Avery Dennison Corporation (AVY) Earnings Call Transcript & Summary

Morning, everybody. I'm George Staphos BofA Analyst for North America Paper/Forest and Packaging. Sorry for the technical difficulties early on in the delay, but we are incredibly pleased to be hosting Mitch Butier, Chairman and Chief Executive Officer for Avery Dennison Corporation, a company I've covered for the last 25 years. Mitch was elected to be Chief Executive Officer effective May 1, 2016, after serving as Chief Operating Officer in 2014. And prior to that, he was CFO. Mitch joined Avery in 2020. Mitch, thanks for waiting with us here and good morning. Very, very happy that you're here. We're going to open up with some near-term discussion, pivot to 2023 and then time allow and hit some other questions in the 30 minutes on this call. So again, Mitch, good morning. You have provided some guidance in November with your earnings call and then at [indiscernible] Industry Conference calling out some of the headwinds near term and in the high end of your guidance. Can you give us an update as we sit here today in terms of what you're seeing at Avery Dennison and as appropriate relative to current trends?

Sure, George. And thank you. Thanks for offering to host us here on this fireside chat. Good morning, everyone. So yes, as far as near term. So we're experiencing a challenging finish to what has shaped up overall as another great year. We expect to finish the year with double-digit organic growth and once again, double-digit EPS growth ex-currency. All while we continue to see more and more of our investments in growth, particularly Intelligent Labels come to fruition. Now that said, it is a challenging finish. The elevated inventory levels that we called out at the beginning of the year and further increase in the middle of the year are being reduced quite swiftly. While we expect double-digit top and bottom line growth, as I said earlier, we have seen a rapid increase in the pace of destocking in our customer base, particularly in LGM Europe. Quarter-to-date, mostly in November, revenue has been off our previous forecast by about $100 million. So we are activating our recession scenario plan that both take near-term cost reduction actions to partially offset and mitigate the lower volumes that I just commented on, while also protecting our investments in our high-growth initiatives, particularly Intelligent Labels. So while the pace of inventory reduction is coming quicker than we expected, George, we see the clear out of excess inventory is a good thing overall and remain as confident as ever in our ability to achieve our long-term strategic and financial objectives.

I guess the first question I would have after that, when your customers -- when you're talking with your customers, what makes them comfortable about the fact that this is more inventory destocking as opposed to reflection of something longer term in terms of consumer demand, to the extent that they have visibility and that you'd have visibility on that, obviously.

Yes. As we said -- as we've been talking about, we don't have a lot of great data out there about what inventory levels are, but it is a very consistent anecdotal voice from our customer base about the level of inventories and that they are now reducing them. And we had anticipated that why did inventory levels increase in the first place. With all the supply chain uncertainty and so forth, people were building inventory to make sure they could secure goods and also when we were going through high inflationary cycle, people wanted to build inventory to help reduce -- buy early before the next price increase. And both of those things are normalizing. So we're seeing normalizing supply chains, availability of goods. The inflationary environment has largely abated. And so that, combined with, I think, in some areas, some clouds on the horizon, particularly in Europe, around the outlook around consumer demand, all those things combined to the shift towards people wanting to have excess inventory to starting to reduce it.

Understood. And aside from the macro and the geopolitical issues in Europe, is there a particular reason from what you see in terms of why the destocking has been most pronounced in European LGM? And in turn, could you give us maybe a walk around the globe in terms of trends that you're seeing both in LGM and RBIS, and IHM in that regard?

Yes. So I mean the biggest adjustment we're seeing in inventory is, if you talk about LGM, and then I'll comment about RBS here in a moment, is really in the maturity. We're seeing it both in Europe and North America the biggest shift relative to our expectations are in Europe specifically. So why in Europe, there was a lot of concern around natural gas availability throughout the summer. So that was one driver. As we all know, there was a severe limit on paper availability at the beginning of the year. So those 2 constraints drove people to build inventory. And we saw some inventory builds in Q2, and that was in response to a very scarce raw material environment in Q1. And we saw even more significant inventory builds in Q3 a bigger than we had anticipated. And it's really the speed with which it's coming out. We knew that it will be coming out at some point, and we see that as a good thing, but it's coming out much quicker, beginning really in November in a meaningful way. And in North America, I think it's just around the same general factors. The inflationary, consistent inflationary price increases coming through are slowing down, reflecting the raw material environment. That, combined with the fact that it's a more stable raw material environment. Paper is still constrained. So we're seeing some inflation in paper and paper is still a bit constrained, but broad-based, we're seeing some normalization there. Elsewhere within LGM. So first couple of months within India, we continue to see good growth. China, as you'd expect, is from what you're seeing in the macro is having lackluster performance as well as you'd expect. That, I think, is more in demand and not inventory. And then within RBS, it's coming in. We had talked about this business tends to see a little bit more of an inventory shift. We've been discussing that. We talked about that quite a bit in the last earnings call. So we're -- that's continuing to play out largely as expected. There's probably a bit more inventory in the system here over the coming couple of months that we're working through.

