Avery Dennison Corporation (AVY) Earnings Call Transcript & Summary

Yes. Good afternoon. It's Lars Kjellberg, Crédit Suisse. Care to introduce Avery Dennison, who's going to be our next speaker. It's great to have Greg Lovins of -- as representing Avery Dennison's CFO. Greg will start with 15, 20 minutes of an introductory remarks and the presentation followed by Q&A. If you have any questions from the audience, please feel free to e-mail me at lars.kjellberg@credit-suisse.com. With that said, Greg, I hand over to you.

All right. Thank you, Lars. Appreciate the opportunity to be here with you today, at least virtually and share our story with you. So we've provided an update on recent business trends just a couple of days ago, which I'm happy to say have been stronger than what we had anticipated back in July. I'll touch on some of those developments today, but really more interested in sharing our long-term story, both the historical view as well as where we're heading. We feel we have a clear path to continued value creation, and that's driven by a balance of both profitable growth as well as capital discipline. And that balance across those 2 aspects helps drive strong consistent free cash flow and enables us to significant return cash on shareholders over time while also building value for our stakeholders. So I'll talk quite a bit about our story here as we go. Before I jump in, I just want to remind you, I'll be making some forward-looking statements today. So please take a look at the cautionary language. And I'll also refer to some non-GAAP financial measures, which are reconciled in the appendix of the slides here. So jumping in on Page 3. We've consistently delivered against our long-term financial targets. We've now got 8 consecutive years of double-digit growth in adjusted earnings per share. And we've delivered that through a combination of above-GDP organic growth and margin expansion. Our return on capital is top quartile compared to S&P industrial materials companies. And that, combined with our strong earnings growth, has really driven superior value creation, both in terms of EVA and also in terms of TSR. There's a number of engines for the continuation of that performance, and those remain strong for the long term. And while, of course, the pandemic and resulting economic impacts have slowed our trajectory here in the short term, we've -- our experience has demonstrated that our markets and our businesses are very resilient across economic cycles. And we expect our markets and our competitive positions in each of the segments to be even stronger as we come out of this one. There are 3 key drivers really of our ability to deliver superior value over the long term. First, we're extremely well positioned within our markets. In our 2 primary businesses, we're the clear market leaders, more than twice as large as our next largest competitors, and we have clear competitive advantages, and I'll touch on those here in a few minutes. Secondly, we serve large growing markets, with more than half of our total revenue tied to 2 key growth catalysts, and those are, what we call, high-value segments and our leadership in emerging regions. And that supports GDP-plus growth with improving margins as we go in the past as well as into the future. And third, we have a great track record of executing against our key strategies, and these apply across our portfolio. That is driving outsized growth in high-value categories and segments, profitable growth in our base business and achievement of our long-term sustainability goals. And we deliver against these key strategies through a relentless focus on productivity, on innovation and through disciplined capital deployment. And in there, we have a combination of product reengineering, restructuring as well as deployment of lean operating principles that continue to contribute significantly to our results. And that focus remains key to our long-term success, not just as a means for us to expand margins and to enhance our competitiveness, but also as a way to provide funding source for reinvestments. Over the past few years, we've ramped up our investments in both organic growth and productivity as well as M&A. And M&A, we view really as a catalyst to drive penetration in the higher-value categories. And we have ample capacity to continue returning cash to shareholders through disciplined share buybacks as well as a growing dividend. And this always allowed us to consistently deliver against our long-term financial commitments, ever since we first publicly announced our goals, like I said earlier, about 8 years ago. And we're confident that the continued execution here of these strategies will translate into superior long-term value creation going forward as well. So let me shift to the next slide here for a minute just to talk about the near term. We've been really impressed with how our teams have come together here to navigate in really what's one of the most challenging periods we've experienced as a company. Our focus continues to be on ensuring the health and the welfare of our employees, while we deliver for our customers and obviously, supporting our communities and minimizing the impact of this recession on our results and for our shareholders, and we're making solid progress on all fronts here. In particular, our sales so far this current quarter have been stronger than we anticipated, as I mentioned earlier. Coming into the quarter, we had expected an organic sales decline of about 7% to 9%. And now we expect roughly half of that rate of decline. Quarter-to-date, through the first few weeks of September, we're down about 2% ex currency and down about 4% organically. And we've shared our monthly trends from March through August on Slide 24 in the appendix, if you want to take a look at the details by business across the last number of months. But for those of you who may be newer to the company, let me provide a little context for the recent trends. Our largest business, Label and Packaging Materials, or LPM, which serves a key role and packaged goods supply chains globally. And that