Avery Dennison Corporation

Ladies and gentlemen, thank you for standing by. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session. At that time, if you have a question, please press the 1 followed by the 4 on your telephone. If at any time during the conference you need to reach an operator, please press star 0. Welcome to Avery Dennison's earnings conference call for the fourth quarter ended December 28, 2019. This call is being recorded and will be available for replay from noon Pacific time today through midnight Pacific time February 1st. To access the replay, please dial 800-633-8284 or plus 1-402-977-9140 for international callers. The conference ID number is 21930677. I'd now like to turn the conference over to Cindy Gunther, Avery Dennison, Vice President, Investor Relations and Finance. Please go ahead, Madam.

Thank you, Jennifer. Today we'll discuss our preliminary, unaudited, fourth quarter and full year results. Please note that throughout today's discussion, we'll be making references to non-GAAP financial measures. The non-GAAP measures that we use are defined, qualified, and reconciled with GAAP on Schedules A4 to A8 of the financial statements accompanying today's earnings release and the appendix of our supplemental presentation materials. We remind you that we'll make certain predictive statements that reflect our current views and estimates about our future performance and financial results. These forward-looking statements are made subject to the safe harbor statement included in today's earnings release. On the call today are Mitch Butier, Chairman, President, and Chief Executive Officer, and Greg Lovins, Senior Vice President and Chief Financial Officer. I'll turn the call over to Mitch.

