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Executives

Amy Low Chasen -

Andrea Jung - Chairman of the Board and Chief Executive Officer

Charles Cramb - Vice Chairman of Developed Market Group and Interim Chief Financial Officer

Analysts

Javier Escalante - Weeden & Co., LP

Dara Mohsenian - Morgan Stanley

Constance Maneaty - BMO Capital Markets U.S.

Lauren Lieberman - Barclays Capital

Alice Longley - Buckingham Research Group, Inc.

Ali Dibadj - Sanford C. Bernstein & Co., Inc.

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

William Schmitz - Deutsche Bank AG

Douglas Lane - Jefferies & Company, Inc.

Wendy Nicholson - Citigroup Inc

Linda Weiser - Caris & Company

Nik Modi - UBS Investment Bank

Christopher Ferrara - BofA Merrill Lynch

Avon Products (AVP) Q1 2011 Earnings Call May 3, 2011 9:00 AM ET

Operator

Good morning. My name is Christie, and I will be your conference operator today. At this time, I would like to welcome everyone to Avon's First Quarter 2011 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 first quarter earnings results. With me on this call are Andrea Jung, Avon's Chairman and CEO; and Chuck Cramb, Vice Chairman, Developed Market Group and interim 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. As usual, on the call, we will focus on adjusted non-GAAP financial measures.

With that, I'll hand the call over to Andrea.

Andrea Jung

Thank you, Amy. Good morning, everybody. Just a few quick comments on the quarter. The first quarter is broadly on track. Our constant dollar revenues, as you saw, were up 4% in the quarter, driven by Latin America and WEMEA M&A contributed 2% to this quarter. Our Beauty sales were up 4% in constant dollars. The 2 categories that really drove that were Fragrance and Personal Care. Active Representatives continue to be soft. They were down 1% impacted primarily by China and North America.

Our adjusted gross margin expanded 80 basis points as effective price management and favorable foreign exchange counteracted mix in commodity cost pressures. Adjusted operating margin was up 30 basis points as gross margin expansion and tight cost control offset higher distribution costs. So our adjusted earnings per share from continuing operations was up 12% in the quarter. Our cash flow was down $41 million, impacted by $75 million pension contribution in the quarter and higher inventory.

If I just go back to February and what we outlined at CAGNY in terms of 2011 sales and operating margin goals by half just on the top line, what we said was that we were looking for core revenue to grow in the low single digits in constant dollars in the first half and then accelerate to mid-single digits in the second half for a full year of mid-single-digit growth. In terms of adjusted operating margin, we said back then that we felt the first half would have adjusted operating margin below prior year and then be up significantly in the second half for a full year outlook of 50 to 70 basis points improvement. And we still feel good about the full year outlook, although as you'll see later the adjusted operating margin will be better than what we said in the first half.

So since CAGNY at the end of February, the whole company's focus has been against the key 2011 operating priorities that we laid out, and again, those were just the historic growth in Brazil and Russia throughout the year to stabilize North America, to reignite our Skin Care category and to deliver meaningful operating margin expansion.

So if I just turn to Brazil to start, we've seen some progress on service in the quarter. It's not yet reflected in our top line results. On the left, we are just tracking our percent of deliveries delayed in the quarter, and you could see some of the peaks, where as we came out of the back half of last year some tough percent of representative orders having long delivery delays. That has pretty much restored itself to the historical norm as you can see that we had as we were exiting the first half of last year.

In terms of the order fill rate, the dotted line is the historical norm for the market, which we have been at for many years. We had the disruption in the middle of the year, so you saw particularly as we got down to probably the trough was in that November, December period. And steadily, the order fill rate has been improving. There's been gradual improvement. But it's not yet back to historical norms yet, but we feel good about the steady progress we're making on that front.

But restoring representative confidence, obviously, is key to improving the top line growth. Once the historical service levels are achieved. Annoyance always does lag service recovery. That's what we found in the history of Avon. Generally, it takes a couple of quarters for revenues to improve. Brazil could take a little bit longer just due to the high number of reps also carrying competitive brochures. It's our largest dual rep market. But again, it takes a couple of quarters for revenue to improve after service were already [indiscernible] recovers. So the highest priority for us now going forward is restoring representative confidence and their activity.

Additional bonuses for zone managers and sales leaders are being put in place from the second quarter on to really return representative activity to historical levels. Personal contact has always been a best practice in this market. It's always been important but never more important than now, so all of our zone managers and sales leaders are focused on really enhancing their contact with top sellers to encourage the activity. We've got energy building representative events across the balance of the year. And then importantly, we were offering higher value, higher energy incentives to our representatives to spur their activity from computers, smartphones, iPads, so high-energy incentives. And as we said in late February, we continue to expect gradual revenue improvement in Brazil throughout the year.

In terms of restoring growth in Russia, we've seen a lot of heavy lifting since the beginning of the year. And it's under way to support the second half acceleration in this market. The categories of Color and Skin Care will benefit from revamped merchandising and product innovation in the second half. We completed the national rollout of the new Sales Leadership compensation plan at the end of January and we're pleased that some of these field programs are showing early signs of progress as we exit first quarter. Our unit leader count is up. We're seeing growth in appointments and activity is also trending up. So early green shoots that the plans we put in place for Sales Leadership are working.

