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Avon Products (NYSE:AVP)

Q2 2010 Earnings Call

July 29, 2010 9:00 am ET

Executives

Amy Low Chasen -

Charles Cramb - Vice Chairman and Chief Finance & Strategy Officer

Andrea Jung - Chairman of the Board and Chief Executive Officer

Analysts

Constance Maneaty - BMO Capital Markets U.S.

Lauren Lieberman - Barclays Capital

Alice Longley - Buckingham Research Group, Inc.

Mark Astrachan - Stifel, Nicolaus & Co., Inc.

Ali Dibadj - Bernstein Research

William Schmitz - Deutsche Bank AG

Douglas Lane - Jefferies & Company, Inc.

Wendy Nicholson - Citigroup Inc

Andrew Sawyer - Goldman Sachs Group Inc.

Linda Weiser - Caris & Company

Nik Modi - UBS Investment Bank

Christopher Ferrara - BofA Merrill Lynch

Operator

Good morning. My name is Rachel, and I will be your conference operator today. At this time, I would like to welcome everyone to Avon's Second Quarter Earnings Conference Call. [Operator Instructions] I'll now turn the conference over to Ms. Amy Chasen, Group Vice President, Investor Relations. Ms. Chasen, you may begin your conference.

Amy Low Chasen

Good morning. Thank you for joining us to discuss Avon's second quarter results. With me on this call are Andrea Jung, Avon's Chairman and CEO; and Chuck 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 and also available on the Investor Relations section of our website.

Today in the call, we'll focus only on adjusted non-GAAP financial measures as we did last quarter. With that, I'll turn the call over to Andrea for high-level comments, and then Chuck will take you through the details of the quarter. Then we'll take your questions. Andrea?

Andrea Jung

Thanks, Amy. Good morning, everybody. Welcome to the call. We delivered another very healthy quarter in terms of top line performance. We're pleased that revenues grew 7% in constant dollars fueled by strength in WEMEA and Latin America. I feel good about our beauty sales increase, which was 7% as well in constant dollars. We had very strong gains in the double-digits in both the Fragrance and the Color categories. Active Representatives grew 5%. Strong performances again in WEMEA and Latin America. And in terms of volume, total and Beauty units were up 1%, that was impacted by China's unit decline. Without China, our units would have been up 4%.

Turning to a second to operating margin, we feel very good about our operating margin, expansion. Adjusted gross margin expanded 260 basis points, largely from continued really strong progress in the supply chain, so the supply chain's productivity gains were the driver there. I feel very good that the advertising in RVP investments continue to fuel the business. They grew ahead of sales in the quarter in-line with our priorities for 2010.

As you saw this morning, our adjusted operating margin improved 80 basis points over last year. And again, a night quarter for us [ph] (16:37) in earnings per share, adjusted earnings per share increased 26% in the quarter to $0.48. Cash -- it's been a priority, we feel good that year-to-date cash from operations is up $166 million, primarily from working capital improvements.

Just a quick comment, as you all saw, last evening, we closed our Silpada acquisition yesterday, very excited about that. It does create a high tier direct-selling growth platform in jewelry for the corporation. Silpada, as we told you, is a high-growth, high-operating margin business. It's a very, very good opportunity for us to leverage Avon's analytic and marketing capabilities to help accelerate Silpada's growth. And down the road, we do see global expansion potential for this party-plan business.

Just to put it in context, though, we do not have acquisition as a strategy unto itself. I mean, as we stated back last year, and continue to reemphasize even through CAGNY this year, the reshaping of Avon's portfolio into some new category opportunities that are in-line from a margin point of view and from a competitive vantage point of view, are very, very important to the short and long-term growth strategy for the company. And we have talked about exiting certain of the categories, particularly in the home area, margin dilutive, not good for our image and our competitive advantage, and identified again broadly higher-tier skincare, a mom and baby opportunity and global jewelry were three of the areas we really felt we should pursue to continue our sustained growth.

So when you look at the recent acquisitions that we've made, since the beginning of this year, Liz Earle, the higher-tier Naturally Active Skincare line, very small but still I think an important accelerator for us in terms of getting Mom and Baby into North America next year, the Tanya Tilia [ph] (18:37) Mom And Baby brand and then obviously our largest of the three -- Silpada in terms of higher-tier party-plan jewelry. These are in-line with the overall company's growth strategy, and we feel very, very good about their opportunities to help accelerate value in these areas.

So our focus now is really on realizing the full potential. That's what -- I had the opportunity to be out last week with 5,000 of the top Silpada representatives at their convention and the reception and the excitement about being part of Avon was really very terrific. And about a month ago, I was with the Liz Earle team, and I think they're doing also a very great job in terms of continuing to drive the business but excitement about the opportunity down the road in terms of what we can bring in partnership.

So the focus is now that we've completed these skills [ph] (19:32) on realizing the full potential of these acquisitions that they play into the total strategic context of platforming us for growth in the categories that I spoke about.

So I'm going to turn it over to Chuck here, but my last overview is just that we feel very good about the year. We're on track to deliver the at least mid-single-digit constant dollar revenue growth in 2010. We're on track to deliver the operating margin improvement in 2010 that we've spoken about, and that's after offsetting Venezuela's devaluation and the SCPA cost. As well as importantly for us, very importantly for us, funding the accelerated investments in strategic growth initiatives and the fact that we have the financial capability to do that and still deliver the operating margin improvement in 2010 -- we feel great about. And then, again, from a long-term point of view, we are on track to deliver our stated operating margin back to the mid-teen levels by 2013. So nothing has changed. Our outlook for this year and longer term, remain on track, and I think we feel very good about where we're at. So let me turn it over to Chuck.

