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Edited Transcript of AVY.N earnings conference call or presentation 27-Jul-20 5:00pm GMT

Q2 2020 Avery Dennison Corp Earnings Call

Pasadena Sep 2, 2020 (Thomson StreetEvents) -- Edited Transcript of Avery Dennison Corp earnings conference call or presentation Monday, July 27, 2020 at 5:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Cynthia S. Guenther

Avery Dennison Corporation - VP of Finance & IR

* Gregory S. Lovins

Avery Dennison Corporation - Senior VP & CFO

* Mitchell R. Butier

Avery Dennison Corporation - Chairman, President & CEO

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Conference Call Participants

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* Adam Jesse Josephson

KeyBanc Capital Markets Inc., Research Division - Director and Senior Equity Research Analyst

* Anthony James Pettinari

Citigroup Inc., Research Division - Director & US Paper, Packaging & Building Products Analyst

* Christopher John Kapsch

Loop Capital Markets LLC, Research Division - MD

* George Leon Staphos

BofA Merrill Lynch, Research Division - MD and Co-Sector Head in Equity Research

* Ghansham Panjabi

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

* Jeffrey John Zekauskas

JPMorgan Chase & Co, Research Division - Senior Analyst

* Joshua David Spector

UBS Investment Bank, Research Division - Equity Research Associate - Chemicals

* Neel Kumar

Morgan Stanley, Research Division - Equity Analyst

* Paretosh Misra

Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst

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Presentation

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Operator [1]

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Ladies and gentlemen, thank you for standing by. (Operator Instructions)

Welcome to Avery Dennison's Earnings Conference Call for the second quarter ended June 27, 2020. This call is being recorded and will be available for replay from noon Pacific time today through midnight Pacific time, July 30. To access the replay, please dial (800) 633-8284 or +1 (402) 977-9140. For international callers, the conference ID number is 21930679.

I'd now like to turn the call over to Cindy Guenther, Avery Dennison's Vice President of Investor Relations and Finance. Please go ahead.

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Cynthia S. Guenther, Avery Dennison Corporation - VP of Finance & IR [2]

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Thank you, Maladin. Please note that throughout today's discussion, we'll be making references to non-GAAP financial measures. The non-GAAP measures that we use are defined, qualified and reconciled with GAAP on schedules A-4 to A-9 of the financial statements accompanying today's earnings release. We remind you that we'll make certain predictive statements that reflect our current views and estimates about our future performance and financial results. These forward-looking statements are made subject to the safe harbor statement included in today's earnings release. We undertake no obligation to update these statements to reflect subsequent events or circumstances other than as may be required by law.

On the call today, dialing in from different locations are Mitch Butier, Chairman, President and Chief Executive Officer; and Greg Lovins, Senior Vice President and Chief Financial Officer. And now I'll turn the call over to Mitch.

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Mitchell R. Butier, Avery Dennison Corporation - Chairman, President & CEO [3]

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Thanks, Cindy, and hello, everyone. Our teams have come together extraordinarily well in navigating one of the most challenging periods we have experienced as a company. The compounding effect of the health, economic and societal crises are having a significant impact in our teams, our markets and our communities. Our focus continues to be on ensuring the health and welfare of our employees, delivering for our customers, supporting our communities and minimizing the impact of the recession for our shareholders. And I'm pleased to report that we are making solid progress on all fronts.

Since the early days of the pandemic, we quickly adopted and then adapted best practices to keep our employees safe and our plants operational, while also taking steps to reduce the financial impact to employees affected by necessary furloughs and layoffs. Despite our best efforts to protect employee health, unfortunately, we have identified roughly 225 confirmed cases of the virus within our 30,000-plus workforce, with the majority of cases apparently reflecting community spread rather than a work-based source of infection.

Now before I shift to our operating results, I'd like to take a moment to comment on one other critical issue. In response to heightened awareness of the profound societal issues of racial and other sources of inequity, we are sharpening our focus on diversity and inclusion, starting with significant efforts to listen to and learn from the experiences of employees who represent racial minorities and other marginalized groups. We are incorporating these learnings and concrete plans to further support our organizational values.

Now turning to business results. While both our top and bottom lines were down in Q2 compared to prior year, results came in better than we expected just a quarter ago. Following a sharp decline in April, total company sales improved sequentially in May and June. A key focus of ours in this lower growth environment is on protecting our overall profitability, which we accomplished in the first half of the year. Year-to-date, adjusted EBITDA margin was up 30 basis points. And in the second quarter, we reported an adjusted EBITDA margin of 14%, despite the significant overall volume decline. This relatively strong margin performance reflects the successful execution of our strategies over recent years and the team's fast actions in implementing temporary cost-saving measures as well as lower costs from incentive compensation.

Now drilling a little deeper into our trends by business. Both LGM and RBIS came in better than our expectations on both revenue and margin, while IHM revenue was a bit short of our forecast.

Our Label and Packaging Materials business, the largest component of LGM, which serves a critical role in packaged goods and supply chains globally remains substantially open to serve customers as the pandemic unfolded across the world. Our sites in Europe and North America experienced significant surges in orders mid-March through April, driven by both increased consumption and inventory build, resulting in backlog that carried us into early June.

In some cases, our lead times were longer than usual due to pockets of disruption in some of our plants located in the COVID hotspots. Overall, though, by leveraging our strong operational excellence, the team delivered record levels of output for the better part of 2 months, all while keeping their colleagues safe. Then in June, LPM sales slowed in both Europe and North America, with a portion of the slowdown reflecting inventory destocking.

