Avery Dennison Corporation (NYSE:AVY), whose portfolio encompasses pressure-sensitive materials and a wide range of tickets, tags, labels, and other converted products, has been increasing the quarterly DPS for 10 consecutive years since the sharp cut in payout amid the Great Recession. In 2020, the company has decided not to trim or suspend shareholder rewards, as despite weaker revenue and pressure on profitability, its liquidity remains ample. It also illustrates that Avery’s portfolio has become much more resilient since the previous global economic slump, and a corollary is that the management has been leading the company in the right direction.

The last time it declared the dividend was on July 22, when AVY announced it would pay $0.58 per share. With the share price of $118.18, this specifies ~2% dividend yield, which is not too appealing, but coupled with possible upside potential spurred by the medium-term revenue growth, it might be worth considering for investors who want to gain exposure to the packaging industry and especially to the RFID technology.

Besides, AVY has a ~21% Cash Return on Total Capital, which points to the fact that it excelled in the deployment of both shareholder and debt investor capital to the most lucrative options. Additionally, according to my calculations, it has an FCFE yield of ~4.66% (vs. the dividend yield of ~2%), which means the amount of organic FCF AVY generated in the trailing four quarters far exceeded the funds returned to shareholders via dividends.

The top line

As Seeking Alpha data illustrate (see Ownership), AVY is almost entirely controlled by institutions, as 89.45% of its share capital belongs to them. The company has three segments: Label and Graphic Materials, Retail Branding and Information Solutions, and Industrial and Healthcare Materials. The dominance of LGM is unquestionable, as it was responsible for 67% of the 2019 net sales, while RBIS was in second place with a 23% contribution. Its essential end-markets and the U.S. and Western Europe combined account for 61% of the total revenue (slide 7).

ChartData by YCharts

The pace of AVY’s expansion in the 2010s was quite glacial, as its 10-year revenue Compound Annual Growth Rate equals only 0.74%. The three-year CAGR is a bit higher and stands at 2.73%, as in the recent years, AVY was active on the inorganic growth front, e.g., in 2016, it acquired the European business of Mactac, “a leading manufacturer of high-quality pressure-sensitive materials.” In 2017, it acquired Yongle Tape. In 2020, it closed the acquisition of Smartrac. The acquisitions somewhat shored up the top line in the second half of the decade, and especially in 2016-2018, but AVY still encountered a sales stasis in 2019-early 2020, precisely before the pandemic spawned a perfect storm in the global economy. The silver lining is that the share of revenues generated from high-value categories (like RFID and specialty labels) rose meaningfully, which means Avery Dennison will likely grow faster than the global GDP (slide 8) when the economic downswing is over.

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The second quarter (ended June 27) was remarkably challenging as total revenues dived 14.9%, while the gross profit fell ~20.6%. Organic decline was a bit less deep, 13.7%. RBIS bore the brunt of the crisis as it suffered from the organic contraction of 35.5% vs. 2Q19, while its GAAP sales fell 29.5%. IH was slightly stronger and posted a 20.9% organic decline in net sales. Finally, the flagship division LGM was almost immune to the sluggishness in the economy stemming from the pandemic, as far as its organic revenues were down only 4.9%.

The culprits of the decline are obvious even without thorough research. As retail stores were closed due to lockdowns, while activity at apparel manufacturing hubs hibernated, RBIS’s sales cratered. IHM, in turn, was pummeled by the clobbered activity in the automotive industry. Finally, LGM, the flagship, fared far better thanks to strong demand from the food, hygiene, and pharmaceutical end-markets.

The Q2 contraction was disappointing, but the silver lining is that the demand in a few of its end-markets had already passed a nadir in spring, and the recovery is underway. AVY itself expects Q3 revenues to be down 7%-9% organically (slide 14), which is clearly not inspiring, but it is still much better than a double-digit contraction.

As a quick reminder, Avery Dennison is the essential customer of Impinj (NASDAQ:PI), a RAIN RFID company I previously covered in April (see page 8 of the Form 10-K). Moreover, in 2020, AVY closed the acquisition of Smartrac, which in the past was another essential client of Impinj responsible for 12% of the 2019 sales. Thus, the high customer concentration of PI was increased even further.

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Impinj suffered from a 31% revenue reduction in Q2, which was much deeper than Wall Street had expected. My cautious surmise here is that the precipitous revenue decline was partly triggered by AVY’s conservative inventory management, as it has been laser-focused on FCF generation despite the crisis, so, it made necessary working capital adjustments in the wake of plunging sales. So, this is disappointing news for owners of PI and an apparently healthy sign for AVY’s investors who are concerned with the dividend payout: AVY has been making necessary steps to protect it.

Cash flow and liquidity as the staples of dividend coverage

For a dividend investor, cash flows are of paramount importance, as a company might have bumper profits but also a receivables problem or issues with inventory management, which will result in the inability to cover investments and dividends.

Thankfully, AVY covered its LTM dividends paid 2.5x (vs. 2.7x in 2019 and 1.3x in 2018), and H1 dividends paid 1.24x. The company also has a share repurchase program, which was not suspended even in the wake of the coronavirus crisis. The LTM total shareholder rewards were covered by FCFE 1.3x.

Answering an analyst’s question on FCF and capital allocation priorities, CFO Mr. Lovins made the following remarks:

…we’re still expecting to deliver roughly $500 million in free cash flow for the year. At the same time, our debt position and our balance sheet remain strong. So we continue to feel comfortable about our ability to continue investing in the business organically, continuing to look for M&A targets, which we’re continuing to do as well and then also continuing to return cash to shareholders, which we’ve done by maintaining the dividend throughout this crisis period so far. And we have share buybacks as we’ve talked about and that’s something that we’ll continue to monitor and evaluate as we move through the back part of the year.

Note: See page 15 for the definition of FCF, it differs a bit from the one I use.

I like to see a margin of safety as the company does not return all its organic FCFE to shareholders, which can somewhat guarantee that if sales and cash flow stagnate (or, in fact, contract, if adjusted for inflation), the dividend payout will likely be protected for a few years until the company finds a fresh and potent driver for the top-line growth.

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Capital efficiency

AVY’s Cash Return on Total Capital stands at ~21%, which means the firm is exceptionally efficient. We also can take a look at Return on Equity, which stands at a sector-leading level of 45.8%. But when I see a figure like this, the first thought I have is if it was inflated by low equity and high debt load. And this is precisely the case of AVY. Avery Dennison mostly relied on shareholder funds in the early 2010s, but then it changed, as the share of borrowed funds in the capital structure rose materially higher 2014. At the moment, its Debt/Equity equals 187%, which is high, but its Net debt/Net CFFO is not overstretched: it stands at ~2.86x.

Conclusion

Recent comments of Fed Chair Mr. Powell on inflation hint that interest rates will continue to be close to zero, as the Federal Reserve will tolerate temporary marginal fluctuations in inflation above a 2% target. So, low-risk bonds will still be barely appealing both for institutional and retail investors.

To sum up, I would not say that a ~2% dividend yield is attractive for me, but AVY might be worth considering for some investors who seek to diversify portfolios and gain exposure to the RFID technology while also taking less risk compared to Impinj, which is a much smaller (and unprofitable) player.

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.



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