Charles Cramb

Thank you, Andrea. Let's start off with a review of our regional results, starting with Latin America. Overall revenues were up a strong 15%, and it's been well-balanced with growth in Active Representative's up 8% and our growth in our average orders up 7%. Pulling in a few of the key countries, Brazil, again another strong quarter of 14% in constant dollars. Venezuela revenues were up 45% in constant dollars.

Most of this growth is coming from our 2009 pricing. We continue to follow our historic Playbook, which is lag and a high-turned flesh [ph] (21:13) environment a bit on the pricing and get or build market share. Which is now starting to take some pricing in Venezuela in the second quarter. But what we're seeing -- yes, volume's down a little bit but when we think about what's going on in the country, we believe that the Playbook is working and we are seeing share gains in that difficult market.

In Mexico, our revenues were up 3% in the quarter. This reflects positive results from our overall turnaround program there. Looking at it a different way, we also see a good balance between price mix and volume. Price mix up 8%, and volume up 7% in Latin America. From a profitability point of view, the adjusted operating margin is 50 basis points lower than the second quarter in 2009.

In terms of investments there, we have significantly higher advertising investments in Latin America, primarily Brazil and that follows where we're showing the strong sales growth. If you think about what we have, if we were to exclude Venezuela, the margin would have been up 90 basis points. So on kind of a like-to-like basis, reported right now adjusted down 50 basis points if we were to take Venezuela out of both this year and last year, we actually would have been up 90 basis points or 140 basis points swing.

At North America, revenues did decline 7% in constant dollars and that's reflecting a combination of the lower average order as well as a decrease in our Active Representatives. We're lapping last year's record recruiting campaign, which did benefit us, particularly Q2 and Q3 of last year, so difficult comparison. When you look at the mix of the business, you see that non-Beauty declined 10% while Beauty sales are up about 4%. And that is a result of our executing our strategy to de-emphasize the non-Beauty business.

Our adjusted operating margin of 8.3% is 70 basis points higher than it was a year ago, and that's despite lower sales, which, normally, you would expect to reduce margin with margin pressure on de-leveraging. What we're seeing here is significant improvements in our gross margin, both favorable price mix and very importantly, manufacturing productivity gains. Also, in North America, we're seeing an improvement in bad debt except in [ph] (23:32) area of emphasis over the last six to nine months.

For the rest of the year, thinking about what our comparisons are, impact of recruiting last year, we're thinking additions to staff will be somewhat lower due to, really, those tough comparisons. And that will show up as a negative impact on our active rep growth, and our margin performance is going to vary quarter-by-quarter. So I wouldn't want you to expect to see improvements like we had to date in each of the remaining two quarters of the year.

Moving to Central and Eastern Europe, the sales growth of 7% in constant dollars -- it's balanced between Active Rep growth and average order growth. Russia was up 7% in-line with the total region. And here we see Active Representative growth of 4%, up against last year's very strong recruiting program.

The adjusted operating margin is almost 11 points higher than it was in the second quarter of last year. Again, manufacturing product gains were a key component. Also within Central Eastern Europe we had a shift in the timing of our advertising, moving advertising out of Q2 this year, to try to better align ourselves with the timing of our new product programs. Therefore, as we look to Q3 and Q4, we should expect to see a significant increase in the advertising support. And thinking about it in hindsight, we probably shifted a bit too much of the second quarter this year to the last house [ph] (24:57) of this year.

Additionally, you have to call out lower brochure costs as a benefit in terms of the margin. We're seeing great productivity from strategic sourcing initiative in terms of paper cost of the line of brochure costs.

In WEMEA, we have very, very strong revenue growth of 19%, and it's driven by both Active Representative growth of 12% and a strong average order increase of 7%. Calling out a few of the key countries, Turkey continues to be a very strong growth engine up 27% in constant dollars. South Africa, up to 72% quarter-on-quarter. And then the U.K. is roughly flat in the quarter as good rep growth in the U.K. offset average order size shrinkage in the market.

Liz Earle -- this is the first time number we're reporting Liz Earle -- we have a full quarter of results and it contributed approximately four points to the region's growth. The adjusted operating margin was 710 basis points higher than last year. Again, the same thing, we're seeing significantly improved manufacturing productivity enhancing the margin. Also high sales growth combined with relatively lower overhead growth contributes to the operating margin performance.

Asia Pacific revenues were up 1%, we benefit here from the Active Rep growth, 9% growth showing in the Philippines, and the offset is the continued weakness in Japan. And from an operating margin point of view, basically flat with a year ago.

In China, continued revenue declines from last quarter reflect the transition away from the hybrid model to one that's focusing on direct selling. The operating loss on an adjusted basis is $2 million. That compares to an operating profit of $8 million one year ago, and that's due to the lower sales.

Importantly, in this market, we have launched the new sales model in July in three cities, and we're very pleased with the preliminary reaction we're getting to the new model, both from the DBs [ph] (27:06) and from our own field force. So we're now tracking fairly well on a profit point of view to our previous guidance, which was from moderate loss in 2010 and then moving more to a break-even position in 2011.