In China, LPM sales improved sequentially, following relatively steep declines in January and February, while the balance of emerging markets, particularly India, deteriorated as lockdown spread across the globe and continue through much of Q2. That said, demand across most emerging markets -- countries improved sequentially in June as the lockdowns eased. In contrast to the surge we saw in LPM in the early stages of the pandemic, we experienced a significant drop in demand for RBIS and the graphics portion of LGM, with April sales down more than 50% organically for both businesses. These businesses then improved sequentially faster than expected in both May and June. Enterprise-wide, RFID was up over 10% in the quarter on a constant currency basis, reflecting the contribution of the recent Smartrac acquisition, which more than offset a 20% organic sales decline related to COVID's impact on apparel demand.

With 75% of the RFID business still tied to apparel, we expect RFID sales in 2020 will grow more than 30% ex currency and will be roughly comparable to prior year on an organic basis.

Our project pipeline continues to expand with customer engagements now up more than 35% since just the start of this year. As these projects continue to move through the pipeline, we continue to expect 15% to 20% growth of our Intelligent Labels platform over the long term.

As you know, we have been continuing to invest to expand our Intelligent Label business, including through acquisition. The integration of Smartrac is on track to accelerate the growth and value generation of this now $500 million revenue business. By leveraging the combined channel access, global footprint and innovation capabilities of the 2 organizations, in terms of product portfolio, process technology and larger R&D and business development teams, we are positioned extremely well to develop solutions that meet rapidly expanding customer needs with a particular focus on apparel and beauty, food and grocery and logistics. And COVID-19 has served to further strengthen the key drivers of our RFID adoption, with new supply chain models demanding better speed and visibility, the need to reduce staffing levels, increased demand for food, product sourcing and handling traceability and increased importance of reduced contact at checkout, not to mention an acceleration of omnichannel retailing for apparel.

Now returning to the total company. As we've said before, we've entered this crisis from a position of financial, operational and commercial strength. Our business is resilient across economic cycles, though the nature of the macro challenges is different today than in past recessions. Historically, our businesses have continued to deliver solid free cash flow in periods of economic downturn and sales and earnings have rebounded quickly in the 12 months following. We're doing more than just weathering the storm. Our teams are adapting quickly to new commercial and operational norms, responding decisively with best practice safety measures and prudent cost reduction, protecting our profitability in a lower growth environment and are positioned well to capture demand as conditions improve. Our strategic priorities are unchanged. We are preserving our investments to expand in high-value categories, particularly our Intelligent Label platform while driving long-term profitable growth of our base businesses, and we remain confident in our ability to continue to create significant long-term value for all of our stakeholders.

I'll now hand it over to Greg.

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Gregory S. Lovins, Avery Dennison Corporation - Senior VP & CFO [4]

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Thanks, Mitch, and hello, everybody. Though this past quarter was one of the most challenging ever for the company, we are executing extremely well. We delivered adjusted earnings per share of $1.27 for the quarter, which was better than our expectations, as the pandemic-driven decline in sales was not as severe as our April outlook assumed.

Specifically, sales declined by 12% ex currency, or 13.7% on an organic basis. And currency translation reduced reported sales by 2.9 points in the quarter. As Mitch noted, despite the drop in revenue, we reported an adjusted EBITDA margin of 14%, down 60 basis points and an adjusted operating margin of 10.7%, down 140 basis points. And we realized $15 million of net restructuring savings in the quarter with close to half of that representing carryover from prior year projects, and we recorded approximately $39 million of restructuring charges. These charges relate to the acceleration of absence that teams are taking this year and the businesses most impacted by COVID-19. And we are now targeting between $60 million and $70 million of incremental net savings from restructuring this year, with roughly half of that in RBIS. We also delivered roughly $75 million in net temporary savings in the quarter made up of belt-tightening actions such as travel reductions, reductions in overtime and temporary labor and furloughs as well as lower incentive compensation accruals.

Turning to cash generation and allocation. Year-to-date, we've realized $109 million of free cash flow with $144 million generated in the second quarter. And we expect free cash flow to accelerate in the second half, reflecting normal seasonality as well as higher net income and a continued focus on working capital productivity.

With regard to the latter, our main focus this year has been the management of receivables, and collections in the quarter were in line with our expectations. We are also now turning our attention to reducing inventory levels, which have ticked up, reflecting the timing of sales at the end of the quarter, some strategic sourcing decisions as well as a little less focus given other priorities in the quarter. We expect inventory ratios to be back in line with our normal levels in the second half.

Our balance sheet remains strong with a net debt-to-adjusted EBITDA ratio at quarter end of 2.1, below our long-term target range of 2.3 to 2.6, and we have ample liquidity with $800 million available under our revolving credit facility and more than $250 million in cash at quarter end. And you may recall that we had drawn $500 million from our revolver back in March in light of the uncertainty of commercial paper markets at the time.

In June, as it became clear that CP markets had stabilized, we repaid those loans. As you know, our long-term priorities for capital allocation support our primary objectives of delivering faster growth in high-value categories alongside profitable growth of our base businesses. These priorities are unchanged in the current environment. In particular, we continue to protect our investments in high value categories, while curtailing our original capital spending plans for the year by approximately $55 million in the other areas of the business. And as noted last quarter, we are maintaining our dividend rate during this period of uncertain global demand, and we have not yet resumed share repurchase activity following our decision in March to pause this program as the crisis unfolded.

Turning to segment results for the quarter. Label and Graphic Materials sales were down 4.9% on an organic basis, driven largely by volume and mix. Sales were unchanged organically in Label and Packaging Materials as modest growth in the base label and specialty label categories was offset by a mid-teens decline for durable label categories, reflecting the general slowdown in durable goods production.