Thanks, Cindy. Good day, everyone. I'm pleased to report another year of strong adjusted earnings growth, with EPS up 9% or 15% on a constant currency basis, despite lower than usual organic growth of 2% due to challenging market conditions. As you know, our focus in the slower top-line growth environment is on protecting our margins in the base business while driving faster-than-average growth in high-value categories like RFID. We are executing well on both fronts, while investing to drive future growth and further strengthen our competitive position. We are largely on track to achieve our long-term financial targets that we communicated three years ago. Greg will walk you through the scorecard in a moment. Our consistent performance reflects the resilience of our industry-leading market positions, the strategic foundations we've laid, and our agile and talented workforce. Our mission is to create value for all of our stakeholders through innovation, operational excellence, and highly disciplined capital allocation. These fundamentals drive the successful execution of our core strategies, in particular, achieving outsized growth in high-value categories, driving profitable growth in our base business, and attaining our ambitious 2025 sustainability goals. In 2019, we made good progress on all of our strategic priorities. High-value categories in emerging markets remain our two key catalysts for GDP-plus growth across our entire portfolio, with over half of our total sales linked to one or both of these. In 2019, high-value categories in emerging markets again grew faster than the average. High-value categories were up mid-single digits, with RFID alone contributing nearly a full point to total company sales growth. Our base business declined modestly, reflecting LGM market share that we see is at the tail end of the last inflationary cycle that we discussed previously. Importantly, LGM's volume trend improved in the back half of the year as we recovered that share. We expect this volume improvement trend to continue into 2020. Our continued focus on operational excellence, which has long fueled our industry-leading service and quality, was again a key enabler of significant productivity gains. The combination of product reengineering, restructuring, and the deployment of lean operating principles enabled us to again expand margins, further enhance our competitiveness, and continue providing a funding source for reinvestment. Equally important, we continue to make solid progress towards our 2025 sustainability goals. You'll be able to read more about this in our new integrated annual report that will come out in March. Just a few highlights. As of year end 2019, we've reduced our greenhouse gas emissions by more than 30% since 2015. Over 85% of our paper is now certified to be sustainably sourced. Close to 95% of our operations are landfill-free. And we further improved our already top-notch employee engagement scores. Now, looking at how our strategies played out in each of our segments. Label and graphic materials delivered modest organic growth under challenging market conditions. The base business was flat overall for the year, which, as I mentioned, reflects that share loss that we largely recovered by year-end. High-value categories once again grew faster than the base, albeit at a slower pace than we're used to due to softer end-market demand. Likewise, emerging markets also grew faster than average, though slower than usual, with strength in India and South America offsetting weak demand in North Asia. At the same time, LGM's adjusted operating margin expanded another 30 basis points to 13.3% in this already high return business as we completed the restructuring of this business's European footprint mid-year. Over the past couple of years, LGM has successfully navigated through a significant inflationary cycle as well as the subsequent transition to the modestly deflationary cycle that we've been seeing more recently, demonstrating the resilience of our business model. Given our strong leadership position in the industry, we are willing to take some year-term share risks through these cycles, knowing that our superior product quality, service, and cost position will ultimately win out. So, while 2019 proved more challenging, reflecting both market-driven headwinds and some missteps on our own part, we are well positioned for profitable growth in 2020 and beyond, with excellent returns in this business. Retail branding and information solution sales increased by more than 5% on an organic basis, driven by over 20% growth in high-value categories, that is RFID and external embellishments. The base apparel business declined modestly, reflecting market demand that was impacted by trade-related uncertainty. While there are signs of potential resolution of this uncertainty, some customers may further rebalance their supply chains. Our global footprint, along with our differentiated product and service capabilities, gives us a significant competitive advantage to win over the long term as we partner with our customers to support their evolving sourcing strategies. Enterprise-wide, RFID products and solutions grew by more than 20%, generating roughly $365 million of sales, reflecting ongoing penetration of apparel, as well as expansion in relatively new verticals, including food, beauty, and logistics. our total pipeline of customer engagements continues to expand. Compared to this time last year, our number of customer engagements, from business case to rollout, is up 50%, driven primarily by categories outside of apparel. As the leader in ultra-high-frequency RFID, we are positioned extremely well to capture these opportunities with industry-leading innovation and manufacturing capabilities and the best, most experienced team in the space. and we continue to build out this platform, increasing our levels of investment to drive growth both organically and through acquisitions and external partnerships. To that end, our purchase of SmartTrack's inlay business, which we expect to close late this quarter, represents an excellent strategic fit for us. Combined, RFID becomes a more than $500 million business, expected to grow 15% to 20% annually over the long term. SmartTrack's capabilities complement our existing product offerings and process technologies while expanding our intelligent labels platform to better serve industrial and retail segments. And their global manufacturing footprint, likewise complementary to our own, strengthens our inlay manufacturing capacity and capabilities. Turning to profitability, RBIS's adjusted operating margin expanded another 120 basis points for the year. The team has done a tremendous job transforming RBIS into a simpler, faster, and more competitive business over the past four years, and we're pleased with the performance we're seeing here. Shifting now to industrial and healthcare materials. Although sales growth was modest for this segment, we believe we outpaced the market across most categories. And, importantly, we made substantial progress towards our 2021 profitability targets, driving 140 basis points of adjusted margin expansion. We've strengthened our management team here and fine-tuned our strategies. We remain confident that this segment will deliver significant value over the medium to longer term. All in all, 2019 was another solid year. As we reflect back on the last few years, we are pleased with how we have leveraged our foundational strengths in operational excellence and innovation to consistently make progress towards our long-term goals to deliver GDP plus growth and top quartile returns on capital. We have driven outsized growth in high value segments while also growing profitably in our base businesses. We have substantially reduced the environmental impact of our operations while focusing increasingly on the development of innovative, more environmentally friendly products. We have continually driven productivity that has enabled us to ramp up our pace of investments in high value segments, particularly RFID, while also expanding margins. And importantly, this progress has been made possible by our amazing team that's dedicated to delivering for all of our stakeholders in a dynamic environment while upholding our longstanding commitments to integrity and excellence. As we look to 2020, we are confident we will continue to make progress on our strategic fronts, including the next evolution of our leadership structure and wave of productivity initiatives. As you know, we have had a theme over the last few years to move more and more decision making closer to our markets, both to increase speed and lower costs. Along these lines, we are now consolidating our corporate and group functions for LGM and IHM. In addition to making the leadership structure nimbler, this and other productivity initiatives we've recently launched will yield significant savings through 2021, enabling us to continue to increase our pace of organic investments while also expanding margins. So, once again, we're pleased with the progress we've made toward our long-term goals over the last few years, and in 2019 specifically, and we expect to make continued progress in 2020. As for guidance, we expect adjusted EPS of $6.90 to $7.15, with our outlook reflecting improved volume growth and continued productivity gains, partially offset by incremental investments and transition costs associated with our next wave of restructuring actions. I'll now turn the call over to Greg.

