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Avon Products Inc. (NYSE:AVP)

Q1 2009 Earnings Call

May 5, 2009 9:00 am ET

Executives

Andrea Jung – Chairman, Chief Executive Officer

Charles W. Cramb – Chief Financial Officer

Renae Johansen – Vice President of Investor Relations

Analysts

William Schmitz - Deutsche Bank Securities

Alice Longley - Buckingham Research

Andrew Sawyer - Goldman Sachs

Connie Maneaty - BMO Capital Markets

Ali Dibadj - Sanford C. Bernstein

Wendy Nicholson - Citigroup

Chris Ferrara - Bank of America/Merrill Lynch

Doug Lane - Jefferies

Linda Bolton Weiser - Caris & Company

Lauren Lieberman - Barclays Capital

Operator

Welcome to Avon's first quarter earnings conference call. (Operator Instructions) I'll now turn the conference over to your host, Andrea Jung.

Andrea Jung

With me today are Chuck Cramb our CFO and Renae Johansen, Vice President of Investor Relations. Since some of our remarks this morning may include forward-looking statements, I refer you to the cautionary statement and the reported numbers in today's earnings release.

As we exit the quarter, I'm encouraged that the strategic actions we're taking to drive top line growth in this challenging economy have begun to yield positive results. In fact, I feel even stronger today that our powerful direct selling channel and consumer brand provide us with significant competitive advantage, never more so than in times like these.

Given this perspective, I'm just going to take a little bit of a non-traditional approach in my remarks today. I'll touch very briefly on our first quarter results and then spend the lion's share of time following up on progress on the strategies we shared with most of you at Cagney. I think this will give you a better perspective on how we see our opportunities playing out, both this year and over the longer term.

Let's turn first to the overall results for the quarter. On a reported basis, revenues were 13% lower compared with prior year. This reflected the significant negative impact of currency exchange. In local currency, revenue was up 3%, this represented an increase in our local currency growth rate from fourth quarter. Driving our revenue results in the quarter was another strong performance in Latin America, as well as a return to growth in Central and Eastern Europe.

On an overall basis, we also saw positive improvements in the key performance indicators of active representatives and units, as well as continued growth in beauty revenue in local currency. These are leading indicators of market share gains and reflect the underlying health of our business.

In Latin America, we saw healthy double-digit local currency growth for the eighth quarter in a row even against tough comps versus last year. All top markets in the region grew revenues in the double digits. Mexico grew 16% in local currency outpacing competitive retail growth rates. Our focus on rebuilding fundamentals in Mexico continues to pay off and we are executing well on all fronts. We also delivered another strong performance in Brazil in the quarter.

We posted 12% local currency growth off a large base as we continue to sustain momentum in this critical market. I was also encouraged by sequential improvement in local currency growth rates in Central and Eastern Europe in the quarter. Following a 3% local currency revenue decline in the fourth quarter, revenues year-over-year increased by 4%. Driving this return to growth was a healthy performance in Russia. There our major focus on improving the representative value proposition began to take hold.

In terms of overall company performance, I was most pleased with improvements in the key top line indicators of active representatives and unit growth in the quarter in the context of the strategies we laid out for you in February. We said that against the backdrop and the reality of unemployment in 2009 we would launch our strongest recruiting drive ever.

We also said that against the toughest consumer environment in decades we would quickly rebalance the mix and emphasize smart value products. In these two ways, we believe that Avon could drive a structural competitive advantage in these unprecedented times gaining market share and emerging in an even stronger position when the recession lifts.

So, let me just take the next few minutes to tell you about the results that we are seeing in these very early days. They clearly reinforce our belief in the advantage nature of our channel and brand. First, in terms of the channel, we were certainly very pleased with the active representative growth of 7% in the first quarter. That compared to 4% in the fourth quarter.

In the back half of this quarter we launched the largest recruiting drive in Avon's history, as we said we would. We almost doubled our investment in recruiting advertising in the quarter. We began aggressively targeting nontraditional sources of leads, such as online search engines, and we started showcasing the Avon's earning opportunities on Internet careers sites and also at career fairs.

Given rising levels of unemployment, we were prepared for a good response; however, I have to say that the level of interest has exceeded our expectations. Additions were up over 30% in March alone and 20% for the quarter overall. We exited the quarter with more than 9 million representatives on board, that's a million more than we had at the end of the first quarter last year. It is an all time high for this business.

The success of our recruiting efforts in the first quarter was evident in virtually every key market but particularly so in the United States. There we saw a dramatic 148% increase in overall leads generated in the quarter. A significant number of these new leads came in from online sources. To facilitate rapid conversion of these leads to additions, we made the strategic decision for the first time ever to share leads, not only with our 1,300 employed district sales managers, but also with our offline sales leadership representative.

This has built field motivation in the back half of the quarter but more importantly it has significantly expanded the number of trainers who are converting leads into new representatives. As a result, in March additions in the U.S. were up an exceptional 47%. We exited the quarter with almost 680,000 representatives in the U.S. Our focus now is on driving the activity and lifetime value of these new representatives as we go forward. So that's the U.S.

Just to give you a quick flavor for how this recruiting strategy is successfully playing out in other major markets. In Brazil, additions in March were up 13% supported by a significant investment in TV recruiting advertising in that market in the quarter. Here again, large portions of leads also came in from online sources. In Mexico, March additions were up 148%. In Russia, they were up 32%, in the U.K., up 74%.

