Jul 22, 2008
Executives
Eric M. Leeds - Investor Relations Dean A.
Scarborough – President and Chief Executive Officer Daniel R. O'Bryant – Executive Vice President, Finance and Chief Financial Officer
Analysts
Jeffrey Zekauskas - JP Morgan Securities John Roberts – Buckingham Research Reik Read - Robert W. Baird Ghansham Panjabi - Wachovia Securities George Staphos - Banc of America Securities
Operator
Welcome to the Avery Dennison earnings conference call for the second quarter ended June 30, 2008. (Operator Instructions) I would now like to turn the conference over to Eric Leeds, Avery Dennison’s head of Investor Relations.
Eric M. Leeds
Our discussion today will reference the earnings release that we issued earlier, along with the slide presentation titled, Second Quarter 2008 Financial Review and Analysis. Both documents were furnished today with our 8-K and posted at the investor section of our website at www.investors.averydennison.com.
Our news release references GAAP operating margin, which includes interest expense, restructuring and other charges included in the other expense line of our P&L. Also referenced are transition costs associated with the Paxar integration that show up in this past quarter in as MG&A expense.
Restructuring charges and integration transition costs tend to be fairly disparate in amount, frequency, and timing. In light of the nature of these items, we will focus our margin commentary on pre-tax results before their effect and before interest expense.
This detail is in Schedules A2 to A6 of the financial statements accompanying today’s earnings news release. Slides 18 and 19 of the presentation contain a reconciliation of margin change to help illustrate the impact of the Paxar acquisition.
We also remind you that we will make certain predictive statements that reflect our current views and estimates about our future performance and financial results. These statements are based on certain assumptions and expectations of future events that are subject to uncertainty.
The Safe Harbor Statement included in the documents that we published today, along with our recent Forms 10-K and 10-Q, address the most important risk factors that could cause actual results to differ from our expectations. Here today are Dean Scarborough, President and CEO; Dan O'Bryant, Executive Vice President and CFO; and Mitch Butier, Corporate Vice President, Global Finance.
We will now turn the call over to Dean.
Dean A. Scarborough
As you know by our news release this morning the economic and market challenges that began the year have continued into the second quarter. We are pleased with our progress in many areas, including the execution of the Paxar integration, our growth and emerging markets and RFID, and the substantial improvement in cash flow over the prior year.
However, we are reducing our outlook for the balance of the year due, mainly, to rapidly rising raw material costs and the expectation of continued weak economic conditions with the possibility of further softening outside the U.S. Sales trends were somewhat mixed in the second quarter, with sequential improvement in Pressure-sensitive Materials and Office Products, but comparatively weaker results for Retail Information Services and a few of our smaller specialty converting businesses.
Pressure-sensitive volume growth improved sequentially, with continued growth in emerging markets and new decoration-transfer applications in mature markets. However, raw material inflation, energy and transportation costs have escalated rapidly in the last 90 days which has had a significant impact on our margins.
We are raising prices again this quarter and anticipate another round of increases later this year if inflation continues to accelerate. The combination of price increases, productivity, and product re-engineering will enable us to recover our margin but there will be some lag in recovery, especially if inflation continues.
The Retail Information Services business was again impacted by slow retail conditions in the U.S. and retailer inventory reduction, which had a dramatic downward impact on apparel imports.
Additionally, while European programs continued to grow, we did see a slowdown related to weaker retail conditions in that region. We did see growth in our new product investment areas, which include RFID, heat transfer and packaging, and we believe we are continuing to take share in the core business.
As expected, the incremental volumes in the second quarter busy season improved our margins from the first quarter. We’re executing well against our integration synergy targets but in the short term those savings have been offset by lower overall volumes and inflation.
We are raising prices and accelerating our productivity actions and we do expect to achieve our long-term targets once market conditions improve. More importantly, we continue to invest in improved service and new products to position ourselves for the coming upturn.
Our Office Products teams had a challenging revenue quarter but did a great job of managing their costs and working capital in the tough environment. The largest impact on revenue for the quarter came from a shift of back-to-school orders into Q3.
Last year a bigger share of our back-to-school orders came through in the second quarter. We are accelerating our efforts to renovate and enhance existing products, investing very selectively in some new ones, and we are having some measurable success despite the tough office product’s environment.
Inflation has impacted office products as well as steel, vinyl, paper, and transportation costs rapidly increase. We raised prices on July 1 and are implementing price increases in October and in January, to recover our margin.
Office Products continue to deliver solid productivity increases, which is one reason why margins have held up so well in this business. I am still very pleased with our trajectory in the RFID inlay business.
Revenues quadrupled in the quarter, consistent with our plan, as orders increased for item-level tracking in apparel as well as other supply-chain programs. The short-term outlook is challenging so we are taking steps to strengthen our businesses to capitalize during economic recovery.
