艾利丹尼森 (AVY) 2010 Q3 法說會逐字稿

Ladies and Gentlemen, thank you for standing by and welcome to the Avery Dennison Corporation quarterly conference call. (Operator Instructions) As a reminder, this conference is being recorded Wednesday, October 27, 2010. I would now like to turn the conference over to Mr. Eric Leeds. Please go ahead, sir.

Thank you. Welcome, everyone. Our discussion will today will reference the earnings release that we issued earlier, along with the slide presentation titled Third Quarter 2010 Financial Review and Analysis. Both documents were furnished today with our 8-K and posted at the investor section on our website at www.investors.AveryDennison.com. We remind you that these results are preliminary, as we have not yet filed our 10-Q.

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. Restructuring charges tend to be fairly disparate in amount, frequency, and timing. In light of the nature of these items, we'll focus our margin commentary on pretax results before their effect and before interest expense. These numbers are reconciled with GAAP in schedules A2 to A5 of the financial statements accompanying today's earnings release.

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 provided today, along with our 2009 Form 10-K and 2010 forms 10-Q address certain risk factors that could cause actual results to differ from our expectations.

On the call today are Dean Scarborough, Chairman, President, and CEO; Mitch Butier, Senior Vice President and CFO; and Cindy Guenther, Vice President, Global Financial Planning and Analysis. I'll now turn the call over to Dean.

Thanks, Eric, and Good Morning, everyone. This is our third consecutive quarter of strong top line growth, driven by our largest segments; Pressure Sensitive Materials, and Retail Information Services. Sales of both segments were above pre-recession levels with volume growth in all regions and continued strength in emerging markets.

As we expected, margins came under pressure, as raw material inflation outpaced price increases resulting in a decline in margins year-over-year. We saw additional cost increases in late Q3, and as a result, have announced additional price increases in the fourth quarter.

Pressure Sensitive Materials delivered solid sales growth though with lower margins sequentially and year-over-year. This is where the inflation has hit us the hardest. Raw material strength in emerging markets, and its focus on end customers, contributed to high single-digit sales growth while Graphics and Reflectives saw also double-digit growth, especially in cast films, and reflective materials.

I recently attended Labelexpo and had the opportunity to talk with many of our customers. The overall mood was positive. Most converters indicated that business was good, although somewhat choppy, meaning that their order books were strong for a few weeks and then would pause.

My take-away is that end users are still reluctant to add inventory and are ordering very close to their demand levels. Converters indicated there was still quite a bit of quoting and new product activity, and customer optimism was demonstrated by robust press and equipment sales during the show.

We showcased several innovative technologies at Labelexpo. One is an ultra thin liner material called ThinStream that enables less waste and lower total applied costs. This innovation is targeted at the food and beverage market segment where pressure sensitive penetration is low.

The second innovation is Fasson Curve appeal, which will enable consumer packaged goods companies to label containers with complex curves, where today the only option is shrink sleeve. Both of these new proprietary solutions are in the early stages of commercialization, but are great examples of our new innovation platform.

I was very pleased with our progress in retail information services, our service improvements and our capability to offer sustainable and brand enhancing solutions along with supply chain and information solutions to major retailers and brands drove 18% sales growth in the quarter. Sales volumes combined with solid productivity enabled solid year-over-year profit growth.

Our FID item level marketing continues to gain traction. Sales of these products more than doubled in the quarter.

Office and Consumer Products results were as expected. Sales during back-to-school season which runs from May through September were flat year-over-year at point of sale and our shipments were down slightly overall as retailers managed inventories down. While we did lose some share in the labels category, I'm encouraged by the sales of our new products such as label pads and notetabs.

We continued to make progress this quarter on the top line and despite greater than expected raw material inflation, we expect to achieve the upper end of the annual guidance range that we provided in April. Now Mitch will give you a more detailed explanation of the quarter and the full year outlook.

Thanks, Dean. Starting with slide 5 and talking through to slide 8. Sales in the third quarter were up organically about 8%. As Dean mentioned, we again experienced strong volume growth in our two largest segments with Pressure Sensitive Materials and Retail Information Services delivering solid growth in all regions. The growth in these segments continues to more than offset the revenue decline in office products.