Going out to the total company income statement, overall revenue of $2.7 billion is up $200 million or 8% versus one year ago. The 7% constant dollar and we still have some exchange benefit of 1%. Our gross margin, moving down the P&L, really benefited from the strong manufacturing productivity gains that you heard me mention for most of our regions. This includes both efficiencies and Strategic Sourcing Initiatives.

Looking at the bridge, the gross margin is 64.9%, up from 62.3% one year ago, an improvement of 260 basis points because even 230 of it is through the productivity area. Transaction exchange is somewhat favorable, 30 basis points as Venezuela has unfavorable transaction exchange and, through the cross rates, the rest of the world is favorable, primarily in Latin America. Price mix is showing no impact although within price mix, we have price favorable and mix somewhat unfavorable, and they cancel each other out.

As we've said, as this quarter shows, we are continuing to invest in both our brand and our channel. Our advertising expenditure's up $16 million, or almost 20% to almost $100 million in the quarter. The higher spending showing in Latin America, predominantly in Brazil where we have the strongest sales growth. Our rep value proposition is -- we're investing in this area somewhat ahead of the sales growth -- the investments are in things like sales leadership, web enablement. Those are the representative tools that we've discussed with you at past meetings. And we've initiated a new project that's called a global order management project. It's in its infancy. We'll be talking to you more about it at later meetings.

And finally, our overhead expense shows that it's up in dollar terms $83 million from a cost perspective, significant in Latin America where we do see some inflationary labor costs, double-digit increases in many of our larger markets. And then in corporate -- and here's where I feel good about how we're spending some of that incremental overhead -- significant investments in those strategic growth initiatives. Initiatives that we've discussed with you both in last year's analyst meeting and then reinforced again at CAGNY. And when we think about these things, what we're really talking about is some of the front-end investments in infrastructure, very [ph] (29:53) new product categories, things like Mom and Baby, Sun Care and Acne. Also includes the M&A costs, the transaction costs are executed and still part of the deal. And the overheads that exist within the Liz Earle business because they are added to the overhead cost and this is -- obviously it wasn't in our numbers prior to the second quarter.

The other part is the FCPA. We're tracking along pretty much the line that we communicated last quarter, $7 million to $8 million a month, which translates into around $24 million, which is what it was in the quarter, and that's up $15 million from last year.

Moving down into the operating margin, that improves a total of 80 basis points and the bridge here shows us moving from the 11% to the 11.8% in the quarter. The operational impact really is everything except exchange, and here you can see at the operating profit level how we benefit both from transaction and translation exchange.

And, by the way, as you look to the future, those things turn against us in the latter half of the year. And we feel that based upon today's spot rates, they'll probably be neutral, both transaction and translation. We'll be looking [ph] (31:11) the total year numbers at the end of this fiscal year.

The operational impact is down 10 basis points, within it I do need to call out FCPA as a drag of about 60 basis points and M&A that's really the acquisition transaction costs for Silpad, a drag of about 30 basis points. So we're down 10 basis points, we have drags of 90 basis points. The rest of the operational business is favorable, but net of those are 80 basis points.

And this will give you just a better feeling for the currency and this is the transaction piece. And what I've shown is where our rates are today and where they were last year from an average P&L rate. And what it means in terms of the transaction -- and so you can see overall, this is the six months year-to-date -- basically it ended up being neutral. Second quarter was favorable. But basing the neutral as Venezuela continues to offset the rest of the transaction games. And then wanting to look the total year, we see a similar thing where $71 million of transaction is favorable, excluding Venezuela, than offset by Venezuela. These numbers are, by the way, somewhat better than what we've described to you last quarter due almost entirely to exchange rate movements.

And this is just to bridge [ph] (32:38) you on earnings per share between adjusted and GAAP, that two big differences being restructuring and then the special accounting items on Venezuela.

Moving now to the balance sheet and cash flow, accounts receivable well below 30 days outstanding. Again, that's our model in terms of how we collect from our representatives. And inventories in dollar terms, we are flat versus a year ago at this time. It does calculate to a six-days improvement to 99 days versus 105. But that's really due to foreign exchange.

Operationally, all of our units are either flat or improved except for North America, which has some increase in their quarter and its inventory coverage. Accounts payable, increase of 13 days to 76 days. This has been one of our areas of focus in terms of managing our working capital as we've negotiated improved terms with our suppliers.

And then capital expenditures are somewhat higher after six months than they were a year ago, some $30 million, with significant investments in both supply chain infrastructure and web enablement. These numbers are in-line with our guidance, which said that we thought we would probably spend roughly up to $350 million in 2010, and that would be against $300 million that we spent in 2009.

From a cash flow perspective then and an overview, our operating cash flow improvements $166 million year-to-date. And it's benefiting us, we're benefiting from a stronger working capital management as well as what I'm calling adjusted net income. You see on the top our use of the term, adjusted net income, is really stake our net income and add back to it the non-cash items. Some people call it cash net income. That's contributed about $70 million year-on-year improvement. And then working capital almost $100 million of improvement coming to the cash from operations gain of $166 million year-to-date.

As Andrea said, our outlook for this year is pretty much unchanged. We're on track to deliver at least the single-digit growth at the revenue line. Operating margin improvements, as well, both GAAP and non-GAAP, despite Venezuela where we had devaluation special items, FCPA cost and a step-up in investments in our strategic growth initiatives. And capital expenditures between $300 million and $350 million, probably nearer the $350 million level.

