Avon Products Q4 2007 Earnings Call Transcript

Avon Products, Inc. (AVP)

Q4 2007 Earnings Call

February 5, 2008 9:00 am ET

Executives

Andrea Jung – Chairman & Chief Executive Officer

Charles W. Cramb – Vice Chairman, Chief Finance & Strategy Officer

Renee Johansen – Vice President Investor Relations

Analysts

Amy Low Chasen – Goldman Sachs

William Pecoriello – Morgan Stanley

Justin Hott – Bear Stearns

Laura Liberman – Lehman Brothers

William Schmitz – Deutsche Bank Securities

Wendy Nicholson – Citigroup

Christopher Ferrara – Merrill Lynch

Nik Modi – UBS

Alice Longley – Buckingham Research

Connie Maneaty – BMO Capital Markets

Filippe Gooossens – Credit Suisse

Jason Gere – Wachovia Capital Markets, LLC

[Allie Debaje – Berstein]

Alec Patterson – RCM

Presentation

Operator

Good morning. My name is Andrea and I will be your conference operator today. At this time I would like to welcome everyone to Avon’s fourth quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks there will be a question and answer session. (Operator Instructions) I’ll now turn the call 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 fourth quarter and full year 2007 results. With me this morning are Chuck Cramb, our CFO and Renee Johansen our Vice President of Investor Relations. Since some of our remarks this morning may include forward-looking statements I refer you to the cautionary statement in today’s news release. For today’s call I’m just going to begin with some high level comments on the quarter and then share my reflections on where we are as we enter 2008. After that Chuck will take you through the quarter’s financial results in more detail and then the two of us will take your questions.

As you’ve read in this morning’s press release Avon delivered another strong performance in the fourth quarter of 2007 reflecting the momentum we’re gaining as our turnaround progresses. The 17% growth in overall revenues in the quarter was truly a standout in my mind. We posted absolute dollar growth of more than $450 million, that’s the largest in Avon’s history. Seven of our top markets grew revenue by over 20%. China increased almost 30%, Brazil grew by nearly 40% and Turkey increased over 50%. Particularly noteworthy for me in the quarter was the strong growth in active representatives which increased 11%. Encouragingly we achieved gains in all regions as we continue to accelerate our investment in the representative value proposition or RVP.

In central and eastern Europe active representatives grew 18%. They benefited from the new three weak campaigns as well as commission changes in Poland and Hungary. In Latin America active representatives grew 12% reflecting strong increases across the region and notable gains of more than 20% in Columbia and Argentina. In Mexico I’m very pleased that active representatives and overall revenues both increased 5% with our investment in field fundamentals paying off and the business stabilizing by year end as we had expected. In North America active representatives few 3%, here our continuing investment in RVP allowed us to offset the negative impact of higher gas prices as well as the general economic slowdown in this region.

If I turn to beauty in terms of our revenues, we saw a 20% increase in the quarter. I’ve been at Avon since 1993 and this is one of the highest beauty growth rates that I have seen in my tenure here. Fragrance was up 23% lead by a record global launch of the Christian Lacroix brand. This confirms to me the strategic value of targeted alliances to drive a real pyridine shift in price point and brand in this category. Color was up 19% on the continued strength of our relaunched color line. Personal care was up 30% continuing to benefit from significantly improved merchandising and skin care was up 9% lead by the successful launch of Anew Ultimate Night Cream and Elixir. Many of you know this product was introduced for us at price points ranging from $50 US to as high as $80 US comparable in China and we saw very strong demand for this across the globe. So here again, we were able to continue to elevate our pricing opportunity and leverage major innovation to drive brand value.

Overall, as we close out the year I’m very, very pleased with the progress we’ve made in reuniting strong top line growth. For the full year 2007 revenues for the company increased 13%. That’s well ahead of where we thought we would be during this first chapter of the turnaround. The numbers tell the story of just how far we’ve come. I’m just going to take a second in constant dollars so that we can level set the performance. In 2005 pre-turnaround, revenues grew only 2% in local currencies reflecting challenges in maintaining Avon’s market share. As we close out 2007 full year local currency levels have accelerated to 8% and we are aggressively recapturing both beauty and direct share across the portfolio. For the full year in 2007 eight of our top markets grew local currency revenues 15% or more primarily in the developing and emerging markets. We also so a noteworthy turnaround in our developed markets where following significant revenue decline in 2005 we saw positive revenue growth at the end of 2007.

In beauty our growth in the year in 2005 was only up 3% in local currencies so at that point we were experiencing a below industry performance as a result of under investment in our core CTF business in the face of intensifying competitive pressures. Only two years later as we close 007 beauty growth as tripled to over 8% in constant dollars almost 1.5 times that of the industry growth rate overall. Encouragingly beauty growth has been broad based across all categories. If you had asked me in 2005 if we could have regained share this quickly, I would have said no. So, I am very pleased with the progress on this front.

In terms of active representatives here again the results two years later speak to the success of our turnaround plan. Active representatives increased 9% for the full year with double digit growth in the third and fourth quarters. We’re seeing a healthy mix of active representative growth across all market segments so to me the early success of our RVP initiatives is clearly broad based which is encouraging and bodes well going forward.

