艾利丹尼森 (AVY) 2013 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to Avery Dennison's earnings conference call for the third quarter ended September 28, 2013.

(Operator Instructions)

This call is being recorded, and will be available for replay from 1 p.m. Pacific time today through midnight Pacific time October 28. To access the replay, please dial 1-800-633-8284 or 402-977-9140 for International callers. The conference ID number is 21610814.

I would now like to turn the call over to Eric Leeds, Avery Dennison's Head of Investor Relations. You may begin, sir.

Thank you. Welcome everyone. Today we'll discuss our preliminary unaudited third quarter 2013 results. Please note that unless otherwise indicated, today's discussion will be focused on continuing operations. The Company's office and consumer products, and design and engineered solutions businesses are classified on our income statement as discontinued operations. The Company completed the sale of these businesses on July 1, at the beginning of the third quarter.

The non-GAAP financial measures that we use are defined, qualified, and reconciled with GAAP in Schedule A2 to A5 of the financial statements accompanying today's earnings release. We remind you that we'll make certain predictive statements that reflect our current views and estimates about our future performance and financial results.

These forward-looking statements are made subject to the Safe Harbor Statement included in today's earnings release. On the call today are Dean Scarborough, Chairman, President, and CEO, and Mitch Butier, Senior Vice President and CFO. I'll now turn the call over to Dean.

Thanks Eric, and good day everyone. I'm very pleased to report our fifth consecutive quarter of better than 30% growth in adjusted earnings per share, reflecting the successful execution of restructuring actions and other productivity initiatives, as well as solid sales growth in both of our core businesses.

Emerging markets continued to be a key growth driver for pressure sensitive materials in the third quarter. We also saw solid growth in our European business. Given the tough conditions in this market, I have been happy to see continued growth here.

Overall, sales growth slowed in September, particularly in North America with a number of our domestic customers citing some softening of end market demand. We have seen better results in the first few weeks of October, but with heightened uncertainty among consumers, we remain somewhat cautious about the trend.

RBIS also delivered solid growth in the quarter, even with some tough headwinds from last year's strong showing. With another solid quarter behind us, we raised our adjusted earnings guidance for the year, with an eye on the uncertainty in demand trends in North America.

We remain committed to our disciplined capital allocation strategy. In the first nine months, we returned over $300 million to shareholders, including the repurchase of approximately 5.2 million shares. Given our strong balance sheet, I'm happy to say that the vast majority of the proceeds from our divestitures remains available for distribution to shareholders, with just a couple of carve-out.

In September, we used $10 million of the proceeds for a special contribution to the Avery Dennison Foundation, which invests in education and sustainability projects in the communities in which we operate. And earlier this month we used $50 million to reduce our pension liability.

Now, I'll provide a few highlights for each of our core businesses. Pressure sensitive materials generated solid top line growth, with better than average growth in emerging markets. We're seeing excitement in the market with our slate of new products introduced at Label Expo, the labeling industry's annual trade show, which took place in Brussels last month.

As the industry leader, one of our key distinguishing features is the consistent stream of enhancements we bring to the market in terms of the appearance, functionality, and cost of our products. Our innovation efforts address all three of these key differentiators, and all were on display at this year's show. I'll share just a few examples from the 17 innovations we presented at the show.

We introduced improved films for durable labeling applications, including a self-overlaminating roll system that creates protected graphics at roughly 30% lower cost, both in terms of raw material savings as well as operational savings for converters. With this new system, what used to take two rolls of material can now be produced with one. We also introduced thinner, clearer, and cleaner films for traditional label applications.

For example, one product we featured at the show demonstrated reduced adhesive ooze, which enables faster and more consistent processing times at our direct customer and at the end user, reducing operating cost for both. The engineering of thinner materials continues to drive profitable growth at lower price points, while also benefiting the environment. It's a triple win -- good for us, good for our customers, and good for the planet.

Speaking of which, sustainability is another key theme for many of our innovations. Our new CleanFlake material was designed to increase the percentage of recycling output for reuse in new PET bottles. As a result of this innovation, the pressure sensitive label can be separated cleanly from the PET flake during the standard recycling process, significantly improving the recycling yield. This technology makes pressure sensitive labeling more competitive for recycled containers, and could open significant new markets for us. With 2 billion PET bottles going into landfill every year, this is an important step forward for the packaging industry.

