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Avon Products Inc. (NYSE:AVP)

Q1 2007 Earnings Conference Call

May 1, 2007 10:00 am ET

Executives

Andrea Jung - CEO

Chuck Cramb – EVP, Finance and Technology

Renee Johansen – VP, Investor Relations

Analysts

Bill Pecoriello - Morgan Stanley

Bill Schmitz - Deutsche Bank

Wendy Nicholson - Citigroup

Amy Chasen - Goldman Sachs

Chris Ferrara - Merrill Lynch

Lauren Lieberman - Lehman Brothers

Nick Modi - UBS

Justin Hott - Bear Stearns

Ezra Solomon - JL Advisors

Linda Bolton Weiser - Oppenheimer

Alice Longley - Buckingham Research

Connie Maneaty - Prudential

Filippe Goossens - Credit Suisse

Presentation

Operator

I would like to welcome everyone to Avon's first quarter earnings conference call. (Operator Instructions) I will now turn the conference over to your host, Andrea Jung. Ms. Jung, you may begin your conference.

Andrea Jung

Good morning, everyone. Thank you for joining us to discuss Avon's first quarter 2007 results. Since some of our remarks today may include forward looking statements, I refer you to the cautionary statements in today's press release.

With me this morning are Chuck Cramb, Executive Vice President of Finance and Technology; and Renee Johansen, our VP of Investor Relations. I have given a very comprehensive strategic overview that we discussed with all of you on February 15th. I know you are all fully aware of the company's turnaround strategies, so within this context, we'll try to keep this morning's call brief given that we believe this quarter again demonstrates that we continue Avon's long-term path to sustainable growth.

I'll begin with my summary of our first quarter performance, Chuck will follow with an additional financial perspective, and Renee will help facilitate Q&A.

As you read in this morning's release, revenues in the first quarter grew 9%, 6% in local currency, with positive performances in each of our commercial business units. This is the first time since the third quarter of 2004 that all six regions have achieved simultaneous revenue increases. So we feel good about our progress we are making, although we may see variability in quarterly results as we move throughout the turnaround.

Fueling our growth in the quarter was nearly $50 million in incremental investment against the brand and the channel. This was funded by our continuing focus on the implementation of our restructuring initiative and cost containment.

In Beauty, a key measure of our progress, we saw double digit growth for the third consecutive quarter with increases in all core categories.

Fragrance grew 12%, with solid gains in the mass premium segment, including sustained brand building for successful 2006 launches. Also during the quarter, we announced a new celebrity fragrance alliance with Oscar-winning actress Jennifer Hudson, and just last week we announced a fragrance partnership with designer Christian Lacroix set to begin in fourth quarter of this year.

In Color, the category grew 9%, including the relaunch of the Avon color brand that began late in the quarter. Personal Care grew 17% with the very successful introduction of Skin-So-Soft Fusions and the relaunch of the Advanced Techniques brand.

In Skin Care, as expected, we had a tough base year comparison against last year's Clinical Eye Lift, but gains in our mass brand Solutions helped drive a 6% increase in the category.

To drive beauty growth in the first quarter, we invested an incremental $32 million dollars in advertising; that was an 80% increase versus prior year, for a total quarterly advertising spend of $71 million. Spending increases were allocated across all geographies, with more than 50% of the increase concentrated in the three high priority markets of China, Brazil and Russia.

This incremental advertising investment helped fund our new Hello Tomorrow campaign, which was introduced successfully in March around the world. Hello Tomorrow is being aggressively leveraged to drive field energy and engagement as well, including recruiting ads in key markets, some of which we shared with you in February. To further support the field in the first quarter, we also invested approximately $15 million incrementally to improve the representative value proposition in major markets. Significantly more will come in the balance of this year.

The combination of these brand and channel investments helped fuel growth across our geographic portfolio during the quarter. In terms of our key geographies, Avon's double-digit growth in emerging markets continues to power the top line in this quarter, with Russia, Brazil, Turkey, Venezuela and Colombia all contributing strongly. In the first quarter, we were also pleased to add China to our list of standout growth markets, delivering as it did an over 40% increase.

In the first quarter, we also made important progress in all of our key turnaround markets. North America, for example, we were pleased that in light of a strong base year innovation comparison, we were able to deliver growth this quarter. In Asia Pacific, revenues in Japan were flat following 11 quarters of decline. In Central and Eastern Europe, we sustained the merchandising recovery in Color that we began to see last quarter, and in Western Europe, the UK is proving that we are unlocking growth in a developed market with the right formula. In Latin America, Mexico still remains a longer-term fix. However, as we exited the quarter, we did begin to see some positive trends in key field measures, so we are making good progress with our turnaround plan there.

So with that brief overview, let me turn to a somewhat more detailed review of our performance by geography, beginning with North America.

In North America, first quarter revenues rose 3% on top of 2006's very strong Clinical Eye Lift launch. Beauty increased 1%, driven by solid gains in Personal Care. Active representatives, which were flat with the prior year, continued to stabilize as we invested in a range of RVP initiatives. These included free bonus brochures, an enhanced fast-start bonus for new leadership representatives and free career seminars around the country, which kicked off in March.

Improving the representative value proposition remains a top priority in this region. We are increasing spending against representative incentive. We will hold a major national leadership conference this August with an expected attendance of over 1,000 representatives and in addition, our new recruiting television commercials just started airing in April. So there is a lot on the plate and we feel good about the progress we are making.

That being said, North America remains a long-term turnaround market. We may continue to see variability in quarterly results, but we believe we are taking all the right steps to ensure sustainability over time.

In Latin America, first quarter revenues grew 7%, 6% in local currency. Driving these results was our performance in Brazil, where revenues increased in the low teens. As we said in February, while we don't anticipate that Brazil will continue to grow at the same torrid rate that it did in 2006, all indications are that 2007 will be another very good year for Brazil.

We exited first quarter with strong momentum. Starting in the second quarter, we also have a robust product pipeline for the remainder of the year which will be fueled by a major ramp up in advertising spend. As a result, we should see the rate of growth in Brazil increase above the first quarter level as we move through the balance of the year. We intend to continue to invest heavily in Brazil, and we are committed to aggressively defending our position in this priority market.

