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Avon Products, Inc. (NYSE:AVP)

Q1 2010 Earnings Call

April 30, 2010 9:00 am ET

Executives

Andrea Jung – CEO

Charles Cramb – CFO

Amy Chasen - IR

Analysts

Lauren Lieberman – Barclays Capital

Nik Modi – UBS

William Schmitz – Deutsche Bank

Wendy Nicholson – Citigroup

Alice Longley – Buckingham Research

Andrew Sawyer – Goldman Sachs

Connie Maneaty – BMO Capital

Ali Dibadj – Sanford C. Bernstein

Mark Astrachan – Stifel Nicolaus

Linda Bolton Weiser – Caris & Company

Jason Gere – RBC Capital

Victoria Collin – Atlantic Equities

Douglas Lane – Jefferies & Co.

Christopher Ferrara – Bank of America-Merrill Lynch

Operator

Good morning. At this time I would like to welcome everyone to Avon’s first quarter earnings conference call. (Operator Instructions) I’ll now turn the conference over to Amy Chasen, Group Vice President, Investor Relations.

Amy Chasen

Good morning, thank you for joining us to discuss Avon’s first quarter results. With me on this call are Andrea Jung, Avon’s Chairman and CEO, and Charles Cramb, Vice Chairman and CFO. I refer you to the cautionary statement in today’s earnings release as well as our non-GAAP reconciliation in the appendix to today’s slides which is also available on the Investor Relations section of our website.

As you’ve seen this morning our press release now has a reconciliation between GAAP and non-GAAP measures to help you better understand the underlying performance of our business. We hope you find this new format useful.

In this quarter we’ve adjusted GAAP measures for CTI as well as the Venezuelan special items. Today in the call we will focus only on these adjusted non-GAAP financial measures. With that I’ll turn the call over to Andrea.

Andrea Jung

Thanks Amy, good morning everyone. We feel great about the performance of the business in the first quarter, with 14% growth, 8% in constant dollars, as well as healthy operating margin expansion on an adjusted basis. We started the year off with strong momentum. In fact this was the second quarter in a row where Latin America and Europe combined grew at a constant dollar sales rate of 15%.

That’s an exceptional performance across 70% of our portfolio given the continuing economic uncertainty around the globe. As you saw this morning beauty sales and active representatives were also both up nicely. So we anticipate this will be another quarter of market share gains for Avon.

So we came out of the gate very strongly as we start the year and Charles will give you full details about the first quarter performance in a minute. However I just wanted to begin my remarks this morning with some comments about China, which I know is top of mind for many of you.

I’ll talk specifically about our business performance but first I just want to share my perspective on our FCPA investigation in that market. Given that this is an ongoing investigation and the facts are still under review we’re limited as you well know in what we can say but I want to be as responsive as I can and recap the status of our investigation to the extent possible.

Avon disclosed in October, 2008 that an allegation had been made about possible FCPA violations in our China business relating to travel, entertainment, and other expenses. The allegation came in the form of a letter written directly to me. As you would expect I immediately turned the information over for proper handling and we began an internal investigation under the oversight of our audit committee and conducted by outside counsel.

Most importantly we voluntarily self-reported the allegation to the United States Securities and Exchange Commission as well as the Department of Justice and again this was voluntary. China is a unique and highly regulated market with its own specific requirements. Nevertheless as a company that holds leadership positions in developing and emerging markets we are also conducting compliance reviews related to FCPA in additional countries.

We disclosed this in July, 2009. I want to clarify that we are conducting these compliance reviews in a selection of markets representing each of our four international business units outside of China. I also want to emphasize again that the allegation that triggered our investigation was in China only. Conducting compliance reviews in these additional markets is the appropriate thing to do in investigations of this type and as we stated, we’ve been cooperating with both governmental agencies.

Three weeks ago as you know four associates were placed on administrative leave specifically in connection with the China investigation. The decision to put people on administrative leave does not reflect any outcome from the investigation. Given this, and given that the associates are not senior executive level officers of the company, we did not file a disclosure and name the names. So that’s where we are in terms of FCPA.

No conclusions can be drawn at this time and as I said the investigation has been going on since 2008. We’ve seen very little management distraction and I’m pleased that from what I can see everyone all around the world is focused on running the business as we want them to be.

So with that now I just want to turn a discussion of our business in China because this was our challenging performance in what was otherwise a stellar quarter. You saw in the press release that we had significant sales decline in this market in the quarter as well as a decline in active representatives.

The effectiveness of incentives was a factor but the larger issue relates to fundamental challenges in our hybrid model. Managing the inherently conflicting needs of retail and direct selling has ultimately constrained both. Over the past year as we’ve shared with you, we’ve begun the complex evolution towards direct selling. Our 2010 results will continue to reflect our decision to significantly accelerate the pace of this transformation.

And this includes the end-to-end realignment of our value chain to support direct selling and de-emphasize retail. What does this mean? It means that we will manage China similar to the way we manage our other markets around the world, all field management and marketing will now be 100% aligned to support direct selling.

Our over 500 employed district sales managers will focus solely on driving direct sales, no longer having to expend energy trying to oversee a hybrid model. We’ll also recalibrate our merchandising and campaign management strategies to deliver direct sales brochure energy to the appropriate piping, frequency flow, and number of pages.