Underlying the recovery in beauty and active representatives of course, is a significant step up in investments that we’ve made over the past two years in advertising and the representative value proposition. In 2007 our advertising investment reached nearly $370 million. That’s the largest in our history, it’s almost three times the $136 million we spent in 2005 and this level of spend achieved a year ahead of our initial plan reflects detailed analytics confirming the specific payback of advertising to our business. This analysis has also confirmed exceptionally strong paybacks from our investments against the channel. Since the turnaround begin we have also boosted spending on our representatives by an incremental $150 million plus. To fund these incremental investments in 2005 we embarked on a radical restructuring of the business to transform Avon’s cost base. We had initially anticipated that the cost to implement restructuring would be in the range of $500 million and that this investment would yield $300 million in annualized savings by 2009. We are on track to deliver the $300 million savings in 2009. In fact, with the recent announcement of the completion of restructuring we now expect that total program benefit will be approximately $130 million higher than planned or a total of $430 million by 2011, 2012 when restructuring is fully implemented. The cost to implement will be just slightly higher than planned at approximately $530 million with the lion’s share of these costs already spent and booked through the end of 2007. So again, a better than expected performance by the organization in terms of taking bold actions against the cost chain. In addition to launching and completing our initial restructuring program, over the past two years we also identified two additional initiatives; product line simplification or PLS and strategic sourcing. These two initiatives combined will deliver more than $400 million in annualized benefits over and above the original restructuring program. So, the commitment to a constant

turnaround mentality is alive and well here.

So as we close the books on the first chapter, I feel great about the progress we’ve made across all dimensions of the turnaround. During chapter one our priority has been to reunite the top line and regain market share in beauty and direct selling. Over the last two years we made the deliberate decision to invest well ahead of the projected benefit extremes from our cost transformation program and also well ahead of overall revenue growth. This was part of a carefully calculated strategy to strengthen our brand in the channel and build a strong foundation for long term sustainability. Given the strength of our results I believe this decision was the absolute right one.

As we enter 2008 we now begin chapter two. This next chapter is about sustaining the top line while also restoring margin growth. We don’t view top line growth and margin expansion as an either or choice. We believe we can deliver a careful balance between the two. In the first chapter we invested significantly ahead of growth. In this next chapter we will continue to invest in advertising and the representative value proposition but these investments will now be more in line with revenue growth. With the major step change in investments now behind us, we have two years of robust analytics under our belt so going forward we believe we can unlock even greater efficiencies from every dollar we spend making investment choices with laser focus for maximum return.

In the first chapter we invested heavily to restructure this business and right size our product line. In the next chapter our philosophy of zero overhead growth will drive a continuous turnaround mentality. The major cost from restructuring and PLS write downs are behind us. For the next several years will be able realizing the significant financial benefits from these costs transformation programs. So as we enter 2008 and beyond I really believe the foundation has been laid and all the elements are in place to balance sustained top line growth with strong margin improvement. During the next chapter we’re going to fortify the powerful global equities which underpin the competitive advantage of this business. I think we have a very competitive global brand. Going forward we will continue to invest in innovation and brand image to drive further share gains. We have a world class representative channel and we’re going to continue to invest in RVP to strengthen our global leadership position in direct selling. We have an advantaged broad based global portfolio and we’re committed to unleashing its full power through strategies to grow each of our geographies and beauty categories.

Finally, we have the right operating model in place today. We can now leverage the full opportunity of our global strategy driving economies of scale to optimize efficiencies and reduce costs as part of this continuous turnaround mentality. This has been the foundation of the four point turnaround plan over the last two years. Going forward the turnaround plan does not change, it just now becomes an ongoing blueprint to drive continuous improvement across the enterprise and to position the company for profitability, sustainability as we move forward.

With that, I’ll turn it over to Chuck for a more detailed financial review of the fourth quarter.

Charles W. Cramb

Good morning everyone. Let me briefly take you through our fourth quarter results. We had another great quarter with sales growth of 17% or 9% in constant dollars. Our gross margin declined from 59.6% in 2006 to 57.8% in 2007. This entire reduction is due to the final obsolescence expense associated with product line simplification. As we said on January 8^th, we have completed our PLS analysis. We have decided the appropriate product assortment going forward and we have defined our exit strategies and actions thus there will be no more PLS inventory charges. We expect early but meaningful financial benefits to come from PLS in the second half of 2008. Those benefits will ramp up throughout 2009 and reach a run rate in excess of $200 million by year end 2009. The early trends from the UK [inaudible] market on this initiative support our expectations of the PLS strategy.

Our SG&A expenses increased 21% in the quarter. This is slightly ahead of our growth in sales due to higher restructuring costs as well as further increased investments in advertising and RVP. Our advertising was up $19 million and our incremental investments in RVP were up $39 million for the quarter. On advertising this brings our total year costs to $368 million, an increase of $119 million or roughly 58%. That’s just over 5% of our beauty revenue. Our analytics support this level as roughly the appropriate scaled investment required. Therefore, you should expect us to spend about the same percent of sales on advertising in 2008 and to achieve greater efficiencies for the dollars spent. Another key investment in the fourth quarter was the incremental $39 million for initiatives to improve Avon’s representative value proposition. Our full year increase was $121. This include investment in our sales leadership program, improved field incentives and costs related to the three week campaign cycle in [inaudible]. In 2008 expect the RVP to grow slightly ahead of sales. We are very pleased that both our advertising and RVP investments are paying off. They have lead to double digit growth in beauty sales and in active representatives.

Our cost to implement restructuring in Q4 were $101 million. That’s $57 million higher than the $44 million recorded in the prior year quarter. Although we have announced our final restructuring initiatives there are future costs that could not be accrued to 2007. These costs which will occur over the next couple of years as we implement our programs are currently estimated at $85 million net of some minor [inaudible] sales. Our restructuring efforts generated savings of approximately $230 million for the full year with roughly $60 million of that occurring in the fourth quarter. That means year-on-year we increased our restructuring savings by $130 million from the $100 million we had generated in 2006.

