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Executives

Andrea Jung – Chairman & Chief Executive Officer

Charles W. Cramb – Vice Chairman, Chief Finance & Strategy Officer

Analysts

Christopher Ferrara – Bank of America-Merrill Lynch

Nik Modi – UBS

Lauren Lieberman – Barclays Capital

Douglas M. Lane – Jefferies & Co.

Connie Maneaty – BMO Capital

Ali Dibadj – Sanford C. Bernstein

William Schmitz – Deutsche Bank Securities

Mark Astrachan – Stifel Nicolaus

Wendy Nicholson – Citigroup

Andrew Sawyer – Goldman Sachs

Linda Bolton Weiser – Caris & Company

Alice Longley – Buckingham Research

Avon Products, Inc. (AVP) Q4 2009 Earnings Call February 4, 2010 9:00 AM ET

Operator

Welcome everyone to Avon’s fourth quarter earnings conference call. (Operator Instructions) I will now turn the conference over to your host Andrea Jung. Ms. Jung, you may begin your conference.

Andrea Jung

Thank you. Good morning everybody. Welcome to Avon’s fourth quarter earnings conference call. I am here today with Chuck Cramb, our Vice Chair and CFO. I just have to remind everyone to refer to the reported numbers as well as the cautionary statement in today’s earnings release.

I think we finished the year very well. We are very pleased with our strong fourth quarter and what was a very good year for the company. If I just actually go back a year ago when we were on the phone with you it is just like every other company. I think we were entering 2009 facing severe macroeconomic headwinds. We were looking at major GDP declines across all of our top markets in the world. Certainly for us as a consumer company we were staring down substantial consumer contraction. Then obviously for Avon when we look at the currency movement a year ago the significant currency meltdown represented a potential $1 billion drag in revenues for the company.

We decided and I think we were pretty clear in our communications certainly with the company and with all of you that early on in the year we were going to go on the offense. We went on the offense and focused on managing what was in our control as a company. This played out really, really well. We updated our play book. We had three years of very successful progress on our turnaround sustainable growth strategy but as we entered this recessionary period we updated our recession play book that as you all know focused on Smart Value. It really focused on having one of the most intense recruiting efforts we have had in our 123 years. We took very aggressive cost actions but most importantly we just stayed the course on the turnaround plan which we felt has been working very, very well.

So that was our playbook for 2009. In a highly challenging year externally we think we delivered standout results. On the left here if you look at fourth quarter 2008 a year ago our constant dollar sales were up 2%. That was really when we began to feel the pressures of the consumer contraction and the effects of the fear out there in the marketplace and the consumer contraction.

As we got into the first quarter of 2009 we really started to implement the play book, focus on the recruiting and the Smart Value products and you can see the progression of acceleration. So 3% Q1 2009, 5% Q2, 7% Q3 and then in the quarter we reported this morning 8% for the fourth quarter this year in local currency which we just think is standout. It took us from a full-year perspective to 6% local currency sales growth, at the high end of that mid single digits in a year like this. As you can imagine we feel very proud of the revenue performance.

Beauty was even stronger. Our Smart Value program fueled this strong performance. So again from a quarterly progression point of view we were really pleased that in the first half of this year we delivered 5% in both quarters one and two in Beauty and that was outperforming peers and we felt the Smart Value program really drove that along with great innovation and strategic pricing on some of our super hits.

If you look at the back half of this year we hit an 8% sales growth in Q3 and then a pretty stellar 9% Beauty sales growth in the quarter as we closed out the year. So we ended this year with 7% local currency sales growth in our core Beauty category which by all measures is a share gaining year.

Behind this was really the volume improvement and the healthy focus upon unit growth. We ignited Beauty unit growth across every price tier which was a goal for our organization. When I look back I think it is one of our biggest accomplishments. Again, if I go back a year ago in Q4 we started to see the pressures and the contraction on unit volumes which concerned us but particularly in the Value or under $5 price points we had shifted away as we were coming out of stronger economic times in the 2007/2008 period. So that drove units down. We focused very deliberately on managing that very well through 2009.

So units grew 2% in the first quarter, 3% in the second, 6% in the third and again 5%, very healthy in the fourth quarter with most important to note units growing across not only the under $5 value segment but in the $5-10 segment as well as the $10 plus. Really healthy growth. Very balanced across the entire portfolio.

When we turn to the field dynamics this was what we were staring down when we entered 2009. So as we exited 2008 average active rep growth was 4%. The trend line was obviously in the under 5% or low single digits numbers. That was something we felt we had to reverse and we had a particular advantage as a direct selling company with all of the progress, innovation and the investments against RVP. So we went on the offense and changed that trend line. We shifted it. We were up 7% in active rep growth in the first quarter and then with a tremendous amount of investment in RVP, in advertising about recruiting as well as our sales leadership rollout. We had an 11% active rep growth in 2Q, 10% in 3Q and ended the year with a very strong 11% obviously boding very well for 2010.

We had strong active representative growth across all of our commercial business units. Double digit growth in four of them and growth of 3% in North America. Again this is very broad based. We significantly out-ran our competition. If we look again at organic Beauty revenue growth in constant dollars we talked at our October 29th investor meeting about the fact that through ¾ of the year when we had looked at performance of the major Beauty competitors we were significantly outpacing them through October.

From the reported results we have seen so far while we are very pleased on an industry basis that everybody seems to be doing a little bit better in Beauty, based on the earnings releases that have preceded ours. At 9% local currency Beauty growth we think we far outpaced the competition and this is a great year for share gains for Avon.

In eight of our top ten markets we significantly outran GDP which for me is a real testament to the success of our recession playbook. In the gray bar you see the GDP of our eight major markets. Examples here are Brazil basically flat to negative with GDP, a little bit stronger than some of the other markets in Latin America but still flat. The pink bar is our Avon performance for the year. At 17% local currency growth in Brazil. That is 18 points difference from GDP. If you go to Russia, 27 points difference. Mexico is 15 points difference. The story is the same which really tells us that for the large part our strategies were even more successful than we had anticipated.

