Avery Dennison Corporation (NYSE:AVY) Q3 2023 Earnings Call Transcript

Avery Dennison Corporation (NYSE:AVY) Q3 2023 Earnings Call Transcript October 25, 2023

Avery Dennison Corporation beats earnings expectations. Reported EPS is $2.1, expectations were $2.08.

Operator: Ladies and gentlemen, thank you for standing by. During the presentation, all participants will be in a listen-only mode. [Operator Instructions] Welcome to Avery Dennison’s Earnings Conference Call for the Third Quarter Ended on September 30, 2023. This call is being recorded and will be available for replay from 5:00 PM Eastern Time today through midnight Eastern Time, October 31. To access the replay, please dial 800-633-8284 or +1-402-977-9140 for international callers. The conference ID number is 22020693. I would now like to turn the conference over to John Eble, Avery Dennison’s Vice President of Finance and Investor Relations. Please go ahead, sir.

John Eble: Thank you, Carlos. 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 from GAAP on schedules A-4 to A-9 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 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 Deon Stander, President and Chief Executive Officer; and Greg Lovins, Senior Vice President and Chief Financial Officer. I’ll now turn the call over to Deon.

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Deon Stander: Thanks, John, and hello, everyone. In the third quarter, we delivered earnings in line with our expectations, grew volume and margins in both segments sequentially, generating strong free cash flow and delivered significant Intelligent Labels growth in new categories such as logistics and food. While earnings were in line with our expectations for the quarter, volume was lower than anticipated on broader macro uncertainty and slow consumption, which the team was able to offset through productivity and cost reduction actions. As I mentioned last quarter, we have activated countermeasures to minimize the impact on our bottom line. We have implemented temporary cost reduction actions, ramped up our restructuring initiatives and pared back capital investments in our base businesses, while protecting investments in our high-growth platforms, particularly Intelligent Labels.

Now a quick update on the quarter by business. Materials Group delivered strong margins and volume improved sequentially as inventory destocking continues to moderate. Volume was down compared to prior year, as customers were still building inventory in the third quarter last year and have been reducing it this year. As you can see on Slide 6, volume in North America and Europe continue to improve at a steady pace in the third quarter. Latest indications suggest that our customers’ inventory destocking is largely complete in Europe and will be largely complete in North America by year-end. Demand in these regions has been softer than anticipated on broader macro uncertainty and slow consumption, particularly in Europe. As destocking continues to moderate, we expect volume will again improve sequentially in the fourth quarter, a trend we have seen through the first 3 weeks of October.

Overall, emerging market label demand was solid in the quarter, up high single digits sequentially, with particular strength in Asia. Materials margin was strong expanding year-on-year and sequentially, as volumes improved and structural and temporary cost saving actions were implemented. Solutions Group sales were up mid-single digits in the quarter. Sequentially, volume in Apparel Solutions and Intelligent Labels improved and adjusted EBITDA margin improved 60 basis points. We expect to drive further margin improvement in the fourth quarter as volume increases. Apparel imports continue to be down compared to prior year in 2019, which can be seen on Slide 6. Following a mixed back-to-school season, retailers and brands continue to factor muted sentiment into their near-term sourcing plans.

Intelligent Labels in non-apparel categories, particularly logistics and food, continues to ramp significantly, and we’re up roughly 75% in the quarter. Our execution of these key rollouts in new categories is delivering significant value for our customers and compelling proof points for broader segment adoption. This growth was partially offset by a decline in apparel, resulting in roughly 10% growth for overall Intelligent Labels in the quarter. We expect non-apparel Intelligent Labels growth to further accelerate in the fourth quarter, along with sequential improvement in apparel, enabling us to achieve low to mid-teens growth for the platform overall in 2023, lower than previously anticipated due to the continued soft apparel market. As adoption in categories like logistics, food and general retail accelerate and apparel rebounds, we continue to expect the Intelligent Labels platform to deliver 20%-plus growth in the coming years as we further advance our leadership position at the intersection of the physical and digital.

Our ability to help address challenges, such as labor efficiency and waste in very large volume categories like logistics and food, is increasingly resonating with customers, and we continue to invest to capture the significant opportunity ahead of us. Intelligent Labels is a great example of one of our key strategies to drive outsized growth in high-value categories. We continue to shift our portfolio towards these categories, both organically and through M&A, and we expect to benefit from higher growth contributions from these categories over the long term. Another example of this is our external embellishments platform. Earlier this month, we announced an agreement to acquire Silver Crystal Group, an established player in sports apparel customization and application, with roughly $30 million in annual revenue as we continue to expand our position in this key growth platform.

