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Avon Products Inc. (NYSE:AVP)

Q1 2006 Earnings Conference Call

April 28 2006, 9:00 AM EST

Executives

Renee Johansen - VP, IR

Andrea Jung - Chairman, CEO

Charles Cramb - EVP, Finance

Analysts

Bill Pecoriello - Morgan Stanley

Justin Hott - Bear, Stearns

Wendy Nicholson - Citigroup

Bill Schmitz - Deutsche Bank

Amy Chasen - Goldman Sachs

Chris Ferrara - Merrill Lynch

Connie Maneaty - Prudential

Lauren Lieberman - Lehman Brothers

Alice Longley - Buckingham

Sandhya Beebee - HSBC

Presentation

Operator

Good morning, ladies and gentlemen. Welcome to the Avon first quarter earnings release conference call. At this time all participants have been placed on a listen only mode, and we will open the floor for your questions and comments following the presentation. It is now my pleasure to turn the floor over to your host, Andrea Jung, Chairman and Chief Executive Officer. Ma'am, the floor is yours.

Andrea Jung

Thank you. Good morning, everybody, thank you for joining us this morning to discuss Avon's first quarter results. Since some of our remarks today may include forward-looking statements, I refer you to the cautionary statement in this morning's press release. With me on this call are Chuck Cramb, our Executive Vice President of Finance and Technology, and Renee Johansen, our Vice President, Investor Relations. Renee will take you through the quarterly results in detail, but I wanted to open with a few brief personal thoughts on the quarter.

Certainly we're pleased that as the year began we came out of the gate with a great sense of energy and urgency. It's still very early days, but as I reflect upon the quarter two things stand out in my mind, which are indicative of some of the positive progress we're making with the implementation of the turnaround plan.

First is the aggressiveness and speed with which we are implementing our cost out program, as evidenced by the magnitude of initiatives that contributed to the $120 million in restructuring costs that we incurred in the quarter.

Second are some early proof points that confirm our belief that the combined power of improved product innovation and increased advertising are the formula for sustainable growth in this business.

Specifically in terms of restructuring, the lion's share of the cost incurred to-date reflect the accelerated implementation of our plan to streamline the organization and reduce the number of management layers, in order to get closer to our markets and our business, and speed information flow and decision-making. Implementing this de-layering initiative has been a major undertaking for the enterprise. I am very pleased that everyone in the organization has understood the urgent need to support this effort.

As a result, we've been able to proceed somewhat faster than planned, and with our most recent 8-K filing highlighting job eliminations for an additional 1,300 associates, this brings our total number of job reductions to over 3,300, since we announced the program late in the fourth quarter. Almost 40% of these reductions come from the management ranks, where we have the higher associated benefits.

Because of the speed with which we've been moving, we anticipate the full de-layering effort will be completed by the end of the second quarter, by which time we will have cut the number of organizational layers from 15 to eight, virtually in half. Additionally we are now on-track to deliver in excess of $150 million in annualized savings from this one single initiative alone. So, I think this is an area of measurable progress in early days. De-layering is already helping us work faster and more effectively as an organization, and importantly, it's providing a significant source of funds that will be aggressively reinvested into the business.

As we said before, our intent is to reinvest in our brand and our commercial turnaround strategies, with initial investments against significantly elevated advertising to support major product innovation.

In this regard, we've already begun to walk the talk in the skin care category, with a major acceleration in the category's first quarter product innovation line up versus a year ago. Additionally a large portion of the first quarter's 57% increase in advertising dollars was targeted to support this enhanced skin care innovation.

We saw this strategy play out very favorably, particularly in the United States and Brazil. In the U.S., a new clinical eye lift sold more than 1 million units on launch in the first quarter, and coupled with continuing successful brand building for a new alternative, helped increase skin care sales 10% in the U.S. in the quarter. This was a dramatic reversal following our four consecutive quarters of double-digit sales declines in that category.

Anew was supported in the U.S. by a comprehensive marketing push including sampling, gift with purchase, extensive public relations, and most critically, sustained print and television advertising throughout the entire quarter.

We saw a similar marketing formula deliver major payback in Brazil with the launch of Anew Alternative in that market. Alternative was launched late in the first quarter, and in just one month we sold over 1 million units there as well, at a $27 price point, helping drive a first quarter skin care in crease in Brazil of nearly 90% in dollars, and more than 50% in local currency. So again, early days, but early signs that we are on the right track. Going forward we will continue to focus aggressively on skin care, as well as all other product categories as I talked to you about in December, to ensure that our innovation calendar is consistently strong, and importantly backed by the appropriate marketing mix and investment level.

As we discussed last November when we shared our four point turnaround plan, we are also aggressively investing against enhanced marketing analytics to determine optimal mix and resourcing levels. This will ensure that as the amount of available funds for reinvestment increases through restructuring, we direct these dollars back for maximum pay back.

Before turning over to Renee, I just want to talk for a few minutes about Central and Eastern Europe and China, two priority geographies for the Company. In Central and Eastern Europe, top line growth continues to be less robust than we would like. We're committed to sustaining market leadership in this region, and we're moving rapidly to strengthen both our brand and channel competitiveness.

On the brand side, a number of major skin care launches are planned for the second quarter, including Ageless Results, our new mid-tier anti-aging line, as well as Anew Clinical Eye Lift, following it's very successful U.S. first quarter introduction. We're looking for a significant step up in advertising, plan to support both launches beginning in Q2 in this region, with accelerated advertising levels continuing as we move through the balance of the year.

On the channel side, we are in progress with a detailed analysis of competitive commission structures, and other drivers of representative satisfaction. We talked to you about this as an enterprise initiative, when we talked about the overall Company's turnaround plan, but we've targeted Central and Eastern Europe for the first phase of this effort, as we evaluate the optimal strategy for incremental investments to drive field competitiveness. So restoring above market growth in Central and Eastern Europe remains a top priority, and will be a major area of accelerated investment going forward this year.

Turning to China, as you know we were officially granted our direct selling license on March 2nd, given the extensive pre-communication, our Beauty Boutique owners were well-prepared for the announcement, and were pleased there was no incremental disruption in our business. Very importantly, our Beauty Boutique owners now better understand their role within our new direct selling structure.