So as we look forward to 2010 we are very, very happy with the momentum we have in the business at this point. We are building on this momentum. Obviously first and foremost after a terrific year from a field and channel health point of view we are sustaining healthy, active representative growth. We are leveraging technology to really begin improving representative productivity. We are driving balanced units as the price/mix growth. When sort of thinking about how we are going to approach the Smart Value program versus pricing in 2010 I think we have struck a phenomenal balance in the fourth quarter and we like that balance and want to continue that.

We think there is a new normal in consumer spending and even if the economy returns we want to keep offering Value products but achieve the pricing particularly in our innovative categories and that will continue. Very importantly we are continuing to fuel a very strong product innovation pipeline supported by stepped up advertising.

Just to name a few of the products and launches we have coming into the first quarter leading to the beginning of the second, we have got a new Reversalist eye product. A very big launch product. That is the United States cover. The next is a very big lipstick, the Mega Impact lipstick, a breakthrough lipstick that already launched in the U.K. this first quarter and is doing very, very well and is launching in many countries around the world.

We have good fragrance strength with continued celebrity endorsements. Zoe Saldana, the actress who stars in Avatar, is a terrific new face for us in our Eternal Magic fragrance brand and that is launching in the early second quarter in the United States. On the right you have one of our new and exciting mascaras, Super Extend Mascara and that is the launch cover in Brazil.

Our restructured P&L is what has enabled us to continue to invest ahead of growth to drive market share gains. We gained market share. From everything we can see in 2009 and that is really the mantra and the name of the game for us in 2010. We have this constant turnaround mentality that has been firmly embedded in the company since 2005 and Chuck will talk a little bit more about that. I couldn’t be more pleased at the way we are aggressively controlling costs but really reshaping the value chain and fueling growth.

We are continue to deliver against our PLS, SSI and restructuring commitments, all of our programs are on track. So despite continued macro uncertainty and the economic disruption in Venezuela we expect to deliver at least mid single digit local currency revenue growth and operating margin expansion in 2010. Our long-term outlook remains unchanged. As we have told you we expect operating margin to return to mid teen’s levels by 2013.

So I am going to turn it over to Chuck to take you through the details of this last quarter. Again, suffice it to say we are very pleased in the company with the performance in this last quarter. It was a very strong finish to a very good year. Four sequential quarters of top line acceleration in local currency, broad based revenue growth.

Chuck is going to show you something that really says that 70% of the geographic portfolio delivered mid teens local currency revenue growth when you look at the very strong Latin American growth on growth at 14% and then you look at Europe, Western Europe as well as Central/Eastern Europe, that I believe grew 17% between the two and they are 30% of our portfolio. That is a large broad based growth at mid teens level.

Our earnings per share were up 15% in the quarter. We have very strong structural working capital improvement starting to kick in and despite negative net income which was pressured by foreign exchange and restructuring charges for us net cash from operations increasing to $782 million was another proud accomplishment for the company.

With that let me have Chuck take you through the quarter.

Charles Cramb

Thank you Andrea. Now let’s hit the fourth quarter with a little more detail. We feel it was a great quarter and really as Andrea said capped off what has been a great year considering the global economic difficulties we faced.

In terms of a few highlights, local currency revenue growth is up 8%. That translates to 13% in reported dollars as currency did finally move a bit in our favor in the fourth quarter. Active rep growth very strong at 11%. In terms of the overall local currency revenue growth we had a great balance in the quarter. Units were up 4% and price mix contributed another 4%, something strategically we were working on to achieve balance in that area. The mix of the business favoring Beauty up faster than the overall business, up 9% in local currency, 15% in dollars, and driven by the Beauty units which were up 5%.

In terms of the major transformational initiatives that we have talked to in the past, all of them are on track whether it is strategic sourcing, product line simplification or the two restructuring programs. This chart shows how our local currency revenue growth increased through the year quarter by quarter coming off of Q4 of 2008 where it was at 2%. We had improvement of 3% in the first quarter, 5% and 7% and then 8% this last quarter. When we show it on a reported basis you can see the significant drag we had since the fourth quarter last year with currency finally moving favorable this quarter and adding about 5% to the overall reported growth.

We were successful in our recruiting efforts in terms of our active representative growth. Here you can see all regions reported growth. Four of them in the double digit area. Talking about the chart I am pretty proud of and that is the fact we have regained the balance between units and price mix. As you took towards the end of 2008 we got out of balance a bit particularly when you think about where the economy was heading with an over-dependency on price mix versus units. We put the play book in place in the first quarter, regained the balance and came out of the year with 4% unit growth and 4% price mix growth. For the total year it balances out to 3% on each of those with 6% local currency growth.

Thinking about Beauty sales in the fourth quarter, in reported dollars they were up 15%. As I said they are ahead of total company sales. They were led by strong, double digit growth in both color cosmetics and personal care. Those two categories did benefit from our Smart Value strategy. Fragrance was also up double digits strongly with Skin Care roughly flat in local currency, gaining 2% in reported dollars. Here the story is really from a product point of view we had great success in terms of our Anew franchise but it was offset by softness in solutions.

Now let’s think about it geographically. First, Latin America, another very strong quarter. 14% constant dollar growth translates to almost 30% in U.S. dollars. Here double digit local currency sales growth in nearly every one of our markets. Just picking off a few, Brazil first, local currency revenue growth up 12%, almost 50% in U.S. dollars, a strong bounce back in currency here. Really what has been driving it all year and that is our investment strategy as we continue to invest in the value proposition and we invest in advertising against the consumer and those programs are paying back.

In Columbia the local currency increase was almost 20%. Venezuela was 32%. Mexico, one of our turnaround markets where we did turn the market around, we reported good performance throughout the year. There is no question some economic softening impacting our results. If you think about it, GDP in Mexico is down about 7% for the year and 9% in the fourth quarter. As we are looking at this business we feel very, very good about the turnaround and of we think a little bit to the future we see the business still showing growth into the first quarter. I think in terms of that economic climate in which we are operating this was a good performance.

Thinking about the price mix that I talked about, really strategic pricing, our strategic pricing is holding. Yes, we do get some benefit from local inflation in the higher inflation markets. In North America it is still a challenge. Constant dollars down 9%. U.S. is down about 7%. I think key here as we talked to you in October at the investors meeting, we have a plan to drive towards sustainable recovery. It will take time to execute and move through but we are executing it as we discussed.