As expected, our operating margin declined to 6.5% in the third quarter, as the benefit of higher volumes was more than offset by rising raw material costs, higher employee-related costs, and increased investments in growth and infrastructure. Now, while our operating margin was in line with expectations for the quarter, we are experiencing additional pressure in raw materials, as Dean mentioned.

Raw material costs continue to rise and we now expect total raw material inflation to be approximately $105 million for the full year. That's $10 million more than when we last spoke to you. The pressure in raw material costs continues to be driven by capacity constraints for certain adhesive components and paper liners. Given this new round of inflation, we are announcing additional price increases. These are in addition to the increases we just implemented in the third quarter.

We previously said that we anticipated closing the price inflation gap by the end of the year. We now expect we will only be able to narrow it by year end, and will not close the gap until early in 2011. This, of course, assumes no additional raw material inflation.

Turning to Slide 9. Our Pressure Sensitive Materials segment again delivered strong organic revenue growth of 9%, although on lower margins of 8.3%. The growth was driven by continued solid performance in all regions of our raw materials business with particularly strong growth continuing in our emerging markets.

Specifically, North America is up mid single digits. Western Europe was up high single digits, and the emerging markets were up in the mid teens. Sequentially, the operating margin for this segment declined 130 basis points, as this segment is experiencing the vast majority of the raw material inflation.

Retail Information Services delivered even stronger organic growth of 18% on higher operating margins. Third quarter revenue comps benefited from significant inventory destocking the prior year, as well as improved retail apparel sales and new programs with key brands in retailers. While July and August retail inventory-to-sales ratios are off of the March bottom, they remain close to historically record lows. This is all the more reason why we're pleased with RIS's revenues in the third quarter.

We are also pleased with the continuing margin expansion in RIS. Operating margins increased 5.6 percentage points in the third quarter, primarily due to volume. The sequential decline in RIS's margin is reflective of the normal seasonal sales trends. So RIS continues to show its operating leverage to the upside on track to double-digit margins.

Looking at Office Products, the decline in sales in the third quarter reflected weak end market demand and increased competition in the labels portion of this business. Office Products operating margin declined in the quarter due to increased consumer promotions, demand creation, and investments in innovation, as well as lower volumes. We previously discussed the competitive situation in this segment, so our margins will remain under pressure here, while we continue to invest and defend. For this year, that means Office Products is expected to deliver low digit -- low double-digit margins.

Our other specialty converting business had solid sales growth on lower margins. These businesses were also adversely impacted by the significant raw material inflation we discussed earlier and is the primary driver of the decline in the operating margin.

Now, moving on to guidance on slides 12 and 13. Just as we did last quarter, we've highlighted the key factors in our current guidance assumptions that are different from what we said in July. Based on the factors listed, as well as other assumptions, we now expect reported revenue growth of 9%, adjusted EPS of $3.10 to $3.20 per share, and free cash flow of $350 million to $375 million.

We are expecting a discreet tax planning event in the fourth quarter that is expected to add approximately $0.40 of EPS this year, and will reduce taxes we expect to pay in future years. While this benefit will reduce our effective tax rate this year, we continue to expect an ongoing tax rate of 20% to 24%.

This benefit is the primary reason why our guidance is up from last quarter. Excluding this expected tax event, full year 2010 adjusted EPS guidance would be $2.70 to $2.80, which reflects the higher end of our previous range.

To highlight a couple of the other key changes in our assumptions, I mentioned the $105 million of inflation, which is up from our previous forecast of $95 million. At current rates, currency is now expected to be neutral to the P&L, and we may make pension contributions greater than $50 million. The actual amount we chose to contribute depends on where free cash flow is ending up in the December timeframe.

On the subject of pensions, I do want to note that we announced that we will freeze our US defined benefit plan at the end of the year. The effect of this change is reflected in the financial statements including a modest curtailment charge. We expect this will modestly reduce our pension expense, but increase our pension contributions in 2011. We will provide more information on the effect of this change to 2011 when we provide 2011 guidance early next year.

