Avon Products Downgraded to $11: Delayed Turnaround and Tepid Business Outlook Weigh on Valuation

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Trefis
AVP: Avon Products logo
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Avon Products

In light of continued disappointing earnings from Avon Products (NYSE:AVP) and the delayed turnaround in its performance, we have downgraded our Trefis price estimate on Avon from $14.06 to $11.08. For the nine months into fiscal year 2014, Avon’s sales decreased 11% to $6.51 billion from a comparable $7.29 billion in 9MFY13. Sales began falling sharply in Q3FY13 after the company implemented various strategies across its geographic portfolio that resulted in a sharp fall in representative retention and engagement levels.

Five quarters since the disruption in operations, Avon’s sales continue to decline at double digit pace and the turnaround is taking longer than anticipated, which has weighed on our outlook for the company. Below, we present some of the key trends that are expected to weigh on the company’s financials going forward. Our revised price estimate of $11.08 for Avon Products stands marginally ahead of the current market price of $10.49.

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Representative Base Expected To Shrink Going Forward

Avon reorganized its independent sales force during the second quarter of fiscal year 2013, and this particular reorganization of field personnel resulted in severe disruption in customer-representative relationships. Other factors were in play as well. There was the fallout of the global hiring system in Q3FY13 and the rollout of the new order management system, as well as a troubled  Service Model Transformation (SMT) module in Canada during FY13. All of these issues contributed to the decline in the number of active representatives for Avon in the region.

Year to date, the total number of representatives in the region declined 18% while regional sales declined 19% on a year on year basis. Avon had nearly 470,000 representatives in 2009, which declined to 314,000 representatives by 2013 end. Going by the rate of decline in representatives in North America, Avon’s active representative count by 2014 end could stand at about 258,000. This continued double-digit decline in active representatives is likely to weigh on sales and put margins under pressure going forward.

In addition to the domestic North American market, other geographies face similar low representative engagement levels, weighing on sales and profits. Year to date, Avon’s Active Representative base in Latin America has declined by 4% on a year on year basis, primarily due to low retention of new recruits in the first 6 campaign cycles. Similarly, representative base in Asia-Pacific declined 9% in 9MFY14 compared to 9MFY13. Avon is reducing its footprint in the Asia-Pacific region, particularly China, where it operates under a beauty boutique model compared to its traditional direct-selling model due to the intensifying competition from local and Korean cosmetics manufacturers.

For full fiscal year 2014, we revised our representative base forecast by nearly 2.3% to 6.02 million compared to our earlier forecast of 6.16 million representatives. Year to date, Avon’s representative count declined by approximately 5% compared to 9MFY13. We expect the recovering North American economy and the subsequent creation of full-time jobs to pile on additional pressure on Avon, particularly due to the fact that Avon representatives are independent and non-contractual workers.

On a longer term, digital channels such as e-commerce are likely to cannibalize sales from the direct-selling channel for Avon, leading to a reduction in representative base. The company launched its consumer-centric e-commerce platform avon.com in the U.S. in Q3FY14 and intends to expand into other key markets in 2015. [1] Our reduced representative forecasts resulted in a 9% decrease in our price estimate for Avon Products.

Margins Expected To Remain Under Pressure from Macroeconomic Headwinds

In the first nine months of FY14, adjusted operating profit margins for Avon across its geographic portfolio declined from 9.5% in 9MFY13 to 8.8%. Adjusted operating profit margins in Latin America, Avon’s largest market by revenues, contracted from 11.6% in 9MFY13 to 11% in 9MFY14. Margin contraction in 9MFY14 in Latin America was a result of higher inflationary cost pressure on raw materials and higher supply chain costs from a prior year period in the region, despite a significant benefit from VAT credits in Brazil in Q3FY14.

Similar to the Latin American region, adjusted operating profit margins in Europe, the Middle East and Africa (EMEA) fell sharply from 14.3% in 9MFY13 to 11.2% in 9MFY14. However, unlike the hyperinflationary environment in Latin America that increased pressure on costs, margins for Avon’s European operations declined from a deflationary environment. Additionally, the sharp depreciation of the Euro against the U.S. Dollar in the third quarter lowered adjusted operating profits even further, with Q3FY14 margins standing at 8.9%.

Going forward, margins are likely to remain under pressure due to slowing economic growth and currency headwinds in various international markets. We have revised our full year 2014 EBITDA margin forecast to 7.5% from our previous estimate of 9.3%. Comparatively, FY13 EBITDA margin for Avon stands at 9%. Margins are likely to expand mildly beginning FY15 following a recovery in markets such as North America and Asia-Pacific. Additionally, tempered macroeconomic headwinds and accelerating economic growth in major developed markets should boost margins for the company.

However, we expect future EBITDA margins to remain lower than pre-recession EBITDA margin levels due to a steady decline in its representative base which should put sales growth under pressure. Although the new e-commerce platform could offset any decline from a lower representative base, we do not have enough data to ascertain the extent of sales or margin expansion possible from this channel for Avon. Our revised EBITDA margin forecast has resulted in a 13% decrease in our price estimate.

Pertaining to Venezuela, Avon is scheduled to adopt the new SICAD II currency system beginning 2015 which should create additional sales and cost pressure. Under the SICAD II system, the Venezuelan Bolivar has been depreciated from the official rate of 6.3 Bolivars to a U.S. Dollar to approximately 50 Bolivars to a U.S. Dollar. This depreciation should lower consumer spending in the region on imported goods and also add to margin pressure from localized operations for Avon.

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Notes:
  1. Avon Products’ (AVP) CEO Sherilyn McCoy on Q3 2014 Results – Earnings Call Transcript, Seeking Alpha, October 2014 []