Avon’s Calling – But is Anyone Answering?

From the nightmare of a corruption investigation to changing demographic base, Avon’s earnings are under siege, and investors may want to brace for yet another negative surprise this quarter.

For decades, the “Avon lady”, toting an array of cosmetics and beauty products door-to-door throughout the neighborhood, has been a familiar sight, to the extent where the company’s advertising tag line became a feature of popular culture. Ladies from Avon Products (AVP.N) may still be ringing doorbells, but the changes in society that have led many members of their target market – stay-at-home mothers – to enter the paid workforce have taken a toll on the company’s basic model. It’s getting harder to convince those with the right marketing prowess to join the company; the number of its representatives has fallen steadily over the last nine quarters, one of only a number of worrying signs for the company. That’s bad news for firm that still counts on direct sales; even Avon’s online sales are still largely handled via portals maintained by individual sales representatives.

Avon’s direct sales strategy also is coming under siege from the increased array of beauty products in department stores and even in drugstores that compete directly with its proprietary items, and that are easy for a consumer to snap up in the midst of other errands. (Another demographic change: many of Avon’s traditional customers, especially those with disposable income to spend on their products, have less leisure.) Add that to competition from online retailers, and it’s easy to understand why, as consumers have found new ways to obtain the kinds of products they want, competition has intensified and Avon’s profit margins have plunged. Today, the operating profit margin for the trailing four quarters stands at a five-year low of 7.2%, significantly below the industry median of 14.3%.

That is taking a toll on the company’s sales and earnings. The company has reported earnings that fell short of the I/B/E/S consensus in each of the last four quarters, and it is on track to repeat that unimpressive feat for the third quarter of 2012. As recently as the end of the second quarter, 90 days ago, analysts were predicting that Avon would record earnings of 27 cents a share for the third quarter; since then, the mean estimate has fallen to a mere 22 cents a share. The StarMine SmartEstimate is lower still, at 20 cents a share, giving the company a negative Predicted Surprise of -7.1%. Of the last ten analysts who have altered their earnings forecasts for Avon, eight have cut them – another warning sign that the company may disappoint investors who have been hoping it will still manage to report earnings that meet the consensus when it announces its results in just over two weeks’ time. Analysts also are slashing their estimates for Avon’s revenues; the consensus has tumbled from $2.67 billion to $2.57 billion over the last 90 days, or almost 4%.

In an environment in which margins are shrinking, sales are weak and earnings appear under siege, it’s hard for the company’s all-important sales representatives to maintain their morale. The result can be a vicious circle, in which that lack of morale – or lack of incentive compensation – contributes to further declines in sales. At the same time, Avon is in a bind: offering those reps greater rewards for generating sales may contribute to the erosion of its profit margins. Unsurprisingly, the company has seen its cash flow fall below its net income in three of the last four quarters.

Avon’s woes are being reflected in its stock price, which fell more than 40% in 2011 and is down another 1.9% so far this year. On the heels of that, CEO Andrea Jung stepped down from that post last September; Sherilyn McCoy stepped into her shoes this past April. The most recent change at the top came only days ago, when Jung announced her resignation from her role as chairman, to be replaced by Fred Hassan, known for overseeing a turnaround at privately-held Bausch & Lomb, a eye health company familiar to many for its contact lenses and products. Jung’s departure and the arrival of Hassan – known as a dealmaker – was welcomed by investors and has helped Avon’s stock regain some ground; its share price had rallied by 7% as of the end of last week in response to the news.

The market may be more content, but that’s just the beginning – Avon must develop a strategy and be able to execute on one. Certainly, it wasn’t encouraging that incoming CEO Sheri McCoy started the earnings conference call at the end of the second quarter – and her first running the company – by confessing up top that the “results are not good” and that Avon is reviewing its dividend, with the aim of bringing it “more in line with our overall performance and our peer group”.Avon currently offers a healthy 5.5% yield, paying 23 cents a share quarterly; in light of the company’s bleak earnings outlook and weak cash flows, it seems likely that generous dividend will be trimmed back, driving away dividend-seeking investors.

More than 80% of Avon’s revenues now come from markets outside the U.S., and in particular from emerging markets. Given that economists expect the slowdown in emerging markets to continue into 2013, Avon’s woes may not be resolved rapidly, even with new leadership. Sales in China tumbled more than 20% during the second quarter of 2012 over year-earlier levels and Avon has acknowledged that direct selling in that country has proved to be a challenge. In fact, relying on foreign markets has proved to be a been a major headache for Avon; the company is mired in allegations of corruption and bribery related to its business activities from Brazil to China, filed by the SEC and the Justice Department after their investigations. Resolving those legal woes also may give the company’s earnings a boost, removing both uncertainty and the enormous legal fees from the picture.

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