Before opening the call to questions, I do want to comment on our increased financial strength. As many of you know, mid last year we began a program to aggressively reduce our debt. We're exceeding our stated goals. We've reduced our debt by more than $400 million since we embarked on this program mid last year. And our net debt to EBITDA ratio is down significantly and now approximately two; a key milestone. This is a significant improvement in financial strength, driven by both higher profits and less debt.

Now, we would be happy to take your questions.

(Operator Instructions) Our first question comes from the line of Ghansham Panjabi from Robert W. Baird. Please proceed.

Hello, guys. Good morning.

Good morning, Ghansham.

You know, on the PSM business, as we look at the first quarter and second quarter operating margins, they were just under 10%. 3Q was obviously pressured by higher raw material costs and just based on your comments, looks like the margin should push higher directionally into 4Q, and also higher into 1Q. But do you still feel though that as we perhaps looked at the rest of '11 and assuming no new inflation that 10% operating margins are still the right level of operating margins for that business?

Yes, Ghansham, this is Dean. Our long-term target hasn't changed. We think that the pressure-sensitive materials sector should operate in the 10% to 12% operating margin range. We're not giving guidance for 2011 but I also expect us to catch up on some of this inflation in the fourth quarter as our price increases begin to catch up with the additional inflation we're seeing.

Frankly, the big question for me is when will the inflation start to curtail? And we just don't know yet.

Okay, and then as you look at trends on PSM for both 2Q and 3Q. Did 2Q benefit from some sort of prebuying ahead of your price increases?

No, we rarely see that in this business. Especially these days because customers -- as I talk to customers, they basically are saying their customers are ordering just at the rate of demand. So everybody's being quite cautious about building inventory. So I don't see any changes in customer behavior trying to build inventory in advance of price increases.

Okay and just one final one on cash flow, just based on Mitch's last comments. Obviously, free cash flow has improved considerably. Your debt position's improved quite a bit as well. You know, understand that it may be too early to qualify -- to think about a dividend increase just based on the cut last year. But what's the Board's appetite on meaningful [slug] of share buybacks?

Well, the Board and we've said this -- I think we said this last quarter. We certainly talked to investors that the Board wants us to get the year "in the can", in other words, put to bed.

We are certainly feeling good about our financial position and our desire is to return more cash to shareholders. And I am feeling pretty good about -- we'll use both potential dividend increases and share buyback as a way to return more cash to shareholders.

We'll look forward to it.

That will very likely happen in 2011.

Okay, thanks, Dean.

Our next question comes from the line of Jeff Zekauskas from JPMorgan securities. Please proceed.

Good morning. This is Silke Kueck for Jeff. How are you?

Hi, Silke.

Morning. A couple of questions. In RIS, it seems that, if I remember the trends correctly, it seemed that July was more sluggish and August, too, and then September really picked up. And are the indications now that because normally it's a seasonal step up from the third quarter to the fourth quarter that the fourth quarter could be really large? Or is it the case that there was some forward selling in September from the fourth quarter?

That's a complex question to answer, but I'll take a crack at it. One of the issues that's been happening in the supply chain for apparel this year, is that there's been a pretty large bottleneck of getting goods out of south China for a number of reasons, and so the seasonality this year is -- has been -- changed a bit.

The third quarter, I think, came in a little stronger because of goods coming in late that normally would have come in the second quarter. I will say that the order trends early in the fourth quarter and late in the third quarter have continued to be positive for us. And I attribute that to our service levels.

We've captured some new programs, and the fact that the inventory to sales ratio in apparel is still relatively low. So, I still remain cautiously optimistic about the business going forward.

But we don't expect, necessarily, the high teens to be the trend going into Q4 year-over-year growth. For the reasons of the shift in timing of the calendarization a little bit this year because of the bottlenecks Dean talked about.

I think like last year, maybe the shift from the third to the fourth quarter was something like, I don't know, close to $10 million in EBIT. So it's not the case that you could initial $10 million in EBIT to the -- on top of the third quarter results. Do you think that's too aggressive?

I think it's hard to predict actually.

Hard to predict. We don't want to get into specific segment expectations overall for the quarter. But overall, you expect Q2 to be the strongest within this business and fourth quarter to be second strongest, followed by the third and then the first quarters.