As I mentioned previously, our biggest short-term challenge is inflation and slowing economies. Executing price increases well will have the biggest upside impact on our results and we expect the incremental benefit of pricing actions to be realized in the second half of the year.
We are executing the Paxar integration and will hit our targets for annual synergy savings from the acquisition. Retail Information Services remains on course to realize roughly $120 million in annual synergy savings when the integration is complete, with 85% of the savings expected to be captured in the run rate by the end of this year.
We are driving increased productivity across the organization. The restructuring actions we undertook in 2007 will drive $45 million to $50 million of annualized savings once fully implemented.
With close to 60% of that value representing incremental savings in 2008 and we’ve initiated a number of short-term actions to reduce operating costs across the company that will offset some of the short-term weakness. We continue to invest in growth acceleration programs.
Emerging markets and RFID, for example, are right on track. We are taking share in Pressure-sensitive Materials by capturing business from alternative decorating technology and through new product and service programs.
And in fact, we are opening a new distribution center in Japan to capture share in this untapped market. In Retail Information Services we continue to see interest in radio frequency identification and our new packaging capabilities and we have invested in new technology that enables us to offer smaller quantities of tags and labels faster and more cost effectively.
Now I will turn the call over to Dan for a more detailed review of our second quarter financial results and our revised outlook for the second half.
Daniel R. O'Bryant
Let’s begin with the financial overview on Slides 5 and 6 of the handout. Net sales were up 20% due to the benefits of the Paxar acquisition and currency translation, reflecting the value of our global diversification.
On an organic basis, sales declined about 1% compared to prior year and I will provide some color on that in just a few moments. Operating margin before charges and transition costs declined by 130 basis points, or about 80 basis points if you adjust for the addition of the base Paxar business.
The year-on-year decline in margin reflects the raw material and energy inflation, as well as carries over of the 2007 price reductions. We continue to anticipate a substantial improvement in operating margin by the fourth quarter, which I will discuss more in the context of our guidance.
Our annual tax rate is now expected to be in the 14% to 16% range for 2008 and we believe a tax rate in the range of 17% to 19% will be sustainable for at least the next few years, reflecting our geographic income mix, reductions in the statutory rates in a few countries, as well as benefits of our tax structure and planning efforts. Now let me walk you through the story on top line sales on Slide 7.
As I said, reported sales were up about 20% compared to the prior year, the Paxar acquisition added about 14 points of growth, and currency translation added 7 points of top line growth and $0.05 of earnings to the quarter. Looking at organic growth trends, on a regional basis, sales in the U.
S. declined by about 4%.
In Europe, sales before the Paxar acquisition and currency were up about 4%. Sales in Asia likewise grew about 4% on an organic basis, slower than Q1 due to the weakness in apparel exports to the U.S.
that impacted Retail Information Services. All of our materials businesses in that region remain strong, with organic growth in the mid-teens.
Sales in Latin American were up 5% versus the prior year on an organic basis with sequential improvement bringing growth back to the level we saw in the fourth quarter of last year. Taking a look at our margins on Slide 8, and once again, for purposes of margin comparison we have added Paxar’s results from last year into our own prior year numbers and provided the backup for that adjustment on Slide 18 of the handout.
So on this adjusted basis, operating margin declined by 80 basis points and Slide 9 summarizes the key factors driving the change in company operating margin. Gross margin before Paxar integration costs declined by 20 basis points compared to the reported results for the prior year.
Adjusting the prior year number to include Paxar, gross profit margin declined by 130 basis points. Now, the primary driver has been the rapid raw material inflation that Dean talked about.
In addition, we have experienced increases in labor costs in China and higher energy and transportation costs and while our selling prices are now on the rise in just about every business, the carryover effect of decreases late last year is still impacting margins. It goes almost without saying that we are accelerating our productivity efforts on every front.
Now this is the time when our Enterprise Lean Sigma process really makes a difference in the company. But even with our best efforts, we won’t be able to completely offset the level of inflation that we’re experiencing.
We estimate that raw material costs were up about $20 million in the quarter compared to the same period last year. For 2008 we have raised our estimates for raw material inflation from last quarter’s $70 million to a current estimate of about $110 million.
I will comment on that a bit further when I discuss our earnings guidance. Turning to operating expenses, before integration costs MG&A expenses as a percentage of sales increased by 110 basis points compared to reported results for the prior year.
If you adjust the prior year number to include Paxar the MG&A expense ratio improved by 40 basis points which partially offset the gross margin decline. Compared to the adjusted prior year, absolute spending on MG&A was up about $11 million.