They can continue to sell to customers at retail, and to provide salon and beauty consultation services as they currently do. However importantly, they will now have an additional way to earn fees by acting as service centers, that provide a variety of after-sales services, such as order pick-up, product returns, credits and billing assistance to our new direct selling sales representatives, who are called Sales Promoters, or SPs.

To cement this mutually beneficial relationship between our Beauty Boutique owners and sales promoters, we've combined our China field management structure into one model, which integrates both channels of distribution. In addition now that our license has been granted, we've begun to significantly step our investment up, to aggressively support the national rollout of direct selling opportunity here, and capitalize on this unique window of opportunity.

This month we launched a comprehensive consumer education campaign in ten major cities, including newspaper and television advertising, a consumer hotline and road shows across the country, to learn how to start a government-approved direct selling business. This is a similar technique to how we launched our business in Central and Eastern Europe more than a decade ago. In addition, We're also investing in field incentives to spur recruiting, and quickly build our total number of sales promoters in this country.

So overall, I would just say we're moving very rapidly in China to take advantage of our unique window of opportunity. Indications are that the performance of our Beauty Boutiques appear to have stabilized as they adjust to the new business model.

In terms of our first quarter performance in China, you'll remember that the first quarter of 2005 was the only quarter last year that was not impacted by the April announcement of the direct selling test; so once again we lap a difficult comparison.

So those are a few very brief comments on the quarter from myself. We've got a lot of work ahead of us, but we are encouraged by our progress in these early days. We continue to move very rapidly against every aspect of the four point turnaround plan, and we'll certainly have a lot more to say about that over the course of the year in other areas of focus, particularly as relates to our commitment to win with Commercial Edge, where there's a lot of great work under way.

So for now I'll close my remarks, and turn it over to Renee, saying that we remain firmly committed to restoring Avon to sustainable growth as we go forward. That's our destination. We've got one quarter behind us, but I think we're taking good first steps on the journey.

Renee Johansen

Thanks good morning, everyone. As you read, Avon reported first quarter 2006 earnings of $0.12 per share, compared with 2005 first quarter earnings of $0.36 per share. Let me first talk to revenue and it's drivers, and then we'll move on to operating results.

As on a consolidated basis, first quarter revenue was $2 billion, up 6% in both dollars and local currency. Active representatives grew 4%, and units increased 3% versus the prior year.

Looking at net sales from a category perspective, Beauty sales, which include color cosmetics, skin care, fragrance and personal care, rose 6% year-over-year in both dollars and local currency to drive the majority of the sales increase. All Beauty product categories increased in the quarter, with the strongest growth in fragrance and skin care.

From a geographic perspective, Latin America, given the addition of Columbia, but also due to the continued strong performance in Brazil, was the key driver of the consolidated Beauty performance. U.S. also contributed nicely to growth in the skin care category.

Overall, Beauty sales continued to contribute about 70% of our total sales. Beauty Plus sales rose 16%, with North America being the key contributor. Beyond Beauty declined 4% driven by continued de-emphasis of this category in several markets.

Operating profit in the quarter was $86 million down $174 million, primarily due to significant costs associated with our turnaround plan. Costs to implement restructuring totaled $120 million, and included costs associated with continued organizational downsizing in all regions, and at the corporate level. Outsourcing of certain U.S. customer service transactions, realignment of certain manufacturing processes, and the exit of certain unprofitable operations.

Additionally, as we spoke about on our last conference call and at CAGNY, we invested substantially against our initiative to improve brand competitiveness, advertising, which we defined as the production and placement of advertising, increased 57% in the quarter to $40 million, with virtually all major markets seeing large increases.

As we began to move aggressively on size of line, we recorded an increase of $27 million of obsolescence expense. This primarily related to discontinued products that historically were sold at marginal value, cannibalizing sales of more profitable products. This was an early action that's part of a larger attack on inventory and size of line. It will entail work on forecasting, production planning, and other elements of ERP.

Outside of our turnaround plan, operating profit was also impacted by $12 million in option expense, with this quarter being our first in expensing options. The quarter's operating margin was 4.3% versus 13.9% in the prior year.

Now moving below the line, net interest expense rose significantly to $13 million from $2 million, due to a higher debt level associated with our share repurchase program in late 2005, as well as higher interest rates.

The quarter's effective tax rate of 20.3% compared with 2005's rate of 31.5%. The lower 2006 rate resulted primarily from tax audit settlements, which more than offset the unfavorable tax consequences of our restructuring activities. By unfavorable tax consequences, we mean that we're losing tax benefits due to the geographic mix of restructuring costs.

Net income in first quarter 2006 was $56 million, and this compared with $172 million a year ago. Average diluted shares outstanding during the first quarter were down year-over-year to $453 million, from $477 million last year on a diluted basis, reflecting our aggressive repurchase late last year. We also purchased about $43 million of stock during the first quarter this year, and at March 31, we had 450 million shares outstanding.

Before moving to the regional review, I'd like to remind you that we adopted a new operating structure January 1st, that established Central and Eastern Europe and also China as standalone operating units. Also as of the beginning of this year, we began allocating certain global expenses to our segments. The results today are reported on that basis and reclassified 2005 quarterly and full year segment information was filed on a Form 8-K on April 12th.

Now let me move on to the regional reviews starting with North America. North America's revenue was $614 million up 3% in both dollars and local currency, with all markets contributing solid increases. The region's units declined 3%, and active representatives were 5% lower. These unfavorable changes were more than offset by a larger average order, that was driven by strong product launches in the Anew skin care line, Anew Clinical Eye Lift and Anew Alternative SPF 25, and also by robust performance in the Beauty Plus category, on sales of accessories and the year-over-year addition of the foundations offering.

As a reminder, Beauty Plus consists of jewelry, watches, accessories, apparel and foundation. If we look at Total Wellness operating across all product categories, it again had a strong performance, helped by our Avon Wellness brand, and our continuing relationship with Curves.