In addition we’ll simplify and tightly calibrate our sales incentives to more effectively motivate and engage our direct sales force. These changes in sales and marketing management will be supported with a realigned field compensation structure. Currently we’ve got two distinct discount structures, one for retail and one for direct selling.

Retail gets preferential treatment. Importantly we will equalize the discount and create one compensation system which is fully aligned to the needs of our direct selling channel. With this change beauty boutique owners who don’t engage in direct sales will be negatively impacted. Those that do however will have a significant upside opportunity.

As we de-emphasize retail we will significantly expand our current service centered network. Right now we’ve got a little over 5000 beauty boutiques. About one third of them already actively engage in direct selling by providing service center support for sales promoters. The other two thirds will need to decide whether to fully embrace direct selling.

The choice is ultimately up to them, but we anticipate that another one third will successfully transition to the updated service center model. The remaining one third will likely stay in retail and will see attrition over time.

At the end of the day we expect to build an asset like service center network which far outpaces our current number of beauty boutiques and this will enable us to significantly expand our overall direct selling penetration, coverage, and productivity.

So that’s a high level view of how we’re going to accelerate our direct selling transformation in China. We’ve spent the last 12 months developing the blueprint for the updated model. Implementation will begin over the summer and will continue in a phased rollout through the first half of 2011. This will enable the requisite IT and training support. There’s going to be the inevitable learning curve as we go through this change so we believe we’re looking at an 18 month window before we see the updated model taking hold.

This will be a comprehensive and complex transition for sure. We have a strong experienced sales and marketing team on the ground in China supported by regional and global centers of excellence. In addition today we were pleased to announce to our associates that we’ve named a General Manager for China. Rene [Ordonia] is a 25 year Avon veteran to lead the next phase of this market’s growth.

He was formerly the General Manager of Southern Latin America when he oversaw a cluster of countries anchored by Argentina. Under Rene’s leadership Argentina has achieved the highest representative coverage ratio in Avon with almost eight representatives for every thousand customers.

Argentina also has one of the strongest beauty image indexes of any Avon country. So we’re deliberately and carefully transferring the direct selling expertise we have cultivated in our number one region and bringing one of our most experienced and respected General Managers to China to lay a strong direct sales foundation for the future.

So we anticipate this is the beginning of a new day in China. We currently still have over one million sales promoters in this market. Our goal is to unleash their activity and their productivity. Our brand image in China remains strong and we recently announced the opening of a new R&D center in Shanghi that will happen in the second half of 2010.

So we are reaffirming the important opportunity we have in China for both growth and healthy profitability over the longer-term. So that’s a perspective and some color on China’s strategic transition. Even with the decline in this market the company delivered exceptionally strong overall revenue growth in the first quarter. This speaks very clearly to the underlying strength of Avon’s balanced global portfolio.

Last October we told you we expected to enter 2010 in an even stronger market position and we’re seeing this play through now with consistent top line momentum across our business. We also told you that this was the year that operating margin would start to expand as we begin to reap the benefits from the multiple cost transformation programs that have underway over the past several years.

Excluding the impact of restructuring costs and Venezuela special items, we were very pleased to deliver 110 point improvement in operating margin in the quarter versus last year. This included increased strategic investment in advertising and the representative value proposition and we also successfully offset higher costs related to our internal investigation.

So we’re on the road to margin improvement as we said. We were also pleased to improve cash flow in the quarter through better working capital management. With this strength in profit and cash flow performance we were well positioned to fund new growth platforms and here I just want to note our recent acquisition in the quarter of Liz Earle, a UK higher tier brand with botanical ingredients and a natural positioning which compliments our own anti aging skin care and broader beauty portfolio.

It also represents an exciting longer-term opportunity for us to develop a stand alone Liz Earle direct selling representative channel globally. So those from me are some of the highlights of the quarter. The strategies are working. Our key performance indicators of the business look healthy. We started the year off with strong momentum and I feel very good about the outlook for the year.

So that I’ll turn it over to Charles.

Charles Cramb

Thank you Andrea, well I think we’ve had a great start to the new year, if you think about some of the highlights we’ve had for the first quarter in constant dollars our revenues were up 8% with currency that was 14% reported.

Active representatives were up 6% and as Andrea said we’re going with the China situation, if you exclude it, it would be actually up strong 8% in active rep growth excluding China. And we maintained good balance between both units and price mix, each of those was up 4% adding up to the 8% constant dollar growth.

Our beauty sales are up pretty much in line with our overall growth at 7% driven by 3% unit growth. In terms of the operating margin on an adjusted basis the operating margin was up a full 110 basis points and the cash flow benefiting from strong work capital programs is up $78 million year on year.

Moving into the geographies starting with Latin America, it was really another good quarter of double-digit sales growth. Overall revenue growth, you can see this at the bottom, was up 14% in constant dollars. And its well balanced between active rep growth at 7% and average order size at 7% as well.

I’d like to call out a couple of countries, one is Brazil, Brazil continues with its double-digit growth of 12%. Venezuela is up a strong 41% in constant dollars and there what we’re seeing is benefits from 2009 pricing as they annualize in 2010. We’ve actually taken very little pricing in 2010, that is part of our overall strategy, take the prices on a lag basis when you’re in a high inflationary environment.

So little pricing in 2010 and as a result what we’re seeing are the volumes are really holding up in what has to be defined at best is a difficult economic environment. Therefore we believe that we are gaining share in that market.