The combination of currency translation and incremental amortization of intangibles from the Paxar acquisition represented more than the entire increase. We offset a portion of these higher costs, along with general inflationary pressures, through our productivity efforts.
Turning to segments on Slide 10, we saw a jump in our Pressure-sensitive Materials business with reported sales up 11% over the prior year’s second quarter to $980 million. Organic sales growth was about 3%, a solid improvement from the first quarter growth rate.
Focusing on the Rolled-label Materials business, about 70% of this business right now is in Western Europe and North America. North America slowed a bit after a strong first quarter.
Europe accelerated in Q2 over Q1 and most of our emerging market businesses continued on their solid growth trend. The Graphics and Reflective business was down a low single digit rate before currency.
This business is more cyclical than others with the U.S. markets slowing the most.
Excluding restructuring and other items, operating margins for our Pressure-sensitive Materials business declined 170 basis points versus the prior year to 8.2%. The decline in Pressure-sensitive Materials margin reflected cost inflation and prior year price reductions that more than offset the initial benefits of this year’s price increases, as well as restructuring and other productivity initiatives.
As Dean alluded to in his opening remarks, the incremental benefit of pricing actions are expected to be realized in the second half of the year. We have anticipated more inflation for the balance of the year but raw material cost forecasting has proven to be an elusive art lately.
If our outlook is right, we have enough in price increases underway to catch up with inflation but we do believe there is substantial risk of more inflation over the next few quarters and we will likely continue raising our prices to keep up. Let’s turn to Retail Information Services on Slide 11.
Reported sales for Retail Information Services were $438 million. That is double a year ago due to the acquisitions of both Paxar and DM Label.
Five years ago this was a $250 million business. Today it’s over $1.5 billion.
Organic sales were down about 3% for all the reasons that Dean discussed. Our major concern here is the rapid fall-off in traffic at the malls in the U.S.
market. Retail Information Services has a very high variable margin so volume declines have had a big impact on our bottom line.
Adjusting the year-ago comparisons for Paxar results, the operating margin before transition costs, restructuring, and asset impairment charges declined 80 basis points to 7%. Integration savings, along with other productivity actions, were more than offset by the combined affect of reduced fixed cost leverage from lower revenues, employee related and raw material cost inflation, and about $9 million of intangible amortization and corporate cost allocations.
Looking at the Paxar integration update on Slide 12, we continue to expect about $120 million in annual synergies when we’re finished blending Paxar into Retail Information Services. Of that $120 million, we realized about $21 million of synergies in the second quarter compared with $18 million in the first.
85% of the targeted savings will be in our run rate by the end of this year and we’re not expecting any changes to our estimate of $165 million to $180 million of integration cash costs. Nearly 2/3 of that is now behind us.
We will incur about $35 million over the balance of this year. Now on Slide 13, we’ve already discussed much of what has impacted our Office and Consumer business, as reported sales were down 3% from a year ago.
Part of the weak top line in the second quarter included delayed shipments related to the back-to-school season that are now positively impacting the third quarter. Ex restructuring charges operating margins were up 110 basis points to 17.3%.
Favorable product mix given the delay in back-to-school shipments, along with restructuring benefits and productivity gains, more than overcame the effect of cost inflation and reduced fixed cost leverage associated with lower sales. Now let me move on to Slide 14 for a look at our cash flow.
First our ratio of debt to total capital at June 30 was 51.9%, down from the prior year ratio of 56.6% immediately following the Paxar acquisition. We expect this ratio to decline further over the next two quarters.
We continue to reduce working capital, which is helping us in the current demand slowdown. Year-to-date cash flow from operations improved by nearly $60 million.
In addition to working capital improvement, year to date capital expenditures were $69 million and we used another $33 million for software. Total cash for capital and software are down $22 million from prior year.
Now Slides 15, 16, and 17 we have set out our revised guidance and outlook for the second half. Anticipated inflation, weaker segment mix, and slowing demand lead us to recalculate adjusted EPS for the full year to between $3.75 and $3.95 a share.
The key issues for the balance of the year will be inflation and our ability to successfully implement our price increases. We obviously still have a gap between the two.
The revised estimate also reflects between $60 million to $70 million of cost synergy from the Paxar integration, about $25 to $30 million in restructuring benefits over the previous year, and benefits from other productivity initiatives as well. The benefits from the Paxar integration continue to grow and RFID is contributing.
As Dean said, we quadrupled sales in that business unit in the second quarter and we are on track to reduce losses there this year just as planned. Currency benefits our top line for the year by 5% and we have lowered the tax rate for the full year guidance.
On Slide 16 we’ve outlined what’s changed between our current assumptions and our previous assumptions for the year. Now with that, let me turn things back to Dean for some additional thoughts before we take your questions.