Operating expenses included $26 million of restructuring expense, and $4 million of increased obsolescence expense. There was also a substantial year-over-year increase in advertising to restore U.S. advertising to historical high levels, largely behind the skin care launches. Including these costs, North America's operating profit decreased 41% to $38 million, and the operating margin was 6.2%. North America's cost to implement restructuring in the quarter included further de-layering of the organization, phased outsourcing of certain representatives and customer service transactional functions, and severance related to closing of the Avon Salon and Spa in New York.

Now to Latin America. First quarter revenue grew 28% to $613 million, or 20% in local currency. As the region benefited from the late 2005 acquisition of our licensee in Columbia, which added 10 points of revenue growth. As we've already mentioned, Brazil turned in yet another strong performance this quarter. Even without Columbia's revenue, the regions revenue would have increased nearly 20%.

Looking at category growth in Latin America, Beauty was a standout driven by strong performances in fragrance in skin care. Total sales of beauty products outpaced overall sales in the region by 4 points. Latin America's representatives grew 12% and units increased 10%, with the Columbia acquisition contributing to the majority of growth in both these measures.

Latin America's operating profit decreased 16% to $69 million, and included costs to implement the organization's de-layering initiative of about $15 million, and higher obsolescence expense of $6 million, as well as a doubling of advertising, primarily in Brazil. The regions operating margin was 11.3%.

First quarter revenue of $233 million in Western Europe, Middle East and Africa, was flat with the prior year, but rose 7% in local currency. Active representatives grew 2%, and units increased 6% versus a year ago period. Turkey was the primary driver of the performance across these measures. Western Europe also had a strong performance in Beauty versus overall growth, driven by the Beauty emphasis of Turkey, with sales of these products outpacing overall sales by 4%.

As a result of a significant $31 million in costs to implement restructuring plans, primarily organization de-layering, this region had an operating loss of $34 million in the quarter. Profitability was also unfavorably impacted by higher product costs, both manufacturing and raw materials, and $4 million of higher inventory obsolescence expense. The operating margin was a negative 14.6%.

Turning to Central and Eastern Europe, the regions revenue rose 3%, 7% in local currency in the first quarter to $306 million. As Avon faced a higher level of competitive activity in the region, units increased 5% versus a year ago period. Active representatives grew 13% reflecting the introduction and rollout of Avon sales leadership throughout the region.

The region's first quarter operating profit was $62 million, which was 30% lower as the regions costs were negatively impacted by costs to implement restructuring plans of $5 million, higher product costs, and $3 million of increased inventory obsolescence expense. The operating margin was 20.2%.

Turning to Asia Pacific , revenue was $190 million, 11% lower in the quarter, or 8% lower in local currency. Units declined 10% as the regions performance continued to be impacted by a sizeable revenue decline in Japan. Active Representatives in the Asia Pacific region decreased 15% in the quarter. This regions results were also somewhat impacted by the closure of our business in Indonesia during the quarter.

We've spoken in the past of Japan's transition to a more traditional dealer-centric direct selling model, from a direct mail customer-centered model. New country and regional management are addressing the need to strengthen field sales fundamentals, the marketing proposition, and the representative earnings opportunity as we execute this strategic move. As a result, that transition continued to impact the country's and region's performance in the first quarter.

Costs of $13 million associated with the restructuring program, together with Japan's sizeable revenue decline, and $8 million of higher inventory obsolescence expense across the region, resulted in an operating loss of $2 million in the quarter, and the operating margin was negative 1.1%.

Now, to China. They had revenue of $47 million in the quarter, a decline of 27%, and 29% in local currency. Units also decreased 18% in the first quarter, as Avon's Beauty Boutique owners in that country continued to place smaller orders with the Company versus a year ago, in connection with the resumption of direct selling.

You may recall that China recorded 37% revenue growth in 2005 first quarter, prior to when Avon received word of our approval for the direct selling test. China's operating loss of $600,000 compares with year ago operating profit of $15 million. Results were unfavorably impacted by the region's revenue decline, higher advertising, as we continued our commitment to consumer investment in this important growth market, and $3 million of costs associated with the Company's restructuring program.

China's restructuring activities this last quarter included realigning the organization structure to support direct selling, as well as closing store counters that we had operated outside of the boutiques. China's operating margin was negative 1.2%.

In the quarter global expenses net of allocation to the operating segments rose 93%, largely due to $27 million of cost to implement our restructuring program.

I'd just like to call out a few points on our cash flow statement and balance sheet. Cash flow from operations was $101 million versus the use of $9 million in 2005 first quarter. 2006's quarter included a smaller pension contribution, $47 million versus last first quarter's $95 million, as well as lower bonus pay outs.

CapEx in the quarter totaled $25 million, lower than last year's quarter, due to completion of large construction projects in early 2005, in particular the R&D Center and the Russian manufacturing facility. During the quarter, we continued to repurchase shares under the existing five-year $1 billion repurchase authorization, with first quarter purchases totaling $43 million.

Inventories ended the quarter up $60 million from the December 31 level with inventory days increasing by seven days. Our global supply chain organization is addressing the inventory issue on several fronts, including the size of line reduction programs that I referenced earlier. The increases in accrued liabilities on the balance sheet is mostly due to the restructuring program, primarily representing severance yet to be paid.

As the March 31, 2006, our cash balances totaled $1.16 billion, up about $100 million from December 31,and debt outstanding totaled $1.8 billion, up about $135 million from December 31, for a net debt position that's $36 million higher than year-end. with that I'll turn it back to Andrea for the Q&A.

Andrea Jung

Thanks Renee, so that concludes the details of the first quarter, and we'll now open it up to Q&A for Renee, Chuck, and myself.

Question-and-Answer Session

Operator

(Operator Instructions) Please hold for just a moment while we poll for questions. Thank you. Our first question today is coming from Bill Pecoriello.

Andrea Jung

Hi, Bill.

Bill Pecoriello - Morgan Stanley

Question on the improved price mix that we saw in North American and Latin America. If you could break that into a split rate, reduced discounting versus product mix? Because certainly you had talked in the past about reducing that discounting, so how much did that contribute? and then as you rollout more of the mid-tier products such as skin care, how do you expect to impact that price mix going forward?

Andrea Jung

Well just in terms of the overall initiative of reducing discounting we talked about that as we came out of the year last year. It does take some time to effect that with brochure planning , et cetera. So we'll be making progress on that over time. I wouldn't say that was the significant change in Q1 is was mostly mix.