Understood. And one question on RBIS. And to the extent that your business has shifted to being much less of a base label business and much more value add, does that destocking as it occurs provide perhaps more margin pressure and provide more cyclicality to your earnings? Or to the extent that you're dealing with a much more value-added product than previously. And if you could remind us on how the mix of your business has changed within RBIS over time. Does that make you a little bit more impervious to what's going on in terms of the cycle?

Yes. I mean still portion of the business is discretionary staples. We've been shifting the portfolio to less -- more to solid staples item. It's the acquisition of Vestcom for example, doesn't have the kind of impact you'd expect through recession largely tied to grocery and so forth. And Intelligent Labels, that's a huge growth driver. And for us, regardless of what economic environment, you can -- you might have for what it might be next year Intelligent Labels, we expect to be $1 billion plus business next year. So yes, there's definitely with the size of the apparel business as part of RBIS, and you'll have the near-term movements around inventory, have a near-term impact. But the strategies we've been deploying across the company and within RBIS specifically are to position ourselves for very profitable growth going forward as we focus more and more on high-value solutions.

Understood. And Mitch, as we think about -- and again, to the extent that you can comment and feel comfortable doing so, should we assume that fourth quarter price cost is neutral to positive or as we get into the first half of '23 that you're at that stage, you're obviously chasing costs like a lot of companies for most of the last 18 months. Can you remind us where you were and what we should expect on that metric if you can comment?

Yes. I mean, so overall, we maintain our pricing discipline, and we'll continue to do that. So I think the bigger question is around just what do we see around the inflationary environment. And it's tough to talk about averages here if you're talking about multiple regions, multiple commodities. So we will continue to maintain our pricing discipline. We talked about last earnings that things were starting to abate, and we had basically been caught up with a lot of the inflation that had already come through, and there were some incremental inflation still in some pockets coming through that we were making further price increases. So we'd expect that dynamic to hold going forward, we continue what we've seen over this cycle and the previous cycle of our pricing discipline would hold.

Okay. And I guess maybe to wrap up this portion. So you've mentioned that revenues are off about $100 million from your expectations for the quarter. I just want to make sure that I heard that correctly. And is there anything else that you would want us to take away in terms of what that might mean in terms of through the P&L and your expectations there?

Yes, I think it's just -- so the speed with which this adjustments happening is quicker than we've seen in the past. Again, we see it as a good thing, positioning us for continued profitable growth as we go into 2023, we're activating our recession scenario, as I commented on, and you've seen us do this in the last -- during the pandemic around just we're having some plant shutdowns between Christmas and New Year. We're using economic unemployment in Europe, which is something that we're not that familiar with here, but it's a way where the government supports when you're in a down environment. And then just good old-fashioned belt tightening as well that we're working through. Now that said, as you've seen before, George, there's usually a couple of month lag from those actions when you take them when they can help mitigate some of the volume shortfall. So immediately in the first month, it's more of the variable flow-through that you've traditionally seen.

No, that makes sense, Mitch, that makes sense. Maybe pivoting to '23 to the extent, again, that you can comment. I mean it's interesting that we've seen a number of consumer packaged goods companies who've had great success raising pricing over the last 12 to 24 months, beginning to cut costs more aggressively and unfortunately look to lay off people, you've had comments from the large retailers recently discussing that they're going to be a lot less willing to accept price increases than in the recent past. Are we at, in your view, an inflection point here on inflation? And you talked about cost reductions, what does it mean for Avery and its business model? And how quickly could you flex your cost structure if you needed to in '23 based on prior case studies?

