Avery Dennison Corporation

Greetings and welcome to the Avery Dennison's Earnings Conference call for the second quarter ended on July 2nd, 2022. This call is being recorded and will be available for replay from 3 p.m. Eastern Time today through midnight Eastern Time, July 38th. To access the replay, please dial 800-633-8284 or plus 1-402-977-9140 for international callers. The conference ID number is 21997966. During the presentation, all participants will be in a listen-only mode. Afterwards, we'll conduct a question and answer session. At that time, if you have a question, please press the one followed by the four on your telephone. If at any time during the conference you need to reach an operator, please press star zero I would now like to turn the conference over to John Eble, Every Denison's Head of Investor Relations. Please go ahead.

Thank you, Malika. 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 A10 of the financial statements accompanying today's earnings release. We remind you that we'll make certain predictive statements that reflect our current views and estimates about future performance and financial results. These forward-looking statements are made subject to the safe harbor statement included in today's earnings release. We have 45 minutes for today's call and we'll conclude by 1115 Eastern Time. On the call today are Mitch Gutierre, Chairman and Chief Executive Officer, and Greg Lovins, Senior Vice President and Chief Financial Officer. I'll now turn the call over to Mitch. Thanks, John. Good day, everyone.

We delivered another record in the second quarter with the EPS of $2.64, well above our expectations and are raising our full year guidance. We now expect earnings of $9.70 to $10 per share for the year, more than 10% above last year and 50% above pre-pandemic levels in 2019. Our ability to consistently deliver impressive financial results rests both on the team's deft ability to execute amidst compounding crises and the strategic foundations we've laid to drive outsized growth in high-value categories, grow profitably in our base businesses, focus relentlessly on productivity, effectively allocate capital, and lead in an environmentally and socially responsible manner. A key element of our strategy to drive outsized growth in high-value categories has been our focus on intelligent labels. We've invested heavily in this platform and the team, seeding new markets, adding new technological capabilities, and expanding capacity. Our strategies continue to pay off and are now accelerating. Looking ahead, we are increasing our growth outlook for this platform to more than 20% through the strategic horizon. This is a tremendous example of our strategies at work. We have refined our strategies over time, raising the bar for ourselves in the process to ensure we continue to deliver superior value creation for all of our stakeholders. Now a quick update on the quarter by business. Label and graphic materials posted strong top line growth for the quarter, driven by higher pricing. Volumes were down due to supply chain constraints, the lockdowns in China, and the impact of exiting Russia that we discussed last quarter. Raw material availability hampered our ability to meet demand. Paper in particular was tight and only began to ease at the end of the quarter, and we anticipate further improvements as we move through Q3. The team is doing a tremendous job leveraging our innovation capabilities to offset a good portion of these constraints. And as discussed last quarter, lockdowns in the greater Shanghai area impacted our materials businesses' ability to produce for much of April. And while restrictions eased as anticipated, they have had an impact on output as well as end demand in China. Overall, volumes remain strong across LGM, up 4% annually versus 2019. While this is slightly lower than our pace from a quarter ago for the reasons discussed, We anticipate a bounce back as we move into the second half. LGM's margin was strong in the quarter, expanding versus prior year and sequentially. We have further accelerated pricing actions, reducing the time lag between when we experience inflation and implement pricing. We anticipate further inflation as we move into Q3, on paper inputs and energy costs in particular, and are continuing to raise prices accordingly. Retail branding and information solutions delivered another strong quarter with significant margin expansion and revenue growth. Strong revenue growth in high-value categories, intelligent labels, external embellishments, and the Vescom acquisition was partially offset by a decline in the base apparel business. Following a robust Q4 and Q1, base apparel volumes were down low single digits in Q2, as some brands and retailers were bringing down inventories that were built up previously. Our outlook assumes further inventory reductions through the balance of the year. We are well positioned to continue to gain share while driving profitable growth in the base. As I mentioned previously, Intelligent Labels' momentum is accelerating. We have a stated target of 15% to 20% annual growth in this business over the strategic horizon and, as you know, we have been delivering at the high end of that target. The growth has largely been driven by apparel, and while we continue to see significant opportunity there, long-term, we see even greater opportunity outside of apparel. As the global leader in RFID, we have been strategically investing to not only capture these new opportunities, but create them. And, as I said earlier, we are increasing our growth outlook for this business and now anticipate more than 20% growth in the coming years. As for the bottom line, RBS continues to deliver strong EBITDA margins, up more than two points compared to prior year, as we continue to shift this business towards higher value solutions. As for industrial and healthcare materials, the segment delivered solid sales growth in the quarter and improved margins roughly two points sequentially, as we accelerated pricing actions to cover inflations. Across the company, I'm pleased with the continued progress we are making towards the success of all of our stakeholders. Our consistent performance reflects the strength of our markets, our industry-leading positions, the strategic foundations we've laid, and our agile and talented team. We remain confident that the strategies we formulate will continue to enable us to generate superior value creation through a balance of GDP plus growth and top quartile returns over the long run. And once again, I want to thank our entire team for their tireless efforts to keep one another safe while continuing to deliver for our customers during this challenging period. The team continues to raise their game each quarter to address the unique challenges at hand. Thank you. Over to you, Greg.

