艾利丹尼森 (AVY) 2018 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by. (Operator Instructions) Welcome to Avery Dennison's earnings conference call for the third quarter ended September 29, 2018. This call is being recorded and will be available for replay from 12:00 p.m. Pacific Time today through midnight Pacific Time October 26. To access the replay, please dial (800) 633-8284 or +1 (402) 977-9140 for international callers. The conference ID number is 21857413.

I would now like to turn the call over to Cindy Guenther, Avery Dennison's Vice President of Investor Relations and Finance. Please go ahead, ma'am.

Thanks, Chris. Today, we'll discuss our preliminary unaudited third quarter results. Please note that throughout today's discussion, we'll be making references to non-GAAP financial measures. The non-GAAP measures that we use are defined, qualified and reconciled with GAAP on schedules A4 to A8 of the financial statements accompanying today's earnings release.

We remind you that during this call, we will 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 Mitch Butier, President and Chief Executive Officer; and Greg Lovins, Senior Vice President and Chief Financial Officer.

And now I'll turn the call to Mitch.

Thanks, Cindy, and good day, everyone. I'm pleased to report another solid quarter. Adjusted EPS grew 15% in line with our expectations and sales were up 6% organically, with both high-value categories and emerging markets continuing to deliver above-average growth.

Label and Graphics Materials delivered a solid quarter. Sales grew organically by more than 6%, driven by both higher prices and volume. Emerging markets and high-value categories were once again up high single digits.

LGM's margin, however, declined more than expected for the quarter, largely reflecting the lag between what -- when we see inflation and when we can adjust pricing. I'm confident that we will see meaningful margin recovery here in the fourth quarter just as I am confident in the strength of our competitive position.

We, again, saw evidence of this in the strong attendance and customer engagement at our industry's recent trade show in North America. Much of the energy in our booth focused on 2 key areas. The first was sustainability, specifically, our products that enhance recyclability. And second, our intelligent labels platform, which is generating as much buzz among our converter network as it has among retailers and brand owners, which brings us to Retail Branding and Information Solutions.

The team delivered, again, another strong quarter with over 8% organic growth and significant margin expansion. The base business of RBIS continued to grow at a healthy clip through ongoing share gain and RFID grew once again by over 20% in the quarter. We continue to see strong engagement among apparel retailers and brands across all stages of the pipeline as well as promising early-stage developments in other end markets. Our investments to sustain this growth in the form of capacity additions, R&D and business development resources are all on track.

Overall, we're pleased with the progress we've made in building out our intelligent label platform as we lean forward to capture this high-growth opportunity. At the same time, we are realizing the benefits from the transformation of the base business that we started just a few years ago. Combined, these catalysts are driving another year of solid growth and margin expansion in RBIS.

Now results in Industrial and Healthcare Materials segment were clearly disappointing. Sales were well below our expectations, largely due to greater-than-expected declines in China. Over the past couple of months, Greg and I have been going through a deep-dive assessment of the IHM segment. We continue to see great opportunity here, both in terms of the market and our own performance. While we've made progress in improving our fundamentals, our pace of change has fallen short of our expectations, so in the process of making adjustments, we remain confident in our long-term strategy for IHM and in our ability to achieve the 2021 growth and margin targets that we laid out for this business.

All in all, another solid quarter. Our strategic playbook continues to work for us. We will continue to benefit from the 2 key catalysts that enable our consistent GDP growth over the long term: that is high-value segments; and emerging markets. And we'll continue to focus on our 4 overarching priorities: driving outsized growth in high-value product categories; growing profitability in our base businesses; relentlessly pursuing productivity improvement; and remaining disciplined in our approach to capital management.

We continue to position the company for superior value creation over the long term and expect to deliver our seventh consecutive year of strong top line growth and double-digit adjusted EPS growth.

Now I'll turn the call over to Greg.

Thanks, Mitch, and hello, everyone. As Mitch mentioned, we delivered another solid quarter. Adjusted earnings per share was $1.45, up 15% compared to prior year and in line with our expectations. We grew sales by approximately 6% on an organic basis, as currency translation reduced reported sales growth by 1.3 points in the quarter. Currency translation also represented a roughly $0.03 headwind to EPS compared to the same period last year.

Adjusted operating margin increased by 10 basis points to 10.7% as the benefit of higher volume was largely offset by the impact of increased investment spending. And we realized $6 million of net restructuring savings in the quarter. Gross restructuring savings, most of which benefited RBIS, were partially offset by roughly $5 million of transition cost for LGM's European restructuring action.

We will continue to incur quarterly transition costs of $3 million to $5 million for this large project through the middle of next year, with the cost tapering off quickly in the back half of 2019. And recall, this project is expected to drive $25 million of savings beginning in 2020, providing a strong return on the total investment.

Turning now to cash generation and allocation. Free cash flow year-to-date was $261 million, up by roughly $5 million compared to prior year. And as we've discussed, we've increased our pace of fixed capital in IT-related spending this year. Gross capital spending year-to-date is up by roughly $20 million.