Overall, we exited the quarter with a 13% increase in the total number of representatives compared with the end of the first quarter last year. So, of course, the name of the game now is to get these new representatives active and earning as quickly as possible throughout the balance of the year.

Just a comment about China, we continue to bring in over 40,000 new sales promoters each month. Active representatives in this market were up over 40% in the quarter. We now have almost 500,000 active representatives in China, so the direct selling business in this market remains healthy and growing.

In the first quarter, the strength in direct selling was partially offset by a significant decline in the average order of the beauty boutiques. This mostly reflected destocking related to the fear of general consumer retrenchment at retail, and we believe that our first quarter performance is not indicative of the full year as we expect our revenue growth to be higher. So, that's the perspective on the enormous opportunity we're seeing at this moment in the direct selling channel.

Turning to the other half of the equation to customer opportunity, here again we're very encouraged by how our smart value strategy is starting to play out. We were pleased that beauty units in the first quarter grew 2% compared with a 2% decline in the fourth quarter. Here, again, we saw a significant impact in March as our smart value offers began to appear in special flyers and brochure sections.

In January and February, beauty units in the under $5 value segment were continuing to decline in our top 14 markets, but in March as we really increased the flow, not only did we reverse this decline, but these value units grew by double digits. Very importantly in terms of the overall strategy, March unit growth also reflected strong gains in the mid-priced tier of $5 to $10, as well as the over $10 segment.

So, in essence we saw unit gains across every price tier in the portfolio in the last month of the quarter. As a result, overall beauty net per unit was up 3% in the quarter, so while driving smart value, we were also very encouraged by our ability to continue to get pricing against key innovation, even in this economy.

These gains in both units and net per unit helped drive a 5% increase in local currency beauty revenue overall in the quarter. On a reported basis, beauty sales declined 12% but, again, in local currency we feel pretty good that this will turn out to be a market share gaining performance. From a category perspective, in color we were extremely encouraged with the double-digit local currency increase in the quarter, half from units half from net per unit with strength in all segments of the price tier.

Personal care revenue grew in the high single digits in local currency in the quarter with units up nicely. This included a very successful introduction of our Naturals value line in Mexico, which delivered 3.4 million units on launch.

Turning to fragrance, here I was encouraged there our high single-digit local currency revenue growth was entirely driven by net per unit. For example, we introduced the Christian Lacroix fragrance absent in Brazil at a U.S. $38 price point, and we sold 500,000 units during the three week introductory period. In skin care, although we did see a local currency revenue decline due to the timing of innovation as well as the consumer environment, here again we were able to take selective pricing.

For example, our newest breakthrough Anew Dermafill was introduced at approximately a $42 U.S. equivalent price in the U.K. And despite the deepening recession in that market, this product launch is on track to be the U.K.'s biggest skin care introduction ever. Likewise in the United States, Dermafill was also launched at a $54 price point and performed very strongly.

So basically the results I'm seeing in the first quarter suggest that our strategic pricing, in combination with great product innovation, continues to work even in the middle of consumer contraction. As we exit the quarter, we remain focused on the right balance between entry and higher tier price points. This will be our formula as we continue to drive for sustainable market share growth this year.

So that's the perspective on the early progress in terms of the strategies we shared with you in February. Again, I'm very encouraged by everything I'm seeing. I feel even more strongly today that our channel and brand confer unique advantages in this moment as we capitalize on this opportunity to significantly expand our franchise. For me this is also a moment when we're heavily relying on analytical insights to better understand the motivations and behaviors of both our sellers and consumers in this environment.

From a representative perspective the question for me is, is this our moment to attract a different kind of seller? Research in the United States confirms we are attracting a high percentage of people who have lost their jobs in the current recession. In fact, we're finding that one of the lines in our advertising that most resonates is, "I can't be laid off."

In the U.S., we're also finding that as more and more of our leads are generated online, we're attracting a seller with a different kind of profile who is gravitating to our e-representative opportunity. E-representatives run their business online and have activity rates which are on average 14 points higher than traditional representatives. We began to see this differential play out in the first quarter in the U.S. Our new representatives demonstrated overall higher activity levels than new representatives recruited during the same period last year. So potentially this is a game changer for us over the long-term.

From a consumer perspective, we're also seeing a shifting profile including massive evidence of trade down, as you can imagine. All of the outside research we've looked at, plus our own proprietary research that we did this quarter, confirmed that beauty consumers are buying less frequently, paying more attention to price and switching to lower priced brands. One point of interest for me is that only 13% of consumers in one of the studies said they plan to resume old spending patterns once the economy recovers.

So, clearly this presents Avon with an enormous opportunity. I believe, in fact, that we may be looking at a true structural shift, a new normal, if you will, in terms of consumer purchasing behaviors, as well as general attitudes towards employment. These shifts don't come around often so this is potentially a seminal moment for the company. And after three years of significant investment in improving and strengthening the brand and the channel, I believe the company is poised and ready to capitalize on this opportunity.

Just a few final comments before I turn it over to Chuck. Clearly, the pressures from currency exchange are enormous, as you read this morning. Our mantra as we move through 2009 is to control what we can control and manage it well. Overall, I feel the organization continues to balance its focus on driving growth and market share gains in a tough environment with an equally strong commitment and tight focus on controlling costs and driving further transformational thinking about value chain opportunities across the portfolio.