Key components of it are to really increase the active representative growth, to focus on increasing the productivity of our representatives and also to focus on retaining the representatives in the business. Reshaping non-Beauty is another key element as we want to focus more on Beauty and deemphasize non-Beauty in our product mix. Then continue to right size our overall cost structure for our sales base.

No question in terms of the pace of that turnaround and how it is going to come through, difficult economic conditions do continue to persist in the U.S. That will delay it somewhat but our destination we feel is unchanged, as is the plan. Over time we will return North America to really at market growth based on the categories we are participating in and a respectable margin performance.

In terms of looking at the numbers, average order down 12%. You can see that number is going to be impacted by both the Beauty and non-Beauty mix but also by the economic difficulties within the North American environment. The real story of the quarter is Central Eastern Europe. 20% constant dollar growth. Here currency is still unfavorable to us so the net results are 12% on a reported basis. We saw a significant acceleration of growth rates in almost all of our countries within Central and Eastern Europe. Our investments are paying off. Our investments in the Smart Value proposition and advertising. If you think of one market that represents top business there I think it is Russia, up 29% in local currency terms.

Importantly, average order for the first time in several quarters is up 5% in this geography. So looking down at the metrics, the other one to point out is the active rep growth that is up strong 15%. Equally impressive are the results in WEMEA (Western Europe, Middle East and Africa) where we have seen 12% constant growth. If I think about it particularly for the developed markets this is strong revenue growth in what can only be defined as a tough economy and it really is the fallout of successful execution of our Smart Value program. Though it impacts the price mix we are not hurting our gross margin percentages.

Within the geography, Turkey had a stellar quarter. Local currency revenue was up almost 40%. When we think about what is driving this it is the investment in the rep value proposition and it is continued success and penetration of the sales leadership in that country. In the U.K. local currency sales are down just a little bit, 3%, as strong active rep growth of 9% was not quite enough to offset the average order pressure. Overall, active rep growth of 17% and units of 19% in this geography.

Thinking about Europe on a combined basis, and this is the way we are organized, but if you think about it on a combined basis it represents roughly 30% of our portfolio from a revenue perspective. That 30% grew an impressive 17% in local currency during the quarter, 15% in reported dollars.

Moving onto Asia Pacific, I would characterize this as a good quarter. We had 4% constant dollar growth. Within the region, solid sales growth throughout despite a double digit local currency decline in Japan. The real growth engine here geographically is the Philippines. The Philippines was one of our top ten markets. Actually it is our largest market in Asia and it continues to deliver outstanding revenue growth as well as profit growth and strong profit margins. The local currency revenue growth in the Philippines was 17%.

In China revenues are down. We are seeing the same thing that we communicated to you last quarter. We are seeing growth in direct sales but it is being offset by the continued decline in Beauty Boutiques as we move strategically to re-mix the source of this business. In terms of breaking out components a little bit, direct selling is up 19% and we still have strong recruiting. Active reps are up 30% and the successful and new retroactive launch is helping there.

In Beauty Boutiques revenues were down 66%. This is really the evolution, which is very complex, as we move towards more direct selling. That is impacting how BBs are ordering. If we think a little bit to the future in the first half of 2010 we would expect continued revenue declines in China. From a long-term perspective we feel the revenue and profit opportunities in this market are immense and we are committed to develop and grow our business there.

Moving to the income statement we have talked about revenue so let’s talk a little bit about gross margin. Gross margin improved 30 basis points in the quarter. This will bridge us in terms of how did that 30 basis points occur. We fought 140 basis points of unfavorable transaction exchange in the quarter and it was really more than offset by strong efficiencies in the supply chain. Some of our programs, strategic sourcing as well as significant productivity improvements have really driven supply chain performance.

Price mix is small under there at 20 basis points. It is actually strong on the price side with mix running a little bit unfavorable and what we are seeing there is we have been able, where we have taken strategic price increases, we have been able to sustain those increases so we have had pricing power where we felt analytically we should take pricing.

Overall SG&A was 70 points higher at 49.8% in the quarter. This is due primarily to the costs to implement our overall restructuring programs. As we think about what is in SG&A both in terms of our investment side as well as our cost side really we are investing in the brand and channel and we are controlling costs. Advertising is up about $9 million in the quarter in support of the strong innovation pipeline and as you think about that increase also remember we benefited in 2009 through the fourth quarter with media deflation as well as significant improvements in productivity so our GRP strength was up. As I look to 2010 I don’t think media deflation is here. In fact we are seeing some signs of media inflation coming back particularly in the international markets. Basically that was a significant increase in our GRP support.

Our RVP, significant investment here as well. This is really investment in our commission structures. That is an important element, structures. As well as the web-enabled tools we have been giving to our representatives to help them conduct their business. It also reflects further implementation of the sales leadership program.

In terms of the overhead really the big change in the overhead is a higher cost due to the costs of implementing our restructuring activities. We did mathematically achieve ZOG if I took out those expenses that go along with some of the investments we are making that are strategic. When I say that I am really talking about things like some of the facilities where we have duplications as we move out of one distribution facility into another, some of the increase is in management but it is only a small increase over a flat year-over-year for the quarter overhead number.

As we look at it from a bridge point of view at the operating margin line, really operations is very favorable offsetting the costs to implement restructuring and the impact of transaction exchange. Last year we reported 13.3%. This year 12.8%. You can see the CTI, cost to implement our restructuring was almost 100 basis points at 90 basis points. You will see transaction exchange, this is for the total P&L what goes into cost of goods as well as overhead costs about 160 basis points. Favorable translation exchange was 70 basis points and as those currencies strengthen against the dollar we get a benefit in margins since the international business has higher margins than the domestic business.

Therefore, the [wasting] for the higher margin businesses benefits us from a margin point of view. The real benefit though when you look at this bridge is the operational impact; stronger sales, improved gross margin, control over our expenses is driving the operational impact of 130 basis points.

From an EPS point of view $0.62 reported for the quarter up 15%. That $0.62 includes $0.06 of costs related to our restructuring initiatives. In 2008 the number was about $0.01.

