Avon Shareholders Should Have Seen This Coming

A few days ago, shares of Avon Products (NYSE: AVP  ) fell an impressive 21.87% as the company reported a deluge of disappointing news. In addition to coming up short on earnings and revenue, the company admitted that it would likely face a significant penalty from the U.S. government for having certain members of its company bribe Chinese officials, a violation of the Foreign Corrupt Practices Act of 1977. Such a large decline indicates that Mr. Market is very concerned about the long-term viability of Avon. This should also make you, the Foolish investor, at least somewhat concerned as well.

Third quarter earnings disaster
Looking at the company's earnings release, I discovered that there appears to be very little to be hopeful about for Avon. For instance, revenue for this quarter fell by 7.5% to $2.3 billion from the $2.5 billion it reported in the same period a year ago. As a result of revenue declining, the company took an even more significant hit to its operating income, which declined by 38.3% from $110.6 million to $68.2 million. This implies an operating margin of around 3%, compared to the 4.4% it saw a year ago.

Due to the significant decline in the company's operating income, its net income went from $31.6 million in the third quarter of last year to a net loss of $5.5 million this quarter. On an earnings per share basis, this converts to a loss of $0.01, compared to the $0.07 it saw last year.

At least the picture's not consistently this bad
Certainly, this news looks bad for shareholders and prospective shareholders, but when you look at the company's performance over the first three quarters of this year and compare it to the same three quarters a year ago, the picture isn't quite as bad (but it is, nevertheless, horrible). Revenue over this time horizon declined by 4.2% from $7.6 billion to $7.3 billion, while net income declined by an astonishing 89.4% from $119.7 million to $12.7 million.

However, the significant hit to the company's bottom line came about as a result of a combination of a loss on the early extinguishment of debt in the amount of $86 million, higher taxes, and a loss from discontinued operations of $50.9 million.

Rather, if you look at just the company's operating income, which excludes more volatile charges, you actually would see that it increased its operating margin from 4.1% of sales last year to 6.1% this year. This positive development can be attributed to the company effectively containing costs. This is shown by the fact that its cost of revenue declined from 38.3% of sales for the three quarters last year to 37.5%, and its selling, general and administrative, or SG&A, expenses have decreased from 57% of sales to 55.8% of sales.

Why this shouldn't come as much of a surprise to shareholders
Unfortunately, unexpected things come up in life from time to time. This appears to be the case with the company's investigation by the U.S. government. Looking at the past five years of Avon's financial results, I believe that it's not too hard to predict that the company will continue deteriorating.

For example, let's take the company's net income over the past five years. Although revenue for the company stayed roughly the same over this time period, its net income has fallen almost annually, which has resulted in its net profit margin declining in the process.

In the table above, I plotted out the company's net profit margin and compared it to one of its competitors, Nu Skin Enterprises (NYSE: NUS  ) . Over the past five years, the net profit margin for Avon has declined from a high of 8.2% to a low of -0.4%.

On the other hand, Nu Skin has performed exceptionally well, seeing its net profit margin increase four out of the five years shown from a low of 5.2% in 2008 to a high of 10.2% in 2012. Nu Skin's increase has come about as a 73.9% rise in revenue, while its costs have been kept effectively in check.

Meanwhile, the primary driver behind the decline in profitability for Avon has been a significant increase in the company's costs, as shown in the table below:

What we see here is that the company's cost of selling, general and administrative expenses has risen as a percentage of revenue on an annual basis, increasing from 50.5% of sales in 2008 to 55.8% of sales in 2012. Despite efforts by management to improve its business, the company saw the 55.8% expense seen in 2012 reoccur, on average, throughout its first three fiscal quarters of this year.

Foolish takeaway
Initially, I think it's understandable for investors to be shocked by news that Avon's earnings and revenue declined significantly. However, when you look at the bigger picture over the past five years, it's not too hard to imagine that the trend would likely continue.

On top of all of this, the company is being hit hard by the U.S. government, which should cause Mr. Market additional concern. Though I do not know what the future holds for Avon, I do believe that it is likely that this trend will continue if management is unable to properly restructure the company to fit the future.

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