Thanks, Mitch, and hello, everyone. I'll first provide an update on our performance against our long-term goals and then walk you through fourth quarter performance and our outlook for 2020. Slide seven of our supplemental presentation materials provides an update on our progress against the five-year targets that we communicated in 2017. And recall that this represents our third set of long-term goals after meeting or beating our previous two sets of long-term targets. As you can see, we are largely on track. Specifically, over the past three years, sales growth on a constant currency basis is in line with our target, up 5.7% annually, while organic growth was close to 4%, just slightly below our target due to the generally slower demand environment in 2019. A reported operating margin hit nearly 11% in 2019, or 11.7% on an adjusted basis, up from roughly 10% in 2016. And due largely to that combination of strong top line growth and margin expansion, adjusted earnings per share was up 18% annually. Return on total capital, adjusting for the distortion related to determination of our U.S. pension plan, came in close to 20% for 2019, well above our 17% target that reflects top quartile performance relative to capital market peers. And our balance sheet remains strong, with our net debt to EBITDA ratio below the low end of our target range. Our consistent progress towards achieving these long-term goals reflects the diversity of our end markets, our strong competitive advantages, and our resilience as an organization to adjust course when needed. Together, these give us confidence in our ability to deliver GDP plus growth in top quartile returns on capital over the long term. Now, at the same time that we communicated our financial goals through 2021, we also laid out a five-year plan for capital allocation, which you can see on slide eight. We're tracking well against this plan, starting with strong cash flow generation, and we put a total of $2.4 billion to work over the first three years of this cycle, allocating it largely in line with our long-term plan. And clearly, our current leveraged position gives us ample capacity to continue our pace of investments for organic growth and acquisitions, while also continuing to return cash to shareholders in a disciplined way. Now let's focus on the fourth quarter. Overall, financial results were solid, with adjusted earnings per share of $1.73, up 14% versus prior year, and about a nickel better than our expectations. We grew sales by 2.1% on an organic basis and currency translation reduced reported sales growth by 1.9 points in the quarter. Adjusted operating margin increased by 80 basis points to 11.9%. And we realized $18 million of restructuring savings net of transition costs in the quarter due in part to LGM's restructuring in Europe. And our cash generation has been strong as we delivered $512 million of free cash flow for the year up roughly $83 million compared to 2018. And this increase reflects both profit growth and improved working capital efficiency. The fixed and IT capital spending, total fixed and IT capital spending came in at $257 million in 2019, which was in line with prior year and a bit lighter than we had expected due to the delay of some spending related to project timing at year end. Utilizing our strong cash flow, we returned $427 million in cash to shareholders through a combination of share repurchases and a higher dividend, in line with the average amount of cash distributed to shareholders over the preceding two-year period. Turning to segment results for the quarter, label and graphic material sales increased by 1.5% on an organic basis, driven by the net effect of volume and mix partially offset by pricing. LGM's base business and high-value categories were both up below single digits in Q4. The base business sales trend improved from earlier this year, reflecting easier comparisons due to the timing of share loss at the end of 2018 and early 2019, as discussed previously. And high-value category growth slowed in the quarter, reflecting a decline in graphic sales due to a challenging prior year comparison in North America, as well as generally softer end-market demand in the quarter. Stepping back to look at LGM sales trends through the course of 2019, organic growth has been relatively stable, between 1.0 and 1.5% each quarter. In the first half, though, volume and mix represented a net negative, with price adding roughly 2.5 points. While in the second half, volume and mix were net positive, with price becoming a headwind by the fourth quarter. Given the sequential deflation that came through in the third and fourth quarters, we do expect pricing to be a roughly one-and-a-half-point headwind to LGM's organic growth in 2020, with the toughest price comp impacting us here in the first quarter. Breaking down LGM's organic growth in the quarter by region, North America declined at a low single-digit rate, reflecting what we believe was a relatively flat market along with lower prices. Western Europe grew at a low single-digit rate, driven by modest market growth and share gain partially offset by pricing. Emerging markets were up low to mid-single digits with relative strength in South Asia, Eastern Europe, and South America, partially offset by a modest decline in China. An operating margin for the segment was strong, up 40 basis points on an adjusted basis to 13.3%. As the benefits of productivity initiatives increased, and the net impact of raw material deflation and pricing were partially offset by unfavorable product mix. Shifting now to retail branding and information solutions, RBS delivered another quarter of strong top-line growth, up 5.2% on an organic basis, driven by continued strength in RFID and external embellishments, which were up more than 20% on a combined basis. Our base business, adjusted for the migration of products to higher value RFID solutions was up slightly versus prior year, a modest improvement compared to Q3 and in line with our expectations. Adjusted operating margin for the segment expanded by 140 basis points to 13.6% as the benefits from increased volume and productivity were partially offset by higher employee-related costs and growth-related investments. Turning to the industrial and healthcare materials segment, sales declined by 1.1% on an organic basis, as a low single-digit increase for industrial categories was more than offset by a mid-single-digit decline in healthcare. We continue to make solid progress on the margin front in IHM, beating our 10% margin goal for the full year. For Q4 specifically, adjusted operating margin increased by 60 basis points to 10.2%. as the benefits of productivity gains and strategic pricing initiatives more than offset higher employee-related costs. So turning now to our outlook for 2020, we anticipate adjusted earnings per share to be in the range of $6.90 to $7.15. We've outlined some of the key contributing factors to this guidance on slide 14 of our supplemental presentation materials. We estimate that organic sales growth will be approximately 2% to 3%, with the midpoint of that range reflecting the carryover effects of the share we recaptured in LGM partially offset by expected price reductions associated with the deflation that we've been experiencing. Our 2020 fiscal year contains 53 weeks, ending on January 2, 2021. The extra week, which we pick up in the fourth quarter, it's expected to add about one point to reported sales growth, with no impact on organic growth. And note that the extra week crosses over the New Year's holiday, so it's expected to be a low-volume week with lower-than-average profitability, and we expect it to add an estimated 10-cent benefit to EPS. And we expect that the SmartTrack acquisition will add about one-and-a-half points of growth for the year, assuming the deal closes late this quarter. Given transition costs and interest expense, we expect the acquisition will be modestly dilutive to earnings in 2020, roughly offsetting the benefit of the extra week, though the effects of the two will not be equally distributed through the year. At recent rates, currency translation is a 30 basis point headwind to reported sales growth, with a headwind in the first half, particularly in the first quarter, becoming a slight tailwind in the fourth quarter. And we estimate incremental pre-tax savings from restructuring net of transition costs will contribute between $30 and $40 million in 2020. And note that a meaningful portion of the savings associated with the restructuring charges we've taken recently will not be realized until 2021, likely on the order of $30 million. We expect that both the GAAP and adjusted tax rates will be in the mid-20s for the full year. with variability in the gap tax rate from quarter to quarter as usual. And we anticipate spending $220 to $230 million on fixed capital and IT projects down from the previous two years as anticipated. The cash payments associated with our restructure initiatives are likely to come in around $35 million, roughly $20 million lower than the past year. And we estimate average shares outstanding assuming dilution of roughly 84 million. Finally, while the coronavirus situation in China is very fluid, in its early days to assess its full impact, we factored in up to a nickel headwind to our EPS guidance, reflecting the mandated delays and starting back up following Lunar New Year that's impacting many regions in China in which we operate. And, of course, our first priority is ensuring the health and safety of our employees, and that's the focus of our team right now. So in summary, we're pleased with the strategic and financial progress we've made against our long-term goals in 2019, and we're committed to delivering exceptional value through our strategies for long-term profitable growth and disciplined capital allocation. Now we'll open up the call for your questions.

