Investment thesis for Avery Dennison
The world’s largest label company, Avery Dennison Corporation (NYSE:AVY) is putting some pep back into its earnings after several uninspiring quarters.
It aims to deliver superior value to shareholders through profitable growth and capital discipline. Those efforts are now paying off as double-digit EBITDA and EPS growth are expected this year and next year.
Although the share price is not a bargain, I believe it will rise to $231 in the next year, providing a capital gain of over 6%. I also rate it as a Buy for its proven business model, its global reach, and its scale.
About Avery Dennison
I’ve long known this company as the one that provides the labels I paste on my folders and occasional documents. However, it is much more than just labels.
Avery Dennison describes itself in its 10-K for 2023 as, “a global materials science and digital identification solutions company that provides a wide range of branding and information solutions that optimize labor and supply chain efficiency, reduce waste, advance sustainability, circularity and transparency, and better connect brands and consumers.”
Besides labels, it sells RFID (radio-frequency identification) products, software that connects physical and digital items, and other products/services. The firm serves a broad range of markets worldwide, through two segments:
- Materials Group takes in labels, graphics, reflective materials, as well as tape and other bonding products. This segment brought in approximately 69% of net sales in 2023.
- The other 31% came from the Solutions Group, which offers information and branding products and solutions. This includes RFID products, digital identification and data management, branding and other products/services.
It has been an active acquirer with several purchases last year:
- Silver Crystal Group, which specializes in sports apparel customization,
- LG Group, Inc., a designer and manufacturer of apparel brand embellishments,
- Thermopatch, Inc., which focuses on labeling, embellishments, and transfers for the sports, industrial laundry, workwear, and hospitality industries.
- It also made a venture investment in a company developing technological solutions that could advance its businesses.
These first three acquisitions cost the company about $231 million and follow two buys in 2022 that cost $35 million.
Avery Dennison is a global company, with about 69% of its 2023 net sales coming from outside the U.S. Similarly, 83% of its employees at year-end were in other countries.
At the close on July 5, 2024, its shares were trading at $216.04, and it had a market cap of $17.47 billion.
Competition and competitive advantages
Listed competitors, in the 10-K, include UPM Raflatac, Lintec Corporation (OTCPK:LNTEF), 3M Company (MMM), and Nitto Denko Corporation (OTCPK:NDEKF) In addition, there are many regional and specialty suppliers.
On competitive advantages, Avery Dennison claims to have technical expertise, size and scale of its operation, a broad line of quality products, reliable service, brand strength and product innovation.
Generally, its margins suggest those are effective competitive advantages:
- Gross profit margin [TTM]: 28.01% versus 28.35% for the Materials sector median.
- EBITDA margin [TTM]: 15.80% versus 16.50%
- Net income margin [TTM]: 6.56% versus 4.81%.
Its return on common equity [TTM] is an attractive 26.10%, considerably higher than the sector’s 5.92%.
Comment: based on this information, I believe Avery Dennison has at least a medium moat.
First-quarter financial results
First-quarter 2024 results were issued on April 24, and included the following highlights:
- Net sales increased 4.0% over the same quarter last year, to $2.2 billion.
- EPS jumped by 43%, to $2.13; adjusted EPS, non-GAAP, was $2.29, up 35%.
- Guidance for full-year 2024 included EPS of $8.60 – $9.10 (compared to normalized, diluted EPS of $6.48 in 2023), while adjusted EPS is expected to range between $9.00 and $9.50.
Management reported that earnings were higher because of higher volume and productivity gains. During the quarter, it also returned $81 million to shareholders through dividends and buybacks.
On the balance sheet, the firm has $8.255 billion in total assets, including $185.7 million in cash and cash equivalents, along with $36 million in short-term investments, for a total of $221.7 million. Total liabilities came to $6.051 billion, including $2.070 billion in long-term debt.
Comments: the firm is bringing in results that should cheer up shareholders, in particular, its EPS and adjusted EPS climbed dramatically on a small increase in revenue. And, it has a strong balance sheet.
Looking ahead to the second-quarter results expected on July 23, I’ll be watching to see if it can post a third consecutive quarter of earnings growth. An increase might be driven in part by lower costs; in the first quarter, it reduced its pre-tax expenses, from restructuring, by $19 million.
From a shareholders’ perspective, reduced costs and higher earnings could translate into more share buybacks and/or dividend increases. The problem with repurchases, when the shares are fully valued, as they are now, is that the company will not be waiting for a dip or correction to buy them back.
Growth
As the following chart shows, Avery Dennison’s revenue and EBITDA have grown slowly over the past decade, while net income has wobbled along. All three metrics now appear to be rebounding after slipping in 2023:
Why the decline last year? In the 10-K, management attributed the lower net sales mainly to lower volume, which was offset to some extent by pricing actions. Net income fell back because of several factors, including lower volume because of inventory destocking, higher restructuring charges, and greater employee-related costs.
As noted above, net sales in the first quarter were up 4%, while EPS sprung up 43%. EPS gains got a bit of a helping hand from share repurchases, with the number of shares outstanding dropping from 80.9 million to 80.5 million.
Look for big earnings gains this year, with the company’s guidance rising dramatically above last year’s $6.48 per share:
The analysts who follow Avery Dennison are also expecting a big gain this year, followed by more double-digit earnings growth in 2025 and 2026:
One of its big growth drivers is Intelligent Labels, “a suite of IOT-enabling technologies that authenticate product history, provide tracking and inventory solutions and conjure richer consumer encounters.” It is part of the Materials Group.