You've got major skin care launches at high net that did extraordinarily well in the United States, so you obviously had high impact there, but it was more mix than price, yet. That doesn't mean we're not going to get at the price discount opportunity, but I wouldn't say that was the driver in Q1.

Bill Pecoriello - Morgan Stanley

Then also on the margin change in the quarter, aside from the stuff that you talked about, the advertising spend and the charges, options; can you estimate how much did the ongoing business transformation savings contribute? What were the cost impact in the quarter? You had referred to high product costs, so how much are whether it be freight rates because of fuel or higher raw material costs impacting? So we could try to get a better feel for the underlying margin change?

Charles Cramb

Yes. There's a lot of pieces there that you brought up in that, Bill. I think if you back up a little bit, in terms of looking at that margin the biggest thing impacting us is the restructuring charge. In terms of the benefits from that program those benefits are really insignificant in the quarter, so think of it in terms of $120 million of charge is really the impact on the margin.

In terms of the running through the P&L, you have mentioned the advertising and you can see that in terms of the $15 million increment that we've put in there. The inventory write-off we've talked about so you can figure that one out, I think one of the other things you're suggesting is gee whiz, we're seeing oil prices escalate. What is the impact on the business year-on-year?

Like every other Company, we do experience the impact of oil. Interestingly the impact of oil is more on freight than it is on material and ingredients. I think from a perspective of looking forward, because it's really just recently that we've seen those oil rates escalate, to give you a little bit of a sense of how we're looking at the business, every roughly $10 per barrel of oil cost increase, hits our P&L by about $32 million of profit. So you can assume at about a 5% cost. Other than that, you've really hit on the major items impacting the margin.

Bill Pecoriello - Morgan Stanley

Also the ongoing savings program that you had. How much has that contributed since the restructuring isn't kicking in yet?

Charles Cramb

I haven't got that as a firm number, but I think if you look at the gross margin number -- you're talking about the transformation program that we've had, right?

Bill Pecoriello - Morgan Stanley

Yes.

Charles Cramb

If you look at the gross margin number, and you see that after you take out the impact of the inventory cost, that our gross margin is more or less even where it was a year ago, within 0.2 or 0.3 of a percentage point, so what you're seeing there is inflation is really being offset, well offset by the impact of that transformation program.

Bill Pecoriello - Morgan Stanley

Thank you.

Operator

Thank you. Our next question today is coming from Justin Hott.

Justin Hott - Bear Stearns

Maybe you could give us a little bit more color on Mexico and Brazil. Can you tell us how sales did in those two countries?

Andrea Jung

Yes in terms of Mexico, they continued to be somewhat soft in the first quarter. As you know I think we mentioned before we've got new management, both at the commercial business units level in Latin America, as well as at the general manager level, and we believe the issues that we're currently facing in Mexico, continue to be largely executional and we are aggressively addressing them. It's a high priority market so again stay tuned, but it was somewhat soft in the first quarter.

Brazil on the other hand continued to perform very, very well. Excellent growth in Beauty, skin care performed extremely well as a result of the strong Anew sales that I mentioned on the alternative products.

I think as Renee mentioned, we have more than doubled the advertising in the first quarter, and we've got growth in active representatives with larger average orders there, so I think you know, certainly we're seeing good category growth in the country, but we are participating in that growth very, very nicely.

Justin Hott - Bear Stearns

The U.K. as well?

Andrea Jung

In the U.K., we saw local currency Beauty sales up very nicely, led by strong performance in the color and skin care there as well, and I think very positively representatives increased, benefiting from the rollout of sales leadership.

As you know we rolled sales leadership outlast year in 2005, but as we get into the second year we're really seeing traction there with nice representative growth, so all of us at the corporate level setting sales leadership rollout, the U.K. is a very positive indicator that again internationally, this is the market that is sort of next after the U.S. In a national way we feel very good about it.

Justin Hott - Bear Stearns

On that, on the Central and Eastern Europe margins, on the decline, how much of that would be due to leadership, and how much of that was higher advertising spend? Ballpark.

Andrea Jung

I have to take out the cost to implementing. Again, there is not significant advertising increases in Q1 in CEE. There will be as we go through the balance of the year ,but because of the product line up, most of the strong product line up launch is backed by advertising start in Q2 in CEE, so in the 57% increase of advertising for the corporation, a lot of it was in North America and Latin America, particularly Brazil. So, CEE got less of it in the quarter there.

Justin Hott - Bear Stearns

Okay. Thank you very much.

Operator

Thank you. Our next question today is coming from Wendy Nicholson.

Wendy Nicholson - Citigroup

My first question has to do with the U.S. rep count growth. In terms of what initiatives you have in place to get that number back up and growing, can you give us a sense of what the timing is of those initiatives, and when we should start to see them take hold?

Andrea Jung

Okay. You know, in terms of the absolute numbers and kind of getting behind them, just I want to say, that I think we're doing the right thing fortifying this year, as we come out of the gate with the fundamentals of the basic selling proposition really focusing on servicing customers and selling to customers, and not chasing volume KPIs, the field incentives have been shifted to sales versus orders, and so I'm encouraged because average customers served actually is up for the first time.

You've got a fix there on the marketing proposition in the early days with strong skin care sales, so the opportunity for us when we get both the marketing and sales fundamentals back on track, is obviously the positive going forward in the U.S. Business.

We are rolling out new work approaches, with a program that will really allow our district managers to focus on growing the business through what we call the fundamentals, or PATD. So I think our district managers are really becoming more productive and working much more with their President Club and leadership up lines. I think leadership up lines are up versus year ago.

We've reversed that deficit we saw in the back half of 2005, so that bodes well for the future, so we are dealing still with some lower activity, as well as some removals of some inactive and unproductive representatives, but the fundamentals are in place that will hopefully continue.

Like I really don't want to talk about "a quarter when" I would just say when the event early days we've obviously got strong average order, which is giving momentum to the business, and now as we focus very, very significantly on fortifying field fundamentals, I think they're doing all the right things.

Wendy Nicholson - Citigroup

In terms of changing bonus thresholds or actual compensation structure, is that stuff still being complemented, or kind of where are we in that?

