December 02, 2009 - 9:43am EST by
2009 2010
Price: 37.96 EPS -$7.13 $1.36
Shares Out. (in M): 106 P/E NM 28.0x
Market Cap (in $M): 4,023 P/FCF 12.8x 13.3x
Net Debt (in $M): 1,693 EBIT 318 349
TEV ($): 5,716 TEV/EBIT 18.0x 16.4x
Borrow Cost: NA

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AVY is a slow destruction short providing 50% return from current levels and little downside. This opportunity exists because AVY's issues have been masked by dilutive acquisitions, accounting manipulations and beneficial changes to input costs and FXGoing forward, AVY will not be able to fill the hole from its secularly declining office products division (which generates 35% of EBIT) because multiple headwinds facing the other divisions will limit growth and compress margins while a strained balance will limit acquisitions. 

I believe AVY is worth $20, or 12.5x base case 2011 EPS and 8x base case 2011 EBITDA - MCX / EV, providing a 50% return from current levels. In an upside scenario I believe AVY is worth $45 per share or 20x 2011upside case EPS and 15x 2011 upside case EBITDA - MCX / EV (which would be the highest multiple since 2005 excluding the previous 2 "depressed" quarters) or 23% higher than current levels. Note that a 15x EBITDA - MCX multiple on an economically rebounded number is unlikely as it would imply AVY has significant growth prospects and stable margins. As AVY has neither of those characteristics or a high probability of achieving my high case numbers, a short at these levels has significant protection

Avery Dennison's (AVY) four segments consist of one that is losing share to lower cost competitors, a second with an expensive, debt financed acquisition that has had negative operating profit in the two years since closing, a third in structural decline and a fourth without a viable business plan. Additionally, the company has seen an exodus of key management, will lose the year-over-year benefit of pricing increases and lower commodity costs over the next two quarters and has changed inventory accounting, pension accounting and warranty reserves in order to boost earnings which is not sustainable.

Variant Perception: The sell side is expecting AVY to grow into its current 14x EBIT - MCX valuation through a restructuring program and the general economic rebound. This viewpoint fails to take into account that AVY's competitive disadvantages are not the result of the economic environment. AVY's issues will be exposed as input cost benefits reverse and low organic growth rates are no longer hidden by dilutive acquisitions and accounting manipulations. This will cause the market to re-price AVY as a no growth company instead of an economic rebound story.

Ways to "win":

  1. Structural decline of office and consumer products is no longer masked by dilutive acquisitions and FX benefits.
  2. Poor competitive position results in continued loss of share and no growth.
  3. Input cost inflation and anniversary of price increases pressure margins.
  4. Unsustainable accounting manipulations end pressuring margins.

Business Description: Avery Dennison's four segments are Pressure-Sensitive Materials (PSM, labels on shampoo bottles and other CPG's), Retail Information Services (RIS, price tags, bar codes), Office and Consumer Products (OCP, basic office products such as binders and highlighters) and Other Specialty Converting (primarily RFID).  PSM, RIS and Other Specialty Converting sales are driven by general economic and inventory levels while also being affected by secular trends such as the move to electronic media and non-label branding (such as in-mold and direct printing). The end users are CPG companies, retailers and supply chain managers among others. Competitors include UPM-Raflatac, MACtac, 3M, Checkpoint, and Alien Technology. The office and consumer products segment is driven by the economy but in addition is also affected by seasonal events such the start of school. The primary competitors are private label brands and the end users are students and businesses.

Segment 1 - Pressure Sensitive Materials (represents 56% of sales and approximately 55% of EBIT):

"Avery competitors are nipping at their market share in high volume and low volume products because they can offer the same product at a lower price." CEO of consulting group

"The pressure sensitive market has too much capacity which is leading to intensified competition and margin pressures." CEO of a different consulting group

  1. Pressure sensitive labels are facing competition from new technologies leading to industry overcapacity.
  2. Competitors have been taking market share and expanding while AVY has slashed CapEx and advertising budgets.
  3. AVY has the highest cost structure in the industry giving competitors an opportunity.

