Avery Dennison Corporation — Fiscal Q2 2018 Form 10-Q
Reporting period: Three and six months ended June 30, 2018, compared with the comparable periods ended July 1, 2017. The interim financial statements are unaudited; each period comprised 13 weeks for the quarter and 26 weeks year-to-date.
Business Context and Financial Position
Avery Dennison operates through Label and Graphic Materials (LGM), Retail Branding and Information Solutions (RBIS), and Industrial and Healthcare Materials (IHM). Approximately 77% of year-to-date sales were generated by international operations, creating exposure to foreign currency, economic, political, and operating conditions outside the United States.
| Metric | June 30, 2018 | December 30, 2017 |
|---|---|---|
| Cash and cash equivalents | $215.8 million | $224.4 million |
| Total debt fair value | $1.67 billion | $1.60 billion |
| Shareholders’ equity | $1.02 billion | $1.05 billion |
| Revolving credit facility | $800 million; no balance outstanding | No balance outstanding |
Key Financial Metrics
| Metric | Q2 2018 | Q2 2017 | Six Months 2018 | Six Months 2017 |
|---|---|---|---|---|
| Net sales | $1,854.2 million | $1,626.9 million | $3,630.6 million | $3,199.0 million |
| Gross profit | $501.4 million | $452.6 million | $984.8 million | $895.0 million |
| Gross margin | 27.0% | 27.8% | 27.1% | 28.0% |
| Income before taxes | $139.9 million | $149.5 million | $299.0 million | $285.4 million |
| Net income | $95.6 million | $120.9 million | $220.8 million | $233.1 million |
| Diluted EPS | $1.07 | $1.34 | $2.47 | $2.59 |
| Effective tax rate | 31.4% | 19.1% | 25.8% | 18.3% |
| Operating cash flow | Not separately provided | Not separately provided | $209.5 million | $175.6 million |
| Free cash flow | Not separately provided | Not separately provided | $127.6 million | $93.0 million |
Second-quarter sales increased 14% year over year, including a 4% unfavorable currency effect. Sales increased 10% excluding currency and 8% organically. Six-month sales also increased 14%, with 8% growth excluding currency and 6% organic growth. Growth was primarily volume-driven.
Material Changes Versus Prior Comparable Period
- Profitability: Q2 net income declined 21% and diluted EPS declined 20%. Six-month net income declined 5% and diluted EPS declined 5%, despite higher sales and pre-tax income.
- Margins and costs: Gross margin declined 80 basis points in Q2 and 90 basis points year to date, reflecting acquisitions, growth investments, and the net effect of pricing and raw-material costs.
- Restructuring: Other expense, net increased to $57.1 million in Q2 from $10.2 million and to $69.9 million year to date from $16.7 million. Six-month restructuring charges were $72.1 million, primarily related to the European LGM footprint consolidation.
- Taxes: The effective tax rate increased materially, reflecting Tax Cuts and Jobs Act provisions, including international tax charges, foreign withholding taxes, and limits on certain deductions, partially offset by discrete tax benefits.
- Segment performance: Q2 LGM sales increased 12%, but operating income declined to $115.5 million from $151.4 million. RBIS sales increased 11% and operating income rose to $45.3 million from $29.5 million. IHM sales increased 40%, primarily due to acquisitions, and operating income rose to $16.6 million from $11.7 million.
- Cash generation: Six-month operating cash flow increased 19% and free cash flow increased 37%, primarily due to improved operational working capital.
- Capital allocation: The company paid $85.3 million of dividends, repurchased $102.9 million of shares, and paid $16.8 million of acquisition-related contingent consideration during the first six months.
Guidance, Outlook, Risks, and Unusual Items
- Management expected 2018 net sales growth of approximately 8.5%, a full-year effective tax rate of approximately 20%, capital and software expenditures of $250 million to $270 million, and restructuring charges of approximately $80 million.
- Management expected cost-reduction savings, net of transition costs, of approximately $25 million to $30 million in 2018. The 2018 LGM restructuring plan is expected to produce approximately $25 million of annualized savings beginning in 2020 and to be largely complete by the end of 2019.
- In July 2018, after quarter-end, the Board approved termination of the underfunded Avery Dennison Pension Plan. The company intended to contribute $200 million in August 2018 using commercial paper and estimated a total non-cash termination charge of $575 million to $600 million, with approximately $100 million expected in Q4 2018 and the remainder when the liability is transferred in 2019.
- Management estimated the net effect of non-cash charges and tax impacts related to the pension-plan termination would reduce 2018 net income by $45 million to $65 million.
- Key risks include demand and macroeconomic conditions, foreign currency volatility, raw-material costs, the ability to pass through price increases, competition, acquisition execution and integration, information technology and cybersecurity risks, tax-law uncertainty, pension obligations, and legal or environmental proceedings.
- The company was a potentially responsible party at 13 environmental sites. Environmental liabilities totaled $18.8 million at June 30, 2018; management could not reasonably estimate a range of potential additional expenses.
- The company expected to begin treating Argentina as a highly inflationary economy in Q3 2018; Argentine sales represented less than 1% of fiscal 2017 net sales.
- The company adopted new revenue-recognition and other accounting guidance in 2018 without a material impact on reported results. It expected forthcoming lease accounting adoption to have a significant impact on the balance sheet and disclosures.
Most Important Facts for Investors to Verify
- Whether organic volume growth and the 8.5% full-year sales outlook were sustained after Q2.
- The extent to which pricing and productivity actions offset raw-material inflation and lower gross margins.
- The timing and cash costs of the LGM restructuring plan, including the expected 2019 payments and projected savings.
- The final accounting charge, funding requirements, tax benefit, and liquidity impact of the U.S. pension-plan termination.
- Commercial paper balances, total leverage, covenant compliance, and continued access to the $800 million revolving credit facility.
- Foreign currency effects, particularly the impact of Argentina’s highly inflationary-economy designation and broader international exposure.
- Progress on the company’s information-technology implementations and the expected balance-sheet impact of lease accounting adoption.