Variable SG&A expenses, things like sales commissions, distribution costs and shipping costs grew somewhat ahead of sales due to higher costs related to oil prices. In the quarter we experienced modest increases beyond the impact of currency in what we call overhead expenses. However, these increases were well below the growth in sales. For the total year these expenses were below the level in 2006 on a constant dollar or local currency basis so we did deliver zero overhead growth for 2007. Let me stress again however that the concept of zero overhead growth is not about the math it is about creating a mentality to constantly drive productivity improvements to offset inflation and to keep overhead costs well controlled. I do believe this philosophy has become a way of life at Avon.

The net financial results was an operating profit for the quarter of $225 million, a 21% decrease from 2006’s level. The operating margin was 7.3% compared to 10.8% in the prior year. The higher expenses related to PLS and the cost to implement our restructuring more than accounted for the margin decline. Our tax rate of 34.2% for the quarter was higher than the 30.4% we had in 2006. The 2007 rate was negatively impacted by the geographic mix of our restructuring PLS costs. The 2006 tax rate had benefited from the favorable impact of statute of limitations expirations and audit settlements.

Normally, I would take a few minutes here to update you on our PLS and SSI initiatives but the CAGNY Conference is just two weeks away. I’ll wait until then to get into the details of those initiatives. But, let me go on record as saying that we do continue on track with both the product line simplification and strategic sourcing initiatives. We expect PLS benefits to reach in excess of $200 million annualized by the year end 2009. SSI is also on track to deliver in excess of $200 million in annualized benefits by year end 2009. As a reminder we raised our projected savings from the restructuring program to $430 million. Upon full completion of all programs in 2011, 2012 with $300 million in savings to be achieved in 2009 the benefits and savings from restructuring, PLS and SSI will bring our total annualized benefits to over $830 million upon full implementation of all initiatives. This is well ahead of the original $300 million of benefits that we first discussed with you at the end of 2005. This momentum gives us confidence that we really are driven by a constant turnaround mentality.

Now, let’s take a look at the balance sheet and cash flow. Our next debt has increased by close to $550 million primarily in higher commercial paper borrowings. The increase in net debt is less than our share repurchases of $667 million during the year. We have started repurchasing under the recently announced new five year $2 billion authorization. Decrease in net cash from operating activities primarily results from increased payments in 2007 for inventories and incentive based compensation. Accounts receivable have increased in line with the revenue growth. We also chose to make discretionary contributions for post retirement benefit plans, both retiree help and pension programs during 2007. Our inventories grew roughly in line with sales although there were significant PLS write downs.

On previous calls I have discussed many of our structural initiatives that will help address inventory management. We will leverage these with our new life cycle management processes that are being introduced this year. These processes will help control both how and when to launch new products and how and when to exit old ones. We are also strengthening accountability for delivering these results across the organization. We believe that we will deliver our target improvements of three to five days reduction in inventory coverage each year starting in 2008 for the next four to five years.

As expected our capital expenditures of $279 million increased $104 million versus 2006. Due to supply chain initiatives which we previously discussed both for infrastructure and for IT systems we expect this year’s capital expenditures to be in the range of $350 to $400 million again, driven by supply chain initiatives. I expect 2008 to reflect significantly improved cash flow both from improved asset management and higher earnings.

A last comment before I pass it back to Andrea, I’m very pleased with our progress in 2007. We delivered strong top line growth to just under $10 billion. Our revenues were up 13% or $1.2 billion. Our active reps were up 9% and our beauty sales were up 15%. We fueled our growth through an increased quarter of a billion of investment in advertising and RVP. We achieved zero overhead growth. We delivered $230 million of restructuring benefits, up $130 million from 2006. We have taken the last of our PLS charges and we repurchased almost $700 million worth of our shares during the year.

With that I’ll hand it back to Andrea.

Andrea Jung

That’s the perspective on the quarter and the year from the two of us. Overall, I feel great about where we are at this point in our turnaround as I said. A lot has been accomplished and as we enter the next chapter we’re well positioned for profitability and sustainability. Just a few closing comments on 2008 before we move into Q&A, while we don’t give guidance I think you can put together a pretty good high level picture of what the full year will look like. We anticipate that revenue growth will be solidly in line with our long term targets of mid single digit growth. We saw some softness in non-beauty in North America in the fourth quarter consistent with retail trends in this market. This softness continues driven by macroeconomic pressures and may moderate this regions performance somewhat in 2008 however, the sustained momentum in emerging and developing markets gives us confidence that we can achieve our targeted revenue goals.

Importantly, in terms of the bottom line, here again nothing changes in terms of our commitment to achieve an operating margin in 2008 which approaches the level of 2005 and just to be very clear our 2005 margin on a GAAP basis was 14.1%. So, in summary net-net I couldn’t be more pleased with what we’ve accomplished and where we are going. Fourth quarter and full year 2007 results are a strong cap to our successful turnaround performance over the past two years. As the next chapter begins I feel great about the foundation that we’ve built and we’re just going to continue doing the right things for this business. We remain committed to managing for the long term and to restoring Avon to sustainable and profitable growth.

With that we’ll open up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll pause for just a moment to compile the Q&A roster. Your first question comes from Amy Chasen with Goldman Sachs.

Amy Low Chasen – Goldman Sachs

Two regional questions, first on Brazil, can you tell us how much Brazil was up excluding currency in the quarter? Similarly, on the UK it looks like that business really accelerated if you could just give us a little bit more detail on what drove that specifically?