Now as a reminder, our free cash flow calculation excludes the onetime cash contribution to the U.S. pension plan associated with its termination. And as expected, we contributed $200 million to this plan in the quarter, allowing us to deduct that contribution on our 2017 U.S. income tax return.

During the first 3 quarters of the year, we repurchased roughly 1.6 million shares at an aggregate cost of $175 million and paid $131 million in dividends. Year-to-date, we returned a total of $306 million to shareholders, up from $221 million for the same period last year.

So turning now to segment results for the quarter. Label and Graphic Materials sales grew 6.4% organically, which included roughly 0.5 point of timing-related benefits largely due to prebuying associated with the price increases taking effect in North America and Europe. Results for the quarter reflected continued high single-digit growth for high-value product lines that was relatively broad-based. In particular, sales for specialty and durable labels were up roughly 10% and sales of Graphics and Reflective products were up high single digits.

In looking at LGM's organic growth in the quarter, by region, results were solid in the mature regions with North America outpacing Western Europe. And we continue to see strong growth in emerging markets led by double-digit growth in South Asia, Eastern Europe and Latin America, which more than offset softer market conditions in China. Adjusted operating margin for the segment declined by 100 basis points, reflecting inflation and the timing of related price realization as well as the transition cost associated with our restructuring in Europe.

As Mitch mentioned, the margin decline was more than we anticipated for the quarter. Raw material inflation came in higher than we expected at the start of the quarter, and we announced new pricing actions, which have taken effect in early Q4. As a result, the net impact of pricing and raw material cost became a more significant headwind for us this past quarter than what we had previously seen. We do anticipate meaningful recovery, margin recovery here in the fourth quarter on a seasonally adjusted basis. And recall that margins in this business typically drop between the third and fourth quarters by roughly 1 point. However, in light of the timing of pricing actions and with the expectation that raw material costs will be relatively stable through the fourth quarter, we expect LGM's Q4 margin to be more in line with Q3 this year.

And while the inflationary pressures have been more significant and persistent than we anticipated at the start of 2018, namely in the mid-single digit range for the full year, we continue to expect to fully recover the cumulative gap between cost and price that we've experienced since the middle of last year.

So turning to Retail Branding and Information Solutions. RBIS delivered another excellent quarter. The team continues to execute very well on its business model transformation, enabling market share gains while driving significant margin expansion. RBIS sales were up 8.2% organically, driven by the continued strength of RFID, which grew once again by more than 20% as well as solid growth of the base business. The growth of the base is particularly encouraging when you consider the holiday timing and prior year sales associated with the World Cup represented a headwind to the quarter on the order of about 1.5 points.

The adjusted operating margin for the segment expanded by 240 basis points to 11.4%, driven by the benefits of higher volume and productivity. These benefits were partially offset by the impact of higher investment spending, particularly in RFID as well as higher employee-related cost.

And finally, turning to the Industrial and Healthcare Materials segment. Sales declined 0.4% on an organic basis, driven largely by a softer automotive market in China. Excluding China, the industrial portion of the portfolio continues to deliver mid-single digit growth.

And IHM's adjusted operating margin increased by 60 basis points, reflecting lower transition costs from prior year acquisitions and lower employee-related costs, which more than offset growth-related investments and the net impact of pricing and raw material cost.

As Mitch indicated, over the longer-term, we remain confident in our target of 4% to 5% plus organic growth for this segment, and we expect to see margin gradually expand to LGM's level or better by 2021.

So turning now to our revised outlook for the company for 2018. We have maintained our guidance for adjusted earnings per share at $5.95 to $6.10. Despite an incremental $0.05 headwind from currency translation in the second half, we've increased our guidance for reported earnings per share by $0.07, primarily reflecting a reduction in our estimate for severance associated with the European restructuring. We've outlined some of the other key contributing factors to our guidance on Slide 9 of our supplemental presentation materials.

In particular, and just focusing on the changes from our last guidance, we now estimate that organic sales growth will be approximately 5.5% for the year, at or near the high end of our previous range. At recent exchange rates, currency translation represents a roughly 1.5 point addition to reported sales growth for the year and a pretax operating income tailwind of roughly $12 million, down from the roughly $18 million tailwind we anticipated in July. We expect savings from restructuring, net of transition cost, to come in near the high end of our previous range, and we have lowered the high end of the range for our estimate of capital spending this year.

So in summary, we're pleased with the progress we've made this quarter and we remain confident in our ability to achieve both our 2018 and long-term goals.

And now, we'll open up the calls for your questions.

(Operator Instructions) Our first question is from the line of Ghansham Panjabi with Robert W. Baird & Company.