Dean A. Scarborough
While we face a challenging environment, I do believe we are well positioned to weather the storm and to position ourselves in good shape for the future. One of the things that help is our geographic and end-use application diversity.
We are certainly being helped by the fact that more than 2/3 of our business is outside the U.S. Also, another factor is that most of businesses are in items that are linked to consumables and only about 15% of our businesses are related to housing, automotive, and other very cyclical segments.
Many of our products are used on things that consumers use every day. A good example is personal care.
We have many label materials used on shampoo bottles and people still do wash their hair in a recession. So while underlying demand does go down for our products in difficult economic times, we don’t see dramatic downturns.
We are clear market leaders in each of our core businesses with very strong competitive advantages. And during these tough times, I find that customers rely on their best suppliers, and that does give us an opportunity to take share.
We have demonstrated our ability to drive productivity and improved cash flow through our Enterprise Lean Sigma programs. ELS has enabled us to get more with our existing capital and to enhance working capital efficiency as well.
Now, we are happy to take your questions.
Operator
(Operator Instructions) Your first question comes from Jeff Zekauskas - JP Morgan.
Jeffrey Zekauskas - JP Morgan Securities
In terms of the Pressure-sensitive adhesive business, could you talk about volumes and price in the quarter. Is it the case that price was down is that right?
Dean A. Scarborough
Well, pricing is up sequentially but still down year-over-year.
Jeffrey Zekauskas - JP Morgan Securities
Like 1%? It’s down that order of magnitude or is it down more.
Daniel R. O'Bryant
It’s still down more than that year-on-year. The heavy discounting took place in the industry was primarily in the third and fourth quarters of last year so it’s going to take a couple of more quarters to lap that.
We had some price compression, mostly outside the U.S. in the first quarter.
So we’re still down more than a point it you look on a year-on-year basis.
Jeffrey Zekauskas - JP Morgan Securities
So that means organic volume growth was up 5%. And what do you make of that strength?
Is that temporary?
Dean A. Scarborough
Well, Jeff, I think the one surprising question, and I know where you’re headed here, is that volume growth for us has been surprisingly strong over the last couple of quarters. We certainly have seen continued strength in emerging markets.
Europe has been relatively strong as well. I believe we might be taking a little bit of share there.
We haven’t seen the numbers yet for the second quarter. And our volumes are up also in North America, but then again, that’s related to a bit of share gain.
Daniel R. O'Bryant
I think, too, we’ve seen in some of the emerging markets sequential strengthening over the last couple of quarters and in the second quarter things were quite strong in Asia in particular but other places as well and that’s becoming an increasingly large part of Pressure-sensitive business, so it’s having more impact these days.
Operator
Your next question comes from John Roberts - Buckingham Research.
John Roberts – Buckingham Research
To the extent PSM was stronger in volume I think the weakness in the RIS volume is surprising. Global apparel demand is not down anywhere near as much as you’re down.
Dean A. Scarborough
Here’s the way I look at it. You have two things going on.
In the U.S. you have POS down for apparel and then you have retailers reducing inventories at the same time.
So apparel imports into the U.S. actually are down.
I think they were down in the high single digits in the first quarter. So that definitely has an impact on our business because everything coming into the U.S.
has some tag on it. Still we saw, in Europe, growth over prior year but that growth has been decelerating.
So the combination of the two is impacting us.
John Roberts – Buckingham Research
Pricing in the RIS segment?
Dean A. Scarborough
It’s a custom business so there is so much churn in the programs, it’s meaningless.
Operator
Your next question comes from Reik Read - Robert W. Baird.
Reik Read - Robert W. Baird
Dean, you’ve talked a couple of times about share gains with some alternative decorations in the U.S. Can you talk about that and then if you are gaining share in Europe, what’s driving that at this point?
Dean A. Scarborough
We are continuing to convert decorating applications in the food and beverage segment to Pressure-sensitive. And we probably have the most success, frankly, in the beverage category.
So things like juices and beer has been a positive plus for us. And that’s continued on.
We have continued to invest in that and that’s great share gain to take because it’s all new business to the industry.
Reik Read - Robert W. Baird
And what might be accounting for that in Europe as well?
Dean A. Scarborough
Well, actually we had a competitor that went Chapter 11 in the UK. So I think that might be a fairly large chunk of it.
Reik Read - Robert W. Baird
And I just want to make sure I understand, from a demand standpoint. You talked about weakening demand in Europe and Asia in your press release but it sounds like Pressure-sensitive in Asia continues to do well and you don’t have any expectation that that changes, is that the correct understanding of that?
Daniel R. O'Bryant
Yes, the weakness that we saw in Asia was really in the RIS business only and that’s, again, related to the retail apparel slowdown in the U.S. markets.
