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Avon Products (AVP:US) has high quality beauty products, a long/distinguished history and a premier reputation in direct sales. It offers its 6.4 million direct sales reps. (‘Avon ladies‘) a compelling income/empowerment opportunity, while offering investors attractive global/emerging markets exposure (83% non-US revenues)

– Sounds like the start of an interesting investment write-up?! But what on earth’s happened to Avon in the past several years? Good God, it’s like hearing your dear old maiden aunt’s been raped by Somalian pirates..!

– Yes, Avon has obvious potential. But every quarter/year, investors are greeted with more struggling results & restructuring, and the promise of better things to come. Yes, on occasion, I’ve almost got excited enough to invest but, like most investors, I’ve seen more new dawns here than a Cartagena whore…

– There’s a great Avon article just out in Fortune, packed with gossip. Andrea Jung, the (now ex-) CEO, is charged with ‘mak[ing] Avon something it isn’t‘. This rings true with Avon apparently desperate to present/believe in itself as a beauty company, rather than a global direct sales company which should be championing its obvious key strength, the Avon lady

– But gossip/stories always come after, and certainly won’t save you in time as an investor. It’s vital (with US companies) to thoroughly digest their 10Qs/Ks – they often reveal a company’s true health, not press releases or presentations

– In fact, if a company’s struggling (or distressed), management commentary might actually be better ignored by an investor! With Avon, particularly in the past few years, there’s been a focus on adjusted figures. In 2009-11, average adjusted operating profit was at 11.1% vs. a GAAP avg. of 9.1%. Similarly, cumulative 3 year EPS was $4.02, just 77% of non-GAAP EPS of $5.19

– But adjusted (or pre-exceptional) figures are pretty meaningless after 7 years of restructuring (and with more to come, presumably). So let’s stick to Avon’s 10Ks. 2005’s a good place to start, as their restructuring began at the end of that year. Here’s my data file for 2005-11:

Avon     (xlsx file)

Avon     (xls file)

– From 2005 to 2011, revenue increased 39% to $11.3 billion, a growth rate of 5.6% pa. Operating profit declined 26% to $855 mio, with margin almost halving from 14.1% to 7.6%, while diluted EPS fell 35% from $1.81 to $1.18. $1.4 bio in restructuring/goodwill impairment/etc. charges is included. Despite this, Avon’s operating profit margin & EPS still ended lower in 2011, even on an adjusted basis..?!

– The market reaction’s captured in the latest 10K: Over 5 years (with 100 as base), Avon’s peer group ended at 128.9, the S&P at 98.8 and dear old Avon at 61.1 – a pretty atrocious relative performance

– This makes Avon’s compensation policy even harder to decipher. Somehow, despite a 35% decline in EPS and a larger decline in the share price, Andrea Jung was paid $82 million in total 2005-11 compensation

– In fact, Avon’s followed a path well-trodden by other struggling companies. First were the large share repurchases. Most listed companies’ repurchases appear simply a function of management confidence. Almost inevitably, they confidently buy tonnes of shares at the highs, and then choke and buy virtually nothing at the lows

– Avon purchased almost zero shares in the past 3 years, despite AVP declining from $25 to $17. Compare to $728 mio of repurchases in 2005, when the avg. price was $35. Or the $667 mio spent in 2007, when the avg. was well over $37. I guess management were still feeling good – 2008 brought a nice, but one-off, bump in results (presumably the fruits of restructuring). Repurchases had to be fully/partially funded with debt in all years

– Next is the acceleration in capital expenditure. Too many companies don’t appear to scrutinize investment/project payoffs closely enough (ex-ante, and especially ex-post), or even consider the impact on cash/debt. But struggling companies are always chasing the dream of more efficient capacity. Each project’s only a small (depreciation) hit to earnings, vs. the promise of a much larger earnings boost from lower costs. Sometimes they even believe greater capacity leads to higher sales…

– Avon’s net capex accelerated from $177 mio to $260 mio in 2011 (and peaked at $364 mio), for a cumulative total of $1.8 bio. On top of $1.4 bio in restructuring expense (not all cash, of course), it’s extraordinary to see their operating margin still declined

– And finally, companies turn to acquisitions as another magic fix. Doesn’t make much sense if they can’t even get their own house in order… They also tend to overpay, thereby diluting shareholders. So what – looks like a free lunch to management: At worst there’s a tiny (interest) hit, the cost hopefully stays hung up on the B/S as goodwill etc., and they enjoy all of the resulting revenues/earnings!