In conversations with industry experts, they noted that direct printing, in-mold labeling and the move to electronic media are replacing labels. As a result, PSM market growth has slowed to less that GDP rates. This has lead to overcapacity in the industry which is causing increased price competition as competitors fight for share.

In addition, AVY has tried to be all things to all people in its PSM division by making at least 2x the number of products any of their competitors make. This has given AVY the industries highest cost structure. For many years AVY was able to get by with this arrangement by engaging in uncompetitive business practices. AVY was sued for their practices and paid $40 million to settle early in 2009.

Competitors have seized on this opportunity by expanding capacity. In the past year Avery's largest competitor, UPM Raflatac, has spent more than $100 million to open facilities in the US, Poland, China, and Russia and is opening an additional facility in Istanbul during 2010. This compares to AVY's 2009 CapEx budget of $100 million in 2009 for the entire company which AVY admits is below maintenance requirements. Industry contacts estimate that Raflatac has stolen more than 15% in market share in high volume products from Avery. Salesmen at Rafaltac said the new investments are targeted at certain niches in the specialty PSM market were Raflatac will have a significant cost advantage over Avery. Industry contacts also mentioned numerous competitors which have been successful against Avery by focusing on specific market areas where they can beat Avery on price.

The sell side believes the PSM division will rebound next year (expect ~5% which would be the best organic growth since 2004) because management has told them the division is correlated with inventory restocking. Using quarterly data since 1998 I found little correlation (less than 0.2) between year-over-year changes in PSM sales and changes in private inventories. I believe PSM will have little growth in 2010 and 2011 (modeled 2.5%) as they continue to underperform market growth rates.

Segment 2 - Retail Information Services (represents 22% of sales and approximately 8% of EBIT):

"If Avery wanted to be competitive they would have to rebuild their manufacturing structure" CEO of Consulting Group

 "The RIS division is losing market share and it has nothing to do with the economy." Former Avery Employee and current Avery consultant

  1. The expensive Paxar acquisition has been a disaster.
  2. Top level executives from Paxar have left to join a competitor
  3. AVY is losing market share due to integration issues and customers spreading supply chain risk.

In 2007, Avery more than doubled the size of their RIS division through the acquisition of Paxar Group for $1.3B (at 16x EBITDA and 24x EBIT). AVY justified the price on the promise of high levels of synergies ($95 million of synergies would lower the multiple to 7.1x EBITDA). Since 2007, the RIS division has had negative cumulative EBIT of $55 million not including the write down of $832 million in goodwill in 2008. This compares to managements guidance at the time of the acquisition of $180 million in RIS EBIT in 2010, while the most bullish analysts currently estimate less than $20 million in EBIT for RIS in 2010. To make matter worse, the acquisition was financed with $1.3B of debt, leaving AVY with net debt to LTM EBITDA of 3.2x. Not only has the acquisition not performed financially, the majority of the Paxar management team has left since the close of the acquisition to join competitors. Specifically, former Paxar CEO Rob van Der Merwe and AVY vice president and general manager of EMEA and South Asia James Wrigley left to join Checkpoint (CHKP). 

Management and the sell side have said the RIS division at Avery has less than 10% share in a $15 billion market and has performed well during the economic downturn. This contrasts with AVY's own management comments from a 2006 investor day where it said the market size was $3.3 billion putting their share at a high level (40%) limiting opportunities for future growth. Avery employees have told me the RIS division is losing market share because of integration issues and because large customers do not want a single source supplier. As a result, I believe RIS will continue to have flat to low single digit growth, in line to slightly below the GDP like growth the RIS market will likely achieve, as they find new leadership, solve integration issues and have difficulty expanding customer relationships because of single source supply chain risks.

