AVY

Avery Dennison Corp. Q1 2005 Filing Summary

Business Context and Reporting Period

This Form 10-Q covers the fiscal first quarter ended April 2, 2005. Avery Dennison Corporation is a global manufacturer of pressure-sensitive materials, office and consumer products, and retail information services. The company operates in four reportable segments: Pressure-sensitive Materials, Office and Consumer Products, Retail Information Services, and Other specialty converting businesses.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 8% year-over-year, driven by a favorable foreign currency translation impact (~$34 million), pricing and product mix improvements (~$30 million), and modest core unit volume growth (~$27 million).
• Profitability: Net income rose 10% to $57.7 million. This increase was aided by a lack of significant restructuring charges in Q1 2005 compared to a $21.4 million pretax charge in Q1 2004 related to the Jackstädt integration.
• Cash Flow: Operating cash flow turned negative ($2.7 million) compared to a positive $65.5 million in the prior year. This was primarily due to a $105.4 million increase in working capital requirements, including inventory build-up for the back-to-school season and pending plant closures, as well as timing of tax payments.
• Segment Performance:
  • Pressure-sensitive Materials: Operating income surged 85% due to cost savings and the absence of prior-year restructuring charges.
  • Office and Consumer Products: Operating income declined 26% due to inventory write-offs, unfavorable product mix, and severance costs from a plant closure.
  • Retail Information Services: Sales grew 14%, but operating income fell 36% due to higher growth-related spending.

Guidance, Outlook, and Risks

• Outlook: Management reduced its full-year 2005 core unit volume growth estimate to approximately 1%, citing weak underlying demand in Q1 and difficult year-over-year comparisons. The company expects selling price increases and productivity initiatives to offset higher raw material costs.
• Cost Expectations: Annual pension and medical costs are expected to increase by $17–$18 million. Interest expense is projected between $55–$60 million for 2005.
• Legal and Regulatory Risks:
  • Antitrust Investigations: The company is subject to ongoing criminal investigations by the U.S. Department of Justice (DOJ) and the European Commission (EC) regarding competitive practices in the label stock industry. The company discovered improper conduct by employees in Europe and expects a material fine from the EC, though the amount cannot be estimated.
  • Class Actions: The company is a defendant in multiple purported class actions in the U.S. seeking treble damages and stockholder class actions regarding disclosure violations.
• Accounting Changes: The company plans to adopt SFAS No. 123(R) in Q1 2006, which will require expensing stock options. The estimated after-tax impact on diluted EPS for 2006 is $0.15 to $0.20 per share.

Investor Verification Checklist

• Antitrust Exposure: Verify the status of the DOJ and EC investigations and the potential magnitude of the expected EC fine, which could be material.
• Working Capital Trends: Monitor the reversal of the Q1 working capital build-up (inventory and receivables) to confirm the return to positive operating cash flow.
• Core Volume Growth: Assess whether the reduced full-year core unit volume guidance of 1% holds, given the slowdown in demand noted in March 2005.
• Restructuring Costs: Track the remaining transition costs associated with the Gainesville, Georgia plant closure, estimated at an additional $4–$6 million.
• Stock Option Expense: Confirm the impact of the delayed SFAS 123(R) adoption on 2006 earnings guidance.