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Avon Products (NYSE:AVP)

Q4 2010 Earnings Call

February 08, 2011 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

Dara Mohsenian - Morgan Stanley

Constance Maneaty - BMO Capital Markets U.S.

Lauren Lieberman - Barclays Capital

Alice Longley - Buckingham Research Group, Inc.

Ali Dibadj - Bernstein Research

Richard Lyall

Mark Astrachan - Stifel Nicolaus & Company, Inc.

Jason Gere - RBC Capital Markets, LLC

William Schmitz - Deutsche Bank AG

Douglas Lane - Jefferies & Company, Inc.

Wendy Nicholson - Citigroup Inc

Linda Weiser - Caris & Company

Christopher Ferrara - BofA Merrill Lynch

Operator

Good morning. My name is Celeste, and I will be your conference operator today. At this time, I would like to welcome everyone to Avon's Fourth Quarter and Full Year 2010 Earnings Conference Call. [Operator Instructions] I'll now turn the conference over to Amy Chasen, Group Vice President, Investor Relations. Ms. Chasen, you may begin your conference.

Amy Low Chasen

Thank you. Good morning. Thank you for joining us to discuss Avon's fourth quarter and full year 2010 earnings 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 on the call, we'll only focus on adjusted non-GAAP financial measures.

You will hear from Andrea in a minute that we're handling today's call a bit differently. As a result, our usual slides that review regional and P&L results will be available on our website.

With that, I'll hand this over to Andrea.

Andrea Jung

Thanks, Amy. Good morning, everybody. As Amy said, given this quarter's disappointing results, I’ve just decided to handle this call a little bit differently this morning. In anticipating your questions, we're going to really focus our comments on three key areas, our revenue in Brazil and Russia and overall company operating margin.

So let me just start with kind of an overview of where we are in 2010 as we’ve close the year and what we're looking at in 2011. 2010 was a tale of two halves for the company. We had a very strong first half, and that was offset by a disappointing second half with the weakness we started to see in third quarter continuing into the fourth quarter.

In the first half, we delivered meaningful operating margin expansion as our strong business performance offset costs related to the FCPA investigation and the Venezuelan devaluation. However, as our revenue growth softened unexpectedly in the second half, operating margin was pressured for the balance of the year, so clearly, disappointing. Our issues were executional rather than structural challenges, and they drove the majority of our second half performance deceleration in Brazil and Russia, and I'll get into that in a minute. But just a quick comment on 2011, and then both Chuck and I will spend more time on this. We are squarely, squarely focused on execution against two priorities, restoring growth in these key geographies and delivering meaningful operating margin expansion in the year.

If you look at this chart, as I said, on the top line 2010 was a year of two halves, driven by Brazil and Russia. So if you look on the left, for the total year, the company delivered, without acquisitions, 5% growth in constant dollars. And that was led by 7% first half, which decelerated to 3% in the second half. When you look at Brazil and Russia, Brazil had a 13% first half and a 4% of second half; and Russia, a 14% first half coming down to a 2% second half, and those two markets drove the lion's share of the deceleration of the company between the two halves. So obviously, the key questions are, for Brazil and Russia, why did our sales decelerate? What are we doing to fix these challenges? How long will it take? Was it structural? Is it secular competition, or is it executional? Let me try to answer these questions.

So when I look at Brazil’s sales, the deceleration was driven by service outages. Just a little context for everyone, Avon Brazil's growth, between 2007 and 2010, outpaced our expectations and our infrastructure plans. Our local currency sales were up 70% between 2006 and 2010. Our orders were up 30% versus the 2007 level as they've reached a 6 million order that was shipped out in Q4 of 2010. So this order scale had started to push our system capacity as our growth outpaced our planned infrastructure investments, and you'll hear in a minute that we have started to really put plans in place, whether it was distribution with new Cabreúva facilities, manufacturing capacity enhancements and some systems. So that had been in the works. However, government-imposed e-invoicing changes in June of 2010 exacerbated the order processing issues for us in the second half. So the system's instability led to service delays for our representatives and then outages of product shortage, and it also reduced our flexibility. So this amplifies some of our demand forecasting misses while it resulted in product shorts at three times our historic norms in this market. So we had lost sales from unfilled orders. We had lost demand as representatives became annoyed. They were still placing their orders but less units per order as they started to receive less than they ordered in previous campaigns and higher returns in this period due to shorts and service delays than the typical norm for Brazil.

When you look at service disruptions, and on this chart you'll see that they created approximately an eight point sales drag in the second half. So in the third quarter, as you can see, we had about four points of sales lost due to incremental shorts, about two points of sales in the third quarter due to again representatives being annoyed and not placing the same kind of demand and then higher returns than normal at about 1.5%. Okay, when you look at the fourth quarter, again, still lost sales due to incremental shorts, a little bit more on the representative annoyance factor going from 2% of sales to about 4% of sales impact and then returns slightly better than the third quarter at about 1% higher than the norm.

When we look at this, the service disruptions far outweighed the impact from competition. So again, I just studied this last month, the percent of impact on the fourth quarter sales for Avon Brazil, you can see that Avon controllable factors were the lion's share of this. So Avon service disruptions was a drag of approximately nine points from our demand. The leading direct sales competition did have an impact, but it was 0.6% on our sales, and then retail competitors, it was 0.3%, pretty good [indiscernible] (18:41). So again, that's the numbers for the fourth quarter, which attribute the shortfall from where we were in the first half to Avon controllable factors and service disruption.

What are we doing about it? Aggressive service fixes are underway. Short, medium and long term, we've got a big plan. But end-to-end, from a short-term point of view, all hands are on deck to micromanage the recovery with the company's best people and resources on site. We're accelerating a large number of legacy system modifications and upgrades. We've added significant incremental finance and IT teams on the ground to manage them, and we're redesigning billing and fulfillment processes to increase flexibility.

