Monday, October 19, 2009

Cosmetic Company Offers Long-Term Earnings

A Beautiful Play on the Weak U.S. Dollar
Written by Kent Lucas, Editor, Taipan's Safe Haven Investor

This global health and beauty products has recently added close to 500,000 sales representatives worldwide and generated 77% of sales from outside North America — a perfect play on a weak dollar…

In 1878, David H. McConnell left his family farm in upstate New York to become a traveling salesman. In 1886, the California Perfume Company was created, selling five fragrances through one sales agent. Soon a sales “army” was added, five products grew to thousands of products, and international sales grew and became core to the company’s history. In 1939 the name was changed to Avon Products and the rest is history, as everyone knows about the Avon lady.

With $10 billion in beauty and skin care product sales, Avon Products Inc. (AVP:NYSE) is the largest direct-seller company in the world. Avon is a top global beauty product and skin care brand and the world leader in lipsticks, fragrances and anti-aging skincare, selling in over 100 countries. Well after a major marketing and advertising effort, the Avon lady is as strong as ever.

Driven by independent sales representatives, the company’s success continues to come from brand recognition, product marketing, geographic expansion and value-oriented offerings. Its business is pretty straightforward, primarily selling beauty products along with some fashion and home goods. The largest and most important segment, beauty, focuses on cosmetics, fragrances, skin care and toiletries.

Let’s mix it up a little bit. In a few of my recent Safe Haven Investor hotlines I have alluded to diversifying the Safe Haven Investor portfolio. Overall it’s constructed very well, provides us with a nice yield, and I really like how it’s positioned for a global economic recovery. With that said, portfolio diversification is important to stock market investment performance. So I’m adding a softer, prettier name to the mix. While this stock is more expensive than other names in our portfolio, it is well worth it given all of the benefits that we get by owning it.

Affordable Beauty Products and the Lipstick Factor

Many of Avon’s broad product assortments are priced under $5 with a strategy of everyday low pricing. These low price points meet the needs of increasingly value-conscious consumers as well as those with lower incomes. The lipstick factor basically says that regardless of the economic state, consumers will continue to purchase small indulgences like cosmetics. That has definitely been the case in this recession.

Imagine in rural China, India and Brazil, women gathering around the local Avon lady to purchase beauty items or rushing to the door when she arrives at their home. That’s what is happening on a daily basis around the world.

In developing countries, beauty and fashion have always been a priority for women. In my visit to India, Cambodia and China last year, it was easy to see how everyone, including villagers, took pride in their appearance. And, if you’ve ever been to South America, you know how important appearance is to women. In Argentina, Brazil, Columbia and Venezuela, appearance is a national obsession (40% of Avon’s sales are from that region). Beauty, especially affordable beauty, is a great global business.

Avon Hires Sales Reps Despite High Unemployment Rates

When people lose their jobs, and a whole lot have in the past two years, quite a few turn to direct selling. We all know about the major unemployment situation in the U.S. and abroad. But that’s not the case for direct sellers.

The direct-selling business — think Tupperware, Mary Kay and Avon — is a $31 billion industry in the United States. Avon had about 5.3 million sales representatives around the globe at the beginning of 2008; now that number is over 5.8 million.

Historically, in good times, when GDP grew at 3.5%, direct sales grew a little faster than that. But during a recession, when GDP is flat to negative, direct sales have been up over 4%!

Many women who are no longer in the workforce want to keep busy, stay social and enjoy newfound flexibility. That’s just what being an Avon sales representative does. It provides instant income, doesn’t interfere with their main job search and they can keep selling even after they find a job. Of course, the extra income is most welcomed. The risk is minimal for both Avon and the sales representative, as investment and start-up costs are low for both.

The beauty of all these additional sales representatives (pun intended) is that when times get better, Avon will have all of these incremental representatives pushing its products, expanding geographically and adding new customers. So while people have viewed Avon as a defensive investment (more on that later), I also like it for its upside when times get better.

Increase in International Sales Positioned Avon to Benefit

When U.S.-based companies sell goods overseas, they typically get paid in that country’s currency. When they convert all those foreign currency revenues back into U.S. dollars, exchange rates can be a big factor. If the dollar is weak, then those foreign currencies exchange into a lot more U.S. dollars — thereby boosting sales figures. And vice versa when the dollar is strong. Wall Street pays close attention to dollar strength when assessing Avon.