And longer-term, that outlook is, as well, unchanged as our commitment remains sustainable, profitable growth. And with that, I'd like to turn it over to the operator to open us up for question-and-answer.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from Wendy Nicholson. Please state your affiliation, then pose your question.

Wendy Nicholson - Citigroup Inc

From Citigroup. My question has to do with the Skin Care business, which, over the last whatever few years, has been such a big driver of your growth. Yet for two quarters in a row, it's been really soft and slower growth in either Fragrances or Color, and I'm wondering whether that's just a timing of new products or what because I'd assume if that business starts to grow again, given how high-margin some of those products are, that would be really good.

Andrea Jung

Yes, Wendy, it's primarily weakness in our Solutions brand, which is a mid-tier brand which we are restaging. We still have good strength in Anew, and it's a little bit of timing there but I feel very good about Anew, its performance in the full year. And so the weakness that you saw in the last two quarters was in the mid-tier Solutions brand.

Wendy Nicholson - Citigroup Inc

So am I right in saying that the pressure on the margin -- there's actually not that much? Is Solutions lower margin than Anew?

Andrea Jung

Yes, Anew was the highest margin and also part of the margins on Solution, not just the growth margin. But we're spending less on supporting that brand until we repositioned it in 2011. So we're spending less on advertising, for example, versus a year ago.

Operator

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

Christopher Ferrara - BofA Merrill Lynch

It's Bank of America. So just on the U.S., and I know you guys have prepared us for sort of uneven and inconsistent improvement in the U.S. Can you just talk a little bit about what we're seeing in this quarter and maybe going forward, I mean, is it tougher macro, as things slow down a little bit as your recovery slows down a little bit, hitting you guys as well as -- has your outlook changed around the U.S. and the progression of its improvement at all? I guess, what are you seeing real time in that market?

Andrea Jung

I mean, I think it's still a challenging market. I do feel like we're making progress. Let me just start on what I think we're making progress on. I mean, we kind of go back to what we said since last year in terms of the three things that the U.S. business is working on and obviously from a cost perspective, $100 million is what we said that we would be able to find in that business and we'll realize half of that this year. You heard Chuck talk about the manufacturing efficiencies, and so some margins are improving despite the negative sales growth. So we've been in this first half offsetting some of the normal negative leverage. Beauty is a higher percent of the portfolio. We wanted that to happen. So I believe that business is about 57% Beauty now versus 53%. So I think we are tracking there to kind of make movement there. And as expected, that move from non-Beauty to Beauty, does cause average order pressure that we are driving, course as opposed to that's market-driven. So that stated march, obviously, in the transition time does affect productivity and net basket size because of the prices of some of the non-Beauty net. So I think we've made some progress, I think we want to still see some results in the field of -- rep growth and productivity are the biggest challenges and opportunities for us. I think the rep growth, as Chuck said, when you look at the negative four [ph] (39:04) in the rep growth this quarter, there was a very historic rep drive for the company, and particularly in North America as we came out of that whole Super Bowl in the second and third quarters last year. And that inflow is down, so the additions number is what's causing the average active rep to be pressured. And I think when we look at it, that really took place second and third quarter, so I think we sort of see more of the same as it relates to the additions numbers being pressured in North America. But long -- you know, again, we don't feel different about our stated target and our outlook for North America in the medium and long term.

Operator

Your next question comes from Bill Schmitz. Please state your affiliation, then pose your question.

William Schmitz - Deutsche Bank AG

It's Deutsche Bank. I'm having a little bit of an issue on the margin side trying to figure out kind of what's going on because there's supposed to be a whole bunch of restructuring statements coming through, and it looks like pretty much all the upside was from the change in currencies. So what are the negative variances on the cost that aren't leading to much better margin expansion?

Charles Cramb

Well, I think, we've actually felt very good about the margin expansion if you look at, say, the adjusted basis of 80 basis points. So, without understanding the real details of how you're looking at it, is difficult to comment. But one of the things that we are doing, and we're doing it and still getting that margin improvement, is investing now in some of those strategic initiatives that we've talked about, and that is a significant investment, whether it's infrastructure to support the new categories that we're getting into, whether it's some of the costs we're involved in, the one-time costs, involved in the transaction of Silpada. So that'd be a piece of it. I think the other thing that, if you just think about margin year-on-year, the incremental FCPA cost is not a small piece on a marginal basis. And then you've got all the normal things that you would expect in terms of some of those cost savings do offset inflationary pressures around the world because there is inflation. We did call out the Latin American one because it's exceptional in terms of the double-digit, but there is inflation in the rest of the world. As we're looking at and tracking those restructuring benefits, we're pretty much bought on what we thought we'd be in terms of delivery. The 2005 program we said that last year, I think it was around $300 million, this year $350 million. That looks pretty good. The 2009 program, we maybe just a little bit light, but we said that would go from $50 million to somewhere around $70 million, but the differential isn't significant. So I think we are delivering the restructuring and I think what's great is we're reinvesting in the business against strategic initiative, and also, by the way, against operational -- things that should benefit operationally. Which would be both the advertising in the rep value proposition.