Segment 3 - Office and Consumer Products (represents 14% of sales and approximately 35% of EBIT):

"Our own brand penetration in the core business increased to 23% in 2008 to over $4 billion with several hundred basis points of growth in office supplies. In 2009, we're launching several new owned brand initiatives... we remain committed to getting to 30% over the next few years." Ron Sargent, Staples CEO

  1. The continued expansion of private label products has put division into secular decline.
  2. Margin compression is likely due to loss of fixed cost leverage

AVY's largest customers continue to increase the amount of private label product they stock due to the higher margin they receive on those products. Specifically, Staples has increased private label from 7% of sales in 2002 to 23% currently and plans to increase it to 30% to 35%. Office Depot is estimated to have 25% to 30% of total sales in private label sales with a goal to get above 30% also. Not only are these larger customers pushing their private label products in their own stores but they have started to enter into partnership agreements to extend their distribution. For example, Office Depot recently announced a partnership with Lil' Drug Store to distribute Office Depot branded products to convenience stores across the country.

While this division represents only 14% of sales, it generates approximately 35% of AVY's EBIT (actually generated 75% of LTM EBIT given issues in other divisions). The division has been contracting since 2005 and will continue to do so based on comments from their largest customers (Staples and Office Depot). Surprisingly, some analysts are predicting year-over-year revenue growth for the Office and Products division in 2010 despite declining organic growth rates since 2003. AVY was able to expand margin in 2007 through cost cutting and selective price increases but as seen below the effects were not sustainable.

AVY's Office and Consumer Products Division 

2003 2004 2005 2006 2007 2008 LTM
Revenue Growth Rate 2.2% 0.4% -3.1% -5.6% -5.2% -7.9% -7.0%
EBITDA Margin 16.1% 16.1% 15.9% 14.2% 17.5% 17.1% 15.4%

Segment 4 - Other Specialty Converting (represents 9% of sales and approximately 2% of EBIT):

"RFID is way down the list on what retailers are looking for... It is difficult to develop a compelling business case for retail RFID deployment" Industry Specialist

  1. RFID does not have a viable business case for widespread distribution at current prices
  2. Prices unlikely to decline as industry is losing money

Avery's smallest division consists primarily of their Radio Frequency Identification (RFID) business. In the early 2000's Wal-Mart and the U.S. government mandated that many of their suppliers start using RFID as a way to more efficiently manage their supply chain. Subsequently, some predicted RFID would become ubiquitous and eventually replace the bar code label. Unfortunately, large scale adoption has never taken place as the cost never justified the implementation. As Gartner RFID analyst Tim Payne told me "Replacement of bar code with RFID tags is a poor business case because there is already a system in place that is difficult to be improved upon." Analysts have correctly stated that in order for AVY to make money in RFID much larger adoption is needed. "Large scale adoption at big box retailers is key to the long-term success of RFID inlays and tags." JP Morgan Analyst, 8/14/09

This division will likely continue to lose money because large scale adoption is very unlikely. In my research, I was told that a business case for even pallet level adoption is difficult to justify. At the current price of around $0.15 per tag, it is still too expensive with almost no benefit for companies with highly evolved supply chains. Industry analysts told me they believe it would take price levels of close to $0.05 per tag to make a viable business case, a level below variable cost (most manufactures cannot cover fixed cost at a $0.15 price level). As a result, the other specialty converting business is likely to continue to lose money for the foreseeable future.

Cost and Accounting Issues:

  1. Input costs are rising and price increases will be anniversaried in 1Q10.
  2. Benefits from changes to pension and inventory accounting will roll off.
  3. Company has been restructuring since 2002 with margins steadily declining during the entire period.

Benefits of lower input costs (which make up ~60% of COGS) and price increases rolling off: AVY historically used a combination of LIFO and FIFO inventory accounting. In 4Q07 AVY changed to pure FIFO accounting in order to delay the hit to gross margins from oil prices increasing 51% year-over-year. According to the company their 2008 raw material costs increased 4% or $125 million lowering gross margin by 1.9% to 25.7%. To compensate for the input cost increase, Avery raised prices in December of 2008 and January of 2009. Those increases in combination with the drop in commodity prices during 2009 and some cost savings expanded GP margin to 28.1% in the most recent quarter. So far in 4Q09 crude prices are up 31% year-over-year (compared to year-over-year drops of 52% and 42% in 2Q09 and 3Q09). These higher costs will start to run through AVY's income statement in 1Q09 just as the price increases are also anniversaried. The sell side is expecting GM expansion in 2010 compared to 2009 which I believe is unlikely to happen given these headwinds and business issues discussed previously.