Andrea Jung

Well, we always continue to evaluate it, but we're obviously looking at a business that obviously wants to drive average order, not just the number of orders, but in terms of threshold et cetera, we continue to evaluate what is driving, it's just in the United States just as we're looking at all of the markets I've said we have a big target on CEE, as it relates to the representative proposition and the reward side of the equation. This is a big, big initiative in terms of analytics, that we have initiated once we turned this quarter, and are focused on the turnaround plan. The United States is a big part of that analysis.

Wendy Nicholson - Citigroup

Okay. And then my second question as it relates to Central and Eastern Europe. You talked about 13% rep count growth. That's actually a huge pick up from what you saw in the back half of last year, but you said that there was increased competitive activity. Obviously Oriflamme is doing great, is it just the fact that you've had a pipeline fill with leadership, or kind of what are you seeing exactly from a competitive standpoint, are they being more promotional and advertising more, or exactly how is that impacting your business?

Andrea Jung

Well I think to your point, the rep growth is healthy. We've got real solid staff growth there, and so the issue is obviously more in the average order, and obviously from the marketing point of view. From an Oriflamme point of view, I really can't speak that much, but certainly they have a new campaign system, a three-week campaign system, that is still not lapping comparative quarters, so that's probably driving a lot of the productivity there.

Having said that I think that we had a very strong skin care quarter and had more difficulties in some of the other categories. I think that again, it's addressing the pipeline particularly in color cosmetics. This was not a quarter where you saw the heavy up in advertising yet. As you saw in some other markets that does start in Q2. So we have a significant push against the pipeline, and making sure from a marketing point of view, to drive that average order back up that we've got strong products, and the kind of investments that we hopefully can see pay off as we are in some other markets in early days.

So we've got Ageless Results is launching in second quarter. Eye Lift is launching in the second quarter, both supported by strong advertising. Again, I think the Oriflamme situation is probably very promotionally driven by that campaign system, but we also didn't have as strong a pipeline backed by advertising in Q1. It's more of a Q2 and beyond situation.

Wendy Nicholson - Citigroup

Fair enough thanks very much.

Operator

Thank you. Our next question today is coming from Bill Schmitz.

Bill Schmitz - Deutsche Bank

Can we start with the de-layering program? I know you said it was done in June, but do you think that the organizational disruption from that is complete, or should we see like a knock out of the next few quarters?

Charles Cramb

I think whenever you go through as major a reorganization as this Company's de-layering, there will be continued tensions within the organization. I think it's tribute right now to the Company that we haven't had, or seen as much as perhaps we could have. We're talking about new roles, new responsibilities, new reporting relationships, so I think there will be continued minor impacts on the business. We haven't seen anything to date that's been dramatic in terms of our operating performance.

Operator

Our next question is coming from Amy Chasen.

Amy Chasen - Goldman Sachs

A couple questions on China. Number one, did you say that your are closing counters? I thought that having some counters in key department stores was part of your strategy. I was trying to understand that a little bit better, and secondly, how quickly do you expect that business to ramp in terms of the direct selling impact?

Andrea Jung

Okay just in terms of counters I think when prior to the approved direct selling regulation, the retail strategy was a combination of dealer-owned beauty boutiques, as well as department store counters. I think that it makes tremendous amount of sense as we're focusing on the business now, to focus on two aspects of the model.

One is the Beauty Boutique and the other is the direct selling business, and so just in terms of priority and focus, we did in fact make the decision to exit the counter business, and I think from everything from control of pricing, et cetera, I just think it simplifies and gives us greater focus on the right areas because they are driving the lion's share of the growth going forward.

Amy Chasen - Goldman Sachs

Does that sort of change the image of the brand? I remember that you had talked about that as an image enhancer, and something that would enable you to command a higher price point.

Andrea Jung

Well, I think that it certainly was a good strategy in it's time. I don't see it as an image detractor, by closing this. I think that we've sat well with other brands for a period of time since 1998, and I think that when you look at brand equity, and consumer perception of the Avon brand, it is quite strong.

I do think that everybody understands the focus now, and I think that in just terms of people focus and core competency that we want to put against it isn't against supporting retail counters department stores. We're really putting all our guns against supporting a direct selling infrastructure, so I'm not worried about image on that.

I think that with the significant brand investment that we're making on advertising in that market, which is one of the highest percent of sales, and will continue to grow that will support both the Beauty boutique, as well as the direct selling model, we'll be able to keep our image, consumer brand image up there.

In terms of time, I mean I really, all I would say is I feel very good that we are doing every single thing we can, to accelerate the recruiting and the infrastructure build supporting direct sales. I mean, again, just having received the license two months ago, I can just tell you that we have a tremendous amount of corporate support, as well as on the ground resource, to establish not only what you would know in the United States as a district manager infrastructure, who will do the lion's share of the recruiting, and also the training, the incentives, et cetera. To ramp this thing up as quickly as possible in this unique window of opportunity where we are.

The only direct selling Company that has been authorized, so this campaign I spoke about I mean we immediately invested an incremental amount starting in Q2, to really have a complete awareness campaign about the benefits of being a direct seller with Avon. That is going on air and in print as we speak all over the country, and so again, I think second quarter will speak the beginnings of how we're ramping this thing up.

Amy Chasen - Goldman Sachs

Do you have a sales estimate for China for this year?

Andrea Jung

We're not talking about that.

Amy Chasen - Goldman Sachs

Okay and last but not least, this is a small question I'm really just curious. You mentioned in passing that you're closing the Salon and Spa in New York? Can you just extrapolate on that a little bit more?

Andrea Jung

Yes. I think we opened the salon in 1998, so and I think it really served a great purpose. It was a billboard, if you would, certainly on Fifth Avenue, and we had a full lot of pressed impressions, etc, But as we're focused on this business, and particularly making sure that we use all of our kind of "advertising" or image investments, to have global applications we made the decision to close this, along with other retail points like the China ones, it really wasn't just about the New York Avon Salon and Spa.

It was just saying let's close down on retail, and focus our investments to drive the kind of returns image-wise that are globally going to take the brands to the next level. So it's just a reinvestment thought but we've been pleased with it, but we made the decision along with other retail initiatives in other places, to close down those aspects.