William Schmitz - Deutsche Bank AG

Okay. I mean, the reason I asked is like the gross margin was great -- 260 bips. But I thought there'd be better stated in the SG&A side. Am I missing something? Usually I take out the currency and the FCPA costs and the high advertising spending. It doesn't seem like there's any sort of overhead leverage to the model at all.

Charles Cramb

I think its because a lot of the investment from we've got does show up in the SG&A, and this is really the first time that's been substantial. I think that may be the balancing piece, Bill.

William Schmitz - Deutsche Bank AG

Okay. Did you say what the dollar number was for these strategic growth initiatives?

Charles Cramb

No, we didn't give an exact number. But if you were -- it's difficult to give an exact number but the bird [ph] (42:44) had updates like people costs, et cetera, we'd come up with a number close to $30 million.

Operator

Your next question comes from Mark Astrachan. Please state your affiliation, then pose your question.

Mark Astrachan - Stifel, Nicolaus & Co., Inc.

It's Stifel, Nicolaus. Just following up on that last question, just curious about your thoughts about the optimum level of reinvestment back into the business over the next three years, just given the magnitude of the cost savings program that you have as well as your stated comments about the relatively low capital requirements of the business. And just one related point to that -- just curious in the quarter how much the pullback in spending in Russia impacted the overall growth in that market in the quarter.

Andrea Jung

Maybe I'll do Russia first. So we did have advertising that was down in the quarter. That was primarily, as Chuck said, because of the flow of the product pipeline and the much stronger innovations that we wanted to support in the back half of the year, really starting in September. As he said, perhaps the pullback had some impact on momentum. So when we look at it, obviously, both the add and the recruiting advertising investment starts in September and it's pretty heavy through the fourth quarter. I think you can start seeing that momentum rebuilding in 4Q.

Charles Cramb

In terms of your question about investment, I think we're pretty much in-line with what we have tried to communicate strategically. The rep value proposition, we've said we're going to continue to invest in that, probably somewhat ahead of the sales growth. However, that gets funded because we are showing the incremental bottom line margin that'll get funded through leverage alternative P&L. And on advertising, again, we've said in the near term, we'll be increasing our rate of advertising somewhat. And that advertising number, it's not going to be a steady smooth change because of the timing of new product launches in new categories that we're going to enter. But if I were trying to think about the business over the next year or two, I think you would see that those two numbers will grow slightly to a little bit ahead of sales.

Andrea Jung

Just want to reconfirm that we view all the opportunities to continue to fund the business within the stated commitment that we have, of that mid-teens margin in 2013. And every investment that we're making -- I mean I feel very good that we're actually accelerating some of the investments on the initiatives. I mean, again, six months through the year to be having the opportunity from an acquisition point of view to have a higher tier Skin Care and jewelry and close those with the cost, probably faster than I thought from a year ago and I feel very good about that. But every investment that we're making on advertising in RVP, we continue to look at its payback and efficiency, we're not going to spend when the efficiency starts to level off or go to a point where we think we've reached that level. So we've got a very tight handle on that, but there's no change in our commitment to ourself, obviously, as well to all of you on that mid-teens margin, that very respectable margin, by 2013. So we believe we can do that and continue to fund for the medium to long term, which is what I feel great about.

Operator

Your next question comes from Lauren Lieberman. Please state your affiliation, then pose your question.

Lauren Lieberman - Barclays Capital

Barclays Capital. I just wanted to talk a little bit about unit growth. So I mean, you pointed out what units would have been ex-China. Can you tell us that, if you have it, that same number for Q1? And then also just there's been such a good balance the last couple of quarters between your growth and price mix that obviously changed this quarter. So was there anything in the mix of products flowing to the brochure? How should we sort of think about that? What impacted this quarter? And what we should think about for the next couple?

Andrea Jung

Let me just kind of go back to the last few quarters. Q4, where we basically had flat unit growth in China, the company was up 4% in units. So it's just if I compare that, 1Q kind of looks like that. Q1, the units were a little bit higher, to us [ph] (47:02) China was down U.S. probably up five or so, five or six. But I think the thing is that-- I go back to Q4 and say, with China, in flat units, the company delivered 4% unit vote [ph] (47:13). That would be sort of the even comparison. But how would I look -- so that's the answer on that -- the, how do I look at units? Remember a year ago, sort of our recession Playbook, was twofold of massive recruiting campaign and massive focus on extra flyers on Smart Value, less than $5 products. In our brochures, as well as, again, separate pieces to really have this fight the recession opportunity. And that drove a lot of units in the second and third quarter of 2009. Not that we're off that strategy and we still have Smart Value but the recalibration, the very careful recalibration in 2010, and that we depend by market in terms of where the consumer is. There's sort of, there is still a focus but there are just many extra flyers as we put out and since last year in Q2, particularly in Russia or in Central Eastern Europe. And in China, specifically, which is its own unique thing, again, a lot of lower-priced units went out in year-ago's quarter. So different merchandising strategy, 2010 versus 2009, although the '10 ended up having pricing at all tiers and available for consumers is still there. So that's a little bit of the comparison. How I look at it is I like the balance, I mean I think if we have 7% sales, I don't want 6% in units. You understand what I'm saying, Lauren? I'm not -- I think we want the productivity. We're getting the pricing. A lot of it has to do with new product introductions. We've got big fragrances and a lot of new coming into the second half which have higher net. So I think it's a balance at low shield [ph] (48:49), big products in the third quarter, again it's a higher-price point than some of the lower-priced hair care products units that we did. So about sort of product mix, as well as a shift in 2010 carefully and slowly to balance.

