艾利丹尼森 (AVY) 2008 Q2 法說會逐字稿

Good morning. Welcome to the Avery Dennison earnings conference call for the second quarter ended June 30, 2008. This call is being recorded and will be available for replay from 2:00 p.m. Pacific time today through midnight Pacific time July 25, 2008. To access the replay, please dial 800-633-8284, and 402-977-9140 for international callers. This conference ID number is 21356708. I would now like to turn the call over to Eric Leeds, Avery Dennison's head of Investor Relations.

Thank you. Welcome, everyone. I very much look forward to meeting and working with you. Our discussion today will reference the earnings release that we issued earlier, along with the slide presentation titled Second Quarter 2008 Financial Review and Analysis. Both documents were furnished today with our 8-K and posted at the investors section of our website at www.investors.averyDennison.com. Our news release references GAAP operating margin, which includes interest expense, restructuring and other charges included in the other expense line of our P&L. Also referenced are transition costs associated with the Paxar integration that show up in this past quarter's M G&A expense.

Restructuring charges and integration transition costs tent to be fairly disparate in amount, frequency and timing. In light of the nature of these items, we'll focus on margin commentary on pre-tax results before their effect and before interest expense. This detail is in schedules A-2 to A-6 of the financial statements accompanying today's earnings release. Slides 18 and 19 of the presentation contain a reconciliation of margin change to help illustrate the impact of the Paxar acquisition. We also remind you that we'll make certain predictive statements that reflect our current views and estimates about our future performance and financial results. These statements are based on certain assumptions and expectations of future events that are subject to uncertainty.

The Safe Harbor Statement included in the documents that we published today, along with our recent forms 10-K and 10-Q address the most important risk factors that could cause actual results to differ from our expectations. Here today are Dean Scarborough, President and CEO, Dan O'Bryant, Executive Vice President and CFO; and Mitch Butier, Corporate Vice President, Global Finance. We'll now turn the call over to Dean.

Thanks, Eric, and welcome aboard. As you know by our news release this morning, the economic and market challenges that began the year have continued into the second quarter. We're pleased with our progress in many areas, including the execution of the Paxar integration, our growth in emerging markets and RFID, and the substantial improvement in cash flow over the prior year. However, we are reducing our outlook for the balance of the year due mainly to rapidly rising raw material costs, and the expectation of continued weak economic conditions, with the possibility of further softening outside the US. Sales trends were somewhat mixed in the second quarter, with sequential improvement in pressure-sensitive materials and office products, but comparatively weaker results for retail information services, and a few of our smaller specialty converting businesses.

Pressure-sensitive volume growth improved sequentially with continued growth in emerging markets, and new decoration transfer applications in mature markets. However, raw material inflation, energy, and transportation costs have escalated rapidly in the last 90 days, which has had a significant impact on our margins. We are raising prices again this quarter and anticipate another round of increases later this year, if inflation continues to accelerate. The combination of price increases, productivity and product reengineering will enable us to recover our margins, but there will be some lag in recovery, especially if inflation continues. The retail information services business was again impacted by slow retail conditions in the US and retailer inventory reduction, which had a dramatic downward impact on apparel imports. Additionally, while European programs continue to grow, we did see a slowdown related to weaker retail conditions in that region.

We did see growth in our new product investment areas, which include RFID, heat transfer and packaging, and we believe we're continuing to take share in the core business. As expected, the incremental volumes in the second quarter busy season improved our margins from the first quarter. We're executing well against our integration synergy targets but in the short-term, those savings have been offset by lower overall volumes and inflation. We are raising prices and accelerating our productivity actions and we do expect to achieve our long-term targets once market conditions improve. More importantly, we continue to invest in improved service and new products to position ourselves for the coming upturn.

Our office products team had a challenging revenue quarter, but did a great job of managing their costs and working capital in a tough environment. The largest impact on revenue for the quarter came from a shift of back to school orders into Q3. Last year, a bigger share of our back to school orders came through in the second quarter. We're accelerating our efforts to renovate and enhance existing products, investing very selectively in some new ones, and we are having some measurable success, despite the tough office products environment. Inflation has impacted office products as well, as steel, vinyl, paper, and transportation costs rapidly increase. We raised prices on the first of July, and are implementing price increases in October and in January to recover our margin. Office products continues to deliver solid productivity increases, which is one reason why margins have held up so well in this business. And I'm still very pleased with our trajectory in the RFID inlay business.