Looking at LPM's organic sales trends by month in region, North America and Europe went from low double-digit growth in the combined March and April to high single-digit growth in May and then declined in June, as Mitch indicated earlier. The trend in China was a bit choppy with a low single-digit decline overall for the quarter, and South Asia saw mid-teen declines in both April and May, reflecting the widespread closures, particularly in India, with a significant sequential improvement in June, which came in nearly even with prior year.

And finally, results in Latin America were down low single digits overall for the quarter. As Mitch mentioned, in the combined Graphics and Reflective Solutions business, sales declined by approximately 30% organically but improved through the quarter. LGM's adjusted operating margin increased 100 basis points to 14.8% as the benefits of productivity, including material reengineering and net restructuring savings as well as raw material deflation net of pricing more than offset unfavorable volume and mix.

And shifting now to retail branding and information solutions. RBS sales were down 28% ex currency, and 36% on an organic basis, reflecting an approximately 40% decline in the base business, driven by site closures and lower apparel demand.

As Mitch noted, ex currency, enterprise-wide RFID sales were up more than 10%, driven by the Smartrac acquisition and down 20% on an organic basis. And note that while LGM represents a separate and distinct channel of access to printers and converters purchasing our RFID inlays for simplicity during the integration. In the second quarter, we decided to recognize the results associated with the Smartrac acquisition solely in RBIS. Overall, results in RBIS reflect strong sequential improvement in demand every month since April.

Looking at the base apparel business, the value channel held up best for the quarter, though still down close to 30% on an organic basis, while premium fashion deteriorated the most. Adjusted operating margin for the segment declined to roughly 1%, reflecting reduced fixed cost leverage in this high variable margin business, which was partially offset by aggressive cost control measures.

Turning to the Industrial and Healthcare Materials segment. Sales fell 21% on an organic basis, reflecting an approximate 30% decline in industrial categories, driven by automotive. Adjusted operating margin decreased 370 basis points to 6.8% due to reduced fixed cost leverage, partially offset by productivity.

And now shifting to our outlook. Given the uncertainty regarding global demand, we are not resuming annual guidance at this time. As we did in March and June, we will arrange an update call in September to let you know how things are playing out.

In the meantime, I'll highlight some of the key pieces of the equation that we have reasonable visibility to now. We expect that our third quarter sales will be down 5% to 7% on an ex currency basis and 7% to 9% organically. So far in July, total company sales ex currency are down about 5% or roughly 7% on an organic basis, with LGM down about 6%, RBIS down about 5% and IHM down about 14%.

Our organic sales outlook for the third quarter assumes that LGM will be down mid-single digits. RBIS will slow down relative to July and be down mid-teens, and IHM will show a modest sequential improvement compared to July.

As mentioned, we also expect to generate restructuring savings net of transition costs of $60 million to $70 million this year, up $10 million from our view in April. And we're targeting roughly $150 million of net temporary savings, which, as noted, includes reductions in accruals related to incentive plans. And note that over half of the full year total for temporary savings has been realized in the first half of the year with much of that in the second quarter.

And keep in mind, the vast majority of the temporary actions we are taking are expected to be a headwind for us when markets recover.

As Mitch said, protecting our margins is a key focus for us during this period of slower growth. Assuming we continue to see sequential improvement in demand trends through the second half, we are targeting to deliver an adjusted EBITDA margin for the full year, in line with prior year.

And finally, we are targeting to generate roughly $500 million of free cash flow this year, roughly comparable to what we delivered last year with our target, including an increase in cash restructuring costs associated with new initiatives, and a higher cash tax rate related to repatriation of foreign earnings. Our free cash flow target includes an expected $165 million to $175 million of spending on fixed -- in IT investments and another roughly $60 million in cash payments associated with restructuring actions.

In summary, we are very well positioned to navigate this challenging environment, and we look forward to coming out even stronger when our markets recover. And now we'll open up the call for your questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions)

And our first question comes from the line of George Staphos with BofA Securities.

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George Leon Staphos, BofA Merrill Lynch, Research Division - MD and Co-Sector Head in Equity Research [2]

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I guess, my question to start is around margin cadence to the extent that you can comment either quantified or qualitatively. You've done remarkable job so far generating temporary cost savings and restructuring, should we assume that you should be able to maintain the same level of year-on-year comparisons in profit dollars for the key segments and third quarter, assuming volume trends don't deteriorate from what you saw in July? Or would there be any reason why the year-on-year comparisons might be more negative in 3Q versus 2Q?

That's question #1.

Question #2 is on RBIS, can you talk to what, if any, at this juncture, conclusions you have on mix of the business as we look out into '21 and '22. And as much as if we are working less in formal settings and more away from the office, does that have any effect on -- from what your customers are saying, premium apparel versus other types of apparel and then in turn, the margin and price point that you're selling at within RBIS?

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Gregory S. Lovins, Avery Dennison Corporation - Senior VP & CFO [3]

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Thanks, George. This is Greg. I'll take the first part of that question, at least. As I mentioned at the end there, we expect our EBITDA margins, assuming -- obviously, we come in the range we talked about for Q3 and things continue to improve as we move through the back part of the year. So we would expect our EBITDA margin for the full year to be in line with prior year. So we're slightly better than prior year in the first half, and we've started to see margins pick up last year in the second quarter. So largely for the second half, we're targeting to be roughly in line with margins that we had in the back half of last year.

I think you asked about any comp differences versus prior year. The only major difference would be the European restructuring that really kicked in, in the third quarter last year. So that was a benefit year-over-year still in Q2. It wouldn't be a year-over-year benefit in the third quarter, but largely we placed with some of the new actions that we've talked about already.

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Operator [4]

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And our next question comes from the line of...

