AVY

Avery Dennison Corp. Q2 2006 10-Q Summary

Business Context and Reporting Period

This Form 10-Q covers the fiscal second quarter ended July 1, 2006. Avery Dennison Corporation is a global manufacturer of pressure-sensitive materials, retail information services, and specialty converting businesses. The company operates primarily in the Pressure-sensitive Materials, Office and Consumer Products, Retail Information Services, and Other specialty converting businesses segments. During the quarter, the company completed the divestiture of its raised reflective pavement marker business, which is now reported as discontinued operations.

Key Financial Metrics

Note: Total Debt is the sum of Short-term debt ($326.5M) and Long-term debt ($721.1M) as of July 1, 2006.

Material Changes vs. Prior Period

• Revenue: Net sales were essentially flat in Q2 2006 compared to Q2 2005 (-0.1%). Organic sales growth of 2% was offset by foreign currency translation (-1%) and divestitures (-1%).
• Profitability: Net income increased 25% in Q2 2006. This was driven by cost savings from restructuring, a lower effective tax rate (22.3% vs 22.6%), and a significant tax benefit ($15.4M) from the sale of the discontinued pavement marker business.
• Restructuring: The company recorded $6.1M in restructuring and asset impairment charges in Q2 2006, compared to $2.1M in Q2 2005. Cumulative charges for the first six months of 2006 totaled $13.3M.
• Accounting Changes: Effective Jan 1, 2006, the company adopted SFAS No. 123(R), recognizing stock-based compensation expense of $10.8M for the first six months. Additionally, shipping and handling costs were reclassified from SG&A to Cost of Products Sold.

Guidance, Outlook, and Risks

• 2006 Outlook: Management anticipates full-year reported revenue growth of 2% to 4%. Core unit volume growth is expected to be 3% to 5%, with a 1% positive impact from pricing/mix, partially offset by a 2% decline from divestitures.
• Cost Savings: Restructuring efforts are expected to yield annualized pretax savings of $85M to $100M when completed. Transition costs for 2006 are estimated at $15M to $20M.
• Financial Targets: Free cash flow is projected at $300M to $350M for 2006. Capital expenditures are expected to be $175M to $200M (or $200M to $230M including software). The effective tax rate is expected to range from 20% to 23%.
• Legal and Regulatory Risks: The company is subject to ongoing criminal and civil investigations regarding competitive practices in the label stock industry by the U.S. DOJ, European Commission (EC), Canada, and Australia. The company expects a material fine from the EC due to discovered employee misconduct in Europe but has not accrued a specific amount. Additionally, the company reported potential violations of the U.S. Foreign Corrupt Practices Act in China, expecting potential fines or penalties.

Investor Verification Checklist

• Discontinued Operations Impact: Verify the sustainability of Q2 net income growth, which includes a one-time $15.4M tax benefit from the sale of the pavement marker business.
• Antitrust Exposure: Assess the potential financial impact of the European Commission fine, which could be up to 10% of annual revenue, and the status of the U.S. DOJ criminal investigation.
• Stock-Based Compensation: Monitor the full-year impact of SFAS 123(R) adoption, with expected pretax expense of $19M for 2006.
• Working Capital: Review the increase in days sales outstanding (58 days in 2006 vs 57 days in 2005) and the impact of seasonal inventory builds on cash flow.
• Segment Performance: Analyze the 12% sales decline in the Office and Consumer Products segment due to divestitures and timing shifts in back-to-school orders.