While emerging markets and innovation drive our top line growth engine, operating margin expansion remains another key to value creation for pressure sensitive materials. We once again topped the high end of our margin target range for this segment this quarter, driven by continued intense focus on productivity.

Retail branding and information solutions continues to make tremendous progress, with its fifth consecutive quarter of solid sales growth and margin expansion. Over the past two years, RBIS has delivered over 200 basis points of margin improvement, and we are on track to deliver on our margin targets for 2015.

We are in the middle stages of a multi-year transformation of this business, and I am pleased with the milestones we've achieved. We've had a good record of share gain over the past few years, with solid progress in our key segments, continued momentum in RFID and brand embellishments, as well as strong growth in our still small but important new markets of Japan, South America, and Russia.

I'm very pleased with the gains we're seeing in RFID. We've commented before on the slower growth of these products and services in 2013 related to a large pipeline fill by one customer last year that did not repeat. But even with the headwinds from this event, the team still delivered 6% growth in the third quarter, and is projected to deliver 20% growth for the full year as we captured new business in Europe. We're targeting continued strong growth for this $100 million part of the business over the next few years.

The value proposition here is all about inventory management. Retailers are seeing good ROIs from their RFID implementations, and we remain the leading provider in the apparel space by combining the best performing products with an in-depth understanding of the use case; that is understanding exactly how our customers can maximize their return on investment in equipment and consumable products.

We're currently working on new rollouts or significant expansions of existing programs with seven major retailers across multiple market segments. We're right on target for the changes to our new, lower cost operating model. Since 2011 we've reduced our factory footprint by almost 15% without sacrificing capacity or service. In fact, service continues to improve, contributing to our market share gains.

We're implementing a hub-and-spoke operating model. In other words, we'll continue to operate a few large sites with a broad range of production capabilities, while fast response units deliver a more targeted range of products utilizing a much smaller manufacturing footprint at substantially lower operating cost.

At the same time, we're increasing our digital printing capacity. We've increased this capacity by 60% over the past two years, and by the end of this year, over a third of our graphic tags and labels will be produced with digital printers. We're targeting to increase that share to over half of our total production.

This fundamental shift in operating strategy allows us to produce smaller quantities with greater frequency and reduced lead time, which is more in synch with customer needs. At the same time, we improved quality, consistency, and repeatability of production runs while more effectively incorporating variable data and other unique features into our products.

With strong leadership positions in our core businesses, our ability to maintain already higher returns in pressure sensitive materials and significantly expand profitability in RBIS, I am confident we will deliver on our financial targets for the year and over the longer term. Now, I'll turn it over to Mitch.

Thanks, Dean. We delivered another solid quarter with 3.6% organic sales growth and adjusted earnings per share of $0.69, which was at the higher end of our expectations. The 35% increase in earnings was driven by productivity, principally restructuring, as well as continued solid top line growth in RBIS and the emerging markets for pressure sensitive materials. The quarter also benefited by about $0.02 from a lower tax rate.

Adjusted operating margin in the quarter grew 120 basis points to 7.7%, as the benefit of our productivity initiatives and higher volume more than offset the impact of product mix in pressure sensitive materials and higher employee-related expenses in retail branding and information solutions.

As mentioned, the productivity improvements were primarily the result of the successful implementation of the restructuring program we initiated last year. We continue to execute our plan to reduce fixed cost and realized a further $5 million in the quarter, bringing the total annualized savings for this restructuring program to $110 million.

Year to date, free cash flow from continuing operations was $105 million, comparable to prior year. As of the end of the quarter, net proceeds from the sale of OCP and DES were $402 million, including the year-to-date negative cash flow from the underlying businesses we divested, as well as the transaction costs and tax payments related to the deal paid thus far.

We anticipate an additional $10 million to 15 million of deal-related cash outflow in the fourth quarter, related primarily to tax payments and transaction costs. So the final net proceeds are expected to come in around $390 million.