During the quarter, we also saw extremely strong performances in the Andean cluster markets of Colombia and Venezuela, which both grew in the range of 20%.

Mexico, as I said, remains a longer-term fix. First quarter revenues in Mexico declined at 9%. However, during the quarter, order growth became positive for the first time in nearly two years. At our meeting in February, Charles Harrington told you that we had just reached this inflection point, and since then we have sustained the trend line as we have continued to focus relentlessly on disciplined execution of field fundamentals. By the end of the first quarter, we had upgraded talent in 75 zone manager positions and significantly strengthened field training and performance management. Our representative morale and engagement is also beginning to improve as a result of better supervision, plus enhanced incentive and motivation program.

Looking ahead, we have just completed a detailed representative activity mixed analysis to quantify the paybacks of our field investments in Mexico, and this will guide incremental spending against RVP going forward. So overall, I'm confident that we are doing all the right things in Mexico. Month by month, we are seeing signs of progress and as we said before, we expect Mexico to improve by the end of year, if not earlier.

Let's turn now to Western Europe, Middle East and Africa. This region again achieved solid revenue growth, up 17%, 9% in local currency, driven by strong performances in Turkey and the UK. Revenues in Turkey increased over 30%, with strong growth in both active representatives and Beauty, fueled by significant incremental investment in advertising.

I know a few of you recently visited us in Turkey and learned more about our business there firsthand. Turkey is proving to be a key growth engine for the company. To fully capitalize on the opportunity, we will continue to invest heavily in both advertising and RVP initiatives, including the rollout of comprehensive web-based business tools.

Along with Turkey's emerging market success, our results in the UK demonstrate the power when we get it right in a developed market. Revenue in the UK increased in the high teens, a solid performance even factoring out the strong pound. Significant advertising and sharp merchandising helped drive growth. Active representatives also increased strongly as sales leadership continues to take hold.

In Central and Eastern Europe, revenue in the first quarter rose 17%, 9% in local currency. We were particularly pleased with the continued strength in Color cosmetics, which increased over 20% as a result of a significantly improved merchandising proposition. But the region's Beauty performance was strong across the board, with standout results in Fragrance as well.

Russia was the largest contributor to the company's overall growth, with a revenue increase of over 30% in the quarter, supported by an advertising investment more than twice the prior year's level. Active representatives showed a double-digit increase following a very successful fourth quarter recruiting effort and reflecting our continued investment in RVP. Representative earnings should get a further boost when the entire Central and Eastern Europe region moves to a three-week campaign cycle in the second half of 2007.

Turning now to Asia Pacific, revenues increased 5%, 2% in local currency following five quarters of declines in this region. Contributing to Asia's improved performance were the results in Japan, where revenues were approximately flat with last year. The transformation of the field structure and the implementation of direct selling fundamentals are starting to deliver results with the direct selling business growing nicely there.

On the direct mail side of the business, year-over-year declines have lessened as we have recalibrated our investments, so these two parts of the business, direct selling and direct mail, are now coming into better balance. We are pleased that Japan was not a drag on regional performance in the quarter and while Japan remains a multi-year fix we are encouraged with the results we are seeing, and we will continue to aggressively drive the turnaround.

Also contributing to the positive performance in Asia Pacific in the quarter was 19% growth in the Philippines, driven by significant progress with the implementation of sales leadership in this market.

Finally, turning to China, this was a strong growth story for the company this quarter. Revenue in China grew 44%, 39% in local currency as the number of direct selling sales promoters climbed to over half a million. Direct selling contributed over one-half of the market's revenue, so this has been a very rapid start up by all accounts.

In terms of our beauty boutiques, I'm very pleased that the number was stable at around 5,500 and we continued to see ordering activity of over 90%. Our hybrid model is playing out well, and the beauty boutique owners clearly understand their role in this growing market contributing to our success. To solidify our first mover advantage, we are continuing to invest in very high levels of advertising, with first quarter advertising in China double the level of the same period last year. China, more than any other Avon market has embraced the Hello Tomorrow campaign and is covering nearly every imaginable venue and media with the message. So we are off to a strong start in China in 2007.

Going forward, while we will continue to build our total sales force, the primary focus there is to steadily improve activity levels through training and incentive programs. China remains a key priority market for investments to ensure that we fully capitalize on our competitive advantage at this unique moment in time.

So that's a quick summary of our top line performance in our key geographies. I'm going to turn it over at this point to Chuck, who will give you an additional financial perspective on the first quarter.

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Chuck Cramb

Thanks, Andrea. Let me get right to some of the highlights for the first quarter. Our revenue grew 9%, again outpacing our long-term target of mid single-digits growth. What I am most pleased about is the broad-based nature of this growth. We saw year-over-year increases in all regions and in each beauty category. We've talked about the importance of this distribution a lot in the past. This really underscores the geographic balance of our global portfolio.

Our gross margin improved 60 basis points, despite a slightly unfavorable product and geographic mix. We benefited from both lower inventory obsolescence charges and improved manufacturing costs. In terms of obsolescence, the first quarter of the year included $12 million of incremental inventory obsolescence charges related to our PLS initiative. This is somewhat less than the $20 million charge we took last year, related to our decision to discontinue the sale of certain heavily discounted excess products. The improved manufacturing costs benefited from operating efficiencies in our factories, where throughput is up over last year.

Our overall SG&A expense has decreased $27 million year on year. There are several components to this, including sharply lower costs to implement our restructuring initiatives and lower absolute operating overhead costs. These were slightly offset by substantially higher investments in both advertising and the representative value proposition, and higher variable costs that follow sales such as freight and commissions.

Our period overhead costs are down versus last year, despite the unfavorable impact of annual salary increases. We are clearly seeing the benefits of our implemented restructuring programs driving compensation-related expenses lower. We are also seeing benefits from other ZOG-type related initiatives. We have used these cost reductions to help fund significant investment increases to drive our sales growth. Advertising is up 80% year on year, in particular, to support our Hello Tomorrow campaign. We have incrementally spent about $15 million against the rep value proposition in support of accelerating the growth of sales leadership, incentive programs, bonus brochure programs and web enablement initiatives, to name a few.