business experienced pretty significant surges in orders in March and April with the early parts of the pandemic, particularly in North America and in Europe. And that was driven by both increased consumption as well as some inventory builds. And that surge in demand created some large backlogs that carried us into early June, at which point, we started to see some slowdown in our sales in LPM, with a portion of that slowdown, we think, reflecting inventory destocking. And you can see that in the monthly trend chart that I mentioned, things stabilized globally for LPM in August and have remained stable so far for the first few weeks of September as well. In some of our more economically sensitive businesses, RBIS and the graphics portion of LGM in particular, we experienced some significant drops in demand in April during the early stages, particularly the lockdowns across the globe. Those businesses improved sequentially, faster than we had expected, frankly, in May and June and have continued to outpace our expectations here since then, with RBS down roughly mid-single digits through the first part of this quarter and graphics down around 10% thus far in Q3. So these solid improvements each month and then our trends here really speak to the resilience of our businesses, which we've also demonstrated, I think, in past recessions. And know the nature of this challenge is certainly different than ones in the past, historically, our businesses have continued to deliver strong free cash flow in periods of economic downturn, and our sales and our earnings have typically rebounded quickly in the year following a downturn. So a key focus of ours here in this lower-growth environment is on protecting our overall profitability. And as we said at the end of last quarter, assuming we continue to see some sequential improvement in demand trends over the balance of the year, we are targeting to deliver adjusted EBITDA margins for the full year in line with prior year. And that's despite the overall decline in volume that I've touched on. This relatively strong margin performance really reflects the successful execution of our strategies over the last number of years and the team's fast actions in implementing a number of temporary cost-saving measures as well as some benefits from some incentive compensation adjustments. And as we've talked about in previous earnings calls, keep in mind that the vast majority of the temporary actions we're taking here, we would expect to be a headwind for us when markets recover as well. At the same time, our balance sheet remains strong. We have ample liquidity, and we expect to generate free cash flow this year roughly comparable to what we delivered last year despite the volume challenges. In short here, we do feel like we're doing more than just weathering the storm. Our teams have been adapting quickly to the new commercial and operational norms. We've responded decisively with best practice safety measures, and taken a lot of significant and prudent cost reductions to protect our profitability here in the lower-growth environment, and at the same time, position us well to capture demand as the conditions improve. Importantly here as well, our strategic priorities are unchanged. We're preserving our investments to expand in high-value categories, particularly in our Intelligent Label platforms, while also driving long-term profitable growth in our base business. So let me, on the next slide, shift back to our broader story and take a step back with a quick overview of the company here. We operate in more than 50 countries, with the strong majority of our sales coming from outside the U.S. The Label and Graphic Materials segment, or LGM, makes up about 2/3 of our revenue base. And here, we provide pressure-sensitive material that's converted by our printing customers to make labels in large-format graphic materials. The next segment -- the next biggest segment is our Retail Branding and Information Solutions segment, or RBIS, and this is close to 25% of our revenue in 2019. This is our converting business, where we're manufacturing tickets, tags and labels for retail apparel products and it's also where the bulk of our RFID business comes into play today. And I'll touch on that here shortly. And then the Industrial and Healthcare Materials segment, or IHM, really rounds out our portfolio. And this segment consists of a number of application-based businesses, where we engineer and manufacture functional materials such as industrial and medical tapes. As I mentioned, our 2 primary businesses are the clear leaders in their markets, and our return on capital is top quartile in industrial firms. And both of these outcomes have been driven by strong and sustainable competitive advantages. First and foremost is our scale, which matters here not just for cost advantage, but also helps us drive customer service advantages and helps us deliver industry-leading innovation across our segments. We're also the only player in the label and graphic material space that's backward integrated into adhesive formulation and manufacturing as well as the design and manufacturing of some proprietary films within LGM. And our strong material science backbone and expertise not only drives cost efficiency here, but it's the engine of our product innovation across the company. On the next slide, you can see the 2 catalysts helping us deliver consistent growth above GDP. Those are our faster-than-average growth within higher-value product categories as well as our leadership in faster-growing emerging regions. On a combined basis, high-value segments in emerging markets represent about 60% of our revenue base in 2019, and we expect high single-digit growth from these categories over time. High-value categories include, as examples, especially Labels and Graphics in LGM, industrial and medical tapes in IHM and RFID within RBIS. And since 2010, these categories overall have grown organically at a compound rate of close to 10%, doubling from about 20% of the portfolio in 2010 to roughly 40% last year. At the same time, our emerging markets have also