We feel very good that in the first quarter we were largely able to mitigate the impact of currency at the gross margin line through pricing, manufacturing productivity gains and benefits from strategic sourcing. We also continue to move forward aggressively with our multiple cost transformation initiatives. We did frontload our investments during first quarter to launch additional smart value sales flyers and to fund record recruiting advertising. These investments reflect an informed decision not to cede this moment and to be aggressive and bold early in the year in our drive for market share.

For the full year, we still expect our strategic investments against the brand and channel combined to remain in line as percent of revenue. So net-net with one quarter behind us in 2009 I'm pleased with our progress across the business as we address the unique issues, but also the extraordinary opportunities of the moment. Yes, the macros are tough, but instead of focusing only on the challenges, our eyes also remain squarely on the opportunities. We're playing offense, not defense.

We've got an incredibly powerful story to tell and we're going to use this moment to tell it. And as I look towards full year 2009, while I don't have a crystal ball, from everything I'm seeing today we're off to the right start. Now it's just about staying in the boat, staying focused on the longer term and continuing to aggressively run our strategic play.

With that, I'll turn it over to Chuck.

Charles W. Cramb

Before I go into details, there's no question that foreign currency, and to a lesser extent, the difficult macroeconomic environment had a significant negative impact on our reported financial results. So our reported results don't clearly reflect the underlying business performance that Andrea just walked through. As discussed in our last earnings call, and in more detail at Cagney, the sudden and significant deterioration of foreign currency rates negatively impacts the translation of our P&L from local currency to dollars.

We also suffer from unfavorable transaction exchange for those costs which are not in the same currency as sales. Exchange alone in the first quarter cost us an estimated four full percentage points of operating profit margin versus the first quarter of 2008. Of this, approximately three points relate to transaction exchange, and the other point to translation exchange as it reduced the relative importance of our higher margin international businesses in our mix.

So, let me walk us through the P&L and give you a sense of what we're doing to address this. Our reported revenues were $2.2 billion. This consists of 3% local currency growth offset by a 16% unfavorable swing in FX. Despite the negative macroeconomic pressures, our overall units were flat. We benefited from favorable pricing and mix and our strategic pricing is holding. We are seeing early success with our smart value programs and our progress is widespread as we have local currency gains in four of our six regions.

Looking forward, I expect our strategic pricing to continue to hold. Our smart value program should expand as we only introduced it late in the first quarter. And our strong growth in new representative additions and active representatives will begin to pay dividends. We will also start to benefit from some inflationary pricing in countries where there have been significant devaluations.

This is particularly true in Central and Eastern Europe as we started raising our prices late in the quarter. We will hold back on inflationary pricing in some countries, as history as shown that we do benefit from our strategy of lagging somewhat on price increases, building market share first, and then increasing our prices on a stronger share foundation.

Our gross margin was 62.8%, that's down just 30 basis points from the 63.1% in Q1 2008. Transaction exchange alone dragged gross margin down over 200 basis points. However, we were able to offset most of the drag through our strategic pricing, increased benefits from strategic sourcing, strong manufacturing productivity improvements and some favorable product mix. I'm really very pleased that we have been able to execute these programs to offset most of the negatives at gross margin.

Let me quickly review where the transaction exposure arises. Our major areas of exposure are euro sourcing to the U.K. and to non-euro markets in Central and Eastern Europe, including Russia and Ukraine. And although we have a major factory in Russia supporting Eastern Europe, even there we're experiencing unfavorable transaction exchange due to a large portion of raw materials being priced in either euros or dollars.

We're also experiencing similar impacts in Latin America, particularly in non-beauty products. And even in North America we have unfavorable transaction exchange as almost all products for Canada are sourced from the U.S. The dollar continued to strengthen against most major currencies during the first quarter. As a result, we may not be as successful in offsetting the margin drag caused by transaction exchange in the short-term.

Its impact may increase since we carried three months of inventory. However, we continue to aggressively develop opportunities to reduce most of the margin drag. These include changing raw material and finish good sourcing, as well as focusing on pricing, our strategic sourcing initiatives, manufacturing productivity programs and managing the product mix, including our PLS or product line simplification program. These types of adjustments take some time to execute. We expect their benefits to be stronger in the second half of 2009.

In terms of gross margin, I know some of you are concerned that our smart value proposition may be a significant negative drain on gross margin as we offer more products in a lower price range. We don't think so and this quarter's results bear that out. This is not a case of having to discount our higher priced units. We have approximately 70% of the units in our portfolio priced under $5.

During 2008, we had decreased the flow of products at this price point some 5% as we focused on the upper end of our price portfolio. In March when our focus on smart value became fully activated, units in this lowest price tier increased 12.5% over the prior year.

SG&A in the first quarter was 55.1% of revenue, unfavorable 390 basis points to last year. About half of our SG&A is in period overhead expenses. As I noted at Cagney, our SG&A is disproportionately dollar denominated, so we are experiencing negative leverage on our period overhead expenses. Transaction exchange was unfavorable to the SG&A cost margins by approximately 60 basis points.

Let's touch first on the investment expenses in SG&A. RVP spending and advertising both increased as a percent of sales. This reflects our strategy to leverage our channel in this economic environment by accelerating our investments since the first quarter. Advertising expense totaled $78 million, 4% lower year-over-year, but slightly higher as a percentage of the total revenue base. Within advertising, the amount spent on recruiting increased while spending on product decreased. We also invested $11 million incrementally in RVP.

For the year, we look for advertising spend to be down due to geographic mix and foreign exchange, as well as media price softness and greater productivity in what we buy. RVP will grow ahead of sales. Combining the two, that's the advertising and the RVP, we expect to invest about the same percent of sales as in 2008, although the mix will continue to shift more towards the representative.