Jennifer? Jennifer?

Thank you. Ladies and gentlemen, if you'd like to register a question, please press the 1 followed by the 4 on your telephone. You will hear a three-tone prompt to acknowledge your request. If your question has been answered and you would like to withdraw your registration, please press the 1 followed by the 3. If you're using a speakerphone, please lift your handset before entering your request. To accommodate all participants, we ask that you please limit yourself to one question and one follow-up, and then return to queue if you have additional questions. One moment, please, for the first question. Our first question comes from the line of Gashan Panjabi with Robert W. Barrett & Co. Please proceed with your question. Please go ahead. Your line is open.

Sorry about that. Hey, guys, how are you? I guess, you know, first off on the 2.5% core sales growth that you're guiding towards at the midpoint, can you sort of break out that construct further by segment? I know you call that a 1.5% or so price headwind for LGM, but what about volumes for each of the segments? And for the coronavirus impact and the nickel that you have baked in, will that impact, you think, both segments, LGM and RBIS, or is it specific to one?

Yes, the first concept on the growth are 2% to 3%, as I talked about, includes volume growth a bit higher than that with about a point and a half of price headwind in LGM, which is about a point to the full company. So we expect a little more volume growth, particularly in LGM, some of the carryover share gains that we had in 2019. And then within RBS, we expect to continue to see strong growth in RFID, contributing similar level of growth for the company that we saw in 2019. Okay. So I think that's the biggest drivers of growth between LGM and RBS for the year. We look at the coronavirus impact. Most of what we factor in that nickel is related to the materials businesses, since those are generally serving demand that's created in China, and that's the biggest impact. And that nickel basically is based on about a week starting up later, post-Chinese New Year. Within RBIS, the factors there are generally serving demand in the other regions. So we do foresee some potential delays of shipments from Q1 into Q2, depending on how this plays out over the next couple months. But the demand, we think, wouldn't be as effective as it would be in the materials businesses.

Yeah, to just add to that, obviously a fluid situation. Our first priority, as Greg noted earlier, is ensuring the safety and health and well-being of our teams. And second, too, ensuring we're supporting our customers as they work to support their overall end market demand as well through this environment. So pretty fluid. Our guidance considers just one week basically lost sales and lost consumption for the direct, for the consumption in region. Just a shift from Q1, Q2 for end demand that's serviced from China to outside of China.

And the confidence, Mitch, on the volume improvement, is that based on visibility you have on share gains? Or are you seeing a better macroeconomic backdrop as the year unfolds? What do you have embedded in there?

