for the period.

7


Table of Contents

Note 5 — Earnings Per Share
The following table sets forth the computation of earnings per share and earnings per share — assuming dilution:
                                 
    Three Months Ended     Six Months Ended  
    August 31,     August 31,  
    2005     2004     2005     2004  
Numerator (in thousands):
                               
Income from continuing operations
  $ 3,241     $ 5,900     $ 29,655     $ 8,836  
Add back — interest on convertible subordinated notes, net of tax
                3,750        
 
                       
Income from continuing operations
  $ 3,241     $ 5,900     $ 33,405     $ 8,836  
 
                       
 
                               
Denominator (in thousands):
                               
Weighted average shares outstanding
    67,102       68,419       67,849       68,210  
Effect of dilutive securities:
                               
Convertible debt
                12,591        
Stock options and other
    812       847       801       847  
 
                       
Weighted average shares outstanding — assuming dilution
    67,914       69,266       81,241       69,057  
 
                       
 
                               
Income from continuing operations per share
  $ 0.05     $ 0.09     $ 0.44     $ 0.13  
 
                       
 
                               
Income from continuing operations per share — assuming dilution
  $ 0.05     $ 0.09     $ 0.41     $ 0.13  
 
                       
Approximately 1.6 million and 1.7 million stock options outstanding in the three and six month periods ended August 31, 2005, respectively, were excluded because the effect would have been antidilutive (3.9 million and 4.1 million stock options outstanding in the three and six month periods ended August 31, 2004, respectively). In addition, the effect of the convertible subordinated notes has been excluded for the three months ended August 31, 2005, and for the three and six months ended August 31, 2004, because the effect would have been antidilutive. See Note 10 for further discussion.
Note 6 — Comprehensive Income
The Corporation’s total comprehensive income is as follows:
                                 
(In thousands)   Three Months Ended     Six Months Ended  
    August 31,     August 31,  
    2005     2004     2005     2004  
 
                       
Net income
  $ 3,241     $ 6,910     $ 29,655     $ 11,148  
 
                               
Other comprehensive (loss) income:
                               
Foreign currency translation adjustments
    (2,043 )     (3,519 )     (16,187 )     (10,566 )
Unrealized gains on securities
    2       253       1       253  
 
                       
Total comprehensive income
  $ 1,200     $ 3,644     $ 13,469     $ 835  
 
                       

8


Table of Contents

Note 7 — Trade Accounts Receivable, Net
Trade accounts receivable are reported net of certain allowances and discounts. The most significant of these are as follows:
                         
(In thousands)   August 31, 2005     February 28, 2005     August 31, 2004  
             
Allowance for seasonal sales returns
  $ 39,595     $ 94,672     $ 39,329  
Allowance for doubtful accounts
    17,255       16,684       17,398  
Allowance for cooperative advertising and marketing funds
    28,394       30,288       20,295  
Allowance for rebates
    46,077       50,638       44,570  
 
                 
 
  $ 131,321     $ 192,282     $ 121,592  
 
                 
Note 8 — Inventories
                         
(In thousands)   August 31, 2005     February 28, 2005     August 31, 2004  
             
Raw materials
  $ 33,320     $ 23,241     $ 38,142  
Work in process
    23,502       19,719       25,792  
Finished products
    291,687       228,088       286,454  
 
                 
 
    348,509       271,048       350,388  
Less LIFO reserve
    77,444       75,890       70,606  
 
                 
 
    271,065       195,158       279,782  
Display materials and factory supplies
    25,068       27,716       29,195  
 
                 
Inventories
  $ 296,133     $ 222,874     $ 308,977  
 
                 
The valuation of inventory under the Last-In, First-Out (LIFO) method is made at the end of each fiscal year based on inventory levels and costs at that time. Accordingly, interim LIFO calculations, by necessity, are based on estimates of expected fiscal year-end inventory levels and costs and are subject to final fiscal year-end LIFO inventory calculations.
Note 9 — Deferred Costs
In the normal course of its business, the Corporation enters into agreements with certain customers for the supply of greeting cards and related products. Under these agreements, the customer typically receives from the Corporation a combination of cash payments, credits, discounts, allowances and other incentive considerations to be earned by the customer as product is purchased from the Corporation over the effective time period of the agreement to meet a minimum purchase volume commitment. In the event a contract is not completed, the Corporation has a claim for unearned advances under the agreement. The Corporation periodically reviews the progress toward the commitment and adjusts the estimated amortization period accordingly to match the costs with the revenue associated with the agreement. The agreements may or may not specify the Corporation as the sole supplier of social expression products to the customer.

9


Table of Contents

The Corporation classifies the total contractual amount of the incentive consideration committed to the customer but not yet earned as a deferred cost asset at the inception of an agreement, or any future amendments. Deferred costs estimated to be earned by the customer and charged to operations during the next twelve months are classified as “Prepaid expenses and other” in the Condensed Consolidated Statement of Financial Position, and the remaining amounts to be charged beyond the next twelve months are classified as “Other assets.”
A portion of the total consideration may be payable by the Corporation at the time the agreement is consummated. All future payment commitments are classified as liabilities at inception until paid. The payments that are expected to be made in the next twelve months are classified as “Other current liabilities” in the Condensed Consolidated Statement of Financial Position, and the remaining payment commitments beyond the next twelve months are classified as “Other liabilities.” The Corporation believes that it maintains adequate reserves for deferred costs related to supply agreements and does not expect that the non-completion of any particular contract would result in a material loss.
As of August 31, 2005, February 28, 2005 and August 31, 2004, deferred costs and future payment commitments are included in the following financial statement captions:
                         
(In thousands)   August 31, 2005     February 28, 2005     August 31, 2004  
             
Prepaid expenses and other
  $ 161,689     $ 156,665     $ 169,770  
Other assets
    540,121       582,401       568,247  
 
                 
Deferred cost assets
    701,810       739,066       738,017  
 
                       
Other current liabilities
    (96,653 )     (65,944 )     (52,621 )
Other liabilities
    (80,905 )     (95,452 )     (67,549 )
 
                 
Deferred cost liabilities
    (177,558 )     (161,396 )     (120,170 )
 
                 
Net deferred costs
  $ 524,252     $ 577,670     $ 617,847  
 
                 
Note 10 — Debt
On May 11, 2004, the Corporation amended and restated its senior secured credit facility. This facility was originally entered into on August 9, 2001, as a $350 million facility and was amended on July 22, 2002, to a $320 million facility. The amended and restated senior secured credit facility consists of a $200 million revolving facility maturing on May 10, 2008. There were no outstanding balances under this facility at August 31, 2005, February 28, 2005 or August 31, 2004.
The amended and restated credit facility is secured by the domestic assets of the Corporation and a 65% interest in the capital stock of certain of its foreign subsidiaries. The Corporation pays an annual commitment fee of 25 basis points on the undrawn portion of the facility. The facility contains various restrictive covenants. Some of these restrictions require that the Corporation meet specified periodic financial ratios, minimum net worth, maximum leverage, and interest coverage. The credit facility places certain restrictions on the Corporation’s ability to incur additional indebtedness, to engage in acquisitions of other businesses, to repurchase its own capital stock and to