In terms of stabilizing North America, we have strong 2011 field and average order initiatives underway. Our plans are in place to stabilize the average order by year end in this market. We've stepped up our Fragrance and Skin Care pipeline significantly along with some strong promotions. We have revitalized holiday giftable offers in the Beauty categories, as well as non-Beauty for the fourth quarter, and we'll be expanding the Mom and Baby launch which was piloted in one region in the second quarter.

In terms of the field, the Believe in your Success incentive program is starting to gain some early momentum as we come out of the first quarter. We're starting to see the participation in this incentive rate really rising and the up line leader count is beginning to stabilize. In addition, as we go through the rest of the year, we're evaluating plans to strengthen the leadership structure for the medium and long term.

From a Skin Care category point of view, some early progress. A lot of work still to do. But as you can see, the fourth quarter of last year, we had a 10% decline in this category, the first quarter of this year a 4% increase. That 14 point delta, a lot of it comes from a very successful $40 million Avon Care launch. That was the launch planned for this quarter, a value, a global value skincare line that launched successfully in Latin America. We are continuing to see solutions weak, but that's ahead of a major second quarter relaunch that should spur that mid-tier brand. And the new declines are lessening in the quarter. We've got a lot of stepped up innovation pipeline starting in third quarter with suncare and then in fourth quarter with a very, very big anti-aging product launch. So early progress.

And then in terms of expanding our operating margin, we are on track. Our gross margin and cost control continue to underpin our 2011 outlook. Again, our adjusted operating margin growth, if you look at it in the fourth quarter, it was down 100 basis points. In the first quarter, it is up 30 basis points. And it's adjusted gross margin which expanded 80 basis points as effective price management and the benefits from exchange more than offset mix and commodity cost pressures.

Advertising and RVP investments were rebalanced as we have talked about it and as we planned. When you combine the 2, the spend was slightly ahead of sales growth, and we look at the full year as these 2 combined being in line with sales growth. And lastly, the tight overhead control partially offset what we had planned for distribution cost increases of 100 basis points.

When we look ahead to the second quarter, we expect constant dollar sales growth in line with or slightly better than the first quarter. We expect adjusted gross margin to be flat to up slightly as effective price management and foreign exchange gains continue to offset commodity cost pressures. And so we look at adjusted operating margin to be about flat versus 2010 next quarter.

For the full year, our outlook remains unchanged. But as you can see for the first half then the adjusted operating margin will be about flat versus down as we had looked at it earlier in the year.

Outlook for the second half in terms of mid-single-digit constant dollar revenue growth is going to be driven primarily by a very aggressive 125th anniversary representative activation program. This is a major global incentive to drive representative and unit growth in the second half. We also have a very robust product pipeline and strong merchandising promotions as we plan to recover as we came out for all of the catalogs in the third and the fourth quarter.

Our adjusted gross margin expansion in the second half will be driven by effective price management and benefits from foreign exchange to offset further commodity pressure. We see the commodity pressure obviously getting tougher as we close out the year. But we still feel good about delivering 50 to 70 basis points of adjusted operating margin expansion for the full year.

And then importantly, before I turn it over to Chuck to give you more details, I just want to say that the whole organization remains squarely focused on driving operational rigor. There's a great sense of urgency throughout the organization, some early green shoots but we are clearly aware we've got a whole lot of heavy lifting to do. Our new Commercial Business Units leaders are hitting the ground running. We have the 2 external searches for a new Latin American CBU leader and CFO. Those are both well underway with highly qualified candidates for both. And also, we've launched an enhanced Process Excellence program throughout the company to drive improved operational execution.

In March, we established a new very enhanced program office and a greater number of dedicated organization resources that are focused on sales and operation planning improvement, particularly demand forecasting as applied planning, which will improve inventories going forward. Gross margin optimization, obviously a big focus for us in terms of making sure that we can focus on sustainable execution in gross margin. And then lastly, global sales incentive management really taking a look to make sure that we really evaluate and have consistency in our power of our effectiveness of our RVP spend in our global sales incentive. So we're going to continue to drive for clear accountability and added operational rigor with roles across the enterprise. So a lot of work has been done on that.

So I think we're making some early progress, but we remain focused on a lot of heavy lifting that's required across the balance of the year to continue to return this business to sustainable profitable growth.

Okay, at this point, let me turn it over to Chuck for a little bit more on the regional results and the balance sheet.

Charles Cramb

Thank you, Andrea. Now I'm going to follow the format that we adopted about a year ago in terms of reviewing the regional performance. Starting with Latin America, across the region, we had strong balance growth which offset the expected soft performance in Brazil. This resulted in an overall double digit or 11% constant dollar growth for all of Latin America. At the gross margin level, we had strong gains due to pricing, favorable mix and cost benefits, including transaction exchange. However, our operating margin did contract 120 basis points. Offsets to the gross margin gains included: one, higher distribution costs of 120 basis points due to the duplicated operating cost in Brazil and Colombia as we transfer to the new facilities; two, higher bad debts, particularly in Brazil as a consequence of our earlier service disruptions; and three, increased investments in RVP.

Moving to North America. North America, our overall revenues are down 2%. However, if you exclude the impact of Silpada, the decline is roughly 10%. The bulk of the sales reduction in the core business resulted from Active Reps being down. The operating margin is 150 basis points less than it was last year. We were unable to reduce overhead expenses in the core business at the same rate as the sales reduction. This more than offset continued bad debt improvements in the U.S. Silpada, which is a relatively small business versus the rest of North America, in Q1 improved the overall margin by roughly 20 basis points.