Revenues quadrupled in the quarter, consistent with our plan, as orders increased for item level tracking and apparel, as well as other supply chain programs. The short-term outlook is challenging, so we're taking steps to strengthen our businesses to capitalize during economic recovery. As I mentioned previously, our biggest short-term challenge is inflation and slowing economies. Executing price increases well will have the biggest upside impact on our results, and we expect the incremental benefit of pricing actions to be realized in the second half of the year. We're executing the Paxar integration, and will hit our targets for annual synergy savings from the acquisition. Retail information services remains on course to realize roughly $120 million in annual synergy savings when the integration is complete, with 85% of the savings expected to be captured in the run rate by the end of this year. We're driving increased productivity across the organization. The restructuring actions we undertook in 2007 will drive 45 to $50 million of annualized savings when fully implemented. With close to 60% of that value representing incremental savings in 2008. And we've initiated a number of short-term actions to reduce operating costs across the company that will offset some of the short-term weakness.

We continue to invest in growth acceleration programs. Emerging markets and RFID, for example, are right on track. We're taking share and pressure-sensitive materials by capturing business from alternative decorating technologies and through new product and service programs. And in fact, we're opening a new distribution center in Japan to capture share in this untapped market. In retail information services, we continue to see interest in radio frequency identification and our new packaging capabilities. And we've invested in new technology that enables us to offer smaller quantities of tags and labels faster and more cost effectively.

Now I'll turn the call over to Dan for a more detailed review of our second quarter financial results and our revised outlook for the second half.

Thanks, Dean.

Let's begin with the financial overview on slides 5 and 6 of the handout. Net sales were up 20% due to the benefits of the Paxar acquisition and currency translation, reflecting the value of our global diversification. On an organic basis, sales declined about 1% compared to prior year and I'll provide some color on that in just a few moments. Operating margin before charges and transition costs declined by 130 basis points, or about 80 basis points, if you adjust for the addition of the base Paxar business. The year on year decline in margin reflects the raw material and energy inflation, as well as carry-over of the 2007 price reductions. We continue to anticipate a substantial improvement in operating margin by the fourth quarter, which I'll discuss more in the context of our guidance. Our annual tax rate is now expected to be in the 14 to 16% range for 2008, and we believe a tax rate in the range of 17 to 19% will be sustainable for at least the next few years, reflecting our geographic income mix, reductions in the statutory rates in a few countries, as well as benefits of our tax structure and planning efforts.

Now, let me walk you through the story on top line sales on slide 7. As I said, reported sales were up about 20% compared to the prior year. The Paxar acquisition added about 14 points of growth and currency translation added 7 points of top line growth and $0.05 of earnings to the quarter. Looking at organic growth trends on a regional basis, sales in the US declined by about 4%. In Europe, sales before the Paxar acquisition and currency were up about 4%. Sales in Asia likewise through about 4% on an organic basis, slower than Q1 due to the weakness in apparel exports to the US, but impacted retail information services. All of our materials businesses in that region remained strong with organic growth in the mid teens. Sales in Latin America were up 5% versus the prior year on an organic basis, with sequential improvement bringing growth back to the level we saw in the fourth quarter of last year.

Taking a look at our margins on slide 8, and once again, for purposes of margin comparison, we've added Paxar's results from last year into our own prior year numbers and provided the backup for that adjustment on slide 18 of the handout. So on this adjusted basis, operating margin declined by 80 basis points and slide 9 summarizes the key factors driving the change in company operating margin. Gross margin before Paxar integration costs declined by 20 basis points compared to the reported results for the prior year. Adjusting the prior year number to include Paxar, gross profit margin declined by 130 basis points. The primary driver has been the rapid raw material inflation that Dean talked about. In addition, we've experienced increases in labor costs in China and higher energy and transportation costs. And while our selling prices are now on the rise in just about every business, the carry-over effect of decreases late last year is still impacting margins.

It goes almost without saying that we're accelerating our productivity efforts on every front. This is the time when our Enterprise Lean Sigma process really makes a difference in the company. But even with our best efforts, we won't be able to completely offset the level of inflation that we're experiencing. We estimate that raw material costs were up about $20 million in the quarter compared to the same period last year. For 2008, we've raised our estimates for raw material inflation from last quarter's $70 million to a current estimate of about $110 million. I'll comment on that a bit further when I discuss our earnings guidance. Turning to operating expenses, before integration costs, MG&A expenses as a percentage of sales increased by 110 basis points compared to reported results for the prior year. If you adjust the prior year number to include Paxar, the MG&A expense improved by 40 basis points, which partially offset the gross margin decline. Compared to the adjusted prior year, absolute spending on MG&A was up about $11 million. The combination of currency translation and incremental amortization of intangibles from the Paxar acquisition represented more than the entire increase. We offset a portion of these higher costs along with general inflationary pressure through our productivity efforts.