But if you look at the businesses where consumption is Asian-based, like all of our materials businesses are, it’s quite strong and it has accelerated over the last few months. So I think we’re not completely immune in our Asian markets from what goes on in the U.S.
but the consumption is 70% to 80% based where we manufacture and those economies continue to be driven by new middle classes emerging. And that is giving us some protection.
So that diversification in our revenue base is helping us out quite a bit. In the quarter, emerging markets represented over 30% of our volume, up around the 32% to 33% marks.
So it continues to be a more important part of the overall mix and so far, so good in those markets.
Reik Read - Robert W. Baird
You have given some color that you’re planning to do more price increases, but given if things stayed where they were today, how long would it take you, at this point, to catch up with that raw material inflation?
Dean A. Scarborough
I would say roughly two quarters. That’s assuming no more inflation, though.
Operator
Your next question comes from Ghansham Panjabi - Wachovia Securities
Ghansham Panjabi - Wachovia Securities
Looking back at previous recessions in the U.S., do you have a sense as to how long these inventory corrections in apparel last? I know it’s a tough question because we have seen a couple of different recessions, but looking back, if you have the data to the early 90s and that’s probably more reflective of a true consumer recession than the last one, how long does it last and how far along are we?
Dean A. Scarborough
Let me tell you, talking to our retail customers, they assume that we are not going to see a decent recovery until sometime in 2009. Most of our customers, in the U.S.
anyway, are saying this has been the worst retail recession in 20 years. Now, if I look back at our business that long ago, there’s a couple of things.
One is RIS was really small and so didn’t really impact us that much. And secondly, at that point in time there was still an awful lot of apparel that was made in the U.S.
being shifted to Asia so I’m not sure we were impacted all that much, at least not to the extent that we are today.
Ghansham Panjabi - Wachovia Securities
And also, in your comments on the Office Products business you noted that mix was favorable. Could you expand on that, please?
Dean A. Scarborough
Our back-to-school product line consists of things like binders and dividers and sheet protectors. They tend to be at the lower margin end of our product categories and printable media obviously is a higher margin product range.
So because back-to-school shifted more to Q3 than Q2, the mix just naturally looked better for the quarter.
Ghansham Panjabi - Wachovia Securities
So for Q3 maybe volumes are better but margins might be lower then?
Dean A. Scarborough
Absolutely, plus we’re getting more raw material inflation at the same time.
Operator
Your next question comes from George Staphos - Banc of America.
George Staphos - Banc of America Securities
I just wanted to follow up a little bit on Jeff’s question earlier. Realizing that it’s tough to measure this within RIS, were any of your other segments, aside from PSM, down year-on-year, if you can measure it, in price mix in the second quarter.
And was that percentage change sequentially for any of the segments worse than what you saw in the first quarter? I would expect the answer is no to that second question but I want to confirm it.
Daniel R. O'Bryant
Generally, in the second quarter we saw pricing beginning to stabilize across the other businesses. The businesses that that would be most relative to are in our other category like our tapes business but also the graphics businesses.
And they started implementing some price increases in the second quarter, so generally if we look out there, things were getting at least stabilized in Q2, if not improving just a little bit, George.
George Staphos - Banc of America Securities
So aside from PSM, was anything down year-on-year, percentage-wise and price mix?
Daniel R. O'Bryant
Well, sure year-on-year most everything was down. Office Products would be the exception.
But we were down in the PS segment year-on-year, because of that carry over effect. If you’re talking sequentially, things began to stabilize and improve in a few places.
If you’re talking year-on-year, our materials businesses pretty much across the board had negative price that carried into the second quarter.
George Staphos - Banc of America Securities
Does that suggest that pricing was negative in RIS in the quarter?
Dean A. Scarborough
George, you just can’t, it’s a custom business and the churn rate is as high as 60% to 70% on a year-over-year basis. There’s no good way to measure pricing in the sector.
The biggest impact there we had was volume decline and the second thing is we did see some inflation coming from people costs and some material costs, especially related to China.
George Staphos - Banc of America Securities
Just trying to get at it because of how big inflation has been for you, how big you expect it will be and the fact that you’re trying to implement more pricing. How do you implement an RIS price increase, since it is such a diverse business?
Dean A. Scarborough
Well, basically you raise your standards, so when customers come back for a new program you load your new costs in and your new margin expectations and it’s pretty much hidden, because if a customer buys a six-colored printed tag that’s 4”x2” one year, and then moves to a larger tag with fewer colors you’re comparing an apple to an orange. But we would expect to get with our new pricing models, we would get the inflation pass through.
But it takes time to do.