In Central & Eastern Europe, the revenues were down slightly. Negative macroeconomic pressures and a reduction in Active Reps contributed to the sales performance. Russia was slightly positive during the quarter. The operating margin improved 90 basis points due to higher pricing and some favorable benefit from transaction exchange.

In WEMEA, we continue to generate strong revenue growth. Sales have increased 15% in constant dollars, including about 4 percentage points from Liz Earle. South Africa and Turkey led the revenue growth with strong double-digit increases. They are also the countries with the strongest Active Rep growth. The operating margin improvement of 260 basis points reflects the strong revenue growth with a much slower growth in expenses. Also contributing is a higher gross margin, which benefits from pricing and some transaction exchange.

Asia Pacific, and here I just want to remind you that Asia Pacific now includes China as a result of our recent reorganization announcements. Overall, revenues have declined 12%. This is due to lower sales in China as we continue to transition away from our hybrid model. Despite the lower sales, our operating margin improved. In China, we have withheld advertising and obtained lower sales incentives. Investments in China will resume once the new sales model starts to take hold.

Now let's take a look at the overall company. Performance first revenue, the constant dollar increase of 4% is balanced between growth and in the core business and sales from our acquisitions. Currency then added roughly 3% to revenue in the quarter. Gross margin increased some 80 basis points year-on-year. We are experiencing commodity cost pressures, which contributed significantly to the 50 basis point increase in product cost. We also had higher labor costs from developing countries where we are manufacturers. Our price mix is a net favorable of about 60 basis points. Of this, price is roughly 150 basis points and while product mix is unfavorable about 90 basis points. Currency benefited us by about 70 basis points, due primarily to favorable transaction exchange.

Moving to RVP advertising and overall cost. The first quarter is indicative of the rebalancing we expect during 2011 as we shift funds away from advertising and into RVP. Together, advertising and RVP did grow slightly faster than revenue. The advertising reduction was primarily in China. Investments and Sales Leadership, higher sales incentives and the Service Model Transformation initiative accounted for the increase in RVP. Our overhead was up about $30 million. The bulk of the increase was due to higher labor costs. Translation exchange was also material in the dollar comparisons.

Partially offsetting these increases were significant reductions in conference and travel cost through greater use of technology such as telepresence. We are also, have an ongoing headcount freeze. Our FCPA cost were similar to those in last year's first quarter.

Moving to operating margin. Our 30 basis points gain in operating margin came despite the significant increase in distribution costs. The high distribution cost reflect the duplicated facility costs, which I mentioned earlier, and significant pressure on delivery costs due to higher gas or fuel prices. Overall, our margin performance was somewhat better than we've expected. We realized better benefits from cost control, higher effective price realization and a slightly more favorable impact from currency.

Our adjusted EPS of $0.37 was up $0.04 or 12% from last year. This charge bridges the GAAP EPS to adjusted EPS. The big difference is in the Venezuela special charges of $0.23 in 2010. These charges were a result of Venezuela being treated as hyper inflationary along with its massive evaluation.

Now to the balance sheet and cash flow. First, the balance sheet. Looking at these key items, inventories continue to be an issue. They're up 16 days from one year ago. Most of this increase is due to carryover of the high balances at the end of last year. It does take some time to incorporate programs to reduce these inventories in our campaign, planning and brochure printing processes. We do however, expect to start the flow of these products in our Q2 catalogs.

We do expect year-end inventories to be down in terms of days coverage versus 2010. Our accounts payable have increased 11 days from a year ago. We have improved our supplier payment terms as a result of benchmarking, a critical element of our strategic sourcing processes. However, you have to expect some variability in this index quarter-to-quarter based on timing of shipments to us. In terms of the cash flow, when you look at this, I think it's important that you look at the schedule starting with the cash-related income, this will avoid the distortions that are created by the non-cash charges from Venezuela in 2010.

There are 3 significant areas I'll reference in the quarterly cash flow comparison. Inventories. Inventories are a significantly higher use of cash this year than last year. Last year, it did benefit from a stronger sales performance in the first quarter, which helped dampen the impact of the normal seasonal growth in Q1. Pension. We made a significant one-time pension contribution of $75 million in the U.S. improving our overall funding to just under 85% on our qualified plans. And taxes, we continue to benefit from the recovery of VAT deposits in Brazil. Overall, had we not made the one-time pension contribution, our cash from operations growth would have roughly equaled the cash related income growth despite the higher inventory build.

So that's a quick review of the quarter. Going back to our outlook, which is unchanged for the year, we expect first half core revenue growth to be low single digit. Growth will then increase in the second half. This should result in total year revenue growth in the mid-single-digit range. In terms of margin, we expect the first half to be roughly flat. This has somewhat improved versus previous outlooks shared with you. However, this gain will be offset in the second half due to further commodity cost pressures. So for the full year, we still expect an improvement of 50 to 70 basis points.

So with that, I'll turn it back to the operator to start our question-and-answer period.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from Chris Ferrara.

Christopher Ferrara - BofA Merrill Lynch

It's Bank of America. So guys, I guess on Brazil, why isn't the order fill rate back to historical norms? I guess, is this going to necessitate Cabreúva being fully online before you can get there? Or will you be back online or back fully online faster than that?