10


Table of Contents

pay shareholder dividends. These covenants are less restrictive than the covenants previously in place.
In April 2005, the Corporation amended its amended and restated senior secured credit facility dated May 11, 2004. The amendment, among other things, increased the maximum amount of dividends that the Corporation may pay to its shareholders, increased the maximum amount of its own capital stock that it may repurchase and extended the period during which the Corporation may repurchase its 11.75% senior subordinated notes due July 15, 2008.
The Corporation is also party to a three-year accounts receivable securitization financing agreement that provides for up to $200 million of financing and is secured by certain trade accounts receivable. Under the terms of the agreement, the Corporation transfers receivables to a wholly-owned consolidated subsidiary that in turn utilizes the receivables to secure borrowings through a credit facility with a financial institution. On August 2, 2004, the agreement was amended to extend the maturity date to August 1, 2007. The related interest rate is commercial paper-based. The Corporation pays an annual commitment fee of 25 basis points on the undrawn portion of the accounts receivable facility. There were no outstanding balances under this agreement at August 31, 2005, February 28, 2005 or August 31, 2004.
During the three months ended May 31, 2004, the Corporation commenced a cash tender offer for all of its outstanding 11.75% senior subordinated notes due July 15, 2008. As a result of this tender offer, a total of $186.2 million of these senior subordinated notes were repurchased and the Corporation recorded a charge of $39.1 million, included in “Interest expense” on the Condensed Consolidated Statement of Income, for the payment of the premium and other fees associated with the notes repurchased as well as for the write-off of related deferred financing costs. As part of this transaction, substantially all restrictive covenants were eliminated from the approximately $10 million remaining outstanding notes. On July 15, 2005, the Corporation called the remaining 11.75% senior subordinated notes. As a result, a charge of $0.9 million, included in “Interest expense” on the Condensed Consolidated Statement of Income, was recorded during the six months ended August 31, 2005, for the premium associated with the notes as well as for the write-off of related deferred financing costs.
At August 31, 2005, the Corporation was in compliance with its financial covenants.
At August 31, 2005, February 28, 2005 and August 31, 2004, long-term debt and their related calendar year due dates were as follows:
                         
(In thousands)   August 31, 2005     February 28, 2005     August 31, 2004  
             
6.10% Senior Notes, due 2028
  $ 298,703     $ 298,503     $ 298,310  
11.75% Senior Subordinated Notes, due 2008
          10,016       9,990  
7.00% Convertible Subordinated Notes, due 2006
    175,000       175,000       175,000  
Other (due 2007-2011)
    2,519       2,580       576  
 
                 
 
  $ 476,222     $ 486,099     $ 483,876  
 
                 

11


Table of Contents

The 7.00% convertible subordinated notes are convertible at the option of the holders into shares of the Corporation’s class A common shares at any time before the close of business on July 15, 2006, at a conversion rate of 71.9466 common shares per $1 thousand principal amount of notes.
Note 11 — Retirement Benefits
The components of periodic benefit cost for the Corporation’s defined benefit pension and postretirement benefit plans are as follows:
                                 
    Defined Benefit Pension  
    Three Months Ended     Six Months Ended  
    August 31,     August 31,  
(In thousands)   2005     2004     2005     2004  
 
                       
Service cost
  $ 128     $ 112     $ 256     $ 224  
Interest cost
    1,811       1,851       3,622       3,692  
Expected return on plan assets
    (1,721 )     (1,428 )     (3,442 )     (2,843 )
Amortization of prior service cost
    23             46        
Amortization of actuarial loss
    358       22       716       22  
 
                       
 
  $ 599     $ 557     $ 1,198     $ 1,095  
 
                       
                                 
    Postretirement Benefit  
    Three Months Ended     Six Months Ended  
    August 31,     August 31,  
(In thousands)   2005     2004     2005     2004  
 
                       
Service cost
  $ 711     $ 628     $ 1,422     $ 1,256  
Interest cost
    1,872       2,221       3,744       4,442  
Expected return on plan assets
    (1,201 )     (1,336 )     (2,402 )     (2,672 )
Amortization of prior service cost
    (1,849 )     (1,559 )     (3,698 )     (3,118 )
Amortization of actuarial loss
    1,771       1,546       3,542       3,092  
 
                       
 
  $ 1,304     $ 1,500     $ 2,608     $ 3,000  
 
                       
On December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”) was signed into law. The Act provides plan sponsors a federal subsidy for certain qualifying prescription drug benefits covered under the sponsor’s postretirement health care plans. FASB Staff Position No. FAS 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003,” (“FSP 106-2”) was issued on May 19, 2004. FSP 106-2 provides guidance on accounting for the effects of the new Medicare prescription drug legislation by employers whose prescription drug benefits are actuarially equivalent to the drug benefit under Medicare Part D. FSP 106-2 also contains basic guidance on related income tax accounting and complex rules for transition that permit various alternative prospective and retroactive transition approaches. The Corporation adopted the provisions of FSP 106-2 effective September 1, 2004. The effect of the adoption of FSP 106-2 was a reduction of the net periodic postretirement benefit cost of approximately $0.2 million and $0.4 million for the three and six months ended August 31, 2005, respectively.

12


Table of Contents

The Corporation has a non-contributory profit-sharing plan with a contributory 401(k) provision covering most of its United States employees. The profit-sharing plan expense for the six months ended August 31, 2005 was $3.5 million, compared to $2.5 million in the prior year period. The profit-sharing plan expense for the six month periods are estimates as actual contributions to the profit-sharing plan are made after fiscal year-end and are contingent upon final year-end results. The Corporation matches a portion of 401(k) employee contributions contingent upon meeting specified annual operating results goals. The expenses recognized for the three and six month periods ended August 31, 2005 were $1.1 million and $1.8 million ($1.1 million and $2.3 million for the three and six month periods ended August 31, 2004), respectively.
Note 12 — Stock-Based Compensation
The Corporation follows APB Opinion No. 25 and related Interpretations in accounting for its stock options granted to employees and directors. Because the exercise price of the Corporation’s stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. The Corporation has adopted the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure.” Refer to Note 3 for information regarding recent changes to the accounting guidance for stock-based compensation.
The following illustrates the pro forma effect on net income and earnings per share if the Corporation had applied the fair value recognition provisions of SFAS 123:
                                 
(In thousands, except per share amounts)   Three Months Ended     Six Months Ended  
    August 31,     August 31,  
    2005     2004     2005     2004  
 
                       
Net income as reported
  $ 3,241     $ 6,910     $ 29,655     $ 11,148  
 
                               
Add: Stock-based compensation expense included in net income, net of tax
    451             451        
 
                               
Deduct: Stock-based compensation expense determined under fair value based method, net of tax
    1,849       1,735       2,878       3,065  
 
                       
 
                               
Pro forma net income
  $ 1,843     $ 5,175     $ 27,228     $ 8,083  
 
                       
 
                               
Earnings per share:
                               
As reported
  $ 0.05     $ 0.10     $ 0.44     $ 0.16  
Pro forma
    0.03       0.08       0.40       0.12  
 
                               
Earnings per share — assuming dilution:
                               
As reported
  $ 0.05     $ 0.10     $ 0.41     $ 0.16  
Pro forma
    0.03       0.07       0.38       0.12  
During the three months ended May 31, 2004, shares held in trust related to a deferred compensation plan were withdrawn from the trust. This transaction had no impact on the Corporation’s results of operations during the six months ended August 31, 2004.