Then in Mexico we’re back to positive growth after that slight decline that we reported in the fourth quarter. I believe this is good evidence that our turnaround plan continues to work well. For the region the operating margin is favorable 170 basis points. It benefits from the strong sales growth and the leverage impact of that sales growth.

In addition we’re getting strong strategic sourcing benefits and not only is it in product costs but its also through the indirects and here we’re seeing some of the great programs that we’ve implemented particularly in areas like paper and brochure costs coming through.

Moving to North America, its on track with the 18 month recovery plan that we’ve outlined to you. Overall revenue decline has slowed to about 3%. The active rep growth is 2% and the average order size is down about 5% due primarily to non-beauty sales. The operating margin is up 400 basis points versus the first quarter of last year. And that operating margin is benefiting from lower obsolescence costs as well as favorable mix and a major item here is that we have significantly lower post-holiday clearance sales and a good part of that can be attributed to the de-emphasis of the non-beauty business.

In addition we are seeing lower distribution costs coming through due to the Zanesville, Ohio distribution center as it starts to gain efficiency. Now we are only at the beginning of that North American recovery so we do need to expect some variability quarter to quarter in terms of our revenue performance and our margin performance.

Moving now to Central and Eastern Europe we saw strong double-digit sales growth, some 16% up and its led by active rep growth and also average order size, both of them benefiting us favorably. Why? Well our investments in RVP and advertising continue to pay off in this market. And within it Russia is extremely strong, up 20% in constant dollar terms.

The operating margin is up about 150 basis points above a year ago. We’re getting the leverage from the strong sales growth but importantly as well we’re getting good performance in terms of our overhead expenses, whether we’re talking about people costs, facility costs, etc., and that helps in the leveraging that we’re getting from the sales growth.

In terms of advertising in this market, there’s also some margin improvement only because of timing of advertising investments this year versus last year. Advertising however was about equal to the level that we had in the prior year. And within Central and Eastern Europe there is some unfavorable transaction exchange that we offset in the quarter.

Moving now to Western Europe, Middle East, and Africa, again strong mid teen sales growth in this market. The revenue growth is 14% constant dollars and it is driven by the active rep growth. The average order growth is slightly down year on year and that’s due to country mix when you think about the strength of Turkey and the mix of the business as well as some good South African growth.

Turkey particularly, very strong, up 22% in constant dollars. Here we’re seeing the active rep growth and that active rep growth is coming from the investments that we’ve been making in both sales leadership, rolling that out through the market as well as RVP investments.

In terms of the UK, it too is positive now, up 2% and again benefiting from active rep growth. The operating margin in Western Europe is up 430 basis points. Like Central and Eastern Europe there’s some unfavorable transaction exchange, but what they’re really benefiting from, the strong sales leverage from the high sales growth, lower obsolescence charges, and significant product cost benefits from strategic sourcing.

Asia Pacific, another good quarter. Its up 2% despite the softness that continues in Japan and its really driven by a strong performance in the Philippines, we’re seeing 16% constant dollar growth and that growth is driven by the active rep growth in that market.

As a result the operating margin is up 410 basis points above the first quarter. Here we’re seeing expense controls benefiting us as overall costs are coming down and we’re seeing significant impact in terms of the margin from the country mix as Japan is the smallest piece of the business but the Philippines growing at strong 16%-plus growth rates, with a very high margin is changing the mix to our benefit.

Moving on to China, Andrea has covered really what’s happened on the sales line, I think I should point out that the operating profit, its swing about $25 million this year versus last year, an $11 million loss this year versus $14 million profit last year. Yes, there is a significant impact from the lower sales plus we have not pulled back on any of our longer-term oriented investments.

Now Andrea mentioned that we’re going to go through an 18 month transition and we’re going to be focusing more and more on direct selling through that transition. Well, what does that mean in terms of thinking about China going forward? I think in terms of this year, we should expect to incur a small loss.

I think as we turn to next year we should think about a business as probably operating at break-even or just slightly positive and then becoming profitable in 2012. Now let’s look at the income statement, first revenue growth is up $300 million, that’s up 14%, as I said 8% of that is constant dollar growth, 6% of that is currency.

Gross margin, gross margin on an adjusted basis improved from 62.9% to 63.2%, its up 30 basis points despite the unfavorable FX impact. And here the FX impact is effectively what we would call transaction exchange in Venezuela. I mentioned that we had some unfavorable transaction exchange in Europe, both Central Eastern Europe and Western Europe, that’s been offset by excluding Venezuela favorable transaction exchange in the rest of Latin America.

So under the term of transaction exchange and how you define it, the 80 basis points that you see here is primarily the Venezuela transaction impact. What is happening here, its really the manufacturing productivity favorable some 80 basis points. Why? Because we have strong cost reduction initiatives coming through.

We’re getting greater productivity in our factories through higher volumes and we’re seeing continued benefits of strategic sourcing. We’ve also called out that price/mix is about 30 basis points favorable in the bridge although its always been a little difficult in this business because of the trend we have in products to differentiate between price and mix. I think in terms of that price is favorable a bit more and mix is a little bit unfavorable in the combination of price/mix.

I think if we look at the P&L what we feel really good about is we’re continuing to invest in the business in both the brand and the channel while we’re controlling our overall costs. Think of advertising, its up $18 million or about 25% versus the revenue growth of 14%. And the advertising is going against both rep recruiting and product.

