EUR 850.00 For Business Accounts Only

Morningstar | Avery Faces Some Margin Pressure on Price/Cost Lag in 3Q

Avery Dennison reported a decent third quarter, with results that remained fairly consistent with our forecasts for 2018. However, the stock fell nearly 5% on fears of the potential impact of a slowdown in China and whether Avery will be able to pass on price increases to recover from softer margins. Margin compression has been a theme across many packaging firms during the quarter, but we think cost increases will eventually be passed on to consumers. That said, if natural gas and paper costs fall further, sales growth could weaken as price is given back. Third quarter aside, we've revised our assessment of the required net new investment for Avery. Accordingly, improved cash conversion has led us to increase our fair value estimate to $86 from $83 per share. Our no-moat rating is unchanged.

LGM, Avery's largest segment, was the primary cause for contention in the third-quarter results. Adjusted operating margins fell by 100 basis points to 12.3% year over year. Management cited input cost inflation as one of the largest drivers, consistent with rising resin and paper prices. Given that the business doesn't run on strict pass-through contracts, Avery doesn't immediately recover cost inflation. We think much of this will be made up over the coming quarters, even if increased competition in the long run will eventually trim recent operating margins.

We think concern over the effects of weaker Chinese export demand or consumption are more warranted. Companywide sales in China were nearly 20% of 2017 revenue, and any severe slowdown in economic activity would weigh on both margins and sales across the LGM and industrial and healthcare materials segments. However, our base case reflects a scenario in which China more gradually shifts from an investment-led economy to a consumption-driven one. We could see product-mix change as that takes place, but wouldn't anticipate severe impacts to margins or sales growth during that process.

Avery's second-largest segment, RBIS, produced an 8.2% organic sales growth during the third quarter. The increase remained roughly in line with the robust second-quarter growth rate, and the segment didn't have to give up operating margin to achieve it. As in past quarters, the largest growth driver is sustained adoption of RFID tags and labels in a wide range of applications. We expect the segment to generate sales growth exceeding 6% per year on an organic basis for the foreseeable future, but think margins may still fall short of management's goals over a full economic cycle. We think midcycle operating margins could be 200 to 300 basis points lower than the past couple of quarters, falling to about 8%.