Comments: if the share price follows earnings, as it usually does, then shareholders should enjoy serious capital gains in the next few years. That’s the result of turning around the revenue and earnings inhibitors of 2023.
Management and strategy
President and CEO Deon Stander has held senior positions at Avery Dennison since 2005, and moved into the corner office in September 2023. Previously, he held a senior leadership role at Paxar Corporation, which was acquired by Avery Dennison.
Senior Vice President and CFO Greg Lovins has been with the company for over 25 years, and in his current role also heads up audit, financial reporting, investor relations, financial planning and analysis, tax and treasury.
Turning to strategy, CEO Stander wrote in the Q1-2024 earnings release, “our long-term goals for superior value creation through a balance of profitable growth and capital discipline.” The word “growth” makes many appearances in its documents; for example, in the 10-K:
- “Our strategy includes increased growth in emerging markets, including China.”
- “Our investment in innovation aims to accelerate growth, expand margins and enable customer success by leveraging scalable innovation platforms and delivering sustainability initiatives and advanced technologies.”
Comments: growth in emerging markets and careful capital allocation are both ways to not only grow sales, but also enhance net income and earnings per share. Those initiatives will help as it aims for adjusted EBITDA growth of 17% this year.
Profitability
Avery Dennison makes a strong showing for profitability, with a couple of exceptions:
One of those exceptions is its five-year net income margin, which trails the Materials sector median by 10.67%. Return on total capital also lags the sector over five years, despite a very strong showing on a TTM basis.
Comments: assuming the company continues to improve its net income performance, both the one year and five-year margins should gain against the sector median.
ROCE also should improve on a five-year basis, assuming it does not issue more shares; that seems unlikely since it bought back 800,000 common shares at an aggregate cost of $137.5 million in 2023.
Dividend grades
Avery Dennison compares favorably with the sector on dividends:
The only mediocre showing is for its yield. The Materials sector median is 2.09% over the past 12 months; over the past five years, the company has averaged 1.61%, which is 4.90% less than the median over the same period.
Comments: this is not a dividend stock, it is closer to being a growth stock that also has a dividend. While the yield may be low compared to the sector, it is richer than the S&P 500 average of 1.35%. Note, too, that the dividend has grown every year for the past 13 years.
Valuation
Investors pushed up Avery Dennison’s price by more than a quarter in the past year:
A quick scan of this excerpt from the Seeking Alpha valuation table indicates Avery Dennison is an expensive stock. That’s compared to both the median and rule-of-thumb metrics such as a P/E ratio of less than 15, a PEG ratio of 1 or less, and EV/EBITDA at 10 or below:
On the other hand, an assessment of intrinsic value from Omni Calculator suggests it is fairly valued or slightly undervalued:
Inputs included normalized diluted EPS on a TTM basis, an expected annual growth rate calculated by averaging analysts’ expected earnings growth for 2024 and 2025, the Moody’s Seasoned Aaa Corporate Bond Yield, and the closing price on July 5, 2024.
Based on the data above, I believe the stock is slightly overvalued. That’s consistent with a company that is expected to deliver double-digit earnings growth this year and next year. Investors also will expect another increase in the dividend and more stock repurchases over the next year. The dividend and buybacks may be relatively small, but they are not unimportant in total returns.
As we saw in the calculation above, the stock’s intrinsic value was put at $231.50, which provides a 6.68% margin of safety. That estimate is close to the Wall Street analysts’ one-year price target of $230.03, and a 6.48% increase over the current price.
I believe the analysts enjoy credibility because of the accuracy of their forecasts over the past seven months:
Based on this information, I am projecting a price of $231.00 in a year’s time. I also give Avery Dennison a Buy rating. The Quant system gives it a Hold, Wall Street analysts offer four Strong Buys, three Buys, three Holds, and two Sells. No other Seeking Alpha analyst has posted a rating in the past 90 days.
My rating is backed up by Avery Dennison’s proven business model, the ongoing growth provided by Intelligent Labels and other initiatives, and its scale.
Risk factors
The firm operates in 50 countries and 69% of last year’s net revenue originated outside the U.S., exposing it to geopolitical risks. In 2023, for example, it took a loss of $24.4 million because of currency exchange rates. In addition, international operations make it sensitive to economic conditions, taxation rates, and even wars.
Procuring raw materials for its factories can be challenging, with Avery Dennison saying in the 10-K there can be price and availability volatility. This is offset to some extent by its pricing power, as witnessed by its ability to increase prices in 2021 and 2022, to deal with inflation.
As an active acquirer, the company risks buying other firms that may not turn out to fit as well as expected. Risks include loss of key customers, employees, and a higher debt load.
New products and improvements to existing products are an important part of its success. As a result, it must continue investing in R&D, which cannot always deliver profitable products or additional sales.
Given the size and decentralization of the company, it depends on its information technology. This makes it susceptible to cyberattacks, natural disasters, and more. One of the more threatening aspects of cybersecurity comes from the increasing number of ransomware attacks.
Conclusion
Avery Dennison has reinvented itself in recent decades, broadening its scope and expanding its geographic horizons. Current efforts to make the company more profitable also made it more valuable, with investors pushing up the price by over 28% in the past year.
There are a few uncertainties, such as its success in integrating acquisitions, its competition, and its ability to keep introducing new products and improving existing ones.
Still, with at least two years of double-digit earnings growth likely ahead, it earns a solid Buy rating.
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