As Dean mentioned, we're using most of these proceeds to repurchase shares and reduce indebtedness, which includes under-funded pension plans. To that end, subsequent to the end of the quarter we used $50 million of the net proceeds to make supplemental pension plan contributions. In light of these contributions and the effect of rising discount rates, we are currently comfortable with our pension funding status.

Given that the proceeds were received in the third quarter, we currently have no outstanding commercial paper and have higher than normal cash levels. While our stated long-term leverage target is net debt-to-EBITDA of less than 2 times, we ended the third quarter at 1.2 times. This is mostly due to the timing difference between when we received the divestiture proceeds and when we can optimally deploy them.

We believe the right long-term net debt-to-EBITDA leverage ratio for us is between 1.7 to 2 times which, combined with our consistently strong free cash flow, gives us ample capacity to return cash to shareholders over the coming years. Speaking of which, we repurchased an additional 1.7 million shares for $75 million in the third quarter.

Turning to the segments. Pressure sensitive material sales were up 3.5% on an organic basis in the third quarter. Label and packaging material sales were up low single digits on an organic basis, while the combined sales for graphics, reflective, and performance tapes increased mid single digits.

On a regional basis, sales for this segment were relatively flat in North America, were up mid-single digits in Western Europe, and grew upper single digits in emerging markets. Looking at the trends within the quarter, sales in July and August were strong, but the business slowed in September, most prominently in North America.

PSMs adjusted operating margin improved 120 basis points to 10.5%, due primarily to the benefit of productivity initiatives. Retail, branding, and information solution sales grew 3.7%, reflecting strong demand among European retailers and brands. Sales to North American retailers were down modestly in the third quarter, due to tougher comps in RFID.

Excluding RFID, sales growth slowed in North America, driven by moderating demand among a number of retailers. Now despite the tougher comps in North America, RFID revenue grew 6% globally, as Dean mentioned, contributing roughly 0.5 point to RBIS's overall sales growth.

RBIS's adjusted operating margin improved 100 basis points to 5.9% as the benefit of productivity initiatives and higher volume more than offset higher employee-related expenses. Sales in our other specialty converting business grew 4.8%, reflecting modest growth in our medical business, the only component of other specialty converting beginning this year. The operating loss in this business was much smaller than last year and last quarter, as one of our partners contributed to the cost of developing a new product in the pipeline.

Moving on to the outlook. We now expect adjusted 2013 earnings per share from continuing operations of $2.60 to $2.70 and free cash flow from continuing operations of $275 million to $315 million. Our guidance is based on a number of assumptions, including the key factors listed on Slide 8. To highlight a few. Our estimate for organic sales growth in 2013 is now 3.5% to 4%. Obviously, the macro environment remains uncertain, and as you know, the nature of our business gives us limited forward visibility.

Our sales outlook for the remainder of the year reflects, at the low end, a continuation of the weak trends that we experienced in September. Full-year savings from restructuring actions is now estimated at approximately $75 million, and restructuring costs and other items that are adjustments to GAAP results are now expected to be approximately $30 million pre-tax.

Compared to our July outlook, the increase in adjustment items relates primarily to the $10 million contribution to the Avery Dennison Foundation from the divestiture proceeds, as well as higher costs associated with new restructuring actions. As mentioned, we utilized a portion of our net proceeds from the divestitures to also contribute an additional $50 million to our pension plans, bringing total pension contributions to approximately $110 million for the year.

In summary, we are on track to deliver our 2015 targets. We've had a solid nine months in a year in which we expect to deliver adjusted EPS growth of between 33% and 38%. Our two core businesses are market leaders and are well positioned for profitable growth which, combined with our continued cost and capital discipline, enables us to expand margins, maintain our financial strength, and return cash to shareholders.

Now we would be happy to take your questions.

(Operator Instructions)

Our first question from the line of Scott Gaffner with Barclays Capital. You may begin, sir.

Morning guys.

Morning.

Good day on Pasadena today, I guess.

It's cloudy and cool, actually.

Yeah, well same here. I was just looking at the organic guidance that you provided for sales growth. And if I look at it, it looks as if the organic guidance that you're guiding to for the fourth quarter is only moderately below where it was in the third quarter.

First of all, is that a good way to read that? And secondly, do you expect better growth out of PSM or from RBIS right now in the fourth quarter?