Turning to the fourth quarter at a total company level. As volumes continue to improve, we expect further sequential earnings improvement. In both of our primary businesses, in past inventory destocking cycles, we’ve seen the pace of volume improvement accelerate as the industry nears the end of the cycle. In light of the broader macro uncertainty and softer consumption, we continue to anticipate a more measured recovery as we indicated last quarter. We remain confident that as volumes normalize and non-apparel Intelligent Labels adoption expands, we will steadily increase earnings to achieve a $10-plus EPS run rate. We anticipate achieving this at some point in 2024, but the timing of this is uncertain. Stepping back, the underlying fundamentals of our business are strong.

We’re exposed to diverse and growing markets. We are industry leaders in our primary businesses, with clear competitive advantages in scale and innovation. We have a clear set of strategies that have been the keys to our success over the long term across a wide range of business cycles, and we are uniquely positioned to connect the physical and the digital to help address some of the most complex problems in the industries we serve. We remain confident that the strategies we formulated will continue to enable us to generate superior value creation through a balance of GDP-plus growth and top quartile returns over the long term. I want to thank our entire team for their continued resilience and commitment to addressing the unique challenges at hand.

And with that, I’ll hand the call over to Greg.

Greg Lovins: Thanks, Deon, and hello, everybody. In the third quarter, we delivered adjusted earnings per share of $2.10, up $0.18 sequentially, driven by benefits from higher volume and productivity actions. Adjusted EBITDA margin was 15.6% in the quarter, up 90 basis points compared to Q2 and comparable to prior year, with adjusted EBITDA dollars up about 7% sequentially. Compared to prior year, sales were down 10% ex-currency and 11% on an organic basis, due to lower volume, largely from destocking, which continues to moderate. GAAP operating margin was 10% in the third quarter, which included $44 million in restructuring charges as we continue to drive productivity across our portfolio. The majority of the charges taken in the quarter were related to footprint optimization initiatives in Materials Europe.

Turning to cash generation and allocation. We generated strong adjusted free cash flow of $310 million in the third quarter, up $170 million compared to prior year. In the third quarter, we continued to make good progress reducing higher inventory levels and certain components, in which we experienced supply disruptions over the last couple of years. And overall, our working capital metrics are in good shape. Our balance sheet remains strong, with a net debt to adjusted EBITDA ratio at quarter end of 2.6. And we continue to execute our disciplined capital allocation strategy, including strategic acquisitions and continuing to return cash to shareholders. In the first 9 months of the year, we returned $309 million to shareholders through a combination of share repurchases and dividends as well as deployed $204 million for M&A.

Turning to the segment results. Materials Group sales were down 16% ex currency and on an organic basis, driven by a mid-teens volume decline as inventory was being built downstream from us last year and continues to reduce this year. On a sequential basis, volumes increased in Label Materials by mid-single digits in the third quarter. Label volume in combined North America and Europe continued to improve at a similar pace in the third quarter as in the second quarter, which can be seen on Slide 6. Volume also continues to improve through the first few weeks of October. Looking at Label Materials organic volume trends versus prior year in the quarter, North America was down mid-teens and up low single digits sequentially. Europe was down roughly 30% and up mid-single digits sequentially.

Asia Pacific was up low double digits and up high single digits sequentially, and Latin America was down mid-single digits and up mid- to high single digits sequentially. Also compared to prior year, graphics and reflective sales were down low single digits organically, and Performance Tapes and Medical were up low single digits. Materials Group delivered a strong adjusted EBITDA margin of 16.4% in the third quarter, up 90 basis points compared to prior year and up 70 basis points sequentially as benefits from productivity and temporary cost-saving actions more than offset lower volume. Regarding raw material cost, we, again, saw modest deflation sequentially. And as I mentioned last quarter, following a period of significant inflation, these lower costs are largely being passed along in price reductions to our customers.

