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What’s Not to Like?
The list of things not to like is extensive.
The most recent is the allegations of bribery in China. Bribery in China as a way of getting business done?
In spite of the pervasive practice of pay to play in China, it is illegal. The Avon (NYSE: AVP) transgression dates back to an audit from 2005 with Avon claiming it was news to them in 2008—three years after the fact.
Allegations include payments to Chinese government officials and third party consultants that left a paper trail of invoices for gifts and travel. Several hundred thousand dollars was paid. The payments were to get licensing for door-to-door sales. Foreign companies using the door-to-door business model were banned in China, forcing Avon to build stores as outlets for products—an expensive way to do business compared to the direct sales model. In 2005, that was reversed and in 2006, Avon was licensed for direct sales. Evidently the bribes worked. Management claims to have no knowledge of the bribery until three years after the fact in 2008. CEO Andrea Jung can be charged with willful blindness and at the very least, the scandal reflects badly on her management of the company. After simmering for six years, prosecutors recently handed a grand jury the evidence. Shares fell 2% the day of the announcement.
Bribery potentially could be a forgivable misstep and not grounds for a management shake-up. In addition to this ethical lapse, Andrea Jung has presided over Avon during some of the poorest operating results in nearly a decade.
The company goes through stagnant periods –the late 1990s and again 2005. Both times it recovered largely due to geographic expansion of its sales force, aggressive restructuring and revising the sales representative incentive structure. The initiative worked in 2007 and Avon revisited double-digit revenue growth at 13.4%. By 2008 they were back to mid-single digits and that has not improved through 2011.
Growth 8 years
Adjusted operating and net growth correct for the $263 million impairment of goodwill in 2011. Ms Jung has lost ability to make Avon grow. Maybe she is distracted? There is a lot that has gone wrong under her tenure prompting one Citigroup analyst to remark during the Q3 conference call:
"I mean, it strikes me that you guys are so totally screwed up in so many ways, the change has to be radical, and I don’t know if saying, hey we’re going to come out in February with new financial targets is enough, that’s it?"
To which Ms Jung responded with a vague word jumble that essentially went nowhere and gave no answers:
"Well, we haven’t set a date yet and we do want to do it and we do want to it right. So, again, targeting first quarter, but if we’re not ready because we are -- everything is part of this review, including outside help versus obviously a strong team of people in the company, but those -- I haven’t set a date and we don’t want to do it prematurely. You are correct on that. In terms of ERP, it’s not the last market. There are other markets in Latin America, but again, we’re not pulling one single person out of Brazil until that’s fixed and there aren’t really any other markets who have the same depth of the legacy issues and/or the interfaces, but we’ll certainly take all the learnings before we go another market."
Sales representative mismanagement
A big motivated sales force is the lifeblood of the direct sales model. By 2008 it was clear that Avon was losing momentum and sales rep growth was seeing a precipitous decline
The vertical axis is growth of growth.
Draw a line from 2000 through 2011 and it’s clear that Avon is not getting enough growth in its sales force to grow revenue. Obviously more reps equals more sales. Losses are especially steep in the US.
There are two types of reps—those looking for a cheaper personal supply and those interested in a career that provides cash. The turnover in the first type is huge and there are fewer career-oriented reps coming online. Part of the problem has been the compensation schedule. Going forward Avon needs to make the pay for performance rate clear for the district managers and invest more heavily in recruiting the foot soldiers that work under the district managers. In the US especially, district manger compensation has been poorly structured and is partly responsible for the drop in reps. There is not sufficient incentive to keep them working hard and bringing new reps into the company. Competitors (Mary Kay) offer better bonus pools and recognition of high earners with gifts and cars.
Morale at Avon is low.
In Brazil, one of Avon’s most successful growth stories, competition is heating up and the Avon brand will have to fight for market share going forward. As many as 50% of sales reps carry dual and competing catalogs—one for Natura (now at 1.2 million reps in Brazil) and one for Avon.
