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Avon Products, Inc.
AVP: My Summary Analysis

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By Pilgreen12
July 25, 2005

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Below is my brief analysis on AVP. I have also posted it on that I posted it on the IV board, but because some of you may not be IV members, I figured I would post it here too. If anyone else has done any research on AVP, please share.

Note: I included some of the approaches described in "It's Earnings That Count" (IETC) by Hewitt Heisermann. All numbers are in millions unless otherwise noted.

Ding Dong Avon is Here!

AVP manufactures and markets beauty and related products worldwide. Its has three product categories: Beauty (cosmetics, fragrances, skin care, and toiletries); Beauty Plus (fashion jewelry, watches, apparel, and accessories); and Beyond Beauty (home products, gift and decorative products, candles, and toys). AVP markets its products through a combination of direct selling and marketing by independent Avon representatives, and through its consumer web site, avon.com. AVP was founded by David H. McConnell in 1886 as California Perfume Company and it changed its name to Avon Products, Inc. in 1937.

Initial Analysis

AVP's signature products are mid-priced makeup and related personal care products. The history of makeup dates back to ancient times, and most women view makeup as a necessity in daily life. Fashion and home decor items compliment AVP's makeup lines in that all of its product lines are targeted at women. AVP has several competitors, but only one significant direct sales competitor, privately held Mary Kay (MK). The broader make-up/personal care products market is saturated and barriers to entry into cosmetics sales are minimal. However, AVP (and MK) differentiate themselves and create significant moats by selling through independent sales reps networks. It is this personal connection between sales rep and customer combined with brand recognition and loyalty that provides AVP competitive advantages.

AVP has 4.9 million sales reps compared to 1.3 million for MK and AVP is sold in 50 worldwide markets versus 30 markets for MK. AVP's sales total is $7,656 versus $1,800 for MK. It took nearly 40 years for MK to develop their second place status to AVP. AVP has a broader product lineup than MK and has significantly greater worldwide brand name recognition. AVP's dominance in the direct sales cosmetics market should provide it significant exploitable economies of scale over MK and the high cost of developing a direct sales network insulates both AVP and MK from other competitors. The independent direct sales rep marketing of AVP is a durable time tested distribution method worldwide, and has been replicated with other products: Pampered Chef, Longaberger Baskets, Princess House Crystal etc.

2004 sales totaled $7,656.2 and breakdown by region as follows: North America $2,568.1 (33.5%), Europe $2,095.0 (27.4%), Latin America $1,932.8 (25.2%), and Asia $1,060.3 (13.8%). Sales grew by 13% from 2003 to 2004 with virtually all of that growth coming from international sales, which has been the trend driving AVP's most recent growth.

There are risks. AVP has experienced significant setbacks in its large North American operations. Sales have been flat in recent years and in its most recent quarterly report North American sales actually fell by 6% year over year. Nevertheless, worldwide revenue actually grew by 6%, with the North American decline, but this increase pales in comparison to its 2003 13% growth. The slowdown in North America has been a recognized problem for several years and has been priced into the stock already. The surprise with AVP in its most recent quarter was an unexpected sales decline in China. Prior to April 2005, China prohibited direct marketing sales in an effort to prevent fraud, and this forced AVP (and MK) to use conventional cosmetics marketing by selling through boutiques in China. In April, AVP announced that they would begin direct sales again in several Chinese provinces, and its boutique owners responded by reducing sales in anticipation of this competition. AVP must assure their Chinese retailers that the expanding independent sales reps will not cut into their business. AVP believes that this conflict between retailers and independent sales reps in China is a short term problem. Once these boutiques are assured of their position with AVP, AVP's sales in China should rebound strongly, and once that happens, the share price should be similarly rewarded. Importantly, the female led management recognizes these challenges and is focused on correcting them.

Nevertheless, because AVP failed to make its quarterly numbers, Wall Street slashed $2,502 (15%) off AVP's market cap in one day (July 19, 2005). AVP's 52 week high is $46.25 per share ($21,831 market cap). AVP closed on July 22, 2005 at $31 per share placing it's market cap at $14,633, a 33% discount from its 52 week high. AVP sports a nice 2.1% dividend yield and its dividend has increased annually since 1991.

