Ten Things Potential Avon Investors Should Know

Consistent execution has been  Avon's  Achilles' heel of late. The lack of improvement from efforts to reignite sales growth and margin improvement has taken its toll on the management group, and despite adamant denials, it now appears that structural issues in Brazil and Russia--two of Avon's largest and fastest-growing markets--have been more of a contributor to challenges than initially admitted. In light of these stumbles, the wide-moat beauty-care firm announced a significant management reorganization in February 2011. Nevertheless, we remain confident in Avon's ability to right the ship, and we find the stock to be an attractive turnaround story for investors with long-term holding periods. While we aren't expecting an immediate reversal in Avon's fortunes over the near term, we believe the current share price--just 11 times our forward fiscal-year earnings per share estimate--represents an attractive entry point.

While we are optimistic about its ability to generate sustainable economic returns, we believe Avon has a number of hot-button issues that potential investors should be aware of. Below, we've provided answers to ten of the most pressing questions that investors should ask before pursuing an investment in Avon.

1) What percentage of sales is generated by Russia and Brazil? What does the competitive landscape look like in these markets from both direct multilevel marketing (MLM) competitors and others?

Brazil is Avon's largest market, with sales of $2.2 billion in fiscal 2010 (about 20% of the firm's consolidated total). Sales in Latin America were nearly $4.6 billion in fiscal 2010 (more than 40% of total sales), with operating margins of 13.2%. On the other hand, Central and Eastern Europe (which includes Russia) generated revenues of $1.6 billion in fiscal 2010 (nearly 15% of total sales), with operating margins of 18.8%. Brazil is Avon's largest market in Latin America, and Russia is the largest market in its Central and Eastern Europe division.

Reliable market share numbers for Brazil are hard to come by, but Natura is a large competitor in that market. Overall, according to ABIHPEC (Brazilian Beauty Industry Association), between 2004 and 2010, direct sellers gained 8% share and the franchise channel gained 2% share, at the expense of retail operators, which lost 10% share. More specifically, between 2009 and 2010, direct sellers gained 0.3% share and franchise sellers gained 0.9% share, which came at the detriment of retailer operators, which lost 1.2% share.

In Russia, according to Euromonitor, Russia's Usage and Attitude Study, in 2010  L'Oreal (OR) maintained 10% of the overall beauty market, while Avon controlled 9% of the market, and Oriflame (a direct-selling firm with consolidated sales of EUR 1.5 billion in fiscal 2010) maintained 8% share.

2) Describe the "Social Benefit Tax" in Russia? Was this tax recently initiated? What is Avon doing to alleviate the cost on the reps from this tax? Are you confident these fixes will work?

The tax structure in Russia is complex, but it appears to us that the changes occurred in light of the 2008 Russian financial crisis. The unified social tax (UST) combines contributions to pension funds, social security funds, and medical insurance (which were previously separated). Annual income up to RUB 280,000 (or about $9,600 at an exchange rate of RUB 0.0342 /$1) is taxed at 26%, and the marginal rate for income above RUB 600,000 is 2%. However, due to pension fund deficits, it was proposed that UST rates increase or that a switch be made from regressive to flat rates.

According to Avon, the tax change was implemented in 2010, which diluted the earnings of first-year sales leaders by about 35%. To offset the impact of the tax burden, Avon launched a new sales leadership compensation plan in January 2011, with the intent of increasing the earnings potential of first-year sales leaders by 25% by easing qualification thresholds, lowering earning thresholds, and adding new bonuses. The firm intends to fund this structure by reallocating some of its advertising investment spending, which we believe is appropriate.

In the first quarter of 2011, Russia's constant currency sales increased 1%, while sales fell 2% in the second quarter. According to management in the second quarter, active representative growth turned positive, and unit leaders began growing again; however, macro pressures are weighing on consumers' average order. In many of Avon's markets (particularly emerging areas like Russia and Brazil), an Avon representative is the only means through which a consumer can gain access to quality beauty-care products, as traditional retailers are less prevalent. As a result, we expect that the firm will ultimately gain traction in this market, and we're encouraged that the firm is investing for the long-term health of the business.