Turning to segments on slide 10, we saw a jump in our pressure-sensitive materials business with reported sales up 11% over the prior year second quarter to $980 million. Organic sales growth was about 3%, a solid improvement from the first quarter growth rate. Focusing on the roll label materials business, about 70% of this business right now is in Western Europe and North America. North America slowed a bit after a strong first quarter. Europe accelerated in Q2 over Q1 and most of our emerging market businesses continued on their solid growth trend. The graphics and reflective business was down low single-digit rate before currency. This business is more cyclical than others with the US markets slowing the most.

Excluding restructuring and other items, operating margin for our pressure-sensitive materials business declined 170 basis points versus the prior year to 8.2%. The decline in pressure-sensitive materials margin reflected cost inflation and prior year price reductions, but more than offset the initial benefits of this year's price increases, as well as restructuring and other productivity initiatives. As Dean alluded in his opening remarks, the incremental benefit of pricing actions are expected to be realized in the second half of the year. We've anticipated more inflation for the balance of the year, but raw material cost forecasting has proven to be an elusive art lately. If our outlook is right, we have enough in price increases under way to catch up with inflation. But we do believe there is substantial risk of more inflation over the next few quarters and we'll likely continue raising our prices to keep up.

Let's turn to retail information services on slide 11. Reported sales for retail information services were $438 million. That's double a year ago due to the acquisitions of both Paxar and DM Label. Five years ago, this was a $250 million business. Today, it's over $1.5 billion. Organic sales were down about 3% for all the reasons that Dean discussed. Our major concern here is the rapid fall-off in traffic at the malls in the US market. Retail information services has a very high variable margin, so volume declines have had a big impact on our bottom line. Adjusting the year-ago comparisons for Paxar results, the operating margin before transition costs, restructuring and asset impairment charges declined 80 basis points to 7%. Integration savings, along with other productivity actions, were more than offset by the combined effect of reduced fixed cost leverage for lower revenues, employee-related and raw material cost inflation, and about $9 million of intangible amortization and corporate cost allocations.

Looking at the Paxar integration update on Slide 12, we continue to expect about $120 million in annual synergies when we're finished blending Paxar into retail information services. Of that $120 million, we realized about $21 million of synergies in the second quarter compared with $18 million in the first. 85% of the targeted savings will be in our run rate by the end of this year, and we're not expecting any changes to our estimate of $165 million to $180 million of integration cash costs. Nearly two-thirds of that is now behind us. We'll incur about $35 million over the balance of this year.

Now on slide 13, we've already discussed much of what has happened -- much of what has impacted our office and consumer business, as reported sales were down 3% from a year ago. Part of the weak top line in the second quarter included delayed shipments related to the back to school season that we are now positively -- that are now positively impacting the third quarter. Ex-restructuring charges, operating margins were up 110 basis points to 17.3%. Favorable product mix, given the delay in back to school shipments, along with restructuring benefits and productivity gains more than overcame the effect of cost inflation and reduced fixed cost leverage associated with lower sales.

Now let me move on to slide 14 for a look at our cash flow. First, our ratio of debt to total capital at June 30 was 51.9%, down from the prior year ratio of 56.6% immediately following the Paxar acquisition. We expect this ratio to decline further over the next two quarters. We continue to reduce working capital, which is helping us in the current demand slowdown. Year to date cash from operations improved by nearly $60 million. In addition to working capital improvement, year to date capital expenditures were $69 million and we used another $33 million for software. Total cash for capital and software are down $22 million from prior year.

Now, on slides 15, 16 and 17, we've set out our revised guidance and outlook for the second half. Anticipated inflation, weaker segment mix, and slowing demand lead us to recalculate adjusted EPS for the full year to between $3.75 and $3.95 a share. The key issue for the balance of the year -- the key issues will be inflation and our ability to successfully implement our price increases. We obviously still have a gap between the two. The revised estimate also reflects between $60 million and $70 million of cost synergy from the Paxar integration, about 25 to $30 million in restructuring benefits over the previous year, and benefits from other productivity initiatives as well. The benefits from the Paxar integration continue to grow and RFID is contributing. As Dean said, we quadrupled sales in that business unit in the second quarter and we are on track to reduce losses there this year just as planned. Currency benefits our top line by 5% and we have lowered the tax rate for the full year guidance.