Yeah, Scott, the RBIS is a stronger quarter for them, and we do anyway, but I think they do have some headwinds last year on the pipeline fill, which -- that we don't have that much forward visibility. But I say fundamentally, we don't, -- we're pretty much predicting the trend that we've seen in the first few weeks of October very consistent with our guidance. So, I think you're reading that correctly.

Yeah, and just the range, because the guidance range we're giving on sales is 0.5 point difference for the full year. And so, if you take the low end of that, it actually would be, you can do the math from where we are the first three quarters is 1.5%, roughly assumption for the fourth quarter, whereas at the high end it's closer to the 4%. Pretty big range for the fourth quarter, given our lack of forward visibility.

Right, okay. but when I look at RBIS, right, correct me if I'm wrong, but Q4 is generally the second strongest quarter for you. Can you talk about, is the first half of the quarter more important for RBIS, or the stronger part of that quarter? How do the trends normally play out in 4Q for -- specifically for RBIS?

The season tends to start in September and run through the end of the year. And December often is more impacted by the timing of Chinese New Year than anything else, because what happens is a lot of the apparel factories, of course, close for a week in either January or February, depending on when Chinese New Year is. So it has a lot more to do with that.

We're expecting -- I'm expecting a decent quarter for RBIS. Again, really tough headwinds with the overall growth rate, but the core business I think should be fine.

Okay and then--

We're talking relative to a various quarters. So one thing to remember within RBIS, we do have tough comps in Q4 from the large RFID pipeline fill that we had that impacted Q3, as well as Q4 last year.

Okay, fair enough. And then just lastly, if I look at pressure sensitive margins running at about a little over, almost 10.5% year to date, obviously the fourth quarter normally comes down a little bit, but if I look at that 10.5% it's well above the 8.5% to 9.5% long-term guidance. Is there something in there that would suggest that margins come down over the next two years? And if so, what would those items be that would pull the margin back down to that long term range?

Yeah, Scott. Actually the target range that we put out was 9% to 10%. So we are above that, and that's something we're going to be looking at as part of our guidance range for when we come out with 2014 guidance in January.

Okay. Yeah, my apologies. I was looking at RBIS target. Thank you.

Sure.

Our next question from the line of Ghansham Panjabi with Robert W. Baird. You may proceed.

Hey, guys. First on pension for 2014. Mitch, could you just provide some parameters on how to think about the cash sort of contribution, if any, just given what you said about being comfortable with where the pension plan is post the $60 million you put in this year and the $50 million, I guess, from the office products sale?

Sure. So just broader context. At the end of last year the pension was underfunded status. Across all pensions globally was $400 million, and we did do a revaluation and part of that was temporary. Everybody expected because discount rates were at an all-time low at the end of 2012.

So we had about a $90 million adjustment from that, and with our additional pension contribution, the total underfunded status is now south of $300 million. So your question about implications to cash flow specifically for next year we will make -- we still have required contributions for the coming few years. The extra contribution we made can be applied to next year's requirement. So we have some flexibility there, but that's a decision that we will make next year.

And we'll provide more insight on that, Ghansham, when we give guidance in January.

Okay, and then in terms of your share buyback program, just based on the residual amount post the proceeds from OCP and the pension contribution, and I guess (inaudible -- background noise) as well. If you combine that with your net free cash flow and using our numbers, which are roughly basically where 2013 is projected, you have the capacity to buyback almost 12% of your market cap. So can you just provide us some parameters in terms of your discipline associated with how you would decide to purchase stock and the timing associated with that?

Sure. So as far as how we go through this, is we basically try to triangulate around intrinsic value. Intrinsic value's the key part for us as far as determining when to buy stock, and then as far as how much there's two things. Depending on where the stock is trading given recent trends, we'll buy more or less in any given week.

Overall, another key thing, though, is amount of volumes that you have. So Q3, for example, is very low volume quarter for us, much lower than it had been for awhile. So, we don't want to, just from supply/demand dynamics within any given week to really move things around one way or the other.

Okay, and then just finally Dean, in terms of Europe, is this a dead cat bounce after years of sort of sub-par growth, or is there something more -- broader going on there in terms of the recovery?