3) It appears as though the problems in Brazil resulted more from poor execution than poor strategy. Will Brazil's turnaround succeed (especially in light of the fact the multi-representatives in this market aren't solely reliant on Avon for income)? Why will it succeed?

In Brazil, order scale pushed Avon's system capacity, as growth outpaced planned infrastructure investments, and these problems were exacerbated by e-invoicing order processing issues. The firm has stepped up its representative value proposition investment to address its representatives' potential annoyance and frustration, as well as curb deflections. In the past, Avon has estimated that 30% of its active representative base in Brazil overlaps by selling products for other direct-selling firms, which is obviously a risk, but not one that is new.

In the first quarter of 2011, constant currency sales in Brazil increased 2%, and grew 4% in the second quarter. Management affirmed that by the second quarter delivery days were back in line with historical norms, but the order fill rate (although improving) is still below the historical average. As a result, the firm is launching enterprise resource planning (ERP) tools to improve service reliability.

However, it is also important to note that the overall beauty industry (including both retail and direct selling) slowed through the first half of 2011 from the low-double-digits growth rate that was expected to the high single digits. While the franchise channel has remained strong, it only accounts for 8% of the total beauty market in Brazil. Despite this, Brazil's beauty market is still 2 times the size of the average global beauty market.

Avon has operated in the Brazilian beauty care market for more than 50 years and knows these consumers well. We also believe the firm's portfolio of offerings, which caters to mass consumers, as well as the lack of infrastructure investments (like store buildings) required to grow, should serve Avon well in this market over the long run. As a comparison, L'Oreal (the leading player in the global beauty-care market) has operated in this market for about 50 years and has yet to gain a meaningful presence.

4) Despite recent management missteps, Morningstar awards Avon's management team a B stewardship score. On the surface, it seems as though management has made some significant mistakes over the past 10 years (with three restructurings over this time period). What reasons can you point to that justify the B score? Is there any reason to suspect another restructuring announcement in a few years?

Admittedly, the Street has been frustrated with Avon's management, particularly over the past few quarters. Despite managment's adamant denial, it now appears that structural issues in Brazil and Russia were more of a contributor to its challenges than was initially admitted. In light of these stumbles, the global beauty-care firm announced a management reorganization earlier this year; however, our concerns regarding Avon's ability to execute have not subsided following this update. Former CFO Chuck Cramb will assume the newly created position of vice chairman of developed markets. Beyond looking externally to fill the CFO suite, the global beauty-care firm also refrained from naming a leader for the Latin America business unit, choosing instead to consider candidates from outside the firm. Given that this is Avon's largest market (accounting for about 40% of sales and more than 50% of operating profits), we would have hoped that the firm would have had a deeper bench from which to draw talent--which is obviously not the case.

Despite the recent management shakeup, we aren't overly concerned about the firm's corporate governance practices. Our B stewardship grade reflects reasonable compensation practices, with 77%-87% of an executive's annual pay based on performance--a plus, in our opinion. In addition, executive management is motivated to meet the targets of its turnaround efforts, which gives us a bit more confidence that the costly restructuring efforts will bear fruit. We are also fans of the required levels of stock ownership for the management group, as this tends to align management's interests with those of shareholders. We are further pleased that directors are held accountable to shareholders on an annual basis and are elected by majority voting. We would applaud a separation of the chairman and CEO roles, which at this time are both held by Andrea Jung, but we view the presence of a lead independent director as a positive.

We agree that constant restructurings aren't a good thing, but continuous improvement is, and we would be encouraged if the firm moved in that direction.

5) Describe Avon's problems in the U.S. What is management doing to fix the situation? This market is not earning a rate of return in excess of its cost of capital. Why do you have confidence that it will in the future?