IETC's Five Minute Test

1. Conditional Auditor's Opinion: PASS.
2. Catastrophic Litigation Issues: PASS.
3. Excessive Special Charges/Losses: PASS.
4. Past Restatements: PASS.
5. Excessive Goodwill and Intangibles: PASS.
6. Debt-to-Equity Ratio in Excess of 75%: FAIL (AVP D/E = 0.98).
7. Year Over Year Revenue Growth: PASS.
8. Excessive Stock Based Compensation: PASS.
9. Excessive Short Ratio: PASS.

AVP's fails the IETC Debt-Equity ratio test, but I don't view this as a problem for AVP. AVP can repay the entirety of it's debt with its FCF in less than two years. AVP's product is subject to frequent repeat purchases that are predictable.

Earnings Analysis

AVP has posted impressive income numbers in the past six years.

                        2004      2003      2002      2001    2000    1999
Accrual EPS (diluted)   1.77      1.39      1.11      .92     1.00     .55
Year over year change  27.3%      25.2%    20.7%      (8%)   81.8%    7.8%
Enterprising EPS         .99      1.03      .54      .14      .79     .09
Defensive EPS           1.16      1.57      1.40      .73     1.21     .30
Earnings per share have increased every year except 2001, which is easily excusable in light of the prior year's increase: an extraordinary 82%. From 1999 to 2004, AVP's income has increased 222%, more than a 26% CAGR. I also calculated enterprising earnings and defensive earnings as described in IETC. The enterprising earnings are all positive and confirm that AVP creates shareholder value. Likewise, the defensive earnings are all positive, which confirms that AVP is able to self-fund its growth. On July 19, 2005, AVP lowered 2005 earnings guidance from $2.12 - $2.17 per share to $2.03 -$2.08 per share. AVP's reduced outlook reduced the projected earnings growth from a stellar 21.5% down to a still very respectable 16%. In its most recent quarter, AVP grew quarterly earnings by 11.4%, but as a result of its reduced outlook of only 16% annual growth, Wall Street slashed 15% from AVP's market cap. Many analysts believe that the reduced earnings growth may still be too high and further reductions may come, but even if AVP earns only $2.00 per share in 2005, that translates into a relatively modest P/E of 15.5 based on its current price. I think the Wall Street pros have overreacted.

Valuation Metrics (per Yahoo, except my ROIC calculation)

P/E based on 2004 Earning                  17.5           
P/E based on Reduced 2005 Earnings         15.1
Operating Margins                        15.98%
Profit Margins                             11.06%
Return on Assets                         20.36%
Return on Invested Capital                 44.5%
AVP's operating and profit margins exceed 10% and its ROA is an inspiring 20.36%. Assuming my calculation is correct, AVP's ROIC is an fabulous 44.5%. Every company should perform this well.

Summary

Although continued earnings growth in excess of 26% is unrealistic, Wall Street's current expectations for AVP anticipate virtually no growth beyond inflation. AVP is an international company with two-thirds of its sales from outside North America, and therefore, although North America is saturated, AVP has enormous growth opportunities elsewhere, most notably in China. I believe that in a conservative scenario growth in the next 5 years will be only 10%, although Wall Street the 5 year growth rate at 12%. With AVP's record it is reasonably conceivable that it can some more years with 20% growth especially as it develops its sales rep network in China and if it is able to stabilize the North American market. Conservatively, AVP should deliver a CAGR including dividends of not less than 13.5%, but more likely it will deliver in excess of 15.5% or more if succeeds at growing North American operations just modestly. AVP is a conservative stock in the consumer products sector that can deliver long term growth greater than the S&P 500, and is currently selling at a clearance sale price. "Ding-dong" the Avon lady is calling you, are you answering her.

Regards,
Emmette

Credit: I read IETC about 6 weeks ago, and mklein9's post at http://boards.fool.com/Message.asp?mid=22770487 led me to this research and write up of AVP incorporating some IETC analysis. For those interested, Mklein9's IETC numbers are in that thread and they are different than mine. I created my own IETC spreadsheet for this exercise, and many of the numbers on my spreadsheet must be entered manually, which may be the culprit of the differences.

Disclosure: I bought some AVP in my wife's IRA after its sharp drop last week. She is also Mary Kay sales representative. ;-).


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