Yes. So -- yes, as far as what the outlook is from an inflation, deflationary environment, this has been tough to call as we've gone through the inflationary environment. My judgment is, and we're seeing the same -- a lot of the same data you would see George and others would see -- is that the inflationary headwinds are dying down. And the question is, do those turn into deflationary more flat and that is a broad question. As I said, we will maintain our pricing discipline. So this is something that given the importance of the branding information, labeling solutions we provide, whether that's materials or full solution sets on their own. We know the value they bring and we'll maintain that pricing discipline. The thing is as you look at 2023, people have asked what's different. So as you look in it, while there's some clouds, as I said, people talking about some recessions are being called, mild recessions in Europe and North America potentially around end consumer demand. And we're looking at an environment where we're having more normalized supply chains, fewer constraints in paper in North America and Europe, in particular. Energy in Europe, I think once we get through the winter, we should be seeing a normalization there next year. Chips and Intelligent Labels are now becoming more available as we go into next year and really the year after. And we should absolutely, as I said earlier, expect less inflation and perhaps even deflation, and we will remain disciplined. I think you'll have a benefit of China being a bit unleashed here. We're starting to see some positive trends there. And again, chewing through the excess inventory early in the year. And the other big changes I already called out versus -- in 2023 versus 2022, we now expect Intelligent Labels to further accelerate and grow more than 20% despite any apparel inventory corrections that might be happening earlier in the year. So the open question, George, is really what's the strength of the macro and end demand. And I know everybody's got to come up with their own assessments of that. And what I can tell you is we are prepared for a wide variety of scenarios. And even in a recession scenario, we anticipate good top and bottom line growth.

And in terms of your ability in past case studies to flex your cost structure on a short-term basis, can you remind us what you're able to do going through the COVID. And if you can, what that means for the future? And if that is still indeterminate, obviously, we can leave that to the side. But remind us what you're able to do in the past and what that means for the future on the cost side?

Yes. So we pulled a significant amount of levers through COVID. And as I mentioned, there's a couple of month delay -- that we had a quarter where you saw the impact coming through then we were able to offset and we actually had income growth in 2020 despite all the challenges that were happening in the macro. So that's what -- yes, we're looking to do. And work through as far as our recession scenario.

Understood. I appreciate that Mitch. I want to switch a bit to Intelligent Labels in RFID. You said in the past -- recent past that you're investing ahead of the curve and what you're investing in now is for 1.5 years or 2 years from now in terms of demand, what is it that you actually need to invest? And is it capacity -- is it a technology gap that you need to resolve? What is investing ahead of the curve mean to the outside to the analysts and investors who focus on Avery Dennison?

Yes, sure. And George, maybe while we comment on that, I'll comment a little bit on some of the demand environment. And again, as I said it before, we're confident Intelligent Labels, which was a $700 million business last year will be more than $1 billion business next year in a variety of economic environments. And we've had some great continued development in the logistics space. In Q4, we're going to reach a 0.5 billion unit run rate with a new program, and it will be a multiple of that in 2023. In retail, we're seeing significant expansions underway outside of apparel, including some new use cases around -- we've just come to an agreement with a major retailer to use our technology and solution to begin using it for electronic article surveillance as well next year. So a lot of great use cases and to drive all that, this is the result, the fruition of a lot of the investments we've made in both innovation and technology as well as market development. And so we're going to continue doing that because we see even greater opportunity as well as hard assets, as you mentioned. So -- we are looking at a significant expansion of our hub in Southeast Asia, which is underway right now. We're looking to break ground on a new plant in North America in Q1. Obviously, we're buying all the manufacturing equipment for that expansion and so forth and we'll continue, as I said before, the OpEx investments, both for commercial and technology innovation. So -- and we'll continue to use, as you've seen, M&A and our venture investments to complement our organic developments. And as you saw, TexTrace, the small investment acquisition we made is a great example of that, where we bought a new technological capability, and that's one of the key enablers to the EAS program I mentioned earlier.

Understood, Mitch. One thing on new areas for IL. And I think in your last Analyst Day, you talked about logistics being a $60 billion unit addressable market. If we assume some normal growth and you ultimately getting to your normal share, in logistics as you are in apparel, which is rather large. I mean, is logistics -- can logistics be on the IL side, a $1 billion-plus opportunity for you, say, next decade, early 2030s. How would you have us think about that, if at all, in terms of putting some numbers on it.

Your math that you walked through and your timing are very reasonable, George.