grown at a high single-digit pace since 2010 as well, shifting from about 1/5 of the portfolio to roughly 1/3 of the portfolio last year. And that's been driven by increased penetration of self-adhesive labels as these economies mature and more consumers are able to purchase more packaged goods, helping drive more volume with label materials. On the next slide, our largest and our most significant high-value category is what we call Intelligent Labels, or RFID within RBIS. And here, we've delivered significantly above-average growth with above-average margins and returns over the last number of years. Following on our acquisition of Smartrac earlier this year, RFID is now a more than $500 million revenue platform for us, which we expect to grow 15% to 20% over the long term, adding roughly 1 point to overall company growth here. And this strong growth will continue to be fueled by apparel, which represents about 75% of the business today, while we make great progress developing some of our other promising verticals. And we measure that progress on the other verticals through our project pipeline, and our customer engagements at the end of the second quarter were up more than 35% since the beginning of the year, within the categories outside of apparel really leading the way for us there. And we're continuing to invest here to expand this business both organically through acquisitions as well as through some venture and minority equity positions. Our recent acquisition of Smartrac really ticked all of our strategic and financial criteria: leveraging the combined channel access, global footprint and innovation capabilities of the 2 organizations. In terms of product portfolio, our process technology capabilities and just a larger R&D and business development teams, we're positioned here extremely well to develop solutions that meet the expanding customer needs with a particular focus on apparel, of course, but also beauty, food and grocery categories as well as the logistics segments. We also feel that COVID-19 has actually further strengthened some of the key drivers for RFID adoption. With new supply chain models requiring faster speed, better visibility, the need to potentially reduce staffing levels, increased demand for product sourcing and handling traceability, especially in food, increased importance of reduced contacted checkout and not to mention, of course, an acceleration of omnichannel retailing within apparel. And that's a leader here in ultrahigh frequency RFID. We're positioned extremely well to capture these opportunities. We've got industry-leading innovation and manufacturing capabilities. We've got the best, most experienced team in the space as well at the same time. Now as I mentioned previously, our general guiding principles are to deliver GDP plus growth with top-quartile returns. And we translate those objectives into specific long-term financial goals, as you can see demonstrated on the next page. This slide shows our progress against our third set of publicly announced long-term financial targets after meeting or beating the previous 2 sets of targets we had set. And we're a return-driven, EVA-focused company, and our targets reflect a balance of strong top line growth as well as margin expansion to sustain top-quartile returns while continuing to expand our EVA over time. And we really believe this is the right recipe to continue delivering above-average total shareholder returns over the long term. And internally, we characterize these targets as commitments. They're not just aspirations for us, the things we're committing to within our company. So we always have redundant strategies at play and multiple paths to make sure that we can deliver. And as a result of those multiple paths and our scenario planning from previous years, we entered this global crisis from a position of strength from a financial, operational and commercial perspectives. And our performance relative to the macro challenges we face, I think, have demonstrated the agility that comes from that forward planning and our strong positioning. Now at the same time, we communicated our financial goals through 2021. We also laid out a 5-year plan for capital allocation, which you can see on the next slide. And we've tracked well against this plan, starting with strong free cash flow generation. And while we've chosen to keep some powder dry in terms of our leverage, we put the total of $2.4 billion to work over the first 3 years of this cycle, allocating, as you can see here, very much in line with our long-term targets. And clearly, our current leverage position gives us ample capacity to continue our pace for investments for organic growth and acquisitions, while also continuing to return cash to shareholders in a disciplined way. Equally important to our progress against our long-term financial targets, we also continue to make solid progress towards our 2025 sustainability goals. In particular, we substantially reduced our environmental impact for operations, while focusing increasingly on developing innovative, more environmentally friendly products. And we don't have time in this forum to go into a lot more detail on our scorecard, but I would encourage you to visit our website for more details on ESG in general and our sustainability initiatives, in particular. To highlight just a few here as end of year-end 2019, we've reduced our greenhouse gas emissions by 32% since 2015. We've got over 88% of our paper now certified to be sustainably sourced, and close to 95% of our operations are landfill free. And we further improved our already top-notch employee engagement scores last year. So in closing, before I open it up for questions, I just want to highlight, particularly during this challenging period, we're maintaining our focus on creating value for all of our stakeholders. We continue to ensure the health and welfare of our employees, continuing to deliver for our customers and supporting our communities and of course, continuing to deliver superior returns for our shareholders. So with that, Lars, I'll open it up to you for some questions.