For the first quarter, our cost implement restructuring initiatives totaled about $10 million. There were no new initiatives approved in the quarter. However, we have been focused on implementing previously announced programs, such as the U.S. distribution realignment initiative and the conclusion of our headcount reduction coming from the delayering program. While the first quarter was relatively quiet in terms of new initiatives, we are on track with our overall program.

As discussed during our investor update meeting in February, we expect that the total cost of our multi-year program will be in the range of $500 million. This includes about $100 million for initiatives yet to be announced. The total program is on track to deliver annualized savings in excess of $300 million when fully realized, including savings of roughly $230 million this year.

The actions implemented to date also resulted in savings of approximately $55 million in the first quarter of 2007, with most of that associated with delayering. We have two major strategic initiatives: the product line simplification, or PLS and strategic sourcing initiative, SSI. These fall outside of the $500 million restructuring program and are incremental to that program.

We have made good progress on each initiative during the quarter. I would like to share some early details on that progress.

For PLS, we continue to analyze our product line across categories and markets to develop a smaller range of better performing, more profitable products. I spoke in detail about this initiative at our investor meeting in February. There's not a lot of new information to share with you at this time. We are still in the analysis phase of this multi-year initiative, but we are making excellent progress in terms of the early analytics. Those analytics are confirming that we can operate with significantly fewer SKUs, reducing our business complexity and our inventory risks, while at the same time improving both profitability and sales growth.

During the first quarter, we incurred costs of approximately $17 million associated with PLS. That includes $12 million of incremental inventory obsolescence. So we are moving right along with this initiative, and we have every confidence that we will deliver projected benefits in excess of $200 million upon full rollout.

Turning now to our strategic sourcing initiative, we launched our first wave of initiatives for this program in March. As part of this wave, we have a number of global and regional teams pursuing opportunities that address some $1.5 billion of our total annual external spend. The teams are gathering detailed technical and supplier data, focusing on things like containers, jars, bottles, tubes; distribution activities, packaging, and a significant segment of our finished goods that we buy directly from third-party manufacturers. We should be in a better position to quantify some of those early savings when we talk to you next quarter. So our SSI initiative is also progressing well and we expect to start to realize initial benefits in the third quarter of 2007 with annualized benefits from this initiative in excess of $200 million by the end of 2009.

Below our operating profit, our expenses were relatively flat despite a significant use of cash to repurchase shares. Our tax rate of 32.4% for the quarter was significantly higher than that in 2006, but a much more normalized ongoing rate. 2006 benefited from significant favorable one-time tax audit settlements and Statute of Limitations expirations.

Now I would like to call your attention to some specific balance sheet and cash flow items. Our cash and cash equivalents total $1.1 billion compared to $1.2 billion at year end, while our total debt increased to $2.1 billion from $1.8 billion at year end. As a result, our net debt increased by $385 million primarily in higher commercial paper borrowings.

Inventories totaled $984 million compared to $900 million at year end. Compared to the prior period, our inventory days were about three days higher. This included a planned increase in inventory coverage. Much of this was driven by actions taken to ensure service levels to our representatives as we launched our new Avon Color line as part of our Hello Tomorrow program. As we have discussed before, we do have a number of initiatives that are expected to reduce inventory levels over the long term. Inventory reduction remains a significant opportunity across the organization.

Our net cash used by operating activities was $160 million in the first quarter. This compares to net cash provided by operating activities of $101 million in the prior year. The year-over-year variance was primarily due to timing of vendor payments, higher payments for incentive-based compensation in 2007, higher pension and post-retirement contributions, and higher cash payments associated with our restructuring charges. Also, we exited 2006 at a very high level of accounts payable.

We repurchased 3.5 million shares of stock in the first quarter for a total of nearly $130 million at an average price of about $37 per share. As I told you on our last quarterly call, share repurchase continues to be an active component of our cash management strategy.

One other item. We also completed a small acquisition in April of our licensee in Egypt, which includes a small manufacturing facility. This is not presently a large market for Avon. However, Egypt does represent an attractive beauty market. With a population of nearly 80 million people, it is the largest in the Arab world. This business will be included in our Western Europe, Middle East and Africa operating segment on a go-forward basis.

To encapsulate our performance, I think a good way to look at it is as follows: in the first quarter of 2006, we had $140 million of charges related to cost to implement restructuring and inventory initiatives. In the first quarter of 2007, the comparative number was $27 million. The net of this is about $113 million less cost in 2007. We invested incrementally nearly $50 million in advertising and the rep value proposition. We had strong sales growth and improved gross margin. Our restructuring savings were approximately $55 million in the quarter. Our period overhead expenses were down. Our variable SG&A expenses increased in line with sales and our total operating profit was up sharply.

Now, I will turn the call back to Andrea before we start to take your questions.

Andrea Jung

Thanks, Chuck. Overall, as we said, we are very pleased with our performance in the quarter. The theme for me this quarter was balanced growth. We had a good balance of growth across all geographies and categories fueled by continued top line investment and solid progress for cost containment initiatives. So we are just making progress here against the turnaround. We all remain committed to restoring Avon to sustainable growth.

So with that, I think we're just going to open it up to Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Bill Pecoriello – Morgan Stanley.

Bill Pecoriello - Morgan Stanley

I wanted to better understand the productivity that you're getting in North America, with the reps flat and the sales up 3; and you were lapping the year-ago period when you also had productivity. So if you could help us understand what's driving it in the quarter, and the sustainability of that looking out?

Andrea Jung

Bill, that was really driven by category mix. Skin Care, which was higher net, was really more than offset by Personal Care strength in the quarter, strong merchandising in Personal Care so a lot of good units in Personal Care, along with innovation. We had a Skin-So-Soft Fusions launch and again, the net there is lower than Skin Care. It really was a category mix issue that drove the unit volume.

Bill Pecoriello - Morgan Stanley

Looking out at the balance of the year, how would you expect that productivity to play out in North America?

Andrea Jung

It's hard to tell. You've got Color in the second quarter and then some major Fragrance and Skin Care launches in the second half, so I think it's going to be a category mix thing, but I think we've got a healthy balance here.