Amy Chasen - Goldman Sachs

Okay, great. Thank you.

Andrea Jung

Okay.

Operator

Thank you. Our next question is from Bill Schmitz.

Bill Schmitz - Deutsche Bank

Hi, sorry, I got disconnected somehow, and maybe I missed this answer. But in China, like some of our sources indicated that January and February were pretty darn good, and then when direct selling started in March, it fell off the cliff relative to what you're going in targets were.

Could you comment on that and kind of what happened in March? It was like a logical progression given the resumption of direct selling there?

Andrea Jung

If you look at the orders by month, a lot of that is just dependent on what the product at the time, but if you just look at the quarter, like I said in my remarks, there was no incremental disruption from the direct selling announcement in March.

As I said, I really believe that the Beauty Boutique business looks to have stabilized when you, again it is still down year-on-year, I think that in addition in the quarter you have got some of the exits of some of those retail businesses, and so that might be a slight difference from what you were seeing in the other two quarters preceding this.

But I think in-line with the business pre disruption in April '05, it's pretty much stabilized activity, continues to be really hanging in there, and it has been strong over many, many months now. So we are considering the fact that with no fall off in the BBs, and now an acceleration of direct selling, that's the plan going forward for our business.

Bill Schmitz - Deutsche Bank

On Central and Eastern Europe and the increased product cost, was that really raw material inflation? Or was there some fulfillment issues there, which was a little bit surprising that given that volume isn't what it has been in terms of growth historically.

Charles Cramb

We had some I call it sourcing cost increases, some of that is currency related. Sure we had material cost increases, but we had those across the world, so it really has to do with source of supply and the mix of the product.

Bill Schmitz - Deutsche Bank

Okay great and lastly, your views on share repurchase. I know you did a lot in the fourth quarter and pulled back in the first quarter, but cash flow is building up on the balance sheet, so what is your outlook for share repurchase going forward?

Charles Cramb

Well we still have authorized a little bit under $1 billion by our Board for share repurchase programs. I believe it's part of our overall capital structure finance mix. We will continue to repurchase. There's nothing in the immediate horizon, in terms of a dramatic change from that position.

Bill Schmitz - Deutsche Bank

So is that the number one priority of free cash flow now?

Charles Cramb

Number one priority. I hate to say it's number one priority because things change overnight. I think we're in a wonderful position, because we do generate a lot of cash in this business. I think the great challenges are where is the best way to redeploy that cash in the business, and share repurchase is one of the things we might look at.

Bill Schmitz - Deutsche Bank

Great thanks very much.

Operator

Thank you. Our next question today is coming from Chris Ferrara. Please announce your affiliation, and pose your question.

Chris Ferrara - Merrill Lynch

I wanted to ask again about Central Europe, it looks like even if you add back the restructuring and the obsolescence charge, margin was still down somewhere around 700 basis points if that's right. Can you talk a little bit more about the sourcing issues, and understanding why that's down so much?

Also as a follow-up, if this is an area of big incremental investment going forward, what does that mean for the future outlook of margins there?

Charles Cramb

In terms of the margin, you're right. If you're looking at the gross margin level, you'd see a significant reduction, due to the cost structure and it's currency, it's sourcing, it's also in terms of when the inventories went in and when they were sold, as inventory valuation revaluation issues, so it's an accumulation of a lot of things in that line.

I think as we look forward the operating ongoing operating margin is a rich one, we've talked about that in the past, and how we redeploy that margin to generate the sales growth we need is something we're working on right now. That's where the metrics analysis is involved.

We've told you that we will be substantially increasing advertising, it's a category of growth in Central and Eastern Europe, the ones we're participating in, so you will see some increase in advertising expense, which will impact the margins slightly.

Andrea Jung

I think though and I know that we've talked about this before. I mean we do intend to invest in Central and Eastern Europe. I think we've got a strong platform there, and both from a consumer point of view as well as a representative point of view we wanted to really understand what it's going to take to optimize return on the investment, as we drive for the competitive position.

Having said that, on a ongoing basis to Chuck's point, I mean even with that, I mean we're not talking about a region that won't have healthy margins. That's still a very healthy margin opportunity for us.

Chris Ferrara - Merrill Lynch

Got it. Switching gears, can you explain to me a little bit more on China, and the incremental services that your people will have the opportunity to provide? How is that revenue generated ,and does that mean a ramp up of the cost for you? Are you shouldering the cost of paying people to provide those types of services?

Renee Johansen

Chris, it's Renee. These are services they are after market services to the representative or to the end consumer, and they would if we weren't providing them through a boutique, they would be provided through an Avon branch or service center that the Company would operate, so they could be collective orders, order pick up for the representative, those sorts of services, returning product, et cetera. Because China is single level, there's no recruiting done by the boutiques, so their opportunity to earn is from assisting us in servicing the representative in that market.

Chris Ferrara - Merrill Lynch

Their revenue gain will be enhanced by -- why would they want to provide those services? How does that help them? Are you paying them to provide those services?

Andrea Jung

Yes, they will earn fees. I mean on top of what they will earn from selling customers at retail and salon or beauty consultations, they will earn fees from those activities, that we will allow them to do, and earn fees off of. It's incremental earnings.

Chris Ferrara - Merrill Lynch

Got it. Thank you very much.

Operator

Thank you. Our next question today is coming from Connie Maneaty.

Connie Maneaty - Prudential

Good morning. I haven't had time to calculate it, so I was wondering if you would just tell us what organic sales growth would have been without the acquisition in Columbia?

Charles Cramb

Sure. Columbia added about 2% sales growth. So you can take the 2% off.

Connie Maneaty - Prudential

4%.

Charles Cramb

No, 6% plus 2%, 4%.

Connie Maneaty - Prudential

In Japan, as I recall, Japan has caused you hiccups like every five or seven years. What's the issue there, and why doesn't it ever seem to get on a long term even keel?

Andrea Jung

Well they are transitioning. I think that the transition to a more traditional direct selling model is not something that we have done over the past. I mean it has been a far more customer-centric model, even with it's hiccups, and I think one of the issues is we have not had a sustainable fundamental direct selling focus in that market, certainly in the years I have been with the Company.