Low Quality Earnings / FCF: In 2008 AVY increased their earnings through cuts to advertising (down 27% or $8.4mm YoY) and increases in discount rates and expected returns for their pension fund (more detail below). Reductions in R&D and warranty reserves (reserves have been cut to only $2 million), also benefited AVY by $2.2mm. In addition, AVY has taken large goodwill write downs in 2009 ($832 mm) and has been going through a restructuring since 2002. Over that time period AVY has recorded over a quarter billion of restructuring costs and over $900 mm in asset impairments but EBIT margin has steadily declined. Amazingly, the sell side still adds back restructuring costs as "one time" despite the fact AVY has been restructuring for over half a decade. FCF increased in 2008 but was boosted by a $166mm working capital benefit and the lowest CapEx to sales since 1990. Going forward the working capital benefit should abate and CapEx should increase (management has stated that CapEx is currently below maintenance levels). The sell side is giving AVY credit for cost savings the company believes they will get in their restructuring plan (guidance of savings of $75 million in 2009 and $85 million in 2010) but given the ongoing restructuring plan which has been taking place since 2002 without any noticeable benefit, I do not treat restructuring costs as one time and only give them credit for 50% of anticipated savings in 2010.

Pension Costs: AVY has changed their pension discount rate and expected asset return assumptions in recent years which has boosted earnings. As seen below, US and international discount rates have increased by 80 bp and 104 bp over the last two years, while the international pension has increased return assumptions by 89 bp. Even with these changes in assumptions and an aggressive 8.75% expected asset return in the US, AVY's pension is underfunded by $350 mm in addition to an unfunded OPEB liability of $62 mm.

Leverage: As of 9/30/09, AVY had $1.8 billion in debt which consists of $1B and $400 million credit facilities maturing in August of 2012 and February of 2011, respectively as well as a $250 million in senior notes due 2017. There are also some small subsidiary debt and about $100 million of HiMEDS still outstanding. Total and net debt to EBITDA as of 9/30/09 were 3.1x and 3.0x, respectively. The tightest covenant for AVY is a total leverage covenant which steps down to 3.5x as of 2Q10. If office and consumer products continue to contract while other divisions do not rebound this could be an issue especially as the first of the credit facilities comes due in 2011.

Conclusion: The opportunity to develop a variant perception in AVY has occurred because the financial statements optically appear much better than business reality. Additionally, management has been telling a story that seems to makes sense given what as occurred economically. When digger deeper it's apparent that AVY faces significant structural and secular issues. In 2010 and 2011 these issues will become apparent and the market will price AVY at an appropriate no growth multiple. Additionally, the "earnings hole" created by the secular decline of the office products division must be filled with growth from other divisions which is becoming increasingly difficult given their low growth markets with aggressive competitors. Specifically, if OCP sales and margins fall 5% and 50bps, respectively than PSM must grow sales by 6.9% just to keep earnings flat. This "earnings treadmill" will eventually catch up to the company giving shorts a catalyst to realize their value. Management and the sell sides belief that OCP will stabilize in addition the other divisions fully recovering ignores the significant issues AVY faces from a variety of sources giving a short position at this level multiple ways to win with limited downside.  

What would make me change my mind (risks)?:

  • 2010 margins show improvement over 2H09 (because of effective cost cutting, price increases, lower input costs or cost saves).
  • Growth rates significantly accelerate in one or more divisions (because gains in market share or large scale inventory restocking).
    • Market share gains and sustained price increases would be more troubling than temporary inventory stocking gains.