Ouch. I think the team's executing really well actually. We've been -- most of this growth was in Western Europe. So I think the team has been focused on innovation and focused on taking some market share.

We have not seen the market data yet from Europe, but generally when I was over there talking to customers they seemed more optimistic than they had in previous years. So, I have continued good hopes. Clearly, 4% more than exceeded our expectations for -- the 4% growth that we saw there exceeded our expectations. But we're really pleased with it, and I like the team's execution, and I think there is more to come.

Just to clarify, I meant the economy, not Avery specifically.

Okay. Well good. Thank you.

Our next question from the line of George Staphos of Banc of America Merrill Lynch. You may begin.

Thanks. Hi, guys. Good morning. I wanted to chat a little bit about the trends you saw in September and the recovery in October. Was that both in RBIS and pressure sensitive, or was it more weighted to one or the other segment?

And can you talk a little bit about which end markets might have suffered the biggest slowdown in September? And have those been the ones that have recovered, or has recovery occurred elsewhere to compensate?

Okay, complicated question. So let me start with RBIS. RBIS had an enormous growth rate in September last year as part of that pipeline fill for a customer for RFID. Even with that, they showed a little bit of growth in September, which for me was a good sign.

We did see some slowdown in the rate of orders for certain segments in the US-based retailers. Especially I would characterize the department store segment and the mass merchandising segment as being softer than we expected. But we still had good performance in the fast fashion, as well as the performance athletic segments of the market. So for me that was still relatively good news.

We performed very well in Europe, actually across most segments. And a number of RFID programs kicked in a little stronger than we had thought. So that was a good sign. But really RBIS was -- in the quarter was very strong in Europe, moderately strong, I would say, in North America.

Pressure sensitive had a really strong quarter last year. So their comps were tough, but we definitely saw softness in some of the end use markets, particularly the ones, those markets that would use film products, whether it be in beverages or in a health and beauty aid categories. And it's consistent with what I at least read so far in some of the earnings for some of the consumer package goods companies talking about consumer takeaway during the quarter.

And so we're starting to see some of that business come back a little bit. And we've seen this trend before,. Sometimes it just gets a little bit choppy occasionally, and I would say -- we're certainly not -- I don't have a deep level of concern, I would put it. But we're being probably a little bit cautious just watching the US consumer and where they're spending their money. I think the fire drill in Washington over the last couple months probably didn't help consumer confidence a whole lot. So, we'll see how things progress.

It's interesting, Dean, because it sounds like on the RBIS side it was more of the mass, or maybe more basic earner who seemed to be weakening in terms of their purchase of products that would demand RBIS. On the other hand with some of the film products being impacted in PSM, those tend to go more towards higher rent. So it seems like it's a little bit of a dichotomy. Would you agree or disagree with that?

No, not really. There are people buy shampoo at Wal-Mart as well as at -- or convenience drug stores, et cetera, et cetera. So I actually think it's consistent.

Those products are sold in grocery stores, mass market, and what we've heard anyway, what we've seen is lower foot traffic, especially at what you would call the lower end of the income pyramid. So that looks consistent to me. It does not look inconsistent.

Okay, I appreciate that. One more question and I'll turn it over. Can you give a bit more color, in terms of how the rollout of digital printing is helping the cost structure for the business in RBIS? And to the extent that you can comment, how much further ahead do you believe you are versus your peers in having that capability in your overall manufacturing network? Thank you.

Yeah, we're not all the way there yet. We'll want to get to about 50% of our volume done digitally. So we're still installing presses and all of that. But it's not just about the kit, to be honest. It's about how you manage the entire workflow from taking the order at the customer and basically not touching it until it gets to the press. So there's a lot of software and data handling that happens. It's a lot more automated than what I would characterize as either flexo or offset printing.

And so, I think we're probably halfway to where we want to be now. And it's a good trend, because customers, again, want shorter lead times, smaller orders, and it just enables us to do this more efficiently, not just on the press floor, throughout the entire order taking and handling process.

You know what? I'll turn it over, but I want to come back to that theme in a minute. Thanks.

Sure.

Our next question from the line of Anthony Pettinari with Citigroup Global Markets. You may begin.

Good morning.

Good morning.