So I guess, Greg, just to clarify on your comment that 4Q margins for LGM will be comparable to 2Q. Can you just elaborate on that? Is it just pricing that will get you there or some level of pricing and productivity? I'm just asking because it seems aggressive given higher ROS and some sort of sequential deceleration of volumes due to the prebuy.

Yes, so Ghansham, as I indicated earlier, we typically do see a bit of margin decline Q3 to Q4, largely driven by the fact that some of our higher-value categories like Graphics and Reflective have their high points of seasonality in the third quarter and then we see a seasonal decline in Q4 sequentially as well as some other categories like logistics labels that pick up sequentially, which are a little bit lower than our average margin for the holiday period and things like Singles' Day in China. So we typically see a bit of a decline Q3 to Q4. With the sequential inflation we saw here in the third quarter, margins came in a bit lower than we had expected as we said. We have implemented pricing actions, which have largely already taken effect at the beginning of October. So we're confident that that's a big driver of the sequential improvement that we'll see from Q3 to Q4. So that'll help us be a little bit better than we normally would be in the third quarter to fourth quarter and that is the biggest driver that we see improving our margin sequentially from what we have seen historically.

So does that mean you're getting pricing net of raw material cost? Because otherwise, the math wouldn't necessarily work on that, right? If...

Yes, I mean, right now, we're expecting raw material cost to be relatively stable from Q3 to Q4 sequentially, and the pricing actions that we implemented at the beginning of the quarter then should be a net benefit in the quarter sequentially versus inflation.

Got it. And then just for my second question, a lot of the CPG customers that reported so far, and there seems to be a -- there seems to be sort of a theme during the earnings season, there's, obviously, been a step function of inflation, everyone's raising prices. There seems to be some level of demand dislocation as inventories are managed tightly not just in the U.S., but also the emerging markets as well. Are you seeing any sort of caution in terms of inventory management from your customers as we cycle into year-end and into 2019?

Ghansham, we're not seeing anything beyond the normal, but it's hard to comment globally. I mean, if you look at the North American market, there's actually quite a bit of buzz in the North American market as far as activity levels. Obviously, China, relative to where it had been, things are a little bit lower growth there. There's no common theme overall as far as what we would call out. We're continuing to see growth and continue to expect in the long term, or the label category, specifically, that the market to grow 4%.

Our next question is from the line of Anthony Pettinari with Citigroup Global Markets.

Just following up on Ghansham's question, with IHM, the weakness that you saw in China, is there any way that you can quantify that either in terms of volumes or earnings? And is that something that sort of worsened over the 3 months of the quarter, maybe into October? Or kind of any color you can give on what you're seeing there?

Sure. So the softness we saw in China in IHM was largely China automotive driven. So across the third quarter -- I'll start back a little bit earlier, for the first half of the year, China automotive market overall had been relatively strong. In the third quarter, the overall market started seeing declines, I think around 5% range in both July and August and then declined a little bit heavier in the month of September. So we did start to see China automotive market, in general, decline a little bit heavier as we moved through Q3. And right now, we expect a softer China automotive market in the fourth quarter as well. China automotive overall is roughly somewhere in the 15% range of our IHM segment in terms of revenue base, but that did have a significant impact on the overall IHM decline in the quarter.

Okay, okay. That's very helpful. And then just stepping back and looking at full year guidance. I guess as you stand here at the end of October, what are the swing points that could get you to the higher end or the lower end of the range? And then, I think in previous years, you've kind of narrowed the range when you reported 3Q, but not this year. Is there any reason for that?

Overall, I think where we're sitting now versus where we were a quarter ago, we still feel like our overall guidance is pretty much in line with our expectations from a quarter ago. We got a little bit bigger currency headwind than we had before, offset by what we think are some operational benefits versus where we were a quarter ago as well. I think in terms of the range or the size of the range, we saw a number of currency movements happening around the world in the third quarter. And our range may be a little bit broader here for the rest of the year to account for potential movements in currencies as we go through the rest of the quarter here, like we saw in Q3. I think if you look at the range overall, the mid to higher end of the range assumes inflation kind of stays stable as I mentioned earlier. With the lower end of range, potentially, you would see some more sequential inflation than we're currently expecting.

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

I guess first question I had regarding volumes in LGM, can you comment how variable information did in the quarter? And the reason I ask, during September, we've heard from some companies that box shipments were perhaps a bit weaker, some of the interior protective packaging material was maybe a little bit slower. So paints a narrative then perhaps partial shipments were maybe a little bit slow during September. Did you see that at all in your LGM business exposed to e-comm and shipments?

Yes, so George, the -- specifically, within LGM, the variable information labels related to e-comm did slow a little bit and I think there's 2 factors to that. One is the one you're calling out, hard for us to gauge exactly how impactful that is. And we actually think, as Greg said earlier, Q4, that tends to ramp. So -- and we are starting to see a little bit of that in October. The other reason is we did cede a little bit of share in this category, basically, as we've been moving price. We talked about -- in North America, we've regained the share that we talked about losing a couple of years ago, but this is one category that we've held firm with the pricing and are willing to, in the near term, cede a bit of share and that's what's happening. So we're seeing it on 2 fronts.