13


Table of Contents

Approximately 0.9 million and 1.3 million stock options were exercised during the three and six months ended August 31, 2005, respectively, compared to approximately 0.5 million and 1.6 million stock options exercised during the three and six months ended August 31, 2004, respectively.
Note 13 — Business Segment Information
The Social Expression Products segment primarily designs, manufactures and sells greeting cards and other related products through various channels of distribution, with mass retailers as the primary channel, and is managed by geographic location.
At August 31, 2005, the Corporation owned and operated 527 card and gift retail stores in the United States and Canada through its Retail Operations segment. The stores are primarily located in malls and strip shopping centers. The stores sell products purchased from the Social Expression Products segment and products purchased from other vendors.
AG Interactive is an electronic provider of social expression content through the Internet and wireless platforms.
Non-reportable operating segments primarily include the design, manufacture and sale of display fixtures.
Segment results are internally reported and evaluated at consistent exchange rates between years to eliminate the impact of foreign currency fluctuations. An exchange rate adjustment is included in the reconciliation of the segment results to the consolidated results; this adjustment represents the impact on the segment results of the difference between the exchange rates used for segment reporting and evaluation and the actual exchange rates for the periods presented.
Centrally-incurred and managed costs are not allocated back to the operating segments. The unallocated items include interest expense on centrally-incurred debt and domestic profit-sharing expense. In addition, the costs associated with corporate operations including the senior management, corporate finance, legal and human resource functions, among other costs, are included in the unallocated items.

14


Table of Contents

Operating Segment Information
                                 
(In thousands)   Three Months Ended     Six Months Ended  
    August 31,     August 31,  
    2005     2004     2005     2004  
 
                       
Net Sales:
                               
Social Expression Products
  $ 336,129     $ 340,374     $ 708,197     $ 721,923  
Intersegment items
    (13,879 )     (17,324 )     (25,554 )     (32,148 )
Exchange rate adjustment
    956       196       5,518       586  
 
                       
Net
    323,206       323,246       688,161       690,361  
 
                               
Retail Operations
    39,085       48,239       81,945       99,562  
Exchange rate adjustment
    1,557       401       2,939       617  
 
                       
Net
    40,642       48,640       84,884       100,179  
 
                               
AG Interactive
    19,583       12,959       47,630       22,404  
Exchange rate adjustment
    (98 )           116        
 
                       
Net
    19,485       12,959       47,746       22,404  
 
                               
Non-reportable segments
    3,156       8,187       7,926       13,578  
 
                               
Unallocated items — net
    1,067       (948 )     2,115       (897 )
 
                       
 
                               
Consolidated
  $ 387,556     $ 392,084     $ 830,832     $ 825,625  
 
                       
 
                               
Segment Earnings:
                               
Social Expression Products
  $ 50,413     $ 60,795     $ 135,378     $ 155,757  
Intersegment items
    (10,163 )     (12,295 )     (18,697 )     (23,231 )
Exchange rate adjustment
    603       202       1,355       359  
 
                       
Net
    40,853       48,702       118,036       132,885  
 
                               
Retail Operations
    (11,049 )     (11,376 )     (17,287 )     (15,520 )
Exchange rate adjustment
    (133 )     (4 )     (175 )     11  
 
                       
Net
    (11,182 )     (11,380 )     (17,462 )     (15,509 )
 
                               
AG Interactive
    485       (2,046 )     815       (1,683 )
Exchange rate adjustment
    41             (54 )      
 
                       
Net
    526       (2,046 )     761       (1,683 )
 
                               
Non-reportable segments
    167       (2,150 )     641       (9,056 )
 
                               
Unallocated items — net
    (22,280 )     (23,496 )     (50,900 )     (92,210 )
Exchange rate adjustment
    203       (4 )     301       (12 )
 
                       
Net
    (22,077 )     (23,500 )     (50,599 )     (92,222 )
 
                       
 
                               
Consolidated
  $ 8,287     $ 9,626     $ 51,377     $ 14,415  
 
                       

15


Table of Contents

Other
During 2005, the Corporation recorded a severance accrual of $18.3 million related to an overhead reduction program that eliminated approximately 300 associates and the Franklin, Tennessee plant closure. Substantially all of the associates receiving payments separated from the Corporation on or prior to February 28, 2005. Approximately 70% of the severance will be paid prior to February 28, 2006, with the remaining payments extending through 2008. The remaining balance of the severance accrual was $8.7 million at August 31, 2005.
In connection with the Franklin plant closing, the Social Expression Products segment recorded an additional charge of $5.3 million during the six months ended August 31, 2005 for the remaining shutdown and relocation costs incurred during the period, including $2.1 million incurred during the second quarter.
Note 14 — Discontinued Operations
On July 30, 2004, the Corporation announced it had signed a letter of agreement to sell its Magnivision nonprescription reading glasses business to AAiFosterGrant, a unit of sunglasses maker Foster Grant. The sale reflects the Corporation’s strategy to focus its resources on business units closely related to its core social expression business. The sale closed in the third quarter of fiscal 2005 although an additional amount may be recorded during the next six months based on closing balance sheet adjustments. This adjustment is not expected to exceed 10% of the cash proceeds. During the third quarter of fiscal 2005, the Corporation received cash proceeds of $77.0 million and recorded a gain of $35.5 million for the sale of Magnivision.
Magnivision meets the definition of a “component of an entity” and has been accounted for as a discontinued operation under SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Accordingly, the Corporation’s condensed consolidated financial statements and related notes have been presented to reflect Magnivision as a discontinued operation for all periods presented. Magnivision was previously included within the Corporation’s “non-reportable segments.”
The following summarizes the results of discontinued operations for the three and six months ended August 31, 2004:
                 
    Three Months     Six Months  
    Ended     Ended  
    August 31, 2004     August 31, 2004  
(In thousands)                
Net sales
  $ 13,024     $ 25,658  
 
               
Pretax income from operations
    1,647       3,771  
Income tax expense
    637       1,459  
 
           
Income from discontinued operations
  $ 1,010     $ 2,312  
 
           

16


Table of Contents

“Assets of businesses held for sale” and “Liabilities of businesses held for sale” in the Condensed Consolidated Statement of Financial Position include the following:
         
(In thousands)   August 31, 2004  
     
Assets of businesses held for sale:
       
Current assets
  $ 23,077  
Other assets
    6,566  
Fixed assets
    10,747  
 
     
 
  $ 40,390  
 
     
 
       
Liabilities of businesses held for sale:
       
Current liabilities
  $ 2,844  
Noncurrent liabilities
    1,618  
 
     
 
  $ 4,462  
 
     