You reference changes in product mix in PSM in the quarter. And I'm wondering if you can give some color on that mix change that might have pressured margins a little bit?

And then as a follow-up to George's question on the consumer, you had pretty strong emerging market results there, and some other companies have referenced maybe a weaker consumer, certainly in Latin America and maybe a little bit in Asia. Are you seeing indications of that?

As part of the second part of your question I'd say no, I don't think we've seen a material change in emerging market growth. We had strong results in South America. We had strong results in Asia as well. And so we haven't really seen an impact of that.

I think fundamentally in those markets, pressure sensitive adhesive technology is taking share versus other forms of package decorations. So that trend is still happening, and as well as I believe we're likely taking some market share, relates back to your first question.

We have focused on getting more competitive so that we can participate in some lower margin product categories, still very good business for us, and we're operating above our target margin operating range. So I feel like this has been a good strategy for us, and we're going to continue to do that.

Part of our innovation program, by the way, is also to continue to take weight out of our products so we can offer materials that are thinner. That means we can be more competitive in some of those segments. So I think, again, it's a smart strategy for us, and it's driving good results.

Okay, that's helpful. And then maybe switching to RFID. I think you referenced 6% growth in the quarter, and maybe 20% growth for the full year. If you were to strip out the impact of that single customer that you didn't get that business this year, do you have a sense of what that full year growth would have been?

80%.

80%, okay, great. I'll turn it over.

Our next question from the line of Rosemarie Morbelli with Gabelli & Company. You may begin.

Thank you. Good afternoon, all. When you look at your results versus plans, you did touch upon the fact that Europe was better than your anticipated. Are there any other surprises that you had during the quarter, whether on a positive or negative way?

Well, I think we mentioned we have some concern about the North American results in pressure sensitive. It was softer than we anticipated and Europe was stronger. And RBIS, frankly because of the tough comps, we weren't expecting as strong as a result, but the team delivered extremely well in that environment.

We didn't anticipate getting any growth in RFID, and we got 6%. So very pleased about that.

Okay, and then looking at Europe. Several companies have mentioned Europe earlier today and the last few days of conference calls, and the impression is not necessarily homogeneous. Some comments are that they are seeing some improvements.

Others will say that yes, they are seeing improvements for the balance of 2013, but when you talk to customers about 2014 then it is a whole different story and it is not clear as to what the anticipation is vis-a-vis those customers. Could you give us a feel for what you are hearing?

Well the one benchmark that I do have is the label show where we participate. And, there are a lot of label press manufactures at the show, and they seem to be doing very well in terms of sales. So it appears to me that a lot of the European customers were buying new equipment for the future. So from that perspective, I took away that they were at least confident enough to put more capital in their businesses to work for the future. So I thought that was a good sign.

Yes, thank you, very helpful. Thanks.

(Operator Instructions)

Our next question from the line of Christopher Kapsch with Topeka Capital Markets. You may begin.

Yes, hi. I had a follow-up on the comments about some of the weakness in domestic pressure sensitive business in September. If you, just curious if you look at the supply chain into that end market, and just simplistically thinking about you selling roll stock into the converters, who sell to the CPG companies, who ultimately sell to the retailers. I'm just wondering, what's the lead time in terms of if a retailer is seeing weak foot traffic, or if they see the consumer in a destock mode, how long does it take for that to back its way up the supply chain to you and your orders into -- you're shipping into the converters?

Chris, that's a great question. I wish I had a precise answer. I'm going to guess a few months. It's really hard to estimate, because remember, we're selling just in North America probably to 2500 label converters who are selling to probably 100,000 end users, and it really depends on the particular supply chain. Some companies react faster than others to those types of trends.

Okay, thanks. And then on just shifting more to RBIS and RFID in particular. Just curious, when you lap the comparison for the big adopter, when did they really curtail their sort of adoption or deployment? So in other words, when would you see the true underlying growth rate for your business come through a little bit more? I guess is it second quarter of next year?

It begins in Q1, that's when you start to see that. The toughest comps were September through early Q1 of last year.

Right and--

I think the underlying growth rate, I'm going to say it is really tough, because the market is still small and when you get a big retailer decide to move quickly, it can influence the year-over-year cycle. But we've had several years in a row now of double digit growth, and I'm going to say 20%, 30% is a good average to take over the next few years. And I could -- that could be on the low end, frankly. You just don't know.