Thanks, and hello, everybody. As Mitch said, we delivered another strong quarter with adjusted earnings per share of $2.64, up 17% over prior year. driven by significant revenue growth and strong margins. Sales were up 17% ex-currency and 11% on an organic basis, driven by higher prices. We delivered a strong adjusted EBITDA margin of 16.4%, up 100 basis points compared to prior year, and 110 basis points sequentially, despite the impact of inflation and supply chain disruptions. Earnings were more than 20 cents better than our expectations from a quarter ago, despite a currency translation headwind, driven by strong operational results and roughly a nickel from one-time benefits. Turning to cash generation and allocation, year-to-date we've generated $282 million of free cash flow, with $209 million in the second quarter, up compared to prior year, driven by our strong net income growth. Our balance sheet remains strong. with a net debt to adjusted EBITDA ratio at quarter end of 2.2, modestly lower than Q1. Our consistent free cash flow generation and current leverage position give us ample capacity to continue executing our disciplined capital allocation strategy to invest in organic growth and acquisitions while continuing to return cash to shareholders. In the first half of the year, we returned $386 million to shareholders through a combination for share repurchases and dividends. Now, turning to segment results, label and graphic material sales were up 15% on an organic basis, driven by higher prices, which more than offset a decline in volume due to raw material constraints and tough comps. Label and packaging material sales were up high teens on an organic basis, with strong growth in both high-value product categories and the base business. Graphics and reflective sales were down mid-single digits on an organic basis. Looking at the segment's organic sales growth in the quarter by region, North America sales were up high teens, and Western Europe sales were up more than 20%, as demand in both regions remained strong. The emerging markets overall were up mid-single digits. The Asia-Pacific region was up modestly, with strong growth in India, offset by a decline in China due to lockdowns in the greater Shanghai area that constrained our operations for much of April. And Latin America grew more than 10%. LGM's adjusted EBITDA margin increased 50 basis points to 17.1% and was up 150 basis points sequentially, largely driven by accelerated price inactions to offset inflation and positive mix. As Mitch said, while we've reduced the time between when we experience inflation and when we implement pricing, our supply chains remain tight and our input costs continue to rise. We now anticipate inflation will be more than 20% for the year, with a mid-single-digit increase expected sequentially in Q3, primarily driven by paper. We continue to address the cost increases through a combination of product reengineering and pricing actions. Shifting now to retail branding and information solutions, RBIS sales were up 27% ex-currency and 5% on an organic basis, as growth was strong in the high-value categories with continued strength in intelligent labels and external embellishments, while the base business was down low single digits. As Mitch mentioned, growth in the base moderated after a robust couple quarters. Our performance and premium channel saw particular strength in Q2, partially offset by a decline in the value channel, where inventory reductions were more highly concentrated. Adjusted EBITDA margin for the segment of 19% was up more than two points, with a positive benefit from higher organic volume and acquisitions more than offset growth investments and higher employee-related costs. Turning to the industrial and healthcare materials segment, sales increased 7% on an organic basis, driven largely by higher prices. Healthcare sales were up high teens on an organic basis, and industrial categories were up mid-single digits. Adjusted EBITDA margin of 13.7% was down compared to prior year and up two points sequentially, driven by higher volume and accelerated price inactions to offset inflation. Now, shifting to our outlook for 2022, we have raised our guidance for adjusted earnings per share to be between $9.70 and $10, a 20-cent increase to the midpoint of the range, despite a roughly 25-cent headwind from currency translation. The increase reflects our strong performance in Q2 and the continued operational increase in the second half. As Mitch mentioned, this outlook reflects more than 10 percent EPS growth versus prior year, which is 19 percent excluding currency translation, and a 50 percent increase in EPS growth compared to 2019. And we now anticipate 16 to 17% ex-currency sales growth for the full year, slightly above our previous expectation, driven by higher prices to mitigate the increased pace of inflation, partially offset by a lower volume outlook and base apparel. As I mentioned, the anticipated impact from currency translation has increased. It is now a roughly $67 million headwind for the full year based on current rates. Given the dollar has continued to strengthen through the first half of the year, assuming rates remain where they currently are, we'll have an additional headwind of roughly $25 million in 2023. Lastly, we continue to anticipate investing up to $350 million on fixed capital and IT projects, and roughly $35 million in operating expense. Adding capabilities and new capacity, particularly in key strategic platforms such as intelligent labels. which is poised to grow more than 20% annually in the coming years. In summary, we delivered another strong quarter in a challenging environment, and we remain confident that the consistent execution of our strategies will enable us to meet our long-term goals for superior value creation through a balance of profitable growth and capital discipline. We'll now open up the call for your questions.