George Staphos - Banc of America Securities
It’s probably semantics but I just want to confirm it, in your prior slide that Paxar synergies were targeted up to $125 million, now you’re saying approximately $120 million. I know these are not big numbers but just wanted to see if anything had changed in your synergy outlook.
Daniel R. O'Bryant
Nothing’s changed, just refining the words a bit. What’s actually going on is we’re achieving all of the synergy cost out that we targeted and we’re actually getting more productivity on top of it as we react to soft market conditions.
So no change in the expectation for what we’re getting out in terms of cost synergy at all.
Operator
Your next question is a follow-up from Jeffrey Zekauskas - JP Morgan Securities.
Jeffrey Zekauskas - JP Morgan Securities
So the organic sales growth in the quarter was negative 0.6%. Can you break that up into price and volume, roughly?
Daniel R. O'Bryant
The price mix component year-on-year was down 1.5% to 2% still.
Jeffrey Zekauskas - JP Morgan Securities
Second, in terms of raw materials you stated that you feared that raw materials would continue to go up. Why are you afraid of that?
Daniel R. O'Bryant
I don’t think we used the word fear. I’m not afraid of it in particular.
In fact I think over the long run some of this inflation is probably healthy to the industry. But the issue right now is that we’re behind the inflation curve.
In our materials business in particular it takes time to get a price increase into the industry and with the pace of inflation right now we just haven’t been able to keep up with it. And we’re raising prices everywhere and sometimes it’s our second or third round already.
So just can’t keep up with it at the rate it’s been coming in. We’ve adjusted our inflation expectation every quarter over the last 90 days and it’s more than double what we came into the year expecting.
So, it’s just a matter of how quickly we can react to it and recover. We will get there.
We have always, I think, been able to get to the point where we’ve covered the inflation, but running two or three quarters behind is pretty tough on margins for 2008. And the damage has been done the first half of the year.
Even if by the end of the year we have caught up, while our margins in the fourth quarter and first quarter may look a whole lot better than they do now, there’s not a lot we can do to recover the margin loss in the first half of the year.
Jeffrey Zekauskas - JP Morgan Securities
You lowered your guidance for the year but your numbers in the quarter were pretty good, so does that mean that you expect the raw material squeeze to be worse in the third quarter than it was in the second quarter?
Daniel R. O'Bryant
Well, the third quarter is similar. We’ve got a lot of price increases that are going in during the quarter and some of them late in the quarter, at the beginning of Q4.
The inflation is already there. So, the gap between our pricing and inflation in Q3 looks a lot like it looked in Q2.
It gets better in Q4, depending on how much new inflation we get. So, our guidance reflects the fact that we’re still going to have margin compression in the second half and in a couple of our businesses, simply have lower sales in the third and fourth quarter they typically do in the second.
So, we do have some lower volumes coming through and a lot of that is in our two high-variable margin businesses, RIS and Office Products, which impacts the earnings for the back half of the year as well. That’s really the story in the guidance, the gap in inflation versus pricing in the second half, and the lower volumes in our highest margin businesses.
Dean A. Scarborough
We were still behind the pricing curve in our second quarter. We don’t give quarterly guidance, so the issues affecting margin related to pricing were very strong in the second quarter.
I think we may have shown that we hit the number, but we didn’t hit our number.
Jeffrey Zekauskas - JP Morgan Securities
Oil is already at whatever it is, $135, and natural gas is already up, which are the precursors of your raw materials. Acrylics pricing is passing through pretty fast right now and so if your prices only need to go up only a couple of percent to offset that inflation.
So, I take it that means that you won’t be able to get something like a 2% price increase in the third quarter but maybe it will take you until next year, is that what you’re saying.
Dean A. Scarborough
I think we’ll see most of it catch up in the fourth quarter, so we are anticipating more inflation, John.
Jeffrey Zekauskas - JP Morgan Securities
How bad were volumes in July, across the board? Or how good were they?
Dean A. Scarborough
Well, they were about where we expected except that the growth came more from our materials business and less from RIS. Are you talking about a single month?
Jeffrey Zekauskas - JP Morgan Securities
I was wondering how July had gone, or how July was going for you.
Dean A. Scarborough
There’s nothing we could report right now that would indicate a change in the pattern for the month of July. So right now it’s still looking more like Q2.
Jeffrey Zekauskas - JP Morgan Securities
In RIS in the third quarter, we don’t really have very good historical numbers, so how seasonally weak is the third quarter versus the second or versus the first? How do you think about that?
Dean A. Scarborough
Well, the first quarter is the softest and the third quarter is the second softest and then the fourth quarter and then the second quarter. And I would guess that Q3 would be more seasonally weak than normal because retailers are going to be cautious about how much inventory they bring in for the holiday season and for Christmas.
So this season will get started slower. It typically starts in September.