Andrea Jung

I think if you look at our progress in terms of the absolute quarter fill rate since the bottom back in November, I feel good about the gradual progress. Well, it's not all the way back up to the level, it is approaching that level. So I think it's going to take a little bit more time but not till Cabreúva is fully up and running. So hopefully, in the second quarter we'll be back to broadly historical order fill rates.

Christopher Ferrara - BofA Merrill Lynch

And I guess just as a follow-up, can you talk at all about the progression of Brazil, right? I'm not looking for real specifics, just understanding from a revenue perspective and from an order fill rate perspective, is March better than February? Is February better than January? I mean, is that the trend we're seeing on sales and on order fill rate?

Andrea Jung

Well, if you look at -- you've got the kind of a timing of Carnival. But if I look at February and March combined, it was better than January in terms of revenues. And if you look at the chart that I showed, it's broadly getting better by month in terms of the absolute OFR. So if you kind of go forward on that thought with the complete focus on getting that order fill rate back to historic norms in the second quarter, we feel very committed to doing that. The sales, as I said, do take a little bit of time because you got that rep annoyance and getting rep confidence back. We really wanted to wait until we had closer to historic levels before we started incenting representatives to increase their activity, but that becomes the focus now from 2Q on.

Operator

Your next question comes from Mark Astrachan.

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

It's Stifel, Nicolaus. I guess similar line of questioning from Russia since you implemented a new distributor compensation plan the end of January, if you could give us a bit of an update there on how things have been received so far and how things are trending going forward, that would be helpful. And then just sort of a related follow-up on Brazil. Given some competitor comments about the Beauty category potentially being a little bit slower-growing this year versus last year, albeit still at better-than-average levels worldwide, I wonder if you can give us some comments there, just an overall category growth in terms of the outlook for the industry.

Andrea Jung

Okay, let me just take Russia first. We implemented fully the compensation changes at the end of January. And as I said, I feel good about the early signs of progress. The number of unit leaders is ahead of our expectations now, and that was where were pressured, as you know, from some of the social tax changes in the back half of last year. But the compensation, which was targeted to improve their earnings, is certainly looking like it is having a good impact. Appointment growth is positive and activity is trending up. So I would say that we feel that those compensation changes have a positive impact. So the field foundation is better going into second quarter than it was as we came out of the back half of the year. In terms of Brazil, I guess the last thing I'm seeing is, and again it's a moving target, but I would say high single digits as the category growth rate may be down slightly from low double digits. But having said that, as we look at our business opportunity, certainly, we are focused squarely on just recovering the service levels and getting our representatives active again and we still feel good about the market opportunity in Brazil. The overall category opportunity is still very good.

Operator

Your next question comes from Bill Schmitz.

William Schmitz - Deutsche Bank AG

Deutsche Bank. So I know you like to benchmark everything. Can you talk about the FCPA benchmarking? And I don't want specifics at Avon, but as you look at some of the other investigations, how long are they taken? And is there anything reason we should believe that will take you guys longer than that?

Andrea Jung

Well, I can't really talk about our investigation, Bill. And just in terms of benchmarking, I'm reading the same things that you're reading in terms -- and I think every case is different.

William Schmitz - Deutsche Bank AG

Okay, yes, because the stuff that I stumbled upon was like 3 years is almost like the longest I've seen from one of these investigations, and I think the 3-year anniversary is in July. Is that factually correct?

Andrea Jung

Factually correct.

William Schmitz - Deutsche Bank AG

Okay, great. And then just in terms of cash conversion cycle, once everything kind of settles out and the noise and the pension and stuff kind of goes away, what do you think is sort of the right cash conversion cycle for a company like Avon?

Charles Cramb

What I've been looking at in terms of our longer-term plan is something that will be a little less than 100% probably in the 85% to 90% ratio. And remember, one of the things that we are going to struggle with for a reasonably long period of time is the cash out investments that we're making on capital equipment. So as you think forward, think about us. Cash conversion rates 85% to 90% is probably about the place that we would operate. I'd love to it see higher than that, but I don't think that would be realistic.

William Schmitz - Deutsche Bank AG

And that's on 2013 and beyond, is that fair?

Charles Cramb

Yes.

William Schmitz - Deutsche Bank AG

Okay, great. Okay, just one more quick one. Just on currency, I think it was about a point of margin. I mean, is it going to be linear-based on translation with the transaction? I know there's a little bit of a lag, but is it kind of catching up now?

Charles Cramb

Linear? No. I don't think you can say it's going to be linear because you have -- it's a year-on-year comparison in terms of the relative currency rates where translation is not necessarily directly parallel with the transaction elements e.g. how we source a product. So there can be some variability quarter-to-quarter on that one, Bill.

Operator

Your next question comes from Wendy Nicholson.

Wendy Nicholson - Citigroup Inc

From Citigroup. Two questions, first of all, in terms of the inventory correction that you expect to see, can you talk about how that's going to occur and why that isn't going to have a big negative impact on your gross margin? In other words, are you just going to idle the plants who work through that? Are you just going to have a tremendous amount of discounting to flush with in the system out of the system?