Mid- to longer-term investments to support continued growth have always been in our plan. Our manufacturing investment of $100 million since 2007 does increase our capacity by 300 million units for this market. You all know about the new state-of-the-art distribution site in Cabreúva, which increases the throughput over 40%, and that is up and running in full in 2011. ERP, you know that we have implemented ERP in Europe and North America. Latin America is next, and Brazil is the first stop, and that transitions 50% to 60% of the company's supply chain and financial transactions, which are being today managed by legacy systems, it allows us to retire those systems to a global solution. And then you've heard us talk about investments we've been making in the Service Model Transformation, which improved the representative's service proposition with a global order management system. So that's what we're doing short, medium and long term.

Service is gradually recovering, with revenue expected to improve throughout the year. If you look on the left, you can see the percent of representative orders that have delivery delay, and the average is somewhere in the norm of 5%, and you can see that at its worst, when we cut over here, it was at 70% of representatives having some kind of delivery delay. And as you get the right of that chart, you are seeing that we're returning to the historic norm in the first quarter. So that's in terms of delayed orders. When you look at the actual order fill rate, the historic norm has been quite high in Brazil. And you can see that as we hit the second half, in the third and fourth quarter, you had numbers that were down to historic lows. And on the very right-hand side, it is gradually improving campaign-by-campaign. It is not back to historic norms, but all efforts are to get it back to historic norms. So it is starting to improve as we turn the corner on this year but not back at our normal level.

Just a reminder of our fundamentals and the structural soundness of our business, we have had 24 quarters of double-digit growth since 2004. Obviously, third and fourth quarter 2010 were not double digits. However, demand growth was double digits. So when you look at the demand growth, as I've asked myself whether the products were effective, the advertising was effective, the incentives were effective, et cetera, demand growth was 13% in the first half and 12% in the second half. And again, you saw the numbers of what reduced that demand growth, which was service.

We've just completed studies about consumer perception. This is market research as of January. It continues to be strong. What is our perception of Avon? And again, 86% of consumers say their perception of Avon is good to excellent. And then, has your opinion of the Avon brand changed since six months ago? Again, just completed last month. And you see 78% say that their perception and opinion of the Avon brand has improved a little to improved a lot.

Our field fundamentals are healthy. Again, this is market research as of this January. Our Active Representative count have continued to grow. In fourth quarter, our orders per campaign, despite the service challenges, reached an all-time high of 1.4 million orders in our highest campaign. And our representative loyalty, in spite of their challenge and annoyance, is very high. In terms of all representatives intending to stay with Avon, it is 85%. In terms of top sellers, it's 91%.

And then if I just look out at an industry level at beauty and channel share, I think Brazil Beauty fundamentals continue to remain strong in Direct Sales. If I look at the period on the left from 2004 to 2010, direct selling gained eight points of market share. Franchise Beauty gained two points of market share in this time period, and retail lost 10 points. So that's 2004 through this last year 2010. But then, if you ask me specifically in this last year, 2010 versus 2009, has that changed? You can see that Direct Sales still gained market share, 30 basis points. Franchise did gain nice share at almost a point, and traditional retail, in spite of heavy investments and a lot of intense pressure, still lost 1.2% market share in 2010 versus year ago.

And I just have to make a comment here. We certainly are completely aware and prepared for intensifying competitive pressures. So we're not ignoring it whatsoever in terms of retail, as well as other direct sales format. I would just say that we are prepared for it, but we still are seeing Direct Sales channel share, not only in the year but for that six-year period.

Let me just turn now to Russia and start by saying, as in Brazil, our challenges in Russia for the company are executional. Avon's market position remains very strong. At the same time, we completed market research just last month on Russia as well. And you could see on the left that in terms of leading beauty brand image, Avon rates number one at 176, followed by L'Oreal and then Oriflame. And if you look at leading brand awareness, beauty brand awareness unaided, again, Avon leads followed by Oriflame and L'Oreal. And in terms of a beauty market share, value share, again, will just closely follow L'Oreal in the number two position in the market, and then followed by Oriflame. So our market position remains strong.

However, in Russia, our deceleration was disappointing and largely driven by execution, as our field growth slowed off a record 2009, you can see again before the solid line in the middle that in the fourth quarter last year, we had well over 25% growth Active Rep growth and nearly 30% revenue growth on a constant dollar basis. And that gave us a tough comp in addition to the fact that our field incentives were not strong enough to anniversary that 2009 momentum, and we are strongly course correcting in 2011. So when asked why they thought their business was down in fourth quarter, 72% of our representatives said that the incentive requirements were too high, 67% said they there were less exciting incentives than the prior year period.

In addition, one of the things that exacerbated our field deceleration was an increase in the social benefit taxes in the Russian market. The new tax rules for entrepreneurs significantly diluted earnings for our first-year sales leaders. So you can see on the left, that before the tax changes until after the tax changes in 2010, an average first-year sales leader with a threshold earnings that are lower than the rest, it impacted her about 35%. And it reduced that group's motivation to recruit. So on the right, if you look at the number of new recruits in the fourth quarter and the percent change, first-year sales leaders highly impacted by the tax change, their recruits were down 15%. That represents about 50% of the recruiting pool. Each side of this represents about half. And those sales leaders with tenure over one year where you have far less impact from these rule changes, their recruits were up 24%. So that exacerbated against field deceleration because of the recruiting impact.

What are we doing here to offset the tax burden? We just launched a new Sales Leadership compensation plan on January 27 of this year, so just days ago. This increases earnings potential of these first-year sales leaders by 25%. It eases the qualification threshold for them. It lowers their earnings threshold and adds a new bonus level when they recruit. So this is going to be funded by reallocating advertising investments because we think it's just that important to recalibrate obviously the compensation for these sales leaders.

