We highlighted in our 9 January article two old economy names, Avery Dennison (NYSE:AVY) and Zebra (NASDAQ:ZBRA), as an original way to play the RFID (radio-frequency identification) and Internet of Things themes. As a reminder, Avery Dennison manufactures tags, labels and packaging materials and is taking part in the RFID "revolution" through the production of RFID tags and printer/encoders designed to write to RFID chips embedded in labels and tags.
After an already solid Q3, Avery Dennison surprised again on the upside in Q4, with organic revenue growth accelerating to +7% vs. +4% in Q3 and adjusted EPS of $0.69 vs. consensus at $0.68. The FY14 guidance called for organic growth of 3-5% and EPS of $2.90-$3.20: these targets were only in line with the Street but we believe that Avery Dennison is likely to keep surprising on the upside as the company is traditionally conservative and as RFID tags and printers gain traction.
In all, this confirms our investment thesis. We said in our previous article that organic growth could accelerate from the flat to low single digit growth seen in previous quarters if consumer spending picked up as Avery Dennison is highly exposed to retail (consumer products and retail apparel account for 65% of revenues) and therefore to consumer confidence & spending trends, in the US and in Europe (25% of revenues). And indeed, consumer spending has been improving recently in both the US andEurope.
More importantly, we believe that the long-term outlook of Avery Dennison is bright: while it's quite hard to accurately determine its RFID exposure, it's quite obvious that RFID is a major revenue driver going forward as RFID is expected to connect billions of objects to the Internet.
RFID likely to become ubiquitous
RFID's traditional application has been in demand recently: RFID labels make the tracking and location of items much easier and more efficient than barcode technology. As such the protection against thefts on retailers' shelves, in the supply chain (in-house thefts) or in sensitive areas (hospitals) is improving.
The other main application of RFID tags is inventory and shipments management, i.e. monitoring inventories to avoid sold-out situations and eliminating shipment errors.
As RFID is still a "new" technology, most retailers that have decided to use it are rolling out RFID selectively… but adoption is likely to increase very soon as many new applications are emerging.
As the technology improves, RFID tags can now extract and record data from a variety of items such as temperature-sensitive products (drugs, biomedical items…, with RFID allowing users to track the temperature of their goods) or basic materials. These new applications and the printers increasing affordability (some printers now sell for less than $2,000) give confidence in the RFID's ability to become ubiquitous. Some research institutes forecast that 80bn items will be connected to the Internet in 2020, directly or through a device, vs. 15bn today, i.e. a c.23% CAGR.
Consensus overly conservative, EPS and valuation upside in sight
In our view, consensus forecasts on Avery Dennison do not yet reflect the RFID potential, as expectations point to roughly 3% annual organic growth over 2014-16 while a mid to high single digit performance is within reach in view of the RFID takeoff. We would therefore expect Avery to deliver much above consensus at the top-line level in coming years.
The rising weight of RFID products within the mix should give a boost to the company's operating margin which is already set to benefit from restructuring measures and productivity actions (+150bp margin gain expected in 2016 vs. the 2013 level). Indeed, RFID-driven growth should come with higher margins as RFID tags and printers are not a commodity contrary to traditional tags and packaging materials.
In conclusion, we are confident in Avery Dennison's ability to deliver EPS growth in the high teens over coming years. This suggests in our view that the stock P/E (16x 2014) still leaves room for additional upside.