Charles Cramb

I don't think it will be a significant amount of discounting that's going to flush it through. I think the good news is that a lot of the inventory build that we experienced towards the end of last year is all product that has the opportunity to be flowed normally through catalogs. We just need a program in the end. I think to me what's more important than any kind of a short-term attack on this is, is the longer-term attack and when I look at inventories, Wendy, I think you know this has been the one area that I continue to be disappointed by in terms of our progress. So we're actually as part of the process excellence program that Andrea has outlined to you folks a little bit, this is going to be one of the key focal points. And when I think about it and what we're going to do starting yesterday is we've really redefined the accountability for inventories. And it's clearly in the hands now of our Commercial Business Unit leaders. They are the ones that are going to be responsible. We've established a new operational role within each of the CBUs which is focused very strong in inventory management. And then within each of those CBUs, the general managers, each of those general managers has an increased level of accountability in terms of objectives, in terms of operating processes that ties in with our sales and operational planning process. Then the other big change that we've made, which I think is also going to be important in terms of getting the inventory reductions that I think we deserve is we changed who's responsible for demand forecasting, and forecasting has always been a problem in this area. But we move demand forecasting out of the marketing organizations and directly in to the commercial general manager, again that same general manager has the accountability through SNLP. So I think the real answer to the question is it's going to be process change. It isn't going to be a lot of short-term tactics. It's really is process change, so we don't build inventory in excess that we really control on a much more disciplined basis than we have demand versus supply planning.

Wendy Nicholson - Citigroup Inc

And is the inventory on, whatever the inflated inventory, is it a particular problem by region? And specifically, I'm wondering even if though you've had a management change in the U.S. business, does the shift to less non-Beauty and more Beauty? Number one, do those plan still hold even though Geralyn is no longer there? And is the inventory a particular issue in the U.S. specifically?

Charles Cramb

Well, let me address that from the inventory side and say that the inventory pressures that we had and the problems we had coming out of the end of last year are fairly widespread, and they just contract those primarily to the sales shortfalls we have and the soft sales that we had third quarter and fourth quarter's. I wouldn't want to point to any one activity that is driving out of the region or product line basis.

Operator

Your next question comes from Linda Bolton Weiser.

Linda Weiser - Caris & Company

Caris & Company. Can you just talk a little bit more about China? And I guess several years ago, when you broke it out as a separate division, it kind of highlighted the emphasis on growth there that, that would be a high growth market for you. And now it's sort of being folded back in. And so can you just give us an update there? And then with all of the issues that you have to deal with here in the short term it seems that there's some other high-growth markets in the world, for example, India that you're just not able to address because of all the near-term issues? Can you talk about what point in time you might be willing or ready to look at other high-growth markets that you're not in now to go into those new markets?

Andrea Jung

Yes. Let me just actually to answer your last question first. I mean, we're really not talking about it, but I can just give you an example. I mean, I think our India growth with 60%-plus in the quarter and it was very, very strong as we came out of 2010. It is an important medium to long-term growth market, but we just had so many other things to communicate with you. But inside the company, we have certainly identified India as one of the sort of rocket market, emerging market opportunities in Asia. So we're very pleased with -- still small but growing really, really fast. In terms of China, the rollout of this new sales model was completed as we closed out the quarter at the end of March. I'm actually pleased, I think we've got -- we're on track. I think too, we said we would break even in 2011 and then look for growth and profitability in China in 2012 and I think we're pretty much on track with that. We actually have several thousand more service centers than we expected. The productivity early on is a little bit lower than we thought but we're focused on productivity. But when you net it together, they're pretty much on track with where we thought we would be when we finish this rollout. So this is a transition year and I don't see anything at this point that changes what we said in terms of where China will be. And we obviously made the decision because of management changes in who was running the region, et cetera, by folding China in, but we are still obviously going to give you visibility and discussion about how we're tracking on this very important long-term strategic growth market for us.

Operator

Your next question comes from Nik Modi.

Nik Modi - UBS Investment Bank

Yes, UBS. Andrea, you could just give us some context on the Service Model Transformation, what that entails and the implications that'll have once it's fully put into the business?

Andrea Jung

Yes, the Service Model Transformation is a multiple-year initiative. It is squarely focused at making service easier for our Avon representatives, and it affects everything that touches her from invoicing, from how easy it is to return, from giving her visibility to product availability from a technology point of view, for her to be able to order any time she's constrained today, in many markets on a single opportunity and a campaign to submit her order. And as we go forward, obviously, that constraint what it means to lift it and allow her to order 24/7 anytime she wants to decide does she want to have segmentation by customer in her order, things like that. So we have been really focused on driving a global set of requirements for this, so this is going to be a global initiative with a global system, order management change, which we think is very exciting but it took about a year from last March to get all the requirements and specifications in with some of our top leaders who understand the field of representatives and every aspect of how she does business. And as we go forward, we continue to work on that now moving to designing code in 2011 and looking for pilot and rollout in the next couple of years. So it's a big undertaking but a very important one and in terms of just sort of very, very competitive service model to sort of that last mile.

Nik Modi - UBS Investment Bank

And then just a quick question on the U.S. Does the U.S. business have too many reps? It just seems like there could be a saturation issue and that every incremental rep starts cannibalizing another one. And I just wonder if there's just a structural issue here in the U.S. market. Any thoughts on that?