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Mitchell R. Butier, Avery Dennison Corporation - Chairman, President & CEO [5]

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Yes, so just on the -- sorry, I want to answer the second question. George, you asked a few questions around RBIS and conclusions on mix of business going into next year. I would say right now, we're not conclusive on various general areas of mix other than the trend of continuing to improve the mix of RBIS overall towards the high value segments. We expect that to continue as it has been, maybe even accelerate. So if you look at with Intelligent Labels, within that business, we expect 15% to 20% growth over the long term. External embellishments, it's now $100 million business. We expect that to be growing well above average in that range as well. So that would be one overall conclusion we have of mix of business in general. And then as far as impacts of, you mentioned, maybe less formal settings around closing. There are just discussions, obviously, about maybe the casualization of the workplace and people working from home, could be a benefit to athleisure at the expense of more formal wear. For us, should that hold true. We're well positioned. A good portion of our sales is with performance athletic businesses now. That's not hitting already. There's quite a bit of inventory in the system. And athleisure in general isn't as seasonal as other categories. So that's down a good amount for us in Q2, but we think that it's a very durable segment of the market where we are extremely well positioned. And for us, just overall, what we're seeing in COVID, a lot of near-term disruptions, but we think it actually plays to our strengths, both as far as market access, global footprint and technological advantage, particularly around Intelligent Labels.

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Operator [6]

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And our next question comes from the line of Anthony Pettinari with Citigroup Global Markets.

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Anthony James Pettinari, Citigroup Inc., Research Division - Director & US Paper, Packaging & Building Products Analyst [7]

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For LGM, is it possible to quantify or characterize any benefit from lower raw materials net of price in 2Q? And how you just generally would expect price cost to play out in the second half as you lap some pricing headwinds, but also pet chem prices are coming back up, but other things like paper coming down, just how would you kind of characterize second half price cost?

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Gregory S. Lovins, Avery Dennison Corporation - Senior VP & CFO [8]

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Yes, Anthony, this is Greg again. So I think we've had a, as I talked about last quarter, low single-digit benefit sequentially from where we ended last year. Through the first quarter, another, I guess, low single-digit benefit from Q1 to where we were Q2 from a raw material basket perspective. And as you said, started out earlier in the year in paper, early Q2, some benefit from films and chemicals. And we are looking at a little bit of pressure in the back half, potentially depending on where the macro goes and where oil goes, et cetera. So I think we may see, given some of the sequential deflation we've had in the first couple of quarters, a little bit of a modest price raw headwind in the second half sequentially from where we are at the end of the second quarter.

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Anthony James Pettinari, Citigroup Inc., Research Division - Director & US Paper, Packaging & Building Products Analyst [9]

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Okay. That's helpful. And then do you think your LGM volumes in 2Q were consistent with what the industry was seeing? Or are you maybe picking up some share, giving up any share? And I guess with negative volumes in 2Q, did you see any change in kind of competitive dynamics maybe in terms of pricing or other behavior?

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Mitchell R. Butier, Avery Dennison Corporation - Chairman, President & CEO [10]

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Yes. So overall, if you look at -- we clearly think we thought at the time that there were some of the surge we saw speak specifically to the mature regions, North America and Europe. Some of the surge we saw was inventory building. And we think we're now seeing the industry, and we are seeing inventory destocking. If you look at our growth over, really just going back March through July, the mature regions grew 6% over that period. So that's above what we've historically seen, which we think is -- we're not through the cycle yet, obviously, clearly, that's above the average consumption within that business, and I'm talking volumes right now. As far as within the -- you ask a share question specifically, so we don't have all the share data in yet. So we don't yet know the answer where we do see it. We do believe we did perhaps lose some very modest amounts of share early on in the cycle. We were -- our plants -- a couple of our plants were in a position where there was COVID hot spots, as I mentioned earlier. And so as we were ramping up production and so forth and, ultimately, got to the point of having record output. But in the early part, we think we didn't see a bit of share. But overall, within the range that we would expect over time, and we're confident that we'll be able to recapture anything that we did lose.

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Operator [11]

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And the next question comes from the line of Ghansham Panjabi from Robert W. Baird & Company.

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Ghansham Panjabi, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [12]

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Mitch, just to follow-up to Anthony's question on the LPM tail off, if you will, in terms of demand. Are there any specific verticals that you're seeing incremental demand -- weakness in LPM as it relates to your destocking comment? Just asking because of the -- most of the CPG companies that reported thus far have been pointing towards still healthy demand. I guess, which end markets are you seeing that destocking?

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Mitchell R. Butier, Avery Dennison Corporation - Chairman, President & CEO [13]

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We're actually seeing it across the board. The surge we saw was in all product categories, and we're further back in the supply chain. And so the compounding effect of pantry loading, which is what the end users would see. But then you've got the -- with the end users, the consumer packaged goods companies have and then the converters as well. And so our converter customers are telling us, yes, they did build inventory, and they are now reducing inventory now that they all are comfortable across the network that there will be a continuity of supply. So we don't have a good read on exactly what it -- how much of it would be destocking versus end consumption. As I mentioned, over that 5-month horizon, there is above-average demand for our products, that's what we're continuing to see. And over the next month or 2, I think we'll be able to sort out exactly how much is destocking and so forth. And again, the market data is not yet in for particularly North America yet, so we don't have a good feel on that.

Within, in general, we believe the market for film business, in particular, because of just the household and personal care, particularly household, has done well from a market perspective, and we're continuing to see good growth in that category, just -- and that's where you probably see the big -- most exaggerated increase in consumption.

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Ghansham Panjabi, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [14]

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Got it. And then in terms of RFID, I mean, obviously, the apparel markets are quite challenged at current. You mentioned that's about 75% of RFID. Can you just touch on what you're seeing for the other end markets? And then just related to that, the 40% decremental you recorded for the RBIS in the second quarter, is that the right number to think about going forward?