Natura grew revenue 6.8% (growth slowed due to supply problems) in Brazil in 2011 and claims 23% of market share. Natura launched 168 products in 2011 and is focused on keeping its brand updated and new. Part of the Avon slowdown in Brazil is no doubt due to aggressive competition and its own marketing failures with a less competitive pipeline of products.
Avon is responding with the initiation of a value brand in the summer of 2012; adjusting pricing across all product lines; and the much-anticipated launch of Anew Genics.
In an admission of some product missteps in Brazil, the company is in the process of measuring its current brand equity and developing a more Brazil-centric product line in order to compete with local companies. The Brazil-centric product focus would include fragrance, skincare and color cosmetics.
Both the competition and Avon saw tremendous sales disruption as they implemented SAP’s Enterprise Resource Planning software. The transition was far from orderly.
SAP ERP consists of several modules including: utilities for marketing and sales, field service, product design and development, production and inventory control, human resources, finance and accounting. SAP ERP collects and combines data from the separate modules to provide the company or organization with enterprise resource planning.
Although there can be major benefits for customers of SAP ERP, the implementation and training costs are expensive. Many companies experience problems when implementing SAP ERP software, such as: failing to specify their operation objectives, absence of a strong commitment or positive approach to change, failing to deal with organizational differences, failing to plan the change to SAP ERP properly, inadequate testing. All these factors can mean the difference between having a successful implementation of SAP ERP or an unsuccessful one.
Avon was unsuccessful.
In Brazil, the ERP implementation created greater than anticipated service disruption. There were three areas of disruption:
- Late representative orders were not visible in the system causing undercounting demand and product shortfall
- Failure to properly schedule arrival of products into the pick and pack line again shorting and delaying product to reps
- Failure of integration of legacy systems and ERP to agree on inventory levels creating higher-than-expected inventory imbalances and shorting product to reps.
Bottom line is reps got frustrated and sales declined. The sales decline was 8% --5% from lost sales due to product unavailability and 3% rep desertion. We can expect defection of reps to be ongoing even as Avon begins to come to terms with ERP.There is a lot of fence mending to do and a lot of competition happy to find a home for the reps. Fortunately for Avon, their biggest competitor Natura also had supply disruption through ERP implementation.
From the Q4 call:
Generally, it takes a couple of quarters for revenues to improve. Brazil could take a little bit longer just due to the high number of reps also carrying competitive brochures (Avon’s largest dual rep market).
What’s To Like?
Not a lot at present.
Perhaps the departure of Andrea Jung will be a catalyst for positive change. They are actively searching for a new CEO
The direct sales model is stable. Should Avon find the will to institute the changes necessary to revitalize the sales force, the low price per share could be a decent entry into a company that has had a long successful run. It’s early yet to make any informed decision whether this is the bottom. There was a bounce when Jung’s departure was announced. This is not going to create success by itself.
The ERP growing pains are temporary and may make the company more efficient going forward.
The dividend of $0.92 and a yield of 4.8%
Cash flow and the dividend
Is the dividend sustainable? The company has pledged to keep it at current levels through 2012. After that, there are no promises being made. It will be up for discussion when the new CEO takes over and implications are that $0.92 paid in 2013 is not a given.
Can they pay it for one year?
There are shortfalls the past two years. Avon is pledging flat capex, no acquisitions, lower pension contributions and a cap on compensation and bonuses. They will also tap into international business cash.
The dividend looks shaky and with austerity measures in spending may be paid in 2012. I would not count on it in 2013. Avon realizes the importance of the dividend and is not going to risk further price freefall by taking it away.
Avon can pay for the year, but it will require increasing cash flow. In order to improve working capital and cash flow, Avon needs to straighten out its supply chain glitches, successfully recruit sales reps and retain them, control inventory expense and bulges, and return to growth.
Avon is not an irresistible buy at these levels without a less obstructed visibility into their future. At present there are a lot of obstacles obscuring a clear picture.
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