Malika?

Yes, certainly. Thank you. For questions, ladies and gentlemen, if you would like to register for a question, please press the one followed by the four on your telephone. You will hear a three-tone prompt to acknowledge your request. If your question has been answered and would like to withdraw your registration, please press the one followed by the three. If you are using a speakerphone, please lift your handset before entering your request. To accommodate all participants, we ask that you please limit your question to one. Once again, ladies and gentlemen, that is 1-4 to ask a question. Our first question is from the line of George Staffos with the B of A, Securities, Inc. Research. Please go ahead. Your line is now open.

Hi. Good morning. Thanks for taking my question. Hi, guys. Good morning. Very early morning to you. I guess my first question to start broadly on the macro, if you could frame for us what your expectations, what's in your guidance for further destocking in RBIS and base would look like over the remaining six months, and relatedly, what your outlook is for emerging markets, particularly China, as regards LGM. Thanks, guys, and I'll turn it over.

Hi, George. Yeah, so as far as our outlook specifically, as we said, the base apparel business within RBIS was down low single digits in Q2, and it's particularly one segment specifically value, the value channel, where we're seeing some of the inventory reduction. So we're not seeing it across the board overall, and we've provided allowance within our guidance for further destocking going on throughout the rest of the year. So that is within our guidance here overall. And just one, you know, just reflecting, I know there's a lot of headwinds around what's going on in the apparel market and what the impacts are in the broader macro. You know, the strength of the business that we have here is we continue to gain share, increase our value proposition within the base. But as you know, a key strategic pillar of ours is to, over time, shift the portfolio more to higher value categories. So this business, RBIS, is now 50% in high value segments, and that's a big part of our resiliency in addition to profitably growing the base. As far as China, yeah, so China, we obviously had, I commented earlier that obviously we had an impact on being able to get product out the door in Q2. A big portion of our facilities were in the Shanghai area. But we're seeing a bit of anemic demand recovering from that. So that is something that we continue to see what you're probably seeing in the headlines and so forth. And that's something that we continue to monitor. But we basically don't have a sudden bounce back in our guidance overall, if that's your question.

Thank you. Our next question is from the line of Gansham Punjabi with Robert W. Baird and Company. Please go ahead. Your line is open.

Robert W. Thank you. Good day, everybody. Now, how should we interpret the strong growth in LGM Europe of 20 percent plus in context of, you know, the macroeconomic environment that is clearly taking hold in the region? You know, was it a function of pent-up demand given various supply chain constraints prior? And what are you seeing in the market at current? And then separately, I apologize if I missed this, but can you also give us a breakup between price and volume by segment?

Yeah, thanks, Kancham. This is Greg. So overall in Europe, the majority of our growth in LGM in the quarter, really across North America and Europe, is pricing-driven. So Europe is where we're seeing the most significant amount of inflation, particularly in paper, as we've gone through the last couple quarters, a lot of that driven by the increase in energy prices that are impacting our paper producers as well. So we'll continue to see the highest level of inflation across the globe in Europe, And that's where we've had the most amount of pricing actions as well as we've moved through the last year or so. So that's largely pricing driven. As we look into really the volume perspective, both North America and Europe, we talked about volumes being down, particularly in paper, due to the constraints we had in the second quarter. I think Mitch mentioned earlier in his comments that we started to see the paper supply flow in late Q2 and increasing into July. So we'll expect that to improve sequentially from a volume perspective, Q2 to Q3. I think your second question was around pricing across the regions in line with, as I just said, most of our growth in Q2 was around pricing. We're continuing to accelerate the pace of our pricing actions and close the gap in terms of the timing of when we see inflation to when pricing actions take place.

