Slow Recovery Could Play Into Avon’s Business Model

Avon (NYSE: AVP) sells everything from beauty and fashion products to home products such as house wares, nutritional supplements and decorative products – basically anything that makes for a good gift for your mother.

Our price estimate for Avon Products’ stock stands at $36.63, roughly 25% ahead of market price.

What makes Avon stand apart from the likes of L’Oreal (NYSE: LRLCY), Estee Lauder (NYSE: EL), Procter & Gamble (NYSE: PG), and Unilever (NYSE: UL) is not just its array of products but also the way it sells them. Avon primarily sells its products through independent sales representatives that make up the largest direct selling organization in the world – over 6.2 million active sales representatives buy these products from Avon at a discount to the published brochure price and earn a margin on every sale. But the difference doesn’t end there.

Avon’s Direct Selling Business Model Could Drive Upside

Eliminating the conventional retail channel (drugstores, department stores, perfumeries, pharmacies etc) helps Avon avoid the relatively higher retailer margins (in excess of 40%) in favor of the commission charged by sales representatives (which we estimate to be close to 25%). This not only lets Avon offer products at more competitive prices but also earn higher profits from the sale.

Direct selling enables Avon to be in closer contact with the final consumers, which creates better understanding of consumer requirements leading to more efficient advertising and research & development spending. Also, since products are shipped from Avon’s warehouse or centralized outlets once the order is placed, it favors better inventory management.

The downside of direct selling is that it leads to dependence on sales representatives. Avon has to incur expenses to advertise and attract talent, train the sales representative and retain these employees by ensuring that they make sufficient margins on sales. We believe this partly explains the breadth of Avon’s products range. On any given household visit, a sales representative stands a better chance to make a sale with a broader products portfolio.

However, the very downside of direct selling has favored Avon during the recessionary 2008-09 and we believe the slow pace of recovery in the US could present further upside to our current $37 Trefis price estimate for Avon Products’ stock.

While the rising industrial output in the US is indicative of a recovery, November’s unemployment data indicates that there is still a lot of ground to cover. Unemployment rate rose to 9.8% in November, the under-employment rate (which includes part-time workers seeking full-time employment and those that have stopped looking) stood at 17% and the proportion of unemployed who have been jobless for 6 months or more rose to its highest ever at 42%. ^[1]

Rising unemployment levels have caused more people to look for alternative/incremental sources of income. And with the ongoing holiday season, it comes as no surprise that Avon’s direct selling business stands to gain from this trend.

Our base forecasts suggest a decline in the number of sales representatives during 2010-13 after a period of steep rises from about 5.4 million in 2007 to 6.2 million in 2009. Our forecasts are based on concerns of reduced earnings potential for each sales representative and a more aggressive macroeconomic recovery. If the number of sales representatives instead ticks upward slightly towards 6.4 million by 2012, there could be 5% upside to our price estimate for Avon Products’ stock. Our current price estimate, at $36.63, already stands about 25% ahead of market price.

Drag the trend-line in the chart below to see the impact of various total sales representatives trends on Avon Products’ stock value.

However, there are two potential factors that could limit upside from this affect. As Avon Products only generates about 22% of its sales from the US, an increase in US sales representatives could have a muted impact on profitability. Further, an increase in the number of sales representatives could generate an offsetting impact on sales per representative, another key metric of Avon’s profitability.

You can see our detailed $37 Trefis price estimate for Avon Products’ stock here.

1. Bloomberg: U.S. Employers Add Fewer Jobs than Forecast, Bolstering Fed Stimulus Plan [↩]