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Marcial: Avon's Allure in Uncertain Times

The cosmetics giant's products are recession-resistant, say Street pros, many of whom rate the shares buy

In good times or bad, women don't skip or skimp on beauty products, whether they live in San Antonio, S?o Paolo, Moscow, or Beijing. That's because most women consider cosmetics and beauty products as staples, or necessities in their daily lives, according to industry analysts. That suggests demand for such products is constant, regardless of economic distress. The toiletries and cosmetics industry is now "ranked to best a majority of industries under our review," wrote Kenneth Nugent, analyst at independent research firm Value Line (VALU), in a recent note to clients.

That's been a boon to Avon Products (AVP), the world's largest direct seller of such personal-care items. On Wall Street, Avon is among the companies analysts categorize as "defensive" plays that thrive even during recessionary times. Of the 14 Street analysts who follow Avon, 10 recommend buying the stock and four rate it a hold.

Since late 2005, shares of Avon had been in an upward spiral, hitting a high of 45 on Aug. 5, 2008. But in October, the stock stumbled, to 23.94 on Oct. 24, from 41 on Oct. 1, when news leaked out that since June, Avon had started an internal inquiry into allegations that certain entertainment and other expenses may have been "improperly incurred" in its operations in China. Avon voluntarily notified the Securities and Exchange Commission and the U.S. Justice Dept. about the investigation, so the Feds could determine whether the company had violated the Foreign Corrupt Practices Act that bars U.S. companies from using bribery to win business overseas. Avon says the probe is still in its early stage.

another buying opportunity

But Wall Street seems unperturbed. "When attempting to draw investment conclusions, we would start with materiality: China is 3% of sales and 0.5% of profits for Avon, so even a worst-case scenario [for the probe] would likely have no earnings implications," says Christopher Ferrara, an analyst at Merrill Lynch (MER), who has retained his buy recommendation on Avon. "We think it's more likely that this investigation proves immaterial from an investment perspective, even to the entire China operation, which itself is immaterial to Avon's earnings (and to its multiple at current levels, in our view)," wrote Ferrara in a note to clients dated Oct. 21.

Ferrara points out that the price decline in the shares should be considered another opportunity to buy the stock. On Oct. 24, the stock had dropped to 24. His 12-month target for the stock is 51, based on his 2009 earnings estimate, excluding special charges, of $2.59 a share. (The stock is currently trading at 10 times the estimated 2009 earnings estimate, vs. a high of 35 in 2007.) The risks to his price target, Ferrara says, include a possible worsening slowdown in the U.S. business and softer growth in the developing markets, particularly in Brazil, which has accounted for a large portion of Avon's sales growth in recent years. (Merrill expects or intends to seek or receive compensation for investment banking services from Avon within the next three months.)

Indeed, most analysts have reduced their estimates on Avon's sales and earnings because of the global economic slowdown. Nonetheless, they remain upbeat about the stock.

"Even after slashing our earnings estimates, we still see close to a 60% upside in Avon's shares," says Nik Modi, analyst at investment bank UBS (UBS), who rates the stock a buy with a 12-month price target of 47, down from a prior target of 52. The analyst cut UBS's 2008 earnings estimate on Avon to $2.11 a share from $2.25 and the 2009 estimate to $2.51 a share from $2.79. Avon earned $1.20 in 2007. (UBS owns Avon stock.)

"We are being prudent and cautious on our revenue and earnings-per-share figures to reflect the current [macroeconomic] environment," says Modi. "But we believe that Avon is better positioned today to deal with these challenges."

5.4 million reps

Modi says investors are underestimating the countercyclical nature of Avon's direct-selling business model and the cushion afforded by the company's many cost-savings initiatives. Investors also underestimate, adds Modi, the "staplish" nature of beauty products in both the developed and developing countries. "Consumption in Avon's key markets is far from collapsing," says Modi, and "trends remain strong in Brazil, Russia, and China."

With Avon's non-U.S. operations accounting roughly for 78% of sales and 80% of earnings, weak results in recent quarters in the U.S. (20% of sales) haven't had a disastrous impact on the company's growth. Some 5.4 million sales representatives market the company's wares in 114 countries. Avon's products include cosmetics, fragrance, and toiletries (70% of annual sales), jewelry, watches, apparel, and accessories (19%), and home products, gifts, and candles (11%).

Truly a global giant, Avon, which began operations in 1886, could well claim Keats' immortal line, "a thing of beauty is a joy forever," as its inspiration. The beauty part, for the company and its investors: the millions of customers that use its products day in and day out. The joy: the prospect of solid, steady profits in dicey economic times.

Unless otherwise noted, neither the sources cited in Gene Marcial's Stock Picks nor their firms hold positions in the stocks under discussion. Similarly, they have no investment banking or other financial relationships with them.

Marcial writes the Inside Wall Street column for BusinessWeek. In 2008, FT Press published the book Gene Marcial's 7 Commandments of Stock Investing.

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