Now, let's look at the rest of the variable portion of SG&A. Brochure costs were up as we have not yet fully cycled out of the inflationary paper costs from last year. Importantly, the higher brochure costs also include additional fliers and brochure pages to offer our smart value. Our distribution cost rose as a percent of sales, primarily due to the impact of processing more but smaller orders. Together brochure cost and distribution expense accounted for an additional 1.6 percentage points of sales year-over-year.

Not surprising in this economic environment, bad debt increased as a percent of sales. The large influx of new representatives also contributed to the bad debt increase as we had a higher rate of non-payment among new representatives. As a reminder, our credit terms with our representatives result in fairly quick collections. We have less than one month of sales outstanding in our receivables. A strict [global] controls and operating model should allow us to contain this increase.

Despite this we have initiated a comprehensive benchmarking of best practices within Avon. There is significant variability of performance against bad debts country by country. I'm sure that this initiative will create opportunities for improvement across the company.

Returning to our period overhead costs, these represent a little less than half of our total SG&A. We did once again have zero overhead growth, excluding the impact of exchange. However, the heavy mix of our dollar base cost, both for North America and for corporate functions, resulted in an overall period of overhead costs increasing by approximately one percentage point of the lower sales. This increase includes the impact of transaction exchange.

While I am pleased with our performance to date, there's no question that we will need to become even more aggressive in our cost reduction programs. This includes, not only our efforts to mitigate the ongoing impact of transaction exchange, but also continuing to attack our overall cost structure. On our second quarter call, I expect to be sharing with you details of significant initiatives under the recently announced restructuring program.

For the first quarter then our operating margin was 7.7%, 410 basis points unfavorable from last year. Obviously, the driver of operating margin decline differs by region with foreign exchange being the key source of decline in the regions of Latin America, Western Eastern Middle East and Africa, Central and Eastern Europe and Asia Pacific.

North America's operating margin was pressured by the sizable revenue decline in that region, [albeit] it was 8% lower year-over-year, the fashion category decreased 13% and home 24%. Coupled with the relatively high overhead cost structure of the North American business, the significantly lower year-over-year revenue led to a sizable decline in margin of that business.

With regard to our major initiatives of strategic sourcing, product line simplification and the two restructuring programs, we continue on track with all of them. As a reminder of the benefits of each, strategic sourcing, now in its third year, should contribute approximately $200 million in 2009. We expect PLS to yield cumulative benefits of approximately $120 million in the year. And lastly, actions under our 2005 restructuring efforts should result in $300 million in cumulative savings for the year.

The first quarter included some early costs, approximately $10 million for the new restructuring program that we announced in February. This is for reorganization costs as well as some consulting fees associated with planning for the initiatives that are forthcoming. We expect this new program to cost $300 million to $400 million to implement and to result in savings by 2012-13 of approximately $200 million. We benefited from a one-time payroll tax adjustment in the quarter, adding about $0.05 earnings per share.

Turning now to the balance sheet and cash flow, as of March 31 our cash balances increased $500,000 versus December 2008, rising to $1.6 billion, the sizable increase in cash is a result of our notes offering in February. We did not fully payoff our outstanding commercial paper by the end of the quarter as some of it turned out in April. Accounts receivable are down from year end reflecting the seasonally lower level of sales in the first quarter. As I said, we have less than one month of sales outstanding in receivables.

Our overall inventories are down six days from a year ago despite the general softening of sales experienced during the quarter. We did benefit some from foreign exchange. We're also seeing significant benefits in Latin America and Europe where between the two, we hold 2/3 of our inventory. The quarter is a continuation of the traction that we started to see near the end of last year.

I feel good about our progress and feel it will continue throughout the year. As a result, we still expect three to five days of inventory improvement for each of the next three to four years. And importantly, balanced against the improvement in inventory, our service levels are holding or improving in all major geographies.

With regard to capital expenditures, spending was $10 million under 2008's level of $51 million. We have carefully reviewed our spending needs for 2009 and are managing our cash conservatively. We project reduced investments in 2009 versus 2008 to between $325 million to $350 million. Our total debt increased by $678 million since year end.

This reflects our mid-February issuance of the $500 million in five year notes at 5.625% and the $300 million of 10 year notes at 6.5%. We were not active with our share repurchase program during the first quarter as we continue to preserve our liquidity given the economic environment.

So to wrap it up, at Cagney we said 2009 would be a tough year given the impact of currency in the challenging macroeconomic climate. This was certainly reflected in our first quarter financial results. Since the dollar strengthened during Q1, we expect transaction exchange will worsen even more in the second quarter. However, I believe we are on the right track as everything we are doing is strengthening our foundation as well as responding to the current environment, both of which will be instrumental to generating long-term profitable growth.

Our overall strategy remains intact. Driven by analytics we will continue to build on the strategic gains of the last three years. We will remain proactive and focus on those things that we can control or manage. Additionally, we expect our operational performance will improve in the second half of the year.

And as I think about that second half, I would expect to see further inflationary pricing, volume gains coming from a higher number of active representatives, a softening of commodity costs, the impact of unfavorable translation exchange diminishing, more relative investments in RVP and advertising in total, and further benefits from our major cost initiatives such as SSI, PLS and our two restructuring programs.

And with that, I'll now turn the call back to the operator to start the Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from William Schmitz. Mr. Schmitz, please state your affiliation then pose your question.