Now as we’ve said in thinking about advertising for the rest of the year, we expect the advertising to increase ahead of sales due to increased investments as well as the impact of media inflation which we are starting to see come back. So where first quarter is representative I think of what we’ve been talking about for the full year.

Same with RVP where we said it would grow slightly ahead of sales and it did in the quarter. And then on the overhead costs, they’re up some $80 million, the are impacted heavily by higher investigation costs related to the FCPA investigation. That’s an increase of about $18 million in the quarter versus what we spent last year.

Additionally in here will be higher costs related to foreign exchange. If I were to take out the FCPA costs overhead does come down as a percent of revenues growing slower than sales growth. Then looking at what happens from a bridge from operating profit to, from 2009 to 2010, between sales leverage and the strong cost controls we’re getting 110 basis point improvement.

We’ve picked up roughly 160 basis points on what I’ll call the operational things, that is taking out the impacts of currency and those are things we’ve already covered. In terms of currency translation exchange does add about 50 basis points to our operating margin due the relative weakness year on year of the dollar. Since our international markets have a stronger margin this really is a country or region mix benefit.

And then the transaction exchange has a cost of about 100 basis points. If I were to exclude Venezuela as I mentioned before, its about neutral but this would be the impact of the higher costs coming through from Venezuela against the much lower currency, two thirds of this would occur in gross margin and about a third of it in operating expenses.

Then to bridge you from our earnings per share adjusted to the earnings per share gap, you can see on this chart the impact of restructuring and really the big differential, the special items in Venezuela that Amy defined at the beginning of the presentation.

Now the balance sheet and the cash flow, and we’re really pleased with our overall cash flow performance in the quarter. The cash from operating activities was $78 million higher, better, that it was in the first quarter of last year. Within the balance sheet our total debt increased about $150 million and this is due to the normal timing of our cash flows.

Remember virtually all of our debt does sit within the US. The cash decrease that we saw of $189 million is from international and its due to the Liz Earle acquisition primarily. Accounts receivable, they are tracking pretty much along with our revenue growth, up with sales and still well below 30 days outstanding.

In terms of inventory when you adjust for the impacts of currency there’s an operational improvement of about seven days, so we continue with strong performance on the inventory side. And then our capital expenditures, they’re pretty much in line with our spending last year. The focus as I think we’ve talked about in the past is on our supply chain infrastructure initiatives as well as IT particularly in web enablement tools.

So looking at cash flow, the operating cash flow we said was up $78 million due to strong working capital management and here you can see where it is, it is all in the working capital which is favorable $80 million with big benefits coming from inventory, and also in accounts payable where during last year we announced the renewed effort and focus against this category.

So as we think about it, we are benefiting from the underlying strength of our global portfolio, in the fact that we do operate globally and how we balance one geography against the other, as well as our significant cost reduction programs.

Just think in 2009 we delivered an EPS of $0.30. In 2010 we have offset about $0.03 drain due to the impact of higher Foreign Corrupt Practices Act cost. About $0.05 of drain due to the impact of the one-time 2009 tax benefit that we received last year, and a $0.04 impact from the performance in China.

And we still delivered $0.33 adjusted EPS, up 10%. So how do we think about the year now? Well, we’re on track to deliver at least mid single-digit constant dollar revenue growth. We’re also on track to deliver operating margin improvement and at this point its both GAAP operating margin and non-GAAP operating margin.

And that’s despite the significant Venezuela devaluation and the subsequent special items. And also the higher FCPA costs and just a quick minute on that, its kind of difficult to forecast exactly what it will come out for the year, but we are assuming that the Q1 run rate of $7 to $8 million a year will continue throughout the rest of this year.

That would result in total year cost this year of $85 to $95 million. Those costs would include not only the continuation of the China investigation which up to now has been the predominant amount of expenditure but also for expanding geographically with the compliance reviews that Andrea described to you earlier.

The $85 to $95 million would compare to about $35 million that we incurred throughout all of 2009 and it was increasing as you went through the year of 2009 on a quarter by quarter basis. And then finally the China transformation where I told you that we shouldn’t expect a profit this year in China.

Longer-term our outlook is also unchanged. We believe as we think about the business that its appropriate to think of it in terms of a mid single-digit annual constant dollar revenue growth on average year on year. And on operating margin that will improve to the mid teens level by 2013.

So that’s our commitment, it remains unchanged, its all about long-term sustainable profitable growth. And with that I would like to turn it over for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Lauren Lieberman – Barclays Capital

Lauren Lieberman – Barclays Capital

I was wondering if you could talk a little bit about North America margins, I understand the idea that from here there’s still some volatility because of the transition in the business model, but just wanted to understand if we should still think about margin expansion every quarter this year, its just that magnitude will be different as we go through the year or could margins still be down year over year in a given quarter.

Charles Cramb

No I think you have to assume that there’ll be some variability in the margin performance quarter to quarter. Some of it will have to do with the development of revenue throughout the year on a quarter by quarter basis and also some of it will be due to the fact that within the first quarter we certainly benefited from what I would say on average be a lower obsolescence cost due to that clearance program or the reduction of it.

Also as we go through the year remember we’re running right now with a significant number of field vacancies that we do want to be filling and in addition we’re strengthening the field incentives, so, I don’t think you should assume progression this year. I think its going to be variable quarter by quarter on the margin.