When I look at category, in addition in Russia, we had weak Color and Skin Care performance that dampened our second half sales growth. If you look on the chart here in red, is color cosmetics performance. And we're coming up against 31% and 35% growth in the third and fourth quarter last year and had challenges with declines in this year's second half. Same thing in Skin Care, again, it's not as strong as Color, but double-digit growth, and we were not able to lap that.

What were these declines driven by? Execution factors again, partly, to some degree, a weaker innovation pipeline than a year ago in Skin Care, our solutions mid-tier brand was down double digits. And then in Color, it's less effective consumer promotions. 2011, we are significantly strengthening our Skin Care offers, starting in the second quarter with a completely revamped solutions brand. Here you see the positioning, but it's completely new formula, completely new brand positioning and packaging, and it launches in Europe and China in the second quarter. In Color, we are stepping up innovation, so this is stronger innovation versus year ago's pipeline with Moisture Seduction Lipstick in the end of Q1 and SuperSHOCK Mascara in the beginning of the third quarter.

If I just get to promotions for a second, I think that we clearly knew we needed to step up the intensity and the excitement of the promotional calendars. So in addition to a stronger product pipeline, we've got a very high impact aspirational consumer promotion tied in. So this is an example that starts at the end of the first quarter with the Moisture Seduction Lipstick where there's a raffle and sweepstakes that includes the opportunity to win a car.

So longer term, just kind of going to the broad view of the Russian market. On the left, you'll see that the beauty industry in Russia from 2008 through 2010 grew about 8%, and that includes a very depressed 2009 because of the global recession and economic impact. We outgrew that by 1.2x. So Avon gained share in the 2008 to 2010 period. And when we look at the market, and again these are Euro monitor sources, for 2011 to 2014, the anticipation is that Russia is going to grow in the high single digits to low double digits. And again, we fully intend to restore our growth in this market to again stabilizing and regaining market share growth.

Turning for a few seconds to the bottom line, and I'm going to let Chuck go into this in depth. Avon's adjusted operating margin was down 10 basis points in 2010. And if you look on this chart, operational factors were offset by 70 basis point drag from non-operational factors related to the FCPA investigation and Venezuela. So operationally, in the year, we had a 60 basis point operating margin improvement, and that obviously included the impact of these significantly lower sales than we had expected in the second half, for a full year total, as I said, of approximately the same as prior year or 10 basis points down.

Clearly, in 2011, our goal is to deliver operating margin expansion on the path to midteens by 2013. Chuck's going to detail this, but this is going to be driven by gross margin gains, recalibrating the company's strategic investments and tightly controlling cost. Very importantly, we have completed the redesign of our annual and long-term executive compensation, which is now fully aligned with the achievement of midteens operating margin by 2013. So that applies to the 2011 annual executive compensation with a high weight on operating margin improvement in this year, as well as that midteens operating margin commitment, which is reflected in the three-year plan for '11, '12 and '13. Okay, so that's executive compensation.

So I'm going to turn it over to Chuck, but I want to say again, I mean, our priority, we're disappointed in how we closed the second half for sure, but we've got very clear priorities, intense focus on execution to restore growth in these key geographies and delivering meaningful operating margin expansion in 2011.

So with that, I'm going to turn it over to Chuck.

Charles Cramb

Thank you, Andrea. Let me expand on what Andrea said. We are focusing even more on margin improvement as we enter 2011 and beyond. Margin improvement remains a key component of our annual and our long-term planning. And importantly, margin improvement will carry significantly more weight in both our annual and our long-term management incentive programs. Margin and incentives will be aligned.

As I think back on 2010, in terms of our adjusted margins, we had confidence as we entered the year that we would show margin improvement. Even after the negative impacts of Venezuela and the realization that the FCPA investigation cost would be substantially higher than they had been in 2009, we still felt we could show some margin improvement in 2010, albeit much less than originally expected. And we also felt we could step up our investments in longer-term initiatives, initiatives that would give no near-term sales growth but that would benefit us over the longer term.

We were still tracking well against these expectations until we experienced the revenue growth slowdown in our two largest and high-margin international markets, Brazil and Russia. And the net end result was that we basically held margin versus 2009, just offsetting the negative impacts of Venezuela and the FCPA investigation costs. So as I think about 2011, I believe that we will show margin growth. However, we're going to manage the business differently to increase our ability to ensure margin improvement. First, we're going to cost the business against a more conservative sales growth assumption. Second, we are changing the mix of investment spending between RVP and advertising with greater weight on RVP, which is more variable with sales. And third, while in 2010 we invested ahead of sales, in 2011, we will pace our investments to be either more in line with or, in some cases, even trailing our sales growth.

These actions should give us greater control over our margin growth in 2011. However, given our declining sales momentum throughout the second half of 2010, what I expect to see is a stabilization of our margin over the first half of 2011 with measurable improvements coming in the second half. I also think it's fair for you to ask about where we expect the margin improvement to occur within our P&L.

So let's take a quick walk through that P&L. We are costing to the conservative side of mid-single-digit revenue growth. We expect to deliver significant gross margin improvement. Like many other companies, we are experiencing input cost pressures, particularly from oil-based commodities such as plastic resins and chemicals and freight cost on materials shipped to our factories.

We are also continuing to face double-digit labor cost increases in Latin America and in Central and Eastern Europe. However, on the positive side, we see room for continued pricing for the ability to improve the mix of our products, particularly with our skin care initiatives, and for further benefits from manufacturing productivity through our well-established strategic sourcing processes and further cost reductions and efficiency gains within our factories.

Our investments in advertising and RVP in total are more or less going to grow in line with our revenues, but we are shifting the mix away from advertising and in favor of RVP. This shift is to take advantage of greater investment returns on RVP. Despite this, we will continue strong advertising support in our larger and more competitive markets.