17


Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
During the second quarter of 2006, the Corporation continued to benefit from strong everyday card sales in North America due to ongoing initiatives, which focus on better understanding and meeting consumer needs and improving the retail shopping experience. Seasonal card units increased dramatically from the prior year quarter due to timing differences related to customers who were recently converted to scan-based trading, the change in strategy for seasonal space management and fall seasonal shipments. These seasonal shifts are not expected to significantly impact full year seasonal results. AG Interactive achieved net sales growth due to prior year acquisitions, new products in the instant messenger business and increased subscribers in the core online greeting card business. Also contributing to the quarter was the continued performance of the licensing business.
Sales in the Retail Operations segment declined from the prior year period, but margins improved as the segment relied less on promotional pricing to drive sales volume. Consolidated margins also improved as a result of product mix, more card product versus non-card product, and business mix, with an increased percentage of sales from higher margin businesses compared to the prior year second quarter. The Corporation also completed a plant closure and consolidation during the quarter and expects to realize cost savings from this activity in the next fiscal year.
Despite these positive indicators, the Corporation remains concerned with its international businesses, particularly the United Kingdom (“U.K.”) market, which remained soft during the second quarter, but improved from the first quarter. In addition to the demand reduction, general cost pressure throughout the business and customer mix are impacting international margins. The Corporation is also experiencing sales and earnings shortfalls in the promotional gift wrap business and the wireless business in Europe.
Balance sheet management, particularly from working capital, continued to provide favorable cash flow. Also during the second quarter, the Corporation repurchased debt of approximately $10 million and repurchased approximately 2 million shares of stock for $46 million under the stock repurchase program. Despite this usage from financing activities, the Corporation ended the second quarter in a strong cash position with combined cash, cash equivalents and short-term investments of $372.6 million compared to $152.8 million at the prior year quarter end.
During the three months ended August 31, 2005, the Corporation recognized income from continuing operations of $3.2 million compared to $5.9 million in the prior year quarter. The current year quarter included $2.1 million pretax for shutdown and relocation costs incurred during the period in connection with the closure of a manufacturing facility. The prior year quarter included a $10.0 million pretax gain as a result of a one-time receipt relating to the Corporation’s licensing activities.
For 2006, AG Interactive changed its fiscal year-end to coincide with the Corporation’s fiscal year-end. As a result, the six months ended August 31, 2005 included eight months of AG Interactive’s operations.

18


Table of Contents

Results of Operations
Three months ended August 31, 2005 and 2004
Net income was $3.2 million, or $0.05 per share, in the quarter compared to $6.9 million, or $0.10 per share, in the prior year second quarter (all per-share amounts assume dilution). Income from discontinued operations, net of tax, contributed $1.0 million, or $0.01 per share, of the net income in the prior year second quarter.
The Corporation’s results for the three months ended August 31, 2005 and 2004 are summarized below:
                                 
            % Net             % Net  
(Dollars in thousands)   2005     Sales     2004     Sales  
Net sales
  $ 387,556       100.0 %   $ 392,084       100.0 %
 
                               
Material, labor and other production costs
    176,316       45.5 %     186,717       47.6 %
Selling, distribution and marketing
    147,328       38.0 %     146,303       37.3 %
Administrative and general
    58,970       15.2 %     57,505       14.7 %
Interest expense
    8,587       2.2 %     9,163       2.3 %
Other income — net
    (11,932 )     (3.0 %)     (17,230 )     (4.4 %)
 
                           
Total costs and expenses
    379,269       97.9 %     382,458       97.5 %
 
                           
 
Income from continuing operations before income tax expense
    8,287       2.1 %     9,626       2.5 %
Income tax expense
    5,046       1.3 %     3,726       1.0 %
 
                           
 
Income from continuing operations
    3,241       0.8 %     5,900       1.5 %
Income from discontinued operations, net of tax
          0.0 %     1,010       0.3 %
 
                           
 
Net income
  $ 3,241       0.8 %   $ 6,910       1.8 %
 
                           
For the three months ended August 31, 2005, consolidated net sales were $387.6 million, down from $392.1 million in the prior year second quarter. This 1.2% decrease was primarily the result of lower sales in the Corporation’s Retail Operations segment and the fixtures business. The Retail Operations segment was down approximately $9 million, half of which is attributable to a decrease in same-store sales and half due to fewer stores. The fixtures business decreased approximately $5 million compared to the prior year as this business unit has focused on eliminating lower margin sales. These decreases were partially offset by an increase in AG Interactive. AG Interactive sales increased approximately $7 million due to the prior year acquisitions in the wireless unit and growth in the online business. The Social Expression Products segment was relatively flat compared to the prior year period as a strong performance in the North American greeting card business was offset by declining gift wrap and international sales. Favorable foreign currency translation added approximately $2 million to net sales.

19


Table of Contents

Unit and Pricing Analysis
Unit and pricing comparatives (on a sales less returns basis) for the three months ended August 31, 2005 and 2004 are summarized below:
                                                 
    Increase (Decrease) From the Prior Year
    Everyday Cards   Seasonal Cards   Total Greeting Cards
    2005   2004   2005   2004   2005   2004
Unit volume
    0.5 %     (2.1 %)     42.6 %     (19.7 %)     4.4 %     (3.9 %)
Selling prices
    (0.9 %)           (5.7 %)     5.8 %     (1.1 %)     0.3 %
Overall Increase/ (Decrease)
    (0.4 %)     (2.1 %)     34.5 %     (15.0 %)     3.2 %     (3.6 %)
Seasonal card unit volume increased 42.6% in the current quarter, driven primarily by the North American business unit. Approximately half of this increase is due to Father’s Day and Graduation card sales, primarily affected by timing differences with customers that implemented scan-based trading subsequent to the prior year second quarter. As noted in the Corporation’s Form 10-Q for the quarter ended May 31, 2005, the implementation of scan-based trading shifted the Corporation’s recognition of a significant portion of sales of Father’s Day and Graduation cards from the first quarter to the second quarter for these customers. Further, since the second quarter is the smallest seasonal card quarter, the unit increase in this quarter appears larger than the decrease in the first quarter on a percentage basis. The remaining increase relates to timing differences on summer seasonal product, shifting from the first quarter compared to the prior year, and earlier shipments of fall and Christmas seasonal product compared to the prior year quarter. Slightly offsetting the North America increases are timing differences of Christmas product shipments in the U.K. due to varying customer delivery date preferences. The 5.7% decrease in selling prices of seasonal cards is due to higher sales of value priced cards across all seasonal programs and the higher volume of fall products that generally include lower priced cards.
Sales of everyday card units increased 0.5% compared to the prior year quarter as continued growth in North America was slightly offset by lower unit sales from the Corporation’s international business operations, however the international business, particularly in the U.K., showed improvements compared to the results in the first quarter. The 0.9% decrease in selling prices of everyday cards was driven by a higher mix of value priced cards.
Expense Overview
Material, labor and other production costs (MLOPC) for the three months ended August 31, 2005 were $176.3 million, a decrease from $186.7 million for the same period in the prior year. As a percentage of net sales, these costs were 45.5% in the current period compared to 47.6% for the three months ended August 31, 2004. The $10.4 million decrease from the prior year is attributable to favorable mix, both product and business, and favorable volume variances partially offset by increased spending. Changes in business mix accounted for approximately $8 million of the decrease as lower margin businesses shrunk and higher margin businesses grew or held revenues flat. The Corporation’s fixtures business

