An Opportunity To Unmask Avon’s Beauty

By Ryan C. Fuhrmann | September 28, 2011 AAA

Avon Products (NYSE:AVP) has a compelling business model that sells cosmetics, fragrances and related products directly to consumers around the world. Unfortunately, for a number of years now it has wasted its advantage of being able to avoid the fixed costs that come with operating retail stores, but the removal of its CEO offers a renewed opportunity to bring in a leader who can boost profits back to more respectable levels.

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Recent Results Recap
Avon saw third quarter sales rise a steady 5.7% to $2.8 billion on double-digit growth in Latin America and solid high single-digit growth in Central and Eastern Europe, as well as the Western Europe, Middle East and Africa. Asian growth was modest at 1% with North America the laggard, reporting a top line decline of 7%. Beauty sales grew 8% to make up the vast majority of sales at nearly 73%. This was followed by fashion and home sales at 16 and 9%, respectively, both of which saw sales fall in the low single digits. The other revenue category accounted for the balance of sales.

Operating profits rose a slightly stronger 7.4% to $278.6 million, as SG&A costs increased at a slower rate than sales. This put the operating profit margin at 10.1%, which is above the high single-digit level posted in each of the last two fiscal years. However, higher other expenses sent net income down 1.4% to $164.2 million, or a net profit margin of just below 6%. Share buybacks helped keep earnings per diluted share flat at 38 cents. For the first nine months of Avon's fiscal year, operating cash flow of $234.2 million fell well below the reported net income of $517.5 million. Capital expenditure of $197.4 meant minimal free cash flow of $36.8 million. (To know more about income statements, read Understanding The Income Statement.)

Outlook
Analysts currently project full year sales growth of almost 5% and total sales of nearly $11.4 billion. The current earnings expectation is $1.83 per share, which would represent year-over-year growth of almost 32%.

Since 2008, Avon's operating margins have experienced a steady decline from about 12.5% to less than 10% in the most current full fiscal year. This has come despite steadily lower sales costs, meaning gross margins have improved. The main culprit to lower profitability has been higher SG&A costs over time. Back in 2004 they dipped below 47% of sales, but ate up almost 53% of sales last year. Free cash flow generation has also been dismal since 2007 and has fallen well below reported net income.

In stark contrast, Tupperware (NYSE:TUP), which focuses on the direct selling of kitchen products but also has a smaller beauty segment, has boosted margins over the years on a steady decline in SG&A expenses. Operating profits stood at 14.3% last year, or more than 43% ahead of Avon's. Free cash flow has also exceeded net income for each of the past two years. Procter & Gamble (NYSE:PG), which also has a sizable beauty segment and boasts operating margins closer to 20%, while beauty pure play Revlon (NYSE:REV) recently reported an operating margin above 15%.

The Bottom Line
Given Avon's direct selling model, there is little excuse for it to be reporting such low margins and free cash flow levels. Its margins are closer to that of Elizabeth Arden (Nasdaq:RDEN), a cosmetic maker that was hit during the latest recession and is still recovering. With a renewed focus on cutting corporate overhead and leveraging the decent annual sales growth into profit expansion, earnings could reach well above $2 per share. The removal of Andrea Jung as CEO offers a great opportunity to find a leader who can execute on the bottom line. At a forward P/E of less than 10, there is ample upside opportunity for investors and they are currently getting paid a generous dividend yield of 5.6%, to wait for a recovery. (For additional reading, check out 5 Must-Have Metrics For Value Investors.)

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At the time of writing, Ryan C. Fuhrmann did not own shares in any of the companies mentioned in this article.

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