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Mitchell R. Butier, Avery Dennison Corporation - Chairman, President & CEO [15]

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Yes. So I'll let Greg answer the decremental margin question in a moment. So specifically around RFID, yes, 75% of the business now with the Smartrac acquisition is linked to apparel. So obviously, for existing programs when their volumes are down of our customers, the existing programs will decline. We expect ultimately apparel, as it has in the past, to rebound. People are still going to consume clothes. And we think we're well positioned within that. And then -- so that's really what the driver is overall of the RFID decline. What we're seeing as far as activity is both in apparel and outside of apparel, those who knew they wanted to drive more automation, increase their speed, and were looking at RFID, are accelerating their efforts and those where it was maybe more earlier in the pipeline discussions, definitely a lot more interest. So as I commented, our pipeline for Intelligent Label programs is up more than 35% just from the beginning of this year, and it's up close to 60% since last year. So a significant increase in about half of the pipeline growth that we're seeing is in logistics. So that area, in particular, standing out. Apparel and food, we're still seeing a 20% increase in both those categories in the pipeline since the beginning of the year. The one where we're, obviously, not getting much traction right now and it slowed down is aviation. So there hasn't been any growth really in the aviation pipeline over the last -- well, since the beginning of the year for obvious reasons. So generally very excited about the opportunities, not only in apparel, a lot of runway ahead of us on that, but also particularly driving within Food and Logistics. Greg, do you want to talk about decremental margin?

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Gregory S. Lovins, Avery Dennison Corporation - Senior VP & CFO [16]

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Sure. Yes. And the second question there, so overall, when we look at the full P&L for the company, our decremental margin was around 20%. And if I break that down, as we talked last quarter, we expected the volume impacts net of the short-term actions to be around 30% for the year. That was about 40% in Q2, and we would have expected that to be a bit higher than normal just given the bigger decline in the quarter. And then we offset part of that volume net of short-term action 40%. We offset part of that with the restructuring savings as well as incentive compensation adjustments. So from an RBIS perspective, obviously, given the size of the sales decline, their impact was bigger. And given the fact that they generally have higher variable margins as well. And they had an impact in the second quarter from, of course, the incentive compensation accrual impact as well. So we wouldn't expect that to change too much for RBIS as we move through the back half, just given the higher variable margins there. And not repeating the adjustment on incentive compensation as well.

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Operator [17]

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Next question is from Adam Josephson with KeyBanc Capital Markets.

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Adam Jesse Josephson, KeyBanc Capital Markets Inc., Research Division - Director and Senior Equity Research Analyst [18]

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Kudos on that monthly sales trend slide, by the way, just -- it really clarifies the monthly trend, so thank you for putting that in there. Along those lines, a question on July. So you said July sales were down 7% organically. Obviously, from April to June, it went from down 17% to down 11% and then down just 7% in July. So just at a high level, Mitch, could you talk about why you're not assuming further sequential improvement from July because based on your 3Q guidance of down 7% to 9%, if anything, you're assuming modest deterioration from that down 7%? I'm just trying to get a better understanding as to why.

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Mitchell R. Butier, Avery Dennison Corporation - Chairman, President & CEO [19]

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Yes. We're expecting continued improvement in LGM and IHM, but it's really around RBIS. And we don't -- if you look at July itself, it doesn't fully reflect what we just think is going on within apparel and brands from our discussions with them. There seems to be a good amount of catch-up in July, particularly, South Asia started to ramp back up. And doing some catch-up on maybe some late back-to-school early fall season. For us, the key thing to watch -- and by the way, July is one of the lowest months seasonally in the year for the apparel business. So it's not a good benchmark overall is what I'd say. So we're being -- basically expecting continued improvement in LGM IHM, but July not being a good baseline for how to think about the entire quarter for RBIS.

As you look through it, the key next area, so back-to-school and fall largely getting behind us and these seasons, obviously, overlap. Holiday is a key season for us, and that's really September, October and maybe early November, that will be a key test for us about just overall confidence in the retail sector and companies going into the holiday season. So that will be the key next area to watch, and we'll be giving updates as we go through that.

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Adam Jesse Josephson, KeyBanc Capital Markets Inc., Research Division - Director and Senior Equity Research Analyst [20]

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And just one other on the temporary cost savings of $150 million. I think you said in the presentation that you expect the vast majority of those to come back next year under the assumption that sales recover. Do you expect that to be the case irrespective of the magnitude of the sales recovery next year? Or in other words, if sales don't come back, might hardly any of those sales costs, excuse me, come back next year? And then just relatedly, you said on the last call that assuming this recession is comparable to the Great Recession that you would expect '21 earnings to be above '19. I'm just wondering how this temporary cost issue fits into that outlook, if you can talk about that.

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Gregory S. Lovins, Avery Dennison Corporation - Senior VP & CFO [21]

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Yes. Thanks, Adam. So I think, as you said, on the temporary cost actions, we're looking at about $150 million this year. If I break that down, a little more than 1/3 of that are kind of the most volume impacted piece, so things like overtime, temporary cost, furlough type of benefits. About 1/3 of it is a little bit more as belt tightening, and that's something that if volume doesn't come back, we could continue to manage. If volume comes back, sorry, on the more volume-related pieces, obviously, that part would go up. And then somewhere around 25% to 30% of it is incentive compensation adjustments as well, both short-term annual incentives as well as long-term incentives that are this year. So that part wouldn't repeat in 2021 as well.

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Mitchell R. Butier, Avery Dennison Corporation - Chairman, President & CEO [22]

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And then the other part of your question, just about expecting things to come back. Yes. We've seen in past recessions, we bounced back quickly in the year following the recession. And so said that again, I just said in the 12 months following whenever the recession ends, we're not foreseeing, and everybody has their own assumptions about when this period will conclude. But we still expect that bounce back that you mentioned, Adam.

