Avery Dennison Corporation — Fiscal Q3 2017 Form 10-Q
Reporting period: Three and nine months ended September 30, 2017, compared with October 1, 2016. Results are unaudited; each period comprised 13 weeks and 39 weeks, respectively.
Business context and reporting period
Avery Dennison operates through Label and Graphic Materials, Retail Branding and Information Solutions, and Industrial and Healthcare Materials. International operations generated approximately 76% of nine-month sales. During 2017, the company completed acquisitions of Hanita, Finesse Medical, and Yongle Tape for aggregate consideration of approximately $344 million, including accrued estimated earn-outs.
Financial performance and liquidity
| Metric | Q3 2017 | Q3 2016 | 9M 2017 | 9M 2016 |
|---|---|---|---|---|
| Net sales | $1,679.5 million | $1,508.7 million | $4,878.5 million | $4,535.7 million |
| Gross profit | $451.6 million | $417.6 million | $1,346.6 million | $1,274.3 million |
| Gross margin | 26.9% | 27.7% | 27.6% | 28.1% |
| Income before taxes | $146.8 million | $128.0 million | $432.2 million | $350.8 million |
| Net income | $108.3 million | $89.1 million | $341.4 million | $258.7 million |
| Diluted EPS | $1.20 | $0.98 | $3.79 | $2.85 |
| Effective tax rate | 26.2% | 30.4% | 21.0% | 26.3% |
Cash flow: Nine-month operating cash flow was $392.6 million versus $365.7 million. Free cash flow was $256.0 million versus $247.7 million, calculated using the company’s non-GAAP definition. Investing cash outflows were $446.1 million, including $309.5 million for acquisitions and investments and $134.9 million for property, plant, equipment, software, and deferred charges.
Liquidity and debt: Cash and cash equivalents were $232.3 million at September 30, 2017, versus $195.1 million at December 31, 2016. Total debt was approximately $1.68 billion, up approximately $389 million year to date, primarily due to the issuance of €500 million of 1.25% senior notes due 2025. The company had a $700 million revolving credit facility and was in compliance with its financial covenants. On October 2, 2017, it repaid $250 million of senior notes at maturity using commercial paper borrowings.
Capital returns: Nine-month dividends paid were $115.8 million, or $1.31 per share, compared with $106.2 million, or $1.19 per share. The quarterly dividend was increased to $0.45 per share. Nine-month share repurchases totaled $104.8 million, or approximately 1.3 million shares; $650.1 million remained authorized for repurchase at September 30, 2017.
Material changes versus the prior comparable period
- Q3 sales increased 11%; sales increased 10% excluding currency and 5% organically. Nine-month sales increased 8% reported and 4% organically.
- Organic growth was driven primarily by higher volume. Q3 organic growth was 5% in Label and Graphic Materials, 7% in Retail Branding and Information Solutions, and 3% in Industrial and Healthcare Materials.
- Q3 net income increased 22% and diluted EPS increased 22%. Nine-month net income increased approximately 32% and diluted EPS increased approximately 33%.
- Gross margins declined year over year, primarily due to acquisitions and the net impact of pricing and raw material costs; nine-month Industrial and Healthcare Materials margins also reflected a program loss in personal care tapes.
- Nine-month other expense declined to $27.5 million from $60.4 million, primarily because the prior-year period included a $41.4 million pension settlement loss. This benefit was partly offset by higher 2017 restructuring charges.
- Operating income increased in Label and Graphic Materials and Retail Branding and Information Solutions. Industrial and Healthcare Materials operating income declined to $37.6 million from $44.8 million despite higher sales, due to employee-related costs and pricing and raw material pressures.
- Restructuring charges were $23.8 million for the first nine months, compared with $14.6 million in the prior-year period. The company expects approximately $50 million to $55 million of 2017 savings, net of transition costs, from the 2015/2016 actions.
Guidance, outlook, risks, and unusual items
Management expected 2017 net sales to increase approximately 8%, the full-year effective tax rate to be approximately 28%, capital and software expenditures to be approximately $215 million, and pre-tax cash restructuring and certain acquisition-related transaction costs to total approximately $40 million. Management also estimated 2017 cash restructuring costs of approximately $35 million.
Tax results benefited from valuation allowance releases, tax examination settlements, decreases in tax reserves, favorable geographic income mix, and a $13.6 million nine-month benefit from the adoption of stock-based compensation accounting guidance. These items may make the effective tax rate variable in future periods. The company stated that it may realize a decrease of approximately $23 million in uncertain tax positions during the next 12 months, primarily from audit settlements and closed tax years.
Key risks include global economic and political conditions, foreign currency fluctuations, demand and customer inventory levels, competition and pricing, raw material costs and availability, productivity execution, acquisition integration, customer and supplier concentration, cybersecurity and information technology disruptions, tax matters, pension and benefit costs, environmental and legal proceedings, and impairment of goodwill or other assets.
The company had environmental liabilities of $22.8 million at September 30, 2017 and was identified as a potentially responsible party at 13 waste disposal or recycling sites. Management believes current legal and environmental matters are not expected to be material individually or in the aggregate, but stated that future costs could exceed accrued amounts and cannot presently be estimated.
Management expected to adopt the revised revenue recognition standard in the first quarter of 2018 using the modified retrospective method and did not anticipate a significant financial statement impact. The company expects the new lease standard, effective for it after December 15, 2018, to have a significant impact on the balance sheet and disclosures.
Most important facts for investors to verify
- Whether organic volume growth and the 2017 sales outlook were achieved without further deterioration in gross margins.
- The sustainability of productivity savings relative to employee costs, raw material inflation, pricing, and restructuring costs.
- Integration progress, final purchase-price allocations, earn-out obligations, and operating margins for the 2017 acquisitions.
- Debt reduction capacity, commercial paper access, covenant compliance, and the effect of the October 2017 $250 million maturity repayment.
- The recurring versus nonrecurring components of the 21.0% nine-month effective tax rate and the expected 2017 rate of approximately 28%.
- Working-capital trends, particularly the increase in operational working capital to 13.2% of annualized sales and lower inventory turnover.
- Potential changes in legal, environmental, tax, foreign exchange, goodwill, and acquisition-related exposures.