That's great. Thank you, Greg. Obviously, you've answered most of my questions anyway. It was an excellent presentation. I just want to stay with the near term for 2 seconds, right? You've obviously done an incredibly good job in taking out a slew of cost. I mean if you think about $1 billion EBITDA base and $150 million cost of temporary cost savings, it's a very significant number. So as we look into the recovery and you talk about these costs, broadly speaking, coming back, how should we look at the drop-through margins as you get a recovery in, call it, 2021? Let's hope we get there.

Yes. Thanks, Lars. So I think -- so as we talked about, we've got about $150 million of temporary or short-term, I would say, cost reduction actions. Out of that, I think you can break that down into about 3 components. One of those is incentive compensation cost reductions. The other are short-term belt-tightening type of actions like travel reductions and other short-term cost reductions. And then the others are really volume-driven, things like less overtime, less temporary labor, those type of things. So -- and each of those is probably roughly 1/3 or so of our -- of the total. So when you look at what comes back, certainly, with the volumes and the markets return, the volume-related aspects of that come back. Some incentive costs, compensation would probably increase next year as well. And then we'll continue to try to manage our costs down. I expect to continue managing travel as much as we can and continue managing our costs until we see broad stability across the markets here. So we would expect a fair amount of that to come back next year from that perspective. At the same time, though, we've been working on our long-term cost structure as well. So a number of restructuring actions this year. I think we've talked about in the last call about $60 million to $70 million of cost savings coming out this year, another $60 million or $70 million coming out next year incrementally. So that's incremental restructuring savings next year will offset at least a decent chunk of the short-term savings at -- or short-term cost at a return when the volumes come back.

Yes. That makes sense. So if you kind of look at the RFID area. Again, clearly, a strong core growth. You spoke about that in the -- the other day when you made the update, maybe a bit of catching up from a weak second quarter and looking into the holiday season. Are you seeing anything in the consumption pattern that would expect you to sustain this quite strong recovery that you're now seeing? Or do you see this as potentially a knock-up and then slow down a bit again as for maybe it's a bit of a catch-up on the exceptionally sluggish market you saw in the second quarter? Or is that not really a risk?

Well, it's a good question. I think it's -- as you alluded to, I think, Mitch the other day commented our RFID revenue. So far this quarter is up more than 20%. And I think that puts us up year-to-date somewhere in the kind of low to mid-single-digit range year-to-date basis. And again, about 75% of our RFID revenue is still in apparel. So we do see our apparel business, our RBIS segment doing better this quarter. Some of that, as you mentioned, we think, is due to retailers getting ready for the holiday period. And I think it's just tough to predict where that will go and where consumer spending and retail sales will go as we move through the back part of the year. So certainly, with a big part of our volume in RFID being tied to apparel, I think we'll wait and see how that develops as we move through the next couple of months.

That's fair. And then coming back to RFID, again. But again, talking about the opportunities, you have talked about very large opportunities, of course, in the food, logistics and other segments. And you also have been investing for that future growth, and yet you're still talking about this as a small business. So how should we see that? And can you give us a time line on when you think these investments will start to -- really start to pay off? And in the context of, call it, again, a time line of 1, 3 or 5 years, what this sort of business, apparel business could mean in terms of that footprint? And where do you really see the biggest opportunities in your pipeline today?

Yes. So we continue to expect -- so our -- as I said earlier, right now, we've got about a $500 million RFID business. It's about 75% apparel, as you said. And we continue to see runway within apparel and continue to see opportunities for growth in apparel. But now with about 25% of that revenue coming from outside of apparel, which has grown on a percentage basis, much more rapidly over the last couple of years. And even as we progress with apparel getting larger and that percentage growth maybe reduces a bit in apparel over time, we'll see that being filled in by growth in some of these other categories, like we talked about beauty and food and logistics areas. And we see some of the drivers for areas like beauty, for instance, to be very similar to some of the RFID drivers within apparel. So we're expecting over time to continue driving 15% to 20% growth in RFID into a combination of growth and continuing growth in apparel, but also starting to see some of those other segments grow more rapidly over the next number of years.