  • From 2007 to the LTM OCP segment EBIT declined by $34 million. If you subtract $34 million from 2007 total company EBIT the operating margin for the entire company would have been 7.0% instead of the actual 7.6%. If you did the same for 2006, company wide EBIT margins would have been 7.9% instead of the actual 8.8%.
  • As a result, my "upside" 2011 numbers (with company wide EBIT margins of 7.9%) actually imply margins are better outside of OCP than in the peak years of 2006 and 2007 (given OCP should decline in 2010 and 2011). As a result, the 2011 "downside" case numbers should be difficult to achieve.

Avery Dennison (AVY)

Base Case
"Downside" Case

2004 2005 2006 2007 2008 LTM
2009E 2010E 2011E
2010E 2011E
Income Statement                          


 Revenue    5,317.0   5,473.5   5,575.9   6,307.8   6,710.4   5,942.4
  5,936.5   6,012.2   6,105.3
  6,113.0   6,311.2

 COGS    3,890.4   3,996.6   4,037.9   4,585.4   4,983.4   4,392.6     4,363.3   4,419.0   4,447.1     4,431.3   4,574.9

 GP    1,426.6   1,476.9   1,538.0   1,722.4   1,727.0   1,549.8
  1,573.2   1,593.2   1,658.2
  1,681.7   1,736.3


 SG&A       957.4      987.9   1,011.1   1,142.5   1,304.3   1,237.2
  1,247.4   1,232.5   1,251.6
  1,222.6   1,262.2

 R&D        13.0       14.0       15.0       16.0       17.0

      18.0       18.2       18.5
      18.5       19.1

 Other       (13.0)      (14.0)      (15.0)      (16.0)      (17.0)          (10.0)      (6.32)     (10.05)        (15.0)      (15.0)

 EBIT       469.2      489.0      526.9      579.9      422.7      312.6
     317.8     348.8      398.2
     455.6      469.9


 Net Interest Expense       (58.7)      (57.9)      (55.5)     (105.2)     (115.9)      (95.1)
     (87.6)      (87.6)      (87.6)
          -             -  

 Other Income       (35.2)      (63.6)      (36.2)      (99.4)      (36.2)     (1,007)       (1,004)      (75.0)      (75.0)        (75.0)      (75.0)

 Pre-tax       375.3      367.5      435.2      375.3      270.6     (789.2)
    (773.8)     186.2      235.6
     380.6      394.9


 Other         (1.3)      (65.4)       14.7           -             -             -  
          -            -             -  
          -             -  

 Tax         (94.3)      (75.3)      (76.7)      (71.8)        (4.5)       35.2         32.7      (41.9)      (53.0)        (85.6)      (88.8)

 Net Income       279.7      226.8      373.2      303.5      266.1     (754.0)
    (741.1)     144.3      182.6
     295.0      306.0


 Diluted Shares Out       100.5      100.5      100.4       98.9       98.7      101.9
     104.0     106.0      106.0
     106.0      106.0

 EPS        2.78       2.26       3.72       3.07       2.70      (7.40)
     (7.13)       1.36       1.72
      2.78       2.89

Margin and Ratios                          

Revenue Growth 12.2% 2.9% 1.9% 13.1% 6.4% -11.4%
-11.5% 1.3% 1.5%
3.0% 3.2%

GP Margin 26.8% 27.0% 27.6% 27.3% 25.7% 26.1%
26.5% 26.5% 26.8%
27.5% 27.5%

EBITDA Margin 12.3% 12.6% 13.1% 13.0% 10.4% 9.7%
10.2% 10.2% 10.8%
11.7% 11.6%

EBIT Margin 8.8% 8.9% 9.4% 9.2% 6.3% 5.3%
5.4% 5.8% 6.5%
7.5% 7.4%

Pre-Tax Margin 7.1% 6.7% 7.8% 5.9% 4.0% -13.3%
-13.0% 3.1% 3.9%
6.2% 6.3%

NI Margin 5.3% 4.1% 6.7% 4.8% 4.0% -12.7%
-12.5% 2.4% 3.0%
4.8% 4.8%


SG&A as % Sales 18.0% 18.0% 18.1% 18.1% 19.4% 20.8%
21.0% 20.5% 20.5%
20.0% 20.0%

