Avon’s Investment in Growth Warrants Upside Despite Margin Pressure

Avon (NYSE:AVP) is one of the  leading players in the beauty and personal care industry and competes with companies like Procter & Gamble (NYSE:PG), L’Oreal (PINK:LRLCY), Estee Lauder (NYSE:EL) and Revlon (NYSE:REV). Along with skin creams, shower gels, fragrances and other beauty products, Avon also makes fashion accessories like watches and apparels, and home products like decorative items, house wares and nutritional supplements. What differentiates Avon from its competitors rest is the way it sells its products. Avon is the largest direct selling organization in the world and has an active sales force of over 6.2 million sales representatives across the globe who sell directly to the consumers.

In a recent article (Investing In Beauty and Personal Care? Look For Cash!, Trefis,  Feb 11’ 2011) we highlighted that Avon has a relatively low cash conversion ratio (free cash flow as a % sales) of around 6% compared to the industry average of over 10%. The cash conversion ratio shows how efficiently a company converts sales to cash by looking at the company’s cash flow rather than reported net income which can be muddled with accounting adjustments.

We have a $36 Trefis price estimate of Avon’s stock.

Avon’s Direct Selling Model

Avon’s direct sales model results in SG&A expenses that diverge some from some of its peers. A common misconception among investors is that SG&A as a percentage of sales is more variable for a direct selling business since representative compensation is tied to how much product the representatives sell.  However, in the case of Avon, representative compensation is netted out of sales as the representatives earn the markup over the discounted retail price at which they buy from Avon.

Avon’s SG&A expenses include advertising, research & development (R&D) and  spending behind increasing the earnings opportunity Avon offers the sales representatives, which it terms the “representative value proposition,” or RVP. Avon’s RVP increased the advertising spend from 1.7% of sales in 2005 to around 3.5% by 2009 behind both new launches and recruiting more representatives, which grew at over 7% year-on-year in 2008 and 9% year-on-year in 2009.

While R&D remained flat at around 0.7% of sales over 2005-07, investments in RVP increased dramatically from a negligible (0%) in 2005 to almost 2.5% of sales by 2009. Avon’s RVP initiatives include building out analytics to evaluate and establish optimum product pricing and discount structures, the frequency and timing of sales campaigns, the implementation and enhancement of its Sales Leadership Program and making better use of technology and online tools that will help increase productivity. This should all combine to help drive sales in the future.

Upside if Profit Margins Improve

While a rise in Avon’s SG&A (as a percentage of sales) from 2.5% in 2005 to over 6.5% in 2009 ate into the cash balance contributing to a low cash conversion ratio, we expect SG&A to stay roughly at currently levels going forward. We also expect Avon to benefit from its strong position in emerging markets where it already derives over two-third of its sales.

We currently estimate Avon’s profit margin, or EBITDA margins, will rise from 12% in 2010 to 14% in the coming years. However, as spending on RVP slows in coming years as we expect and sales pick up from the investments in its sales channels, this could lead to a better profit margin scenario than we currently expect. If EBITDA margins improve by 2 percentage points during our the forecast period, this could lead to about 10% potential upside to our current $36 Trefis price estimate of Avon’s stock.

While we still do not forecast a significant improvement in cash conversion ratio in the near term since Avon’s focus on emerging markets warrants heavy investments to build capacity, the resulting revenue growth should alleviate investors’ concerns.