Bill Pecoriello - Morgan Stanley

On the advertising spending up 80% in the quarter and you had talked about up 35% for the full year as a goal and how we should expect that to play out balance of year also, in light of how strong it was upfront in the year.

Chuck Cramb

Yes. We're still holding to that estimate that we gave you for total year advertising. I think what you are looking at from a timing point of view is really the result of two issues. One is in the first quarter of 2006, we did not advertise at our average rate for the year, so we get an automatic uplift from that. The second one is the strong support we put against the Avon Color launch and the Hello Tomorrow campaign. That's why you see a very strong percentage growth in Q1.

Operator

Your next question comes from Bill Schmitz – Deutsche Bank.

Bill Schmitz - Deutsche Bank

Chuck, can you just comment on what the RVP spending is going to be for the year? I know it was $50 million this quarter.

Chuck Cramb

The $50 million, by the way, is a combination of the advertising increase and the RVP increase, just to clarify that. The RVP increase was a smaller number, it was about $15 million. We expect that to increase incrementally year on year by about $100 million through the year. When you think about how we are spending it, it is really an investment to accelerate our sales leadership program. It's also addressing incentives for the reps and special programs to try and help them reduce their fee structures. Things like incremental bonus brochures would be a good example there.

Andrea Jung

Also the CEE campaign frequency investment is in the second half.

Bill Schmitz - Deutsche Bank

Can you talk about Poland? I know there's a lot of great markets, but that one seemed to be struggling recently. Any comment on that and what you need to improve there?

Andrea Jung

Poland was flat in the quarter and obviously we are pleased with the balance of CEE. We continue to focus on the turnaround there. That really was more of an average order situation, but I think it was unique to Poland and so merchandising for the region, as you can see, really has had a good recovery, since we have made some of the changes we had talked about in the fourth quarter. We continue to work on Poland. I think the fundamentals in terms of the field are the ones that are going to drive that business, and turnaround.

Bill Schmitz - Deutsche Bank

Can you just talk about the local currency sales growth in Brazil? I know it was down sequentially, but I think there was a lot of currency in the previous quarter.

Andrea Jung

In 1Q, yes. It was high single-digit growth before currency impact, which took it into the low teens. What I would just say about Brazil is we think it was a good quarter for Brazil. We talked about the fact that we are not looking for Brazil to have the torrid pace of last year's growth, but we are looking for another year of good double-digit growth in that business. I do think that we should see the rate of growth from Q2 to Q4 to be higher than Q1. You have to remember actually we had some tough comparisons in the baseline, a 90% dollar increase in Skin Care in 1Q06. So the timing of launches is really Q2 through Q4 and we are going to invest aggressively behind those. So we intend to have another good year.

Operator

Your next question comes from the line of Wendy Nicholson - Citigroup.

Wendy Nicholson - Citigroup

Could you talk a little bit about the 2% rep count growth in Latin America? How different was that? Mexico reps, I assume, were down again but what about Brazil? How much were they up and when should we expect to see a pickup in that number?

Andrea Jung

We expect to see a pickup in that number going forward Q2 through Q4.

Wendy Nicholson - Citigroup

Are there specific initiatives planned? We haven't seen 2% rep count growth in Latin America as far back as I can ever remember. That's just a very low number. Is there something that was an anomaly in terms of a lack of recruiting activities?

Renee Johansen

Wendy, you hit it with the Mexico negative in the first quarter. Andrea did comment that as we exited the first quarter, we had seen an inflection point in Mexico with orders on a campaign versus a campaign a year ago beginning to improve so we will have that going with us as we go through the rest of the year.

Wendy Nicholson - Citigroup

Second question is on the reps in China. I know that we all see the aggregate number once a month. But my question is, are you going to at some point start giving us a rep count number? An active rep count number for China? So we know how many of those people who have signed up are actually submitting orders month after month?

Renee Johansen

I think we did, and it was in the press release: 168,000.

Wendy Nicholson - Citigroup

Oh, I'm sorry. I didn't see that.

Renee Johansen

168,000 fit the Avon definition of active reps.

Wendy Nicholson - Citigroup

168,000. You are going to give us that regularly on a quarter-to-quarter basis?

Chuck Cramb

Yes, we will.

Wendy Nicholson - Citigroup

Perfect. I'm surprised, Chuck, that you said that PLS is still in the analytics phase. Because when we do our very back of the envelope adding up of the SKUs in the brochures that we get here in the US, it looks like the SKU count on the Color cosmetics has actually come down pretty sharply. So is that just the timing of new products? What's going on there?

Chuck Cramb

There are a lot of pieces to that. I think if you look at it in 2006, we did have a significant SKU count reduction in the US as we attacked what I would call the low-hanging fruit. It was leading into PLS, it was encouraged by PLS, but the real PLS benefits are yet to come. I would also suggest that what you are looking at is significantly improved merchandising. One of the things you are reacting to is really the merchandising that you are seeing in our catalog and the clarity of it. You tie that in with the new product program and you have the answer to what happened in 2006 going into 2007.

Operator

Your next question comes from Amy Chasen – Goldman Sachs.

Amy Chasen - Goldman Sachs

Can you just talk a little bit more about the UK? The growth there was very impressive. What drove that?

Andrea Jung

I think it was a combination of things. We feel that strong, solid merchandising and continued investment; basically advertising close to double. We had some very good launches; we had a very strong launch of a couple of Color cosmetics products. I would just summarize the UK by saying they are operating well on all fronts. Average active reps were up nicely. I think you have been following this with us, they've implemented sales leadership. It's been in its second year now and third year going in. It is really taking hold. So we continue to see sustained average active rep growth. And those fundamentals, in my mind, combined with increased investments against the brand in the Beauty business are the two things that are driving that business.

Amy Chasen - Goldman Sachs

Do you expect that momentum to continue throughout the year?

Andrea Jung

I think the UK will have a very good year this year.

Amy Chasen - Goldman Sachs

Chuck, could you repeat the comment about why inventory days were up? I didn't hear you.

Chuck Cramb

Yes. We deliberately increased our inventory cover on Color products going into through the first quarter for the launch of the new Avon Color which came early in March, as well as supporting that Hello Tomorrow campaign. We wanted to ensure we had high service levels for our reps with such a major initiative.