On Slide 16, we've outlined what changed between our current assumptions and our previous assumptions for the year. Now, with that, let me turn things back to Dean for some additional thoughts before we take your questions.

Thanks, Dan. While we face a challenging environment, I do believe we are well positioned to weather the storm and to position ourselves in good shape for the future. One of the things that helps is our geographic and end use application diversity. We're certainly being helped by the fact that more than two-thirds of our business is outside the US. Also, another factor is most of our businesses are in items that are linked to consumables and only about 15% of our business are related to housing and automotive and other very cyclical segments.

Many of our products are used on things that consumers use every day. A good example is personal care. We have many label materials used on shampoo bottles and people still do wash their hair in a recession. So while underlying demand does go down for our products in difficult economic times, we don't see dramatic downturns. We're clear market leaders in each of our core businesses, with very strong competitive advantages and during these tough times, I find that customers rely on their best suppliers and that does give us an opportunity to take share. We demonstrated our ability to drive productivity and improve cash flow through our enterprise lean sigma programs. ELS has enabled us to get more with our existing capital and to enhance working capital efficiency as well. Now, we're happy to take your questions.

Thank you. (OPERATOR INSTRUCTIONS) Your first question is from the line of Jeff Zekauskas with JPMorgan.

Hi, good day. In terms of the pressure sensitive adhesive business, can you talk about volumes and price in the quarter. Is it the case that price was down? Is that right?

Well, pricing is up sequentially, but still down year-over-year.

Right, like 1%? It's like down that order of magnitude, or is it down more?

It's still down more than that year on year. The heavy discounting that took place in the industry was primarily in the third and fourth quarters of last year. So it's going to take a couple more quarters to lap that. We had some price compression mostly outside the US in the first quarter. So we're still down more than a point, if you look on a year on year basis.

So that means organic volume growth was, I don't know, up 5? And, what do you make of that sort of strength? Is that temporary, or is that going away?

Well, Jeff, I think the one kind of surprising question, and I know where you're headed here, is that volume growth for us has been surprisingly strong over the last couple of quarters. We've certainly seen continued strength in emerging markets. Europe has been relatively strong as well. I believe we might be taking a little bit of share there. We haven't seen the numbers yet for the second quarter. And our volumes are up also in North America, but then, again, that's related to a bit of share gain.

And in some of the emerging markets sequential strengthening over the last couple quarters and in the second quarter, things were quite strong in Asia in particular, but other places as well. And that's becoming an increasingly large part of the pressure-sensitive business. So it's having more impact these days.

All right. I'll get back in the queue. Thank you.

Your next question is from the line of John Roberts with Buckingham Research.

Good morning, or afternoon, guys.

Hi, John.

Hi, John.

To the extent PSM was stronger in volume, I think the weakness in the RIS volume is surprising, at least. Global apparel demand is not down anywhere near as much as you were down.

Well, let's see. I think the way -- here's the way I look at it. You have two things going on. You have -- in the US, you have POS down for apparel, and then you have retailers reducing inventories at the same time. So apparel imports into the US actually are down. I think they were down in the high single digits in the first quarter. So that definitely has an impact on our business, because everything coming in the US has some kind of tag on it. We saw -- still we saw in Europe, growth over prior year, but that growth has been decelerating. So the combination of the two is impacting us.

Pricing in the RIS segment?

It's a custom business, so there's so much churn in the programs. It's kind of meaningless.

Thank you. Your next question is from the line of Reik Read with Robert Baird & Co.

Dean, you've talked a couple of times about share gains with alternative decorations in the US. Can you talk about that and then if you are gaining share in Europe, what's driving that at this point?

Yes, the -- you know, we're continuing to convert decorating applications in the food and beverage segment to pressure-sensitive, and we probably have the most success frankly in the beverage category, so things like juices and still beer has been a positive thrust for us, and so that, that's continued on. We've continued to invest in that and that's great share gain to take because it's all new business to the industry.

And then what might be accounting for that in Europe as well?

Well, actually, we had a competitor go at -- went Chapter 11 in the UK, so I think that might be a fairly large chunk of it.