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Operator [23]

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And our next question is from Neel Kumar, Morgan Stanley Investments.

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Neel Kumar, Morgan Stanley, Research Division - Equity Analyst [24]

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In IHM, it looks like decremental margins came in around 23% in the quarter. Was this generally in line with expectations? And maybe as the kind of flow-through margin we should think about for the third quarter as well?

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Gregory S. Lovins, Avery Dennison Corporation - Senior VP & CFO [25]

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Yes. Similar to the rest of the company, I think, I mean, IHM overall, the bigger declines that we saw were in industrial, particularly in the automotive categories, just given automotive productions in the quarter. So those are the areas we had the biggest declines. I think when we look forward, we would expect automotive to maybe get a little bit better as we move through Q3, still expecting to be down. I think we talked about before, we're down kind of mid-teens in July and expect that to get a little bit better as we move through the quarter or modestly better as we move through the quarter. So we would expect decremental margins to be at a similar level, I think. Overall, IHM, in the total company we talked about last quarter, volumes net of short-term actions is roughly 30%, areas like RBIS, IHM, a little bit higher than that and areas like LPM, a little bit lower than that.

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Neel Kumar, Morgan Stanley, Research Division - Equity Analyst [26]

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Great. That's helpful. And then just one on your corporate expense. It came down pretty significantly to $11 million this quarter versus the $19 million to $20 million level in the last few quarters. Is that a reasonable basis to think about for the second half of the year? And how much of that is coming from permanent or temporary cost savings?

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Gregory S. Lovins, Avery Dennison Corporation - Senior VP & CFO [27]

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Yes. So a big part of the decline sequentially is related to the incentive compensation adjustment that I talked about. So we would expect the back half incentive compensation accruals remain low but not to have the catch-up that we saw in the second quarter. So we would expect corporate costs to go back up, closer to where they were, I think, maybe still slightly better than where they were in Q1, but certainly higher than what they were in the second quarter.

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Operator [28]

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And next question is from Josh Spector, UBS Securities.

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Joshua David Spector, UBS Investment Bank, Research Division - Equity Research Associate - Chemicals [29]

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Just on free cash flow, I mean, you reiterated your target for $500 million for this year. Just curious when you feel like you could be comfortable deploying some of the cash since your balance sheet is in relatively good shape here and assuming things get better through the second half will improve through the second half of the year?

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Gregory S. Lovins, Avery Dennison Corporation - Senior VP & CFO [30]

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Yes. Thanks, Josh. So as you said, 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 remains 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 past 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.

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Joshua David Spector, UBS Investment Bank, Research Division - Equity Research Associate - Chemicals [31]

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Okay. And just on Smartrac, I mean, you've now owned that for a little bit more than a quarter. And I know last quarter wasn't exactly normal, but are there any things you could point towards in terms of incremental positive surprises since you've owned it? Or where we should see perhaps more upside versus what you were thinking when you acquired the business?

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Mitchell R. Butier, Avery Dennison Corporation - Chairman, President & CEO [32]

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Overall, the integration and just -- is going extremely well and actually ahead of schedule for us. The synergy opportunities and most of that's growth synergy opportunities are on track is what I'd say. The business in the quarter was down from prior year. It's got a link tied into apparel as well, but down less than the average overall, and we're seeing quite a bit of opportunity, both in the apparel and logistics space, combining the 2 -- strengths of the 2 businesses. So overall, pleased with what we're seeing from a capability standpoint, the link of their R&D capabilities with our process technology capabilities, the footprint and just the complementary channel access that we bring.

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Operator [33]

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Our next question is from Jeff Zekauskas with JP Morgan.

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Jeffrey John Zekauskas, JPMorgan Chase & Co, Research Division - Senior Analyst [34]

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What was the rate of change in volume in your LPM business in July versus your Graphic Materials business?

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Gregory S. Lovins, Avery Dennison Corporation - Senior VP & CFO [35]

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Yes. From a sales perspective in July, as we talked about a minute ago, overall LGM is down about 6%. That's with the LPM business being down kind of in the low to mid single-digit range and graphics being down roughly in the mid-teens.

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Jeffrey John Zekauskas, JPMorgan Chase & Co, Research Division - Senior Analyst [36]

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Avery is usually a company that has a good look on economic growth. It's sort of an early indicator of all kinds of trends. But it's a little bit difficult for you, I guess, to see those trends because of some destocking. Like do you have a feeling of your business in general, getting better, exclusive of the destock? Or is it just too hard to tell given the markets you sell to?

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Mitchell R. Butier, Avery Dennison Corporation - Chairman, President & CEO [37]

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Yes, Jeff, it's tough to tell. When you talk about being an early indicator in the past, it was often going into a downturn. We had a good feel for it before, and we actually would experience it a quarter or 2 before everything else. And no other reason other than I would just say it was kind of collective wisdom across the value chain of people having a little bit more uncertainty rationing down inventory levels because we're further back, it would have a compounded effect for us. And then on the flip side, to your point, when things were starting to stabilize and get better and inventories are starting to rebuild, we would see the exact opposite effect in the surging demand. This is, obviously, playing out differently where the surge came first. And that everybody was concerned about just what would their continuity of supply look like. And even in our industrial categories within IHM, we actually had pretty healthy growth still in March and April, which were just automotive supply chains making sure they had enough product of all the various categories because people were worried about running out.

So this is playing out different across the businesses, particularly the 2 materials businesses than we've seen in the past. And there is a lack of clear visibility of what's happening around an inventory levels, obviously, at the pantry level and everything else.