William Schmitz - Deutsche Bank Securities

Deutsche Bank. Can you just comment on your results relative to some of the other direct sellers this quarter, because I know LED America was strong, but it looks like 12% in Brazil versus 26.5% up for Netura. And then even in Russia, you don't give the number out, but I know [Oraflen] was up 24% so can you also give us your growth rate in Russia, and then explain any of the variances versus those other direct sellers in those markets?

Andrea Jung

Let me just say this, I mean, without necessarily commenting specifically on any given quarter or any given promotion done by our direct sellers. We feel good in general that direct sales is doing well in this environment, but to speak about Russia, for example, our active reps were up 18% in Russia in the quarter.

I think we made a lot of changes, as you know, in 2008 from a competitive point of view as well as just from the sustainable growth turnaround strategy in terms of rolling out our sales leadership program and investing in advertising for recruiting etc. and we're starting to see that pay off. So I feel very good about the field health in Russia and think we will be very competitive there.

In terms of Latin America and Brazil, I mean, on this base I could not be more pleased with our results. Don't look at it kind of percent by percent but just on the second largest business we have, I think the investment strategy, the RVP and the advertising continue to pay back. We had really balanced growth there, very nice volume growth and our beauty growth there was up in the mid-teens.

William Schmitz - Deutsche Bank Securities

Great, and did you say what the growth rate was in Russia in local currency?

Andrea Jung

Our local currency Russia business was up 6% in local currency, reps were up 18%.

Operator

Your next question comes from Alice Longley. Ms. Longley, please state your affiliation then pose your question.

Alice Longley - Buckingham Research

Buckingham Research. I guess this is for Chuck. Can you break out a little bit more clearly the 390 basis point contraction in the SG&A ratio? I've got the 160 basis points from the brochures and distribution costs, 100 basis points from overhead and that's 260. Can you just clarify the other 130 basis points?

Charles W. Cramb

Sure, you've got – the Bagdas piece was a significant piece of this and that was…

Alice Longley - Buckingham Research

What is that? How much is that?

Charles W. Cramb

That's about 50 basis points and then the other piece is the increase in RVP and advertising, which is about 70 basis points.

Alice Longley - Buckingham Research

Well, advertising's a separate line.

Charles W. Cramb

Yes, but it's still in our SG&A. When you look at our financials, Alice, remember we show SG&A in total and then we give you an advertising number, which has already been included in that SG&A line.

Alice Longley - Buckingham Research

And then related to that, you broke out four positives for gross margin, pricing, sourcing, mix, and productivity improvements, can you give us how much each of those were beneficial to gross margins?

Charles W. Cramb

No, I don't have that detail right here.

Alice Longley - Buckingham Research

Which was strongest?

Charles W. Cramb

They all contributed fairly. I don't want to say equally, but they all were fairly material in the mix of the improvement we were offsetting, but with actually 240 basis points in terms of the transaction exchange. Of that, 240 points we came out at 30 net, so we had 210. And I would say the biggest numbers probably 40% of that, say 9/10 is due to the pricing in mix.

Operator

Your next question comes from Andrew Sawyer. Mr. Sawyer, please state your affiliation then pose your question.

Andrew Sawyer - Goldman Sachs

Yes, sure, Goldman Sachs. I just wanted to follow up quickly on the price in mix dynamic. Can you just help us through what type of price increases you're seeing in some of the emerging markets where you've seen devaluation, and also as you emphasize value a bit more, how would you expect the mix dynamic to play out as we move across the year?

Andrea Jung

We took some strategic pricing, as Chuck said, probably about 90 basis points due to pricing. We had pricing pretty much in all of our commercial business units, and so we're not changing anything as it relates across the year to strategy with regards to particularly, even in fragrance and even in skin care, where the analytics tell us we can continue to get price with innovation, those are holding.

Inflationary pricing, a little bit of it but more to come across the year, we're looking at it market by market across the year, as we've talked about and as Chuck said in his remarks, we do lag inflation to some extent to build share. We look very closely at direct sales competitors. Primarily as our consideration set, not just retail pricing that's taken in those cases across those boards.

But in some markets whether it's, I think we've talked about the Ukraine, starts to take some in Russia, starting to take some in Latin America. We're going to be seeing inflationary pricing to come throughout the year.

Andrew Sawyer - Goldman Sachs

Here's a quick follow-up one if I could. On the inventory side, can you help reconcile why it was such a big use of cash versus days outstanding being down?

Charles W. Cramb

That whole comparison depends upon what you're going out inventory level is, as well as your current inventory level is. I think from a balance sheet point of view, and exchange plays a part in this, but from a balance sheet point of view, we only built inventory, and I'm not taking the exchange piece out of this now, but our inventories were only up about $40 million from year end 2008. That's a pretty low increase versus history.

Operator

Your next question comes from Connie Maneaty. Ms. Maneaty, please state your affiliation then pose your question.

Connie Maneaty - BMO Capital Markets

What do your analytics tell you about the conversion of the new additions to active reps? What percentages of them actually are successful in making the transition? And would you also just describe for us what the difference is between an addition and an active rep?

Andrea Jung

Yes, first of all we're really looking at this research now, so we'll have to play that out because they really basically just joined us in a significant number, but joined us in March and so that's why we're being very intense about really understanding who they are, where they're coming from, are they coming in online.

And obviously, one of the things again in our thesis here is that the more of them that come in online who are prone to being e-representatives, would say that this will be a more active rep. The activity is higher among e-reps etc., so all of our strategies and our focus is to convert them.

