Avon Calling, Again

MONDAY, MARCH 13, 2006
By JACQUELINE DOHERTY

AFTER A YEAR OF MISERY, AVON PRODUCTS is giving itself a makeover. The iconic marketer of make-up and skin-care products is slashing management layers, bolstering its overseas presence, spending more on advertising and focusing on lower-priced items. Success could reinvigorate its moribund revenue growth and send its shares, now 29, climbing 20% in the next year or so.

"It's not a stock for the faint of heart," says Diana Joseph, a portfolio manager with Chicago-based Dearborn Partners, who began nibbling at the shares for clients and her own account earlier this year. But "there is a reasonable probability the company will regroup, and it is a business with high margins and high cash flow," she adds.

If Avon's restructuring goes well, the shares (ticker: AVP) could rise to 35 in the next 12-to-14 months, Joseph figures. Along the way, investors will pocket a 2.4% dividend yield.

As the stock's 30% slide in the past 12 months suggests, Avon fans are few these days. Six analysts rate the shares Hold, while four are telling clients to sell. Growth investors largely have fled the name by now, and have been replaced by value funds such as Davis Selected American Shares (SLASX) and Oakmark Equity & Income (OAKBX), presumably drawn by the company's strong cash flow and historically low price/earnings ratio of 17 times expected earnings.

Attitudes toward Avon, which is based in New York, have changed notably since we penned a skeptical piece on the company more than two years ago ("A Thing of Beauty?" Jan. 19, 2004). At the time, much of Wall Street was bullish, although we thought investors were paying too much for a company whose U.S. growth was slowing. Our caution was premature -- Avon subsequently rallied to 46 from 33 -- but it wasn't misguided. By last fall, Avon had fallen to 24.
Citigroup analyst Wendy Nicholson, a growling bear in January 2004, upgraded her recommendation to Buy from Hold last fall, and currently has a $32 target on the shares. "Long-term, Avon will grow earnings twice as fast as the Standard & Poor's 500," she maintains.

To justify buying Avon shares today, you have to believe the company's restructuring will bear fruit. That's because last year's results were nothing short of ugly. After boosting revenues by 10% in 2003 and 13% in 2004, Avon suddenly posted a 5% increase, to $8.2 billion in 2005. Net income was flat, at $848 million, or $1.81 a share from operations. The year ended on a particularly poor note, with fourth-quarter net falling 37%, to $183 million. Restructuring charges dented results and will continue to depress earnings this year, although analysts are estimating operating earnings per share of $1.67 in 2007, which should mark the start of a rebound.

Avon's U.S. sales kick in roughly a quarter of total sales and a fifth of operating profit.

Consequently, the company has relied on robust growth overseas. Last year, however, even foreign markets were disappointing. Sales in Central and Eastern Europe rose by 15%, well below the 47% increase they clocked in 2002. In addition, Pacific-region sales contracted by 0.3% overall, and those in China fell 20%, compared with a 42% increase in 2004.

To some degree, Avon shot itself in the foot in '05, by slashing U.S. advertising spending 50%. But much of the drag came from events outside its control. Higher oil prices and rising interest rates squeezed spending by middle- and low-income consumers. And global competition has intensified, with industry giants such as Procter & Gamble (PG) and L'Or?al (LRLCF) putting lots of research and advertising dollars behind products in the $15-to-$25 retail price range. In the past few years, they have made it much easier to find high-quality skin-care items at the local drugstore, striking at the core of Avon's market. Avon's Anew skin-care line, meanwhile, fetches more than $30 a jar.

The solution: Introduce more products, bolster offerings at lower prices, such as the Solutions line of skin products, and boost advertising spending. This quarter, Avon is introducing Anew Clinical Eyelift, with a gel for the upper eyelid and a cream for below the eye, for $28. In the second quarter, the company will unveil Ageless Results, a skin cream based in part on Anew technology, that will sell for $12 to $15 per item. Also ahead: an instant-dry nail polish that will retail for $8. Avon hopes to bring new products to market faster than in the past, owing to a $100 million research facility it opened in Suffern, N.Y., last year.

IN A RECENT PRESENTATION, Avon CEO Andrea Jung, 47, said the company will reverse its ad-spending cuts in the U.S.; television viewers already have seen the results. U.S. TV advertising, which shrank to 10 weeks in 2005 from 21 weeks in 2004, will jump to an estimated 47 weeks this year. On a worldwide basis, ad spending will rise 50% this year, and double by 2008. Jung and other Avon executives declined to speak with Barron's.