But I do feel like this, it's not an if RFID's going to happen. It's a how fast and what's the rate of adoption going to be. So I have a high level of confidence that this is going to be a great business for the future.

Got you. Well, I have just a couple follow-ups on that sort of adoption curve. If you're looking at, you mentioned, I think, seven major retailers that are looking at adoptions. And presumably this is all focused on item-level RFID, not the bar code labels that also have an embedded inlay in them.

And if you look at those and understanding that they're making that decision based on an ROI analysis. I'm wondering about the breadth of their deployment. Is it tending to be, if you have visibility into this, towards larger ticket items? Like something like an apparel item that cost $20, $30, $50, $100?

Or is it when Wal-Mart had been adopting, they went down to very low-price SKUs, but supposedly they've throttled back on that. So I'm just wondering if the ROI case based on these retailers that are adopting is supporting a breadth of adoption across items, at even SKUs that are low-priced?

So I would say there are about three factors that are important. One is the price. That's actually not the most important. The other one has to do with complexity of the SKU set. So think about things like shoes or intimate apparel or jeans where you have an enormous variety of SKUs that are kind of hard to track. And then replenishment rate. Those three, we actually have a formula, which I won't share, to help retailers understand these are the key factors.

What we find that happens, though, is retailers tend to start in certain departments. They get the ROI, and then they get some other incremental benefits in other areas as they move forward. And we've had one major retailer just going to go wall-to-wall because once you've started to tag 60%, 70% of your items overall, the retailer is just saying, well I have such good inventory control now, incrementally that extra cost isn't going to be bad. So yes, those are the key factors.

Got you. And then just finally on that. There had been some, in the trade press there's been some noise about of a non-practicing entity, an AKA Patent Troll, which acquired basically a bunch of -- a suite of a portfolio of Micron technologies, RFID patents several years ago, and some of the early adopters have been purportedly been throttling back a little bit over the spectrum of litigation associated with that. It sounds like, based on what you're seeing, this is not having an influence on any sort of adoption trajectory for the industry as a whole.

Well, certainly it hasn't in Europe, because it's not particularly relevant there. But I think these things tend to get resolved over time, and I anticipate that this won't be an issue for the long run.

Okay, thank you.

Our next question is a follow-up question from the line of George Staphos, Banc of America Merrill Lynch. You may begin.

Hi, everyone. I just wanted to confirm the guidance for the fourth quarter is, the low end is predicated on your October trend or your September trend? And if I didn't get either of those right, if you could just recast it, that would be great.

It's the September trend, which we saw in the early parts of October, and October did see a little bit of an improvement from that trend, as Dean mentioned, but it's September.

Okay. The next question I had, are you seeing any signs of capacity increases in coating in pressure sensitive? And for that matter, how are you set for coating capacity over the next one to two years?

In Europe, of course, we have had a European competitor announce some closures of capacities, specifically I think in Spain and in Switzerland. So, we've definitely seen some activity there. There is a smaller competitor that's adding capacity in the US. And our capacity situation is just fine in mature markets.

We're going to be adding -- we just added some capacity in Malaysia and India. We're going to add some new capacity in India next year, and likely be looking at adding some capacity fairly soon in China as that business continues to grow.

Okay. And then back to digital presses. I'd asked could you quantify, if not precisely maybe directionally, or with some qualifiers, how this ultimately improves your cost structure within RBIS, and is it additive to the longer-term margin goal of 9%, or is it supportive of that goal?

It's supportive of the footprint reduction goal that we've announced. So, digital printing takes up less space than, let's say, certainly than offset printing. You don't have really any pre-press that you have to as well.

They're more flexible assets, so less footprint relative to the output.

But its all part of the strategy we have to move RBIS margins to the target range. So, what I'm trying to do is help investors understand we have a very clear set of milestones, okay? We're at about -- we've reduced our footprint by 15%, on our way to get to 25%.

Digital printing is supposed to be 50%, it's around 25% or 30% now. So, but indicative that we believe we're on track to hit our margin targets, as we promised back in 2012.