Operator
Your next question is a follow-up from John Roberts - Buckingham Research.
John Roberts – Buckingham Research
I’ve already beat this RIS price discussion to death here, but is there anyway you can talk at least about variable margins because the operating margins obviously are impacted by volume, by restructuring, but the variable margin would be more indicative of mix effects or whether customers are trading down, or competitive pressures. Even without giving absolute numbers, maybe directionally, whether variable margins were maintained?
Daniel R. O'Bryant
Yes, I think the best way to get a handle on that is to look at the RIS results in Q1, which was a very soft quarter, and what those margins looked like in Q2. And the variable contribution as we seasonally ramped up was in the high 30% range or close to 40%.
So, we get huge impact in that business because of the high variable margins and that hasn’t really changed. You can go back a year ago and look at the incremental margin on volume, you can look at it now, and it’s similar.
There is margin pressure in the business but, as Dean said, it’s coming from inflation right now and it takes some effort to react to that in terms of prices, as programs change over and so on and to drive productivity. But still, from a variable margin prospective the volume makes a big difference in how much EBIT we produce in this segment.
John Roberts – Buckingham Research
You would say there’s not a lot of customer trade-down going on in the business.
Dean A. Scarborough
It’s all over the map. Some customers want to buy cheaper tags and labels.
Other customers want to buy, frankly, more expensive tags and labels because they want to differentiate their product at point of sale.
John Roberts – Buckingham Research
But on average, it’s unchanged?
Dean A. Scarborough
I would say on average there’s really no change.
John Roberts – Buckingham Research
And even though you have a relatively high market share, the smaller players, the competitive intensity hasn’t picked up to where they might be pressuring the business?
Daniel R. O'Bryant
I would say it is no more than we would normally see.
Operator
Your next question is a follow-up from Reik Reid - Robert W. Baird.
Reik Read - Robert W. Baird
Is the acceptance of these price increases a little difficult to get at this point and that’s why you say, Dean, it’s more of a fourth quarter where you see a catch up, or is that because you’re anticipating more inflation?
Dean A. Scarborough
There’s always resistance to price increases, customers don’t like price increases. But, in today’s world, it’s pretty much becoming accepted.
So, the conversation has changed with most of our customers from, we don’t want a price increase to how long are your prices going to last now. But the real issue for us is accelerating inflation.
So we announced a group of price increases that come into the third quarter and inflation has gone up much more rapidly than we anticipated. I’ll give you an example.
In Office Products, we typically raise prices once a year because it’s difficult for our customers to pass those price increases through. But we raised prices in July, we’re raising them again on some products in October, which is unprecedented, and then again, on some other product categories, in January.
And it’s simply because inflation in certain categories has gotten so intense we have no other option but to pass the cost on.
Daniel R. O'Bryant
This gap between what we’ve been hit with in inflation, and what we’ve been able to recover and price, is a temporary gap. We’ve been through this before and it comes back.
The pace has been our challenge, just getting prices up quickly enough. So it’s really masking our ability to generate profit as we go.
When we catch up over the next couple of quarters and we start to see volume come back, I think the underlying ability to generate profit and cash flow in this business is really going to be solid. Because a lot of things are going right.
The RIS integration is going extremely well. We’re getting a lot of productivity as we implement ELS in our materials businesses.
Office Products is very reliable in their ability to maintain margins and so on. So, we have an underlying business that is very strong.
The size of the gap between pricing and inflation is significant right now, we’re going to get through that, and the business is going to improve. We still expect margins to be ramping up as we go through the next couple of quarters.
Reik Read - Robert W. Baird
On the RIS side of things what’s your assumption now in terms of where the retail apparel markets are from a gross standpoint and, Dean, you’ve talked a number of times about retailers wanting to lower inventory. How much more can they lower that bar before things begin to level out?
Dean A. Scarborough
Well, I think the good news there is I think they’re probably getting about as low as they can get to be honest. The good news is we’ll start to lead the recovery when retailers start to order products because they’re running out of stuff in the stores.
We’ll see a surge in orders, which is typically how these things operate.
Reik Read - Robert W. Baird
As it pertains to the RFID space, apparel winds up being an important market for you. If I exclude Marks & Spencer, because that’s a unique case, does the weakness that you’re seeing right now slow down some of those efforts or are they moving forward regardless.
Dean A. Scarborough
They’re moving forward. I think Marks & Spencer isn’t so unique anymore.
We’re involved in at least 15 pilots now with different retailers around the world. American Apparel is a good example.
They are installing RFID in their business. We’re talking with a lot of retailers.
Retailers are looking at this today because the cost and implementation are much lower than they were a few years ago and this is just a great way to make sure they’ve got the right products in stock and they can improve their sales. So, I actually think there’s more interest today than there has been in, certainly two years ago.