Andrea Jung

Chuck can give you exact numbers here but both markets had a great performance even in constant dollars.

Charles W. Cramb

We were up strong double digits in constant dollars in Brazil Amy.

Amy Low Chasen – Goldman Sachs

And in the UK?

Charles W. Cramb

And in the UK solid single digit.

Andrea Jung

Solid single digit growth, mid single digit.

Amy Low Chasen – Goldman Sachs

Was the Brazil number an acceleration versus recent trends or about in line?

Charles W. Cramb

It’s pretty much in line. We’ve had strong growth in Brazil throughout the year. The first quarter I think was a little soft from a growth rate point of view and then it just accelerated second, third and fourth.

Andrea Jung

I would just say if we kind of capped the year in Brazil it is clearly the second largest market in the Avon world, a huge revenue market, very profitable. But, the bold moves are paying off there and even with the scale as huge, these aren’t even numbers off a huge scale. So, you talk about 40% in dollars or mid teens in local currency, this is not off a $200 million market, this is off a over billion dollar huge profitable market for us and I think the moves that we’ve made to gain share bouncing productive growth with rep growth has really been working.

Amy Low Chasen – Goldman Sachs

Can you also just give us a quick update on where you stand in turnaround for Mexico?

Andrea Jung

Yeah, I’m very pleased with the progress in Mexico. We said we would stabilize this business by the end of this year. We did that. It’s been several years, it wasn’t a one year turnaround but revenues being up 5% and importantly reps being up 5% I think this was a situation where we started to see sales fundamentals paying off and we said revenues would follow.

Amy Low Chasen – Goldman Sachs

So you expect an acceleration in 08?

Andrea Jung

I think that Mexico has really kind of stabilized and I’m looking for a better year certainly than the last two in Mexico.

Operator

Your next question comes from the line of Bill Pecoriello with Morgan Stanley.

William Pecoriello – Morgan Stanley

It looks like you directed a bit more of the reinvestment into RVP in the fourth quarter with the $120 million plus in the full year, you’d looked in the $100 million originally. What drove that decision? What regions did you put the extra RVP investment into? Then, when you look at 08, it sounds like you’re moving a little more of the mix to RVP than advertising and I just wanted to get your thinking behind that.

Charles W. Cramb

Sure. Bill, it really is driven by the analytics and the results we’ve seen throughout 2007. But, even entering 2007 we had expected the balance to move towards rep value proposition from an investment point of view. I think you can remember back in the analyst meeting we talked about the advertising uplift and the RVP uplift to be much more in balance for advertising to be the [inaudible] in 2006. In terms of where we’re spending it, it really is across the board. Some of the major initiatives when you think about them are in incentives that are in the three weak campaign in central and eastern Europe. They’re in terms of programs in Latin America as well. But again, you’re talking about markets that are strong growth markets and also the markets that are our biggest so that correlation particularly for CE in Latin America holds.

William Pecoriello – Morgan Stanley

Then you just reiterated in 08 that you expect to grow basically in line with sales on those numbers and still maintain the mid single digit revenue growth. Given the step up in competitor spending in beauty, that continues in slowing macros in certain regions. How do you plan to adjust reinvestment by region or any of the RVP advertising mix by any of the key regions?

Charles W. Cramb

Again, that goes back to the analytics. If I use advertising as an example, I can use RVP as an example too and it depends on what elements of the RVP but, what we have now is the ability to understand where we get the highest sales lift or the highest pay back of the mix of the activities that we participate in. In using advertising as the simple example, the classic do you use 30 seconds versus 15 seconds? Do you advertise product? Brand equity? Or the recruiting advertising campaign that we use? What’s the geographic mix and how do we change the balance? When we look at things like that we really believe that we have the ability to improve the efficiency of every dollar spent. So, even though we may see advertising only going up roughly in line with sales, the efficiency of that advertising or the absolute value of it is higher than what the dollar would suggest. Then, the same thing happens for the rep value proposition in terms of looking at structures of incentive programs, the value of those incentive programs, how we’re executing the three week campaign. All those metrics are in place now and give us a pretty high degree of confidence that we can manage that mix.

Operator

Your next question comes from the line of Justin Hott.

Justin Hott – Bear Stearns

Maybe I missed this but can you tell us how much skin grew excluding fx on the sales line? And, a question on China too, the rep count, what you talked about last quarter on rep count and cleaning up maybe some of the inactive reps by your own definition, is that going according to plan?

Andrea Jung

Yeah. Just quickly on skin care it’s really low singles. Again, we got a benefit from exchanges we did in the [inaudible] but, the other categories were solid, solid double digit growth. In skin care we had very good performance in our new launch of ultimate night cream elixir, a little bit more weakness on some of the other parts but it’s a big category opportunity for us in 2008. A very, very strong pipeline, a big focus for us in 08. A lot of our innovation as you know within color as we relaunched the line in 2007. China is doing very well, as far as I’m concerned. Strong growth and a very big priority market now that we can really have a meaningful base and look at active reps up 73%. I mean that’s a great number of revenues, basically 30% growth. BBs are stable in this market, the focus on activity and productivity is playing out. I’m very pleased with that and we continue to have this managed strong pipeline of 40,000 or so a month. Those are the numbers that are meaningful to us.

Justin Hott – Bear Stearns

So on skin care Andrea, would it be just a case that the focus this year has been on color? The focus next year could be more on that category and you expect improvements?

