AVY

Avery Dennison Corp. Q2 2003 10-Q Summary

Business Context and Reporting Period

This Form 10-Q covers the fiscal second quarter ended June 28, 2003. Avery Dennison Corporation operates in two primary segments: Pressure-sensitive Adhesives and Materials, and Consumer and Converted Products. The reporting period reflects the impact of recent acquisitions (Jackstädt, RVL, and L&E) and ongoing integration efforts. The Company announced an agreement to sell its European package label converting business, which is now classified as discontinued operations.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 14% in Q2 and 19% YTD compared to the prior year. Approximately 60% of the incremental sales were driven by acquisitions (Jackstädt, RVL, L&E), with the remainder attributed to favorable foreign currency exchange rates and organic growth in Asia and Eastern Europe.
• Margin Compression: Gross profit margins declined to 31.2% in Q2 from 32.8% in Q2 2002. This was caused by a shift in business mix toward lower-margin Pressure-sensitive Adhesives, higher raw material costs in Europe, start-up costs for new equipment, and transition costs from cost reduction programs.
• Interest Expense: Interest expense rose significantly to $14.5M in Q2 (from $9.7M) and $29.4M YTD (from $19.0M). This increase reflects higher debt levels from acquisitions and the refinancing of $400M in variable short-term borrowings into fixed-rate Senior Notes in January 2003.
• Discontinued Operations: The European package label converting business is now reported as discontinued operations. The Company expects to recognize a gain of $25M–$30M upon the completion of the sale, expected in late 2003.

Guidance, Outlook, and Risks

• Outlook: Management expects sales growth and productivity initiatives to drive profit improvement over the next 12 months. Capital expenditures for 2003 are projected at approximately $200M. The effective tax rate is expected to remain around 28% for the full year.
• Legal Proceedings (Critical): The U.S. Department of Justice (DOJ) has initiated a criminal investigation into competitive practices in the label stock industry. Avery Dennison is an unnamed "Leading Producer" referenced in the DOJ's complaint challenging the UPM/Bemis merger. The Company has been subpoenaed (or expects to be) and is facing multiple class-action lawsuits alleging antitrust violations and disclosure failures. Management states the effect may be adverse and material but is unable to predict the outcome.
• Cost Reduction: The Company is executing cost reduction programs initiated in 2001 and 2002, involving approximately 700 positions globally. Approximately $7.6M remains accrued for severance and lease cancellation costs.
• Foreign Currency: International operations constitute ~50% of net sales. The Company remains exposed to exchange rate fluctuations, which provided a favorable impact in the first half of 2003.

Investor Verification Checklist

• Antitrust Investigation Status: Verify the current status of the DOJ criminal investigation and the potential financial impact of the associated class-action lawsuits.
• Discontinued Operations Sale: Confirm the closing date and final proceeds of the European package label business sale to CCL Industries.
• Acquisition Integration: Assess the progress of integrating Jackstädt, RVL, and L&E, specifically regarding the realization of projected synergies and the impact on gross margins.
• Debt Structure: Review the amortization schedule of the $32.5M loss from the settled interest rate swap and the impact of the new Senior Notes on future interest expenses.
• Working Capital: Monitor the "Working Capital from Operations" ratio, which decreased to 8.0% of annualized sales, driven by higher accounts payable and receivable balances.