Amy Chasen - Goldman Sachs

Okay, so in the second quarter we'll see that reverse?

Chuck Cramb

Yes, we're looking for reversal through the year. I hope you will see a measurable reduction in inventories by year end.

Operator

Your next question comes from Chris Ferrara – Merrill Lynch

Chris Ferrara - Merrill Lynch

Chuck, I wanted to ask about ZOG a little bit and I know that all of the ZOG savings are not incremental. When you say $55 million savings in the quarter, I'm guessing that does not include ZOG initiatives? How are you going to tease it out as you report back to us historically what the savings were?

Chuck Cramb

You are right. They do start to blur between what is directly related to those restructuring activities and what the ZOG are. The way we characterize it, that $55 million that we talked about, we directly attribute that amount of money to the initiatives that we talked to you about. The biggest one being delayering. So delayering was a big chunk of the $55 million. On top of that, we have other overhead reductions taking place as we attack every one of our costs in the business.

Let me give you a couple of examples that might clarify it. One would be travel and entertainment. We introduced a new global travel policy which defined and tightened up on who would travel when; business versus economy class, as well as the frequency of travel. A second area is real estate. As we have looked at our real estate on a global basis, and that's a centralized organizational structure reporting to me, but as we looked at it, we have said where can we consolidate and reduce space? Some of that would come maybe from the delayering activity as we reduced headcount. But here at corporate headquarters at Avon we had three floors in our building. We reduced it to two.

Another good example is insurance, taking a very hard look at deductibles and self coverage and what is the right mix of insurance. So those are the kind of things where you attack every single cost every single day. It is a mentality that you instill in the organization. It makes you zero base budgets and it makes you really control costs. That would be the difference between ZOG and the restructuring. Does that help?

Chris Ferrara - Merrill Lynch

It does. All those examples you just gave, those are ZOG and those are not included in the $55 million you stated, correct?

Chuck Cramb

That's correct.

Chris Ferrara - Merrill Lynch

This may be a silly question, but it is easier to ZOG early than it is later, right? Is that fair or not fair because you have to implement this into the culture of the organization?

Chuck Cramb

When ZOG becomes a discipline and a way of doing business , you're right, every year you say, how can I ever ZOG again? But you can ZOG. Now in any given year, or any given part of the organization, there may not be a ZOGing going on, but overall you can get there. You can really drive costs over a long period of time. Not forever, but over a very long period of time.

Chris Ferrara - Merrill Lynch

This one is on an entirely different note. As we look at your ad spending, which obviously is growing pretty quickly, if you extrapolate some of the increases and again, not of the same magnitude, but if you push your ad spending up by 30, 40 basis points, you get to a point where by '08 you are looking at maybe 6%, 7% of beauty sales as an advertising rate which is astoundingly close to your retail distributed competitors out there. I know there is still probably twice that or a little bit more. At some point, like you did at Gillette, do you step back and say hey, advertising at 11% of sales, you are not getting bang for your buck there. What is the possibility you run into a wall like that at Avon?

Chuck Cramb

I'm not sure, because we are not looking at advertising as a percent of sales. We look at it based upon the analytics we've got. We look at it in terms of the sales split that we think we can deliver and we are constantly checking back against what we expected and what we are actually delivering. We will continue to increase advertising as long as the analytics say we are going to be able to increase the sales and thereby generate more profit. There is no guideline as percent of sales right now.

Andrea Jung

We're doing the separate analytics by market. So you may see that Color cosmetics has a higher payback in Turkey than it does in market X. I think it's informing us and guiding us to where the investment will have the best payback and it is actually by media type and by category.

Chris Ferrara - Merrill Lynch

I know it is early, but have you yet found a product line or market where you have increased advertising and your analytics have told you that hey, you don't really need to move on from here?

Andrea Jung

I think what we showed you in February was we are still at the point and yes we are not at 11% of Beauty sales at this point yet. But we are still at a point where all the advertising is really above that line of a one-to-one payback. Some are very, very high or higher than others. We're still making choices, even though we are significantly increasing here. That's helping us guide it. But at this point it would be fair to say that broad based for the enterprise full categories and all media types are still not penetrated enough to have a payback that starts to look marginalized.

Operator

Your next question comes from Lauren Lieberman – Lehman Brothers.

Lauren Lieberman - Lehman Brothers

I was just curious in China about the volume growth versus the change in price mix. If that was a concerted effort or decision to shift the balance more in favor of price mix or how we should think about that going forward?

Andrea Jung

I think it's product mix when you look at it, so it's a product mix. You might have had a big promotion last year because of Color product and this year we had higher Skin Care volume, et cetera. So again, it is product mix. Nothing major differentially in terms of pricing.

Lauren Lieberman - Lehman Brothers

But still in terms of mix, I mean is this a sustained shift such that you are getting maybe as you are training some of the reps, they are being trained to focus on different product areas versus what was selling through at the boutiques?

Renee Johansen

Again, as elsewhere in our business, it's more driven by the launch cycle that we have, the product launch as we launch new innovation.

Lauren Lieberman - Lehman Brothers

Still, units up 15. I mean look, there's no question that China's doing very well. I'm just trying to understand the 15% unit growth with such high changes and new additions to active reps, I would have expected that to be higher. I am just trying to understand if there is an effort to be more focused on mix and profitable sales growth versus units.

Andrea Jung

Well, obviously we like the balance in the first quarter of '07. We did have a very successful Skin Care launch and obviously that is a higher net. So again, the timing is different in terms of product launches. Whenever we have a Skin Care launch you're going to get that net per unit.

Lauren Lieberman - Lehman Brothers

The second question is on the Christian Lacroix partnership which candidly, I would just think that's not a great fit with your core consumer. Jennifer Hudson, I get that; so maybe just a little bit of the thought processes on partnering with Christian Lacroix, a very, very prestige, premium brand name. What are analytics you've done to suggest that's going to resonate well with your core consumer?