Our distribution expenses, which include warehousing and freight to customers, will be under some pressure due to the higher oil prices and their impact on fuel. We will also experience incremental cost particularly during the first half of the year as we transition out of the old distribution center in Brazil to the new one. Effectively, we will have duplicated cost as we run both facilities. We expect our overhead expenses to grow at a rate lower than sales. This is despite the negative impacts of assuming that we will achieve a target bonus payout in 2011 versus payouts that were well below target in 2010. We are also experiencing double-digit wage pressures in Latin America and Central and Eastern Europe. We will reduce these negative impacts by further benefits from our restructuring programs, by tighter controls over labor costs, including a freeze on vacancies except for the most critical positions, and by repacing or slowing down our investments in longer-term strategic initiatives.

Put all together, this is the path that should yield margin improvement with greater flexibility to deliver it. Despite our higher sales and improved margin, which will yield higher net income and earnings per share, our free cash flow in 2011 will probably be similar to that of 2010, as we will be facing the negative headwinds of incremental pension payments of about $75 million, an unfavorable mismatch of CTI cash versus expenses of at least $50 million, and also, we're well below the target payout, a portion of our three-year long-term incentive cash plan for the years 2007 to 2010. We'll offset some of this with continued improvements in trade accounts payable, as well as progress on inventory programs. Our capital expenditures are expected to be somewhat less than in 2010 when they were $331 million. So that summarizes how I am thinking about 2011 in terms of margin improvement and cash flow.

Now I would like to turn it back to the operator to start the Q&A session.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Bill Schmitz.

William Schmitz - Deutsche Bank AG

It's Deutsche Bank. There's a paragraph or a sentence in the press release that says the business fundamentals remain solid. Do you guys really believe that? I know you walked through some of that, but why is that in there? Because you kind of want to see some more urgency here.

Andrea Jung

Yes, I think, Bill, we're talking about the structural business. I think the strategies to invest in the brand, to invest in the channel, the pricing structure of the brand, I think those continue to be the right direction for the company. We have executional issues. I think I detailed them, and we're not happy about them, but I think that's separate from having the wrong strategy.

William Schmitz - Deutsche Bank AG

You talk about the mid-single-digit growth for the year. But kind of like the way you wrote that same sentence, does that mean the first quarter is going to be well below mid-single-digit growth? Or am I just reading too much into that commentary?

Charles Cramb

Bill, I can't really answer that question because that's a guidance question in terms of what first quarter outlook might look like. What we did say, however, is that in terms of the margin improvement, because of the slowing of sales momentum through the third and fourth quarters, we wouldn't expect to see that coming in early in the year.

Operator

Your next question comes from the line of Dara Mohsenian.

Dara Mohsenian - Morgan Stanley

It's Morgan Stanley. So it sounds like you will clearly be pulling back on advertising going forward. But historically, you've indicated that your analytics showed your marketing spending was driving a solid payback. So do you think the payback on marketing has changed here? Has something changed on that front? And are you concerned that the pullback could drive a slowdown in organic sales growth going forward, particularly given the heightened competitive environment in the industry?

Andrea Jung

Yes, just to give you an example, in the fourth quarter, I mean, I think that the climate that we had in advertising was primarily in China. And the paybacks are difficult in China when we're going through a model transition. So I think we're trying to look at it pretty carefully and make sure that, again, major markets where we saw a lot of competition, Brazil, Russia have good levels, strong levels, as Chuck said, and you've got to look at it over several year periods. So I think we were talking about the fact that in certain categories, we were seeing that we were getting to scale and there are certain geographies where we have started to pull back, and we'll continue to pull back until again the model stabilizes, and those are dollars reallocated into RVP. China would be an example. It's a shift and the net of the two, and I think you’ve got to balance those two levers in terms of how we're going to fuel the growth. The net of the two, advertising and RVP, will still be an increase in 2011, but in line with sales growth on a more conservative basis not ahead of as we've reached scale.

Dara Mohsenian - Morgan Stanley

And then on a related note, within your organic sales growth results, the composition was a bit disconcerting and that you were really reliant on pricing and mix to drive your growth and you've experienced unit declines. Can you discuss the balance you expect going forward, if you'd expect to see unit trends rebound, and also if you think you can continue to post the strong pricing growth going forward just given the competitive industry environment?

Andrea Jung

Yes, we do expect to see unit growth starting to -- I mean they were negative, so we'd expect them to be positive. If I really dive into the price mix in the fourth quarter, I think you've got to take out the acquisitions and actually even take out Venezuela, which impacts that. And I think you look at several regions in the world where we didn't really push, I would say, pricing and mix. Even Latin America x Venezuela is about balance sort of 3% units, 3% pricing, and North America was up 5% in price mix and units were down but there I think the lost units were really tied to the drop. And the staff, number of doors, so to speak, is the key driver there. I think we have been really effective in pricing and not losing specific units if you dive into where we took price with the analytics there. So that is the impact. But overall, going forward, yes, some resumption of unit growth, a little bit more balanced in 2011.

Dara Mohsenian - Morgan Stanley

And on the pricing front, are you comfortable you'll hold on to this pricing going forward?

Charles Cramb

There's nothing that we seen in our analytics that suggests that the pricing has had any negative impact in terms of the unit development or the market share. So those analytics continue to bear out, and we feel we've done the right things.

Andrea Jung

Yes, just on the absolute number, 3% is really the pricing number. It's obviously swayed by M&A, as well as Venezuela. But if you just kind of look at core, the way we look at it, it's about 3%.

Operator

Your next question comes from the line of Wendy Nicholson.