Lauren Lieberman - Barclays Capital

Okay. That's really helpful. And then just to further, so on Central and Eastern Europe, in particular, is the unit shift we've seen there, is that primarily or does that shift a little bit as you were talking about kind of ramping up the advertising in the spend and the launch activity in the second half?

Andrea Jung

Yes, I think there -- I can't speak to units in 3Q. I think if you kind of look at the reps, et cetera, I think you're going to see on the total more similar in the second quarter and the third, and then, again, because we start a lot of this in September onwards, building momentum in 4Q.

Operator

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

Andrew Sawyer - Goldman Sachs Group Inc.

It's Goldman Sachs. I'm just wondering if you'd give us a little more context around the end game from an M&A perspective? Is the objective here to replace the revenue streams from the Beyond Beauty businesses which you're phasing out? Or how should we size up what you're thinking about there?

Charles Cramb

Actually, it's not to replace the revenue stream from the non-Beauty, let me answer that piece first, because the acquisition, Silpada being the most significant one, Silpada will be Is Ra Nowton [ph] (50:20) will be Ra Nowton [ph] (50:21) independent business within the Avon portfolio. Silpada is all about a category that we love and it's also all about a higher-tier positioning of that category. And it's also going to give us some learning in terms of party-plan, which is a bit different than our traditional direct selling. So the M&A strategy isn't to replace the non-Beauty reductions. Liz Earle -- that's another significant one -- that one again, it was a category, Skin Care, that we felt very good about. Naturally Active was a positioning that we liked and it was higher-tier. Now in the case of Liz Earle, it does have a multi-channel present. And our opportunity, we think, is to move it into more the direct selling channel, similar to what we have. But it's not going to be a fully integrated business. It, too, will have a significant proportion of its business standing alone. When we think M&A, we really think about what are the categories? What are the profiles of those categories? What is the profitability? And extremely importantly, who is the management team that comes along with it? Yes, there may be times when we buy a product or something that'll fit in the portfolio. But that is strategically what we're after right now. That helpful?

Andrea Jung

The Mom and Baby, which is very different than what Chuck just talked about in terms of Liz Earle and Silpada. That is going to be within the North American core business and opportunities to sell those products instead of some of the other non-Beauty products in the U.S. So there, on that one, that answer is it is, I think, a more desirable category that will replace some of the exiting categories for the core Avon U.S. Representative, which is not true of the other two. That helpful?

Operator

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

Ali Dibadj - Bernstein Research

I'm from Bernstein. Just want your help on something. Your balance sheet shows $984 million in cash and I think all of that, or most of that, is overseas. So in that context, I'd love to get underneath and try to understand the -- why, I guess, it was sensible to pay $650 million, which is about 2/3 of your cash, or almost all of your cash, if you be repatriated for kind of non-Beauty business that, so far, I guess doesn't target your new demographic target, and you're not really integrating. I guess, particularly in the context of, your alternative might have been to buy back your own stock, so it just seems to me, kind of an odd decision in terms of capital allocation. And maybe to tack on to that, how much cash do you actually have now after the close of the transaction?

Charles Cramb

There's a whole ton of questions there, Ali. Let me just try to couple the important ones. I think, in terms of Silpada, that was an opportunity that we saw that we felt that we could add significant value to through some of the things that we are core strengths and, in particular, when we think about our analytics and think about where should that business go? How do you look at the consumer? How do you look at the segmentation of the consumer? How do you look at the way they are penetrated, versus where they're not penetrated -- just a North America. It's a great business, it has great growth characteristics of its own. We think we can accelerate it. It, by the way, has wonderful operating margins. So I'd put that one in the realm of -- hey, it's just a great opportunity and it fits strategically what we said we really want to be, which is attracting higher tier and in the jewelry category. So I look at that and say great acquisition. In terms of how we're funding it, we've made a decision that we do not want to, at this point in time, with this interest rate environment that we're seeing, which looks like it's stable for quite a while to come now, we decided we don't want to pay the tax premium that might evolve if we're to bring back the cash that is off shore. And you're right, most of the cash is off shore. So the acquisition -- all of the payment has to be made in the U.S. and it's through a combination of cash that we have been able to free up as well as some debt. And in the intermediary term, we'll probably stake commercial paper on it but look for some kind of a funding later on. It's not a one or the other, it's really how good was the opportunity?

Ali Dibadj - Bernstein Research

Yes. It just seems like a lot of money for given the cash they have on hand, you know?

Charles Cramb

Yes, I guess we'll -- over the next four quarters, you'll start to see just how good that business is. It really is a great business with great people running it.

Ali Dibadj - Bernstein Research

About pricing, and just to add on, your pricing over the past several quarters, actually has been more than 50% of your organic growth on average. And given the unit, I guess, disappointment sort of this quarter of 1%, if you look historically, the last time pricing was even close to 50% of your organic sales growth, as it has over the past few quarters, was kind of 2003-ish, 2004 period. And after that, had to take down pricing pretty aggressively after. So, I'm trying to figure out why that won't happen this time? Of course, exclude Venezuela, because I know you're taking a lot of pricing there.

