Why This Traditional Cosmetic Giant Might Be in Trouble

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Jan 28, 2014

The high level beauty industry is one of the most competitive and challenging segments of the personal care market segment. As such, firms like Estee Lauder Companies Inc. (EL, Financial), The Procter & Gamble Company (PG, Financial) and Sally Beauty Holdings Inc. (SBH, Financial) are under constant pressure to override their competitors. Avon Products Inc. (AVP, Financial) is no stranger to this scenario, with over 100 years of trajectory in the cosmetics industry. The multilevel marketing company is the world’s largest direct seller of female products, with 6 million active representatives in over 65 countries worldwide. The sales combination of beauty, fashion and home goods has helped this company establish itself domestically and internationally as a strong market competitor. However, the last few years have put a strong halt on the company’s profitability and management changes have shifted gears on this beauty firm’s route, causing investment guru Ray Dalio (Trades, Portfolio) to sell out his shares. Â

What Once Was, No Longer Is

Avon has had a rough few years, and the world’s largest direct seller that was once the most popular beauty product supplier is now facing some serious and very necessary changes. Although it still generates $10.7 billion in revenue, the trend since 2011 has been negative. This is due to several factors, but one of the most important ones is the firm’s past lack of investment in technology, which has put it at a competitive disadvantage. Therefore, Avon’s management decided last year that an additional $150 million to $200 million incremental spending would help revitalize the company’s technology department. The beauty firm also spent another $150 million to build a state-of-the-art distribution site in Cabreuva, Brazil, which will ship over 70% of Brazil’s overall product volume. It’s also meant to improve productivity via automated systems and advance order picking technology.

But technology isn’t Avon’s only issue. The company’s overexpansion has unfortunately caused it more problems than benefits, and it’s now looking to cut losses in regions like South Korea and Vietnam, in order to focus resources on highest-return countries. In fact, the aim for 2016 is to reduce costs by a radical $400 million, an ambitious, but realistic goal. However, the sale of Silpada (acquired by Avon in 2010 for $650 million) for merely $85 million, was a good effort to cut losses, but raised the company’s debt even further and dropped returns on capital by 20%, leaving it at a current 14.7%. This downward trend is expected to continue in the next years, and will reach 10% by 2022.

International Losses

This company’s asset-light direct selling model was originally effective for entering developing markets, since its growth did not require infrastructure of any kind. Nevertheless, web-based tools for representatives, enterprise resource planning systems and superior supply chain management have become crucial to service these markets today, all of which Avon has yet to develop. In addition to this, the firm’s multilevel marketers in emerging nations have presented some issues by not selling exclusively Avon products. Order delays and mix-ups have also caused frustration among customers, leading them to switch to other beauty product providers.

The firm’s significant international presence, which reels in 85% of total revenues, puts it at an additional risk, given unfavourable foreign currency translations and economic or political instability. The Venezuelan government, for example, devalued its currency in February 2013, and if it chooses to restrict companies’ pricing decision, Avon could face severe profit losses (14% operating profits derive from Venezuela). The beauty giant’s ongoing investigation related to potential violations of the Foreign Corrupt Practices Act is yet another bump in the road. And given that the company’s $12 million settlement offer was rejected, a much larger penalty is to be expected when the case closes. With a downward spiking operating margin of 2.90% (fiscal 2008 reported 12.50%) and negative EBITDA growth of -22.60%, I feel very bearish about Avon’s future, at least in the short term. Â Â Â Â

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Disclosure: Patricio Kehoe holds no position in any stocks mentioned.