Avon's 1Q Far From a Beauty

 Avon Products'  first-quarter results indicated that it is going to take more than a quarter or two for management to right its ship; however, we believe the stock looks undervalued at just 16 times our fiscal 2011 earnings per share estimate. Despite the near-term challenges resulting from execution missteps and soft consumer spending, we contend that Avon's low-cost, expansive sales and distribution network will enable the beauty-care firm to generate excess returns on invested capital over the longer term.

First-quarter sales increased a modest 2% year over year (excluding foreign currency movements and acquisitions made last year), reflecting higher prices and improved mix. Tight consumer spending continues to weigh on the North America segment, where internal sales tumbled 10% from the prior-year period. While management announced plans a few months ago to add leadership to levels beyond four to improve representative compensation and ultimately reignite sales growth in this market, we remain skeptical. We have long said that by limiting the downline--the individuals that each representative recruits into the sales network--Avon is better able to control the sale of its products (which has plagued other direct sellers). From our perspective, investments in supply chain, product innovation, and marketing support are ultimately what will be needed to put Avon on more solid ground.

Favorable foreign currency and higher prices offset the impact of rising commodity costs, as the adjusted gross margin expanded 80 basis points to 63.9% and the adjusted operating margin increased 30 basis points to 9.9%. While advertising expense fell 15%, Avon shifted some of that spending to support its representative base--a positive, in our view. We believe recent restructuring efforts should eventually enable the firm to realize the scale benefits from its global network, but near-term headwinds (higher costs and internal struggles) could constrain profitability this year, as we forecast 11% operating margins for fiscal 2011.

We were disappointed that additional details surrounding the management reorganization announced in February, whereby CFO Chuck Cramb will assume the newly created position of vice chairman of developed markets, have yet to surface. Beyond looking to fill the CFO suite, the global beauty-care firm also has refrained from naming a leader for its Latin America business unit, choosing to consider candidates from outside the firm. Given that this is its largest market (40% of sales and 50% of operating profits), we'd hoped that the firm operated with a deeper bench from which to draw talent.

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