Okay, and then I just want to make sure I understand from a demand standpoint, you talked about weakening demand in Europe and Asia in your press release, but it sounds like pressure-sensitive in Asia continues to do well and you don't have any expectation that that changes. Is that the correct understanding of that?

Yes, the weakness that we saw in Asia was really in the RIS business only, and that's, again, related to the retail apparel slowdown in the US markets. But if you look at the businesses where consumption is Asian-based, like all of our materials businesses are, it's quite strong and it has accelerated over the last few months. So I think we were not completely immune in our Asian markets for what goes on in the US, but the consumption is 70, 80% based where we manufacture, and those economies continue to be driven by new middle classes emerging, and that's, that is giving us some protection. So the diversification in our revenue base is helping us out quite a bit. In the quarter, emerging markets represented over 30% of our volume, up around the 32, 33% mark, so it continues to be a more important part of the overall mix and so far, so good in those markets.

Okay, and then just one follow-up on the price increases. You've given some color that you're planning to do more price increases, but given if things stayed where they were today, how long would it take you at this point to kind of catch up with that raw material inflation?

I would say roughly two quarters.

Okay. Great. Thank you much.

That's assuming no more inflation, though.

Yep, understood. Thanks much.

Sure.

Your next question is from the line of Ghansham Panjabi with Wachovia Securities.

Hi, guys.

Hi, Ghansham.

Looking back at previous recessions in the US, do you have a sense as to how long these inventory corrections in apparel last? I know it's a tough question because we have seen a couple different recessions, but, looking back, if you have the data to the early 90ss and that's probably more reflective of a true consumer recession than the last one, how long does it last and how far along are we?

Well, let me tell you, talking to our retail customers, they, they assume that we're not going to see -- they are not going to see a decent recovery until sometime in 2009. Most of our customers in the US anyway are saying this has been the worst retail recession in 20 years. Now, if I look back at our business that long ago, there's a couple of things. One is RIS was really small and so it didn't really impact it that much. And secondly, at that point in time, there was still an awful lot of apparel that was made in the US being shifted to Asia. So I'm not sure we were impacted all that much, at least not to the extent that we are today.

Okay. That's very helpful. And also on -- in your comments on the office products business, you noted that mix was favorable.

Yes.

Could you expand on that, please?

Well, that -- our back to school product line consists of things like binders and dividers and sheet protectors. They tend to be the, at the lower margin end of our product categories. And printable media obviously is a higher margin product range. So because back to school shifted more to Q3 than Q2, the mix just naturally looked better for the quarter.

So for 3Q, maybe sales -- volumes are better, but margins might be lower then?

Absolutely. Plus we're getting more raw material inflation at the same time.

Okay, great. Thank you so much.

Your next question is from the line of George Staphos with Banc of America.

Hi, everyone. Good morning. I just wanted to follow up a little bit on Jeff's question earlier. Realizing that it's tough to measure this within RIS, were any of your other segments, aside from PSM, down year on year if you can measure it in price mix in the second quarter, and was that percentage change sequentially for any of the segments worse than what you saw in the first quarter? I would expect the answer is no to that second question, but I want to confirm it.

Yes, generally in the second quarter, we saw pricing beginning to stabilize across the other businesses. The categories that -- or the businesses that that would be most relevant to are in our other category, like our tapes business, but also the graphics businesses, and they started implementing some price increases in the second quarter. So generally if we look out there, things were getting at least stabilized in Q2, if not improving just a little bit, George.

Okay. So aside from PSM, then, was anything down year on year, percentage-wise on price mix?

Well, sure. Year on year, most everything was down. Office products would be the exception, but we were down in the PS segment year on year because of that carry-over effect. If you're talking sequentially, things began to stabilize and improve in a few places. If you're talking year on year, our materials businesses pretty much across the board had negative price that carried into the second quarter.

Okay. So does that suggest that pricing was negative in RIS in the quarter?

George, you can't -- it's a custom business, okay. And the churn rate is as high as 60 to 70% on a year-over-year basis. There's no, there's no good way to measure pricing in -- the biggest impact we had there was volume decline and the second thing is we did see some inflation coming from people costs and some material costs, especially related to China.

Okay. Just trying to get at it because of how big's inflation's been for you, how big you expect it will be and the effect of trying to implement more pricing. How do you implement an RIS price increase, since it is such a diverse business?