Andrea Jung

I think that the, again, when you look at the Fragrance strategy, there's tiered pricing in the portfolio and we have mass fragrances and mass premium fragrance and so we are covering all price points. We are not blocking the whole entire portfolio of this designer, but we have clearly seen that celebrity/designer and a little more mass premium pricing is what's working for us. We have had extremely good response as you can imagine, from our field and zone managers particularly in Europe. Again, this will not be a department store pricing. It will be at the higher end of Avon pricing, but certainly not in department store land. I think it will be a very affordable piece of being able to get added designer look and feel. So we feel very good about it.

Operator

Your next question comes from Nik Modi – UBS.

Nick Modi - UBS

Can you talk about any potential opportunities in markets like Russia, Brazil to get deeper geographic penetration?

If you think about the U.S. and investing more in advertising, investing more in R&D, do you see over the next three years the opportunity to trade up your portfolio into higher price point goods? Thanks.

Andrea Jung

In terms of deeper geographic penetration, they're a little bit different, Russia and Brazil. One of the things we look at it is reps per 1,000 population and you've got a higher penetration in all of Latin America or Brazil would be at the heart of very high penetration of reps per thousand, with 1 million reps now in that market. Again, I think geographic penetration, while always something we look at from an analytic point of view in terms of what parts of the country we can penetrate, we are looking for opportunities with the rep value proposition there to increase productivity.

While we're going to have a nice number of reps growing, we still believe again at 1 million reps, I think you have a different proposition. Those things we are trying to address in that market, whether it's Internet ordering opportunities, whether it's call centers, whether it's multiple ordering opportunities, do address in large sales force in the opportunity to ease the effort side of the equation.

When you move to Russia, a little bit different with 11 time zones and a business that is growing very quickly. The reps per thousand are not the same as some of our developing markets that have been in business for 40-plus years. We think there is still opportunity to have representative per thousand population opportunities, particularly as you move east away from European Russia. That combination of trying to address the service and logistics aspect, as well as some of our rep value proposition opportunities there, would have more of a coverage sway than perhaps in some of the Latin American countries where it's already quite high. Is that helpful?

Nick Modi - UBS

That is. And then just on the U.S.?

Andrea Jung

From an R&D point of view, I think again we are pretty clear about where we can go and where we don't necessarily want to go. We are not trying to trade this brand away from our core consumer. We have really seen, particularly starting with our Skin Care category, that we have earned the right, if you would, from a brand point of view to achieve a more mass premium price point. Anew would probably be the best example where we can now not only readily but successfully sell at an over $30 retail price Skin Care product which is 2X what it was some ten years ago.

I think that with the brand investment, with the technology we are putting behind it from our R&D facility as well as all of the field energy around it, we have found we can get pricing that way. That's where we're going in Fragrance, for example. We have very big success with Selma Hayek's group of fragrances Today, Tomorrow, Always. They actually powered a lot of the European business in the first quarter and those are higher net; again, not department store prices.

So as we look at it category by category in Color, there is opportunities there. We launched an Anew foundation or a new Color business which is a complement to our new Skin Care franchise. That was launched in the first quarter of this year and is starting to do nicely, higher net. So slowly, and I want to make sure you don't think it's dramatically, we are moving the price tiers up, backed by advertising and backed by innovation. Still, though, I think addressing a mass consumer but getting a little bit more up in net, but not out of the range and walking away from who we are.

Operator

Your next question comes from Justin Hott – Bear Stearns.

Justin Hott - Bear Stearns

A question on China. First, what is driving the boutique owners to remain in the business? Can you explain what their proposition is that you are basically flat right now?

Andrea Jung

Yes, we're pleased, Justin, that we have 5,500 beauty boutiques and that number was stable in the quarter. I think that we spent a lot of time, as you know, in parallel to the major focus on prospecting and appointing new sales promoters. We spent a lot of time communicating to our beauty boutique dealers over the lion's share of the year what their role would be in the support of direct sales and service centers. Obviously from a moment in 2005 where there was a lot of confusion and we weren't allowed to tell them, once we were able to communicate quite clearly and effectively how they would be able to service and/or support the representative proposition, they have embraced that. And in my mind that's exceeded my expectations.

They provide after sales services, order pick-up, product returns, credits, product trials, billings, all that. But very importantly now as we focus on productivity and/or activity in that market, the beauty boutique dealers or owners are increasingly becoming a larger part of our ability to focus on that. Our original focus has been with our division managers and our zone managers, who are the primary recruiters, if you would. But our service center owners, our BB owners, now are really being trained to help train for activity and drive activity with sales promoters as well.

So they understand their role. They understand how they have an economic benefit from being a service center, the more SPs they serve. That has been something I think all of us feel very pleased about. It says we can have this hybrid model with obviously a significant number of fixed access points at the same time that we've been very successful recruiting, obviously, a tremendous numbers of sales promoters.

Justin Hott - Bear Stearns

Is there a stabilized number that you would be looking for in terms of beauty boutiques? When Amway has 150 and you have 5,500?

Andrea Jung

It is interesting. I think one of the things I said to all of you is it is hard to tell until you get into it. I probably would have said a year ago that the number would have continued to decline. Not at rapid rates, but I would have been surprised to say that we had still 5,500 at this point. So I'm very pleased. They obviously find an economic proposition here that we are very excited about.

Justin Hott - Bear Stearns

And one other question, Andrea, on your model out there and maybe the regulatory environment. Obviously, pure direct selling or a pure rep structure of commissions from Avon some of your competitors seem to have more, have payouts more similar to multi-level marketing I guess is the right way to put it. How would you say the regulatory environment is treating that so far? What do you expect?

Andrea Jung

Well, it's hard. I'm not prepared to discuss how our competitors are doing their business, by or not by what is the single reg for all. I just want to continue to say that we are abiding by the regs, which we believe are the same regs for all parties. We have not seen impact from direct selling competition. That is not to say our eyes aren't wide open, but we continue to believe that China's going to be a big success for this company with this hybrid model we just spoke about, with BBs as well as focus now on activities. So the laws are, as I understand it, the laws as it relates to single level.

Justin Hott - Bear Stearns

On Japan can you give us the sales growth rate of the base direct selling business?

Andrea Jung

Yes. It was up double-digits.

Operator

Your next question comes from Ezra Solomon – JL Advisors.