Andrea Jung

Yes. Skin care is going to be a big priority category for us obviously from an innovation point of view but also it’s good for margins as well.

Justin Hott – Bear Stearns

In China forgetting the accounting of what an active rep or an inactive rep is, you’re gaining people at the rate of 40,000 a month right now?

Andrea Jung

In terms of kind of a recruiting strength if you would, I think we’ve got a very good continued pipeline, consistent pipeline. It’s not spotty or lumpy but I think we have a consistent approximately 40,000 people who are joining us as SPs monthly.

Justin Hott – Bear Stearns

And, rep retention and I guess the work of your kiosk owners, can you update us there? The number of kiosks?

Andrea Jung

Stable and their business is very healthy. If you go back two years and talk about really driving something that had never been done, it’s never been done at Avon and I don’t think it’s been done anywhere, stabilizing this sort of hybrid franchise retail business as well as a direct selling business and all that came with it. We worked extremely hard to develop a good hybrid model where both sides of the equation are winning and that’s exactly what I’m seeing today.

Justin Hott – Bear Stearns

And rep retention?

Andrea Jung

In terms of rep retention, our focus is on productivity and we have been actively removing the lowest producing SPs to clean up the base.

Operator

Your next question comes from the line of Laura Liberman with Lehman Brothers.

Laura Liberman – Lehman Brothers

Just on elixir I wanted to see – you did site it as being something that was good but, at that higher price point do you think maybe results of the elixir were a little bit below where they could have been in a different macro environment this quarter? And, if in fact that is the case, would that impact your pricing or your launch decisions for other skin care innovation in the first half of 08, maybe pushing stuff a little later out?

Andrea Jung

No. Actually Laura, I think that the fourth quarter, even in the environment, US elixir did very well in terms of over performance at what we thought a over $50 price point. Then, you go to the emerging markets obviously where the momentum continues to be robust and we’re not seeing any macro pressures and to get $60 and $80 price points in some of these markets I think speaks to the fact that we can improve our mix, our margins, the image of the company, that we can sell more premium priced products. The full line up isn’t going to $50 to $80 but I think with the right product breakthrough, innovation, packaging and formula I think it does have a halo more importantly over the rest of the brand. If I just go to Christian Lacroix for a minute, I know it’s a different category but I have to say again, this was another paradigms breaking price point in this category and the results were very similar. We hit sort of highest priced fragrance and skin care. I wouldn’t change the pricing strategy at all. The analytics are telling us, and we’ve done a lot of pricing analytics in key markets to date that particularly in skin care and fragrance we can and should take price. So, we’re getting the information that allows us to make these moves and they’re working.

Laura Liberman – Lehman Brothers

Then just one other follow up on North America, obviously the non-beauty categories were weak this quarter and I guess, for me anyways, in hindsight its like okay that really sticks with the macro environment. But, with PLS and I understand there will be more discussion at CAGNY, will the book have more of an emphasis on beauty and a little bit less of that, in my view, somewhat more discretionary stuff because I don’t really think cosmetics is discretionary? Or, is it really just across the board that it will have an impact pretty consistently across the categories?

Andrea Jung

On PLS?

Laura Liberman – Lehman Brothers

Yeah.

Andrea Jung

Well, I think certainly and this will include North America, there is a focus on continuing to reduce and optimize beauty SKUs so there will be a reduction. But, there is enough small reduction in SKUs in non-beauty and this was sort of independent of the macro environment, that is what the optimization product portfolio work that we’ve done for the last 18 months has told us so you will be seeing reduction in SKUs in non-beauty in the US brochures. And again, US is sort of isolated in the percent of the business and the amount of this business in the world.

Laura Liberman – Lehman Brothers

Is more so a reduction in non-beauty than in beauty?

Andrea Jung

I think it’s slightly more in non-beauty than beauty. We can’t forget that it does give us good representative earnings and there is a halo effect in terms of strong representative participation in non-beauty [inaudible] our beauty sales so we have to be careful there. But, I think that is what this optimization and this work did, was to make sure we don’t make stupid mistakes. So, this was carefully done even pre-macro pressure.

Renee Johansen

I just want to remind everybody to try and limit yourself to one question so that we can get to all of our callers today. Thanks.

Operator

Your next question comes from the line of Bill Schmitz with Deutsche Bank Securities.

William Schmitz – Deutsche Bank Securities

Chuck, can you help us with kind of how the operating margin is going to progress next year? Because, it’s like 500 basis points of margin expansion, where is it coming from?

Charles W. Cramb

Sure. Number one, in terms of its structure I think you have to think in terms of, and let’s kind of just walk our way down the P&L, gross margin will be up sharply. There will be no more PLS charges hitting the gross margin line. I think you’ll also see some benefits in there from product mix and a little bit on the pricing front. I think you should then move down and think about some of our investment spending, advertising we said would grow more or less in line with sales as with RVP. It think you should expect to see continued significant leverage on our cost structure as sales grow and the overheads don’t fall except those overheads that are variable, things like distribution, shipping, commissions, etcetera. If you pull that all together I think you’ll find that we have something that should come close to the objectives that we set out for ourselves. In terms of the pace and when we start to see it, don’t expect it to happen in the first quarter. It will gradually improve over time as we run through the year. A part of that is a timing of the benefit streams that we’re getting out of other elements that impact margin such as the return on restructuring and very importantly the returns on our SSI initiatives; which, by the way, is up in the gross margin. The improvements grow quarter-by-quarter through the year. The other thing obviously is our scale of business, we are a seasonal business to some degree so our fourth quarter is always a bigger quarter and therefore we have greater leverage on those expenses.

