AVY

Avery Dennison Corp. - Q3 2008 10-Q Summary

Business Context and Reporting Period

This Form 10-Q covers the fiscal third quarter ended September 27, 2008, and the nine-month period year-to-date. Avery Dennison Corporation is a global leader in pressure-sensitive materials, retail information services, and office and consumer products. The company operates in a challenging economic environment characterized by tighter credit conditions and slower growth in mature markets, partially offset by growth in emerging markets.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Reported sales increased 3% in Q3 and 13% year-to-date. However, on an organic basis (excluding currency and acquisitions), sales declined 2% in both periods due to weak economic conditions in mature markets.
• Margin Compression: Gross margins declined due to raw material and energy cost inflation, negative product mix, and reduced fixed cost leverage, which offset benefits from price increases and productivity initiatives.
• Restructuring Costs: The company recorded $12.5 million in restructuring and impairment charges in Q3 2008 (down from $33.6 million in Q3 2007). Year-to-date charges were $23.9 million compared to $43.2 million in 2007.
• Tax Rate: The effective tax rate dropped significantly to 7% in Q3 and 8% year-to-date (vs. 12% and 19% in 2007), driven by discrete tax benefits totaling approximately $37 million related to the realizability of deferred tax assets.
• Acquisitions: The company completed the acquisition of DM Label Group in April 2008, contributing approximately $26 million to year-to-date sales. The integration of the 2007 Paxar acquisition continues to generate cost synergies.

Guidance, Outlook, and Risks

• 2008 Outlook: Management expects high single-digit revenue growth for the full year, driven by acquisitions and favorable currency translation. Organic sales are expected to decline approximately 2% for the full year, with a steeper decline anticipated in the fourth quarter.
• Earnings & Cash Flow: The company anticipates an increase in annual earnings and free cash flow for 2008 compared to 2007, despite higher raw material costs.
• Cost Synergies: Total annual cost synergies from the Paxar integration are estimated at $120 million. Prior year restructuring efforts are expected to yield incremental savings of $30–$35 million in 2008.
• Key Risks:
  • Legal Proceedings: The company is a defendant in class action lawsuits regarding alleged anticompetitive practices in the label stock industry. While government investigations have been closed, civil litigation remains pending.
  • FCPA Violations: The company reported potential violations of the U.S. Foreign Corrupt Practices Act involving employees in China and recently acquired companies. Fines or penalties are possible but amounts are unpredictable.
  • Environmental Liabilities: The company is a potentially responsible party at 19 waste sites with an accrued liability of approximately $60 million.
  • Market Conditions: Volatility in financial markets and adverse economic conditions could impact customer demand and credit availability.

Investor Verification Checklist

• Organic Sales Trend: Verify the sustainability of the 2% organic decline and the severity of the expected Q4 drop.
• Cost Inflation Pass-Through: Assess the company's ability to pass on raw material and energy cost increases to customers without losing volume.
• Legal Exposure: Monitor developments in the label stock class action lawsuits and potential FCPA penalties.
• Debt Covenants: Confirm continued compliance with leverage and interest coverage ratios (currently compliant) amidst potential earnings volatility.
• Acquisition Integration: Track the realization of the projected $120 million in Paxar synergies against the $165–$180 million in associated cash costs.