Lauren Lieberman – Barclays Capital

Okay just to be clear, are you saying margins could still be down year over year in a given or do you just mean sequentially we should be thinking that way.

Charles Cramb

Both will happen, both could happen. We could have some margin quarter to quarter comparison that’s unfavorable, we also are not necessarily going to see steady progression quarter to quarter.

Lauren Lieberman – Barclays Capital

Do you have a sense of what the year over year swing will be in cash restructuring, just thinking about how it impacts your cash flow this year.

Charles Cramb

We haven’t necessarily announced all of our programs so I’ve got to be a little sensitive to that in terms of what we might or might not do, but as I’ve looked at it and thought about what I see coming from a net income perspective for restructuring versus cash outlay, I think we have about $100 million differential.

That is that the cash outlays will exceed restructuring by about $100 million. And most of that is tied up with supply chain initiatives, for instance, the Zanesville, Ohio distribution center and the Glenview closure and what happens is the cash payouts for those redundancy programs. Similar thing happening in Brazil and a couple of other countries where we’ve had some supply chain initiatives.

So its about $100 million difference negative as we’re looking at it today.

Lauren Lieberman – Barclays Capital

And that’s negative versus what’s in the P&L.

Charles Cramb

Negative cash versus won’t show up as a restructuring charge, yes.

Operator

Your next question comes from the line of Nik Modi – UBS

Nik Modi – UBS

Just a quick question on transaction, how should we think about that going forward, clearly the cross rates with the Central Eastern European currencies versus the euro have obviously gotten more favorable, how do we think about that in terms of the lag and then is this Venezuela, can you just help us think about how this Venezuela issue will impact that particular issue over the next couple of quarters.

Charles Cramb

In terms of the transaction exchange, when we came into this year we talked about I think it was a $55 million transaction benefit coming through the P&L to the company excluding Venezuela. We’re still tracking pretty much in line with that, in fact with the various cross rates and the mix of our business it may be down a little bit but its not a material number.

So I think in terms of thinking about those cross rates it will still be favorable in that vicinity. In terms of the Venezuelan one and I might continue to want to show Venezuela and talk about it separately because to me when you have hyper inflation and maxi devaluation sure you could call it transaction exchange because it kind of fits the definition, but it really is local inflation and if we were to continue to track at the level we’re tracking at right now, and we didn’t have any further mitigation, the total year would be probably be about $100 million adverse for the Venezuela situation.

And that’s pretty evenly spread quarter by quarter.

Operator

Your next question comes from the line of William Schmitz – Deutsche Bank

William Schmitz – Deutsche Bank

Just on the share repurchase I know the authorization was sort of $2 billion in 2007 and you only bought back $200 million of stock, is there anything sort of structural about that, the cash flow not coming in as you expected or is it because maybe of the restructuring savings are so back end loaded that there’s going to be a big repurchase later in the period.

Charles Cramb

No, I would say it was the, I’m looking for a word and I can’t find a good one, but I would say it was the calamity of the end of 2008 and what, the macroeconomic conditions that I think impacted all of our businesses. It drove us to conserve liquidity and that has been kind of the program now.

I know that that authorization is still outstanding. At this point in time I have not expectations to in the short-term anyway, resume share repurchase but it is a longer-term opportunity.

William Schmitz – Deutsche Bank

Because it expires in 2012 right.

Charles Cramb

Yes.

William Schmitz – Deutsche Bank

Do you still think a billion dollars of cash flow from operations is sort of the right number for this year.

Charles Cramb

I don’t think we said this year.

William Schmitz – Deutsche Bank

Maybe I’m just imagining that.

Charles Cramb

No, we talked about getting to a billion dollars and then sustaining it but that wasn’t meant to be this year.

Operator

Your next question comes from the line of Wendy Nicholson – Citigroup

Wendy Nicholson – Citigroup

My first question is just a follow-up from Nik’s when you mentioned the pricing you had taken in Venezuela last year, at what point in the year did you take that pricing so in other words when are we going to lap that and maybe not see such strong local currency growth. And then my second question is in the US business, the non-beauty business being down 6% how much of that was just I don’t now if you can tease out how much was just weakness in that segment of the market versus your specific actions if you will to take out SKUs in that portfolio.

Andrea Jung

On US, I think it’s a combination. I think that the non-beauty business being down in North America is a combination of structural refocus as you know as we’ve got this programmatic de-emphasis on several of the categories. And there still is more weakness in some of those categories than beauty which was flat in North America with some volume growth which we were pleased about.

Wendy Nicholson – Citigroup

But its fair to say that that 6% could actually get worse before it gets better because it sounds like you’re making some pretty dramatic actions to boost profitability and I assume part of that is taking a lot of SKUs out.

Andrea Jung

Yes, I think you’ve got to kind of just [divorce] kind of consumer recovery from that category for us because we want to de-emphasize.

Charles Cramb

On the pricing side in Venezuela those prices were taken throughout the year so it isn’t like they have one period where they took price increases so what I would expect to see is a gradual decline in the year on year benefit of the pricing.

Operator

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

Alice Longley – Buckingham Research

When you reported your fourth quarter you commented that strong momentum was continuing into the first quarter can you comment on what momentum looks like into the second quarter now particularly in the three regions, Latin America, Central and Eastern Europe, and the Europe, Middle East, etc.