Okay. And then on that front, same -- a similar question or a segue type of question. Given the pricing action, are you seeing any intensified competitive activity beyond variable information then and as far as -- and are you seeing for that matter, kind of a related question, any signs of a broader slowdown in your LGM business? Again, didn't sound like it, but just kind of probe the frontier here?

Yes, I mean, growth rates, as you could tell, were robust overall. As far -- we are in a competitive market, but this inflation is broad-based, and I think everybody's raising prices to the extent they need to. And you're always going to, in a period of change, have some puts and takes on the subsegments. So we've got to look at the macro and then we look at the individual customers and product categories. And that one that you called out is the one where we've seen a little bit slower for things to move. But broad-based, we're seeing the market adopt the price increases, meaning the converters are taking them because they know that the inflation's coming through and they're working and passing those through on to the CPG firms and their other end users. As far as broad-based on volume, yes, I mean, if you look for the full year, year-to-date, our volumes are up right in the middle of our long-term range for this business of 4% to 5%. Within Q3, they're below the low end, they're -- about half of the growth was price and half was volume within LGM, so a little bit lower in Q3. And Ghansham, that might have been the question you were trying to get to earlier, but a little bit slow, but that's not unusual in a single quarter to see things move by 1 point or 2. But overall, we're seeing broad-based continued growth.

Okay, Mitch. My last one and I'll turn it over and come back. So you mentioned RFID continued to grow at 20% in the quarter, recognizing we're still early in terms of the adoption phase and it tends to be customer by customer and, cliché of clichés, lumpy quarter-by-quarter. Are there any end markets that you're seeing particularly good growth? I assume it's mostly apparel, but are you seeing any pickup in the other areas? And do you have any kind of early read on the outlook on RFID for 2019?

Yes, so George, we said our target here was to grow 15% to 20% plus over the longer term, and we grew more than 20%, and have been on that track. So it's been at the higher end of that range. And we're counting to see momentum on many fronts as we discussed. Over 95% of the revenue is still apparel and we expect -- we're seeing a tremendous amount of momentum continue within apparel. But we are seeing early traction in the other categories as well, particularly food, beauty and logistics. So helping with the automation of logistics companies particularly how to automate that last mile, last leg of delivery. So those are quite a bit of activity. Just from a pipeline perspective, I think from the beginning of the year, our overall pipeline has increased 30%. Each stage of the pipeline has increased somewhere between 20% to 40% and the nonapparel portion of the pipeline has doubled since the beginning of the year. So lot of momentum, lot of traction, but a lot of it, as you said, early stage outside of apparel.

Our next question is from the line of Edlain Rodriguez with UBS Securities.

So quick question. So you just mentioned that you might be losing some market share because you're being firm on prices. Like what would you be losing those share to? I mean, do those guys have a cost advantage over you?

So my comment was about a specific subcategory in a specific region because that's where the question was. So overall, we're actually seeing relatively stable share or gaining share in North America. And in North America, if you look over the last few years, we had lost some share between '14 and '16. We've recovered that. We're seeing stable share in other regions. So in broad base, do people have more of a cost advantage, the simple answer is no. Our scale advantage, our material science capabilities, our process technology, we see as advantage relative to the rest of the marketplace. So no, we don't see that we're cost disadvantaged or anything else.

Okay, that's what I thought. And one quick one on IHM. I mean, at the end of August, you had a management change there. Like what wasn't working right? And how quickly you believe you can fix those issues?

Yes. So simply, if you look back over the last few years, we've made a few adjustments in each of our businesses. And if I look at the -- some of the shifts we needed to do, we need to pivot a little bit more to just focusing on the fundamentals and I draw the analogy that was one of the aspects we focused on within RBIS. And here, just getting on the fundamentals of excellence in service, in quality and in cost, that's one area. And the other would be -- and that's -- I'd draw the analogy of RBIS there. We did other things within RBIS, dramatic cost reduction, distributing decision making and so forth, but this is more on the first aspect. And then the other is just we're managing a little bit too much to the average. So disaggregating our approach to the markets and having an end-to-end segmented strategy. And that's something we talked about both when we did the strategic pivots within LGM as well as the strategic adjustments within RBIS is having a more segmented approach, disaggregating the business and that's what we're going through right now. So we see a tremendous amount of opportunity within the market, obviously, within our performance as well. And if I just call back, again, to those previous changes, LGM was a strategic pivot, I would say, and more of just segmenting the business. RBIS was a strategic -- a major shift strategically as well as a major refocus on the fundamentals. And here, strategy's right, market's growing and it's really around focus on the fundamentals and rebalancing the strategy. As far as timing, we'll give an update in the next earnings call. As I said, Greg and I are going through a deep-dive assessment. We're working through that with the rest of the team. We've got a very capable team at their local level and we're working with them to identify how we further segment this business and get the fundamentals right. So we'll update you in January.