Additionally, higher profit margins come from some international markets and we all know, long term, which markets will grow the fastest: emerging markets. That’s the greatest opportunity for Avon and the company’s greatest point of focus. Avon is a big player in Latin America, where it generates 40% of its sales. China is a tiny portion of its sales but is growing substantially while most other markets have declining sales year-to-date.

We all know about the pressure facing the U.S. dollar. Countries like China and Russia have made undertonesabout a new global currency. China, which owns trillions of U.S. (dollar denominated) debt, has been making a lot of noise about the long-term stability and worthiness of the U.S. dollar. Given how much debt our Treasury is issuing to pay for the stimulus package to get us out of this horrendous recession, it has a legitimate concern. The U.S. and the dollar just aren’t as safe and sturdy as they once were: Interest rates are low, inflation is forthcoming, and our explosion in debt is happening before our very eyes.

Avon, with so much non-U.S. business, greatly benefits from a weaker dollar, similar to a lot of hard-asset names in our portfolio. Investors seek refuge in names like Avon whenever the dollar falls. That is something to look forward to.

Battling the Recession Hedge

So what happens if there is a double-dip recession, maybe a so-called W-shaped scenario? Well, in my humble opinion, the chances of that scenario playing out in the U.S. economy are somewhere between zero and 35%.

If that is case, then the defensive nature of Avon as a consumer staples stock is so valuable. Consumer staples stocks outperform at the beginning of a recession so if we do have a double dip, Avon will be a good stock to own!

The chart below shows the performance of the Consumer Staples Select ETF (XLP:NYSE) (blue line) vs. the S&P 500 Index (red), at the beginning of this recession (Dec. 28, 2007 – Dec. 30, 2008). Consumer Staples outperformed by 20%!

Growth At A Reasonable Price?

“Price is what you pay. Value is what you get.”
– Warren Buffet

So you might be saying, OK, the story sounds great but Avon trades at such a high valuation compared to the overall market and to most other names in the Safe Haven portfolio. But similar to our winning holding 99 Cents Only Stores (NDN:NYSE), paying up for fast-growing stocks is OK. Let me explain.

GARP is an investment approach commonly used in the investment world. It stands for “Growth at a Reasonable Price.” Some folks confuse the nature of a value investor, like me, with a “growth” investor. Those who try to define value investors as those who only buy low-priced or valued stocks and growth investors as buying higher-priced, faster-growing stocks are quite mistaken, in my case particularly. Using another Buffet quote: “Growth and value investing are joined at the hip.”

Obviously, I don’t like overpaying for anything, not even water (yes, I always get tap water at restaurants instead of expensive bottled or carbonated stuff). Let me use buying a car to make an analogy. A value investor who would pay $18,000 for a $20,000 Saturn car shouldn’t mind paying $80,000 for a $100,000 Porsche — assuming that the value investor was quite wealthy and actually wanted a Porsche. My point being, they are both value transactions.

A growth investor will rarely own cheap, low-multiple, beaten-down stocks because they might not grow as fast as they want. But a value investor, in theory, can buy any stock at any price, as long as they are getting good value for it. That’s what I’m doing with Avon. I don’t mind paying 15–18 times earnings at price of $30–$35, if I believe that the stock is worth $45 and will grow earnings by 50% from 2008–2010. That’s GARP.

Restructuring Efforts Saves Avon Over $200 Million

Avon has had operational issues over the years, but the company enacted a major restructuring program in 2005 and a new one this past February. The company says it will realize $900 million in savings from the 2005 efforts and the 2009 program should generate well over $200 million in annualized savings in starting in 2012. Among several initiatives, they are focused on downsizing and streamlining the organization, revamping their supply chain process and implementing more global and efficient manufacturing.

I expect Avon to offer more than 12% long-term earnings growth and even more than that over the next few years. This will be driven by global sales growth in the mid to high single digits due to emerging markets growth, the benefits of the additional sales reps, and favorable foreign exchange effects. Add in operating margin expansion due to the significant restructuring and cost-cutting programs and earnings will recover nicely in a year or two.

Earnings for 2010 and 2011 should be around $2 and $2.50 respectively, as these savings kick in and the global recovery is in full swing. Applying an 18 multiple gets us to $45 or 30%–40% upside in 16 months before adding the 2.6% yield.

Avon is a global story, a value story, a restructuring story, and a hedge versus a weak dollar and against the chance of a double-dip recession. Looking good!

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