Moving then quickly into the balance sheet and cash flow we really did make great progress I believe in terms of strengthening our balance sheet and cash flow despite the economic environment in which we were operating. Just think about cash and debt, overall our net debt is down $250,000,000 from one year ago at year-end. Our accounts receivable are up but that is due to the higher sales as we continue to operate in a disadvantaged business model with less than 30 days outstanding.

Our inventories on the balance sheet show an increase of 60 days versus a year ago. However, from an operational point of view this represented an eight day improvement because exchange significantly impacts how this number gets reported from a dollar point of view. A little bit of elaboration there, if you think about what has happened with the weakening of the dollar and strengthening of international currencies towards the end of the year we ended up translating our inventories at a stronger exchange rate than our average cost of goods sold.

So if you just did the math in terms of the inventory value versus the cost of goods sold working back over the prior 12 months it looks like inventories are moving up in terms of cover just because of the math. So that is kind of [kind of what] in the view. What is interesting is we talked about this a year ago and exactly the opposite thing happened in 2008 where the dollar strengthening resulted in the international inventories being understated from a translation point of view average wise versus the average cost of goods sold. So we had a double whammy in terms of the numbers. From a pure operational point of view, taking off all those types of currency movements however, it was a very, very strong eight day improvement year-over-year.

In terms of capital expenditures we talked about managing our capital. We have talked about really either delaying or eliminating discretionary types of expenses. We managed it down to just under $300 million, well below 2008 and at the bottom end, the low end of the guidance we had given you.

In summary, we are pleased with our performance this quarter. Very pleased. We have seen local currency revenue growth increases for four straight quarters now. We have seen three quarters in a row of double digit active representative growth in the company. In terms of units in Beauty it has been fueled by our Smart Value program at 5% unit growth and it is also well balanced with our strategic pricing programs. Despite unfavorable FX transaction expense, our gross margin improved and we have been able to maintain strong cost controls throughout our organization.

If you think about it in a broader prospect for 2009 we equally pleased with how we have managed. We have leveraged our model to drive top line growth. We have savings and benefits coming through from our restructuring programs and our strategic initiatives. These helped to offset the significant pressure from foreign currency. Our fundamentals remain strong and our actions to counter the economic climate are strengthening our foundation for future growth.

For 2010 we will continue to drive top line growth and operating margin improvement. Before I turn it over to the Q&A, I think the impact of Venezuela is a key question that has been asked. We did issue an 8-K. We have had disclosures in our Q’s prior but I want to take you through how we are seeing that impact now. We all know about how Venezuela went hyper inflation this year declared in January. That is in the accounting rule from the SEC in terms of over three consecutive years you have an inflation rate higher than 100% you have to go to hyper inflationary accounting. They also had a devaluation in Venezuela that came up with two official exchange rates.

In 2009 the rate was $2.15. In 2010 at least in January it is $2.26 for what is defined as essential goods and $4.03 for nonessential goods. We are assuming in terms of our business it will fall into the nonessential goods category. It is not totally clear coming out of the Venezuelan government yet but that is effectively from the $2.15 is a 50% overall devaluation which will affect obviously the translation of our results.

I think importantly as we think about Venezuela it does not impact our business fundamentals there. We are a strong business in Venezuela. We have great representative count. We have great growth in representatives. We have good growth in terms of their overall productivity. If you think about it we have been in Venezuela for 54 years. After 54 years where there have been ups and downs and crises we are the market leader in the Beauty category.

We have managed to evolve as a company. We know how to operate in these environments. Think about hyper inflation in Brazil and Mexico in 1993 and 1994. We had the Russian Ruble meltdown in 1998 and we had the significant devaluation in Argentina in 2002. If you think about our experience operating through those crises and our continued commitment even during crises to operate within emerging markets it really has paid off.

A couple of the examples are in Latin America. Latin America now represents some 40% of our sales with high operating margins. Russia, the other one referenced, is nearly a $700 million business now with a margin even higher than that we have in Latin America. So from a business fundamental perspective we remain confident that we will manage through the devaluation in Venezuela. We will put actions in place to try and mitigate the impact of translation exchange with the 50% devaluation through operating performance improvements in Venezuela as well as around the rest of the company.

In addition, however, there are some nonrecurring what I call accounting treatments that will impact our quarter results in 2010. The first is the $85 million unfavorable impact on operating profit from reporting non-monetary assets. Non-monetary assets really the big number here is inventories at the historical U.S. cost base. There will be no tax benefit because it really is just an accounting treatment. Basically the inventories on hand at the end of 2009 will not be devalued from a dollar point of view at the new translation rates in the 2010 P&L. Therefore we will have an unfavorable $85 million impact from that lack of devaluing them along with the revenues and the locally incurred costs.

The second item is a $50 million after-tax charge that is below operating profit and this primarily reflects what we have to do in terms of writing down our monetary assets as well as some undeferred tax benefits that we have. This is one we have talked about as well in the past in terms of we have quite a bit of cash because we are very profitable in Venezuela so the most significant part of this is a write down of that cash from a U.S. dollar point of view. Again, this is an after-tax charge. Both of these are nonrecurring as we look to operating and moving forward in that environment.

These numbers are not terribly different than I think what we have been disclosing in our 10-Q. I know a lot of you have actually complimented us for the full disclosures in what has been a totally uncertain environment. I am hoping these few charts here really clarify what the Venezuelan impact is on us particularly in 2010.

So our long-term outlook remains unchanged. We are on track to deliver at least mid single digit local currency revenue growth and operating margin improvements in 2010. As stated previously, we still expect operating margins to reach the mid teens levels by 2013. Our commitment continues unchanged and it is sustainable, profitable growth.

With that I would like to turn it over to the operator so that we can start the question and answer period.

Question and Answer Session

Operator

(Operator Instructions) The first question comes from the line of Christopher Ferrara – Bank of America-Merrill Lynch.

