Avon Products, Inc (AVP) Analyst: Joe Miano Recommendation: SELL Estimated Fair Value: $13 – $24 1. Reasons for the Recommendation Given the estimated fair value and current market price hovering between 13 and 14 dollars a share, Avon appears to be undervalued, but the SELL is recommended due to an outdated direct selling business model, decline in revenues and operating margins, and the many uncertainties surrounding the new management team. The common proposal amongst analyst is a hold and the future forecasts given are not great. The 2012 yearly forecast expected Avon to generate 10.76 billion in revenue, and have a negative growth of 4.70% (after 3 quarters their growth rate is -6.42%). The 2013 growth rate of Avon is forecasted to be a mere 1.50% compared to 3.90% for proctor and gamble, 6.8% for Elizabeth Arden and 3.50% for Revlon. Despite these weak forecasts, the high target price for Avon is $29, the low is $13 and the median target price is $17, from yahoo finance. I do not agree with their high target price or recommendation. Due to all the issues Avon is facing I believe it is unlikely the company will even reach my high target price of 24 dollars. The most likely value for Avon is near the bottom end of the estimated fair value. Negative Avon is reliant on their direct selling business model and independent representatives and McCoy is focused more then ever on this model. I am highly against direct selling. According to IBIS World direct selling in the US is forecasted to shrink at a rate of 1.2% annually over the next 5 years and only 13% of all personal care customers purchase their products through direct selling compared to 68% who buy from mass merchandisers; data from the mintel database. Avon predicts global direct selling to grow at an annual rate of 4%-5%, however I was unable to confirm their numbers. Customers no longer order through catalogues. This strategy is outdated especially in mature markets where women no longer spend their day at home waiting for the Avon lady to ring their doorbell. McCoy is attempting to modernize direct selling by giving Avon ladies online and mobile resources but I do not see this idea working. In February of this year Sheri McCoy was appointed the new CEO of Avon. As a former vice chairman for the company Johnson & Johnson, she is credited for reshaping their pharmaceutical division for the better. But, when she took over their consumer business she did not fair as well. One analysis was quoted in a Reuters article saying that while at Johnson & Johnson “McCoy had inherited a bit of a mess, (referring to their consumer segment) but unfortunately for her I think that mess never got better.” I believe her past experience proves she has the ability to reshape a division/company but her work is not constant or guaranteed. Ms. McCoy has spent the first 6 months visiting major markets throughout the world, meeting with management teams, evaluating the strengths and weaknesses of her company and overhauling upper management. She is confident they have identified the problems associated with the negative growth rates and falling profit margins. In the latest conference call she discussed how they would drive top line growth and manage costs. Her ideas are vary simple and her focus is on simplification and fundamentals. To drive top line growth she wants to take a market-by-market approach and focus on reshaping their products, focus on and restore the health of representatives by giving them more technology and tools to sell Avon products, and finally focus on the key geographical markets Brazil and America. These steps pg. 1 Avon Products, Inc (AVP) Analyst: Joe Miano are very vague and it is too soon to tell if her ideas will work. She also plans to “aggressively manage” down SG&A cost and implement reductions of at least 400 million in the next three years; again very vague as to how/where they may cut expense. Sheri McCoy released their goals over the next 3 years and they are aggressive. Their goal is to achieve a mid single digit revenue growth and low double digit operating margin. If they achieve these numbers Avon’s value should reach the estimated fair value of $24 per share. Ms. McCoy believes these goals are reasonable and realistic but they are dependent on everything going right. I believe these goals are a long shot because she has not convinced me her ideas will produce results. Avon has experienced sporadic growth over the past 7 years ranging from 3% to 13% excluding the -4% in 2009, with the 3% coming most recently in 2011. The first half of 2012 has seen a decline in revenue by 6.42%, operating margin down 61.9% and there is no reason to expect a drastic recover in the final quarter. Sales are underperforming in all regions given positive GDP and industry growth. Profit margins are well below the historical average. Earnings per share are extremely low and dividends were cut by nearly 75%. Avon is at its worst financial state since 2005 other then in 2009, possibly. Management is caught up in the bribery case and implementing a new structure that may or may not work. The bribery scandal has cost Avon $280 million in legal expenses as of April 1, 2012. Originating in China, the scandal was followed by extremely weak sales for the region declining 21% the beginning of 2012. In referring to China, Avon has quoted “attempt to shift to a direct-selling model in the country is proving tougher than expected”. Avon has begun to change their distribution strategy to department stores; still Asia pacific is the weakest performing region. The negative growth over the past year and a half is extremely disappointing given Asia’s high GDP growth and emerging middle class. Not only has the scandal increased expenses it has stained the companies reputation. McCoy has expressed concern in settling this case now rather then later, still it is unknown when this will occur, how much it will cost, or if Avon can turn around sales in the region. Positive I like the industry Avon operates in, beauty, fashion, and home all have steady growth forecasts, even in mature markets. In the US all three industries are forecasted to grow at annual rates of 3.3%, 2.8%, and 2.4% over the next five years. The emerging markets and BRIC countries have even higher forecasts and Avon has a strong presence in many of those countries. The global growth rate for the beauty industry is expected to grow at 6% annually with the majority of growth coming from the emerging markets mentioned. Brazil, Russia, and China are attractive markets but very competitive. Avon has positive operating profit in Brazil and Russia yet still has potential to do better. China is suffering but given its market Avon has a lot of potential in this country. Overall the outlook for the beauty, fashion, and home industries are positive especially in emerging markets where Avon has a strong presence. Using relative valuation and peer comparison the price of Avon appears undervalued. Avon falls below the median of their competitors in nearly every price or enterprise multiple. Six out of seven comparable companies have a higher P/E and EV/EBITDA ratio then Avon. However, Avon’s profit margin and estimated long-term growth rank at the very bottom of their competitors and the risk is above average. These last three comparables are not attractive qualities, indicating Avon may not be undervalued as the pg. 2 Avon Products, Inc (AVP) Analyst: Joe Miano PE and EV/EBITDA conclude. Historically Avon’s PE has traded at a premium to the S&P 500 of 1.35%; today Avon is trading at a higher premium of 1.84%. This would indicate Avon is currently overvalued which would make sense considering the high ratio. In comparing Avon to its own historical prices the company would appear to be overvalued as well. The sum of the parts valuation estimates the low price of Avon at $18.55 and the high price at $47.83. These numbers are not very accurate. 2. Company Analysis Strength Avon has a recognizable brand with loyal customers. Avon is the world’s largest direct seller of beauty, fashion, and home products, with 6.4 million independent representatives operating in 140 countries throughout the world. Their sheer size and global network gives them the strength to generate billions of dollars in sales. Their direct selling strategy is very cost effective enabling them to sell quality products at a discount to their competition. However, this model is dependent on people still buying from direct sellers which I have already discussed is not the preferred way for people to purchase beauty products. Weakness Avon is highly dependent on direct sellers. As we saw in China, the government and citizens did not respond well to the idea of door-to-door selling. Avon tried to force the strategy but got in trouble with the bribery scandal and has failed to generate any income. After checking if the number of representatives has a direct effect on total sales, it does not. Revenue has increased while the number of active representatives has decreased and vise versa. The average order among representatives can affect total revenue. Thus I have concluded revenue is driven more by demand then by total representative numbers. But Avon continues to center their focus upon representatives.