We used the base broad economic forecast that you would be looking at as well for 2020, but the specific improved trends reflects the improved trends we saw in 2019, particularly at LGM. And if you recall, the first half, we're comping lower share positions within LGM within that business. Then hopefully on the RBS side, outside of RFID, which we continue to expect continued strong growth, both there and external embellishments. But we had a some negative impacts from the volatility just around the tariff situation and so forth. So that's – we do expect an improvement overall. A lot of it's just comping some weaker trends that we saw, particularly in the first half in LGM.

Okay. And then for my second question on RFID, you know, legacy Avery RFID has been growing, you know, pretty steadily at, you know, probably 20% or so a year. How does that compare to SmartTrack in terms of their growth rates? What does it add from a technology standpoint to Avery? And which particular end markets are you getting incremental exposure to? I think you call that industrial and retail ability. So just more clarity there. Thanks.

Yeah, so SmartTrack was a leader in developer and manufacturer and RFID inlays. The new technology it brings us is areas such as NFC, so near-field communications, as well as sensors around moisture and temperature sensors and so forth. And a number of new applications. I mean, they obviously serve the base apparel business like we do, but they also bring a number of new applications such as interactive garments that, you know, enable people, for example, in ski jackets to have real-time interaction through social media, using connected and smart appliances, toys. There's a number of various end applications. And from an end market perspective, increased expansion exposure within retail and then also in the automotive sector as well. So those are some of the new capabilities and technologies that it brings. And as far as growth, their growth rate is below ours. So we've talked about our long-term growth objective being 15% to 20% plus organically. We've been delivering around 20%, as you suggested, John Shum. We're now saying the combined NC we expect to be 15% to 20%. The reason their growth was slower was just they were growing slower in retail with Avery organically taking a bit of share each year in the space. But in two, just automotive saw a little bit of a slowdown, particularly in 2019 for all the other reasons that we've been talking through. So very strategic acquisition brings us great capabilities, and we're confident we're going to be able to deliver 15% to 20% growth with the combined entity. with margins above the average profile consistent with what we've been delivering so far.

Our next question comes from the line of George Spassels with the USA Securities. Please proceed with your question.

Hi, everyone. Good morning. Thanks for taking the question. How you doing? First question I had was on the restructuring, Mitch and Greg. If you could provide a little bit more detail, and to the extent possible, I recognize that you can't share everything, obviously, but what's involved with the next restructuring action? You mentioned, I think, combining some back office or organizational structures between LGM and IHM. What else is involved down the road? You know, might we see some, you know, further production capacity melded together or, you know, folded in given the investments that you've made? And what do you say is your actual net benefit from productivity and restructuring actions this year? I know there's some that will trail into 21 and beyond, but what do you get this year, net of transition costs?

Yeah, so I'll answer the first part of the question. Greg can cover the outlook for the statements. So specifically, George, I mean, again, the next wave of restructuring actions that we are recently unfolding, the biggest single one there in the charging Q4 relates to the consolidation of the functions between IHM, corporate, and LGM. So it's exactly what you called out. We see an opportunity to move faster and reduce costs by better integrating and removing that extra functional level. to be able to deploy more of those resources locally for driving growth. So that's the largest area of the restructuring. There's a number of other initiatives, and we'll comment on those in due time.

Yeah, thanks, Mitchell. I think from the savings perspective, in 2019, we had about $50 million of restructuring savings net of transition costs in the year. As we said earlier, we expect that to be about $30 to $40 million in 2020. with about 20 to 25 million of that being carryover from the actions that we did in 2019. The largest part of that carryover, of course, coming in in the first half from that European footprint action.

Our next question comes from the line of Anthony Cuninari with Citigroup Global Markets. Please proceed with your question.

Good morning. Hello. In LGM, it sounds like high-value products were really strong for the year, but graphics and reflectives were down a little single digits in 4Q. I think you talked about a tough comp, but I think you also mentioned demand maybe being a little bit softer. And I was wondering if you could tease out the impact of those two factors and kind of any thoughts on what you're seeing in graphics and reflectives in 1Q or what you expected.

Yeah, so not much view yet in 1Q, just given the early start to the year and where we are right now. I think in the fourth quarter, we did have probably an even split between the challenging comps, particularly in North America from prior year, and a little bit of slowness across the other regions from a graphics perspective. Still last year, we grew in, I think, low to mid single-digit range for graphics overall for the year. So, you know, we'd expect to get closer to that level for full year 2020 as well.

Okay, that's helpful. And then just on RFID, there's a Japanese producer that made an announcement about printable ICs that can maybe reduce tag prices to two cents or less. And I guess without talking about any particular competitor, do you think printable IC technology is something that could potentially be impactful to the RFID business? Is it really something that's new? Just any just general thoughts about that in RFIDs?