Our next question comes from the line of Lars Kjellberg with Crédit Suisse Europe.

I just want to come back a bit to China, again. What is happening in China? You called out the automotive but also on the LGM side. What has changed? And how -- what are you seeing heading into Q4 in 2019? And also on the cost inflation side, you give base case scenario will be stable inflation. What caused that incremental higher inflation in Q3? And what are you now seeing that you would expect that to stabilize?

Sure. To start, the China -- the China question, again, the automotive impacts in China really affected the IHM segment. In terms of LGM, we were up modestly in the quarter, not at the same pace we had been in the first half, but that was also against some very tough comps from prior year where we grew in mid-teens in China in Q3 of 2017. So despite those tough comps, we're still up a little bit here in the quarter versus prior year. And we continue to see the market growing in the third quarter as well, albeit at a slightly slower pace than what we had in the first half. And again, for -- right now what that feels to be is just a little bit softness in the macro in China. As you've seen, GDP come down a little bit and PMI come down a little bit, that seems to be affecting overall demand at least in the short term here. And that's what we've experienced in the quarter. But we continue to grow here, we continue to be in kind of that mid-single-digit rate for year-to-date. So we feel pretty good overall about where we are in China right now. We did see the blip here. The automotive piece had a bigger impact on IHM, but in LGM, we continue to grow albeit at a more modest pace in the quarter.

On the question -- I think your other question was more about what we saw in terms of inflation sequentially from Q2 to Q3, above our expectations. And at the time in the second quarter, we had started to see propylene, particularly, in the U.S., rise throughout the second quarter. We thought that might soften a little bit in Q3. It did not; it actually went up a little bit early in the quarter, softened maybe a little bit in the back part, but that was a part of the impact versus our expectations. And we continue to see paper increases throughout Europe and Asia, in particular, as well on the third quarter. Really overall, Q2 to Q3 was pretty broad-based and it was probably the highest sequential inflation quarter we've seen over the last 4 or 5 quarters, which is why we've done a number of incremental pricing actions as well as we started the fourth quarter here.

And hopefully, if I can, just one more question on, if you roll out RFID and clearly, doing that very successfully, are you making any progress in any other markets outside North America because it seems to be mostly North America that progress is made?

No, it's actually relatively broad-based. It's in North America, it's in Europe, again, largely in apparel. Latin America, we've got a number of key developments going on. Asia Pacific as well and a lot of that is linked to global companies rolling it out within Asia Pacific, so it's relatively broad-based.

Our next question comes from the line of John McNulty with BMO.

I guess one of the things, I guess, I'm a little curious on is the Label and Graphics. The margins, obviously, came under pressure on the raw material front. Yet it looks like the Industrial and Healthcare Materials margins, which I would think have somewhat similar overlapping raw material trends, didn't really take much of the hit. I guess can you help us to understand why that might be? Or are we off in terms of what the relative raw material baskets might look like for these?

Yes. So John, basically, if you're asking why didn't it come up -- under the same pressure as LGM, I think, that was the crux of your question. Last year, there was quite a bit of acquisition integration cost, one, that weighted down. And then -- so that's basically overall. And then second, a lot of the inflation -- we talked -- we see a lot of it going on in chemicals and resins, but it's also in paper-based, is a big portion of it as well. And the paper-based inflation does not hit IHM.

Got it. Fair point. And then, I guess, speaking of M&A, we haven't seen much from you guys recently. I guess given the markets' selloff, are you seeing more opportunities out there? Or are you seeing guys less willing to sell, just given that maybe they're thinking valuations are too low at this point? I guess how should we think about that?

Yes, the recent market -- John, I'd say, it's too recent for it to change expectations and behavior within the M&A -- our M&A pipeline. The M&A pipeline we continue to work and engage with parties, and I think that you shouldn't expect anything really to convert this year, but we have a number of active engagements that we are working through. And as we've said, we're in a position of strength should there be some sustained adjustment in valuations and so forth. And that's what we're continuing to work through.

Our next question comes from the line of Adam Josephson with KeyBanc Capital Markets.

Mitch, just on the trade war between the U.S. and China. Can you just talk about what impacts any protracted trade war could have on your RBIS business as well as any impact on the other businesses?

Yes, so specifically, for RBIS, the big question would be if there -- and it's very small today the amount of tariffs that are associated with apparel. But if there was a broad-based tariff on apparel, I think you'd see a bit more of an acceleration of the migration out of China into other regions for apparel sourcing. That will take time. They're just such a huge infrastructure within China. That would take some time, but it's actually where we would be, from a position standpoint, very well positioned. We are -- can support our retailers and brand owner partners as well as the mega apparel manufacturers and helping migrate that volume. So that's something that we see as a position of strength for us and something we can provide tremendous partnership and support to our customers through that migration. I think the bigger question, and you have to draw your own conclusions if there was a major tariff in the time frame what would that do to end pricing and so forth. You ask the broader question of trade conflict between and/or major economies.