Charles Cramb

I don't think that is an issue at all. I think, in fact, as we look longer-term, rep building is going to be a critical component under a dilution model in North America. So I would leave it just the other way and say get the field fundamentals right, get Active Representatives both recruited and stay active. It's going to be key to turning that business around.

Operator

Your next question comes from Dara Mohsenian.

Dara Mohsenian - Morgan Stanley

Morgan Stanley. So Andrea, just wanted to return to Brazil for a minute. You seem fairly cautious on the top line recovery there in the balance of the year, I think you indicated it would be gradual, but your comps do get much easier in the back half of the year. So I'm just wondering if there has been a significant negative impact on morale as a result of the hiccups and that's what driving some of the caution there?

Andrea Jung

Well, there is a negative impact. I mean we saw it in the fourth quarter. We're seeing it in the first quarter. But having said that, we are going up again, to your point, easier comps so we do see gradual improvement in revenues. It takes a while. One of the things that I feel good about is certainly the number of orders, the number of representative on staff still. I mean our representatives are still with us. It's the activity that has been pressured obviously as they're cautious about placing x amount of units more because they've been burned as it relates to how long it took them to get them in the fourth quarter, et cetera. So as I said, as this recovers to historic levels we now are going out because we didn't want to do that before we were comfortable that we were back at these historic levels in terms of no more delays and in terms of an order fill rate that they've been used to, to go out and really drive through incentives and strong affiliation, the kinds of end [ph] programs, prizes and incentives for our representatives to fully engage back with us at their normal levels.

Dara Mohsenian - Morgan Stanley

Okay, and you had indicated in January you did some market research that indicated 85% of your reps and Brazil wanted to stay with Avon. Do you have an update on that number? Have you done any more market research recently?

Andrea Jung

Yes, our market research continues to show they're not -- it validates the fact that we are not seeing -- we don't have a retention issue. They're not leaving Avon. Their activity is down in turn and their average order, the number of pieces they're putting in has been pressured because of their just concern about putting too many eggs in the basket if they're not going to get it. But there hasn't been any increased -- lead people or representatives leaving the company.

Dara Mohsenian - Morgan Stanley

Okay. And Chuck, if I could just slip in a second question, can you just give us an update on the FX transaction impact you're expecting for the full year in 2011? And also, what was it in Q1? I think I missed it on the slide deck.

Charles Cramb

In Q1, it was -- I just want to make sure I give you the exact, right number. We had about 80 basis points impacting both our gross margins as well as some of our expenses. I think as we look through the year, that transaction impact will flip flop. It all depends on the currency obviously and how they move. But generally, we are looking for continued gains from transaction exchange not at the 80 basis point rate, however, that we have in Q1 because the favorability year-on-year, quarter-on-quarter diminishes.

Operator

Your next question comes from Ali Dibadj.

Ali Dibadj - Sanford C. Bernstein & Co., Inc.

I'm from Sanford Bernstein. A couple of things. One is just to focus in on the U.S. for a little bit. I'm trying to understand the thought process there. The U.S. was down, what? 10% organically this quarter. That's on a down 3, which is down on a down 10, which is down on a down 7. It's looks if I go back to the other 7 to be fair [indiscernible] that's on plus 3 organic growth. But a very long trail of downs. How does the U.S. really fit strategically in your overall portfolio? Do you need to have it? And Chuck, now that you are running the U.S. or at least above the U.S., are you earning your cost of capital in the U.S.? And if so, by how much?

Charles Cramb

Well, let me start backwards and work forwards. Number one, with a margin that's in the low to mid single digits or mid-single digits, we're not earning our cost of capital. Obviously, margin improvement is going to be a part of the turnaround of this business. Secondly, in terms of the business and our portfolio, I think it is a critical business that can grow at least with category, if not a bit ahead of category. Over the long term, once we get the fundamentals right. And when it does that, we ought to have a business that can deliver double-digit margins. So it will more than cover the cost of capital at that stage. And now I think about, well, what are we doing and what do we need to stop on doing and I think our strategy that we outlined some 18 months ago timing a little bit different, but the elements remain the same, and they were cost, reduced costs. I think we've actually done a very good job there when you look at the cost movement versus those declines in sales that you've referenced. We talked about reshifting the portfolio, rebalancing the portfolio away from non [indiscernible]. I think there we actually went a little too far. We starved the market faster than the representative and there was a halo impact on the rest of her business as well. So I think we need to rebalance that a little bit and I think we're kind of excited right now as a team because we will be addressing that with introducing or what I would holiday giftables, actually with a separate merchandising or catalog presentation as well for the holiday periods, whether it's Christmas, Mother's Day, Father's Day but starting at the end of this year. I think when we look at the representative, it's all about improving her average order size. And so you think about the giftables. You think about what we're coming out at the end of the year with the breakthrough product on skincare, if you think about the Mom and Baby franchise which we'll start to expand. And so I think we have things for the representative from that perspective. But I think the real answer is going to be how do we strengthen the leadership structure in the company. And that is the third prong that we talked about in terms of, really, in moving the business model forward, and it's going to be a focus on, really, how do we develop leadership within the model, how do we strengthen that opportunity in terms of the path to title [ph ]advancement, how do we manage as we go through leadership, a much more focus on growing the leadership element of the business, helping leaders develop their down lines, rewarding people on sales and productivity rather just on staff. I think here is where the real benefit is going to come in terms of enriching the earnings opportunity for everyone. So I look at those elements and I say, hey, we've hit on 2 of the cylinders. The third one is yet to come, but I'm really excited that it will come. I'm really excited that it will add significant value. And there's a lot of other things that we're doing to longer term for the rep that we've talked about in the past. But it's technology in terms of tools we give her. It's a service model transformation, which Andrea has talked about. And it's also our refocusing on customer segmentation. So I think we have a lot of things in the arsenal. We going to have to go on a deliberate path to execute these and execute these flawlessly. But I really do believe, Ali, that this is a business that can deliver the kind of return that we're looking for and that'll be based upon getting back into double-digit margins.