So this does take time and transition, and we've got new management there in both the region and country, and I would just say to you that we are all over aggressively addressing this transition.

I just would say and I think you make a fair point about past hiccups, they're under a very different strategy for Japan. We have looked at this thing up and down, and I think that the correct strategic focus going forward, is against a more traditional direct selling model and business, but that will take some time, so we are baking that time into our thinking, so it is not doing the same thing. We are doing something different now, and again it's early to call, but I would say that I think we've got the management against this in high priority.

Connie Maneaty - Prudential

Okay. So that I mean so that there's a legacy here of a different selling model in Japan, and now you're trying to put it on the same platform as the rest of the Company?

Andrea Jung

It's more customer centric, basically almost preferred customer club-type business, and then we've had different categories, and different pricing within that customer club, and changes in that over the history, that have changed the business course. As you and I can recall things happened in the mid-90s, et cetera Connie, but those were really against a more, very customer centric, it really wasn't selling. It was just find finding discount customers, that was more the Japanese model for certainly the time I've been with the Company.

Connie Maneaty - Prudential

Also back to China. Who's going to make more money, a Beauty Boutique owner or a rep, and what's the difference in the income potential for each part of the structure?

Renee Johansen

Connie, it's going to -- as I think with any direct selling organization or anything -- it's going to be somewhat related to where she's located, and the amount of effort she puts into it.

The government obviously has capped the commission for direct selling at 30%. Depending on the volume done at a boutique, she could earn greater than that off of her product sales, but again she has overhead associated with that, that a direct seller doesn't have. So it's going to depend on each person's individual effort, and the economics of her selling situation.

Connie Maneaty - Prudential

Are you closing or have any Beauty Boutiques closed? What's the current number?

Renee Johansen

We still have a number close to 6,000. They've come down a little bit, because there have been some that have exited over that time period. No unusual turnover from what we had seen in the past, obviously with our focus on direct selling we're not replacing beauty boutiques, as we would have in the past.

Connie Maneaty - Prudential

Finally, just so we can stick it into our models, what did department store sales represent of total China?

Renee Johansen

It was a number somewhere around 10%.

Andrea Jung

A little bit less than that.

Connie Maneaty - Prudential

Okay, great. Thank you.

Operator

Thank you. Our next question today is coming from Lauren Lieberman.

Lauren Lieberman - Lehman Brothers

Sticking with China, I wanted to know if you could share a little bit about inventory levels at the boutiques. You mentioned that in the past three quarters, it was inventory reductions rather then a change in sell through?

Charles Cramb

Yes. I think as we're looking at it now we're seeing a pretty steady flow, in terms of the ordering pattern, which would suggest that the inventory reduction program is behind us.

Lauren Lieberman - Lehman Brothers

Okay. In the boutiques, if I may, where exactly do you think they were storing all of the inventory, because I was in China a few weeks ago, and the stores aren't that big, so I had trouble understanding where there could have been three months of inventory.

Andrea Jung

Lauren again, as I said close to 6,000 Beauty boutiques and again when I was out there last also, I mean, again some of the Beauty boutiques and the inventory levels of Beauty boutique was all stocked in the store, and the stores aren't that huge. So, yes.

I think Chuck's point though is more important point is as we looked today and going forward, I really think that issue is largely behind us, and that this steady order pattern of ordering and the stabilization makes us feel that again that is stabilized, and now we just focus on making sure that they better understand their role as direct sellers, and how they can earn fees, and their earning opportunity to support the direct selling system, as well as their own opportunity with customers and then focus largely on this major recruiting effort.

Lauren Lieberman - Lehman Brothers

In the cities where you had the test going, what do sales promoter growth numbers look like?

Renee Johansen

We're not going to disclose those growth figures.

Lauren Lieberman - Lehman Brothers

Okay. Are they up, down, or flat? Can we do that? Just directionally?

Renee Johansen

We've been actively recruiting sales promoters in some of those areas, for you know, we'll be coming out probably this summer on our one year anniversary, and obviously because of the additional rules and regulations there, it does take a little bit longer in China.

Lauren Lieberman - Lehman Brothers

Moving on from China. In Latin America you just mentioned that organic sales were 4%.

Charles Cramb

That was the total Company. That was the question was of the Company's 6% you take Columbia out, how much is your total sales and that's where the 4% came from.

Andrea Jung

Organic was 20% in Latin America, even without Columbia.

Lauren Lieberman - Lehman Brothers

Well it was 12X currency, right?

Charles Cramb

Yes. You figure 28 goes to 20, and the 20 goes to a little above 10, if you take Columbia out.

Lauren Lieberman - Lehman Brothers

That's great. Thank you.

Operator

Thank you. Our next question today is coming from Alice Longley.

Alice Longley - Buckingham

My question is about the inventory obsolescence write-offs in the quarter that was a big number, and I'm just wondering is that sort of the end of it? Have you written off what you think you need to write-off, or is the big increase in days of inventory on hand an indication that maybe more of that is coming?

Charles Cramb

Alice, I'm not terribly pleased with our inventory position. I think that we need to really aggressively address it. I think that program is more, in terms of what are the root causes, what drives those inconvenience stores up and how much of it is forecasting versus how we handle inventories versus some things we've done in the very short-term to address some potential service level issues.

I can't tell you whether there will be a significant additional charge or not as we get into it, but we are going to be very aggressive on our size of line reduction, that is part of simplifying the business, and helping take costs out.

We also are aggressively addressing what I nicknamed here, SLOBS -- which is slow moving and obsolete -- again there's been a historic process here, whereby over time we tend to sell marginal stocks, or stocks that are aging at very low markups or even at cost, because that has a cannibalization impact, we're looking hard at whether those programs should continue.

So I think when you put all of that together will there be more inventory provisions. Probably, but right now I'm not in a position to quantify it, and we've done what we should have done in the first quarter, based upon what we have in inventory.

Alice Longley - Buckingham

Okay, and that leads to a bigger question which is, one of the broad comments you've made about the problems that Avon has sort of their different problems in different regions, but you said you're going to be looking closely at pricing, and looking closely at compensation. I'm trying to see what, on a broad Company basis, you're doing on those two issues.