That's great, Dean. The last question just related to that, when do you say you get to 50% having rolled out digital press throughout RBIS?

When? Well, it should be close to 2015, actually.

Okay. All right, thanks guys.

Sure.

Our next question is also a follow-up from Scott Gaffner with Barclays Capital. You may proceed.

Thanks. Just one clarification. On free cash flow year-to-date, what is the -- you said the divested businesses were actually negative free cash flow year to date. Can you provide that number? And then also is the $10 million to $15 million, I think that's what you referenced, $10 million to $15 million of additional cash on divestitures would be spent some time in the fourth Quarter. Is that included in the free cash flow guidance?

So the free cash flow guidance we have is for continuing operations. So that excludes any of that. The $10 million to $15 million extra I referenced was basically getting you from, if you look at the exhibits behind the -- in the financial statements, you see we have $402 million of net proceeds now. I'm just saying we have another $10 million to $15 to pull off of that. So that will drop down to roughly $390 million.

As far as the negative free cash flow, there was negative free cash flow of about $40 million in the first half for those two businesses related to investments you make in working capital. You'll recall OCP was a seasonal business, as well as we had some of the transaction, pre-closing transaction costs within there, as well. So that's why we lump it all together, because that wasn't really the operating level of free cash flow for those businesses.

Okay, and then just one longer term question. As more and more sales move to e-commerce, what sort of impact should we think about that having on your business? Because I would assume you get less tickets, because you don't have the in-store ticket anymore, but maybe you get RFID sales. How do you think about that changeover over time?

Well, actually Scott, it's a good question. Retailers don't change their branding or ticketing, whether it's sold in store or online, and in fact it actually provides some new opportunity for us, because what's happening is that retailers want you to be able to buy things online and then return them to the store if you want to, or even pick them up at the store. And so that requires, let's say on a return, that item actually has to be reticketed.

It happens a lot, especially when you buy stuff online, it doesn't fit or you didn't really like the color, et cetera, et cetera. So what we found is that there's just no difference between the branding and ticketing, and we have come up with solutions to help retailers manage a more seamless interface between, again, their bricks model and their clicks model.

Thank you.

Could be some upside for PSM, by the way. It means there's more bar code labels out there, as people buy online and get stuff shipped in cartons.

And with that, we have time for one more question. And that will be from Christopher Kapsch with Topeka Capital Markets. Please go ahead.

Yeah, just one follow-up on RBIS. You mentioned you felt like you're on track with your progression towards your longer-term margin targets in that business. And I'm just wondering if as RFID grows at a higher growth rate than the core RBIS business, if that's going to influence those margin targets at all? Just as that business is growing, are those margins accretive to the overall segment, or is it something that's just consistent with the targets that you already have out there?

So, they are absolutely consistent with targets. The targets we have out there are targets for 2015, which is only two years from now. And so, they're consistent, and then the margins for RFID are comparable to the overall margins we have for the overall RBS business. It's modestly higher currently.

Okay, and then one last one. You mentioned layering in some higher employee-related costs in that segment. Is that associated with a broader RFID adoption, or what's driving that?

No, that's just part of the fundamentals of this business. This business, as we've talked about, is more labor intensive than pressure sensitive, and a lot of that labor is in the emerging markets where the wage rates are higher.

So when we've talked about this business, forget restructuring and productivity, but this business needs to grow 1.5% to 2% to kind of maintain margins, if you will. That is because it needs that level of growth to offset the natural wage inflation headwinds.

Got you, thank you.

Mr. Scarborough, there are no further questions at this time. I will turn the call back to you. Please continue with your presentation or closing remarks.

Well, thanks everyone for participating today. I'm pleased with the excellent progress we've made so far this year. Our value creation formula remains straightforward.

With modest top line growth, ongoing productivity improvements, and highly disciplined capital management we'll continue to drive double digit earnings growth and solid free cash flow, most of which will give back to shareholders. I would like to thank the Avery Dennison team members for delivering another strong quarter. Thanks again for joining us today, and look forward to speaking with you again soon.

Ladies and gentlemen, this does conclude the conference call for today. We thank you all for your participation, and kindly ask that you please disconnect your lines. Have a great weekend, everyone.