20


Table of Contents

experienced improved margins as that business focused on eliminating lower margin sales. The quality of sales or product mix within certain businesses reduced MLOPC by approximately $10 million. Less promotional pricing in the Retail Operations segment improved margins in that business. The overall reduced sales volume in the current period accounted for approximately $2 million of the decrease in MLOPC. Offsetting these decreases were approximately $2 million of shutdown and relocation costs for the plant closure announced in 2005, increased creative content costs of approximately $2 million and approximately $4 million for increased costs for raw materials and plant operations, particularly paper costs. Also, changes in the LIFO reserve added approximately $2 million in the current year quarter.
Selling, distribution and marketing costs for the three months ended August 31, 2005 were $147.3 million, increasing from $146.3 million for the same period in the prior year. As a percentage of net sales, these costs were 38.0% in the current period compared to 37.3% for the three months ended August 31, 2004. The $1.0 million change is due to higher licensing related expenses of approximately $4 million (as a result of higher royalty revenue) partially offset by reduced costs of approximately $3 million in the Retail Operations segment arising from fewer stores.
Administrative and general expenses were $59.0 million for the three months ended August 31, 2005, an increase from $57.5 million for the same period in the prior year. The increase of $1.5 million from the prior year period is primarily the result of increased systems development spending and administrative costs embedded in the acquisitions made during the last six months of the prior year.
Interest expense for the three months ended August 31, 2005 was $8.6 million, a decrease from $9.2 million for the same period in the prior year. The decrease of $0.6 million is due primarily to interest savings resulting from the debt repurchase in July 2005.
Other income – net was $11.9 million for the three months ended August 31, 2005, a decrease from $17.2 million for the same period in the prior year. The $5.3 million decrease is partially due to the one-time receipt of $10.0 million in the prior year period related to licensing activities partially offset by increased royalty revenue of $8.1 million in the current quarter compared to the prior year.
The effective tax rate was 60.9% and 38.7% for the three months ended August 31, 2005 and 2004, respectively. Since the second quarter has seasonally low income from continuing operations before income tax expense, any changes to the tax assets and reserves on the Condensed Consolidated Statement of Financial Position are magnified in the effective tax rate calculation. During the three months ended August 31, 2005, the Corporation eliminated deferred tax assets relating to certain foreign net operating loss carryforwards. In addition, the Corporation reduced its deferred income tax assets to reflect the change in Ohio tax laws.

21


Table of Contents

Results of Operations
Six months ended August 31, 2005 and 2004
Net income was $29.7 million, or $0.41 per share, in the six months ended August 31, 2005, compared to net income of $11.1 million, or $0.16 per share, in the prior year period. Income from discontinued operations, net of tax, contributed $2.3 million, or $0.03 per share, of the net income in the prior year six months.
The Corporation’s results for the six months ended August 31, 2005 and 2004 are summarized below:
                                 
            % Net             % Net  
(In thousands)   2005     Sales     2004     Sales  
Net sales
  $ 830,832       100.0 %   $ 825,625       100.0 %
 
                               
Material, labor and other production costs
    356,789       42.9 %     368,332       44.6 %
Selling, distribution and marketing
    302,602       36.4 %     292,955       35.5 %
Administrative and general
    122,098       14.7 %     121,642       14.7 %
Interest expense
    18,269       2.2 %     61,857       7.5 %
Other income — net
    (20,303 )     (2.4 %)     (33,576 )     (4.1 %)
 
                           
Total costs and expenses
    779,455       93.8 %     811,210       98.2 %
 
                           
 
Income from continuing operations before income tax expense
    51,377       6.2 %     14,415       1.8 %
Income tax expense
    21,722       2.6 %     5,579       0.7 %
 
                           
 
Income from continuing operations
    29,655       3.6 %     8,836       1.1 %
Income from discontinued operations, net of tax
          0.0 %     2,312       0.3 %
 
                           
 
Net income
  $ 29,655       3.6 %   $ 11,148       1.4 %
 
                           
For the six months ended August 31, 2005, consolidated net sales were $830.8 million, up from $825.6 million in the same period in the prior year. This 0.6% increase is due primarily to increases in AG Interactive as well as approximately $7 million of favorable foreign currency translation. The increase in net sales of approximately $25 million for AG Interactive is due to sales from the additional two months of activity resulting from the fiscal year change and from the prior year acquisitions. Partially offsetting these increases were lower sales in the Retail Operations and Social Expression Products segments and the fixtures business. The Retail Operations segment was down approximately $17 million, half due to fewer stores and half due to the decrease in same-store sales. The Social Expression Products segment decreased approximately $7 million as unfavorable gift wrap and international sales were only partially offset by improvements in the North American greeting card business. The fixtures business decreased approximately $6 million compared to the prior year due to the business unit’s focus on eliminating lower margin sales.

22


Table of Contents

Unit and Pricing Analysis
Unit and pricing comparatives (on a sales less returns basis) for the six months ended August 31, 2005 and 2004 are summarized below:
                                                 
    Increase (Decrease) From the Prior Year
    Everyday Cards   Seasonal Cards   Total Greeting Cards
    2005   2004   2005   2004   2005   2004
Unit volume
    0.1 %     (0.8 %)     (4.0 %)     (3.7 %)     (0.9 %)     (1.5 %)
Selling prices
    0.1 %     (0.9 %)     2.0 %     2.3 %     0.5 %     (0.2 %)
Overall Increase / (Decrease)
    0.2 %     (1.8 %)     (2.0 %)     (1.5 %)     (0.5 %)     (1.7 %)
For the six month period, seasonal card units are 4.0% lower than in the prior year period. This decrease is primarily year over year timing differences related to the new merchandising strategy for seasonal space management and delayed Christmas unit shipments in the U.K. due to varying customer delivery date preferences. The increased selling prices in the period were driven primarily by improved product mix of Mother’s Day cards, with a lower volume of value priced cards than in the prior year.
Everyday card units are up slightly in the six month period, as improvements in North American card unit sales, due to product mix enhancements, were partially offset by soft international everyday card unit sales, particularly in the U.K., during the first quarter. The slight improvement in selling prices for the six month period was driven by the Corporation’s international business operations as the mix of cards sold shifted to higher priced units, partially offset by lower selling prices on everyday cards in the North American business with the shift to a higher volume of value priced cards.
Expense Overview
MLOPC for the six months ended August 31, 2005 was $356.8 million, a decrease from $368.3 million for the same period in the prior year. As a percentage of net sales, these costs were 42.9% in the current period compared to 44.6% for the six months ended August 31, 2004. The $11.5 million decrease from the prior year is attributable to a favorable mix partially offset by increased spending and unfavorable volume variances of approximately $2 million due to the change in sales volume. Both favorable product and business mix reduced MLOPC by approximately $34 million. Improved margins due to less promotional pricing in the Retail Operations segment and production improvements in the fixtures business both favorably impacted MLOPC. These decreases were only partially offset by spending increases of approximately $20 million. These increases included approximately $5 million of higher creative content costs, approximately $5 million of increased costs for AG Interactive, primarily related to the additional two months and the prior year acquisitions, and approximately $5 million of shutdown and relocation costs for the plant closure announced in 2005. Changes in the LIFO reserve added approximately $4 million to MLOPC in the current year period.