Ali Dibadj - Sanford C. Bernstein & Co., Inc.

So just to follow up, the action plans you laid out all sound compelling, but I struggled to see what I guess different than before?

Charles Cramb

What's really different is nothing from the strategy we've laid out 18 months ago. It's how we're executing it, and it's these really -- the big item from a strategic perspective is really strengthening the leadership structure and the role of leadership within the organization.

Ali Dibadj - Sanford C. Bernstein & Co., Inc.

And then how does price mix play into that? Maybe that's even a broader question for a little company, we heard more balanced price mix. We're not getting that yet. How should we think about that and how are you thinking about that in the U.S. but even more broadly for the whole company going forward?

Charles Cramb

It's a broader question than the U.S. It really is a company-wide question. And sure, we're in a moment where with all the commodity pressures that you see you have to be effective in managing prices and in managing price realization. So that is the key element. But over the long term strategically, you're right, spot on and that we need greater balance in terms of growth that comes from price and mix versus growth that comes from unit growth. And the unit growth is going to come from as much from an increase in Active Representatives that it is the average order of the representatives in terms of number of units in her basket.

Andrea Jung

Yes, I'll just add on to that, Ali. I mean, I think that growth in reps is going to be correlated with unit growth, the unit trends, which were still weak in the quarter and we're looking at a pretty aggressive opportunity in the second half to get them back in line. So if you're talking about mid single digits in the second half, I would hope that about 2% of that comes from volume or unit. And a lot of our promotions and our incentives plan for the second half are driving that. So I feel good. Okay, so that -- if you just look at mid single digits, I'd look at a couple of points of that coming from units in the second half.

Operator

Your next question comes from Lauren Lieberman.

Lauren Lieberman - Barclays Capital

It's Barclays Capital. Can you guys just talk about the U.K.? Because I think organic sales decelerated pretty significantly. We've got it as up 4% in the fourth quarter and then down 5% in Q1. Can you just talk a little bit about what's going on there?

Charles Cramb

Yes, I think you're right. There is what looks like a swing in terms of the trends in the U.K. Fourth quarter was unusually strong. Very, very high promotional activity, a lot of discounting, a lot of taking advantage of the holiday season. I think as we're looking at that business moving outwards, to be flat to the low single digit run rate is probably right given that there still is a tough economic environment there. That tough economic environment, by the way, is not helped much by the fact that they did take an increase in VAT in 2011. So I think from an overall core business, excluding the Liz Earle business, I think if you think of the performance in 2011 somewhat paralleling what we had in 2010, that's about right.

Lauren Lieberman - Barclays Capital

Okay, but what drives the acceleration from a 5% decline in Q1?

Charles Cramb

I'm sorry?

Lauren Lieberman - Barclays Capital

What would drive an acceleration from a 5% decline this quarter?

Charles Cramb

It's just timing of programs. It's the merchandising activity. It's the way we do some catalog work.

Amy Low Chasen

It's not -- Lauren, it's Amy. It's not down 5%, it's down 1% in the first quarter.

Lauren Lieberman - Barclays Capital

Okay. And that's excluding Liz Earle?

Amy Low Chasen

It's excluding Liz Earle.

Operator

Your next question comes from Doug Lane.

Douglas Lane - Jefferies & Company, Inc.

It's Jefferies. Can we talk a little bit about Silpada, what you're seeing on top line growth there? And is it still on track to add $0.03 to $0.05 to earnings this year? And have you formulated any more concrete expansion plans geographically for the next year or so?

Charles Cramb

Okay, Silpada. I think the big story in Silpada is the price of silver. And if you remember, when we made the acquisition, silver was $16, $17 an ounce and we all know where it is now. We knew where it was yesterday and moves so much , but it's in the $43, $44 range, which obviously is putting margin pressure on that business. In terms of development of the business, the revenues are roughly -- they're kind of flattish to where we expect them to be. When we look at the business from an accretion point of view, it is accretive overall, whether it'll be $0.03 to $0.05 or not depends on how successful we are with the second half of this year and the programs we've put in place. And those programs, as you would expect, have resulted in a significant change in our product offerings. The only -- you cannot raise prices to fully offset silver and expect to keep your representatives or your consumers as you had them prior to those kind of significant price increases. So we're looking at -- not only looking at, we're implementing fairly significant changes in the product range, changes which allow us to have price increases without a direct comparison, last catalog versus this catalog and also the content of the product in terms of silver versus semi-precious stones. So as we're looking out over 2011, it may not be quite as the $0.03 to $0.05, although there will be accretion of this acquisition to the business. And if it isn't $0.03 to $0.05, we'll be darn close to it.

Douglas Lane - Jefferies & Company, Inc.

