Avery Dennison: The Opportunity Created By The 2010 Dividend Cut

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 |  About: Avery Dennison Corporation (AVY)
by: Tim McAleenan Jr.

Summary

Avery Dennison cut its dividend to $0.80 in 2010, and this has provided an avenue for the company to repurchase meaningful amounts of stock and clean up the balance sheet.

The company is currently repurchasing over 5% of its stock annually, and growing earnings by 7% organically.

This stock is not for everyone, as profits declined considerably during the financial crisis and some investors may prefer to avoid the potential volatility during recessions.

In 2010, Avery Dennison (NYSE:AVY) cut its dividend from $1.22 per share to $0.80 per share. This move was especially curious because, even when the Board correctly anticipated a decline in profitability for 2011 (as earnings per share plunged from $3.15 per share to $1.74 per share), the company still possessed the resources to make its old dividend payments.

In other words, the 2010 dividend payment of $1.22 could have been supported by the $1.74 earnings per share figure in 2011 (or the cash flow figure of $4.06 per share if we find those figures to be better indicators for a company operating in the chemical adhesive industry). The dividend payout ratio would have been 70.11% of earnings or 30.04% of cash flow. Even though the dividend did get cut down to $0.80 per share, it is important to recognize the distinction that the profits were there to support the dividend payout, but the Board chose to retain a higher percentage of corporate profits.

Why is this distinction important to draw?

Because it explains why Avery Dennison has been able to quietly repurchase and retire a noticeable chunk of company stock without getting a lot of attention because most investors have still been dwelling on the 2010 dividend cut.

In 2011, Avery Dennison had 106.3 million shares outstanding. Today, the company has 95.2 million, for a 10.44% decrease in the share count (with the pace picking up over the past twelve months). And the buyback has been picking up the pace, as the company now repurchases $60 million shares per quarter, or about $240 million per year. At the current pace, Avery Dennison is retiring 5.21% of its total share count each year.

In addition to buybacks, Avery Dennison has been using the artificially low payout ratio created by the 2010 dividend cut to shore up its balance sheet. The pension is now nearly funded, with $1.3 billion in current pension assets coming close to covering the company's $1.6 billion in pension obligations. The debt has been refinanced at absurdly low levels, so that Avery only has to pay $60 million in interest payments over the long haul. The company's total liabilities have decreased from $2.0 billion to $1.5 billion over the past two years. While no income investor enjoys seeing a dividend payment decline from $1.22 annually to $0.80, the management team has responded by allocating capital in a highly intelligent manner by getting the share count down and cleaning up the balance sheet.

According to Avery Dennison's most recent annual report (which you can find here), the company is on target to accomplish the following growth figures between now and 2018: sales growth of 5% annually while experiencing 18% returns on capital, which then converts to earnings per share growth in the 12%-15% range.

Those goals are ambitious and seem plausible in the event that the economy keeps expanding. My figures are a tad bit more conservative. I expect 3% sales growth (in line with recent years), which Avery Dennison has historically been able to convert to 6%-7% earnings per share growth. However, the company is also repurchasing 5% of its shares annually (which it did not have the cash flow room to do before), and this creates the likely possibility that the company will achieve earnings per share growth in the 11%-12% range over the next five years.

Based on 2014 expectations of $3.05 per share in profits, Avery Dennison currently trades at 15.7x profits. Given that Avery Dennison's long-term valuation is in the 17x-18x profits range, this suggests the possibility for modest P/E expansion that could add a cumulative boost of 11%-12% to your total returns compared to buying the stock at fair value.

This stock is not for everybody - particularly those who do not like volatile earnings reports during down years or the occasional dividend cut. Avery Dennison saw its profit figures see-saw from $3.30 in 2008 to $1.97 in 2009 back up to $3.15 in 2010. Some investors don't want to deal with that kind of profit-reporting volatility, and if you prefer businesses that consistently grow each and every year, then this likely isn't the stock for you.

However, for the enterprising investor, there is a lot to like. The dividend is on the rise, consuming a bit less than half of the company's profits. Earnings have a realistic probability of growing at a clip of 12% annually, fueled by 5% sales growth that converts to 6%-7% earnings growth plus the fact that Avery Dennison is currently repurchasing a little over 5% of its stock annually. When you combine this with the fact that the company's P/E ratio is slightly below normal, you can see how the 2010 dividend cut has created a unique opportunity for investors over the next five years.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.