Yeah, that development specifically is relatively early stage. I'm not going to talk too much about the specific development, but overall we're quite close to the developments in the industry. We're a leader in the space, and we look at anything that expands the product offering, including lowering the cost, even if it's got more reduced storage capacity, as being good for the industry and good for us. So it's something we're close to and following, but yeah, I can't give too many specifics, but there's a number of developments going on, just like we're developing within our pragmatic venture investment that we have another route to low-cost basically circuitry, if you will, integrated circuits. So, yeah, we're close to it. We think it could be exciting for the overall industry and exciting for us.

Our next question comes from the line of John McNulty with BMO Capital Markets. Please proceed with your question.

Yeah, thanks for taking my question. So with regard to the deflationary environment, do you expect to give all raw material benefits that you should be seeing back in the form of price, or do you get to keep or capture some of it at this point? I guess how should we be thinking about that as we look at 2020?

Yeah, I think from a 2020 perspective, right now we're expecting price and raw material input costs to be relatively neutral year over year. So as we went through the back half of 2019, we saw sequential deflation start to pick up in Q3, a little bit more than in Q4, really largely centered around paper coming down in the back half of the year. And as you know, typically when we have price up or price down, there's a quarter or so lag, so we probably kept a little bit of that in the back half of last year, and then we'll pass that through more as we enter 2020. So I'd expect 2020 to be closer to neutral from a price and raw material input cost perspective.

And just to build on that, we don't think of it as passing through necessarily and toe forth. It's basically each of the, we're talking to the average and every single region, every single product category is different. So it depends on where the inflation is happening as far as across the spectrum between our base and higher value segments, as well as whether it's paper or more chemicals based. And right now it's more paper based, which all of us and all of our competitors tend to be equally exposed to from a commodity standpoint. So It varies. We're going to continue to manage it. As I commented on, we did it successfully through the last inflationary cycle, and now we're in a modest deflationary. Our guidance assumes that it's, as Greg said, relatively net neutral.

Our next question comes from the line of Adam Josephson with KeyBank Capital Markets. Please proceed with your question.

Hey, guys. This is actually Michael. I'm going in for Adam. Thanks for taking my question. Just one on IHM quickly. You know, obviously a nice margin expansion this year. Can you talk about sort of what your outlook is for 2020 and how far you think you're going to take that?

Yeah, so expectations on IHM, as you said, we had margins up low over a point in 2019. And we had said when we were sitting here a year ago, we were targeting 10% margins in LGM in 2019, and we delivered a little bit better than that. Our expectation in 2020 is to continue improving our margins, and we're targeting 11% or better in 2020 on the path towards our long-term target of 12.5% or higher. So we'll continue to improve or expect to continue to improve in 2020 and then further improvement again in 2021.

Okay, thanks. And then just back to input costs for a second. You mentioned paper has been deflationary, probably the biggest. Can you just give us a sense of how deflationary it's been just on a percentage basis?

Yeah, so I think, you know, for the full year 19, we still had net inflation year over year. Started to see that deflation in the back half. I would say kind of in the low to mid single-digit range from a percentage perspective. What we're expecting in 2020 is kind of low single-digit deflation, consistent with what we talked about before, about a point and a half or so of price down as well in 2020.

And much of that carryover. Exactly. On both fronts.

Our next question comes from the line of Jeffrey Sakakis with J.P. Morgan Securities. Please proceed with your question.

Thanks very much. Is SmartTracks a profitable business, or can you talk about its profit characteristics in rough terms?

Yeah, so overall, I mean, I'll just talk about The business in general, so we talked about EPS. We expect it to be a hit in 2020 related to integration costs and everything else that goes along with the first year of acquisition. Next year, we already expect EBITDA margins. Their EBITDA margins now are above our company average. They'll be above the company average again next year, just like our RFID business. And we expect to be commensurate with our RFID business's EBITDA margins in 2022. So that's where the profitability is now, and we expect it to be comparable to our existing RFID business in a couple years' time. Okay, great.

And in terms of raw material costs year over year in the fourth quarter, were they down about $10 million, roughly?

Yeah, so in Q4, we were down, as I said a minute ago, kind of low to mid-signal digit percentage from a deflation perspective. particularly largely in LGM because that's obviously where we use the primary amount of our paper. So IHM, for instance, doesn't use as much paper as a percentage of its materials.

Our next question comes from the line of Paritosh Nishwal with Berenberg Capital Markets. Please proceed with your question.

Thanks for taking my question. First, on the RFID side, is there any interest to grow any other technological capability in that business, for example, maybe scanners or sensors or maybe more printers or maybe even some software?