Okay.

You would not expect, I would say for the reasons Dean has commented on, the third quarter did not drop off as much as normal. And so, therefore, we wouldn't expect the fourth quarter to bounce back quite as strong.

But you still expect the fourth quarter to be better than the third.

In a normal circumstance, yes.

Okay. I'm sorry.

It's hard.

That makes it clear. In terms of -- in terms of raw materials, are the pressures that you are seeing due to some shortages, maybe in acrylics. Can you mitigate these somehow by purchasing globally and do you -- and do you expect the -- do you expect the tightness to continue, or moderate into next year? Maybe you can comment whether you have the opportunities to purchase more regionally.

Well, we do purchase globally. And I think our team has done a terrific job of making sure we've stayed in supply. In fact, some of the reason that we -- it's cost us a little money, is that we went out on the spot market a bit early, and made sure we had sources of supply. A couple of our competitors have put certain products on sales allocation for a while due to the shortages, but we did not have to do that.

We didn't expect to see any deflation in the back half of the year from acrylic monomers, although the industry talk was -- and what we've actually seen is an acceleration of cost increases rather than the other way. So, I think until the supply/demand situation gets in better balance, it's going to be -- continue to be tight. We've done -- I think our team's done a great job of global sourcing to make sure that we have secure supply sources for adhesive.

And just related to that, how much price have you achieved to date in Pressure Sensitive, and what are you looking for in the fourth quarter? What's the price increase that you're going out with?

Let me answer now and Mitch will comment on how much price we've achieved. We have announced a mid to high single-digit price increase in North America, and also in China we've announced an increase in the mid single-digit range as well. I know we're looking at this in other regions.

As you might guess given the US dollar, the inflation tends to be more intense in dollar denominated countries. It's a pretty substantial price increase, but we need it. Our margins are really taking a hit because of the adhesive costs.

So overall, as far as the level of price increases, we are behind the curve. And given that the curve keeps accelerating on the raw material inflation, we keep adding -- doing more price increases, but continue to be behind the curve. And we don't expect to close it until early next year.

If you ask within PSM, the amount of the price increase depends what your starting point is overall. But we've recovered less than half, about a third of the total inflation that we've seen in the third quarter relative to third quarter of last year within PSM.

And now we're facing an additional $10 million of incremental inflation in the fourth quarter, which we didn't see when we spoke with you three months ago, which we want everybody to remember.

Silke, you mentioned the seasonality in RIS, and that it could be less -- more muted this year than in a normal year.

But I think it's also important to remember the seasonality in office products. And the seasonality in office products would likely be magnified in a situation this year because BTS doesn't have a lot of the areas where we're experiencing the increased competition and that could impact office products more in the fourth quarter as well.

(Operator Instructions) Our next question comes from the line of John Roberts from Buckingham Research Group. Please proceed.

Good morning, guys.

Good Morning.

I was a little surprised that capital expenditure is coming in at the low end of the previous guidance. I guess what aren't you doing, or are things just sliding into 2011, maybe? And related to that, could RFID materially affect CapEx for next year?

So we're coming in at the low end for the reason you stated. It is more the spend is actually just sliding into 2011. So we won't provide specific guidance for 2011, but you would expect capital expenditures to increase next year versus where they are this year.

And one of the other reasons for that, other than just the timing of the ramp up curve, is RFID. So we do expect increased capital expenditures for RFID next year relative to what we have this year.

You can't quantify that yet?

No.

Okay, and then secondly, if raw material costs stayed just where they are right now or at least where your expectations are -- you're expecting some additional rise here in the current quarter -- would 2011 over 2010 kind of be half of that $105 million or so, because half of the increase here has occurred in the second half of the year? Things were going -- actually, things have accelerated, so you might think that 2011 might be up over 2010 by more than half of the 2010 over 2009 change?

It really accelerated between the second quarter and third quarter, and while we're still seeing more in the fourth quarter, but as you can see, it's $10 million incremental from what we previously thought. So it's roughly half, I don't have the specifics in front of me, but it's roughly half you could expect to carry over, mostly in the first half of the year.