The difference between an addition and an active representative is an addition is someone who comes in and we've appointed in the quarter. An active rep is someone who turns in an order, okay, on an average basis so she has to be actually placing an order with us as opposed to have just come in.

Connie Maneaty - BMO Capital Markets

Additions aren't really productive yet, it's just an indication that they might be?

Andrea Jung

Yes, they've joined the company. They've invested in the appointment kit. They've officially been appointed into the company. They're not just a lead. A lead is somebody who just shows interest and then somebody has to actually appoint her.

Operator

Your next question comes from Ali Dibadj. Ms. Dibadj, please state your affiliation then pose your question.

Ali Dibadj - Sanford C. Bernstein

Thanks, it's Bernstein. My question is really around some of the comments you gave, Chuck, at Cagney saying a safety net of cash that's offshore. And it makes me think that there may be a mismatch between where you have your cash geographically and where you need to use your cash, for example, the restructuring cost that you mentioned, coming up here.

Is there a mismatch or am I misreading your increase in debt and in fact not paying down your CP and having some cash on hand to maybe use for severance costs or other types of cost that you need for example in the U.S.?

Charles W. Cramb

Yes, Ali, in terms of why the cash went up and the debt went up, that really was due totally to timing of my commercial paper which terms out in April. Remember, we were borrowing commercial paper on 30 and 60-day basis primarily. So that increase that you saw is really just due to that timing element.

In terms of the other question that you raised, I think it's a good one. Yes, we do have a little bit of a mismatch between the cash generated in the U.S. and it's not just U.S. profits. It's things like royalties and it's the dividend that we choose to bring back.

But in terms of meeting our overall cash demands, we have a lot of flexibility in terms of accessing the offshore cash at relatively low tax penalties if we decide to do so. So, I feel from a liquidity point of view, whether it's geographically biased or not, we really are in very good strong shape.

Ali Dibadj - Sanford C. Bernstein

So you wouldn't have to repatriate? Is that what I'm reading?

Charles W. Cramb

You might have to bring some back. We do bring some back. I mean, we bring back some every year. What you do, though, is you make the determination of whether current earnings are permanently reinvested or not. We have not made that determination for 2009.

Ali Dibadj - Sanford C. Bernstein

And then on inventory, just a follow-up on a question before, totally respect the number that it's not much of an increase versus history. But history at foreign exchange hurting inventories in a sense and I think you mentioned some of this in your prepared remarks. Here we have foreign exchange actually kind of helping in some sense, reducing our inventory, but we're not seeing it go down. And the way I look at it, for what it's worth, is day's inventory on COGS. You're not seeing it go down, so I'm struggling with that.

Charles W. Cramb

As we looked at it, we acknowledged that of the six days, some of that is FX but some of it is operational. I look at the movements from December to March because, although there is further deterioration in currency, it's not a huge deterioration versus what we were seeing in say 2008.

So, I looked at a $40 million increase coming out of a fourth quarter, and you understand the seasonality of our business, as we replenish some of the inventory going forward, I looked at a $40 million increase as fairly decent management.

Ali Dibadj - Sanford C. Bernstein

Even with foreign exchange.

Charles W. Cramb

Pardon?

Ali Dibadj - Sanford C. Bernstein

Even with foreign exchange?

Charles W. Cramb

Even with FX, because I'm going from a December balance sheet rate and to a March balance sheet rate. It's not that big a number.

Ali Dibadj - Sanford C. Bernstein

And maybe just the last question I had and forgive me for this. I used to bug you guys about just get rid of the U.S. business. Let me, given rep productivity and given how much you're spending here. If I could be more specific, one, how are you going to get rid of non-beauty, if that's even in the cards in the U.S.?

Andrea Jung

Well, our focus obviously is on beauty. Our focus this year is on driving beauty unit share gains, volume, and the recruiting, which are heavily linked. We have a very tight inventory control on non-beauty as we are deemphasizing it in this business this year.

I feel very good about the fact that I said over the quarter that we are being very constrained in terms of the amount that we are bringing in, even for holiday seasons, trying to make sure that the number of SKUs is much tighter than a year ago given the extreme consumer contraction and pressure particularly on the home business. So that's something that we continue to deemphasize and the key to the total North American business and margins ,obviously, is growth and we are looking at beauty, obviously, to continue to drive that.

Ali Dibadj - Sanford C. Bernstein

Is that where PLS is really going to hit because we didn't see any real number this quarter?

Charles W. Cramb

I'm sorry, did what?

Andrea Jung

Is that where PLS is going to hit. I would just … go ahead.

Charles W. Cramb

We're on track with our PLS. We didn't give an exact number. To give exact numbers, you have to do [retrenching] analysis market-by-market and as we've now gone global with the program. But if you were to ask me to estimate it based upon some of the things we do know, number one, in the quarter, when we look at beauty growth for the opportunistic products, those are the products that we were able to give increased catalog exposure to because of reducing the size of the product line.

The growth in those opportunity products is two to four times what it was in beauty in general. And as we try to do the math through, I would estimate roughly, had we not had the PLS process, we would have missed the benefit of somewhere around $25 million to maybe $30 million of profit in the quarter. So PLS is really delivering what we thought it would. We said it should be about $120 million benefit this year. We still feel very good about that.

Operator

Your next question comes from Wendy Nicholson. Ms. Nicholson, please state your affiliation then pose your question.