With newer products and more advertising, Avon hopes to wean itself from price discounting. Last year, the company generated 80% of its sales from discounted products, up from 65% five years earlier.

Avon also hopes the buzz created by its redoubled efforts will energize its sales force of 4.8 million representatives, mostly women, around the world. Jung implied that she was studying compensation levels to ensure that the company offers competitive packages. As most "Avon ladies" are paid by commission, it's possible she'll have to alter compensation formulas, resulting in higher costs, if lower-priced products begin to comprise a larger percentage of sales.

The company also may need to appease some current and former Avon ladies, who are attempting to gain class-action status for a suit they filed several years ago in Superior Court in Los Angeles, contending that they received and were billed for products they never ordered. We detailed their allegations a year and a half ago ("It's Not Pretty," Oct. 11, 2004). The company contends these are individual customer-service issues.

NO REORGANIZATION IS WITHOUT RISK. William Pecoriello, a Morgan Stanley analyst, worries that instead of generating incremental sales, customers will buy the new, lower-priced products instead of higher-priced merchandise. Pecoriello, who has an Equal Weight rating on the stock and a $34 price target, also notes that Avon's 100% increase in U.S. ad spending this year will return only to 2004 levels.

The company's "share of voice," or the amount of spending it does relative to competitors, is likely to be down in 2006, compared with its level in 2004, as other personal-care companies have been boosting ad outlays.

To pay for new-product development and increased advertising outlays, Avon plans to cut 20% to 30% of its middle- and senior-management positions by this summer. Thursday, the company said that Susan J. Kropf, president and chief operating officer, will retire after 35 years with the company, and won't be replaced. While these cuts show Avon means business, they could disrupt the company's operations, says Morgan Stanley's Pecoriello.

Despite the cuts, Avon is establishing business units for China and Eastern Europe, to complement North America, Western Europe, Latin America and Asia Pacific. Theoretically, the result will be a flatter organization more in touch with representatives and customers.
In all, Avon forecasts savings of $300 million annually, half from management changes. Funds will be reinvested in the business, with half directed to advertising and half to research and development, sales-force enhancement and such.

"This is a multiyear plan that will touch every aspect of this company," Jung said in a recent presentation. Success could bring long-term revenue growth in the mid-single digits, as measured in local currencies, and operating margins should improve in 2007. Avon's operating margins peaked at 15.9% in 2004, and look headed to 11% this year.

Citigroup's Nicholson believes that the restructuring will allow Avon to generate 11%-to-12% earnings growth in 2007 and beyond. She's expecting flat-to-single-digit revenue gains in the U.S. and developed Europe, and 10% revenue growth in emerging markets, the source of more than half the company's sales.

In the past 10 years, Avon's price-earnings multiple has ranged from a 43% discount to a 53% premium to that of the S&P 500. If Jung & Co. deliver, Nicholson says, the stock's P/E could expand to a 35% premium, versus a 21% premium now.

Several developments could enhance the upside. Avon recently received permission to have a direct-sales operation in China, although approval came much later than expected. Until now, the company has had about 7,000 small shops in China. About 5,500 are franchised, and the remainder are company-owned.

AS AVON DEVELOPS A DIRECT-SALES FORCE in that country, it is likely that some of these shops will close, others will shift to the direct-sales model and still others will become salons, says Morgan Stanley's Pecoriello. In anticipation, the stores dramatically reduced their inventories last year, and sales declined 20%, from $220 million. China sales are expected to climb sharply in the future.

"China could be a $1 billion market for them," Pecoriello observes. "If you take a five-year view of China, there's a pretty big opportunity for them." Much depends, he adds, on the company's business model in China.

The Bottom Line

Avon Products hit a speed bump last year, and its shares fell to 24 from 46. They're now around 29, but could rally 20% as the company's makeover produces results.

Investors also tend to overlook the fact that Avon is a cash cow. Even with last year's disappointing results, the company generated $895.5 million of operating cash flow. Nicholson expects future cash flow to average more than $700 million a year.

The company's strong cash flow and balance sheet give it flexibility to pay a dividend and buy back shares while restructuring. Avon had $590 million of debt, net of cash, at year's end. It repurchased $728 million of stock in 2005 and increased its dividend 6%. In 2006, Nicholson believes that the cosmetic maker could repurchase up to $400 million of stock. That would contribute roughly 4% to growth in earnings per share for the year.

Avon's restructuring has been a long time coming, and like any makeover, could take longer than expected to complete. For shareholders, however, the result could be a beautiful thing.