From everybody we speak to, the sense is consumption of packaged goods continues to remain strong on a relative basis, particularly consumption, if you think of packaged foods, if you think of packaged household care. Personal care, it's kind of on the normal growth rate. There was inventory stocking earlier on, but people aren't shampooing their hair anymore in this environment than they were before, but they're cleaning their counters, if you will, more in this environment than they were before. So we do see some clear signs of some different paths for different end markets, but a little bit tough for us to tell right now. We've got to get through the next few months to have a clearer view on that overall, Jeff.

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Operator [38]

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And our next question comes from the line of Paretosh Misra with Berenberg Capital Markets.

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Paretosh Misra, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [39]

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So a question on your RFID business. So you're generating about $0.5 billion in sales currently. And you mentioned customer engagement is up, I guess, I think, 35%. So how should we think of the revenue opportunity from this pipeline? I'm trying to see if -- what's the typical revenue per customer or per adoption? And these future customers, potential customers could represent even bigger opportunities than what you currently have.

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Mitchell R. Butier, Avery Dennison Corporation - Chairman, President & CEO [40]

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Yes. So overall, it's with the pipeline growth that gets to our 15% to 20% average growth that we're expecting going forward, and we've delivered at the high end of that organically in the past. So that's what that comes from specifically. As far as size of programs, there's a lot -- all different sizes of programs, we have smaller specialty programs in some categories and then very large volume programs in others. So it actually runs the gamut, if you will, across. So our confidence in our ability to grow this business at the 15% to 20% level is reinforced by the pipeline and just the increased level of insights we have by the investments we've made in business development, market development teams over time and just finding more and more use cases.

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Paretosh Misra, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [41]

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Got it. And then maybe as a follow-up on that. So you're selling some of these RFID products through converters and some are directly to customer. Is that only a function of the end market or the kind of customers you have, or is there some different strategy or a value addition that you're providing to customers?

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Mitchell R. Butier, Avery Dennison Corporation - Chairman, President & CEO [42]

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Yes. So there's from a channel standpoint, so roughly 75% of the business is direct to the end users and 25% goes through converters. Most of that converter leverage is coming through Smartrac, and that's where we're looking to combine it with the strengths of LGM. But most of the business is direct to end customers is where the sale happens.

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Operator [43]

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And our next question is from Chris Kapsch with Loop Capital Markets.

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Christopher John Kapsch, Loop Capital Markets LLC, Research Division - MD [44]

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Yes. So I had a question about LGM margin trends and expectations for how that metric may play out over the balance of 2020 and maybe setting up for next year. So in the quarter, operating margin was up 100 bps, you called out some of the variances that contributed there. But so some of the reengineering benefits and restructuring savings could be viewed as structural or stickier at least, and you were able to deliver that margin improvement in spite of arguably adverse mix with your highest -- higher-margin graphics and reflective volumes being down pretty dramatically more than the strength in the label business, which is now sort of not reversing, but moderating. So I'm just wondering if that mix inflects, how does that set up for the margin trends over the balance of the year? And how do you think about the margin potential for that segment in a more normalized basis looking forward?

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Gregory S. Lovins, Avery Dennison Corporation - Senior VP & CFO [45]

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Yes. Thanks, Chris. So again, overall, I talked about our EBITDA margins. We expect to be roughly flat to prior year, assuming the top line plays out, as we've talked about for the whole company. We haven't given or not giving EBITDA margin targets by business. But when we look across the trends, as I mentioned earlier, we have had some positive net pricing raw materials in the first half in LGM, where we see raw materials generally stabilizing a bit right now and a little bit of a modest headwind, as I mentioned earlier, on net pricing rolls as we move into the back half in LGM. Otherwise, I don't really see significant changes. I mean, normally, we have a seasonal Q2 to Q3, a bit of a margin decline each year in LGM. So normally, you would expect to continue seeing that type of a trend as well. But otherwise, not any other major trends that I would see affecting margins through the back half.

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Christopher John Kapsch, Loop Capital Markets LLC, Research Division - MD [46]

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And just to follow-up on that is the -- just wondering if the mix improvement -- if there's an inversion in terms of the negative sales variance is tied to the Graphics and Reflective business being less negative over the balance of the year. Is that enough to move the needle on from a mix standpoint, and therefore, margin standpoint vis-à-vis the label business?

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Gregory S. Lovins, Avery Dennison Corporation - Senior VP & CFO [47]

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Yes. I think...

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Mitchell R. Butier, Avery Dennison Corporation - Chairman, President & CEO [48]

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Yes. Let me just -- overall, there's a lot of factors going on. And I think what you should -- as Greg commented on our overall total company EBITDA margin is what we expect for the second half and full year. And what we would reasonably estimate is actually a pickup in margins in RBIS and IHM, particularly RBIS, as the revenue begins to rebound on a sequential basis from the trough in Q2, and that will be partially offset by a moderation of some of the margins in LGM.

Within LGM, you have some mix benefits potentially around Graphics coming back as you highlight, there are obviously a number of other factors. And we've really moved quite quickly on these temporary cost savings, which impacted Q2. So there's a number of factors going different directions. I think overall takeaway, feel confident with total company margins even in this lower demand environment. We're going to be able to maintain our EBITDA margins for the full year. In the second half, there will be -- if you -- the first half as a starting point, a little bit of moderation in LGM for various -- particularly tempered cost savings timing, offset by benefits coming from RBIS and IHM, particularly RBIS.

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Operator [49]

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Next question is from George Staphos, BofA Securities.