Well, basically you raise your standards so when customers come back for a new program, you load your new costs in and your new margin expectations and it's pretty much hidden because if a customer buys a six-color printed tag that's 4 inches by 2 inches one year and then moves to a larger tag with fewer colors, you're comparing an apple to an orange. But we would expect to get with our new pricing models, we would get the inflation pass-through. But it takes time to do.

I understand. One quick one, I'll turn it over. It's probably semantics, but I just wanted to confirm it. In your prior slide deck, the Paxar synergies were targeted up to $125 million. Now you're saying approximately 120. I know these are not big numbers, but just want to see if anything has changed in your synergy outlook.

Yes, thanks. Nothing's changed, just refining the words a bit. What's actually going on is we're achieving all the synergy costs out that we targeted and we're actually getting more productivity on top of it as we react to soft market conditions. So no change in the expectation for what we're getting out in terms of cost synergy at all.

Okay. Thanks, Dean.

(OPERATOR INSTRUCTIONS) Your next question is a follow-up from the line of Jeff Zekauskas with JPMorgan.

Yes. So the organic sales growth in the quarter was negative 0.6%. Can you break that up into price and volume roughly?

Yes, it was nearly the price mix component year on year was down 1.5 to 2% still.

Price mix was down 1.5 to 2.

Right.

Okay. Second, in terms of raw materials, you stated that you feared that raw materials would continue to go up. Why are you afraid of that?

I don't think we used the word "fear." We said -- I'm not afraid of it in particular. I think in the long run, some of this inflation's probably healthy to the industry, but the issue right now is that we're behind the inflation curve. As you know, in our materials businesses, in particular, it takes time to get a price increase out into the industry and with the pace of inflation right now, we just haven't been able to keep up with it and we're raising prices everywhere. Sometimes our second or third round already. Just can't keep up with it at the rate it's been coming in. We've adjusted our rate expectation every quarter over the last 90 days and it's more than double what we came into the year expecting.

So it's just a matter of how quickly we can react to it and recover. We'll get there. We have always, I think, been able to get to the point where we've covered the inflation. But running two or three quarters behind is pretty tough on margins for '08 and the damage has been done in the first half of the year, even if by the end of the year we've caught up while our margins in the fourth quarter and first quarter may look a whole lot better than they do now. There's not a lot we can do to recover the margin loss in the first half of the year.

So you lowered your guidance for the year, but your numbers in the quarter were pretty good. So does that mean that you expect the raw materials squeeze to be worse in the third quarter than it was in the second?

Well, the third quarter is sort of similar. We've got a lot of price increases that are going in the quarter and some of them in the late of the quarter, the beginning of Q4, the inflation's already there. So the GAAP between our pricing and inflation in Q3 looks a lot like it looked in Q2. It looks better -- margin compression in the second half and then a couple of our businesses simply have lower sales in the third and fourth quarter than they typically do in the second. So we do have some lower volumes coming through and a lot of that is in our two high variable margin businesses, RIS and office products, which impacts the earnings for the back half of the year as well. That's really the store and the guidance, the GAAP inflation versus pricing in the second half and the lower volumes and our highest margin businesses.

And if I may add, we were not -- we were still behind the pricing curve in our second quarter. As you know, we don't give quarterly guidance, so the issues affecting margin related to pricing were very strong in the second quarter. You may have shown that we hit the number, but we did not hit our number.

What I mean is that oil's already at whatever it is, $1.35 and natural gas is already up, which are the precursors of your raw materials. Acrylic's pricing is passing through pretty fast right now and so if your prices are -- your prices only need to go up only a couple of percent to offset that inflation. So I take it that means that you won't be able to get something like a 2% price increase in the third quarter, but maybe it will take you till next year, is that what you're saying? I think we'll see most of it. We'll see most of it catch up in the fourth quarter, but we are anticipating more inflation, Jeff.

How bad were volumes in July across the board? Or how good were they?

Well, we -- they were about where we expected, except that the, the growth came more from our materials business and less from RIS -- I'm sorry. You're talking about a single month?

Yes, I am--

-- Jeff?

I was wondering how July had gone, or how July was going for you.

There's nothing that we can report right now that would indicate a change in the pattern for the month of July. So right now we're still -- still looking more like Q2.

And then lastly in RIS, in the third quarter, we don't really have very good historical numbers, so how seasonally weak is the third quarter versus the second or versus the first? How do you think about that?