Charles Cramb

That’s awfully close to guidance. I think what I would say is that we continue to feel very good about our performance in terms of growth prospects. I’m not going to give you region by region projections but Latin America continues to be a very strong hold for us. I think if we look at the European businesses again strong, although in any given quarter there’s some variability.

So I think from the fundamental side of the business and from the strength of the beauty business and from what we’ve seen in terms of our gaining share in the marketplace we feel reasonably good but any further detail on that would be too close to guidance I think.

Alice Longley – Buckingham Research

My other question is North America what is in your mind as to where your margins can end up being in North America, can they get up into the double-digits.

Charles Cramb

Sure, I think Geralyn has talked about that in terms of when she gets through her transition and when we get through some of the major supply chain initiatives, remember for instance we’re closing a factory in North America which will benefit her from a gross margin perspective that she will be operating in the double-digit arena.

Operator

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

Andrew Sawyer – Goldman Sachs

I just had a quick question on the field fundamental comments for North America, I know you alluded to changing some field manager incentives, I was wondering if you could go into a little more depth as to what exactly the changes in incentives are and then separately on the US reps, as you phase out non-beauty are you doing things with their commission structures to help alleviate the anxiety they’d have about those changes.

Andrea Jung

Just on the de-emphasis of non-beauty and the emphasis on beauty just sort of having been with some of our managers and representatives just several weeks ago, as we kind of talked about the strategies for top line and particularly for some replacement categories and some emphasis on beauty I think that we had a pretty good reaction to that as it relates to hair care, skin care, mom and baby we talked about.

And so the de-emphasis very importantly has a basket refill which I think everybody feels very good about the fact that again net, net they can make more money, higher level commissions as long as we’re not just taking things out and not putting things in so I think the basket replacement thought was well communicated and I think got very positive feedback.

And in terms of the field incentives and the changes, we feel very good about our new sales leader there. First focus when we talk about field fundamentals obviously is just to make sure that just as you said the incentives are aligned, that the earnings opportunity when we look at the mix shift continue to give us competitive earnings so that there’s not a takeaway from a representative point of view.

A lot of performance management which was very important to us both in Poland and Mexico where he had previous experience and making sure that things like on some of our focus, our expectations of how many units per rep are being sold on an [inaudible], those are some of the things that we feel very good about and we continue to see progress in leadership and leadership up line participation as well as staff growth.

But kind of just making sure and relooking and ensuring that sales leadership continues to be an effective vehicle now that we’ve been in this market so long is also very important to that field management team.

Andrew Sawyer – Goldman Sachs

Are you changing the commission structures for the field managers then.

Andrea Jung

No we just continue to look and nuance and enhance, but there’s no huge changes right now.

Operator

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

Connie Maneaty – BMO Capital

I appreciate the comments you made up front about China and it does bring to mind some follow-up questions, one of them is how public is this Foreign Corrupt Practices Act investigation in China and I’m wondering if it is in any way related to the decline in your business results and if competitors may be taking advantage of it and poaching some of you sales agents. And secondly if you would just clarify maybe I wrote it down incorrectly, I think you said the costs associated with this were $7 to $8 million a quarter but was it $7 to $8 million a month.

Charles Cramb

It was $7 to $8 million a month. If I misspoke I apologize.

Andrea Jung

In terms of the business, it really was a decline in active reps and revenues really was what I said, it was the effectiveness of the incentives and most importantly the challenge in the hybrid model. Again we have done information and talked to, to get consumers as well as sales promoters, our SPs in the market and those are the reasons, not anything else relating to the internal investigation.

Connie Maneaty – BMO Capital

Does the weakness in the China business though maybe not related to your internal investigation but do you see some of the reps just jumping ship and going elsewhere.

Andrea Jung

No we actually see a lot of our sales promoters and our representatives when we do it, have still very positive perception towards Avon, and again they are still buying. The average order size is smaller and a lot of that is due to the incentive fatigue and ineffectiveness as well as just the activity rates. So the staff is still very positive, we continue to recruit at very high levels. The issue is activity in China and that’s what we’re working on.

Operator

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

Ali Dibadj – Sanford C. Bernstein

I know we’ve talked a lot about this net income and cash flow disconnect for a while, in the past it sounds like a lot of it was driven by restructuring charges but we actually haven’t seen any major ones recently, particularly not in this quarter. I know there’s some timing but I was getting encouraged about this but on the flip side you continue to have disconnect and you continue to see things like prepaid expenses now up about 20%. Its still unclear to me of these other long-term assets up about 25% year on year, so it seems like you’re continuing to spend cash earlier than your actually expensing the charge. And I’m just trying to figure out whether there’s just something about your business model that is, that creates that dynamic or is there just something else going on that I keep missing.

Charles Cramb

There’s a lot of technical things in what you’re saying. I think just a couple of things. Number one, in terms of restructuring and its impact, you make the charges when you make the decision, the cash then goes out afterwards. So for instance if you have a factory that you close you book the expected restructuring charge, job loss charge, at that point in time you make the decision.

When you actually close the factory and make the payments is when the cash goes out. So we generally if it were one initiative, we would generally see charge first, cash coming second and that’s part of what I projected for 2010 in terms of programs that we have announced and what the charges are going to be versus what the cash outlay is going to be, significant negative.