We try, Mitch, we try. One quick question. Just why should we expect to see IL accelerate next year beyond 20% given the obvious headwinds that we're seeing in apparel, is it just that the value proposition goes up that much more. We've got labor constraints. We have other cost constraints. Inflation maybe is abating, but it's not dead. Maybe I'm answering the question for you. But the obvious one is, hey, apparel is so big to IL. Apparel is going to be weak, why won't IL also be weak. Help us kind of solve that.

Well, the strength of the growth in the programs that I mentioned are more than offsetting that. So around logistics as well as the areas outside in retail outside of apparel. And to me, a great testament just to the solutions we're providing are that the retailers who have multiple categories are expanding quite quickly to other categories as well. And then the other -- and we talked about this during the pandemic as well. This type of environment is one that is a -- where our technological solutions enable automation, reducing lead times, giving greater visibility, reducing labor intensity of people's operations -- this is an area where people do want to invest. And that's what we saw during the pandemic. There was actually an acceleration, a heightened focus around bringing on our technological solutions. And we would we're seeing that now, and we would expect to continue to see that.

Okay. And switching gears to LGM, it sounds like paper supply chain is reasonably back to normal? Would that be fair? And similarly, within the other inputs that go into LGM, where do you stand in terms of supply chain now? And it sounds like the order book caught up and then some in LGM in the third quarter. Is it possible to talk about, again, the degree to which you'll have to see destocking there or maybe thinking about it differently, what you think your customers' consumption is relative to what your shipment exit rate was going into the fourth quarter? Any things there that you can share that we can then size up how long the destocking might last?

Yes, George. So your first point around supply chains and paper getting normal, I would say it's normalizing, but not yet. So it's still normalizing and there's still a couple of pinch points on the paper supply less so in Europe, more so North America remaining there. Yes, as far as what we're seeing as far as the pace of this, this is a pretty significant shift in the pace of inventory levels. As I said, we see this as a good thing if it continues at this pace, we'll be through it quicker. And that's -- it's happening different than what we've seen in the past is actually happening in North America and Europe at roughly the same time. So whereas in the past, it would kind of be one region would seen inventory reduction than another one. We're seeing it basically at the same time, given the interconnection more of supply chains now than we've seen historically. So I -- we're prepared for multiple scenarios. I'm not going to give a prediction. I think what we're doing right now is seeing things go from excess inventory to more normal inventory, and that could take us into early next year. And question is really what your assumptions are around the macro and what the impact of that would be.

Understood, Mitch. Maybe to wrap up. And again, thank you for your time. Thank you for allowing us to host this update call where you showed some of your thoughts. We've seen the invested capital of Avery move up a bit with the acquisition of Vestcom and some other acquisitions. Tell us why investors should be comfortable about that pickup and really the yield you're getting on Vestcom as a business within the overall portfolio. Given the macro uncertainty, how should we expect your capital allocation strategy might change or might not change. What will the priorities be? And then maybe to finish it up its like the earnings call where we get 1 question, we try to jam 15 into them. Bigger picture, what should investors be taking away from this? And what should we expect from Avery in the years to come?

Thank you, George. Yes. So as far as the capital side, it's basically a reflection of the increasing growth prospects that we have, and that's what we've been investing in. And so that -- if you I think the overall area you say, what should give investors comfort is that the investors know we are an EVA-driven and focused company. And it's the largest part of our incentive-based compensation around that. So that's something that we are -- everything we do down to looking at individual customers, solution categories, product categories that's what shapes our capital allocation, decisions about where we nurture where we see new investment where we harvest. So that very much reflects I think the surge in growth in LGM, LPM, specifically over the last couple of years, in addition to all the intelligent labels investments required some incremental investment over that time, and that tends to be step function change and we've been through that period, and I would expect that to start normalizing in the coming couple of years. Yes. As far as going forward, what should people expect, people should continue to expect great things from us. We've got a tremendous amount of momentum. We continue to grow profitably in our base businesses while we've been shifting the portfolio to more and more to higher value solutions. Our focus is on sustainable innovation. We're a leader in our space. We're looking at more and more harnessing the capability and opportunities around digitization in general and automation and we're doing that by leading within intelligent labels our broader platform. And so overall, superior value creation for all of our stakeholders, including our investors, is what the investment community should expect over the coming years.

Mitch, very clear. Thank you so much. Really appreciate again you allowing us to host. We wish you the best of everything, the rest of the quarter and for the holiday season and the same for everybody who's listening in. Thanks so much from BofA, and we wish you all a great rest of the day. Thanks, everybody.

Thank you, George.

Thank you, Mitch.