Well, the first quarter is the softest, and the third quarter is the second softest and then the fourth quarter action then the second quarter and I would guess that Q3 would be more seasonally weak than normal because retailers are going to be cautious about how much inventory they bring in for the holiday season and for Christmas. So this season will get started slower. It typically starts in September.

Okay, thank you very much.

The next question is a follow-up from the line of John Roberts with Buckingham Research.

Thought I beat this RIS price discussion to death here, but is there any way you can talk at least about variable margins, because the operating margins are obviously impacted by volume, by restructuring, but the variable margin would be more indicative of the mix effects or whether customers are trading down or competitive pressures. Even without giving absolute numbers, maybe directionally, whether variable margins were maintained?

Yes, I think the best way to get a handle on that is to look at the RIS results in Q1, which is a very soft quarter and what those margins liked like in Q2. And the variable contribution as we seasonally ramped up was in the high 30% range or close to 40%. So we get huge impacts this that business you a of the high variable, variable margins and that hasn't really changed. You can do bock a year ago and look at the incremental margin on volume and you look at now, and it's similar. There's margin pressure in the business, but as Dean said, it's coming from inflation right now and it takes some effort to react to that in terms of prices as programs change over and so on, and to drive productivity. Still, from a volume perspective, volume makes a big difference in how much EBIT we produce in this segment.

So you would say there's not a lot of customer tradedown going on in the business?

It's all over the map. Some customers want to buy cheaper tags and labels. Other customers want to buy, frankly, more expensive tags and labels because they want to differentiate their products at point of sale.

But on average? Sort of unchanged?

I would say on average, there's really no change.

And even though you have a relatively high market share, the smaller players, the competitive intensity hasn't picked up to where they might be pressuring the business?

We haven't really seen -- I would say it's no more than we would normally see.

Okay. Thank you.

Your next question is from the line of Reik Read with Robert Baird Company.

Just a follow up on the price increases. Is the acceptance of these price increases a little difficult to get at this point and that's why you say, Dean, it's more of a fourth quarter where you see a catchup, or is that because you're anticipating more inflation?

There's, there's always resistance. Customers don't like price increases, but in today's world, it's pretty much becoming accepted. So, the conversation has changed with most of our customers from we don't want a price increase to, well, how long are your prices going to last now? But I -- the real issue for us is accelerating inflation. So we announced a group of price increases that come into the third quarter and inflation has gone up much more rapidly than we anticipated.

I'll give you an example. In office products, we typically raise prices once a year because it's difficult for our customers to pass those price increases through. We've raised prices in July. We're raising them again on some products in October, which is unprecedented, and then again on some other product categories in January. And it's simply because inflation in certain categories has gotten so intense, we have no other option but to pass the costs on.

I'll add one thing, too, just a thought with this. This gap between what we've been hit with in inflation and what we've been able to recover in price is a temporary gap. We've been through this before and it comes back. The pace has been our challenge, just getting prices up quickly enough, so it's really masking our ability to generate profit as we go. When we catch up over the next couple of quarters, and we start to see volume come back, I think the underlying ability to generate profit and cash flow in this business is really going to be solid because a lot of things are going right. The RIS integration's going extremely well. We're getting a lot of productivity as we implement ELS in our materials businesses. Office products is very reliable in their ability to maintain margins and so on. So we have an underlying business that's very strong. The size of the gap between pricing and inflation is significant right now, and we're going to get through that and the business is going to improve. We still expect margins to be ramping up as we go through the next couple of quarters.

And if I could ask one more question on the RIS side of things, what's kind of your assumption right now in terms of where the retail apparel markets are from a growth standpoint and, Dean, you've talked a number of times about retailers wanted to lower inventory. How much more can they lower that bar before things maybe kind of level out?

Well, I think we're -- the good news there is I think they are probably getting about as low as they can get to be honest, and the good news is that when -- we'll start to lead the recovery. When retailers start to order products because they are running out of stuff in the stores, we'll see a surge in orders, which is typically how these things operate.

And then just one question off that as it pertains to the RFID space, apparel winds up being an important market for you guys. If I exclude Marks & Spencer, because that's kind of a unique case, does the weakness that you're seeing right now slow down some of those efforts or are they moving forward regardless?

They are moving forward actually. I think Marks & Spencer isn't so unique anymore. We're involved in at least 15 pilots now with different retailers around the world and American Apparel's a good example. They are installing RFID in their business and we're talking with a lot of retailers. Retailers are looking at this today because the cost of implementation are much lower than they were a few years ago and this is just a great way to make sure they have got the right products in stock and they can improve their sales. I actually think there's more interest today than there has been in certainly two years ago.