Reik Read - Robert W. Baird
But the underlying economic issues aren’t impeding that at all?
Dean A. Scarborough
Not so far.
Operator
Your next question is a follow-up from John Roberts - Buckingham Research.
John Roberts – Buckingham Research
We were talking about the Office Products increases. I think you said you got a price increase in July, one coming in October, and did you say you’ve got pricing announcements to your customers all the way out to January 2009?
Daniel R. O'Bryant
That’s correct.
John Roberts – Buckingham Research
How does that work? You’ve gone out to Office Products retailers and told them in January they will be seeing a price increase?
You can’t have any visibility of your raw material costs between now and then.
Dean A. Scarborough
Well, we have enough. It depends on the product category.
We have given them a range of what to expect for January of 2009 so that they can do their planning.
Daniel R. O'Bryant
Some of that, again, is making up for inflation that we’re absorbing today, that has already hit us and we’re recovering in January.
John Roberts – Buckingham Research
So if you saw more raw material increase that is unexpected, more than what you’re expecting between now and let’s say even October, you would go out with a February price increase or March 2009 price increase.
Dean A. Scarborough
It’s hard to anticipate that. I hope we’re not in an inflationary environment like we were 25 years ago where we were raising prices every 90 days.
Our preference would be to, in Office Products anyway, would be to have one, maybe two price increases a year. But if we see the type of inflation that we’ve seen lately, going out every 90 days, we would do it.
John Roberts – Buckingham Research
A lot of packaging materials in Office Products?
Dean A. Scarborough
You have steel, you have vinyl, and you have transportation costs. Those are the major categories, and plastic.
Those are the ones that seem to have the highest rate of inflation right now.
Operator
Your next question is a follow-up from George Staphos - Banc of America.
George Staphos - Banc of America Securities
Given that you’re telling customers what your future price increases will be, what are the risks of pre-buying here? Secondly, as we take a step back, should we expect most of the inflation for the back half of the year to really reside in Pressure-sensitive Material or how would you have us think about it?
Dean A. Scarborough
George, on the pre-buying, so far we haven’t seen a lot of impact. If anything, we’ve seen behavior change from customers, especially retail customers.
They are working on preserving cash, in a down environment. So inventory is much more important to them, or lower inventories are more important to them than pre-buying on price increases.
That’s a big one.
George Staphos - Banc of America Securities
In terms of inflation, we should expect most of the impact where? Pressure-sensitive would seem to be to be the most, but how would you have us think about it?
Daniel R. O'Bryant
That’s right. The materials business has been feeling the most of it.
Probably 2/3 of the inflation hitting there I would guess. I don’t have the exact number but it’s definitely more impactful there than it is in the other segments.
George Staphos - Banc of America Securities
Just as we think about where things maybe have slipped from a macro standpoint relative to where you last gave guidance and you talked about, obviously, RIS being weaker, apparel being weaker in the U.S. Were your expectations for recovery in the second half and that’s why you’re giving yourself a little bit more room in the guidance now?
Or where was there some additional weakness.
Dean A. Scarborough
Well, we didn’t mean our expectations for the second quarter, George. And we anticipate a slower volume environment as well as the accelerated inflation in the back half.
We’re starting to see things slow down outside the U.S. at the same time.
Daniel R. O'Bryant
There are two major factors that caused us to change the guidance. One is that from what we originally expected in the back half versus now, we still have a big gap, particularly in Q3 between price and inflation.
And the second one is that on the revenue line more of that revenue is coming out of the Materials business and less out of the Office Products and RIS business, where our higher incremental margins are. And that impact is a good part of having pulled our expectations down a bit in the second half.
George Staphos - Banc of America Securities
Just qualitatively, if we hold current macro trends flat and we assume no more inflation than what we’ve already seen, I don’t want pricing or inflation to enter into your answer here, how much more opportunity do you have to improve working capital over the next couple of years? Could you actually grow free cash flow in 2009, given what you know right now relative 2008 to date, given whatever initiatives you think you may be able to undertake?
Daniel R. O'Bryant
We do have room on the cash flow and I think these last two quarters have shown it. We have been unhappy with our working capital performance over the last couple of years.
There are some reasons for that, but frankly, as a focus, it is better now than it has been and we’ve been generating a significant amount of cash out of our working capital and we’re not finished. I think there is still another $50 million or maybe more over the next year, year and a half that we will squeeze out of working capital.
So, we’re confident in our ability to generate cash flow and pay down debt as planned, even with some of the top line challenge that we are having right now and the margin loss. We are still committed to our cash flow targets.
Operator
At this time there are no further questions.
Dean A. Scarborough
Thanks and we will talk to you next quarter.