William Schmitz – Deutsche Bank Securities

A follow up along those lines too, sorry Renee. Cap ex spiked in the quarter, what is that related too?

Charles W. Cramb

It’s relating to purchase of land and starting construction of buildings primarily the Zanesville warehouse distribution facility. There’s also some IT expenditure in there but the big numbers are the infrastructure numbers on supply chain.

William Schmitz – Deutsche Bank Securities

What kind of GDP growth are you assuming next year for the sort of model to get to mid single growth I think [inaudible] on the US.

Charles W. Cramb

Overall, and remember I don’t give guidance so I don’t want to give too much guidance here.

William Schmitz – Deutsche Bank Securities

[Inaudible] economist.

Charles W. Cramb

Being an economist I would suggest that our model shows most of our growth coming from our emerging and developing markets and I don’t see that changing any next year.

Operator

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

Wendy Nicholson – Citigroup

My question relates to the US business and if we can learn a little bit more about kind of what went on there in the fourth quarter. Frankly, the number wasn’t as bad as I hard worried it might be between the weaker consumer and also the out of stocks you experienced. If you could kind of quantify how much out of stocks might have impacted the business. And also, Andrea your comments about the US performance maybe being moderate in 2008, given the consumer issues are there plans to step up the investment level in the US in particular maybe with the RVP initiatives more than you would have otherwise thought simply because of where we are in the economic cycle? And then my last question particularly as it relates to the US, I know a couple of years ago you gave us a statistic that talked about how much discounting you had had to do back then in the US business to sort of flush out inventory. Is there an apples-to-apples statistic in terms of how much discounting is going on in the US business now?

Andrea Jung

Well, without giving guidance here I’m going to kind of repeat some of the things I said and give you a little bit more color. Yes, like you said I think we started to see some weakening consumer trends in several non-beauty categories. It was particularly apparent in accessories and, I think a few of you have said completely mirrored the general retail trends out there in December retail data. That consumer pressure, if you would, we see that continuing into these categories. But, I think the good things in our strategy is we really remain focused on RVP which again, independent of this macro pressure we have felt very good about the focus on the things that we were putting in to offset what has always been an activity pressure from gas, etcetera. This isn’t kind of new necessarily to 2008 we have seen a negative drag from fuel for many, many quarters now and the move that we’re making and taking from sales leadership reindexing, the fee reductions, the focus on the move to the Internet, the rep advertising which is certainly driving good additions and very good opportunity for people to join when the economy gets tough, targeted free brochures and improved incentives. Those are the things that we already had in the plan and will continue to look, I think you asked the question to Chuck, are we going to do more of it if the opportunity arises and the paybacks look good? Certainly, we’re going to be able to do that but that’s all within the company’s margin commitment that we talked about so I’m not worried about that because we always have planned for something isn’t going to go exactly as you planned from a macro point of view so those are the kinds of things we can cover when we start a year.

But, I am encouraged just on your last point actually, by some pricing actions that we have taken in beauty in the US whether it be in Lacroix or elixir but the pricing analytics that we have put into place and the US is one of the first markets that are really playing out in the early part of the year say that in spite of the macro environment we can get selective pricing in beauty and that I think is a healthy indicator as it relates to the ability still to improve gross margins despite the macro trends. That’s how I feel about sort of if you call it discounting pricing. I think there are some opportunities here selectively in spite of what is going to be a macro pressure. I don’t think we’re going to be able to take pricing obviously in some of the non-beauty categories, I think we’re just going to have to weather the cycle but, that’s a cycle that’s isolated to North America.

Wendy Nicholson – Citigroup

Just last question on the US business, can you talk directionally sort of October, November, December did you see a real acceleration of the US revenues if you can as the quarter progressed?

Andrea Jung

In the non-beauty categories of apparel and accessories, yes. December was the weakest month of the three.

Operator

Your next question comes from the line of Chris Ferrara with Merrill Lynch.

Christopher Ferrara – Merrill Lynch

Just to be clear, the approaching 14.1% operating margin target for 2008, is that a full year average target? Or, is that just where you plan to be by the end of Q4?

Charles W. Cramb

That is a full year target. So, that will be the total year’s profits divided by sales.

Christopher Ferrara – Merrill Lynch

Okay, I just wanted to make sure. A question on the charges, Chuck on January 8^th you guys said there’s going to be about $230 million in charges in Q4, I think the number came in about $205. Why the difference when the quarter presumably had already closed when you guys issued that outlook?

Charles W. Cramb

I think a big piece of it was due to some final determinations on what exactly we could accrue – accruals in the international environment. You remember the European program we announced was very significant and really coming to grips with where we were, what the US accounting rules were and how we could approach it were the biggest single difference. Then, there were some minor true ups on some of the other costs. If you were talking about PLS, that is a little different as well and that just has to do with truing it up based on what the actual inventories were at the end of the year.

Christopher Ferrara – Merrill Lynch

Just finally, I know you have spent a lot of time talking about what you guys are doing to improve working capital and in particular inventory but I guess can you just talk specifically, just to understand what was going on specifically this quarter? Why were inventories up 27% when you add back the charges? Then, why were accounts receivable, I know not up much more than sales but still up in excess of sales, why was that the case this quarter?