Wendy Nicholson – Citigroup

With Citigroup. My first question has to do with the sort of monthly progression of the sales growth in the first quarter. Given the rep growth, it sounds like accelerated during the quarter and it sounds like you put more of the inflationary pricing at the end of the quarter than at the beginning, is it fair to say that we saw sequential improvements in local currency terms in sales growth as we went January, February, March?

Andrea Jung

We had a really good March.

Wendy Nicholson – Citigroup

And is there any reason why, is there any timing the campaigns, because I'm trying to get comfortable. It sounds like second quarter is just going to totally sting from an FX prospective, but is there any reason to think that local currency sales would decelerate from here or do you think the first quarter represents the low point for the year?

Andrea Jung

Without giving guidance, I would just say that it is a momentum business. We are exiting the quarter with strength in strategic fundamentals of the beginnings of this rep recruiting effort, as well as the focus that started in March, but that continues all year on the smart value play. And so I see no reason why we would have any deceleration.

Wendy Nicholson – Citigroup

Now just switching gears quickly for one second, can you talk about China? I know it doesn't matter at all to the earnings of the company right now, but I think psychologically it's very important. And that was the one number that came in well below my forecast.

And, I understand the concept of the destocking at the beauty boutiques, but kind of what gives you confidence that that really is a one-off situation? Are you looking at this as an opportunity to maybe shut down some of those beauty boutiques, because you've held open an awful lot of stores over there? So, kind of what is your thinking over there and how do we know that 4% is a true anomaly.

Andrea Jung

First of all, I think that direct sales is becoming a bigger and bigger percent of the China business, which I think is a good thing. Remember, I think we've talked back before where it had grown to sort of 50% it's well over that, I think that it's going to be 70% plus and growing of our China business.

So if you just sort of take out the kind of BB mirroring, kind of the retail thing, we feel good about direct sales. We think that there will be acceleration. Obviously, we said that we don't believe that the first quarter represents the full year. But I still think they'll probably be destocking in the beauty boutiques. So ergo I think direct sales will continue to progress.

Okay, I think we've got strong programs, smart value, as well as the recruiting ramp-up is no different than the rest of the company really showed some nice improvements in March going in to the second quarter. So I think you're going to see the direct sales driving that increment on the balance of the year.

Operator

Your next question comes from Chris Ferrara. Mr. Ferrara, please state your affiliation then pose your question.

Chris Ferrara – Bank of America/Merrill Lynch

Bank of America/Merrill Lynch. Chuck, on the SG&A sort of reconciliation that you've given, I was just looking for a little bit more color on where some of those drivers might be going as we look forward. So I guess, FX we can kind of calculate ourselves, and I understand as ads in RVP aren't going to go higher, they're probably going to come in a little bit. But, the distribution brochure cost bad debts, maybe brochures a little lumpy first quarter but how do the rest of those sort of play out as the year goes on?

Charles W. Cramb

I think as I would look at it, there's a couple of things and each of them is a little bit different. But, on the distribution side, as the length of activation of our activity of our representatives grows, that is as we move from brand new representatives to more experienced, their order tends to increase.

A lot of what we saw in distribution was really due to the average order size being relatively small. It costs about the same to distribute a box of $100 worth of goods versus $200 versus $50. So the productivity improvement we would expect to see throughout the year and into the future and this is not a one-year phenomenon, but into the future should allow that number to improve a little bit.

Bad debts, it's a similar thing. Plus I really think that the program we've got underway right now, it will take a while to really understand what the key elements are that really differentiate some of our top performance. Things like who uses finance charges versus who doesn't, how do they incentivate collections? What's the role of the district manager, zone manager in collecting for an independent rep? How do you use collection agencies?

I think all of those things would bode us well from a learning experience to be able to see a reduction in that bad debts percentage. And the other one, on the brochure cost side, yes, a little lumpy. I think we'll see some relief in terms of the paper costs as they did soften a little bit towards the end of the year, although, we were under some contracts. So I see some improvements this year and I see no reason why that can't continue into next year.

Chris Ferrara – Bank of America/Merrill Lynch

I guess just following up as you look at how that forwards, I mean, is it fair to say that the pressure in gross margin picks up as you go into the next couple of quarters because FX starts to flow through inventory more and maybe some of these drags on SG&A kind of diminished a little bit of a year ago. So the shift goes from gross margin to operating margin as you go through the year. Is that right?

Charles W. Cramb

Definitely, the pressure on gross margin next quarter will be greater than it was this quarter because we're expecting, just based upon the movement in currencies in the first quarter, we're expecting transaction change to be worse.

Chris Ferrara – Bank of America/Merrill Lynch

Just a real quick question on the taxes, obviously, the new administration is looking to close I guess loopholes in corporate tax and I know your tax rate isn't particularly high relative, or low sorry, relative to the U.S. corporate rate, but how is that affecting you guys and what's your early read on it?

Charles W. Cramb

I think it's really too early to come out with much of a read on it. I think because we do have a tax rate that's not terribly different from the U.S. statutory rates, I wouldn't expect a major change. But until we see how the legislation moves and what gets passed, I really think it's premature to talk about it.

Operator

Your next question comes from Doug Lane. Mr. Lane, please state your affiliation and then pose your question.

Doug Lane - Jefferies

Yes, Jefferies. Can you give us an update on what you're seeing in Mexico with the flu outbreak down there? Direct selling is, obviously, a very social model. I'm just wondering if it's impacting your business in any way.