The firm's strategy in its home market to shift its offering to a larger concentration of beauty-care products proved to be ill-timed. Previously, management was targeting 65% of its U.S. sales from beauty products, but now the firm is targeting 55%-60% over the longer term. In addition, Avon needs to stem the decline in its active representatives, as well as stabilize average order size.

While the U.S. is a smaller piece of the firm's consolidated business, the continued challenges Avon faces on its home turf are concerning. According to the global beauty-care company, in the U.S. about half of its representatives aren't covered by leadership (which means that they may not be getting beneficial training and guidance). In an effort to reignite sales growth, the firm is shifting its representative structure in the struggling domestic market to more closely mirror the setup in Mexico (which was implemented over the past several years), and the firm is investing to improve the potential compensation incentives for its representatives (which includes simplifying the fee structure to one fee that is based on order size and expanding a representative's earnings potential to include previously excluded sales like demonstrations). If results south of the border are any indication (14% growth in the third quarter of 2010, 14% in the fourth quarter, 16% in the first quarter of 2011, and 18% in the second quarter), Avon should ultimately realize improving sales momentum at home. However, we are taking a more cautious stance--we think Avon will be challenged to generate growth in the domestic market as fast as Mexico--and we are holding tight on our forecast for low-single-digit revenue growth in North America over our five-year explicit forecast. Management expects that these efforts will be fully implemented by year-end 2012. In addition, Avon is investing to improve sales leadership earnings and reenergize holiday offers and giftables, along with launching a new mom and baby business.

In the first quarter, North American revenue fell 2%, while active reps dropped 6%; however, average order size increased 4%. But the second quarter proved to be more challenging, as local currency sales fell 8%, while active reps were also down 8%, and average order was flat compared to the year-ago period. We believe that it will take some time for these efforts to yield measurable improvements.

 

6) Management is projecting fairly sizable margin improvements over the next couple of years. What are the drivers here? How confident are you that management can achieve its targets?

Operating margin expansion is definitely a prime focus for this management group. In fact, management's annual incentive plan has shifted from emphasizing operating profit dollars to operating margin, and Avon's long-term incentive plan drives alignment with operating margin goals. Payout only occurs if significant margin expansion is realized over the next three years, as Avon needs to generate operating margins of 14% by 2013, which is up from a low-double-digit margin in fiscal 2010. No payout will occur if operating margins are less than 13.5%.

Emerging and developing markets are higher-margin businesses for Avon, so as they become a larger portion of the mix, margins should improve. More specifically, Avon is aiming for 3%-4% annual supply chain productivity savings resulting from strategic sourcing efforts (including raw materials and components, as well as maintenance and logistics), distribution improvements (including the opening of two new facilities in Brazil and Columbia, as well as automating existing facilities), and more effectively leveraging its global manufacturing footprint (including increasing beauty outsourcing from 10%-15% up to 30%-35%, as well as consolidating production among facilities).

We forecast reported operating margins of 12.4% by fiscal 2013, and 13% by fiscal 2015, so while we expect these efforts to yield some profit improvement, we're more skeptical than management.

7) What are the effects of Internet competition on Avon? Can people who don't want to deal with the reps simply order Avon's products online? Is Avon's business model becoming antiquated?

While Avon's competitive set includes other online players, it also competes in this realm, and consumers of the direct-selling firm can order over the Internet rather than ordering through a representative. Further, we don't believe that Avon's model is becoming antiquated. In fact, in our opinion, the firm's direct-selling model plays very well in emerging markets, where the most common selling channel is at home, and it is low-cost, making sales highly incremental to margins. In addition, between 1997 and 2008 (according to Euromonitor), the direct-selling channel took share in every region around the world. For example, within the cosmetic, fragrance, and toiletries market, direct sellers maintained 22% share in Central and Eastern Europe (which is up 13 points), 33% share in Latin America (up 7 points), 12% share in North America (up 3 points), 4% in Western Europe, the Middle East, and Africa (up 1 point), and 11% in Asia Pacific (up 0.3 points).