And Smartrac, you commented before that, that was about 50-50 between apparel and non-apparel.

Correct. So we account 90% apparel as a company prior to the acquisition, where Smartrac had a broader position outside of apparel. And that's part of the synergies with the acquisition is helping get more involved in more specialty applications, stronger in some of the other areas where we weren't as strong in outside of apparel.

LGM, if we switch to that for a second. I mean it continues to see very strong growth, and it's clearly your biggest segment. I would assume e-commerce plays a big role certainly this year and potentially as a longer-term driver as well. In what other areas are you seeing this year, robust volumes and areas of growth? And again, we can, obviously, in a way, fit that into potentially RFID as you talk in Intelligent Labels. So could you see these markets merging over time and as customers and then consumers want more Intelligent Labels that there's a real synergy between the 2 businesses?

Yes. So certainly, on your last point, I mean we continue to look at -- given our strong position in the LPM business and our access to -- we sell to over 10,000 converters across the globe. So strong access to converters that participate in many, many different markets. And we really look at that as an enabler of us to leverage our strong RFID capabilities and the technologies and the -- what we've shown we're able to do in apparel from an RFID perspective to really pull that into other segments. So we're continuing to work very closely between the LPM team and the RFID team as well as our new Smartrac colleagues here to continue to find ways to drive that through LPM. So that's going to be a piece that certainly is a part of the LPM strategy going forward is continuing to leverage our RFID capabilities throughout our LPM channels. Through -- I guess, the first part of your question, where we've seen other strength, particularly, I guess, early on in the pandemic, of course, it was in packaged goods areas where we saw people staying home more, eating from home, working from home, so buying more packaged food, buying more packaged household items as well. And so those are areas that we've seen stronger, particularly early on in the pandemic. Now that's kind of leveled out a little bit, I think, now that people have gotten more used to the situation across the globe here. But certainly, early on, that's where we saw some incremental growth.

One business from the outside when you kind of look into it is IHM, it's something you've been talking about from some time and talking about the opportunities and the potential strong growth from that area. I'm just a bit curious because you have the highest value -- highest share of high-value categories in the business, and I think you categorized that as around 74%. But it's the lowest margins. And while we can see some sort of logic between, I guess, the label business and the RBIS business. So the question is really, how does IHM fit into this? And why doesn't it add better margins given the high-value categories in that business? So what's -- essentially, what's missing for that business to perform in line with the sort of margin targets that you have, right, because it's been going on for quite some time.

Yes. So I think -- well, to answer the first part of your question, we share a number of strong things between LGM and IHM. So our manufacturing capabilities are basically the same. We're coating adhesives onto films and papers for tape, just like we would for a label material within LGM. And we share the same adhesive production and adhesive development team. So there's a lot of synergies from an R&D perspective as well as from an operational perspective between LGM. And now I'm sure you've heard us talk over the last few years about how we've been integrating some leadership there more, particularly in operations and R&D and other areas to help drive some of the improvements. And actually, I feel like prior to -- obviously, COVID challenges hitting us earlier this year and heavily impacting areas like automotive, which is about 1/3 of the IHM revenue base. We were starting to make progress and have been making some progress on IHM margins. And so we're continuing to work that path, and we feel like, over time, we still feel strong opportunities within automotive or tapes and adhesives to grow there as cars will continue looking at ways to get lighter, continue to reduce noise and vibration, and we think tapes and adhesives have a lot of runway there. We continue to see operation -- opportunities for medical tapes and adhesives as well. So we feel good about the markets that we participate in here, the opportunities that we have. And certainly, these are more cyclical businesses and they've been hit, particularly in automotive, more heavily here than some other parts of the company during this time. But we've started to come out of that a bit. We've seen in China where the businesses come out of the COVID challenges first. We've started to see some growth in China in our tapes business and in our Yongle Tape business there. So we still feel good about the opportunities here, about the ability to get our margins up where we'd like them to be and our ability to grow as the markets recover.