But the underlying economic issues aren't impeding that at all?

Not so far.

Okay. Thanks.

Sure.

Your next question is from the line of John Roberts with Buckingham Research.

We were talking about the office product increases, I think you said you've got a price increase in July, one coming in October, and did you say you've got price announcements to your customers all the way out to January '09?

That's correct.

How does that work? You've gone out to office product retailers and told them in January you'll be seeing a price increase? You can't have any visibility in your raw material costs between now and then.

We have -- we have enough -- it depends on the product category. Giving them a range of what to expect for January of '09 so that they can do their planning.

Some of this, again, is making up for inflation that we're absorbing today that has already hit us and we are recovering in January.

So if you saw more raw material increase that is unexpected, more than what you were expecting between now and let's say even October, you would go out with a February price or March price increase '09?

It's hard to anticipate that. I hope we're not an inflationary environment like we were 25 years ago, where we were raising prices every 90 days. Our preference would be to, in office products anyway, would be to have one, maybe two price increases a year. But if we see the type of price inflation we've seen lately, going out every 90 days, we would do it.

Lot of packaging materials in office products? Maybe provide a little color on the raw materials there.

You have steel. You have vinyl. You have transportation costs. Those are the major categories.

Okay.

Those are the ones -- and plastic. Those are the ones that seem to be -- have the highest rate of inflation right now.

Thank you.

Sure.

Thank you. Your next question is from the line of George Staphos with Banc of America.

I have a few. I'll ask them in sequence to lessen the time. First off, given that you're telling customers what your future price increases will be, what are the risks of prebuying here? Secondly, as we take a step back, should we expect most of the inflation hit for the back half of the year to really reside in pressure-sensitive material? Or how would you have us think about it? I had two quick questions, but let me start with those.

Yes, George, on the prebuying, so far we haven't seen a lot of impact. If anything, we've seen behavior change from customer, especially retail customers. They are working on preserving cash in a down environment. So inventory is much more important to them, or lower inventories is more important to them than prebuying on price increases.

Got it.

That's a big one.

Okay, and in terms of inflation, we should expect most of the impact where pressure-sensitive would seem to me to be the most, but how would you have us think about it.

That's right. The materials business has been feeling the most of it. Probably two-thirds of the inflation hitting there, I would guess. I don't have the exact number, but it's definitely more impact full there than it is the other segments.

Okay. Just as we think about where things maybe have changed from a macro standpoint relative to where you last gave guidance, you talked about obviously RIS being weaker, apparel being weaker in the US, were your expectations for recovery in the second half and that's why you're giving yourself a bit more room in the guidance now, or where was there some additional weakness?

Well, we didn't meet our expectations for the second quarter, George, so -- and we anticipate slower volume environment, as well as the accelerated inflation in the back half. We're starting to see things slow down outside the US at the same time.

I would think, too, that the other thing -- there are two major factors that cause us to change the guidance. One is that from what we originally expected in the back half versus now, we still have a big GAAP, particularly in Q3 between price and inflation. And the second one is that on the revenue line, more of that revenue is coming out of the materials business and less out of the office products and RIS business where our higher incremental margins are, and that impact is a good part of having pulled our expectations down a bit in the second half.

Last one, just qualitatively, if we hold current macro trends flat and we assume no more inflation than what we've already seen, I don't want pricing or inflation to enter into your answer here, how much more opportunity do you have to improve working capital over the next couple of years? Could you actually go free cash flow in '09 given what you know right now relative to '08's base, given whatever initiatives you may think you may be able to undertake? Thanks, guys. Good luck on the quarter.

We do have room on the cash flow and I think these last two quarters have shown it. We have been unhappy with our working capital performance over the last couple of years. There are some reasons for that, but frankly the focus now is better now than it has been and we've been generating a significant amount of cash out of our working capital and we're not finished. I think there's still another $50 million or maybe more over the next year, year and a half that we'll squeeze out of working capital. So we're, we're confident in our ability to generate cash flow and pay down debt as planned, even with some of the top line challenge that we are having right now and the margin loss. We're still committed to our cash flow targets.

Thanks.

Thank you. At this time, there are no further questions.

Thanks, and we'll talk to you next quarter.

Ladies and gentlemen, that does conclude the conference call for today. We thank you for participating and ask that you please disconnect your line.