Christopher Ferrara – Bank of America-Merrill Lynch

I wanted to get into the Venezuela thing. I understand the $85 million transaction drag. It seems like it is essentially legacy pre devaluation inventory sitting on the books you have to filter through. The question is when you think about 2011 or even run rate for second half 2010 into 2011 what is the Venezuelan impact? In other words the 85 seems like it is temporary but what about the third piece which you didn’t talk about or quantify in the 8-K which is the ongoing impact? Just the general devaluation impact. Is that just that 10% of your profits or 11% of your profit hit by 50% because the transaction drag was already covered with the 85?

Charles Cramb

Not at all. First, you are right in terms of the inventory on the books. That should filter through to the first half of the year, or 6-7 months. When you think about it longer term if all that ever happened was a translation of the results then I think you are correct. When we think about Venezuela however, when we think about countries who saw hyper inflation you always manage against that environment. You don’t do things that are illegal.

We know Chavez has been very strong in terms of don’t be egregious on price increases and we would never do that but in a highly inflationary environment you are certainly going to manage the business either in the cost structure, in trying to get the gross margin up and if I think about that a little bit I think about our business model which is fabulous in terms of we have a business model that enables us to really manage the mix of the products we want to sell. I think product line simplification really shows us some of the power of that and throughout the company.

As we think about managing the mix and changing the portfolio of products that we may want to really emphasize we can actually reset our store with every catalog. So unlike traditional retail literally every three weeks or so if we wanted to and if we thought it would be conducive to improving the Venezuelan performance we will be able to reset the store and I think gain back much of what we lost. We are not going to get it all back overnight. There is no question about that. That Venezuelan market has been a great one for us. We are a market leader in the beauty products and play a leadership role. I can’t predict what is going to happen with currency. I can’t predict what is going to happen in that environment which is highly inflationary. It is hyper inflation now but I feel very, very confident we will see an improvement versus just that straight devaluation in the Venezuelan business particularly when you look well into 2011 and beyond.

Operator

The next question comes from the line of Nik Modi – UBS.

Nik Modi – UBS

If you could talk about the RVP expenses and how we should think about that going forward, is there a lot more coming or should we think about this growing in line with sales? Can you provide some perspective there?

Charles Cramb

As part of our turnaround we did significantly step up our RVP and we talk about the need to have stepped it up which has been a great driver in terms of our active rep growth and productivity. I think as we look to the future we will be spending or investing in RVP at a rate that is somewhat higher than our overall sales growth rate. A significant part of that will be in developing web enablement tools for our representatives to help them grow their business. So if you are trying to think about future P&L structure, assume that RVP will grow somewhat ahead of sales but it is not enough to [step up.]

Operator

The next question comes from the line of Lauren Lieberman – Barclays Capital.

Lauren Lieberman – Barclays Capital

Could you talk a bit about the U.K.? I that is historically a really strong market for you and it feels like at least from what I get to read in the newspaper that things are starting to get a little bit better there rather than worse. That wasn’t really the case in what you saw this quarter.

Andrea Jung

I think from the year point of view we really I think held our business very nicely in what was one of the toughest economies in 2009. I think that it is going to get a little bit better in the U.K. Cautiously optimistic and I feel good about the 2010 prospects for the U.K. I think their fundamentals are extraordinarily strong. The field execution has been terrific. I was just with 19 of our leading sales managers from the U.K. this week and I would say they have had an impressive performance through the year and they are optimistic that with some tailwind from the economy slightly improving, the brand strength as well as the investments we continue to make bode well for us in the U.K.

Lauren Lieberman – Barclays Capital

So when we are thinking about momentum because I always think about momentum being so critical in the direct selling business you would characterize the momentum in the U.K. as actually being positive, not negative at this point?

Andrea Jung

The reps were up 9% in the quarter. It was an average order pressure which did offset that environment. In the U.K. which has far less non-Beauty than the U.S. for example but still it was a larger quarter of non-Beauty in the year. I don’t see anything from the early launches we have had in Beauty that would say it wouldn’t be an improving trend line in the U.K. in 2010.

Operator

The next question comes from the line of Douglas M. Lane – Jefferies & Co.

Douglas M. Lane – Jefferies & Co.

In the press release you outline about $875 million of cost savings coming down the pipe in 2010. Can you give us a feeling for how much of that you expect to reinvest in the business and how much you think will drop to the bottom line?

Charles Cramb

First in terms of what is outlined from a benefit stream point of view that is since the inception of the program, it is not incremental in 2010. I just want to make sure we are talking about the same thing there. In terms of how we are looking at the business right now, given we feel we will be increasing our operating margin I think you have to as you think about the components of it believe we are now at that point where before historically we have been reinvesting in our incremental advertising, incremental RVP that will be shared somewhat between investment and earnings per share. It is not an exact formula as to how much goes one place and how much goes another but it is fundamental in terms of our delivering improved margin next year.

Douglas M. Lane – Jefferies & Co.

Your improved margin comment is a GAAP comment in that you will absorb the Venezuela hit and still be able to expand margins, correct?

Charles Cramb

That is correct.

Operator

The next question comes from the line of Connie Maneaty – BMO Capital.

Connie Maneaty – BMO Capital

In the third quarter you mentioned or the 10-Q that Venezuela was 5% of sales and 11% of profits. I am wondering how it ended up for the full year given the growth in the fourth quarter and secondly in which quarter in 2009 did you start reporting how your transaction comped? The third question is how do you know you will get the 4.3 rate instead of having to use the parallel markets?

Charles Cramb

One, one quarter doesn’t significantly change the contribution in Venezuela in 2009 so roughly those percentages are fine. Second question, you don’t know whether or not the rates are going to move and whether or not we are going to be using the parallel rate right now. The economic literature and our discussions with our auditors says the best rate we could use in terms of planning for 2010 is the non-essential official exchange rate. So that is the one that we are planning on right now.

The third question, the transaction exchange hits really started coming in the first quarter of 2009. Remember there is a three month lag since we carry about three months of inventory. So when the currencies all moved dramatically in the fourth quarter of 2008 we didn’t see a significant transaction cost, there was some transaction cost but the real stuff or the real significant impact on our P&L started in the first quarter of 2009.

Connie Maneaty – BMO Capital

So I guess that means that excluding what you have to do with inventories the real impact going forward is the translation impact since you will have already absorbed a full year of higher transaction costs, right?

