AVY

Avery Dennison Corp. Q2 2005 Filing Summary

Business Context and Reporting Period

This Form 10-Q covers the fiscal second quarter ended July 2, 2005, and the six-month period year-to-date. Avery Dennison Corporation is a global manufacturer of pressure-sensitive materials, office and consumer products, and retail information services. The company reported 110,462,275 shares of common stock outstanding as of July 30, 2005.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 7% in Q2 and 7.6% year-to-date. Growth was driven by favorable foreign currency translation ($41M in Q2, $75M YTD), pricing and product mix improvements, and modest core unit volume growth (1% in Q2, 2% YTD).
• Profitability: Net income rose 30.5% in Q2 and 21% YTD. This was significantly aided by a favorable comparison to 2004, which included $35.2 million in pretax restructuring and impairment charges related to the Jackstädt integration. 2005 charges were significantly lower ($2.1M in Q2, $5.4M net YTD).
• Cash Flow: Operating cash flow decreased significantly to $88.1 million YTD from $180.3 million in the prior year. This was primarily due to changes in working capital, including increased accounts receivable from higher sales, seasonal inventory builds, and timing of payments.
• Segment Performance: The Pressure-sensitive Materials segment saw operating income rise 63% YTD. The Office and Consumer Products segment saw flat operating income due to inventory write-offs. The "Other specialty converting businesses" segment saw a 77% drop in operating income due to RFID development costs.

Guidance, Outlook, and Risks

• Outlook: Management expects core unit volume growth to be flat to slightly positive for the full year 2005. They anticipate selling price increases and productivity initiatives will offset higher raw material costs. The effective tax rate is projected at approximately 24% for the full year, excluding potential repatriation impacts.
• Capital Allocation: Capital expenditures are expected to be approximately $200 million for 2005. The company plans to recognize stock option expense beginning in Q1 2006, with an estimated after-tax impact of $0.15 to $0.20 per share on diluted EPS.
• Legal and Regulatory Risks: The company is subject to ongoing criminal and civil investigations by the U.S. Department of Justice (DOJ), the European Commission (EC), and Canadian authorities regarding alleged anticompetitive 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. Multiple class-action lawsuits are pending.
• Other Risks: Risks include the ability to pass on raw material costs, economic conditions affecting demand, and the impact of the American Jobs Creation Act of 2004 on foreign earnings repatriation (potential tax liability up to $20 million).

Investor Verification Checklist

• Legal Exposure: Verify the status of the DOJ, EC, and Canadian investigations and the potential magnitude of the expected EC fine, which is described as "material" but unquantified.
• Working Capital Trends: Monitor the significant decline in operating cash flow and the increase in days sales outstanding (57 days YTD 2005 vs. 59.7 days YTD 2004) to ensure collection efficiency remains stable.
• RFID Investment: Assess the impact of continued spending on RFID business development on the "Other specialty converting businesses" segment margins.
• Stock Option Accounting: Confirm the impact of the delayed SFAS 123(R) adoption on 2006 earnings, as the company expects a $0.15-$0.20 per share reduction in diluted EPS.
• Debt Levels: Review the total debt reduction to $1.16 billion and the company's ability to maintain its A- credit rating amidst legal uncertainties.