Wendy Nicholson - Citigroup Inc

From Citigroup. My first question has to do with your guidance policy, Chuck, and it seems to me that it's highly unfair that you give us guidance that you want to give us, but you don't give us what we want to know. For example, give us a sense of the first quarter. And I don't think where you are now it's right for you to cherry-pick what you think is termed guidance and what not. And I guess it's your policy, whatever. But can you give us a sense at least in the fourth quarter of relative to your own internal forecast how the business trended? In other words, if we're supposed to believe the two pieces of guidance you're giving us, how did you track in the fourth quarter relative to your own internal expectations because we really don't know. The second question I have is while it's great that you guys are being compensated, I think on the external targets, it's crazy that you weren't to begin with, but whatever. My bigger picture question is maybe something more drastic needs to happen. And Andrea, it's great that your problems aren't structural, but if they're all execution, well then shouldn't there be a bunch of people who lose their jobs over such awful execution?

Andrea Jung

Let me just take that last question first. Okay, Wendy, and then I'll let Chuck talk a little bit about what we expect in the fourth quarter, et cetera. But just certainly, clearly, operational rigor on the ground is the huge priority for the company. And I've got to make the right organizational -- make sure we have the right organizational structure, which may be different than it has been and make sure we have the top talent and skills in the right positions to deliver and execute this year. And when I have something to announce, I certainly will. But clearly, that is the priority.

Charles Cramb

Wendy, in terms of guidance, I know that you and I talked philosophically through many years about it. So to answer your question specifically, and as we were tracking through the year, and you saw Andrea's chart, which showed first half, second half, and first half was strong, we were more than offsetting the impacts of Venezuela, we had the FCPA cost going upward also offsetting those. But when we came into the third quarter and saw that we were experiencing a slowdown in the revenue, you remember that we actually said that we pulled off of our guidance about increasing the margin this year, which is what in fact happened. We came in flat with a year ago. So I think we try to give you some sense of what the business might look like. In terms of the second part of that question is how did we perform in the fourth quarter against what we internally expected? It was softer performance than we had expected. It's continued disappointing in terms of how the business develops. So I hope that at least puts us in the context. We don't want anybody to have inappropriate guidance out there, and that's why we changed that guidance on margin improvement for 2010, and then our delivery against what we expected going into the end of the year, it was an underperformance.

Operator

Your next question comes from the line of Chris Ferrara.

Christopher Ferrara - BofA Merrill Lynch

It's Bank of America. Onto the management competition thing again, I guess, it is great that you guys have adopted operating margin. I just wanted to understand, are your targets based on absolute levels of operating margin? Or are they based on year-over-year improvement? And then along those lines, is the base year for 2010, is that based on the GAAP base year? Or is it based on the pro forma base year? So if you could just give us a sense for what kind of improvement and what kind of absolute levels are key bogeys for you guys to get paid, that would be really helpful.

Charles Cramb

In terms of the margin, it will be based upon an absolute level of margin. There are going to be parameters so that you can't achieve the margin by doing really bad things for the business, but the overall margin objective will be a specific objective going into 2011. And it will be on adjusted operating profit because we still have some cost coming through from restructuring, but in general, specific is I think the best answer that you're looking for.

Christopher Ferrara - BofA Merrill Lynch

So it will be based off of a -- it'll be a specific –- so for 2011, the annual target will be a specific achievement of the 2011 adjusted margin off of the adjusted 2010 base period?

Charles Cramb

Yes, absolute margin.

Andrea Jung

Correct, and the same thing on the long term, Chris, it's an absolute number for three years.

Christopher Ferrara - BofA Merrill Lynch

And then, is that three-year target, the 2013 target, that is also an adjusted number, or is that a GAAP number?

Charles Cramb

It ends up being a GAAP number by the time you get to 2013 because there's virtually no costs left. The transition costs run out. This year will be our last big year of transition cost. Next year 2012, we'll have some significant cash flow issues as we close down two factories. But by 2013, GAAP and adjusted are the same.

Christopher Ferrara - BofA Merrill Lynch

I guess I'm just thinking in terms of, if there's an incremental restructuring program that you guys announced, is there leeway within the writing of your comp targets that you'd switch to an unadjusted margin target for 2013? In other words, can you do a GAAP '12 and get paid because the adjusted one is higher than that just because you had restructuring charges?

Charles Cramb

No, I would consider that, playing a game with the numbers.

Andrea Jung

No. The answer's no.

Operator

Your next question comes from the line of Doug Lane.

Douglas Lane - Jefferies & Company, Inc.

Jefferies & Company. Just, Chuck, looking at a couple of things that are impacting this year and then how that shapes up the impact next year. Can you give us some help on what the FCPA costs were this year, and what the impact from Silpada was this year, and then where you think FCPA and the Silpada will impact 2011?

Charles Cramb

Okay, in terms of FCPA, this year we ended up with costs in total of just under $100 million. I think that exact number was $96 million. In terms of thinking about that in the future, I can't you give any guidance on it. I don't have any guidance on it. I think the best thing is an assumption that's got to be your assumption, I will tell you that I've assumed that the costs for 2011 will be similar to what they were in 2010.

Douglas Lane - Jefferies & Company, Inc.

And then the EPS impact from Silpada acquisition midyear, and then with the full year EPS impact is expected to be in 2011?

Charles Cramb

I think when we made the acquisition, we said that we thought that the first full year EPS impact would be about $0.03 to $0.05 after the fact we do have a high amortization of goodwill, and that kind of looks like the objective that we are still running against for 2011?

Charles Cramb

Just directionally, it should be a modest dilution in 2010 and a modest accretion in 2011?

Charles Cramb

It's actually a very, very small accretion in both years.

Douglas Lane - Jefferies & Company, Inc.

And just lastly on the year changes, Venezuela was obviously a big hit in 2010. Is Venezuela going to be another hit in 2011? Or do you reset the bar down and that kind of goes away?

Charles Cramb

I'm trying to figure out how to answer that one because there's so much uncertainty with Venezuela in terms of the economy and in terms of the government-mandated programs. But as we're thinking about that business, which by the way for us is a very great business, strong business, growing market share, growing rep base. We would look at it, and it's been reset to a value that's 50% of what it was a year ago, and that's the translation, devaluation. There should be no accounting things running through going into the future other than what normally happens with high translation.