I think some of the other movements in the balance sheet that you’re talking about without sitting down with you and looking specifically at the balance sheet but don’t forget we do have the Liz Earle acquisition was completed in this first quarter. Don’t forget that we like many other companies operating in Brazil had some issues in terms of deferred recoveries on VAT which was basically suspended through all of 2009, actually be benefiting us this year as we start to get that money back plus don’t have the deferrals so that will make it a messy balance sheet cash flow I guess.

But other then that there’s nothing specific in the business model. Yes our prepaid expenses as a balance sheet item are probably on average higher than the traditional CPG company relatively and that’s due to the brochures that we develop, buy the paper for and then print and then hold and then distribute.

So those kind of business model things that I would think about in looking at that balance sheet. I hope that was somewhat helpful.

Operator

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

Mark Astrachan – Stifel Nicolaus

Quick clarification on the FCPA, are there any sort of fines involved in your expectations of what you mentioned per month.

Charles Cramb

No, that was just the cost of ongoing investigation and expanding it to compliance reviews in some of the other geographies that Andrea mentioned.

Mark Astrachan – Stifel Nicolaus

And then on Latin America price/mix, how much of that was contribution from Venezuela.

Charles Cramb

I don’t have that number.

Andrea Jung

Some of it was from Venezuela but we had some nice price/mix in other markets as well.

Mark Astrachan – Stifel Nicolaus

And sort of related to that then as you look out at the environment there price/mix in that region seems to be a bit higher than it is in other regions, could you just talk a little bit about what you see as the opportunity for taking pricing and some mix shifts versus what you see as the active reps and volume growth in that segment particularly with respect to Brazil or I know your competitor has taken some pricing this year.

Andrea Jung

I feel very good about our opportunity to continue to get price. Certainly price/mix I’ll speak specifically about Latin America but I’d even include CEE where we were pleased to get some price/mix as well and I think in certainly these developing emerging markets where we have put a lot behind the strategy of increased innovation, a lot behind technology investments, web investments for our representatives.

So think these things combined with the pipeline are allowing us to see some really nice results not only in holding up our volumes on active rep growth but getting price/mix. We feel very good in Brazil specifically to your question about the investment strategy behind the brands, the increased innovation, and product image, advertising etc. that continues to pay back. So we feel like we have a very successful model to grow both very balanced orders as well as average order and get that mix.

Operator

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

Linda Bolton Weiser – Caris & Company

Just on the investigation do you have an estimation as to when all of your investigation will be concluded and there’ll be a public announcement about whether or not there’s been wrong doing and then secondly on the FX transaction and translation I think you tried to explain how the negative FX transaction was offset by positive FX translation in the quarter can you describe quarter by quarter in the next few quarters when the net effect is positive and when it becomes negative of transaction netted against the translation.

Andrea Jung

Let me just say on the investigation the timing is a tough question, we are in year two. Its pretty hard to speculate the duration of these things. We’re in the middle of it and that’s where we’re at.

Charles Cramb

The interaction of transaction and translation is a little more difficult to answer. If you think about it transaction exchange and I’m thinking Venezuela out of this so we’re talking about that $50-odd million of benefit. It was neutral in the first quarter, second and third quarter it should go positive and then the fourth quarter a little bit less positive.

In terms of translation we have benefits in the first quarter and they will diminish second, third, and fourth quarter. Just thinking about the flow. I can’t in my mind try and exactly correlate the two together but I think if you just drew the picture of the fact that we got a 6% gain in the first quarter and it’ll diminish somewhat through the year for translation and then on the other side the transaction side, better performance second and third versus fourth quarter you’ll come pretty close to the way the numbers would work out.

Operator

Your next question comes from the line of Jason Gere – RBC Capital

Jason Gere – RBC Capital

Just two quick questions, one just on the operating margin improvements I know there’s a lot of puts and takes to take into consideration with China and Venezuela but in the quarter your SG&A excluding advertising this is like the first quarter that you got really good leverage in probably a year and a half, so just wondering I know you’ve been a little bit unclear about how much operating margin we should look at but I was just wondering if you could it into context on the SG&A side going forward.

Charles Cramb

We did get good improvement this quarter and benefiting from the strong sales growth as our cost reduction programs. I think as we go through the year I am hopeful that we’ll continue to see improvement. It won’t be, I’m going to tell you it will not be a [zog] year in terms of math. The [zog] mentality still is in this company there’s no question about it, we’re driving every cost down. We’re doing the value added analysis in terms of where we spend money but when you think about some of the things we’ve talked about for a long-term growth we’ll be investing in some infrastructure both white space as well as to support our ongoing growth.

So in overall terms, yes, we’ll show some SG&A improvement. We will get greater productivity out of what I call the variable expenses in distribution and it looks pretty good for the year in terms of having something come through that’s material.

Jason Gere – RBC Capital

And then just the second question can you just talk about your success I guess this quarter in Russia where I think one of your other direct competitors struggled and even some of the traditional players out there suggesting the consumer environment was pretty weak but you obviously put up some good numbers, so just wondering if you could put some context around that.

Andrea Jung

We were really pleased with our strong double-digit growth there. Number one reason I would say is from the representative value proposition this is the payout of the investments that we’ve made in sales leadership and the commission structure changes that we’ve made in that market that we’ve talked about over the last several years.

