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Avon Case Study Highlights Where Consumer Analysts Go Wrong


Valuation analysis suggests there's not much reason for portfolio managers to bother researching the company right now.

As I write my consumer sector analyses for this site, I hope to impart some investment wisdom that readers can use in other sectors and in their own analysis.

I have found that good valuation analysis is important to investing, obviously. Good preliminary valuation work on a stock can save you a lot of research time by directing you to the best opportunities and allowing you to forget about many other stocks. But there are still many people who stick to PE ratios and who shy away from discounted future earnings or cash flow approaches, which is my favorite valuation method for consumer stocks.

Another important approach is to keep an eye on the forest rather than the trees, again obviously. But many times even institutional analysts and portfolio managers do not.

Avon (AVP) is a case in point. While I have had big problems with Andrea Jung, the recently deposed CEO, for many years and wonder why she will be staying on the board, the hiring of a new CEO from outside the company, when it happens, will be a catalyst for some value investors to take a hard look at the company for a turnaround. But let's do some valuation analysis using the big picture (forest) considerations placed into an academically (and real world, too) correct three-stage earnings growth model adjusted for risk.

The Yahoo sell-side analyst average earnings per share (EPS) for 2012 is $1.76, though that is almost certainly higher than normalizable levels (via my gut) and will be higher than what it actually report after a new CEO clears the decks with a lower bar for his future performance. The sell side five-year EPS growth CAGR is 6.5%, which experience tells me is worthless, especially with no base number to hang your hat on, but I need numbers for my valuation exposition. Another consideration for my valuation is a terminal earnings growth rate of 2% for years 11 through infinity, which is fairly standard for consumer staples.

Here's where the market screws up. Because Avon sells cosmetics, the company is considered to be a consumer staples company, which has a low risk relative to the market. I typically assign a 4% risk discount to a big, large-cap consumer staples company in addition to the risk-free rate, which in this case is 4% (3% for the 30-year Treasury, plus 1% for a less-than AAA issuer and the fact that interest rates are unsustainably low). The end result is a $36 price target, 109% above the $17 price now.

Back to the forest. Avon is not only a consumer staples stock. It's also a retailer of its own products. (Amazing how many institutional investors -- analysts and portfolio managers -- do not understand this.) And it has been in the retail side that it has had most of its problems over the years. A decent retailer would be worthy of a 7% risk discount; average 4 and 7 and you get a 5.5% risk discount for Avon. The deserved price is now $29, a 65% appreciation. Use 6% for its being a non-decent retailer (sales via reps) direct and you get $25.

Avon finds it difficult to grow or even maintain earnings and sales reps in mature economies because of the inroads from retailers, mostly mass merchandisers focused on lower end customers. You can go into Walmart (WMT) and find Rimmel and some other brands selling below Avon's prices. So Avon is in a race to stay ahead of retailers in the developing world. But we know that will not end well for Avon. So it should be obvious that a 2% terminal growth rate is too high. It could be 0 or maybe minus 2%, or somewhat more negative. Using the 5.5% discount and a 0% terminal growth rate results in a $25 price. A negative 2% terminal growth implies $23.

If the new base earnings level ends up being $1.40, down only 20% (my gut would say that that is a real possibility), and you assume a 6% risk premium is justified with negative 2% terminal growth, the present $17 stock price is justified.

This is why I like three stage earnings discount models and will generally use them. It is also why I do not think that there is much reason to do research on Avon now.

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No positions in stocks mentioned.
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