And just to build on that within RBIS specifically, so the overall growth, the vast majority of that is volume if you look at it from an organic basis. We don't usually talk price within RBIS, but we are raising prices within RBIS as well because of the inflation, particularly in intelligent labels, just given the inflation we're seeing on integrated circuits for that business.

Thank you. Our next question is from the line of John McNulty with BMO Capital Markets, U.S. Please go ahead. Your line is open.

Yeah, thanks for taking my question. So, you know, you raised the smart label long-term growth target to 20 or better than 20% for the foreseeable future. I guess, can you speak to your pipeline and how that's evolved to give you the confidence to raise that target? And then I guess also, can you speak to maybe how we should think about the profitability of the business? I know historically you've kind of said, look, it's better than the corporate average and kind of left it at that. Will this higher growth drive greater operating leverage and maybe even further improve the overall profitability of the business? How should we be thinking about these things?

Yeah, so just your first question. Yes, we're raising our outlook for this platform to 20% plus over the coming years beginning next year. And yeah, the pipeline is robust. We've been talking about the pipeline. We've been investing in this over the years. food, logistics, general merchandise, as well as our strength within apparel. And so we saw momentum building, as we've talked about, and particularly during the pandemic in the last couple of years. But it takes a little while for those to completely ramp, one. Two, we mentioned that we'd be hard pressed to exceed our 20% this year just because of chip supply. So as we look into 2023 and 2024, The chip supply is still going to be constrained, but we've been able to secure additional incremental supply to be able to go above that 20% and let this flow through. So this is a key shift that we're seeing as we go into next year and beyond. The largest contributor of this business, as you know, is apparel. It's about three-quarters of the business. And while the percentage growth outside of apparel has been higher for the last few years, the unit volume growth has been bigger in apparel just given its size. We see that starting to shift next year. The largest unit volume contributors will be the ones outside of apparel next year. Still strong growth in apparel, but it's going to be outside. So it's all the elements we've been working and talking through. If you look at food, QSRs continue to get great momentum there. If you look at general merchandise, we are having significant growth on home goods and toys and so forth as retailers see the opportunity to apply the lessons from apparel into other categories. Grocery within food, we are excitingly just starting a new pilot with a large grocery company, and that's really linking. We talked about when we did the acquisition of Vescom. the strategic opportunity to leverage their sales channel and data management capabilities to introduce it there. So we've just started a pilot within food. And then logistics, we're seeing a number of opportunities across different companies that we're working through. So strong momentum overall. The pipeline is robust, and what you're seeing is it's starting to realize and come through. That said, yes, we will be 20% plus, but the supply chains remain tight, and that's also feeding into the inflation, and we're passing through the price increases that we need to recover that inflation and it's sticking so that's that's overall if you ask about the profitability of the profitability of this business is above average that's what we've commented on before we are even with this more significant revenue growth we will continue to keep investing in this business so that higher profitability is after the incremental investments we've been making and we will continue to do so because we see significant opportunities over the long term in this space

Thank you. Our next question is from the line of Anthony Petinari with Citigroup Global Markets Inc. Please go ahead. Your line is open.

Hi, this is actually Brian Bergmeier sitting in for Anthony. I was just wondering, you know, more than halfway through the year now, if it's possible to provide a range for free cash flow guidance. I think in years past, you've been maybe 90 to 100% of net income. Do you think that's a fair range to use this year? And then on the FX headwind that you called out in the slides, is it possible to say how much of that headwind has already happened in the first half and how much you're expecting for the second half? Thanks.

Sure, so on your first question, last year we delivered a bit more than 100% from a cash flow conversion perspective. I think our expectation for this year, given some of the increased pace of CapEx as well as some working capital increases with all the inflation and pricing actions, we expect it to be a little bit lower than 100, but still in that 90 to 100% range for this year as well. On the FX headwind, we've got about a 25 cent increase versus our previous guidance. About a nickel of that was in the second quarter, and the other 20 cents is in the back half.

Thank you. Our next question is from the line of Josh Spector with UBS Securities, LLC, U.S. Please go ahead, John, and open.

Yeah, thanks for taking my question. Just curious on LGM and the margin outlook here for second half. I mean, you guys have continued on really well. offsetting the higher costs with pricing and talked about some new initiatives that you've done to speed that up. It seems like your guidance implies that margins might slip 100 basis points plus in second half. Obviously, there's some end market weakness, but curious if you can draw some color there about what the major factors would be and why you wouldn't stay at kind of that recovered type level here in the second half.