So, its sort of, when it comes to roost and you’re seeing it now and I would just couple that with very importantly strong brochure merchandising, the focus, very balanced tier pricing. We are seeing gains there in the value tier as well as the mid tier and then our higher tier so it’s a broad based growth across the tiers of the product categories.

So all in all I think we’re doing a great job with our share position and very strong investments and they’re paying out.

Operator

Your next question comes from the line of Victoria Collin – Atlantic Equities

Victoria Collin – Atlantic Equities

I wonder if I could just dig a little deeper into the Central and Eastern Europe part of your business, you’ve had two quarters now strong double-digit and I just wondered whether the sales growth there is from some of the better and sort of elevated platform or whether maybe its in reference as well to the earlier question that you are gaining share from competitors and secondly in Western Europe if there’s anything happening there that’s contributing to the double-digit sales growth.

Andrea Jung

We just couldn’t be more pleased with our combined European growth. Central and Eastern Europe not just Russia but very nice performances across the region and I think that’s certainly when you look at Russia we’re leading share, number one share and share gaining last year. If you look at 2009 we gained share and that’s certainly from everything we’ve seen this quarter looks like that’s happening again.

But some nice performance as well in Central Europe. And if I look at Western Europe you’ve got some amazing performances in Turkey, South Africa, and then the UK’s return to growth in this quarter, a nice growth in the UK which is obviously a very developed market and we think that the absolute growth in Western Europe is continued to accelerate if you track it from 1Q last year, its just been a steady acceleration. I think it was 12% in the fourth quarter, now its 14% now so very sustainable, very broad based across that region and I think you look at the profit margins and the leverage from those sales, its just so well managed. As Charles said we’ve got sourcing gains, we’ve got tight controls on costs, all the investments we’re putting in are paying back.

So we look at that 30% of the portfolio, Europe, growing 15% and obviously that’s a nice large piece of the geography. I think some of you have talked to us before about always loving Latin America, 40% of business, but we have another big piece Europe now that’s also gunning pretty well, so that makes for 70% as I said of the portfolio and we’re very happy about that. Its very broad based.

Operator

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

Douglas Lane – Jefferies & Co.

I also noticed that the, in China that the reversal between the fourth quarter and the first quarter in active representatives going from up 31% in the fourth quarter to down 25% in the first quarter, pretty striking, also makes me wonder if the brand is not being impacted by the publicity there. Maybe the way to ask the question is what generated the 31% growth in active representatives in the fourth quarter when your organic sales was negative in China last year in the second half.

Andrea Jung

This really is all about the activity of the direct selling side of the business and the activity was negative. So when you look at the China business its not about recruiting, its not about brand or brand image strength, it is largely around double-digit activity declines in the direct sales part of the business which as I said were two thoughts, one was the incentive were less effective, ineffective in some ways in driving activity.

But very importantly the beauty boutiques and their role in driving sales promoter activity was not there in the quarter. The BBs, the beauty boutiques have decelerating and their revenues have been decelerating throughout the year in 2009 as we pointed out. But because many of them weren’t engaged particularly as we came into this quarter in direct sales, that effects the activity of our sales promoters and so that is what we are kind of cleaning up if you would and driving out the lack of focus and confusion and that is why we are accelerating the transition to kind of a 100% focus on direct sales.

That was the factor internally.

Douglas Lane – Jefferies & Co.

That makes sense but I guess maybe what doesn’t make sense is you had negative organic sales in the third and fourth quarter last year, yet your representative activity in the fourth quarter was up 31%. So maybe you can help us understand what drove that impressive number.

Andrea Jung

There was a combination, I think there was a promotion against activity, around a new product in a new and the timing of those incentives weren’t as strong in the first quarter but again you kind of hit a tipping point in terms of BB engagement is the main point and while their sales were down they were still promoting and driving more activity in sales promoters then they did in the first quarter so that’s the differential from the second half of last year to the first half of this year.

So that tipping point again if I can step back for a second I would say we obviously last year as a total company was involved very much in that recession playbook and driving smart value and over arching company focus on recruiting and we feel really good of how we came out.

This is the year that we really want to take on a very important but I think very positive China whole transformation to 100% direct sales because we can at this point with the size of the BB business that has come down it’s the moment to really again drive the direct sales focus and revalue the value chain and that’s going to impact 2010 but it’s the absolute right thing to do for the long-term.

Operator

Your final question comes from the line of Christopher Ferrara – Bank of America-Merrill Lynch

Christopher Ferrara – Bank of America-Merrill Lynch

It sounds like you’re saying that the extension of the internal investigation into other markets, it sounds like its not necessarily driven by any suspicion I guess the way you’re phrasing it saying that’s it spread to countries that represent the regions kind of gives me that impression, am I thinking about that correctly.

Andrea Jung

We’re conducting compliance reviews in additional countries that we disclosed and they represent a selection of markets in each of our four international business units which is the appropriate thing to do. The allegations that triggered it was China only.

Christopher Ferrara – Bank of America-Merrill Lynch

So they weren’t brought on by any other specific allegations in any other markets at all.

Andrea Jung

That’s what I just said is that the allegation was in China and these reviews are in a selection of representative markets across all of our international businesses.

That concludes the Q&A. Again appreciate everybody’s support and we feel really good about the momentum that we have coming into this year and appreciate everybody being on the call. Have a good weekend.

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Source: Avon Products, Inc. Q1 2010 Earnings Call Transcript
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