Ezra Solomon - JL Advisors

My question is around the representative response to the product line simplification. As I know in the past, this caused some concern among representatives and confusion. I was wondering if you're seeing any of that now?

Chuck Cramb

No, we're not seeing any of that now. We actually think that the product line simplification is going to be a healthy change for the representatives. It will allow them to focus better in terms of selling, in terms of understanding our product line, in terms of managing their consumer through the store. So the research that we've done to date has been very reinforcing in that area.

I think the big challenge that we're going to have is to really continue to train them and help them understand that this is an added value or an extra value for them. But to date, we've heard nothing from them that would concern us.

Operator

Your next question comes from Linda Bolton Weiser – Oppenheimer.

Linda Bolton Weiser - Oppenheimer

In China, I think you had been commenting and the numbers had indicated previously that the activity level was about 50% of the total number of reps and it looks like now it is only about 33%. Do you think that will go lower as we continue to see the total numbers go higher?

Andrea Jung

Well, I think it's a number that is going to take time to go up, but our whole focus is on making that number. You've got a denominator and numerator, so the denominator here is pretty high this point with over 0.5 million.

I would just say the following. We intend to continue to recruit but the focus is really going to be on activity. We've been focused on training. As I just mentioned, now we have accomplished what I would have liked to have seen us accomplish in terms of prospecting and appointing skills, very, very good progress on that front. Now on the training front, our managers are really understanding how to train. Training is a big component of activity or productivity, and the BBs are really now being able to train the sales promoters.

The second thing that I think is important in terms of activity is, I'll call it Avon merchandising. But we have been a retail business up until we opened direct sales. So the catalog was more retail driven. Merchandising and brochure merchandising actually is a large driver of activity. So we are moving it and morphing it into having more direct selling offers and having more of a direct selling rhythm in that market. So a big piece of work is going on there which I feel very good about.

We are really beefing up our incentives in every campaign. There are productivity prizes. We've got some guaranteed commission rates that help early SPs. Those things will drive activity.

Linda Bolton Weiser - Oppenheimer

Chuck, I think you were talking at CAGNY when you were asked about cost reduction possibilities. I think you mentioned the business model is highly transactional in nature, more so than a Proctor & Gamble or Colgate or something. Yet now we are seeing these big cost reductions. Are your views changing in terms of the potential profitability of this model versus a Gillette or a Proctor?

Chuck Cramb

No, not at all. I think what we were referring to at CAGNY was the nature of some of the problems we got into with being a highly transactional business. When the company was growing at double-digits, the tendency was to add people as opposed to try to change and automate some of the processes that underlie servicing those transactions.

Our job is to really address and attack the transactional base to do it more efficiently and really take the costs out. So I don't see any difference in my view on the company right now. I think there are opportunities to take the costs out and certainly that's what our initiatives were all about in terms of some of the restructuring initiatives, as well as how we think about ZOGing.

Linda Bolton Weiser - Oppenheimer

Can you also explain why the cash impact of the restructuring is greater this period than last? Didn't you have a lot of headcount reductions last year?

Chuck Cramb

If you think about it, last year we were announcing the programs and there are certain accounting rules which require you to accrue for those costs upon decisions. Now what's happening is we're actually paying the cash related to those programs. So last year, you accrue the cost and then you pay the cash out as people depart.

Linda Bolton Weiser - Oppenheimer

But I thought all the people departed last summer?

Chuck Cramb

We still have people leaving now. Remember since delayering, the reductions in staffing actually go through the end of the first quarter. The other thing is that we have some people who go on a deferred payment basis. So they don't take a lump sum distribution. They actually take their pay over two years.

Operator

Your next question comes from Alice Longley – Buckingham Research.

Alice Longley - Buckingham Research

I was wondering if you could give us more detail or color on the RVP changes or programs that are working the best? Sort of along the line of the detail you gave us on what's working in ZOG?

Andrea Jung

The RVP initiatives that we are investing in are a continuation obviously of rolling out sales leadership; bonus brochures, free brochures is something that we're doing not just in the United States but a few other markets now that we are seeing the payback on that, which are free brochures and distribution to certain tiers or certain top-selling representatives and getting the store open, if you would, to more customers. So that relieves their economics, if you would, of buying the brochures on their own dime.

Stronger incentive programs and that we are doing and seeing in many markets. Television commercials in the United States we saw the recruiting commercial, but we have print recruiting commercials in several markets and looking at relief of fees in certain markets to make sure we just continue to put the rep economics in a better, more balanced place.

So those are the major areas of RVP. Each market has a different set of solutions as we discussed in February. But those would continue to be where we invested, as Chuck said, over $800 million incremental in 2007.

Alice Longley - Buckingham Research

When you mentioned a stronger incentives, is this mainly higher mark-ups?

Andrea Jung

Rep incentives: prizes, programs, trips. One of the things that I think is very important that we said in February, but I want to underscore it here is that the analytics are driving these investments. Just like advertising, where each market has a detailed analytic on whether it's Skin Care or Color that we should invest behind. The group of initiatives I just mentioned, all which come under RVP, are being looked at in each market to see where the better payback is. So we can see incentives, for example, in certain markets that have very huge paybacks and we are doubling down there. Others are in the very early stages of leadership, which is showing a higher payback than traditional and we'll put the money down there. So it's been very analytically driven ,and that's how we are informing where the $100 million incremental over last year will go.

Alice Longley - Buckingham Research

Could you give us an update on where you think the operating margins of Avon can ultimately go, given the nature of the business?

Chuck Cramb

There is nothing new since what we talked about in February at the investor's meeting. We said we would start to approach the 2005 margins next year. We said we saw some gradual improvement year after year beyond that. Other than that it would be a guidance question. That's as far as I can go.

Operator

Your next question comes from Connie Maneaty - Prudential.

Connie Maneaty - Prudential

Andrea, I think you said in your prepared remarks that sales went up in every region and it had been a long time since that happened. While you were pleased that's what was reported in the first quarter, you expected there to be some variability going forward. What did you mean by that? Are there specific programs that you think will affect sales growth in any particular region during the balance of the year?