Charles Cramb

Yes, and you do have to take that as well. I think when you talk pricing, and I'm not quite sure what metrics you're looking at, but I assume you've got mix in there as well, which has to do with our portfolio. I think the important difference -- if you were to say, hey, Chuck, just tell me -- I think you might have a few years back to aggressive pricing, are you sure you're not now? I think the most important part there is the analytics that we bring to the pricing decisions. We have that, what we call, IMI, Integrated Marketing Intelligence group, that is all over pricing in every single, and we look at a market-by-market competitive versus our own position perspective, and those analytics have encouraged us to take some strategic pricing, and to date, I know of no place where we said, we goofed, we went to far. Those prices have held. So I think the real answer is that pricing is based upon analytics more than anything else, and analytics have improved themselves.

Andrea Jung

Yes, I mean, Ali, there's down to a deodorant in country X, pricing it at $0.99 versus $1.29, what's the elasticity? I mean, that did not exist in 2003.

Operator

Your next question comes from Nik Modi. Please state your affiliation, then pose your question.

Nik Modi - UBS Investment Bank

UBS. Andrea, quick clarification, did you say that the U.S. Beauty business was up 4%? And if I heard you right, is that -- did you gain share this quarter?

Andrea Jung

No, it was down. Yes, down 4%. I think the U.S. Beauty market was also down as I understand it, but again, probably 1% to 2% as I understand total Beauty. So again, not a robust industry, but I look at our 4% down in Beauty, very much tracking with reps down, number of doors. So I think it's really a channel impact there.

Nik Modi - UBS Investment Bank

If I can follow up on Lauren's question about the price mix. So in the back half of the year, I mean, should it kind of be the same type of algorithm in terms of price mix being a large version of the organic sales number?

Andrea Jung

I think we're going to see balance. I think that when you -- I'm looking at the balance, I think units will be probably up slightly from the plus one. But I want to see that balance. And I think that, again, rep productivity and price mix are still important as we carefully calibrate and we're committed to margins. And everything that goes through the value chain, I think, 2009 was rightfully a year about a lot of volumes, a lot of units and a lot of reps coming in because that was our recession gain. But now it was about keeping them and making them more productive, more training, more category, higher baskets. This is all in line with the strategy, very carefully calibrating it with analytics. So I think I would look in the second half at slightly better than plus one, but I'm not looking forward plus five or six if you're tracking.

Operator

Your next question comes from Doug Lane. Please state your affiliation, then pose your question.

Douglas Lane - Jefferies & Company, Inc.

Jefferies & Company. Can you drill down a little bit more on your progress you're making in China and kind of maybe lay it out a little bit of a more detailed roadmap over the next four to six quarters, how you expect that to play out? And do we have another couple of quarters of 30% kind of sales declines ahead of us here?

Andrea Jung

Well, I'm just going to go back to what we said last quarter because I think it's safe to say this is transition is going to take some time and I think one quarter is not enough time to change what I said last quarter. I think we said then, it takes about 18 months before the model, the new model that we talked about, is expected to take hold. I do feel good. It's preliminary and so it's just anecdotal at this point, as opposed to parlaying it into results. But we have launched this new model in three cities in China. And the reaction from beauty boutique owners, in terms of understanding the new role they could choose to play in the new model, has been broadly positive. So that's encouraging and that gets rolled out nationally at the end of October, and that's going to phase in. So it really takes through the first half of 2011 until the whole country is in the new model. We said that we would see a small loss in 2010, a break-even in 2011. We don't believe there's any reason why this isn't going to be a good double-digit margin market for us because it's highly Beauty and Skin Care oriented and those are high-gross margins. So nothing has changed from that except that we're on track to -- we've launched it in three cities, the rollout is safe as I just said to you, and the economics we stated to you, nothing changes for me from that. So it's going to be probably a modest loss in 2010.

Douglas Lane - Jefferies & Company, Inc.

Just to get my mind around it, when you launch a new sales model in three cities, does that mean that now you expect those three cities to really start to contribute to growth and, meanwhile, the cities that haven't converted over or the regions that haven't converted over yet are kind of in a holding pattern, if you will, and not really performing up to par? Is that -- and it's kind of a rolling roll-out, if you will? Or you just...

Andrea Jung

It's a rolling roll-out. You're going to see negative revenues in the next -- until you transition this model. Hopefully it'll start to abate as more and more cities have the PS side of this business with a new model starting to get growth, and you're still going to have the -- and again, we have to see how many BBs convert before I can tell you what's the decline on that BB side of it. So that's what we needed to kind of say, look, let's take 18 months before we can see the real growth rates from this new model.

Operator

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

Alice Longley - Buckingham Research Group, Inc.

Buckingham Research. My question is Venezuela representative sales, is it now? And what would your organic growth have been in units and price without Venezuela?

Charles Cramb

Venezuela's like about 3% of our revenue in the quarter. In terms of units, Venezuela units were down a little bit, but Venezuela's relatively small as a percent of the total. So I wouldn't try and peg that in as a significant driver for the total company performance.

Alice Longley - Buckingham Research Group, Inc.

So the organic growth components would have been the same?

Charles Cramb

The same as?

Alice Longley - Buckingham Research Group, Inc.

As the one in the six without Venezuela?

Charles Cramb

It was a small unit decline. Remember, that whole market is in some turmoil right now, so even with our unit declines, we believe we grew share in the new category.

Alice Longley - Buckingham Research Group, Inc.