Operator

Your next question comes from the line of Rick Lyall.

Richard Lyall

John Bristol. So you guys said that your core pricing was three percentage points in the fourth quarter versus the 7% price mix that you site in the release. You had negative gross margins of 90 basis points. What level of pricing do you need to improve gross margins? What are your specific product cost pressures, and how can you manage them going forward?

Charles Cramb

The gross margin decline that we experienced in the fourth quarter was heavily weighted, Rick, by a change in mix. In terms of the pricing versus the comp dynamics, that’s the kind of pricing that we have been able to take should help us in terms of maintaining the margin. I think the real benefits in terms of gross margin are going to come from productivity on the factory side. Although we'll no longer call out strategic sourcing, it's an embedded process, and it continues to deliver benefits in terms of our procurement programs. In terms of manufacturing productivity, we continue to have strong gains that are offsetting our labor cost increases more than offsetting them. And then in terms of the mix side of the business, I look to 2011 to show improved mix throughout the business particularly within the Beauty category, and with that, a stronger performance on Skin Care. So I don't look and say, hey I got to have x amount of pricing to make sure I get margin improvement. I have to look at all of the factors together, and those are the key factors that I think will drive gross margin improvements next year.

Richard Lyall

You're going to close two factories. Can you talk about the magnitude of the margin benefits in closing those factories and the timing of those?

Charles Cramb

Well, the two factories are scheduled to be closed during 2012, so the first real benefits start to flow through in 2013. In terms of the benefits, there's a lot of benefits, not the least of which would be inventory management. There are throughput benefits in terms of changing sourcing to better utilize other Avon factories, but also importantly, to use outside contractors much more than we have in the past, particularly in the Beauty business where we're today maybe outsourcing 10% to 15%. I think when we get to a stabilized position, that number will be somewhere between 30% and 35%. That will have a cost reduction program attached to it. Those costs will be offsetting impacts of inflation. So I'm not going to break them out separately, but it's not an immaterial number.

Operator

Your next question comes from the line of Lauren Lieberman.

Lauren Lieberman - Barclays Capital

It's Barclays Capital. I guess where I want to start is I appreciate the candor around what is Avon-specific. And I would actually happen to agree that the brand, the brochure, the advertising in infinitely better place than it was when this whole restructuring started now many years ago. What's still really unclear to me is just how as managers you remained so incredibly far from the everyday operations of your business. I was in Russia in May and I asked questions about spending levels, and directly what you guys have just commented on is spending its scale, will it start to normalize and margin expansion begins. The response was no, we love spending money. We want to keep the momentum. So then the answer when you report the next quarter when Russia disappoints, we pulled back on spending to hold back in order to support fourth quarter launches. Now we've been through the fourth quarter. It doesn't look like spending went up. It doesn't look like the reason is anything having to do with the pace of launches. It's now executional. The reasons are changing. So can you tell me how are you getting it so wrong in a market that is so big and so important? This problem did not pop up this quarter.

Andrea Jung

I think that we had said in the third quarter that there were weaknesses in which I just talked about again here more in Color and Skin Care. Color, mostly on promotion. Skin Care, mostly on the pipeline. And the staff and recruiting numbers, which were weak against last year's base were exacerbated by the social tax change that really started to play itself out as we moved into the end of third quarter to the fourth quarter as it related to representatives and their behavior in recruiting and that first line of sales leader. So I've tried to explain that. But I understand what you're saying, and I would just say that operational rigor in the market is critical.

Lauren Lieberman - Barclays Capital

So in both Russia and then in Brazil where what you guys do as direct sellers is you process lots and lots and lots of orders. So again, the scale of that business as its grown shouldn't have been a surprise, and I know you said that you've seen it building. More specifically, what do you do? How do you add people and capabilities to be quicker to understand what's going in these very large and important markets while still telling us margins can go up so significantly when there's clearly a lot of fixing to do?

Andrea Jung

Well, if I just take Brazil, for example. The assumptions in the margins walk to midteens by 2013 includes long-planned infrastructure investments, technology investments, et cetera, in Brazil. When we look at the business case, for example, on our Cabreúva plant in terms of the numbers of orders that we expected to come through the system by 2010, we had seen for quite some time that we were about a year ahead of schedule in terms of units and orders. And so what we had done was obviously start planning for this new distribution facility, which we have been working on, and is going to be on time, on schedule, but doesn't open until 2011. Again, ERP and the longer-term systems solutions that get us to a global platform and get us off some of these legacy systems. And Brazil is one of the oldest markets in the portfolio, so therefore, it is saddled with some legacy systems that isn't true for some of our newer markets. But Brazil's legacy system issues will partly be addressed when ERP gets put in there, and we had been planning that. This change, we've had many, many changes being required every year by the government in Brazil. This particular invoicing change really exacerbated our situation before we got into the medium to long-term fixes, which really start in 2011. So again, that's what we're doing. So we do have that short-term fix. But in the long-term fix, that's already implied and does not increase spending levels from what we assumed by 2013.

Operator

Your next question comes from the line of Linda Bolton-Weiser.

Linda Weiser - Caris & Company

Caris & Company. The profitability in North America actually was very good in the quarter, and I think you had like an 8.8% margin for the full year. Can we assume those things stay on track in North America in terms of improving profitability further in 2011? And then secondly, China also, the profitability seems to be improving. Can we assume in 2011 that China is profitable? And then can you explain a little further in China why the rep count decline is so significant. If you're kind of phasing out the boutiques, how come you're not picking up more in terms of on the direct selling model piece of it? Why is that rep count declining so significantly? And then finally, when you said, Chuck, that margins should stabilize in the first half 2011, just to clarify that tiny little guidance statement, do you mean sequentially that overall, the operating margins should sequentially stabilize? Or can you clarify that please?

