Label It “Opportunity”

Label It “Opportunity”

3M’s purchase of Avery Dennison’s office products business makes more sense than it might seem at first.

CEO George Buckley joined 3M in late 2005 with a mandate to energize a company then known for growing no faster than the overall economy. His plan was based primarily on firing up innovation—hardly novel for 3M, except that his predecessor worked so hard at efficiency that observers concluded 3M’s innovation culture had suffered.

Now six years into his tenure, Buckley liberally peppers his talks to investors (and, presumably, employees) with references to “NPVI,” or New Product Vitality Index. It’s 3M’s measure, basically, of the percentage of sales coming from new “successor products”—items that don’t just replace a product but are new to the world. In his comments during 3M’s “2012 Outlook” meeting for investors in December, Buckley reiterated that his goal is for NPVI to reach 40 by 2016. He also noted that NPVI was only 21 percent, or possibly lower, when he joined the company.

Complementary acquisitions are part of 3M’s growth story, too. A month after the 2012 Outlook meeting, the company announced its first big acquisition of 2012: the $550 million cash purchase of the Office and Consumer Products business (OCP) of California-based Avery Dennison Corporation. 3M is buying the group for about 5.8 times estimated 2011 earnings before taxes, depreciation, and amortization. The group had 2011 revenue of about $765 million. It has seven facilities and about 3,000 employees. And among the assets 3M will acquire are the Avery and Hi-Liter brands. 3M said that its primary motivation is to add scale to 3M’s distribution of office products.

3M estimates the acquisition will be approximately $.06 dilutive to earnings per share in the first 12 months following closing. Excluding purchase accounting adjustments and anticipated integration expenses, 3M estimates the acquisition will be $.03 accretive to earnings per share over the same period.

At first glance, it’s pretty hard to square this deal with any CEO’s strategy of growth through innovation. What customer is looking for innovation in labels, file folders, and pink highlighters? My guess is that Avery’s office and consumer products’ NPVI approximates zero. And there is also no getting around the financial challenges in Avery’s OCP operation. Avery sells binders, name badges, writing instruments, and other products in addition to its well-known consumer labels. We all use labels in tasks such as Christmas card mailings—but, apparently, fewer Avery labels than we once did. Maybe we use cheap knockoffs, or are simply using labels less often.

In any case, this business has been on a seven-year revenue slide, shrinking by nearly one-third during that time. Over that same period, 3M’s own Office Supplies Division was growing nicely.

So it was surprising to see that 3M followers in the investment community were excited by its purchase of this fading business. Their view is that Avery’s OCP group is the kind of operation that could use a little 3M innovation.

Stopping the Shrinkage

3M is best known in this segment for selling through Target and other big retailers, although it has competed head to head with Avery in some segments. Avery has more of a professional office products channel than does 3M, and that channel has been shrinking. Consolidating distribution “is the easy stuff [3M] can do,” says Mark Henneman, co-manager of the Mairs and Power Growth Fund in St. Paul. “But how do they get it to stop shrinking? That’s why I just have this sense that they must have something in mind.”

The answer may be to just start doing the things that Avery had largely stopped doing. According to an analysis put together by Nicholas Heymann of Chicago-based William Blair & Company, 3M has been taking market share from Avery since the mid-2000s —in part due to the 2010 acquisition of Japanese label manufacturer A-One. Avery responded to 3M’s competitive pressure by actually cutting its spending: Avery’s capital spending declined in the OCP segment by more than 75 percent from 2004 to 2010. It appears that Avery had turned it into a cash cow, employing a classic strategy for a declining business: that is, milk it and then seek an exit by selling to a competitor still committed to the market.

Heymann observed that “one of the aspects of the OCP business that attracted 3M was Avery Dennison’s seeming underinvestment in the business from a product innovation and marketing perspective. This is an opportunity to regenerate the business’s product lines and market the premium Avery brand.”

According to what analysts have reported, 3M told its shareholder base that it approved of the transaction based upon an assumption of roughly flat revenue. If that is the best that happens, it will still prove to be an attractive investment. But 3M management hopes to do better. Henneman from Mairs and Power notes that sometimes innovations can seem pretty simple, such as the application of new coatings or adhesives from the broad portfolio of 3M technologies, or a simplification in the supply chain that takes cost out of a process.

“Good Deal”

Analyst Laurence Alexander of New York–based Jefferies & Company, who published a rough estimate for the Avery operation post-closing, showed revenue declining slightly the first year as operations are integrated, and then increasing a modest 3 percent per year thereafter. The punch line is, if that kind of modest growth scenario plays out, annual operating income for the group will come back to 2007 levels of about $175 million by year seven. At that rate, returns on invested capital will exceed 22 percent. Thus the headline of Alexander’s research notes reads, simply, “Good Deal.”

“This is going to be an interesting one to watch,” Henneman says. “Maybe it can be a new model for 3M acquisitions if this turns out to be successful. They can buy underutilized businesses or products and refresh and revitalize them. They do that to their own businesses all the time.”

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