– After a decade of virtually no M&A, Avon pushed the boat out in 2010 with 2 acquisitions (Silpada & Liz Earle), costing $786 mio (net of a Japan sale). I haven’t noticed an appreciable revenues/earnings contribution, but a $263 mio writedown (40% of Silpada purchase price) just one year later tells its own story!

– Moving on: There’s been precious little progress with key working capital components. Inventories & receivables should be obviously squeezed during restructuring, for efficiency & cashflow, but they’ve barely shifted from 17.6% to 17.0% of revenues

– Bad debt’s an avg. 2% of revenues. Small perhaps…but actually amounts to $215-248 mio pa. Absurd for a direct sales company?! Should be pretty simple: You vet each rep. (as effectively as possible…), they pay for each order, and nothing’s shipped if the previous order payment hasn’t been received. Am I missing something? So how do you lose nearly a quarter of a billion on bad debt?

– Returns are 3.8% of revenues, while shipping & handling’s a colossal 9.5% of revenues (almost $1.1 bio). These seem pretty high, but hey what do I know? Advertising’s more than doubled since 2005. That’s a relatively small 2.8% of revenues (vs. a 3.7% peak), but begs the question: How does an increased ad. budget benefit a direct sales company? As long as you’ve a decent reputation, surely the money’s better spent on improved incentives for your reps?!

– At the other end of scale, R&D at $78 mio has barely shifted over the years. Sure, beauty’s far less complex than ads suggest, but spending just 0.7% of revenues on R&D seems low

– Then there’s a $95 mio 2011 bill for FCPA/compliance reviews etc. Nope, not a fine, it’s simply the investigation/compliance cost! Companies bitch about FCPA, but it’s clearly a statute with teeth – prevention’s far cheaper than cure! Something Wal-Mart (WMT:US) is now going to painfully learn

– Moving on, 83% of Avon’s expanding debt was floating rate at yr-end 2011. And they’ve only $264 mio of FX hedges, primarily for inter-co/net asset hedging. Therefore, FX/interest rates have been mostly a significant positive, mitigating the recent earnings’ decline. For example, Brazil is 21% of revenues, and the real’s 19% stronger in the past 3 years. On the other hand, these exposures could cause significant adverse P&L volatility/risk at any time…

– Let’s return to some other common corporate problems. First, Avon’s 2011 US pension plan assumed return’s a (not uncommon) 8%. This is almost 1% higher than the assumed asset allocations/returns provided, and 1.5% higher than actual 10 yr returns. You have to look back 20 years to see that kind of return. The 2012 assumption’s a more realistic 7.1%, but doesn’t address a $603 mio employee benefit liability

Venezuela: Everything’s recorded at the official 4.30 VEF exchange rate, vs. a far worse black market rate. Avon’s business there is starved of FX/imports, and has stacked up $131 mio of unpaid royalty/dividend payments to the US since 2005. Venezuela still represents 4% of Avon’s revenues, 5-7% of its operating profit, and $196 mio of its cash! Risk can’t even be mitigated by converting the cash to USD – 99% is held in bolivares

– This risk’s clearly disclosed. But should a subsidiary even be included in a company’s B/S and P&L when the official FX rate & sub. earnings/cash have been virtually inaccessible for years? But companies are following guidance here, so that’s really a question for the SEC… And there are plenty of other companies with Venezuelan exposure: Brink’s (BCO:US) is a well-known example

– Substantially all of Avon’s cash & cash equivalents are held outside the US, due to undistributed earnings of foreign subs. While this may have mitigated a rising (on average) effective tax rate, most of Avon’s $1.2 bio cash is now inaccessible for debt pay-down, for example, unless a serious tax bite is incurred

– A familiar problem with US corporates: The accessibility of cash, and a safer balance sheet, are sacrificed for lower taxes & higher earnings. Tech/pharm companies are the most extreme examples. But investors are perhaps to blame also… Unless risk-aversion really sets in, too many investors seem happy to simply focus on adjusted earnings/growth, ignore the B/S, and to hell with cashflow!

