After Another Bad Quarter, Are There Signs of Hope for Avon Products?

Sheri McCoy, Avon, CEO


Shareholders in cosmetic-products icon Avon Products (NYSE: AVP  ) couldn't be faulted for losing hope; the company's shares remain in a funk, down almost 40% over the past twelve months.  Indeed, they are probably wishing that Avon had taken the buyout offer that competitor Coty (NYSE: COTY  ) had offered a few years ago, an offer that was summarily rejected by management.

Avon's latest financial update didn't instill much confidence either; it reported worse than expected profitability, hurt by a decline in the overall size of its direct-selling workforce.  On a bright note, though, the company finally settled up with the Feds over its violations of the Federal Corrupt Practices Act, or FCPA, agreeing to pony up a total of $135 million. So at its current discounted price, is Avon a good bet for investors?

What's the value?
Avon is one of the largest direct-selling companies in the world with a network of roughly six million independent representatives located in 62 countries.  Its mega sales force has made it a major player in the cosmetics business; it offers a wide variety of products focused on the skincare and fragrance categories, which together account for more than half of its total sales.  Avon has also used its large selling network to try to build sales momentum in related product areas, like jewelry and footwear.

Unfortunately, Avon hasn't shown much business momentum lately; it reported a sales decline in its latest fiscal quarter that was primarily a function of fewer representatives in its sales force, including a double-digit drop in North America.  The company was also negatively affected by a need to engage in promotional behavior to drive sales, a trend that led to a sharp decrease in its operating profit during the period.  The net result for Avon was weak operating cash flow, which hurt its ability to fund new product development and improve its position in the hyper-competitive cosmetics business.

Of course, Coty hasn't exactly been lighting the scoreboard up in recent quarters either; it reported a top-line decline in fiscal 2014 due to substantial weakness in its Americas geography, the source of roughly one-third of its total sales.  More importantly, the company's profitability has been negatively affected by weak pricing in the fragrance and nail product categories, which led to a double-digit decline in operating income.  Fortunately, Coty has a lower cost structure relative to Avon which allows it to generate solid operating cash flow even in difficult periods, and this fuels its ongoing investments in licensed brands like Marc Jacobs and Davidoff.

Looking into the crystal ball
The good news for Avon investors is that management seems to acknowledge the company's deficiencies; it initiated a turnaround plan in 2012 that aims to create up to $400 million in annual cost savings, while building strong relationships with its independent sales force.  The bad news is that a turnaround will likely take time, judging by the numbers that Avon put up in its latest fiscal quarter.

As such, investors should probably look for a cosmetics industry player that is posting growth in the current environment, like Ulta Salon, Cosmetics & Fragrance (NASDAQ: ULTA  ) .  One of the best stories in the cosmetics business over the past few years, Ulta continued to post solid growth in its latest fiscal year; it posted a 20.3% top-line gain that resulted from a strong comparable-store sales gain and a double-digit expansion of its store base.

While the company's profitability slipped during the period versus the prior-year period, Ulta limited the overall damage by continuing a strategic move into the premium cosmetics segment; it mostly engineered this through in-store boutiques developed in partnership with leading vendors, including L'Oreal and Estee Lauder.  More importantly, given management's belief that it can double the size of its store base over the long run, there seems to be solid upside left in Ulta's profit growth trajectory.

The bottom line
Avon is an intriguing turnaround story, as Barron's aptly pointed out in a recent column, but it is probably only for patient, long-term investors who are willing to wait for the company's turnaround plan to take hold.  Despite a pricier valuation, Ulta seems like a better bet given its ability to increasingly attract customers across the price spectrum, which should allow it to post future sales and profit gains.

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