And did you give an organic kind of top line growth that Silpada's running at currently?

Charles Cramb

Right now it's roughly flat. It's roughly flat.

Operator

Your next question comes from Alice Longley.

Alice Longley - Buckingham Research Group, Inc.

Alice Longley, Buckingham Research. Could you give us some more detail on the progression of operating margins in Latin America? I think they were down 120 basis points in the first quarter. Will they be down that much or more in the second quarter and then give us something for the year please? And then also my other question is on inventories. They were up 16 days in the first quarter. Could you tell us the progression there as well? Will they be up more or less than that in the second quarter?

Andrea Jung

Best in that in the second...

Charles Cramb

Yes. I was going to take the inventory one. You'll see some progression on inventory throughout the year but starting in Q2. On the margin question, I'm not really prepared to go into quarter-by-quarter margin change for a region, but it should be progressive improvement. This is [ph] for the company.

Alice Longley - Buckingham Research Group, Inc.

So down less in the second quarter than the first?

Charles Cramb

I think so. I'm not going to give it quarter-by-quarter for regions. We just don't go into that kind of detail. Alice, I'm sorry.

Operator

Your next question comes from Javier Escalante.

Javier Escalante - Weeden & Co., LP

Weeden & Co. Andrea and Chuck, my question has to do with the metrics you used to assess the health of direct selling businesses in general and the impact of your investment in particular. When you acquire Silpada and Liz Earle in the due diligence process to assess whether this business were attractive, I wonder whether do you look at metrics in terms of the actual size of their sales force? And whether this sales force was increasing or decreasing, and whether you also look at the retention rate of this business particularly for those for the leadership reps to the equivalent to your leadership reps? And if the answer is yes, I wonder what is the rationale of not disclosing basic metrics like this as your direct selling peers do say, Herbalife? This request, if you will, will help investors to really assess whether the bonus is an incentive that you are being handing out to the field are sufficient to drive retention rates particularly in markets like Brazil where you mentioned that your sales force actually cross-sell competitive products like Natura and Zigiti [ph].

Andrea Jung

Okay, Javier, let me just quickly say yes, we do look at those metrics. We look at them certainly for Silpada who has a small but very much smaller than Avon but very, very productive sales force with obviously good programs in place and good retention. And Liz Earle was not a direct sales business. So again, it was something that we plan to do in the future. It would take them to look at the opportunity to put it into direct sales. But there weren't any sales force productivity or retention metrics on Liz Earle when we acquired them. But just in terms of your question, I meant, I hear you and just a comment about leadership reps. I mean, I think the retention or, if you would, the removal rates, et cetera, for leadership representatives are considerably lower once they get to titles than the average. So there's a clear correlation with those who are involved in leadership have better retention, and that continues to improve the higher they go in terms of title advancement. And a lot of RVP is going into Sales Leadership incentives and commissions. So we are by definition over time trying to improve retention, not just through leadership, but obviously though some of the things that I talked about earlier with the Service Model Transformation, making it easier to do business with us and making our proposition have differentiators certainly and particularly if they're selling dual books or other direct selling product lines. But we do have a significantly improved retention once someone is in the leadership program as an up line.

Javier Escalante - Weeden & Co., LP

But the request probably is why don't you try to disclose this to investors? I understand that it's not about the actual retention numbers say 10, 20. I don't know, but whether investors are going to be able to basically track whether the spending that you are making on RVP is enough, right? Whether the turnaround is reliable and sustainable. And you, yourself are doing that when you buy a direct selling business, so you are basically asking investors to buy Avon shares without having the benefit of the kind of metrics that you do ask when you buy direct selling businesses. So how can we -- I mean, it's just kind of like frustrating for us to be guessing all the time whether the retention rates are increasing rather than be guessing, wouldn't be better for investors to just simply see them and that's it.

Andrea Jung

Well, I think your request or your recommendation I hear, I understand it. I hear it, I will spend some time talking to Amy about this. I mean, we have felt to date that Active Representatives and how many in our sales force are engaged in the business. Submitting and selling is the way we've looked at the health of the business and our RVP investment returns. But I understand what you're asking and take a look at it, okay?

Javier Escalante - Weeden & Co., LP

Yes, that will help derisk the shares for sure, I think. So thank you for taking the question.

Operator

Your final question comes from Connie Maneaty.

Constance Maneaty - BMO Capital Markets U.S.

Just one final question. What has been Avon's experience in the U.S. with representative behavior when gas prices are high?

Andrea Jung

Well, there is certainly some impact. Although when we looked at it in the first quarter, it wasn't a huge major negative. There was a little bit of a negative, but I don't think it's just gas prices. Connie, I would just say that cost-of-living increases, food cost I mean, when you combine gas price and cost-of-living increase, while it didn't play out as the real issue in our business and/or a major negative, I would think it's safe to say it certainly continues to be a headwind in 2011 and I think the environment is still tough for our consumer. I mean, when I looked at some statistics on the U.S. mass beauty market, it was down. It was down, and so certainly we're committed to turning this business around. You heard Chuck talk about the strategies that remain constant in terms of how we intend to do that. But we have headwind from certainly for our consumer and some macros in the category are not working for us as tailwinds certainly yet. So that's where I am in terms of North American macros.

Okay, everybody, I think that was the last question. So thank you very much and we'll talk to you soon. Take care.

Operator

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

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