Yeah, so overall we refer to it as leveraging RFID to build out our intelligent labels platform, and one of the reasons for the shift in the language is to not limit ourselves to thinking just about the, at the time, UHF RFID inlay technology. So, yes, we are looking broadly beyond the specific technologies that we've, from a legacy standpoint, had. We already are in the printers business, so we do manufacture printer RFID-enabled printers. We are investing more and more in the information solutions capabilities, which information solutions is a key aspect of RBIS's core business as far as managing data between the retailers and brands and their globally outsourced apparel manufacturers. So building on that, and as I mentioned earlier, SmartTrack actually does bring some sensor technology with it as well. So we are looking primarily around technologies that link the physical to the virtual world and enable the Internet of Things. So heavy focus around the inlays capability and looking at other capabilities on the periphery to invest in to enable further growth.

I see. Thanks, Scott. And then in the LGM-based business, if you could maybe just talk about the outside the inflation, deflation, but just the supply-demand balance that you're seeing and when you think you might be in an environment where you might be able to raise prices.

Sorry, if you have questions about what the supply-demand environment is, I think we've talked about that overall, but what our outlook is going into 2020 on growth overall. The volume trends have been improving. In the second half of 2019, we expect to continue to improve into 2020. And from a pricing standpoint, we're very disciplined, look at ourselves being the market leader, not just doing what's right for our business, but the industry. And when I talk through managing successfully through the inflationary cycle, raising prices multiple times to move ourselves to where we wanted the business to be, and adjusting course as we started to get in the deflationary cycle. So our pricing actions, we talk about it broad-based here, but it's very specific, targeted customer-by-customer, product-by-product, and so that's what informs our decisions around pricing, both up and down.

Our next question comes from the line of Neil Kumar with Morgan Stanley Investments. Please proceed with your question.

Great. Thanks for taking my question. Can you just talk about your cadence of volumes through the fourth quarter and what level they've been at so far in January?

Sure. So, again, as we talked about a little bit earlier, our volumes, particularly in LGM, were a little bit stronger in Q4 than they had been earlier in the year. So in LGM, the first half, as we said, volume and mix was a net down year over year, and in Q4, the back half, we started to see improvement in volumes, including in the fourth quarter, as we picked up some of that share gain, as we've talked about already.

Overall, the reading Q4 is difficult month to month because of timing of holiday shifts, Thanksgiving, Christmas moving a little bit earlier every period. So the overall trend macro that Greg laid out is the right one to focus on as we go into – January, January is also very difficult to read into all of East Asia because of Lunar New Year is relatively meaningless as far as the trends outside of that. What we're seeing in January is consistent with the revenue guidance that we're giving with looks like, again, around timing of holidays and so forth, there might have been a little bit of deferral of some shipments in North America from Q4 into Q1, a little bit maybe of more shipments than we expect in Europe in Q4 versus Q1. So they basically balance out in total.

Yeah, and when you look at organic growth in the first quarter, that will be our largest price headwind year over year. So that will have an impact on the quarter, certainly compared to the full year impact on price.

Great. That's helpful. And then you mentioned that 2019 CapEx was a bit lighter due to the delays in spending. But then your 2020 capital spend guidance is still coming down about $30 million to $35 million. Can you talk about what's driving that, and is a 2020 CapEx a decent run rate to think about going forward?

Well, we have our long-term, we laid out a five-year capital allocation plan, which basically had $250 million on average spend over that period. I know that's a loose average. We spent a little bit more than that the last couple of years. We did say that we would have a bit higher during those two periods. We've been able to spend a little bit less, partially because of the delay, as Greg commented on, as well as we've found ways to spend a little bit less on the existing projects that we had planned. So our five-year average that we've laid out is $250 million. It's less than that in 2020 as we've walked through. If you pull back from the numbers, we've also discussed we've gone through a period of recapitalization of our footprint in North America and Europe, which is a key driver of the greater investment in 2018 and 2019. And obviously that's now complete, and that's not something that happens all that frequently.

Our next question comes from the line of Christopher Cash with Loon Loop Capital Markets. Please proceed with your question.

Yeah, thanks for taking my question. So just a follow-up on SmartTrack is the way you describe the profitability of that business, I'm trying to understand why you're suggesting it would be dilutive. I think you said it's more profitable than your RBIS segment or at least consistent with your RFID portion of your segment and We know what we paid for it, the annualized sales rate. So just trying to understand, are you just not, you're not excluding your integration costs as one time in nature to describe it as dilutive? It looks like it should be accretive.