23


Table of Contents

Selling, distribution and marketing costs for the six months ended August 31, 2005 were $302.6 million, up from the $293.0 million for the same period in the prior year. As a percentage of net sales, these costs were 36.4% in the current period compared to 35.5% for the six months ended August 31, 2004. The $9.6 million increase from the prior year is due to increased costs of approximately $10 million in the AG Interactive segment primarily as a result of the additional two months of activity and the prior year acquisitions and higher licensing related expenses of approximately $2 million (as a result of higher royalty revenue). Also contributing to the increase are higher merchandiser and field sales expenses of approximately $3 million. These increases were partially offset by reduced costs of approximately $6 million in the Retail Operations segment due to fewer stores in the current year period.
Administrative and general expenses were $122.1 million for the six months ended August 31, 2005, an increase from $121.6 million for the same period in the prior year. The increase of $0.5 million compared to the prior year six months is due to costs embedded in the AG Interactive acquisitions and the additional two months of activity offset by lower consulting expenses.
Interest expense was $18.3 million for the six months ended August 31, 2005 down from $61.9 million for the same period in the prior year. The decrease of $43.6 million is due primarily to the debt repurchase from the first quarter of fiscal 2005. The Corporation recorded $39.1 million for the payment of the premium and other fees and the write-off of deferred financing costs associated with the repurchase of $186.2 million of the 11.75% senior subordinated notes during the prior year period. Interest savings of $4.7 million were realized due to the reduced level of debt. Partially offsetting these decreases is $0.9 million for the payment of the premium and the write-off of deferred financing costs associated with the repurchase of the remaining $10.2 million of the 11.75% senior subordinated notes during the current year period.
Other income – net was $20.3 million for the six months ended August 31, 2005, down from $33.6 million in the same period in the prior year. The decrease of $13.3 million is due primarily to the one-time receipt of $10.0 million related to the Corporation’s licensing activities and a $3.1 million gain on the sale of an investment, both in the prior year period.
The effective tax rate was 42.3% and 38.7% for the six months ended August 31, 2005 and 2004, respectively. During the six months ended August 31, 2005, the Corporation established additional tax reserves to cover anticipated examination adjustments. In addition, the Corporation reduced its deferred income tax assets to reflect the change in Ohio tax laws.

24


Table of Contents

Segment Information
The Corporation is organized and managed according to a number of factors, including product categories, geographic locations and channels of distribution. The Social Expression Products segment primarily designs, manufactures and sells greeting cards and other related products through various channels of distribution, with mass retailers as the primary channel, and is managed by geographic location. As permitted under Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information,” certain operating divisions have been aggregated into the Social Expression Products segment. These operating divisions have similar economic characteristics, products, production processes, types of customers and distribution methods. At August 31, 2005, the Corporation owned and operated 527 card and gift retail stores in the United States and Canada through its Retail Operations segment. The stores are primarily located in malls and strip shopping centers. The stores sell products purchased from the Social Expression Products segment and products purchased from other vendors. AG Interactive is an electronic provider of social expression content through the Internet and wireless platforms.
The Corporation reviews segment results using consistent exchange rates between periods to eliminate the impact of foreign currency fluctuations.
Social Expression Products Segment
                                                 
    Three Months Ended             Six Months Ended        
    August 31,             August 31,        
(Dollars in thousands)   2005     2004     % Change     2005     2004     % Change  
Net sales
  $ 322,250     $ 323,050       (0.2 %)   $ 682,643     $ 689,775       (1.0 %)
Segment earnings
    40,250       48,500       (17.0 %)     116,681       132,526       (12.0 %)
Net sales of the Social Expression Products segment excluding the impact of foreign exchange and intersegment items, for the three months ended August 31, 2005, decreased $0.8 million or 0.2% from the same period in the prior year. For the six months ended August 31, 2005, net sales decreased $7.1 million or 1.0% from the prior year period due to decreases in the gift wrap business and the international greeting card divisions, primarily the U.K. business, which were only partially offset by improvements in the North American greeting card business, primarily due to less terms granted to customers in the current period.
Segment earnings excluding the impact of foreign exchange and intersegment items for the three months ended August 31, 2005, decreased $8.3 million or 17.0% compared to the prior year period. Segment earnings during the six months ended August 31, 2005, decreased $15.8 million or 12.0% compared to the prior year period. These results reflect the impact of soft international sales, particularly in the U.K., lower sales in the gift wrap business and increased costs for raw materials, particularly paper costs, partially offset by the improvements in the North American greeting card business. Also included were shutdown and relocation costs associated with the plant closure of approximately $2 million during the three months ended August 31, 2005 and approximately $5 million for the six month period and LIFO reserve changes of approximately $2 million in the three months and $4 million in the six months.

25


Table of Contents

Retail Operations Segment
                                                 
    Three Months Ended             Six Months Ended        
    August 31,             August 31,        
(Dollars in thousands)   2005     2004     % Change     2005     2004     % Change  
Net sales
  $ 39,085     $ 48,239       (19.0 %)   $ 81,945     $ 99,562       (17.7 %)
Segment loss
    (11,049 )     (11,376 )     2.9 %     (17,287 )     (15,520 )     (11.4 %)
Net sales excluding the impact of foreign exchange in the Retail Operations segment decreased $9.2 million or 19.0% for the three months ended August 31, 2005, compared to the same period in the prior year as same-store sales were approximately $5 million or 11.4% lower compared to the prior year period. Net sales for the quarter decreased approximately $4 million due to fewer stores. For the six months ended August 31, 2005, net sales decreased $17.6 million or 17.7% compared to the prior year period as same-store sales declined approximately $8 million or 9.2% compared to the same period in the prior year. The average number of stores for the six months ended August 31, 2005, was approximately 9.7% less than in the prior year period, which accounted for approximately $9 million of the decrease in net sales.
Segment earnings excluding the impact of foreign exchange was a loss of $11.0 million in the three months ended August 31, 2005, compared to a loss of $11.4 million in the three months ended August 31, 2004. For the six months ended August 31, 2005, segment earnings was a loss of $17.3 million compared to a loss of $15.5 million in the prior year period. Earnings were unfavorably impacted by certain noncapitalizable implementation costs associated with a systems infrastructure upgrade. The impact of lower sales on earnings was softened due to less promotional activity and favorable product mix that improved the gross margins by approximately 5.6 percentage points. Segment earnings benefited from lower store rent and associate costs due to fewer stores.
AG Interactive Segment
                                                 
    Three Months Ended             Six Months Ended        
    August 31,             August 31,        
(Dollars in thousands)   2005     2004     % Change     2005     2004     % Change  
Net sales
  $ 19,583     $ 12,959       51.1 %   $ 47,630     $ 22,404       112.6 %
Segment earnings (loss)
    485       (2,046 )     123.7 %     815       (1,683 )     148.4 %
For 2006, AG Interactive changed its fiscal year-end to coincide with the Corporation’s fiscal year-end. As a result, the six months ended August 31, 2005 includes eight months of AG Interactive’s operations.
Net sales of AG Interactive excluding the impact of foreign exchange increased $6.6 million for the quarter ended August 31, 2005, compared to the same period in the prior year. For the six months ended August 31, 2005, net sales increased $25.2 million compared to the prior year