Andrea Jung

Well, actually through yesterday, and I just had an impressive call with our team down in Mexico. We have not seen an impact on activity or orders coming in this campaign. I mean I don't want to predict what will the effacement given sort of the easing numbers that the government is reporting etc. right now. We have not seen impact.

Doug Lane - Jefferies

As I understand it, they really clamped down on gatherings and what have you. Is Avon structured down there where the personal face-to-face meeting, you can get around that with other means, phone call, the internet? I mean how do you go about doing it specifically?

Andrea Jung

Yes, all of the above. I mean, it's a relationship business. So it's one-on-one and then a lot of them are their friends, etc. So there's a lot of trust there. The largest item we have an extraordinarily comprehensive plan for managing situations like these in the direct selling environment. Remember, we managed stars and even with the fear of the Avian Bird Flu in the past, we put a complete crisis management and instruction as it relates to our sellers, as well as our associates for any kind of these things given our model.

So we know how to do this, but net-net I'm thinking, knock on wood, we have I think a model that's based on trust and there is the Internet, etc. You can order in, fax, Internet so there are other opportunities.

Operator

Your next question comes from Linda Bolton Weiser. Ms. Bolton Weiser, please state your affiliation then pose your question.

Linda Bolton Weiser - Caris & Company

I'm Caris & Company. Can you elaborate a little bit more on, it seemed like you saw some weakness in the U.K. and I know Estee Lauder had talked about quite the opposite that they were very strong in the U.K. What's going on there? Can you give a little color?

Andrea Jung

Yes, great field execution, so active representatives up 4% and that continues to be strong. It really was the non-beauty business, which is probably a reflection similar even though it's a smaller percent to U.K.'s total business than the U.S. very similar major double-digit decline so that wouldn't mirror the beauty business that Lauder was talking about. So it was again in the non-beauty categories where we're doing the poorest, if you would.

But I feel good that the U.K. has a great strategy for smart value in beauty. All the things that we're doing around the world certainly I was pleased to see what the programs are going into the second quarter and the third quarter. So I feel good about the beauty business in the U.K. and the field execution.

Linda Bolton Weiser - Caris & Company

And then also, can you elaborate a little bit more on the 8% beauty sales decline in North America? Just where were the biggest declines and which part or categories?

Andrea Jung

I think we saw some real tough category performance in fragrance and skin care, which I think probably, is not surprising. All I would say it's early days and one month doesn't equal anything, but certainly in the month of March we did see, I think Chuck talked about unit improvements in March, but that includes the U.S. in beauty. So, we are slowly but surely, obviously, the strategy no differently than anywhere else is starting to work in North America as well.

Linda Bolton Weiser - Caris & Company

And how is Poland in local currency sales?

Andrea Jung

Really in line with the rest of Central and Eastern Europe, Linda.

Operator

Your final question comes from Lauren Lieberman. Ms. Lieberman, please state your affiliation then pose your question.

Lauren Lieberman - Barclays Capital

It's Barclays Capital. Just following up on the U.K. question, my understanding had been that smart value actually kicked off in the U.K. earlier than any other market, I think even in the fourth quarter. So just wanted to talk about how the increase in recruitment if you've seen it flow through into an increase in productivity or is it a mismatch and that the smart value happened but the recruiting kind of came later?

Andrea Jung

Well, I think for the whole company, obviously, the recruiting and I think I mentioned the numbers in terms of March were strong everywhere, so, again, [inaudible] I think you have to play it out. The second thing is that they are driving very hard on the recession strategy and the products that were flowed in smart value working very well. I think as I said the pressure in the U.K. was specifically on the higher priced non-beauty that really pressured their average order.

Lauren Lieberman - Barclays Capital

And then just in terms of skin care, even though I think you mentioned it had to do with the timing of launch activity, but I was surprised by the divergence in skin care because I would think if anything Avon would be benefiting from trade down broadly in skin care. So maybe can you maybe just discuss that a little bit? Was it that it was a particularly difficult comparison and do you expect skin care to more mirror the rest of the beauty's performance as we move on from here?

Andrea Jung

Yes, I think that first of all that color and personal care because of just the nature of those categories performed well and will continue to perform well. I was pleased, and sometimes you have to kind of look at launches in the quarter. I was pleased even though volumes were flat in fragrance, but net was up 9%, this is kind of where pricing did take hold and I think we have some very strong performances.

And I would look at skin care going through the year as certainly probably not as robust at growth as some of these lower priced smaller net categories, but I think it's a little bit of a comparison. We've got some big innovations coming up including in the second quarter, so I feel good about skin care. I mean I think it's going to be kind of improving performance with the innovations that come out.

Operator

There are no further questions at this time.

Andrea Jung

Well, thanks everybody, just appreciate everyone being on the call this morning. I'll just stay that it is a challenging environment, but I think that we are very optimistic that we're well positioned for continued growth. My headlines would be this major focus on rep recruiting is working. We feel very good about that. We are gaining beauty share as we come out of the quarter. And we've got significant cost cutting initiatives and opportunities that are going to benefit our margins long-term.

Lastly, that we have very strong overall financial position with good liquidity, no significant near-term debt maturity, over $1 billion in offshore cash and committed to delivering a sustainable healthy dividend. So I think we're off to a good start certainly on the top line and we're going to do all the right things for this business. Meet the challenges of today, but just focus squarely on share gain in the channel and the brand going forward. So thanks everyone. Talk to you soon.

Operator

This concludes today's conference call. You may now disconnect.

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Source: Avon Products Inc. Q1 2009 Earnings Call Transcript
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