Yes. Now just a couple of others. On the organic sales growth of 6%, how much was volume versus price?

Within LGM, it was roughly equal mix price and volume.

And how did that compare to previous quarters?

It's ramping as you'd expect because we've had -- on the price side because we've had sequential price increases every quarter for 4 quarters now I believe.

Okay. Yes, sure. And FX-wise, what are your assumptions for the euro and renminbi? And can you just remind us what your sensitivity is to those currencies? And just relatedly, have -- the FX fluctuation, have they had any impact on your margins, positive or negative?

Yes, so I think our assumptions on the euro are right around $1.15. The RMB, I think, it's 1 -- $0.145 type of range in terms of our assumptions for the rest of the year. And you know that we have had some number of impacts. We've talked a little bit. I think we talked a little bit about Argentina. Argentina, we did move this quarter to U.S. dollar-based functional currency given the high inflation environment there. And that certainly is something we're managing through. In a number of other countries, particularly in South Asia, we've seen some weakening of their currencies against the dollar. And there are some of the raw materials that are purchased in dollars, so we're also doing pricing actions in some of those countries to manage that currency-driven inflation at the same time. So that had a little bit of an impact on our margins this quarter as well. And that is some of the sequential pricing that we'll see from Q3 to Q4 as we manage through some pricing actions driven by that currency-related inflation as well.

Our next question comes from the line of Scott Gaffner with Barclays Capital.

Mitch or Greg, if you look at the LGM margins, based on the assumption that you gave us for the fourth quarter of essentially flat 3Q margins from -- or 4Q from 3Q, you still have down margins year-over-year. Is that -- how much has the price cost impacted margins year-over-year into 2018? And Greg, I think in your prepared remarks, you talked about cumulative cost recovery. Does that imply that we should still see more recovery as we move into 2019, even if raw materials remain flat?

Yes, so I guess, overall, when you look at the margins in '18 versus '17, I did call out in the quarter here, we had some transition cost related to the European restructuring. We also had a little bit of that in the second quarter as well. And that does, for a year basis, so far give us about 20 or 30 basis points of impact versus prior year. In terms of inflation, our biggest impact -- and we had a pretty modest impact price inflation in the first couple of quarters. The biggest impact here has been in Q3. As we said, sequentially, we expect that to improve as we move into the fourth quarter. I think those are really the biggest drivers of margins year-over-year, a lot of give and takes otherwise.

And continued recovery into 2019? Or do you feel like at the end of 20 -- at 4Q you're back where you were?

I think based on the pricing actions we've taken, if raw material environment remains stable, in the next couple of quarters, we'll make up the cumulative gap that we've had over the last number of quarters. So that's our expectation right now, if markets remain stable. As we said before, if we continue to see some more sequential inflation, we need to do more sequential pricing actions, we'll do that accordingly. It may take us a quarter or so to get that through, but we will take those actions as necessary. If the markets remain stable, then we think, in the next couple of quarters, we'll be able to close any gap that we've had over the last year or so.

And Scott, I think one of the things we're trying to communicate is if you look at it in addition to everything Greg laid out, if you look at our normal seasonal pattern of margins within this business, Q2 and Q3 are higher than Q1 and Q4. And that had been tracking true all year despite inflation because the timing over the lag was shorter, little bit longer right now by really just a month or 2 and so we saw a dip within Q3. That's if you look at the normal seasonal trend. The other element is we do have transition costs that have -- coming in for the European restructuring that are hitting the second half and we'll continue in and through the first half of next year, which we will start seeing savings in the second half of next year. So if you're trying to think about normal -- think of normal seasonal trends and as you go into next year, there will be some of the savings start to come in, in the second half of next year on top of that because of this restructuring program.

Right, okay. And then just approaching the M&A opportunity, capital allocation question a little bit differently. While multiples in the M&A private space might not have changed over the last few months, your stock price definitely has, down, call it, 20% or 25% from the peak. Year-to-date, you've accelerated a little bit of a share repo, but any thoughts around maybe increasing that significantly more from here on a go-forward basis?

Yes, I mean, John (sic) [Scott], overall, we don't comment on the timing or amount, but what we did do is -- I mean, if you look, we've paid -- funded $200 million of the pension and we're -- our leverage ratio is still well below the newly revised leverage ratio that we have. And so we have ample capacity and what you can see on a relative basis, we have stepped it up, and we will continue to show discipline as we do that. Our objective is not to be well below the low end of our target range; long term, we want to be within that range and that's our expectation to get there. Obviously, it depends on timing of M&A and everything else, but as I said earlier, don't expect anything to convert imminently here. But you shouldn't expect us to be anything other than disciplined and leaning forward more as things, prices go down and pulling back a bit as they surge up.

