Avon Has At Least 40% Upside Potential

| About: Avon Products, (AVP)

There is a lot going on with Avon Products (NYSE:AVP) these days. The company missed earnings in the 3rd quarter, causing a loss of confidence in the company. Q3 EPS of $0.38 was $0.08 lower than the consensus estimate. Revenue of $2.7 billion was also lower than the mean estimate of $2.82 billion.

However, that was not the primary reason behind the recent sell-off. The company acknowledged that it is facing a SEC probe related to its communication with analysts in 2010, and its compliance with the Foreign Corrupt Practices Act in international markets. The stock dropped by almost 20% after this news, but it regained half of these losses so far in November.

As of the time of writing, Avon stock was trading at $19, with a 52-week range of $17.55 - $31.60. It has a market cap of $8.3 billion. Trailing twelve month [ttm] P/E ratio is 11.18, and forward P/E ratio is 10.3. P/B, P/S, and P/CF ratios stand at 4.5, 0.7, and 13.6, respectively. The 3-year annualized revenue and EPS growth stand at 3% and 4%, respectively. Operating margin is 10.5%, and net profit margin is 6.5%. The company has some debt issues. Debt-to-equity ratio is 1.4. Avon pays nifty dividends. The projected yield is 4.8%.

Avon is not rated by Morningstar, but for some reason, it is categorized as a slow-growth company. However, with an almost 5% yield and near single digit P/E ratios, I think it should be considered as an income-value company. While its trailing P/E ratio is 11.1, the stock has a five year average of 23.8. Thus, Avon is trading well below its historical average.

Out of 17 analysts covering the company, 4 have buy and 13 have hold ratings. Wall Street has diverse opinions on Avon’s future. The bottom line is -11.6% growth, whereas the top-line growth estimate is 26% for the next year. Average five-year annualized growth forecast estimate is 11%. Related industry peers include Procter & Gamble (NYSE:PG), Colgate-Palmolive (NYSE:CL), Kimberly Clark (NYSE:KMB), Estee Lauder (NYSE:EL), Energizer Holdings (NYSE:ENR) and Nu Skin Enterprises (NYSE:NUS).

What is the fair value of Avon, given the forecast estimates? We can estimate Avon’s fair value using discounted earnings plus equity model, as follows.

Discounted Earnings plus Equity Model

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:

V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

The earnings after the last period act as a perpetuity that creates regular earnings:

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r

While this formula might look scary, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate and the discount rate. To be as objective as possible, I use Morningstar data for my estimates. You can set these parameters as you wish, according to your own diligence.

Valuation

Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. Since we are in the middle of the year, it will be more feasible to take the average of ttm EPS of $1.70 along with the mean estimate of $1.83 for the next year.

E0 = EPS = ($1.70 + $1.83) / 2 = $1.77

Wall Street holds diversified opinions on Avon’s future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 11%. Book value per share is $4.25.

The rest is as follows:

Fair Value Estimator

V0

E0

$1.77

V1

E0 (1+g)/(1+r)

$1.77

V2

E0((1+g)/(1+r))2

$1.77

V3

E0((1+g)/(1+r))3

$1.77

V4

E0((1+g)/(1+r))4

$1.77

V5

E0((1+g)/(1+r))5

$1.77

D

E0(1+g)5/[r(1+r)5]

$16.05

BV

Equals

$4.25

Fair Value Range

Lower Boundary

$26.64

Upper Boundary

$30.89

Minimum Potential

40.14%

Maximum Potential

62.50%

Click to enlarge

You can download FED+ Fair Value Estimator here.

I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for Avon is between $26.64 and $30.89 per share. As of November 9, Avon was trading at a price of $19. The current price indicates that the stock is deeply undervalued. Based on my estimates, Avon has a minimum 40% upside potential to reach its fair-value range.

Peer Comparison

It is a good idea to check with its peers to see where Avon stands among the industry. The average yield in the industry is 2.8%. Average industry P/S, P/B, and P/E ratios stand at 1.8, 3.7, and 16, respectively.

Company

Yield

O-Metrix

Fair-Value Range

YTD Return

Avon

4.84%

7.35

$26.64 - $30.89

-32.84%

Proctor & Gamble

3.27%

4.04

$59.66 - $82.93

3%

Colgate-Palmolive

2.59%

3.48

$74.43 - $79.91

14.30%

Kimberly Clark

3.95%

3.92

$63.82 - $77.71

16.06%

Estee Lauder

0.64%

1.87

$63.24 - $76.57

45.66%

Energizer Holdings

0%

3.39

$77.80 - $112

-2%

Nu Skin Enterprises

1.27%

3.70

$42 - $50.62

65.82%

Click to enlarge

Nu Skin was the best performer, returning almost 66% since January. Its performance is followed by Estee Lauder and Kimberly Clark, which returned 45.66% and 16%, respectively, in 2011.

Avon’s yield of 4.84% is the best among its peers. Kimberly Clark comes second with a yield of 3.95%, followed by Procter & Gamble, which offers a yield of 3.27%. Thanks to its high yield and low valuation, Avon has the highest O-Metrix score of 7.35. As companies with higher O-Metrix scores tend to outperform, I expect Avon to be an outperformer.

Avon offers the best value for the investors. Other companies also seem to be more or less fairly valued. However, Estee Lauder is obviously overpriced. It is trading with a high trailing P/E ratio of 29.91, and forward P/E ratio of 23.75. Naturally, it has the lowest O-Metrix score of 1.87, which is also well below the market average.

Nu Skin has the highest annualized EPS growth expectation of 13.40%. While that is a strong buy signal, these expectations are already priced by the market. Nu Skin is trading around a price $49, which is at the upper end of its fair value range.

Click to enlarge

Summary

Avon has been one of the biggest losers of 2011, returning -33% since January. However, the company has great upside potential. As of November 9, Avon was trading at $19, significantly lower than my fair-value range of $26.44 - $30.89. Its price to book sales ratio of 0.72 is also below the market average of 1.8. Its O-Metrix score of 7.35 is also the highest among its peers. The stock has at least 40% upside potential to be fairly priced. Standpoint Research recently initiated a buy rating with a target price of $25.

Surely the SEC investigation will put a strong pressure on the stock price. However, one-time events should not impact the stock price in such a drastic way. As Efficient Alpha suggests, the market has overreacted to the news. The 18% plunge after the SEC investigation news resulted in a market cap loss of almost $2 billion. I do not think such a penalty will ever be imposed on any company of Avon’s size. I expect the actual settlement to be in a fraction of this loss. Obviously, that created an opportunity to buy Avon shares well below their fair value. Thus, I expect Avon to be an outperformer over the long term.

I also expect Procter & Gamble to be an outperformer. At a price of $64, the stock is trading at the lower end of its fair-value range. Based on the fair-value analysis, Avon offers the highest value, followed by Procter & Gamble, and Energizer Holdings. Kimberly Clark and Nu Skin look fairly valued, but Colgate-Palmolive and Estee Lauder are relatively expensive.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.