8) Is there a mismatch between the geographies in which Avon generates revenues and the geographies in which costs are incurred?

This issue was highlighted particularly in 2009. Avon's business is primarily international, with about 80% of its sales generated outside of the U.S.; however, the firm's cost structure is primarily dollar-based, exposing the firm to currency translation risk. For instance, in 2008, 20% of sales were generated in the U.S., but 70% of its selling, general, and administrative expenses were dollar-based. As a result, when the dollar weakens, Avon maintains positive leverage on operating profit and margin, but when the dollar strengthens, the reverse is true. Adjusting its pricing and product mix, as well as working to further reduce or contain costs, are levers that Avon has at its disposal to combat these challenges.

With regard to transaction exchange, the firm's global sourcing and manufacturing increases its exposure depending on whether various countries are sourcing U.S.-based commodities or Euro-indexed commodities. Avon expects that its strategic sourcing initiatives, flexible cross-border sourcing, product substitutions, and raw material substitution will be able to offset some of this pressure.

9) Average inventory has increased 12% year over year. Is this an issue?

Inventory increased by 11 days in the first quarter of fiscal 2011 to 116 days, as compared with the year-ago period, resulting from the carryover of its high year-end 2010 inventory balance. Despite this, the firm is still forecasting that days will decline for the full year. More specifically, the firm is targeting that inventories should range between 80 days and 90 days over the longer term, with a 3-5 day improvement annually. We're less optimistic than management, as we forecast that inventory days will improve by about a day per year through fiscal 2015 to 100 inventory days. Between 2004 and 2008, inventory days averaged 94 days, and as a result, management's expectations may be slightly aggressive, from our perspective.

10) Please provide background on the Foreign Corrupt Practices Act (FCPA). What, specifically has Avon done that's gotten them in hot water, and why were they so eager to do it? What are the damages to Avon, and how can you estimate them? How do you know that Avon will be allowed to continue operating in markets where these bribes were given? More generally, how serious is this threat?

Avon's internal investigations (which were initiated internally in June 2008) are focused on expenses for entertainment and gifts "in connection with our business dealings, directly or indirectly, with foreign governments," according to its filing. During its internal probe, The Wall Street Journal reported that Avon uncovered millions of dollars in questionable payments to officials in Brazil, Mexico, Argentina, India, and Japan. As a result, the firm has terminated several employees, including S.K. Kao, the former general manager; Jimmy Beh, the China chief financial officer; C.Q. Sun, the former head of corporate affairs for China; and Ian Rossetter, the former head of global internal audit and security.

Avon's challenges related to the FCPA probe aren't unlike what several other firms are facing. In fact, from 1978 to 2002 the SEC/DOJ prosecuted a little over three cases a year under the FCPA, but since that time, there has been on average 18 firms per year that have faced penalties and fines from the SEC/DOJ. The top 10 fines imposed thus far by the SEC/DOJ have ranged from $70 million to $800 million, with an average fine among the 10 largest of just over $300 million. From our perspective, while this investigation is far from a positive, we believe that the biggest risk to Avon is related to the negative headlines rather than the ultimate financial penalty that the firm ultimately incurs.

Conclusion
While we expect that it will take the firm a few quarters to correct recent execution struggles, investments in supply chain (including the opening of its new facility in Brazil), product innovation (such as its expanded hair-care lineup and holiday gift launches), and marketing support for its products and its representatives are ultimately what will be needed to put Avon on more solid ground, from our perspective. If execution missteps persist, the upside catalyst may be farther away than we expect. But for investors that are willing and able to overlook short-term execution hiccups, the market is providing an opportunity to establish or grow a position in a solid, wide-moat firm at an undervalued price. This stock may not be appropriate for investors with a short investment horizon, but with a 3% dividend yield, shareholders are paid to wait.