Charles W. Cramb

I’ve got receivables going up exactly with sales, maybe a little bit of that is the timing and the flow in the quarter but I have it in line. So, let me just address it on the inventory and there I think the way I’d like to approach it is more macro than not. Some of that, by the way, dollar increase is due to currency, some of that, if you want to add back the charge or the obsolescence, yeah we’ve been drifting up through the year. Have I been happy with that progress? No. I never thought it would be a quick fix but I did think we’d get some fast attraction but I also, and I think this is what you’re getting out of it, I also have to acknowledge that we did make a conscientious decision this year to really protect those RVP investments we were making and to improve our service levels because those investments would not pay back if we couldn’t deliver and improve our order fill rates, and this is in Europe. We actually did that, we improved our overall order fill rate by as much as 10 full percentage points. So, some of it we created ourselves, I think we didn’t do as good a job as we could have and we probably put a little too much inventory into it. So, that’s kind of what happened in 2007.

As I look forward I think we’re doing the right things. I’ve talked to you about the structural changes, they all work together. I jokingly sometimes call it my alphabet soup. But, I think the most recent thing and I mentioned it in the pre-read here was we’re really bringing it all together through life cycle management and the PLS initiative is a big piece of this but we’re putting in place through that process the real controls on how and when and what to introduce in terms of new products and at the same time how and when and what to exit to make room for those new products. It’s a real controlled system over our SKU count. Organizationally we’re also clearly putting that responsibility on our new president Liz Smith. Finally, we recognize the need to really have unwavering discipline really throughout the organization and therefore reinforcing what we’re doing in our compensation scheme both in terms of our annual bonus program and also our long term incentives. And sure, not much progress this year, I think we’ve got the foundation laid, I think we’ve got great initiatives underway at various stages of development that will drive us to our commitment, our expectation which is a three to five day reduction for each of the next four to five years.

Renee Johansen

I just want to remind our callers one more time we have six more questions in the queue and if we want to get through these please try to limit yourself to one question. Thanks.

Operator

Your next question comes from the line of Nik Modi with UBS

Nik Modi – UBS

Just a quick question on the commission changes in Poland and Hungary. If you could provide any early learnings from that and is that going to get rolled out in other markets in 2008?

Andrea Jung

I feel very good about Poland. We don’t usually talk about Poland specifically but we’re really seeing some step change results from the actions we’re taking and its combined now with the three week campaigns so it’s not really isolated to one thing but we did put a test in CEE to Poland and Hungary, Poland being the larger of the two markets. Revenues were up close to 30% in these markets in the quarter, Reps up 16%. It’s sort of a small cost big motivator thought which is really about upping or moving up threshold commission rates, a very big attraction to our top sellers and also as you can imagine really helps the recruiting message in terms of giving headline rates. A lot of learning but, a good quarter for our first start and we’re going to take a lot of our learnings from Poland and Hungary and look at it across what it could mean for the balance of the region. But, I think it was a power by new commission combined with the three week campaign and that’s a result in Poland that I’m very happy about.

Operator

Your next question comes from the line of Alice Longley with Buckingham Research.

Alice Longley – Buckingham Research

My question is about inventory as well, if you add back all the PLS charges for the year actually your inventories would have been up more like 35% at the end of the year without the PLS charges and it sounds as if part of the RVP strategy is to produce massive amounts of stuff, throw it at the reps and see what sticks. Basically, I’m looking for reassurance that you won’t end up doing something similar in 08 which would end up hurting margins with higher inventory obsolescence.

Charles W. Cramb

If we do that we don’t believe in our PLS initiative which is really all about having the right assortment to go to market with. Sure, we’ve made some mistakes not just in 2007, in 2006 and prior and we’re living through those mistakes. I think we’ve cleaned it up in terms of having finally decided what the right assortment is on a going forward basis and also made some tough decisions in terms of the exit strategies for the products and inventory and that is why we had such a large write off. The product line simplification initiative, sure it is all about assortment but, in terms of the processes and the systems it’s also all about how do you introduce new products? We use the term gating, what’s the gating process for new products to enter the system? It has to have certain penetration thresholds, you have to understand the attributes of that new product and what is a product that we have to move out of the system. I think historically we did a pretty good job, as you mentioned, lots of new products in. We didn’t pay a whole lot of attention to moving products off of the SKU count. So, I’m looking at this and saying, “Hey PLS will enable us to avoid the kind of problems that you’ve described.”

Alice Longley – Buckingham Research

My only other question is on your sales guidance for next year you said something about mid single digit growth which is clearly a lot slower than what you’re seeing now. Is this you telling us you expect some deceleration or are you being conservative?

Charles W. Cramb

We don’t give guidance as you know and the only thing we do give is long term guidance and that’s where that guidance comes from. We’ve always said that for the business over the long term mid single digits. In any given year it could be a bit above that or a bit below it but, that’s our guidance.

Operator

Your next question comes from the line of Connie Maneaty with BMO Capital Markets.

Connie Maneaty – BMO Capital Markets

Could you just help us explain on the PLS charge that you took in the fourth quarter I assume that is some portion of the products to be that you’re doing away with were either donated, destroyed or discontinued. What portion went to those three buckets and how will what remains to be discounted affect the 2008 gross margin especially early in the year?

Charles W. Cramb

I can’t break that out into those buckets, I don’t have that kind of granular detail but you defined the appropriate buckets. In terms of impact on margin, as we looked forward what we had is we developed sales plans where it made sense to continue selling some of those products for a period of time. Obviously, there’s no provision on that. In terms of our overall margin guidance that we have given for next year, it does incorporate any impact for selling off products that over the long term won’t be part of the catalogs.

Connie Maneaty – BMO Capital Markets

Do you know if most of the PLS charge in the fourth quarter, if you don’t have the exact percentages, were most products destroyed or donated? Or, are most products to be discounted?