Andrea Jung

Let me just answer the questions on China. Sort of based on top line acceleration, I'm just going to confirm what we have said before, that we expect Avon China to become profitable in 2012. And obviously, though, we continue to really manage costs carefully in that market although as we go through this transition. As it relates to the decline in Active Representative, just a reminder that as part of the move away from Beauty boutiques into direct sales and the new direct sales model, which is focused on service centers and more stellar representatives driving productivity, part of this loss is some of the, I would just call the more customer representatives that were part of and attached to the retail model and the Beauty boutiques. So when I look at the pilot, it is rolled out, it’s now 20% of the market, and the full new direct sales model will be rolled out nationally by the end of this first quarter, so the end of this March. And some of the early indications are positive particularly as it relates to activity improvements and average order increases. So that really is the answer of having more productive representatives, which is are focus in the new model. And in terms of North America and its operating margin, we did have strong gross margin improvement in this market. We are realizing the restructuring savings. This is one of the tenants [ph] (1.04.16) of the turnaround, is obviously real good cost management, and we had a benefit. When you include the total, we had a benefit from an accounting adjustment. We think while it may be variable by quarter, obviously, our long-term goal here is to get North America back to respectable margins.

Charles Cramb

Linda, you asked one other question, which was the margin comment that I made, that would be quarter-on-quarter, so prior year to this year, so first quarter last year, first quarter this year.

Operator

Your next question comes from the line of Ali Dibadj.

Ali Dibadj - Bernstein Research

I'm from Bernstein. So I guess I'm trying to ask this question in the most, I guess, objective, open-minded way possible, given with some know as [indiscernible] (1.05.16) stock and some of the rationale you've kindly given us today, but if I kind of take a longer view and I look at the past 10-plus years, we’ve had something like three restructurings. We've had Eastern Europe, Mexico and Japan issues. U.S. business has clearly kind of struggled, arguably falling off a cliff. We had some Venezuela aggressiveness I'd argue, [indiscernible[ (1.05.37) is still an issue, China growth issues, free cash flow productivity issues, clearly increased competition from traditional CPG companies; and kind of the list goes on and on and on, not to mention your GAAP EPS is the same as it was in 2003. When do you in the aggregate think that this is actually a structurally-challenged company, not just a set of one-time issues that can kind of be explained away? And if this is not a structurally challenged set of symptomatic of a structurally challenged company, what does a structurally-challenged company look like?

Andrea Jung

Well, I think that structurally challenged question, I think if you look and the answer is different obviously by market. But let's just take, again, as I said this morning, two of our important growth assumed drivers going into the medium to long-term, brand health erosion, consumer perception changes, market share losses over extended periods of time, that to me would be structural challenges in the developing and emerging market. A China business model, which has had constraints because of government regulations, the only regulated market that we have – China’s business model that I think gives attractive earnings once we get through this transition that does not gain share over the medium to long term because there are other factors. At that point, I would say then you have a structurally-challenged model, way too early to call, but I think we're doing the right thing. So I mean, those would be my answers, Ali, that I think numbers are the numbers and a sustained share loss over a period of time says you have structural issues in the developing and emerging markets in spite of what we're spending in. And so I don't we would deny that, but I really don't believe we are anywhere near that point. I think that again, there is a strong brand health, and I don't want to beat a dead horse, and I am not happy about it from the execution challenge in Brazil. But I think you've got a very not only structural sound but still growing. And albeit, I think there has been a lot of dialogue and conversations, and we've had it with many of you over the last several quarters as it relates to competitive pressures. And I absolutely agree that strict markets in Brazil and Russia are huge intensified spending targets for lots and lots of companies. But having said that, kind of the share that we have and I think the model and the changes that we have been investing in over these years, whether its e-enablement distribution capacity increases and/or brands in channel investments are the right things to do for this business to continue to gain share.

Operator

Your next question comes from the line of Connie Maneaty.

Constance Maneaty - BMO Capital Markets U.S.

Would you tell us what the operating margin target is for management compensation? And if you don't give it on the call today, will it be in the proxy? That's the first question. Second question relates to the prior one that may be asked a little bit differently. There have been executional issues in many markets over time. There was Mexico with field fundamentals and then North America, now Brazil and Russia. And every time we hear about these, you're always putting your best people into these circumstances to execute a turn around. But from your point of view, what needs to happen internally so you don't have execution issues, so that you are able to deal with whatever the local government changes without it appending results for a quarter or more?

Andrea Jung

In terms of the operating margin specific target, again, just being confirmed with the compensation committee as we go into the proxy, but I think it will detail the commitment to the midteens by 2013. I don't think we're going to disclose annual absolute, but know what our base is, and midteens is the absolute number that's going to be in the final year 2013, so every year builds towards that. So that's operating margin. And in terms of execution, as I said and I’ll just go back to Brazil for one second, the complete, I guess, focus on the execution of those things which do retire legacy systems, do expand the infrastructure so that it does not have that capacity constraint, which is a combination of the manufacturing capacity, new distribution facility as well as, again, an order management solution. So it’s not just Brazil but for the entire company, a global order management solution over the next couple of years as well as the finishing up of the ERP installation worldwide for the JD Edwards solution are the important aspects that, again, from an enterprise point of view allow us not to have that stress.

Operator

And your next question comes from the line of Mark Astrachan.

Mark Astrachan - Stifel Nicolaus & Company, Inc.

It's Stifel Nicolaus. Just one follow-up on Brazil and then one other question. Can you comment on the sales trends or volume trends sequentially in the quarter and the fourth quarter and sort of month by month just based on some of what you had talked about in terms of the issues in the quarter? And then unrelatedly, just back on the question about long-term growth, given direct selling category trends and personal care category trends, particularly in emerging markets, shouldn't sales growth be at, at least a mid-single digit level, which I think you've even referred to in the past in terms of your overall growth? And then sort of related to that, how doesn't the decision to invest less hurt that long-term algorithm?

