Avery Dennison Corporation — Fiscal Q3 2018 Form 10-Q
Reporting period: Three and nine months ended September 29, 2018, compared with September 30, 2017. The interim financial statements are unaudited and cover thirteen- and thirty-nine-week periods.
Business context and reporting period
Avery Dennison operates through Label and Graphic Materials (LGM), Retail Branding and Information Solutions (RBIS), and Industrial and Healthcare Materials (IHM). International operations generated approximately 77% of nine-month sales. The company began treating Argentina as a highly inflationary economy on July 1, 2018, resulting in a $3.4 million peso remeasurement loss.
Financial results and key metrics
| Metric | Q3 2018 | Q3 2017 | 9M 2018 | 9M 2017 |
|---|---|---|---|---|
| Net sales | $1,759.7 million | $1,679.5 million | $5,390.3 million | $4,878.5 million |
| Gross profit | $459.2 million | $451.6 million | $1,444.0 million | $1,346.6 million |
| Gross margin | 26.1% | 26.9% | 26.8% | 27.6% |
| Income before taxes | $168.0 million | $146.8 million | $467.0 million | $432.2 million |
| Net income | $149.5 million | $108.3 million | $370.3 million | $341.4 million |
| Diluted EPS | $1.69 | $1.20 | $4.16 | $3.79 |
| Effective tax rate | 10.5% | 26.2% | 20.3% | 21.0% |
Reported sales increased 5% in Q3 and 11% year to date. Organic sales increased 6% in both periods. Q3 growth reflected higher volume and pricing; nine-month organic growth was primarily volume-driven. Gross margin declined because pricing benefits did not fully offset raw-material costs and growth investments.
Q3 segment sales were $1,194.2 million for LGM, $398.4 million for RBIS, and $167.1 million for IHM. Segment operating income was $152.9 million, $42.4 million, and $15.3 million, respectively. Nine-month LGM operating income declined to $418.1 million from $436.6 million, while RBIS increased to $122.4 million from $82.9 million and IHM increased to $44.9 million from $39.1 million.
Cash flow, debt and liquidity
- Nine-month operating cash flow was $187.7 million, down from $389.9 million, primarily because of the $200 million contribution to terminate the U.S. Avery Dennison Pension Plan (ADPP), higher tax payments and incentive compensation payments.
- Management-defined free cash flow was $260.5 million, compared with $256.0 million, after adding back the ADPP contribution and incorporating capital and software expenditures.
- Capital and software expenditures were $154.2 million; net cash used in investing activities was $127.4 million.
- Cash and cash equivalents were $217.6 million at September 29, 2018, versus $224.4 million at December 30, 2017.
- Total debt was approximately $1.87 billion, up approximately $285 million from year-end, primarily due to commercial paper borrowings used for operating needs and the ADPP contribution. Current debt was $571.7 million and long-term debt was $1,295.3 million.
- The company had no borrowings under its $800 million revolving credit facility and was in compliance with its financial covenants.
- Nine-month dividends were $130.6 million, or $1.49 per share. Share repurchases totaled $175.1 million for approximately 1.6 million shares; $450.2 million remained authorized for repurchase at quarter-end.
Material changes versus the prior comparable period
- Net income increased 38% in Q3 and 8% year to date; diluted EPS increased to $1.69 and $4.16, respectively.
- Q3 results benefited from lower restructuring expense, lower employee-related costs, productivity savings and lower interest expense. The effective tax rate also benefited from $36.6 million of discrete tax benefits, including a $31 million benefit related principally to pension contributions and an $8.6 million foreign-currency tax benefit.
- Year-to-date other expense increased to $66.9 million from $27.5 million, primarily because restructuring charges rose to $65.7 million from $23.8 million.
- Debt increased materially, while operating cash flow declined, reflecting the pension-plan funding and working-capital and tax-related uses of cash.
- The company paid $200 million to terminate the ADPP. It expects total non-cash termination charges of $575 million to $600 million, with approximately $100 million expected in Q4 2018 and the remainder when the liability is transferred in 2019.
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%, and capital and software expenditures of $250 million to $260 million.
- Expected 2018 restructuring charges were approximately $70 million. The European LGM footprint-consolidation plan is expected to reduce headcount by approximately 150 net positions, be largely complete by the end of 2019, and generate approximately $25 million of annualized savings beginning in 2020.
- Management estimated that non-cash charges and tax effects from the ADPP termination would reduce 2018 net income by $45 million to $65 million.
- Key near-term risks include global demand and political conditions, foreign-exchange volatility, raw-material costs, the ability to pass through price increases, competitive pricing, customer and supplier concentration, acquisition execution and integration, information-technology and cybersecurity risks, tax-law changes and legal or environmental proceedings.
- Lease accounting guidance was expected to have a significant impact on the company’s balance sheet and disclosures upon adoption, although the full effect was still under assessment.
- The company reported environmental liabilities of $17.9 million and was a potentially responsible party at thirteen sites; management stated that current legal and environmental matters were not expected to be material based on available information.
Important facts for investors to verify
- Whether the ADPP termination ultimately produces charges and cash funding needs within management’s estimated ranges, including the 2019 annuity purchase.
- Whether pricing and productivity initiatives offset raw-material inflation and growth investments sufficiently to restore gross margins.
- The sustainability of earnings excluding the $36.6 million of Q3 discrete tax benefits and other restructuring-related items.
- Commercial paper levels, debt maturities, interest costs and continued compliance with revolving-credit covenants.
- Progress, costs and savings from the European LGM restructuring plan and the effect on LGM operating performance.
- Final effects of the Tax Cuts and Jobs Act, uncertain tax positions and the company’s remaining accounting assessments.
- The balance-sheet and disclosure impact of the upcoming lease-accounting adoption, as well as ongoing foreign-currency and Argentina-related exposure.