Got it. Thank you.

Our next question comes from the line of Peter Ruschmeier from Barclays Capital. Please proceed.

Thank you, and good morning.

Good morning.

I'm curious on your comments of RFID tracking sales having doubled. Can you remind us where you're tracking on an annualized run rate basis. And, I guess, related to this, so I can hopefully make this one question, what is the mood of your retail customers in terms of their willingness to spend the capital needed to enable them to more aggressively use your tags?

Yes, the $50 million target in total external sales for us in RFID-related items, we're still on track for that. We signed an additional agreement in the last quarter with a major retailer who is implementing item level tagging. Unfortunately, I can't say who they are. But, there's an increasing appetite for implementing these programs across the industry.

So the capital expense, frankly, isn't huge for a lot of these retailers. I mean, compared to what they are spending their money on today. So, I consider it to be a real positive trend.

The one point I want to make, though, is that the sales increases and the profit increases we're getting in RIS are barely impacted by current RFID item levels. So, we still have a lot of traction left in that business without RFID. And for me, RFID's really icing on the cake. And so it remains a good medium to long-term upside for this business. But it's tracking along really well.

And if it's not much capital on the customers' behalf, what is the pushback, if any, on why they are not embracing it more aggressively?

It's really -- there's two things. One is the change management process. You have to change the way your processes work in the store and in your supply chain. And if you have 1800 stores, that takes time to do. And the second thing is, of course, the increasing consumables cost. The price ticket goes from $0.01 to $0.02 to $0.10 to $0.12 cents, and that's an ongoing cost. There's clearly a payback and a benefit for that activity, but most retailers like to test the concept out in a number of product lines or number of stores to gain confidence that they can execute, and then they tend to roll out.

Thank you very much.

Sure.

Thanks, Pete.

Our next question comes from the line of George Staphos from Bank of America Merrill Lynch. Please proceed.

Hi, this is actually Benjamin Wong on behalf of George. Hello Mitch. Can you provide some more details about what's behind what's on the tax event in 4Q? Thanks.

Sure. This is a tax planning event that's occurring in a non-US jurisdiction. And it's essentially coming in the form of a net operating loss as a result of some of the legal entity and restructuring that we've done throughout the year.

And so it's being triggered in the fourth quarter and we'll recognize the benefit. It's non-cash this year and we're expecting to get the cash benefit in a few years time.

Okay. Thanks for the color, Mitch.

You're welcome.

We have a follow-up question from Jeff Zekauskas from JPMorgan Securities. Please proceed.

Good morning. Just a quick follow-up. In office products, if I remember correctly, maybe the spend related to fending off the competition at Office Depot was something like $5 million to $6 million this year. Does that still seem like the right number or do you expect to spend more?

Well, I'm not sure we gave specific numbers. We -- obviously the label defense strategy is costing us some money. It was a very promotional quarter in terms of offering consumers discounts by both ourselves and our competitor. We -- incrementally though, on an annualized basis in terms of demand creation and innovation, are about $10 million -- it's about a $10 million to $15 million annualized spend. So that's -- those are the numbers we've been talking about.

And as a follow-up, can you discuss the new Fasson product that's competitive with shrink wrap technologies. The Fasson curve, is that available in the market, or when will it come and do you know -- what do the initial sales look like?

Well, the initial sales are pretty small. So, we're in the process of commercializing this right now with a couple of end users. Basically, it's a combination of material science and equipment that we have developed. And we're able to put a -- I guess you would call it a shrinkable pressure sensitive film onto a complex curve product. And we're literally in the process, we'll have our first couple of installations in by the end of the year in the first quarter.

There's a high level of interest from our end users, especially in the health and beauty categories, who want to use complex container shapes to differentiate themselves on the shelf. So, a lot of work going on. It's not going to be material sales this year, probably not even next year. But it's a great example of innovation and certainly it's a big door opener for us in a number of end use customers.

Thanks very much for clarifying.

Sure.

(Operator Instructions) Our next question comes from the line of John Roberts from Buckingham Research Group. Please proceed.

