Avery Dennison: RFID Adoption In Retail Driving Profitability

Avery Dennison Corp. (NYSE:AVY) with a market cap of $10.7 billion is a global leader in retail branding solutions and label graphic materials. The company manufactures and supplies the printed materials for merchandise labeling and tags across various industries. Avery Dennison has grown its international operations in recent years through a number of acquisitions and is now doing about $7 billion in revenues over the last twelve months. Given the business is highly cyclical, growth has been pressured in recent periods by a weaker global macro environment while the company has been able to drive profitability by betting on higher-margin segments where it sees a runway for growth. The company just reported its fiscal Q3 earnings with better than expected results which sent shares high and is now trading at a new all-time high. This article recaps the latest financials and our view on where the stock is headed next.

Source: Finviz.com

Q3 Earnings Recap

AVY reported fiscal 2019 Q3 earnings on October 23rd with non-GAAP EPS of $1.66 and GAAP EPS of $1.71 which beat both expectations by $0.05 and $0.10 each respectively. Revenue of $1.76 billion was flat year-over-year and $10 million ahead of the consensus. The stock is up about 9% since the report, breaking out of a tight range over the past year. The story has been more muted growth over the past year, but Q3 favorably presented some more positive trends as management has been able to maintain margins. Favorably, the firm-wide operating margin increased by 40bps to 11.3% from 10.9% during the period last year. CEO Mitch Butier in the earnings press release made the following comments:

“We continue to deliver solid profit growth despite soft market demand. Our focus in this slower growth environment has been to protect our margins in the base business, while driving faster-than-average growth in high value categories like RFID, and we’re executing well on both fronts.

Considering the organic comparable sales numbers, the company's core business segment of Label and Graphic Materials, which represents 67% of total revenues, grew by just 1.2% y/y. On the other hand, the other two segments including Retail Branding and Information and Industrial and Healthcare Materials are the growth drivers each up 4.1% and 3.7% respectively.

Source: Company IR

One point worth highlighting which we discuss further below is the company's RFID solutions, "radio frequency identification," which are small tags that emit data signals as a high margin business for the company and benefiting from accelerating adoption by customers. AVY says the RFID business grew 20% in Q3 supporting an operating margin increase for the retail branding and information solutions segment up 60bps. Margins in Industrial and Healthcare Markets were also strong up 120bps benefiting from higher volumes and product mix.

Beyond the current revenue trends in the low-single digits, profitability outlook remains strong. The non-GAAP earnings this quarter which excludes some restructuring charges increased by 14% year over year. Management is guiding for full year non-GAAP EPS in a range between $6.50 and $6.60. If confirmed, the midpoint would represent an increase of 8% from last year's $6.06.

Source: Company IR

Analysis And Forward-Looking Commentary

One of the main positive trends for the company is a steady adoption of RFID tag and label technologies across industries but driven by the apparel business. AVY notes that it currently has a >50% market share. The concept here is that merchandise items with embedded "radio frequency identification" can make inventory management more efficient as a store or warehouse can have real-time information. The trade publication 'RFID Journal' describes the technology as boosting inventory accuracy by 95%.

Retailers have been struggling with lost sales due to out-of-stocks since, well, forever. Study after study shows that at least 8 percent of items are out of stock at any given time. But it's even worse: inventory accuracy is only at about 65 percent in many stores, and customers leave stores about 30 percent of the time without finding at least one item they want to buy. Poor inventory accuracy reduces a retailer's ability to show products to online customers. RFID enables companies to boost inventory accuracy to about 95 percent without having to invest in additional labor.

As it relates to Avery, the company as an established leader will be able to establish the industry growth which is a higher margin business. The applications go beyond retail and include other industries like logistics. The thought is that operating income contribution can support more sluggish results from the traditional labels business.

Source: Company IR

Valuation

While recognizing Avery Dennison's market leadership position and steady earnings growth, our concern here comes down to valuation. We highlight that among a number of trading-based valuation multiples, the stock appears expensive relative to historical averages. The P/E ratio at 46.3x and an EV to EBITDA multiple of 29.5x in particular are otherwise expensive considering revenue growth which by management guidance is still in the low-single digits for the year. Based on the 2019 full year adjusted EPS guidance at $6.55, AVY is currently trading at a forward P/E of 19.6x, in this case more reasonable, but not in the 'value' range by most measures.

Source: Data by YCharts/ table by author

One of the developments for the company has been the number of targeted acquisitions conducted in recent years which added to the company's debt position. AVY ended Q3 with $224 million in cash and $1.5 billion in total long-term debt. We calculate a leverage ratio based on net debt to EBITDA of the last year at about 3x, which is high. Valuation and debt levels are a weakness for Avery Dennison at this point but not enough to warrant an outright short or sell rating.

It appears the market is focusing on the acceleration of free cash flow that reached approximately $475 million over the last twelve months, representing a price to free cash flow ratio of 23x. The trend in free cash flow is a strength for the company and at least justifies some of the market action in the stock and premium shares currently command.

Data by YCharts

Conclusion

Following a particularly weak Q1 and Q2 for Avery Dennison when sales declined on a year-over-year basis, Q3 presented a turnaround of sorts with expanding margins and a more positive outlook. We balance our favorable views of the company against what we presented as our valuation concerns to

rate AVY as a hold

.

The market is very positive on the shares as it trades at a new all-time high. The challenge will be for management to execute on its growth targets. Investor monitoring points should include tracking changes to the company's debt level to confirm the expected deleveraging going forward. Risks to watch are global cyclical conditions and a potential for a deterioration of the economic growth environment which would represent a downside for company estimates.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.