Charles W. Cramb

It’s very, very heavily on destruction or charity gift.

Connie Maneaty – BMO Capital Markets

Okay. So minor impact from the fourth quarter charge going forward?

Charles W. Cramb

Right. Oh yeah.

Operator

Your next question comes from the line of Filippe Goossens with Credit Suisse.

Filippe Gooossens – Credit Suisse

Chuck, before I ask my question for you just a clarification on something I’m confused about. At some point in time during the call you said that RVP spending would equal sales growth which is in line with what you said on the third quarter earnings call but then at some other stage you said it may actually be a little bit above sales growth. Can you just clarify so I make sure I understand that correctly.

Charles W. Cramb

I think we’ve said in terms of our overall plan advertising more or less in line with sales and RVP, no more step ups like we had in 2006, 2007, in line with or slightly ahead of sales growth but not a significant amount of differential.

Filippe Gooossens – Credit Suisse

Then my real question, Chuck as you get more comfortable with your future cash flow it’s what earnings, or working capital improvements, can you just kind of refresh our minds in terms of how you feel about the tradeoff between dividend increases versus share buybacks?

Charles W. Cramb

Sure. I think strategically I still believe in operating sort of peer group payout ratios therefore, I wouldn’t expect to see dramatic increases in dividends other than what grows from the normal income and if we have excess cash I prefer to use that in terms of share repurchase at this point in time.

Operator

Your next question comes from the line of Jason Gere with Wachovia Capital Markets, LLC.

Jason Gere – Wachovia Capital Markets, LLC

Just a question on the early success of the Christian Lacroix and the fragrances you were talking about targeted alliances. I guess trying to think down the road, how with your mid single kind of sales growth, what percentage do you see this as tying into that type of growth going forward in terms of future targeted alliances?

Andrea Jung

Well, I can’t give you that exact number but just to give you an idea we had 23% fragrance quarter and about half that growth came from Lacroix’s success. So, that I think speaks to the significance of it. We do have a lot of confidence built from this year, 2008, we have several designer celebrity endorsements planned for the back half in fragrance. Again, we feel very good about that strategy.

Operator

Your next question comes from the line of [Allie Debaje] with [Berstein].

[Allie Debaje – Berstein]

Just a few things, one is it looks like you made some progress on North America. I’m wondering if you’re whether yet earning your cost of capital in North America or not and if not, when would you?

Charles W. Cramb

I can’t answer that question specifically. That’s way too much detail for a call like this. Also, in terms of our cost of capital there’s all sorts of allocations that go into that because we don’t run North America as a totally independent operation. There’s an awful lot of allocations and sharing so we look at it more the cost of capital for the total business as opposed to any one geography. What we do look at however in the analytics is whether or not we get good returns for our variable investment and I feel we do. I feel we can improve those North American margins as much as the rest of the company in terms of a thrust. So, I think that’s the best way I can answer it for you [Allie].

[Allie Debaje – Berstein]

Could you narrow North America, with the 1% local currency growth can you give us a sense of how much of that was from elixir and the great success you had there?

Andrea Jung

Well, I think it’s not going to be a material amount because it’s one SKU and I think that we did well with Ultimate and elixir in total but the actual elixir product, I wouldn’t want to attribute part of the sales growth in North America to that. I think that the total beauty growth which was up 6% was really a highlight in the quarter in North America.

[Allie Debaje – Berstein]

Switching gears a little bit to overseas and to China in particular, just doing some quick math on the 40,000 incremental reps you’ve got every month that would suggest, I think over call it a six to nine month timeframe you lose roughly 60% of the reps who signed up? So, the turn is roughly 60% in six to nine months. Particularly, you described this job in China being a full-time job is that kind of what you’d expect or not?

Andrea Jung

Yeah, I think that we’re focusing obviously on productivity and retention but just those numbers in their sheer size along, I think 40,000 and the consistently of it speaks to the fact – if I go all the way back to the only national license of our scale that we’ve got is that competitive advantage and a lot of the advertising that we have done as it relates to what a great earnings opportunity this is in this country. I think it just speaks to the consistency of the attractiveness of Avon. Not everybody is going to be able to understand and be trained properly in terms of really making it a viable long term full-time job. So, when you look at that just in terms of the absolute numbers they’re just large numbers but I’m pleased with the numbers because it means we’re doing a good job creating an Avon opportunity and now the work once they come in is making sure that we keep those that are productive so that number doesn’t surprise me. What’s pleasantly surprising me is the 40,000 consistent a month versus what I might have thought before we got the license.

[Allie Debaje – Berstein]

Just a last quick kind of housekeeping question, on SSI in particular, I think we were expecting $15 million this quarter. Did that come through because it sounds like things are on track.

Charles W. Cramb

They are on track, it did come through.

Andrea Jung

We have time for one more question then Renee and IR can take the rest.

Operator

Your next question comes from the line of Alec Patterson with RCM.

Alec Patterson – RCM

Just one question, you’ve got quite a foreign exchange tailwind and I guess I wanted to get a read on your mid single digit outlook for the year on sales in the context of that very strong tailwind.

Charles W. Cramb

Assume that if that tailwind continues that will be a plus to our guidance.

Alec Patterson – RCM

That is if the current rates hold that tailwind.

Charles W. Cramb

We don’t look for a significant variation on the rates when we give the guidance so, if we have strengthen, or let’s put it the other way a weakening of the dollar, that should help us in our performance just like it did this year.

Andrea Jung

Thank you everybody. We appreciate everybody’s time. Have a great day. Bye.

Operator

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

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