– But the main problem with Avon’s far more prosaic. Ignoring the 2nd half 2011 price collapse, AVP’s otherwise traded near an avg. $29 in the past 3 years. This appears to be based on diluted adj/continuing avg. EPS of $1.73, with the ever-present promise of a $2.00+ EPS if everything starts turning rosy. So, AVP’s mostly traded on a 14 to 17 P/E ratio…not so bad, let’s buy!?

– But my first problem’s valuation. Investors seem to grant some stocks an almost perpetual do-over. Why pay that kind of P/E for Avon’s recent performance?!

– My second problem’s the gap between adjusted & GAAP earnings. When faced with constant restructuring/writedowns, adjusted earnings are meaningless. Focus instead on AVP’s GAAP earnings, which declined consistently from $1.45 to $1.18 in the past 3 years. So, Avon was actually on a 24 P/E fairly recently.

– My final problem: Cash earnings, or FCF (i.e. Free Cash Flow: Net operating cash less net capex), exceeded net income only once in 7 years, and averaged 73% of net income over the period! 2011 FCF was at 77% of net income, so for much of the year AVP traded on a true cash P/E of 32!

– I haven’t mentioned the absurdly high dividend! In the past 5 years, it’s consumed 95% of available FCF. Couple this with M&A and share repurchase, and no wonder gross debt’s doubled to $3.3 bio. Net debt’s even rougher, more than tripling to $2.1 bio. In fact, I consider the employee benefit liability’s basically another senior obligation, so I’d argue true net debt’s now at $2.7 bio

– And now there’s another new dawn for Avon. Andrea Jung’s no longer CEO, after polite re-assignment to her Chairman role – surely a poor governance decision… Sheri McCoy was just announced as her replacement. Sure, she’s had a stellar career with Johnson & Johnson (JNJ:US), but yet again there’s no direct sales management experience. Presumably, fresh reorganization & restructuring for Avon will be top of her agenda

– The only real saving grace for Avon’s the announcement of a $23.25 bid from Coty, just 1 week before McCoy was appointed. Avon predictably, and promptly, rejected the bid as too lowI strongly disagree, m’lud!

– But Coty’s not going away, and might even pay more if they can perform proper due diligence. They have backing from the Joh. A Benckiser group, BDT Capital Partners (headed up Byron Trott, Warren Buffett’s favourite banker!) and a highly confident letter from JP Morgan (JPM:US), so they can go the distance. And now rumours are surfacing Richmont Holdings may be preparing its own bid…

– But it’s hard for me to invest in a bid (even a firm bid) if I estimate intrinsic value‘s far lower than the share/takeover price. I don’t even see much point venturing an AVP intrinsic value here…but yes, it’s well south of the current $20.57 share price!

– And AVP’s discount to Coty’s bid is alarming. Considering arbitrageurs’ appetite, a 12% bid discount’s surprising and indicates they assign a pretty high probability of ultimate bid rejection/failure (and a subsequent fall in AVP). It would be a real tragedy for shareholders if there isn’t a successful bid in the end

– And what’s the alternative? Grit one’s teeth through more expensive & uncertain restructuring? A possible slashed dividend? The promise of coming out the other side to a reinvigorated Avon? Ouch! If I held AVP, it would be far more tempting to just cut & run right now! Plenty of better opportunities awaiting your cash… But if you really want to try eke out a few more dollars on Avon, I’d recommend you walk/drive/fly to the Coty, or Richemont, HQ and beg them to seal a deal asap – seriously!