Charles Cramb

Yes. Actually this is probably a good time. You are right. We still have some fourth quarter carry over into the first quarter 2010 negative but if you are on the screen, I put together two charts for this presentation. This is just to give you an idea of what happens with transaction exchange. It is really two big buckets in terms of what is happening in Latin America and the cross rates to the dollar. As you can see we had about $77 million of transaction exchange in the P&L this last year. In Europe it is really the cross rates to the Euro as well as to the other large countries where we manufacture. That is almost $120 million and a lot of others mostly due to Canada, the U.S. and some of the Asian currencies.

That’s what happened in 2009. So everyone thinks if that is where it stays those costs are good. As we move into 2010 you can see we do have some favorable movements from a transaction point of view but the percentage changes are nothing as big as they were negatively in 2009. Net result is when everything flows its way through from a timing point of view we do expect to benefit in 2010 by about $50 million. So there will be some transaction benefit in 2010. Then the other piece of it as you quite readily point out is translation exchange should run in our favor in 2010 if the rates hold where they are today. Does that clarify it for you?

Connie Maneaty – BMO Capital

So it sounds like the transaction benefit that hits mostly then in the second half.

Charles Cramb

That would be more second half loaded, yes.

Connie Maneaty – BMO Capital

And the translation is on an all in basis so your negative with Venezuela for the whole year and positive with most other currencies.

Charles Cramb

Certainly for the first three quarters because we have a fourth quarter this year that has beneficial rates.

Operator

The next question comes from the line of Ali Dibadj – Sanford C. Bernstein.

Ali Dibadj – Sanford C. Bernstein

A quick follow-up on Venezuela. Given that it is such a big impact on the year with cost of $0.70 to $0.80 of which maybe $0.25 or $0.30 are kind of ongoing I guess besides the one-timer. I am trying to understand, if you were to look back given that it has become again 11% of your operating costs, what would your growth have been in Latin America and as a company overall in 2009 without the benefits one got from Venezuela?

Charles Cramb

I can’t do those numbers in my head that fast. If I took Venezuela out of Latin America we would still have very strong growth in Latin America. The fundamentals in the business across all of the geographies within Latin America are good. Yes, Venezuela was one of the stronger performers so it would dampen it a little bit but from a business fundamentals perspective and a growth perspective it would still be very, very strong growth. Obviously when you think about the total company it diminishes even more. We are talking small numbers in the scheme of growth numbers.

Ali Dibadj – Sanford C. Bernstein

11% of your operating profit, 40% is Latin America so you are talking one-quarter or one-third of Latin America growing at 30% pricing, i.e. margins growing pretty highly. It feels like there is some sort of amplification effect when you get to the bottom line right? I know the number is on the back of the envelope 4-5 points of growth. Is that it?

Charles Cramb

I have numbers to put on top of that but I would have to work it out. I can’t do it on the conference call. You are right, Venezuela does have a higher margin than the total company.

Ali Dibadj – Sanford C. Bernstein

The other question I had was on balance sheet and cash flow. Clearly good progress on the cash flow. You had told us back in October I think very helpfully so that you are going to see some volatility. Is this the turning point? Are you really going to see much more net income matching to cash flow going forward? How should we think about that as a concern or something to watch for? In particular if you could give a little bit more detail on this prepaid expenses line? That again that has gone up by about 35-36%, much higher than your sales. So a bit of help there would be great.

Charles Cramb

Sure, I think because we haven’t closed out the 2009 restructuring program it is awfully hard to comment on what the differential might be between cash flow and net income in 2010. I do think the significant swings we had really starting with the 2005 program, I think they are moderating but there will still be some mismatching going on particularly quarter by quarter but also for the year. I do expect cash flow to improve in 2010 all in regardless of what happens with those programs.

In terms of the more technical question what is going on prepaid expenses and other. It is up a lot. It is really three big buckets. The first one is just the currency impact. That added about $100 million. The second one is the deferred tax account. The third one is VAT as our business grows in countries that have VAT particularly Latin America and if you think about the European countries that VAT account fills. In addition in Brazil there are some government deferrals in terms of their refunding the VAT program back to companies. That should start to flow out towards the end of the first quarter, early second quarter of 2010. So those are the three big chunks of what is happening in the prepaid expense and other line.

Ali Dibadj – Sanford C. Bernstein

This quarter what was the big driver of the cash flow improvement? You listed a couple on the page but I just wanted to get underneath it.

Charles Cramb

I think it is our working capital management. I think I haven’t really thought about it in terms of what the big driver is. I think it is all elements. I look at that balance sheet and say it is all elements working. When I look at the cash flow I like to look at the net debt number, that $250 million reduction and I think about our containment of capital expenditures as well. I think last year it was near $400 million for instance on CapEx and brought it down to under $300 million this year. So it really is all components that we did pretty well on.

Operator

The next question comes from the line of William Schmitz – Deutsche Bank Securities.

William Schmitz – Deutsche Bank Securities

Can you talk about the U.S. and if there is a sense of urgency in fixing the business? Earlier in the year there was a theory you were going to get great rep growth because the economy was soft and all of these reps were going to be great contributors and it was going to be additions to the inquiries and they were really high. It doesn’t seem like it is translating into unit growth at all. Is there a fix in place or a merchandising change or anything beyond what you talked about at the analyst meeting as kind of an emergency fix to the U.S. business?

Andrea Jung

The U.S. in terms of the express business is still a challenge obviously in terms of average order. To break it out a little bit yes you are right. If I look at the year additions were up very, very strongly and ending staff which is always a very good metric was up 10% so for us that is double digit ending staff bodes well. Flowing it through obviously average order and activity are the pressure on that. If I just even go underneath it, maybe this will help you a little, we are in this transition and this pressure of non-Beauty as we strategically reshape the mix. It is going to take time to play out but I am encouraged by certain things.

If I go under activity for example, which is down somewhat. Down less than a point but down. If I look at representatives who sold beauty their activity improved actually several points. It is about flat to those who are selling the fashion group and it is down 7-8% for the home representatives who sell home. So you are going to see that pressure on activity as well as obviously the average order compression in that category. That has is a big [play] and does not allow what I think are really strong field fundamentals that bode well for the future to play themselves out as you are looking at the numbers.