Yeah, so there's a number of factors driving what are strong margins really across the company, but in LGM as well in the second quarter. One of those is a strong product mix. Our specialty business was up quite a bit in the quarter. The growth more than 20% in the quarter with volumes up as well. And our bulk paper business was down in the quarter given some of the paper constraints. So we had a strong mix impact in Q2 in particular. We also, as we've said earlier, we've been accelerating our pricing. We're getting closer and closer to pricing real-time with the inflation. And as we're seeing that inflation, Q2 is actually the most significant inflation we've seen since this cycle started a year or so ago. But some of that inflation is sitting in inventory still at the end of the quarter and will come through when we sell that inventory through here in the third quarter. And then there's a number of much smaller one-time type items in Q2. So I think when we look forward, we'll see a little bit of a mixed impact from Q2 to the back half as that base paper volume comes back into play here in the third quarter. And we see also a sequential inflation increase. We talked earlier about paper continuing to be a headwind for us with paper increasing, particularly in Europe, but also in North America. So overall, some near-term impacts, but we remain confident in the long-term trajectory of this business and the margins expectations we have for this business continue to be strong and we expect to continue delivering strong top line growth overall for this business with strong margins, strong capital efficiency, and that generates strong EVA over time and continue to drive strong EVA growth across this business.

Thank you. Our next question is from the line of Mike Roxland with Truist Security. Please go ahead. Your line is open.

Thanks, Mitch, Greg, John. Congrats on another solid quarter. My question is around your backlogs and where they currently stand. Have you seen further extended where they were relative to 1Q? And given continued inflation, do you still continue to mark-to-market your backlogs? And if so, what has the cost and response been for that type of approach, and will you continue to use that approach going forward?

Yeah, so we do reprice the backlogs, one. Two, yeah, the This business usually doesn't have a backlog. We don't talk about backlogs in this business, and that's where we ultimately want to be, given just the quick delivery times and so forth. Given the constraints and the high demand in the end market, backlogs began to creep up a couple of years ago, and we're seeing a slight moderation going from Q1 to Q2, and we want that moderation to continue throughout the second half. Part of that is people getting back in the queue just given the uncertainty of availability of raw materials and everything else. That's something we called out previously and that's something that we expect to work down through the second half, particularly when, as we commented on, the constraints around paper and so forth, people are seeing in the macro that that's been easing in the second half of Q2 and we're seeing it ease further here in Q3. still remains extremely high. We haven't commented on the magnitude of it. This business shouldn't have much of a backlog, and that's what we hope to get back to here in the coming few quarters.

Thank you. Our next question is from the line of Paritosh Mishra with Barenburg Capital Markets LLC. Please go ahead. Your line is open now.

Thank you, and good morning, guys. So in your RFID business, given that you are raising prices How much of the improved long-term outlook is due to pricing versus volumes?

Well, we just put a plus on there. We're not going to comment on pricing, volumes, and dynamics, but the plus is the shift can be completely attributed to volumes.

Thank you. Our next question is from the line of Christopher Kuppers with Loop Capital Markets LLC Research. Please go ahead. Your line is open now.

Yeah, good morning. My question is focused on LGM and your commentary about second half volumes recovering after being down in the second quarter. Just curious how the current volume trends look thus far into third quarter and how you see the second half recovery that you anticipate being manifested. Will the recovery skew towards certain business units or product lines, or do you expect it to be more or less pronounced in certain geographies? Any color there? around that commentary would be helpful. Thank you.

So just high level, the volume trend had been improving throughout the course of Q2, and we see that continuing into Q3. The volumes are still down at the beginning of Q3, but that's as we expected as the raw material constraints continue to free up and so forth. So we are starting to see here very recently getting to the levels that we would expect. So it's completely consistent with our guidance that we provided, and we're seeing an upward trend as we commented on.

Thank you. There are no further questions at this moment. I will turn it back to the speakers for any closing remarks. Thank you.

Great. Well, another great quarter and another great performance by the team. So I just want to thank our entire team once again for their tireless efforts, dedication, and focus. It's truly remarkable. We continue to raise the bar for ourselves and deliver. So thank you to the entire team, and thanks to everybody who joined the call here.

Thank you, ladies and gentlemen. That does conclude today's call. We thank you for your participation and ask that you please disconnect your lines. Have a good day.