Shifting now to Solutions Group. Sales were up 5% ex currency and 1% on an organic basis. As high single-digit growth in high-value categories was partially offset by a mid- to high single-digit decline in the base business, as retailer and brand sentiment remains muted. Adjusted EBITDA margin of 16.4% was up 60 basis points sequentially and down 250 basis points compared to prior year, driven by lower organic volume, higher employee-related costs and strategic investments in Intelligent Labels, partially offset by productivity and temporary cost actions. We expect adjusted EBITDA margin will again improve sequentially in the fourth quarter. Now shifting to our guidance. In the fourth quarter, we expect adjusted earnings per share to be in the range of $2.10 to $2.25, up significantly compared to prior year and a steady sequential improvement at the midpoint, despite the softer consumption environment.

In the fourth quarter, we expect organic sales growth compared to prior year. Label Materials volume to improve as inventory destocking continues to moderate; Intelligent Labels volume in new categories, particularly logistics and food, to continue to accelerate; further structural cost reduction actions to be implemented as we continue to focus on driving productivity across our businesses; and more than a $0.05 sequential headwind from typical seasonality due to less shipping days in the fourth quarter. We remain confident that we will steadily increase earnings to achieve a $10-plus adjusted earnings per share run rate. So given the level of macro uncertainty, the timing is difficult to predict. The sequential improvement will be driven by the normalization of Label Materials volume, the continued growth in non-apparel Intelligent Labels, the impact of ongoing productivity actions and structural cost reductions, and the normalization of apparel volumes.

We’ve outlined additional full year considerations on Slide 13 of our supplemental presentation materials. We continue to estimate that incremental pretax savings from restructuring, net of transition costs, will contribute roughly $65 million. We anticipate investing roughly $300 million on fixed capital and IT projects, down roughly $25 million from our previous outlook as we pared back capital investment slightly. An anticipated impact from currency translation has increased and now reflects a roughly $18 million headwind for the full year based on current rates. And we continue to expect our full year adjusted tax rate will be in the mid-20% range. In summary, we’re continuing to improve our results. And despite the near-term challenges, we remain confident in our ability to continue to deliver exceptional value through our strategies for long-term profitable growth and disciplined capital allocation.

We will now open up the call for your questions.

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Q&A Session

Operator: [Operator Instructions] Our first question comes from the line of George Staphos with Bank of America.

George Staphos : My question, to start, is on Intelligent Labels. And the less-than-expected growth in total, driven by apparel, if I understood the commentary correctly, and it sounds like it was apparel related to consumer sentiment that drove the variance. And I guess if you could provide more detail in terms of what was the expectation in terms of market, in terms of consumer demand, in terms of sentiment, in terms of what your customers were saying relative to what transpired in the third quarter? And then, in turn, why you think that improves over the next one to two quarters?

Deon Stander: Thanks, George. If you recall what we said earlier in the year, was that we anticipated that apparel wouldn’t recover through the remainder of the year, but we see slight sequential in volume improvement. And as we showed, I think, on Slide 6, George, you can see what we had anticipated was that continued apparel imports we’ve done so sequentially continued over a full period quarter. And in addition to that, we continue to actually see somewhat surprisingly that inventory to sales ratios are also declining. And so the combination of that, I think, is really factoring into kind of more muted apparel near-term sentiment as brands and retailers think about their sourcing opportunities. In addition to that, we have seen the expansion of our non-IL apparel business significantly, particularly in logistics and food, as we really are demonstrating the value to our customers that those solutions are able to bring.

And as I look forward then into Q4, we’re anticipating a little bit more recovery in apparel. And we also have, as I mentioned the last time, a number of new apparel programs that are in rollout. Sometimes they switch between quarters as they ramp, we’ve typically seen that over time, but that will also add to our apparel IL volume growth as we go into the fourth quarter, George.

Operator: Our next question comes from the line of John McNulty with BMO Capital Markets.

John McNulty : So I guess my question is really about the guide. So 3Q, you did about 2.10. You’re basically looking flat to up about $0.15 in 4Q. And I guess, if I think about it, you’ve got the big RFID improvement, particularly in the logistics. You got incremental cost saves, which seems like combined, those would put you at the high end of the range without any assumption for less destocking at the core, falling raws or anything like that. It sounds like maybe a little bit seasonality, but I guess what am I missing in terms of the bad guys here? Because it seems like the outlook for 4Q — or the guidance for 4Q is kind of unusually or extremely conservative.