I think that we have clear plans in place to drive the sustainable recovery and obviously average order and productivity growth. We said we thought I think in October this would take about 18 months. We are very much driving that. You can be assured without taking it through every little plan that everyone in the U.S. organization is driving pretty hard to achieve that hopefully earlier. If we get some tailwind in the economy we would certainly like to see growth in the second half. It is the same strategy. I don’t think we need to have knee jerk reactions.

I feel very, very good that the fundamentals are in place and if I peel, which we are doing every day, the numbers back it still says the field strategy, the recruiting strategy, the lead strategy and the focus on activity and where we are losing it versus where we are not speaks strategically we are doing the right things. This movement away from non-Beauty as you know it isn’t going to get pretty in a quarter or two but it is the right thing to do.

William Schmitz – Deutsche Bank Securities

Can we talk about China for two second? Can you separate sort of the lost sales from the Beauty Boutiques closing down and less activity there from the trends in the underlying business?

Andrea Jung

It is a complex evolution and I think that is our word for it. We are flat in the middle of this transition. The BB sales are obviously down significantly. It is interesting because their activity is down slightly and actually the number of BB’s is still largely the same. It is really their average order size. Their average order size is down significantly although the fall off in activity and the number of them is less than I would think. Alright? So that is sort of how I am looking at the BBs as the business is transitioning to more direct sales and the results are reflecting that shift, their pressure is mostly and wholly in their average quarter size. We had a successful launch of Retroactive, the number one SKU in that market, and the recruiting still remains strong. We have to focus obviously in sales promotion activity. That has been a long stated as we have brought this many sales promoters into the business that is really the managing teams number 1-3 focus there. There is no change in the long-term. It is choppy as we go through this transition.

William Schmitz – Deutsche Bank Securities

Does that mean the economics are too lucrative for the Beauty Boutiques? They are still 4-5,000. Wouldn’t they close if they weren’t making any money?

Andrea Jung

We are looking at everything. Value chain of each segment and obviously making sure that we are focused on the return on investment in each segment in regard to where we see the future growth. So this is all part of this complex evolution and transition and obviously that is where we are going to see some continued pressure. Again I feel good about the model. I just answered your question on the shift from non-Beauty to Beauty. It takes time. So I think we are strategically doing the right thing.

Now I am talking about shifts between BBs and [DS]. These are the only two markets in Avon right now that have been having structural transition that is important and the right thing and we have seen through the end of it the right place on both markets. Is that helpful?

Operator

The next question comes from the line of Mark Astrachan – Stifel Nicolaus.

Mark Astrachan – Stifel Nicolaus

Relating to price mix if you could just sort of walk us through some of the puts and takes and your views on how that should look in 2010? In particular in Latin America where in some of the larger markets there it seems like some of the competitors are more than willing to take pricing. Is that something you would consider following sort of hand in glove there? A second and sort of related question, one of the slides in the presentation sort of peaked my interest and looking at the growth in the value segment from a Beauty standpoint versus [inaudible] and it sort of looked like a lot more growth this quarter than it has been in prior quarters. I know you have talked a bit about not having a whole lot of an impact from a margin standpoint but I am just wondering if that still sort of holds true and sort of what your thoughts are on the impact of the value segment growth going forward?

Andrea Jung

Let me just answer the fourth quarter and the value segment and maybe Chuck can take a larger view of where we are in the price mix and we feel good about that. I think that is timing of launches and products I wouldn’t look at the fourth quarter independently from the full year as it relates to tier growth. We basically had very nice mid single digit growth in all of the tiers when I look at it as we came out of the year. That to me is well balanced. I think the flow of kind of color and personal care launches and/or focuses in some of our brochures may have delayed it somewhat but I don’t see as we go forward that it is unbalanced.

We think there is a new consumer, which I think is healthy, value equation where good innovation and terrific opportunity to get into the brand and enjoy the product there will be a nice balanced mix and that we will continue to flow from our value products even if economies start resuming in the U.K., etc. we are not going to get off our Smart Value program. We think it is going to be evenly balanced to sort of pricing in terms of some of the categories like skin care and fragrance.

As it relates to meeting competitor’s pricing I would just say you have to remember it is really going to be very much where we originally priced versus where they were priced. There are some markets where we have had competitors higher priced than us. We can’t really speak to their pricing strategies but ours are done with very careful analytics of where we have pricing power by segment and by tier. We have been very successful at that and I think we have got the right parameters this year and next year.

Charles Cramb

I think you pretty much hit it. Given our market leadership particularly in Latin America most markets we have the leadership or shared leadership position. There is no question we have pricing power and we have seen the sustainability of it. If I look to 2010 and beyond there will continue to be pricing opportunities. We will also be continuing to improve mix. I think they can go hand in hand but the most critical part of that is as Andrea mentioned we have the analytics behind it. Those analytics are constantly reviewed. When you are talking about dynamic markets where competitors do change prices both up and sometimes down.

I think we are on top of that. Right now our prognosis for next year is we should benefit from both a price and a mix improvement.

Andrea Jung

Our success at defending market share has really been in the investment in brand advertising including advertising and channel investments really against technology and the structural commission changes and/or leadership program as opposed to discounting or pricing which we don’t think is a structural change. I think we have got good gross margin power now and that has taken us four years of significant investment our competitive defense in markets are really a strategic blocking of very, very competitive technology and brand power.

Charles Cramb

Brand power being critical. We have built the brand equity over the last four years.

Operator

The next question comes from the line of Wendy Nicholson – Citigroup.

Wendy Nicholson – Citigroup

Just a follow-up on Bill’s question on China. Can you say the percentage of revenue split between what goes through the Beauty Boutiques and direct selling right now?

Andrea Jung

It is going to be less in Beauty Boutique. So less than half.

Wendy Nicholson – Citigroup

On the tremendous rep count growth in Europe, both Central Eastern and Western Europe was there something strange in the quarter from a humongous promotion or a gymboree or something that brought all that growth in? I am wondering how sustainable that is. Obviously you have got very easy comps on the local currency side in both of those markets going into the New Year. Should we have confidence you are looking at double digit local currency growth in both of those markets for the first half?