Thank you. On the final slide where you updated the contributing factors, currency went from a negative $8 million to neutral, so there's $8 million [since] July -- or $8 million in the second half, and I would expect almost all of that would be in the fourth quarter, is that correct?

It's spread between the third and fourth quarter. A little bit more is in the fourth, but it was spread evenly.

So it was positive in the fourth?

Relatively evenly. Sorry?

Currency was positive to EBIT in the third quarter and so the fourth is less than $8 million?

Yes, relative to our previous guidance, yes.

Okay. Thank you.

You're welcome.

Our next question comes from Christopher [Johncast] from [EDR] Research group. Please go ahead.

Yes, hello. I just had a follow-up on some of the discussion around Fasson. I think you said that because of the acrylic monomer situation and the way you manage it versus your competitors that they put some of their customers on allocation. So, I'm just wondering if that is sort of a global situation or just domestic, and did that allow you guys to pick up some share there, contributing to the volume comps?

I don't think the share -- we've been -- we feel we've been gaining a little bit of share this year. We don't -- we do not have the numbers for the third quarter. I don't know that it's resulted in much share gain, but I think it has resulted in customers understanding the seriousness of the raw material situation.

I think the sales allocations, if I remember correctly, really only occurred in the US market. I'm not sure they occurred anywhere else. But I think it's giving a lot of support for the -- I guess it happened in the EU as well. And the -- but it's more about customers start to worry more about supply than they do absolute price levels. So it's that type of situation.

That's helpful, thanks.

We have a follow-up question from George Staphos, Bank of America Merrill Lynch. Please proceed.

Thanks. Hello, guys, good morning. Jumped on the call late. If you've answered any of these already, I'm happy to take the answers offline. I guess the first question I had, though, if you haven't covered it already, is where do you see inventory levels for retail apparel relative to what you would hope to get to at the customer side and what would be a healthier level?

And then I guess the second question would be how would you frame the incremental margin progress you saw in the business in the quarter relative to what your overall expectations would be and ultimately your longer term, I guess, 12% margin target?

Yes, on the inventory to sales ratio, the -- it's still near its historical lows for apparel and footwear. I don't expect it to climb a lot, mainly because retailers are continuing to be cautious about how much inventory they put in stock, so they don't have to reduce it in terms of doing a lot of promotion.

Back-to-school actually came in better than most retailers expected. It was late this year. I think that had more to do with the weather. And as I said earlier in the call, the early read on Q4 for us is quite nice. So, I think we're sitting in a relatively good position in this business. In terms of the margin flow-through for Retail Information Services, they are exactly on track with what we expected.

Okay. Thanks. Thanks, Dean. I had two follow-ons, if I have time for that. One, in Office Products, did you comment about share trends there? And whether you're seeing any further move from new competitors into your existing share, whether that's been more or less stable since the last couple of quarters? And then emerging markets, I'm not sure if you gave it or not, but what kind of profit growth have you seen in emerging markets? How large from a profit standpoint are your emerging market businesses now? Thanks.

Well, in Office Products, we didn't talk specifically about share. Actually, the third quarter was when we began to see the biggest magnitude of share loss because it wasn't until the beginning of the quarter that one of our retailers decided to displace many of our SKUs at retail.

And so we lost probably six to eight share points in the quarter. It was actually less than we expected, and that was the run rate coming out of the quarter, actually. So we didn't lose that much share in the quarter.

And so we did okay. And it was obviously a very promotional period for us. And that share loss obviously was just in the label category, which is you know 20% of our sales. So it's not across the board.

The question around emerging markets, still those operating margins are higher than the company average. So growth is still strong in emerging markets. So that's definitely helped.

Okay, thanks. I'll turn it over.

Mr. Scarborough, there are no further questions at this time. Please continue with your presentation or closing remarks.

Okay. Well, I would like to thank everybody for joining the call today, and just to sum up, sales at our two largest segments are actually above 2008 levels and they are more than offsetting the sales decline at Office Products.

And although inflation pressured margins more than we anticipated, even with the additional inflation, we're on track to meet our year end targets for earnings and free cash flow. So thanks, everyone, for joining. And we look forward to speaking with you again.

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines. Have a great day, everybody.