Andrea Jung

I don't want you to measure quarter to quarter. We are doing the right things. We obviously, I think, as I recall us saying in February, I think we have the right turnaround plan to drive revenues and operating profit growth in this year. We just think there is a timing, for example, of new product launches. I think we are doing the right sustainable things at it relates to the RVP. There are certain things that come into the second half in terms of changes to brochure cycles. There are differences in the timing of the innovation calendar, so that would drive average order differences one quarter to another. On balance on the year, I don't see anything different than we talked about for the year. I wanted to make sure quarter by quarter there may be variability between regions.

Connie Maneaty - Prudential

The charges in the first quarter seem to be light versus what you expect for the year. Could you talk about what the flow charges might be this year? Also, since PLS is still in an analysis phase, when will it start to have an impact on the gross margin?

Chuck Cramb

In terms of the charges, we are really on our overall plan. Remember we said it's a long term plan. It goes through really the year 2009. Of the $500 million, there is about $100 million of programs yet to be announced. So I think you need to do the math and think about the flow forward. But the $400 million between now and 2009 is the way you have to think about, the announced programs.

In terms of PLS, the impact on the business, and it will be a margin impact at gross margin and also will be a sales impact. That also is really a three-year initiative and we're going to take that slowly. We're going to make sure our analytics are tested in market. This is all about getting the right product assortment, not in an individual or given market, but across the Avon geography. So we have to not only understand what happens in individual markets and test the analytics, but make sure we understand the reaction to the program across the various markets.

I haven't got a firm date in terms of when you could start to really report a measurable benefit from that. We do expect some minor benefits early next year but not significant.

Connie Maneaty - Prudential

Are there minor costs or minor growth margin contraction implications for the rest of 2007?

Chuck Cramb

The only thing would be as we identify areas where we have a certainty that we shouldn't keep the product in the portfolio. You'll see continued obsolescence charges just like you did in the first quarter.

Connie Maneaty - Prudential

Great.

Operator

Your next question comes from Filippe Goossens – Credit Suisse.

Filippe Goossens - Credit Suisse

Chuck, we have seen now acquisitions in Egypt as well as Colombia. Any other key growth markets where it would benefit the organization by taking over a distributor or a licensee?

Chuck Cramb

Right now there is nothing material in terms of taking over a distributor or a licensee. We continue to evaluate opportunities as they come along. But at this point in time, there's nothing significant on the immediate horizon.

Filippe Goossens - Credit Suisse

Moving on to the U.S. side of the business, clearly some improvement there with the 5% increase in volumes. If I look at the landscape out there in the U.S., more people starting to talk about the consumer running out of speed. We are hearing it from the cruise lines, we hear it from the airlines, we hear it from a number of retailers. Based on your initial read, are you hearing anything that would also indicate perhaps somewhat a more challenging environment for your customer in North America?

Andrea Jung

North America is a turnaround story that is starting to show results. It is a long-term proposition and we're pleased with the performance. I would just say that we, for example, looked at fuel prices and then showed you in February that fuel price does have an impact on rep activity, on consumers depending on where they go, could they dampen rep activity somewhat? The proof is that there is a correlation there, but I think the thing I want you to focus on is we are focused in North America in this turnaround on the things we can control. So the investments back against the brand, the big push with innovation that's coming in specifically in the second half. The RVP that I talked about, which again in the United States as we showed you has some really good paybacks. Those are the things we believe can counter whatever is going on. Those are our initiatives that we're focused on in terms of what we can control.

Filippe Goossens - Credit Suisse

Then the other question is with regard to Turkey. Obviously a market where you have done very well, a market that remains key to you. Do you have any historical information in terms of what happens when there are some political problems in that country? As you know, there are potential problems looming with the presidential elections with the military starting to intervene once again. Have you had any historical evidence what happens to consumer behavior when there are these types of potential events in Turkey?

Chuck Cramb

Every developing market, when it goes through some of the things Turkey is going through, each one is going to be different depending on the circumstances. I know that today, in terms of how we are looking forward, the business does continue buoyant. I think time to time, there are temporary dislocations in developing markets, but our business model seems to be fairly resilient to them.

The one example and you know this one too, just because of where you are is Venezuela is an excellent example. We have had years of turmoil and there our business has continued to grow quite strongly. So you can never predict exactly what might happen but we are pretty confident that that the business model will be buoyant even in some of the upheavals we are potentially seeing.

Filippe Goossens - Credit Suisse

My final question, again perhaps focusing a little bit more on Latin America. I'm trying to get a little bit more color in terms of trying to understand the difference in performance between Mexico and Brazil. Obviously Brazil has been a tremendous success story for Avon, Mexico is still a work in progress. I'm trying to understand, Andrea, to what extent one of the drivers for the difference could also be more socioeconomic in nature?

What I'm basically trying to find out is we did some recent field research in Mexico and what we learned is that if you try to grow your business with the, as we call it, the middle to the upper middle income type customer in Mexico City, that you still need to perhaps overcome a perception issue that the Avon brand historically has been more identified by lower socioeconomic groups within the city? And therefore, that perhaps it might be a little bit more difficult to penetrate that more upscale type of customer. Is that an observation that you would share? If so, what can you do to better position the brand awareness with your target groups out there?

Andrea Jung

Well, in the medium to longer term, certainly in Mexico, the concept of investing heavily against the brand, and taking a lot of the learnings that we have had in some of the categories where we can boost not only revenues but image, those apply to Mexico and we will be doing the analysis and the investment there. They are already the recipients of some incremental brand investment.

But the major short-term issue is not structural, it is field fundamentals. That has been the biggest problem. That is the major difference today, the more and more we obviously dive into and drive this turnaround. That is where I think some of the actions that we have taken are really starting to take hold now, and why I feel good about the fact that we'll stabilize this business by the end of this year.

I think that is it in terms of questions. Any follow ups, I think you can all get to Renee and Rob. I know it's been a long morning, but we appreciate everybody being on the call. I want to leave everyone with the continued commitment we have as a management team that we are aggressively driving this turnaround. It is a multi-year effort. Having said that, we feel good about the quarter and we are managing this business for the long-term and taking all the steps we think we need to take to restore the company to sustainable growth.

I appreciate everybody's interest and we'll talk to you soon.

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Source: Avon Q1 2007 Earnings Call Transcript
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