Andrea Jung

I would just say that we think structural investments paid off. These changes are sustainable because it really wasn’t about one quarter for the recruiting drive. It really was about sales leadership really taking hold whether it was in Turkey or whether it was in Russia. It was about the commission changes we put into Russia really driving rep value proposition from a structural basis. We were just there, four markets in Central and Eastern Europe last week, and I have to say I have never felt better about the sustainable growth strategy. Obviously we have the translation of Venezuela but I have to tell you Central and Eastern Europe’s growth at those kinds of margins is a very nice offset.

Charles Cramb

We are not going to comment on your question in terms of give me a little guidance on first half sales but we do believe what you are seeing from a rep point of view is not a little blip. That should be better sales revenue and great productivity coming out of those regions.

Operator

The next question comes from the line of Andrew Sawyer – Goldman Sachs.

Andrew Sawyer – Goldman Sachs

A quick follow-up on the Western European piece. With the strong revenue growth you called out Turkey and the U.K. was down slightly. Which countries geographically were the big contributors there to the growth beyond Turkey?

Andrea Jung

Believe it or not South Africa, again it is not the largest market but it is one of the fastest growing. It is actually very good direct sales and very good Beauty market. Grew again at Turkey’s rate in the 30-40% for the second half. Actually in Continental Europe very, very strong performance in Italy. Very strong performance in Portugal. So very balanced growth. It has certainly exceeded our expectations going into a tough recessionary region in the world. We were really pleased with this performance.

Operator

The next question comes from the line of Linda Bolton Weiser – Caris & Company.

Linda Bolton Weiser – Caris & Company

I was wondering if you could talk a bit more about Mexico. It seems like now you are talking a little bit more about that market being impacted by the macro factors a bit more. Do you consider Mexico a mature market? Can you comment on what the rep growth in Mexico was in the quarter? Also for the Eastern European market can you talk a little bit more about the other country performance in there and can you tell us roughly what percent Russia is? Is Poland still the second biggest market in Eastern Europe and how did Poland do in the quarter?

Andrea Jung

Let me start with Mexico. First of all I don’t think the fourth quarter is reflective of 2009 performance or 2010 performance. We will just start with that. Yes, the economy and the GDP are a little bit weaker in Mexico and for me mostly if I get tactical about it we had an extraordinary fragrance margin last year in Mexico. This year they were good. Not as good. Not as great. So that category which I think was a launch on launch comparative was weaker. That was really mostly the attribution of the campaigns internally.

Mexico has sustainable turnaround. The fundamentals are very strong and certainly as Chuck said it is a tough environment. It is one of the ones where GDP got worse in the fourth quarter and then better. It is a little bit more mature than some of the other markets in Latin America but I think it is still in our minds a strong fundamental market. We are looking for good growth in 2010 outpacing GDP again. So I feel good about Mexico. Nothing has changed in terms of my confidence in their healthy fundamentals.

Eastern Europe, other performances. The Ukraine really managed through the crisis incredibly well. Very strong sales growth. Our revenues were up 37% in the quarter. We had a tough first half in the Ukraine as you know with the devaluation and what we were facing as we came out of 1Q and we had to move through pricing recovery following that massive devaluation. For the full year up 20% in local currencies in the Ukraine. Reps were up 18% in the quarter. Very strong recovery in the second half in the Ukraine and the team in Kiev I feel very good about how they have managed through the crisis and what their prospects are.

Poland, also really recovered to growth. Nice quarter. A lot of the markets in Central and South Europe obviously showing nice turns. Same thoughts. We really put a tremendous amount of our investment on Russia first but what is true for Russia is obviously true for the rest of Central and Eastern Europe. The strategic tenets and investments. We are investing more in Central Europe as well in 2010 and we saw a nice uptick there. The other two large markets in CEE are Poland and the Ukraine and both did very nicely in the fourth quarter. Russia is about half I guess we said of the region.

Operator

The next question comes from the line of Alice Longley – Buckingham Research.

Alice Longley – Buckingham Research

I have one technical question. You said transaction is likely to be a $50 million benefit this year. Does that exclude the $80-85 million inventory hit in Venezuela?

Charles Cramb

A great clarification. Yes it does. I did not put that in, in terms of how to think about transaction exchange for 2010. You can X those two off if you want [to stay] at that historic dollar reporting is transaction exchange.

Alice Longley – Buckingham Research

Just to repeat you still think your operating margins will be up net of that $85 million negative impact in Venezuela?

Charles Cramb

At this point in time yes I do.

Alice Longley – Buckingham Research

Also related to Latin America when you get these huge devaluations at least historically you get fairly rapid offset in local currency pricing. Could you comment on that for Venezuela? Also, there are a lot of moving pieces in Latin America now with currency being negative in Venezuela but positive in other countries. Is it fair to think that putting together organic growth in Latin America and currency that Latin America sales are likely to be down in 2010?

Charles Cramb

No, definitely not. I would be shocked.

Andrea Jung

I will have Chuck talk to the inflation and pricing in Venezuela in a minute but just…sales in Latin America we think we are going to have another very strong year in Latin America. It was a terrific year in 2009 but the fundamentals really have never been better and inclusive of Venezuela we see a very, very positive year in Latin America.

Charles Cramb

In terms of your country specific question about Venezuela, yes traditionally when you go to high inflation or hyper inflation pricing follows. I think there is a lot of sensitivity because there are government rules about not being egregious in those price increases. We certainly will not do anything even though we have market leadership there, we will not do anything that will violate the spirit or the intent of any rules that come from Chavez’s legislation. So that is a little bit of an uncertainty. But I think we just look at the fundamentals of the business in Venezuela in terms of the size of our active rep base, the size of their sales performance and productivity. Sure there will be a little bit of reported disruption but it is still going to be a great market for us in the near-term and the long-term.

Andrea Jung

I think that ends Q&A and certainly any other questions you can call into IR. We appreciate everybody’s interest and support. We feel very, very good about 2009 and think we have great momentum going into 2010. Thanks everybody. We will talk to you soon.

Operator

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

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Source: Avon Products, Inc. Q4 2009 Earnings Call Transcript
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