Going Global and Finding Value With Avon Products

| About: Avon Products, (AVP)

Avon Products, Inc. (NYSE:AVP) is a leading global beauty, fashion and home furnishings company. It is truly a global company with almost 90% of its employees based overseas and approximately 80% of its revenues. Its largest single country market is Brazil, not the United States.

Avon Products Inc. manufactures and markets beauty and related products worldwide. Its product categories include color cosmetics, fragrances, skin care, and personal care; fashion jewelry, watches, apparel, footwear, and accessories; and gift and decorative products, housewares, entertainment and leisure, and children's and nutritional products. Avon Products Inc. markets its products through direct selling and independent representatives, as well as through distributorships. The company was founded in 1886 and is based in New York, New York.

Source: Yahoo!Finance

AVP is one of the world's largest beauty companies and the largest based in the United States when measured by annual sales.

Competitors in Cosmetics and Beauty Products

Ticker Name Last Close Market Cap ($ millions) Annual Sales ($ millions)
OTCPK:LRLCY L'Oreal SA $23.31 69,839 25,890
OTCPK:KCRPY Kao Corp. $26.96 14,562 12,730
AVP Avon Products, Inc. $27.72 11,913 10,863
EL Estee Lauder Companies, Inc. (The) $91.91 18,145 7,796
OTCPK:SSDOY Shiseido Co Ltd $19.90 7,960 6,924
IFF International Flavors & Fragrances, Inc. $57.67 4,628 2,623
REV Revlon, Inc. $14.95 776 1,321
RDEN Elizabeth Arden, Inc. $29.33 844 1,104
HELE Helen of Troy Limited $27.95 858 648
IPAR Inter Parfums, Inc. $18.75 571 409
PARL Parlux Fragrances, Inc. $3.47 71 148
FACE Physicians Formula Holdings, Inc. $4.21 57 78
CAW CCA Industries, Inc. $5.70 40 51
FHCO Female Health Company (The) $4.80 133 22
Data provided by Zacks.com services. Data is downloaded on March 4, 2011. Stock prices are of March 3, 2011.

Furthermore, AVP shows very strong geographic diversification with respect to its revenues. However, revenue growth is driven almost completely by Latin America.

Source: AVP 10-Ks. WE is Western Europe, ME is Middle East and C&E is Central and Eastern.

Discounted Cash Flow Analysis
I completed a discounted cash flow analysis on AVP to evaluate it as a potential long investment. The discounted cash flow method is one of the basic tools for valuing companies. Essentially it states that the value of an enterprise is equal to its future cash flows discounted at an appropriate rate to account for the risk in those cash flows. This methodology produces a value that is reflected to the expected cash flow. It does not provide any insight into potential risks or sensitivities.

The appropriate discount rate is based on whether the cash flows have been adjusted for servicing debt or are prior to debt service. I used the unlevered free cash flow method which targets an enterprise value. The appropriate discount rate should then reflect both the cost of debt and the cost of equity. In this case, a weighted average cost of capital (WACC) is appropriate. The required equity return can be calculated using the Capital Asset Pricing Model with an equity risk premium, an equity beta, and a risk free rate (approximated by the 10 year U.S. Treasury Bond rate). The unlevered free cash flow in its simplest form equals net income + depreciation/amortization – changes in working capital – capital expenditures + interest expense * (1 – tax rate).

WACC Components
WACC Component Value
Risk Free Rate 3.5%
Beta 156.0%
Equity Risk Premium 6.0%
Required Equity Return 12.9%
Cost of Debt 4.5%
Tax Rate 35.0%
Debt Weighting 20.4%
Equity Weighting 79.6%
WACC 10.8%
Source: AVP 10-Ks, Yahoo!Finance

The key observation here is that the cost of debt seems relatively low based on the ratio between interest expense and balance sheet debt. However, since debt is a small portion of the overall capital structure, the impact on WACC should be limited. This might be a sensitivity to check.