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George Leon Staphos, BofA Merrill Lynch, Research Division - MD and Co-Sector Head in Equity Research [50]

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My last 2. I just wanted to first go back partly to cover Adam's question again and then also your comments on -- to my question on RBIS. Not looking for a guarantee, but I just want to make sure. So at this juncture, your view of Avery's ability to snap back post this recession is no different. It's all just a question of when the recession ends that marks when that recovery starts. And on RBIS, based on the growth that you're seeing in value-added and the mix enhancement that you get there. Looking forward, RBIS should have at least the same type of growth and margin potential as it did prior to COVID, would you agree to both of those statements?

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Mitchell R. Butier, Avery Dennison Corporation - Chairman, President & CEO [51]

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Yes. We expect this business is resilient, it will bounce back. The timing depends on what's going on in the macro and everything else. And we are -- RBIS, there's a lot of questions around retail and apparel overall, when we look at the mix of that business was below average, how much was in high value segments, if you go back 6 years ago -- 5, 6 years ago, even very recent -- more recent than that, a couple of years ago, it's a mix of high value segments, both Intelligent Labels and exterior embellishment. We see being well above average as far as it's mix. So some very strong long-term secular growth. I won't call them tailwinds because team is doing a phenomenal job navigating the environment. But that's what we expect. So absolutely, and yes.

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George Leon Staphos, BofA Merrill Lynch, Research Division - MD and Co-Sector Head in Equity Research [52]

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Okay. And my other question on cash flow guidance. Prior, it was $500 million plus. Now it's approximately $500 million, which is noble, given everything that's been going on. You called out 3 things: accelerated restructuring, more taxes on repatriation and the inventory build early in the year. Is there anything else that would cause a slight decrement in free cash flow outlook for the year? Or did those 3 things capture it?

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Gregory S. Lovins, Avery Dennison Corporation - Senior VP & CFO [53]

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Yes. Thanks, George. I mean, those are the drivers. I mean, we just made, I guess, a modest adjustment to our expectations on cash flow for the year. Again, as you said, a little bit higher restructuring cost, given the higher savings we expect this year and next year, a little bit higher cash tax rate. And then operationally, we're largely where we had expected a quarter ago, a little bit more work to do on working capital, particularly inventory as we talked about.

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Operator [54]

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And our next question is from Adam Josephson, KeyBanc Capital Markets.

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Adam Jesse Josephson, KeyBanc Capital Markets Inc., Research Division - Director and Senior Equity Research Analyst [55]

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Just my last 2 questions. One on LGM sales trends. So Mitch or Greg, so in 2Q, down 5%, July, down to 6%. And then for the quarter, you're saying down mid single. So modest improvement, it sounds like sequentially. Within that, are you assuming the LPM destocking will be over? Or are you assuming a continued drag from the LPM segment. Just trying to disaggregate those 2 in 3Q?

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Gregory S. Lovins, Avery Dennison Corporation - Senior VP & CFO [56]

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Yes, Adam, as I think I said a minute ago on Jeff's question on July, we've seen in LPM, kind of low to mid-single digits in July, Graphics down mid-teens. And that's really our expectation right now for the quarter is low to mid-single in LPM and Graphics down in the mid-teens. So we're looking at a mid- single-digit decline overall for LGM. We've already seen in North America, an improvement in July versus what we had seen in June. I think in Europe, it's a question, as Mitch already talked about a number of factors just as well as the August holiday period and how things return there or not. So I think it will be a few weeks or so until we really get a better view of the trends in Europe.

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Mitchell R. Butier, Avery Dennison Corporation - Chairman, President & CEO [57]

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And overall, I do think -- I do just think the thing to focus on is the -- it's just end consumption, what you think is going to be happening going in both Europe and North America, elsewhere as well, of course, because that's where the inventory piece will work its way through, and we didn't expect that to permanently stabilize, I mean, stay at the higher inventory levels longer term. We're hearing a lot of the anecdotes as well as hard evidence that some -- a lot -- a number of categories with our labels do have increased consumption on a relative basis, but what's going on in the broader economy because a lot of our VI labels don't just go on e-commerce, they also just go on regular supply chain goods and help with the restaurant industry and everything else. So I think that's the bigger area to impact probably the second half is what your own assumptions are about in consumption. We know we are well positioned. We feel good that what's going on and the focus around more hygiene is enhancing the focus around needing packaging and needing more disinfectants with which our labels go on and so forth. So on a relative basis, we feel that the market is positioned well. We're obviously well -- extremely well positioned within that market. Question is a little bit more just what your assumptions are around the macro and when do we come out of this?

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Adam Jesse Josephson, KeyBanc Capital Markets Inc., Research Division - Director and Senior Equity Research Analyst [58]

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Yes. And Mitch, just one more on Europe. So your primary competitor in Europe talked about the market being up 10%. You guys are down mid-single, and I think Anthony asked about market share, and you said you might have seen a bit of market share early in the quarter. Was that in Europe, specifically mentioned? And was that just related to the COVID cases you had and your inability to operate normally as a result?

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Mitchell R. Butier, Avery Dennison Corporation - Chairman, President & CEO [59]

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Yes. And -- yes, I was referencing Europe specifically. And our comments, a reference point of mid single digits versus the comments of up 10%. We're talking revenue, the market is evaluated in terms of volume primarily. And so from a volume basis, we're up high single digits, almost 10% within the quarter within Europe.

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Operator [60]

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And there are no further questions at this time. I will now turn the call back over to you for any closing remarks.

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Mitchell R. Butier, Avery Dennison Corporation - Chairman, President & CEO [61]

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All right. Well, thank you, everybody, for joining us. And once again, I want to thank our entire team for the tireless efforts to keep one another safe and continuing to deliver for our customers. I look forward to speaking to all of you later in this quarter when we provide an update. Until then stay safe, everyone.

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Operator [62]

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And ladies and gentlemen, that does conclude our conference call for today. We thank you for your participation. Everyone, have a great rest of your day, and you may disconnect your lines.