Yeah, Chris, so this is Greg. So the modest negative in 2020, as you said, includes some of our integration, project management costs of that integration, as well as some interest costs related to the funding of that acquisition. And then, of course, related to amortization. So I think earlier Mitch was referring to EBITDA margins being at or above, sorry, our company average and similar to our existing RFID business. Obviously, we haven't closed the deal yet, so we're still working through the exact amortization impacts, but that will have an impact at the EPS perspective. So right now, with the integration costs and the incremental interest costs related to it, we expect a modest negative in 2020. And as Mitch said earlier, roughly breakeven is slightly positive in year two.

Okay. And then within your LGM segment, you described some of the high-growth categories as sluggish, I think graphics in particular. Can you just elaborate on what may have changed there? Because the cadence of that business I think had been, you know, generally a pretty positive or sustained in a decent growth trajectory. So just wondering if there was an inflection there, in the quarter or anything specific that's contributing to the weakness in that business. Thanks.

Chris, is your question about graphics?

Yes, graphics specifically.

Yeah. So, Greg talked through the growth that we saw all of 2019, specifically in Q4. There were headwinds around some tough comps and so forth. Aside from that, though, graphics within LGM, The vast majority of their revenue is tied to consumer non-discretionary. Graphics is a little bit more cyclical, given that it's tied to car wraps and other things that can, in a period of uncertainty, be deferred for a bit. So generally, as you think across cycles, this one's a little bit more cyclical than the rest of labels and graphics materials. Overall, though, we saw growth for 2019, specifically within Q4. As you'll see quarter to quarter, there's some choppiness.

Our next question is from the line of George Spassos of BOFME Securities.

Thanks. Two follow-on questions, guys. Thanks for taking them. First of all, Mitch, can you talk a little bit further about how you view the strategy for IHM and how it's been evolving? You know, the company, I think, has been saying for several years now that it's a core business, and, you know, you view it as, analogous to LGM in terms of what you can do to improve margins. You know, certainly some of the questions that we get from investors, clients don't necessarily always see it that way. So how do you see the strategy in IHM evolving and with this restructuring, you know, how do you see the management structure changing or not within IHM? That's question number one. Question number two, can you just update us on sustainability trends as regards to closing the loop on your products, you know, from RFID to LGM label material. Thank you, and good luck in the quarter. Thanks, George.

So from an industrial healthcare material standpoint, just broadly, I mean, this is a near adjacency to labels and graphics materials. It's pressure-sensitive material. You leverage our adhesives capabilities, both innovation as well as just the capacities that we have, as well as the coding capabilities. So if you were to look in the plants, it would look similar to the specialty assets that we have within LGM. The difference is they're used for functional materials. They're not printed on. So the adjacency is very much from a back-end perspective. They are separate markets, so we will continue to have separate leadership running these businesses as we do today. So that is overall what the – link is to lgm and the synergies what we've been talking about over the last couple years is creating more linkage and on that back end manufacturing r&d and so forth as well as the support functions uh integrating that so that we can have very focused dedicated commercial and general management uh leveraging that core capability across the two to attack the markets um and then broadly those these are spaces that have secular tailwinds within the market there's a migration of uh from mechanical fasteners like nails and screws to tapes and adhesives, and that's something that we see as a broad market that we want to continue to invest in. So that's on IHM on sustainability. We obviously have made tremendous progress and an industry leader on many fronts on this. We were out early with the drive towards and committing to a set of 2025 goals back in 2015, making great progress on that, both on reducing the environmental impact of our operations as well as innovating products and solutions. Yes, specifically about RFID and LGM. So within RFID, RFID is a great enabler to support our customer sustainability goals. With increased tracking, you can have much greater reduction of waste. whether that be in apparel as well as within food and so forth. So RFID we see as a great enabler to reduce waste through the entire value chain. And from an LGM perspective, here we've been focusing constantly with longstanding tradition, we call it Think Thin, so reducing the material content of our materials. But on top of that, we've really been focusing more of our R&D efforts around coming up with innovative products that are focused on recyclability. So enabling more efficient recyclability at the end package, which includes clean flake, and we're focusing on next-gen innovations there, as well as using more recycled content in our actual products. We had some launches at Label Expo that came out with, you know, the first-ever recycled PE face material package. as well as recycled PET products and so forth. So we're using our innovation prowess to be able to continue to be the innovation leader for the space in meeting our customers' sustainability goals.

Mr. Boudreaux, there are no further questions at this time. I will now turn the call back over to you for any closing remarks.

All right, well, thank you, everybody, for joining us. The fourth quarter capped a very solid year, and we're positioned well going into 2020. Thank you all again for joining us, and we look forward to seeing many of you at our analyst meeting in May.

Ladies and gentlemen, this does conclude today's conference call. We thank you for your participation and ask that you kindly disconnect your lines.