No, my point is your corporate organic growth would've been 1% unit and 6% price...

Charles Cramb

Price, no, because we would have had, it might have impacted the pricing a point or so. Maybe -- I don't know, somewhere between one and two points.

Alice Longley - Buckingham Research Group, Inc.

And Venezuela margins excluding the charges are now above or below the corporate average?

Charles Cramb

Right now, they're below.

Alice Longley - Buckingham Research Group, Inc.

Okay. My point is if there's continued devaluations there, the impact on 2011 gets reduced versus...

Charles Cramb

Oh yes, oh definitely. Because it's a much smaller piece of our total business.

Alice Longley - Buckingham Research Group, Inc.

Okay. And just on another sort of question about this kind of percentage of the pie, in China, what percentage of your business now there happens through the retail format?

Charles Cramb

It's very...

Andrea Jung

It's less and less.

Charles Cramb

Yes, it's small.

Alice Longley - Buckingham Research Group, Inc.

So it's now down to less than a quarter of the sales?

Charles Cramb

It's probably around there, maybe slightly less than that. If you asked me to guess, I would've said 20%, I don't have that number.

Andrea Jung

I would, too.

Operator

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

Linda Weiser - Caris & Company

Caris & Company. Chuck, can you just explain like on the cash flow numbers, I mean, you're experiencing good improvement in cash flow growth year-over-year, but your absolute level of cash flow appears to be lower than comparable companies that one might look at. Can you just explain why the CapEx year-to-date is 1.5x D&A instead of more in-line with depreciation and amortization?

Charles Cramb

Sure, and it all ties in with the fact that -- the simple answer is if you go back a number of years, I think we under-invested in capital, both in infrastructure on the supply-chain side and capital equipment for manufacturing productivity. So we've got some catch-up there. And then we're now investing an accelerating rate against representative tools, improve their productivity. So what you have to do is you take a look at the depreciation rates of the old spending at lower levels versus the depreciation rates which are much longer likes, and a lot of the investments we're making now. And you get that kind of -- I don't want to call it a distortion -- but you get that kind of ratio which is, we're going to be investing at a rate higher than our depreciation.

Linda Weiser - Caris & Company

What do the new investment have longer depreciation lives?

Charles Cramb

It's the nature of the investment. Each of our capital items has a different life depending upon what it is. For instance, if you invest in a building and remember the distribution center that we put into Zanesville, or the distribution center we're finishing in Latin America, two very major projects. They have -- and don't quote me on this, because I can't remember exactly -- but I believe, those lives are in the 30 year range. So thinking about 3% depreciation a year.

Linda Weiser - Caris & Company

Okay. I understand that. And then on the deceleration in Active Rep growth, I know in past analyst meetings, you've shown us data about retention levels after you have recruitment surges and how you want to try to retain the reps that you've spent money to garner. And can you just comment on whether those retention levels are improving or not improving? And did you expect to see this deceleration after the surge that you made in recruitment last year?

Andrea Jung

Yes, I think the primary difference is in the inflow, not the outflow. I think the retention rates are broadly similar. As a matter of fact, in the United States, I mean there's actually an improvement in the retention rate, but the big issue is the inflow versus last year's big surge between the advertising of the recruiting, et cetera. So it is driven by inflow, not outflow, the change.

Linda Weiser - Caris & Company

Okay. And then I forgot a few talks specifically about Central and Eastern Europe, the rep count, deceleration there to 4%, it's really a lot lower. Is that, again, related to the level of investment in the quarter or is there something else that you can talk about?

Andrea Jung

No, I think it's a combination of the strength of last year's very strong recruiting incentive program. So the growth, while lower, I think the deceleration from Q1 came from a combination of that versus last year's big impact on the recruiting and the additions level as well as the advertising pullbacks. Those two things on that energy halo was probably part of the deceleration. That is building back up in September onwards.

Operator

Your final question comes from Connie Maneaty. Please state your affiliation, then pose your question.

Constance Maneaty - BMO Capital Markets U.S.

BMO Capital. Could you just help us understand a little bit on Silpada? I understand the compound annual growth rate of sales was maybe 20% or 25% over the last five years. But of 2008 and 2009-type recession years, what did it slow to? And also, if there's no integration synergies coming out of this business, I think we calculated in 2012 that the incremental EPS would be limited just to a penny or two. So could you give a little perspective on each of those?

Charles Cramb

Yes, I'm going to frustrate you a little bit on the revenue question, being a private company. There's not a lot I can say about those historic numbers. I will say, however, that like everybody else, they did experience somewhat of a slow down. They came out of it healthier than, I think, most people operating in that category. Thinking about the U.S. economic issues. I think in terms of, I'm not sure what you've got built into your model but I certainly feel that the guidance we gave, that $0.03 to $0.05 next year, is conservative. I think it will be realizable. So I would be hard-pressed to see that the incremental, kind of growth we would expect out of that business with the kind of margins that business can deliver, I could not equate to the kind of accretion you've got, Connie.

Andrea Jung

You guys are going to love this like we do

Charles Cramb

Yes, we do love it.

Andrea Jung

I don't think there are any more questions. So I know you've got a busy morning. Thanks, everybody, for being on the call. And if there are any further questions, you can follow up with Amy. Take care.

Operator

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

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Source: Avon Products Q2 2010 Earnings Call Transcript
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