Greg Lovins: Yes. Thanks, John. So I would say when we look at the guide at the midpoint when you adjust for that seasonality, as you mentioned, we’re up about $0.15 sequentially. Obviously, at the high end, a bit higher than that. When we look at what’s driving that, as you said, we’re expecting pretty significant Intelligent Labels growth Q3 to Q4, as we’ve already talked about. We are seeing the start of Q4 here, sequential volumes in our label business continuing to improve as well as we’ve talked about as we see that steady improvement. Now what we’re also seeing, and I think Deon mentioned this earlier, we are continuing to see more macro uncertainty. We’ve seen the data on retail volumes in Europe continued to decline sequentially in the third quarter.

And generally, I think we’re seeing a bit muted sentiment and cautiousness from whether it be apparel retailers and brands as well as consumer packaged goods companies. And so we’re looking at that and trying to factor into our guidance a little bit of cost sense from them as they enter the end of the year. And we’ll see how that plays out as we get through holiday and how that sentiment evolves. So right now, we’re just seeing some cost senses there on the end user side. So we’re trying to factor that into our guide as well.

Operator: Our next question comes from the line of Ghansham Panjabi with Robert W. Baird & Company.

Ghansham Panjabi : I guess going back to your comments on destocking. Have the categories that were sort of first in on the destocking curve from 4Q of last year, have they started to inflect higher on a year-over-year basis at this point? And then related to that, it seems like many of the CPG customers are actually being much more aggressive on cutting inventories just given the higher cost of holding inventory, given interest rates and also inflation. How is that factoring in, in terms of the outlook for the first half of next year, the way you see it at this point? And then also more importantly, as it relates to the $10 of run rate earnings, the time line of that?

Deon Stander: Thanks, Ghansham. I think the thing that we’ve seen more recently is that kind of more broader macro uncertainty and slower consumption. And Greg, I think, called out, particularly in Europe macro retail data volume, is actually sequentially down each month over the last couple of months. And we do see consumer packaged goods volume still below last year in the large number of consumer packaged goods companies as well. And I think that caution, whether it’s in that particular end market or also in apparel, I think it’s just part of what we’re seeing as a consequence of higher interest rates and this impact on consumers and how they react. And so we’re seeing — we’re starting to see some of the sequential improvement from inventory destocking, particularly for the categories that went in first.

And you’ve seen that in our results, and you continue to see that even in our forecast for the fourth quarter, Ghansham. As I think about it now, given that uncertainty, it makes it very difficult to call when that $10 run rate will happen. That’s why we think it will happen at a point during next year, but the timing of it uncertain. I’m very confident in the fundamentals of our business. And I’m confident that when volume really does return, we can see a clear path to that $10-plus run rate as we move forward.

Operator: Our next question is from the line of Jeff Zekauskas with JPMorgan Securities.

Jeffrey Zekauskas : I have a two-part question. I was looking at your bar graph for volumes on Slide 6. And when you measure it, it looks like Q4 of ’22 was 1.2 inches, and Q4 — and October is 1.4. So it looks like the volume is up 16%. Is that right? And second, you’ve got two tranches of debt, you’ve got — both about 1% rate. You’ve got 300 in August of 2024 and you’ve got 533 in the first quarter of ’25. Is your intention to pay those down or to refinance them?

Greg Lovins: Yes, Jeff, so I guess starting on the bar chart, I think with the scale, I think you can’t quite make that direct conclusion from that scale. What we’re seeing is, if you recall last year in Q4, really in October, we were still seeing some stocking up, particularly in Europe. And then we started to see in November that pretty sharp downturn towards converters starting to destock. And that’s what’s carried through. So now when we’ve gone through Q4, we’re still seeing volumes below prior year in Q3, picking up a bit in Q4, closer and closer to where we were, obviously, back to that early part of the Q4 levels. But overall, yes, you can’t make a direct comparison there. I think in the third quarter, our volumes were down mid-teens versus prior year.

And when you look at that, obviously, last year, there was stocking up going on in the third quarter. It was actually our highest quarter of stock build last year. And then obviously, we’re still taking some inventory down here this quarter at the rate of about, I think, more than a week in North America and a little bit less than that in Europe. So that’s how I think about those two things. From a debt perspective, some of that depends on M&A opportunities and things like that and how they evolve over the next year or two and how that capital allocation plays out. Absence of M&A or something major from that perspective, then I think we’d be looking at next year probably continuing to pay down the debt with cash flow. But again, that will determine a little bit on what the opportunities are and how we proceed from an M&A perspective.

Operator: Our next question from the line of Josh Spector with UBS Securities.