Andrea Jung

Well, I think that given the weaker momentum coming out of the year, the full core press but some time needed that I think the mid-single digits as opposed to just given kind of how we ended and as we've come out of 2010 made sense. In terms of the Brazil sales trends, the demand sales actually were even, and we saw some of the higher than third quarter, believe it or not, demand growth in some of the campaigns in the fourth quarter. It was the filling of those orders that was the issue not the actual demand in terms of sequential 3Q to 4Q, or even 2Q to 3Q to 4Q, I think I showed you that.

Charles Cramb

Let me just add a little bit on the growth question you asked because I think it was also longer-term in nature. You're correct, the Beauty category is an advantage category. The channel is advantage in the emerging and developing markets. So as you look at the business, I can see where you would want to come to the conclusion that the overall growth has an opportunity to be stronger than perhaps what we declare. But that's what we're going to [indiscernible] (1.13.22) the business to, and that's how we're going to think about our infrastructure and think about moving forward. And obviously, if the growth is better than that, we'll be in a wonderful opportunity to make decisions about what to do with that incremental profit.

Operator

Your next question comes from the line of Alice Longley.

Alice Longley - Buckingham Research Group, Inc.

Buckingham Research. My question's about Brazil again. Could you give us more detail on what the real problem was? I guess you're saying it was not filling orders. What does that have to do with the government required e-invoices? You cited manufacturing capacity. Is it that you hadn't planned well enough for enough capacity? Is it because you didn't predict well enough exactly what people wanted? What was the real reason you're having trouble filling orders, and how long does it take to correct that?

Andrea Jung

We'll go back to some of those things on my slides, but the capacity in the country was definitely about a year ahead of what we had projected, and we had been working on solutions and have in place solutions for that, and what I was just saying is for manufacturing capacity to distribution capacity, those things were all in place for 2011. In 2010, in the middle of the year, as we have dealt with government-required changes, but this particular e-invoicing change required did exacerbate many of our processing issues and led to some system instability. That system has been stabilized. But that had some de facto impacts of service delays to our representative and outages of products and I’ve quantified what those were. So while demand remained high, we were unable to fill because our product shorts were about three times their norm.

Alice Longley - Buckingham Research Group, Inc.

And the reason for the problem was the e-invoicing?

Andrea Jung

E-invoicing was really the catalyst to this issue, yes.

Alice Longley - Buckingham Research Group, Inc.

And are you the only company that had trouble with the e-invoicing, or was this a widespread problem?

Andrea Jung

Well, I think a lot of people were affected by e-invoicing, but I can tell you that why it challenged us was a legacy system environment. If we had been 10 years old and had a different systems platform, it would've been a lot easier to convert over. So this I think had a particular challenge because we're 55 plus years old in that market and have multiple legacy systems that have not converted yet to ERP in this market, which we are planning to do.

Alice Longley - Buckingham Research Group, Inc.

And then the idea that this is going to get corrected through 2011 with the better distribution and manufacturing. How can you convince us that you're going to be able to make that massive transition, particularly with the distribution centers smoothly?

Andrea Jung

Well, the distribution center is already up, and we are running, as Chuck mentioned, duplicative costs just to ensure that full transition. But we've been very pleased but as a guarantee, if you would, and there will be some extra cost in the first part of 2011 just to make sure we don't flip over to one side. But everything we say is pretty stable as we've cut over already in this past end of the year. In terms of ERP, we are fully prepared, but we're not going to do it on a non-stable environment. So we are ready to put ERP into Brazil, but we will not do that until the environment is stable and move it to the global solution. And then what we believe are the short-term, as I said, system modifications and upgrades allow us to feel very comfortable that we could get through until we go to the ERP, and the Cabreúva facility I feel very confident about in terms of moving over and shifting over to that in 2011.

Charles Cramb

We've given ourselves effectively 12 months to do the transition from one facility to the other. In the fourth quarter of this year, we were shipping some of the non-Beauty business out of the new facility, and we have a rolling in through the first three quarters. By the end of the third quarter, we should be fully operational, somewhat conservative. But given the size of the Brazilian business, given its importance, it was an area that we just didn't feel we needed or wanted to take any risk, and thus the long transition program.

Operator

Your final question comes from the line of Jason Gere.

Jason Gere - RBC Capital Markets, LLC

I guess I'll just switch to maybe the U.S. a little bit. We've seen three years now of declining organic sales. By our calculation, 11% organic sales in this quarter is probably the worst that we've seen in quite some time. So I guess can you just give us a sense how much increase in RVP is going to be needed to kind of improve the trends? The rep expectations, how are they being managed because the rep growth is declining too? So I'm just wondering if you can give us some clarity when we should see the U.S. actually start to get better on what has been three years of easier comps.

Andrea Jung

The U.S. performance did remain pressured in 2010. I think the major challenge was anniversarying a very, very strong recruiting number in 2009. To enhance, again, the rep numbers going forward in 2011, we have shifted about $20 million, so it's not incremental but a shift to a significant acceleration and enhancement of Sales Leadership earnings to expand recruiting. So that is a very hefty incentive and actual enhanced earnings opportunity for the amount you can make on a recruit, as well as an average order enhancement in the second half for more giftable programs, as well as a mom and baby business in this market. So we have actions for increasing average order, but the primary focus from an investment point of view in 2011 is to enhance our rep growth. We do have a couple of negatives, but we hope they ease our macro. One is really the U.S. Beauty growth again was down in 2010, and that was a little bit of headwind because we did anticipate some modest growth in the category as we are shifting out of non-Beauty into Beauty. So we've got short-term actions to stabilize the revenue in 2011, enhancing all of our focus and a significant amount of money in the first half on our Sales Leadership earnings expansion.

Operator

And that was your final question.

Andrea Jung

Okay, thanks, everybody. And if you have any follow-up questions, Amy will be here to answer them. Thank you.

Operator

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

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