R&D as % Sales 0.2% 0.3% 0.3% 0.3% 0.3% 0.0%
0.3% 0.3% 0.3%
0.3% 0.3%

Tax Rate 25.1% 20.5% 17.6% 19.1% 1.7% 4.5%
4.2% 22.5% 22.5%
22.5% 22.5%

-4.7% 32.1% 59.7% 25.2% 1.1% 23.1%
26.5% 26.5% 69.8%
27.5% 27.5%

Cash Flow                          

 CFO         517        442        511        499        540        474
       469        478        506
       530        538

 CapEx         (202)       (184)       (188)       (224)       (193)       (153)         (153)       (175)       (200)         (175)       (200)

 Levered FCF         315        257        323        276        347        321
       316        303        306
       355        338


CapEx as % sales 3.8% 3.4% 3.4% 3.5% 2.9% 2.6%
2.6% 2.9% 3.3%
2.9% 3.2%


 D&A         187        198        201        243        278        262          262        262        262          262        262

 EBITDA         656        687        728        823        701        574
       603        611        660
       717        732


 Tax on EBIT @ 32.5%        (152)       (159)       (171)       (188)       (137)       (102)
      (103)       (113)       (129)
      (148)       (153)

 CapEx        (202)       (184)       (188)       (224)       (193)       (153)
      (153)       (175)       (200)
      (175)       (200)

 Change WC            (8)         (26)         (52)       (289)        166          30
           0         (11)         (15)
        (28)         (29)

 Unlevered FCF         294        318        317        122        537        350
       347        311        316
       367        350

 Receivable  Days Out  61 Days 58 Days 60 Days 64 Days 54 Days 62 Days
62 Days 62 Days 62 Days
62 Days 62 Days
 Inventory Turns  9x 9x 8x 7x 9x 9x
9x 9x 9x
9x 9x
 Payable Days Out  58 Days 53 Days 57 Days 54 Days 49 Days 54 Days
54 Days 54 Days 54 Days
54 Days 54 Days

 Net PP&E       1,374      1,296      1,309      1,591      1,493      1,393
     1,393     1,393      1,393
     1,393      1,393


       884        863        910      1,114        989      1,009
     1,008     1,020      1,036
     1,038      1,071
 Inventory         432        440        497        631        584        512
       508        515        518
       516        533
 A/P             617        578        630        679        673        651          646        654        659          656        678

 Net Working Capital         699        725        777      1,066        900        870
       870        881        896
       898        927


Invested Capital      2,074      2,021      2,086      2,657      2,393      2,263
     2,263     2,274      2,289
     2,291      2,320


EBIT / IC 23% 24% 25% 22% 18% 14%
14% 15% 17%
20% 20%


 NI / Sales  5.3% 4.1% 6.7% 4.8% 4.0% -12.7%
-12.5% 2.4% 3.0%
4.8% 4.8%

 Sales / Assets        1.21       1.30       1.29       1.01       1.11       1.17
      1.18       1.19       1.21
      1.21       1.25

 Assets / Equity        2.84       2.78       2.55       3.14       3.45       3.92         4.20       4.20       4.20         4.20       4.20

18.1% 15.0% 22.0% 15.3% 15.2% -58.0%
-61.7% 12.0% 15.2%
24.6% 25.5%




1H10 earnings disappoint as input cost rise and year-over-year price increase benefits roll off. Additionally, continued declines in office products and the lack of a rebound in other division's pressure margins as fixed cost leverage declines faster then productivity improvements. Even if input costs decrease significantly, the earnings hole created by the continued secular decline of the office products division (which will no longer be filled with acquisitions) will become apparent in 2H10 forcing the market to adjust its multiple.

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