Fair enough. Just one last one on -- you threw up the sustainability comment in regards to the recent conference that you guys attended. Are you actually seeing any orders there? Or is it just more level of interest has increased? What's kind of happening there from a little bit more granular perspective? And good luck in the quarter.

Sure. Thanks, Scott. So it's broad-based on the sustainability front. So a lot of interest in our products that enable enhanced recycling, like our CleanFlake product as an example, which is -- we brought out 4 years ago and as the market had greater need for more recyclability, we are seen as the innovation leader who can bring those products to bear, more interest in our push around using sustainably sourced materials. Certified paper, we had a target of increasing that dramatically. We're now at 88% of using certified papers coming from sustainably sourced force and so forth. So overall, there's a desire for the whole sustainability theme. Our customers like to be able to tell the message to the end users around what we're doing around greenhouse gases, sustainably and responsibly sourced materials. Those are the areas that we're working on. And then, specifically, the biggest -- if you look at a specific product, it's products that enable recycling and these are products that we've started developing a number of years ago. The biggest one that you'll hear is CleanFlake, which came out 4 years ago, which enables recycling. We're looking to expand that portfolio and investing our R&D resource to do just that. So more thematic, Scott.

Our next question comes from the line of Jeff Zekauskas with JP Morgan Securities.

When you look at your October volumes, did the trend seem a continuation of what you saw in September? Or did it seem a little bit slower or a little bit faster? And in general, how does the overall global economy look to you, given that the market seems to be a little bit more pessimistic about economic prospects going forward?

Yes, so as far as, I mean, the first few weeks or shipments that we have, we're seeing exactly what we'd expect consistent with our guidance, kind of consistent with what we saw over Q3 in general, and particularly, mature doing -- China's still a little bit lower than normal growth and the rest of regions continuing on the pace that we talked about earlier. As far as our global outlook, I mean, if you look at where things are, U.S. is growing a little bit higher than the average of what we're seeing. Europe has moderated a little bit, but still growing at a healthy clip. Latin America is stronger than the headlines reveal. Hard for us to tell, because we don't have good market data, how much that's market versus just our strength of our position. South Asia, doing very well. Part of that, you have to recall, is coming off easy comps from last year. There was quite a few adjustments with India making quite a few adjustments in their Goods & Services Tax as well as the monetary items. And then China and Korea are both seeing a slowdown in their growth rates. So I'd say overall pretty broad-based. A couple -- a big country China, being slower growth, and the U.S. being a bit faster growth, and we're not seeing a shift in that, specifically, in the U.S.

You contributed $200 million into your pension plan and there's another $30 million coming next year. How much of that do you get back through tax benefits? And what's the timing of the amounts?

Yes, so Jeff, we actually -- as we said, we made the $200 million contribution in the third quarter, and we applied that contribution to our 2017 tax return. So we saw a benefit in our GAAP tax rate in the third quarter of I think roughly in the range of $30 million related to that $200 million contribution we made.

I'm not interested in the change in your GAAP rate. I'm interested in the cash benefit you get from the contributions in the form of a tax benefit?

The cash tax benefits?

In other words, you pay the money, you get some sort of deduction, and then that monies -- those monies will be refunded to you in the future. No?

Yes, we have some cash tax benefit. I'm not exactly sure the amount related to versus the amount of the overall tax rate benefit. So that's something we'll have to follow up on, Jeff.

Okay, great. In general, you talked about recouping your raw material and inflation. Your gross margins have been under a little bit of pressure for a couple of years now. When do you expect your incremental gross margin to be higher than your average gross margin? That is when do you -- will it take until, I don't know, the second or third quarter of 2019? Or could it come before that? Or will it -- will be later? I mean, even with your margins being flat sequentially, your margins will be lower than they were last -- your gross margin will be lower than what it was last year and still, your incremental gross margins will be lower than your average gross margins by quite a bit.

Yes, so a number of things will contribute to that. So we talked a little bit about transition cost that's weighing down GP a little bit. And as we've said over the last number of quarters, we've increased the pace of our CapEx, and we should have some depreciation coming in now on those assets that we've recently put into service, and we don't have full benefits of them yet at this point either. So that's weighing on GP percent in addition to the volume and price benefits -- price impacts -- or sorry, price and inflation impacts that we've seen. So we'll start to see price inflation even out as we said if raw material environments stay relatively stable. And then, as we've talked about, we have a number of actions like the Europe restructuring that will start to benefit us in the back half of 2019. So I think as we move through 2019, we'll start to see those improvements benefit us. We'll continue to have the transition cost in the first half of next year, but we will have benefits in the second half as we execute that action. So that, along with the price and inflation dynamics, we expect to see improvements in the back half of next year.

If I could just add, Jeff, don't forget the pure math of adding 3 points to price is 50 basis points on your margins. So just factor that into your thinking too.