Year Status Net Income Depreciation Change in Working Capital Capital Expenditures Unlevered Free Cash Flow
2008 Historical 875 187 (450) (381) 352
2009 Historical 626 175 (226) (296) 465
2010 Historical 606 195 (458) (331) (377)
2011 Projected 995 211 19 (331) 784
2012 Projected 1,064 225 14 (338) 828
2013 Projected 1,116 239 15 (345) 884
2014 Projected 1,172 252 16 (351) 943
2015 Projected 1,233 264 18 (359) 1,004
2016 Projected 1,299 276 19 (366) 1,071

The calculated free cash flow does show a disturbing shift in working capital requirements that is due to a difference in how my DCF model computes it versus historical figures from Yahoo!Finance. Certain other current asset acquisitions are embedded in the changes in working capital causing it to be a greater negative. AVP had done a good job of pulling in accounts receivable and stretching out accounts payable during the downturn as noted below.

Historical Working Capital
Year Status Days Receivables Days Payables Days Inventory
2008 Historical 39.8 173.8 93.2
2009 Historical 27.4 201.9 100.2
2010 Historical 27.8 201.3 104.1
Source: Yahoo!Finance. Note that Days Payables and Days Inventory are based on COGS.

AVP appears to compare well to its comparable companies based on valuation metrics.

Valuation Comparables
Ticker Price/Cash Flow P/E (Trailing 12 Months) P/E (F1) Price/Book
AVP 12.2x 15.3x 13.8x 7.1x
EL 21.0x 27.3x 25.0x 7.5x
IPAR 15.4x 20.8x 19.1x 1.9x
FHCO 14.5x 17.8x 13.7x 8.2x
RDEN 14.1x 21.0x 19.8x 2.1x
IFF 13.1x 17.1x 15.3x 4.6x
SSDOY 12.4x 25.8x 36.2x 2.1x
FACE 11.8x 42.1x 40.1x 1.1x
HELE 9.8x 10.2x 8.4x 1.3x
Average 13.8x 21.9x 21.3x 4.0x
Data provided by Zacks.com services. Data is downloaded on March 4, 2011.

AVP does have below average margins for net income and EBITDA, despite above average Gross Margins. Part of this might be attributed to mix of products sold. However, L'Oreal shows extremely strong margins as the industry leader.

Margin Comparables
Ticker Revenue ($ Millions) Gross Margin EBITDA/ Revenue Net Margin
LRLCY.PK 25,890 70.8% 19.9% 11.5%
KCRPY.PK 12,730 57.4% 14.9% 3.5%
AVP 10,863 62.8% 11.3% 5.6%
EL 7,796 76.5% 14.1% 6.2%
SSDOY.PK 6,924 75.1% 11.8% 5.2%
IFF 2,623 41.7% 18.6% 10.0%
REV 1,321 65.5% 18.6% 24.8%
RDEN 1,104 44.9% 7.2% 1.8%
HELE 648 43.1% 16.3% 11.1%
IPAR 409 57.2% 15.2% 5.5%
CAW 51 57.0% 11.6% 6.8%
FHCO 22 58.2% 21.1% 30.3%
Average 5,415 58.4% 14.4% 9.7%
Data provided by Zacks.com services. Data is downloaded on March 4, 2011.

AVP clearly represents a good way to create global diversification. The discounted cash flow analysis suggests that it is approximately fairly valued to possibly undervalued.

Valuation Component Value
Enterprise Value $ 14,278
Debt and Liabilities $ 3,152
Cash $ 1,180
Potential Equity Value $ 12,305
Current Equity Value $ 11,913
Potential Appreciation 3.3%

Here is the rub, while AVP is slightly undervalued by the discounted cash flow, its margins seem to trail the industry leaders and the comparables being below the average might in this case not reflect an undervaluation, but rather concern over future prospects - perhaps due to lower margins. AVP does offer an attractive 3.3% dividend yield which is above average for the industry and the highest among the larger firms. In addition to an attractive dividend, it would provide good global diversification to a portfolio since its correlation to SPDR S&P 500 (NYSEARCA:SPY) is around 75%, which is actually a lower correlation than iShares MSCI Emerging Index Fund (NYSEARCA:EEM). However, I would be interested in additional analysis around two main areas:
  1. Better understanding the growth prospects. The assumed long term growth of 5% is below its recent growth in many emerging markets.
  2. Would one of its competitors be a better investment in this space?

An investor with a strong focus on current income, might consider this a good potential long due to the dividend, reasonable valuation, and diversification benefits.

Disclosure: I am long SPY.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.