Pricing, you've been doing really well and you say with Anew at these high prices, so that doesn't sound like there's been a change there. Have you changed your thinking to stay with pricing, have you changed thinking about pricing, and also if you're going to be reducing the maybe ongoing SKUs, so that you have less that you're selling at low margins or cost?

Andrea Jung

Yes. Alice, my thinking hasn't changed at all on the opportunity in pricing over the turnaround period. I was just saying that we're not going to claim first quarter. We were already able to affect the pricing as it relates to significantly reduced discounting.

All I was saying was that mix was more the impact with Anew in Q1. Medium to longer term though, as soon as we can effect it, and we're working very hard on it, absolutely reducing the frequency and the depth of discount is a major Company initiative, and all of our commercial business unit's marketers have this as a significant target going forward. So it has not changed our position on this, but it's a key corporate priority. I just didn't want you to think it's already been effected in Q1.

Alice Longley - Buckingham

So the longer term trend with pricing would actually be up, because you're going to be reducing your SKU count, and in the process reducing -- ?

Andrea Jung

Yes, I think a combination beyond just Anew, I think the concept of putting more into the pipeline, and we advertise more, and we earn the right to take pricing on our products with a smaller line that have higher innovations and investments behind it.

We were pleased certainly that we had units and net per unit equally at 3% at the total enterprise, but on that 3% that came of net per unit we would like to see more of that from price, not just mix going forward. That's how we would like to see that, say half and half orders and order growth, average order growth.

I'd like to see it coming more from price and that the investments behind it will make sense. So we're doing this with greater analytical support this time, making sure that we really understand price elasticity, and we have major work going on starting in the U.S. to understand price elasticity, which is different by category, and different by product line, to see where we can really target the opportunity, but this is something we hope to really realize.

Operator

Thank you. Our last question today is coming from Sandhya Beebee.

Sandhya Beebee - HSBC

I had a few questions. The first one is in the North American local currency sales growth of 3%, can you give us more color into how well Beauty did versus Beyond Beauty and Beauty Plus?

Renee Johansen

Beauty Plus was the strongest performing category in North America, followed by Beauty, then there was a decline in Beyond Beauty.

Sandhya Beebee - HSBC

Okay, but were Beauty sales positive in North America this quarter?

Renee Johansen

They were about flat.

Sandhya Beebee - HSBC

Then about the representative count being down in North America, I know some of it is activity, but can you just give a sense of what the morale is in the field right now, and also with higher gasoline prices, I guess crimping your core customer base, that was an issue for you before. How do you envision the North American representative performance and the activity levels, progressing over the course of the next few quarters?

Andrea Jung

Well I can tell you that I think the representative morale is good. I mean obviously sales are positive so people are feeling very good after a tougher 2005. I'm not hearing as much as if you would about the gasoline prices than I am the marketing offer. It seems stronger.

They feel good about the support the Company is giving behind this on the advertising, the brochures are beginning to really be more effective. I can just tell you from a leadership point of view, anecdotally I brought in our top 12 senior executive unit leaders to New York, we had a full day work session and while we are continuing to fine tune. I will tell you that the fundamental opportunity is extremely encouraging, and is structurally very sound, so people are feeling very good both in the up line, and as I understand it, in the field at large.

Sandhya Beebee - HSBC

Great. You also talked about some new tools being rolled out to the district managers. Can you just give insight as to what those are, and how those are supposed to help them motivate the representative base?

Andrea Jung

Well, really it's a new work approach which really allows her to focus on the fundamentals of the businesses, and so other activities that would be more operational or administrative are being taken over by the Company, as opposed to making her do it, so in terms of some of the time now, answering the phone and helping representatives get customer service or tracking orders.

The Company is taking over that activity in some of the cases in this test, so then we are investing to take that burden off her, so that she can move her time away from administration back to recruiting and training, which are the fundamentals of the business.

That is a really positive shift, so the investment is ready to take all of that burden of just non-value-added administration. She is Avon to a lot of her representatives, and someone has to answer the questions, and take it off her shoulders, and let her spend time doing what she should be doing.

Sandhya Beebee - HSBC

Is this just for the district managers, or also supposed to be something that helps from some of the unit leaders as well?

Andrea Jung

Well it's primarily a program against the district managers but the investments we're making in some of the service level upgrades are true for up line as well as employee district managers.

Sandhya Beebee - HSBC

With Susan leaving, Andrea and Chuck, how do you envision your roles changing in terms of what you'll be doing to spearhead the turnaround effort?

Andrea Jung

Well I think that we've got a very, very strong group. You know, as Renee said, we've now changed the operating structure with five commercial business unit leaders, and two global business unit leaders, and we're operationalizing obviously the shared accountability as we drive stronger fundamentals, and supply chain fundamentals along with the regions. So I feel very good about the structure of how the senior leadership is taking on.

Everybody has common goals, they are empowered to do their job, but very importantly between Chuck and myself, we've got a real divide and conquer thought, that was really the philosophy behind de-layering, is getting closer to the business, closer to the market, but making sure there's not duplication of roles and responsibilities, not having three and four people doing the same thing.

We wanted to make sure that whether it is restructuring initiatives, and the cost out who is taking the lion's share of the time on that, it is not the same executive necessarily taking the same time on some of the growth and commercial edge opportunities, so I think we've had a good divide and conquer.

We're have a very focused plan as you know, the four point turnaround plan is well known to all, we have really been communicating this throughout the organization. We've got priority geographies and everyone knows what they are, so I'm not visiting 100 geographies.

I'm visiting four and five geographies that really need either the investment and/or the turnaround, and I think that we feel that we've got the divide and conquer thing set in place to move forward, and effect this obviously important turnaround, but it's pretty focused.

Sandhya Beebee - HSBC

Thank you.

Andrea Jung

Thanks, Sandy. I think that's it. I think that was the last question, and we appreciate everybody's time, and we'll talk to you soon. Take care.

Operator

This does conclude today 's conference call. You may disconnect your phone lines at this time, and have a wonderful day. Thank you for your participation.

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Source: Avon Products Inc. Q1 2006 Earnings Conference Call Transcript (AVP)
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