Okay. And just lastly, when you think about the -- I guess the trajectory of volume growth in your LGM business, is it slightly slowing down? Or is it consistent with what it's been? How do you feel about that overall?

Overall, volumes, I think in the third quarter, were a little bit slower than we had. We have a number of these kind of timing-related impacts over the last number of quarters. But overall, volumes in Q3 were just a little bit slower, really driven by China being a little bit slower than it had been in the first half. We continued to have volumes in the developed regions largely in line with where we had been overall and then the other emerging markets continued to grow very well. So I think overall, the only real slower growth rate we've seen on a broad level was China in the third quarter from what we had previously been seeing.

Our next question comes from the line of Chris Kapsch with Loop Capital Markets.

Yes, just a couple of follow-ups. The pricing dynamic in LGM and, specifically, to achieve the sort of flattish margin that you mentioned in the fourth quarter, assuming raw material cost inflation is roughly flat sequentially, what order of magnitude of pricing traction do you need on the price increases that you unveiled in early October in order to achieve that sort of flat margin?

Yes, we said we -- overall, our impact -- our view is making sure we have enough price to offset the material inflation we're seeing. We're seeing inflation in that kind of 5% impact and you would expect to see then pricing in the low to mid-single-digit rate in order to offset that. We also have, as I mentioned, a little bit of currency-driven inflation. We have currency price increase taking effect in the fourth quarter as well. So I think overall in the fourth quarter, you would expect to see kind of low- to mid-single-digit impacts from pricing within LGM.

And are there any regions where you see the traction on the price increase more challenging than other regions in LGM?

I don't think any one region is more challenging than other. We've done price increases really across the -- all of the regions over the last year, 1.5 years in multiple increases in most of the regions and we don't necessarily see any one region being more challenging than the others at this point.

Okay. And if I could just follow up a little bit on China because I think it's important. I mean somebody mentioned the 25% markdown in your stock. If you were to tie that to just 2 regions, there would be, I think, concern over this raw material cost inflation that's precipitated recently and then slowdown in China. And I think you guys have -- in the context of getting through pricing and restoring margins, I think you've talked about being manageable. I think there's still a lot of questions about, obviously, what happens in China. But can you just talk about the trends and maybe quantify the growth that you saw? I mean, you talked about slower demand, and I'm talking about LGM specifically, setting aside the automotive exposure in IHM. Can you just talk about what sort of the magnitude of growth that you actually did see there? And was that decelerating during the quarter or was it just consistently softer with just a generally softer Chinese economy?

Yes, Chris, so we saw kind of low-single-digit growth in China in the third quarter. That had been off really mid-single digits for the first half of the year. So we did continue to see growth there. That was a little bit softer than what we had seen as we said, and really, we actually saw growth improve as we moved through the quarter, with September being a stronger month than July and August were versus prior year. There was a little bit of a holiday benefit in there year-over-year as well, but overall, we saw September start to improve in China from what we had seen in July and August.

And has that improvement in China sustained thus far into October? I know we only have a few weeks of orders, but...

I think from a run rate perspective, we continue to feel good about our volumes in China and our ability to continue growing in that region. I think, as we said last year, in the third quarter, we had mid-teens growth in China and some of that continued into early fourth quarter last year. But overall, we feel good about the pace of our volumes in China and what we're able to deliver for the rest of this year.

Yes. So Chris, just to build on that, if you -- you made some broad comments upfront. And I think, overall, we remain confident in our ability to offset the inflation that comes through, leveraging our position in the markets and the strength of our markets and the healthy nature of them. You're going to always have, in these periods of change, a little bit of pieces moving around, but overall, we feel good with the market share positions that we have, continuing to leverage our competitive advantages. And China right now is, yes, growing a little bit slower. We believe because of the macro as well as very tough comps. This business was growing mid-teens last year in Q3. But also for me, talks about the resilience. When we talk about emerging markets as one of our key growth catalysts, it doesn't mean China. It means broad-based emerging markets. We're seeing strong double-digit growth in all of South Asia, in Latin America, in Eastern Europe. So we've had this before, and we've had periods where South Asia slows down and other regions are picking it up. So I think it really speaks to the strength of our position globally in the portfolio, the fact that we have these high-value segments, which are 1/3 of the overall company that are growing faster than the average. And so our resilience is really what we focus on, continuing to build that resilience to be better positioned across the economic cycles. And we feel that we're well positioned to continue to offset inflation just like we've done. You may have a bump on a quarter or 2, where you're a quarter ahead or a quarter behind, but that's what we expect and what we continue to be confident in.

And I will turn the call back to Mr. Mitch Butier.

Okay, well, thank you, everybody, for joining the call. We're, again, pleased with the continued strength of our competitive position in healthy growing markets and delivering another solid quarter. We expect the company to continue our strong performance both as we conclude the year and entering next year. And really, just want to thank the entire team for their commitment and focus on delivering exceptional value for our customers, our employees, our communities and our shareholders. So thank you, everybody.

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.