26


Table of Contents

period. The $6.6 million increase in the quarterly period is primarily due to the prior year acquisitions within the AG Mobile wireless division, which contributed approximately $5 million to net sales in the current year quarter. Net sales in the core online business improved by approximately $1 million in the quarter and $3 million in the six months compared to the prior year periods. The additional two months of activity accounted for approximately $11 million of the $25.2 million increase in the six month period while the prior year acquisitions contributed approximately $11 million to the increase. At the end of the second quarter of 2006, AG Interactive had approximately 2.3 million paid subscribers versus 2.2 million at the prior year quarter end.
Segment earnings excluding the impact of foreign exchange increased by $2.5 million for the quarter ended August 31, 2005, compared to the prior year period. For the six months ended August 31, 2005, segment earnings improved by $2.5 million. Segment earnings for the core online business improved approximately $3 million in both the quarter and six months ended August 31, 2005, compared to the respective prior year periods, but were partially offset by acquisition costs, higher technology costs and the cost of new business initiatives. The additional two months of activity had no significant impact on segment earnings.
Liquidity and Capital Resources
The seasonal nature of the Corporation’s business precludes a useful comparison of the current period and the fiscal year-end financial statements; therefore, a Condensed Consolidated Statement of Financial Position for August 31, 2004, has been included.
Operating Activities
Operating activities provided $33.7 million of cash during the six months ended August 31, 2005, compared to providing $81.7 million of cash in the same period in the prior year.
Accounts receivable provided $11.7 million of cash from February 28, 2005, compared to using cash of $0.2 million in the same period in the prior year. As a percentage of the prior twelve months’ net sales, net accounts receivable were 9.0% at August 31, 2005, compared to 11.9% at August 31, 2004.
Inventory was a use of $75.7 million from February 28, 2005, compared to a use of $72.2 million in the same period in the prior year. As a percentage of the prior twelve months’ MLOPC, inventories were 33.1% at August 31, 2005, compared to 34.1% at August 31, 2004.
Other current assets were a use of $17.9 million of cash from February 28, 2005, compared to a source of $8.6 million in the same period in the prior year. The difference relates primarily to the timing of tax payments and refunds between the current and prior year periods.
Deferred costs — net represents payments under agreements with retailers net of the related amortization of those payments. During the six months ended August 31, 2005, amortization exceeded payments by $52.8 million; in the six months ended August 31, 2004, amortization

27


Table of Contents

exceeded payments by $71.0 million. See Note 9 to the condensed consolidated financial statements for further discussion of deferred costs related to customer agreements.
Accounts payable and other liabilities were a use of $29.9 million during the six months ended August 31, 2005, compared to a source of $2.4 million in the prior year period. The change from the prior year is due primarily to tax payments, severance payments and bonus and profit sharing payments in the current period.
Investing Activities
Investing activities used $19.5 million of cash during the six months ended August 31, 2005, compared to a use of $1.9 million in the same period in the prior year. The increase of $17.6 million is primarily due to increased capital expenditures in the six months ended August 31, 2005 and the proceeds received from the sale of the marketable security investment of $19.1 million during the six months ended August 31, 2004.
Financing Activities
Financing activities used $98.4 million of cash during the six months ended August 31, 2005, compared to $207.0 million in the same period in the prior year. The current year amount relates primarily to the Corporation’s program to repurchase up to $200 million of its Class A common shares announced on April 5, 2005. During the six months ended August 31, 2005, $96.6 million was paid to repurchase approximately 3.9 million shares under the repurchase program. The prior year amount relates primarily to the repurchase of the Corporation’s 11.75% senior subordinated notes.
The receipt by the Corporation of the exercise price on stock options provided $21.3 million and $18.7 million during the six months ended August 31, 2005 and 2004, respectively. During the six months ended August 31, 2005, $96.6 million was paid to repurchase approximately 3.9 million Class A common shares under the Corporation’s $200 million repurchase program. In addition, in accordance with its Articles of Incorporation, the Corporation repurchased Class B common shares at a cost of approximately $1.4 million in the current period. In the prior year six months, the Corporation repurchased shares at a cost of approximately $9.4 million, primarily Class B common shares.
During the six months ended August 31, 2005, the Corporation paid quarterly dividends of $0.08 per common share, which totaled $10.9 million.

28


Table of Contents

Credit Sources
Substantial credit sources are available to the Corporation. In total, the Corporation had available sources of approximately $400 million at August 31, 2005. This includes the Corporation’s $200 million senior secured revolving credit facility and its $200 million accounts receivable securitization financing. There were no outstanding balances under either of these arrangements at August 31, 2005.
On May 11, 2004, the Corporation amended and restated its senior secured revolving credit facility. This facility was originally entered into on August 9, 2001, as a $350 million facility and was amended on July 22, 2002, to a $320 million facility. The amended and restated senior secured revolving credit facility consists of a $200 million revolving facility maturing on May 10, 2008. The amended facility is secured by the domestic assets of the Corporation and a 65% interest in the capital stock of certain of its foreign subsidiaries. The Corporation pays an annual commitment fee of 25 basis points on the undrawn portion of the facility. The facility contains various restrictive covenants. Some of these restrictions require that the Corporation meet specified periodic financial ratios, minimum net worth, maximum leverage, and interest coverage. The credit facility places certain restrictions on the Corporation’s ability to incur additional indebtedness, to engage in acquisitions of other businesses, to repurchase its own capital stock and to pay shareholder dividends. These covenants are less restrictive than the covenants previously in place.
In April 2005, the Corporation amended its amended and restated senior secured credit facility dated May 11, 2004. This amendment, among other things, increased the maximum amount of dividends that the Corporation may pay to its shareholders, increased the maximum amount of its own capital stock that it may repurchase and extended the period during which the Corporation may repurchase its 11.75% senior subordinated notes due July 15, 2008.
The accounts receivable securitization financing agreement was amended on August 2, 2004, to extend the maturity date to August 1, 2007. The Corporation pays an annual commitment fee of 25 basis points on the undrawn portion of the accounts receivable facility.
During the three months ended May 31, 2004, the Corporation commenced a cash tender offer for all of its outstanding 11.75% senior subordinated notes due July 15, 2008. As a result of this tender offer, a total of $186.2 million of these senior subordinated notes were repurchased and the Corporation recorded a charge of $39.1 million for the payment of the premium and other fees associated with the notes repurchased as well as for the write-off of related deferred financing costs. As part of this transaction, substantially all restrictive covenants were eliminated from the remaining outstanding notes. On July 15, 2005, the Corporation called the remaining notes outstanding. As a result, the remaining $10.2 million of 11.75% senior subordinated notes were repurchased and the Corporation recorded a charge of $0.9 million for the payment of the premium as well as for the write-off of related deferred financing costs.
There were no material changes in the financial condition, liquidity or capital resources of the Corporation from February 28, 2005, the end of its preceding fiscal year, to August 31, 2005, the end of its latest fiscal quarter and the date of the most recent balance sheet included in

29


Table of Contents

this report, nor from August 31, 2004, the end of the corresponding fiscal quarter last year, to August 31, 2005, except for the changes discussed above and aside from normal seasonal fluctuations. The Corporation’s future operating cash flow and borrowing availability under existing credit facilities and its accounts receivable securitization financing program are expected to meet currently anticipated funding requirements.
Critical Accounting Policies
Please refer to the discussion of the Corporation’s Critical Accounting Policies as disclosed in the Corporation’s Annual Report on Form 10-K for the year ended February 28, 2005.
Prospective Information
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 the Corporation’s operations and business environment, which are difficult to predict and may be beyond the control of the Corporation. Important factors that could cause actual results to differ materially from those suggested by these forward-looking statements, and that could adversely affect the Corporation’s future financial performance, include, but are not limited to, the following: retail bankruptcies and consolidations; successful integration of acquisitions; successful transition of management; a weak retail environment; consumer acceptance of products as priced and marketed; the impact of technology on core product sales; competitive terms of sale offered to customers; successfully implementing supply chain improvements and achieving projected cost savings from those improvements; increases in the cost of material, energy and other product costs; the Corporation’s ability to generate revenues from licensing activities and maximize the value of its intellectual property; the Corporation’s ability to comply with its debt covenants; fluctuations in the value of currencies in major areas where the Corporation operates, including the U.S. Dollar, Euro, U.K. Pound Sterling and Canadian Dollar; the timing and impact of new product introductions; escalation in the cost of providing employee health care; and the outcome of any legal claims known or unknown. Risks pertaining specifically to AG Interactive include the viability of online advertising and subscriptions as revenue generators, the public’s acceptance of online greetings and other social expression products, and the ability of the mobile division to compete effectively in the wireless content aggregation market.
The risks and uncertainties identified above are not the only risks the Corporation faces. Additional risks and uncertainties not presently known to the Corporation or that it believes to be immaterial also may adversely affect the Corporation. 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 the Corporation’s business, financial condition and results of operations.

30


Table of Contents

Item 3. Quantitative and Qualitative Disclosures About Market Risk
For further information, refer to the Corporation’s Annual Report on Form 10-K for the year ended February 28, 2005. There were no material changes in market risk, specifically interest rate and foreign currency exposure, for the Corporation from February 28, 2005, the end of its preceding fiscal year, to August 31, 2005, the end of its most recent fiscal quarter.
Item 4. Controls and Procedures
The Corporation maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Corporation’s reports under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms and that such information is accumulated and communicated to the Corporation’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives.
The Corporation carries out a variety of on-going procedures, under the supervision and with the participation of the Corporation’s management, including the Corporation’s Chief Executive Officer and Chief Financial Officer, to evaluate the effectiveness of the design and operation of the Corporation’s disclosure controls and procedures. Based on the foregoing, the Corporation’s Chief Executive Officer and Chief Financial Officer concluded that the Corporation’s disclosure controls and procedures were effective as of the end of the period covered by this report.
There has been no change in the Corporation’s internal control over financial reporting during the Corporation’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Corporation’s internal control over financial reporting.

31


Table of Contents

PART II — OTHER INFORMATION
Item 1. Legal Proceedings
The Corporation is involved in certain legal actions and claims arising in the ordinary course of business. The Corporation does not believe that any of the litigation in which it is currently engaged, either individually or in the aggregate, will have a material adverse effect on its consolidated financial condition or results of operations.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
(a)   Not applicable
 
(b)   Not applicable
 
(c)   The following table provides information with respect to purchases of common shares of the Corporation made during the three months ended August 31, 2005, by American Greetings Corporation.
                                 
                    Total Number     Maximum Number of  
                    Shares of     Shares (or  
                    Purchased as     Approximate Dollar  
            Average     Part of Publicly     Value) that May Yet Be  
    Total Number of     Price Paid     Announced     Purchased Under  
Period   Shares Repurchased     per Share     Plans     the Plans  
June 2005
  Class A – 520,000   $ 26.55 (2)     520,000 (3)   $ 140,716,271  
 
  Class B – 500(1)   $ 26.97              
July 2005
  Class A – 630,000   $ 25.93 (2)     630,000 (3)   $ 124,383,348  
 
  Class B – 52,153(1)   $ 26.84              
August 2005
  Class A – 835,000   $ 25.00 (2)     835,000 (3)   $ 103,509,237  
 
  Class B – 208(1)   $ 25.52              
Total
  Class A – 1,985,000   $ 25.70 (2)     1,985,000 (3)        
 
  Class B – 52,861(1)   $ 26.83                
 
(1)   There is no public market for the Class B common shares of the Corporation. Pursuant to the Corporation’s Articles of Incorporation, all of the Class B common shares were repurchased by the Corporation for cash pursuant to its right of first refusal.
 
(2)   Excludes commissions paid, if any, related to the share repurchase transactions.
 
(3)   On April 5, 2005, American Greetings announced that its Board of Directors authorized a program to repurchase up to $200 million of its Class A common shares over a 12-month period, which will expire in April 2006. These repurchases will be made through a 10b5-1 program in open market or privately negotiated transactions in compliance with the SEC’s Rule 10b-18, subject to market conditions, applicable legal requirements and other factors.

32


Table of Contents

Item 3. Defaults Upon Senior Securities
Not applicable
Item 4. Submission of Matters to a Vote of Security Holders
(a)   The Annual Meeting of Shareholders of the Corporation was held on June 24, 2005.
 
(b)   The following individuals were elected at the Annual Meeting of Shareholders to Class I of the Corporation’s Board of Directors with a term expiring in 2008: Morry Weiss and Stephen R. Hardis.
The following individuals were continuing Class III directors with a term expiring in 2007: Scott S. Cowen, Harriet Mouchly-Weiss, Charles A. Ratner and Zev Weiss.
The following individuals were continuing Class II directors with a term expiring in 2006: Joseph S. Hardin, Jr., Jerry Sue Thornton and Jeffrey M. Weiss.
(c)   The voting result at the Annual Meeting of Shareholders for the election of Class I directors was as follows:
                   
Nominee     Votes For     Votes Withheld
Morry Weiss
      97,529,580         3,338,205  
                   
Stephen Hardis
      78,667,529         22,200,256  
Item 5. Other Information
Not applicable

33


Table of Contents

Item 6. Exhibits
Exhibits required by Item 601 of Regulation S-K
     
Exhibit    
Number   Description
 
10.1
  American Greetings Corporation Executive Deferred Compensation Plan, Effective October 26, 1993
     
10.2
  Amendment One to American Greetings Corporation Executive Deferred Compensation Plan, Effective January 1, 1996
     
10.3
  Amendment Two to American Greetings Corporation Executive Deferred Compensation Plan, Effective November 1, 2000
     
10.4
 
Amendment Number Three to the American Greetings Corporation Executive Deferred Compensation Plan – American Greetings Corporation Executive Third Party Option Plan, Dated March 27, 2002
     
10.5
  Form of Agreement for Deferred Compensation Benefits
     
10.6
 
Form of Agreement under Amendment Number Three to the American Greetings Corporation Executive Deferred Compensation Plan – American Greetings Corporation Executive Third Party Option Plan
     
10.7
  Performance Share Grant Agreement dated August 2, 2005, between American Greetings Corporation and Zev Weiss
     
10.8
  Performance Share Grant Agreement dated August 2, 2005, between American Greetings Corporation and Jeffrey Weiss
     
(31) a
  Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
     
(31) b
  Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
     
(32)
  Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

34


Table of Contents

SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
                 
    AMERICAN GREETINGS CORPORATION
 
               
    By:   /s/ Joseph B. Cipollone    
             
        Joseph B. Cipollone
 
          Vice President, Corporate Controller, and Chief Accounting Officer *    
 
               
October 7, 2005
               
 
* (Signing on behalf of Registrant as a duly authorized officer of Registrant and signing as the chief accounting officer of Registrant.)

35