The idea I'm submitting is a long investment in Avon Products (AVP). This is basically a busted yet valuable brand opportunity / reversion to the mean thesis...
REASON FOR OPPORTUNITY:
- Operational performance has been dismal for a number of years. Lots of overpromising and underdelivering. Previous CEO destroyed a ton of value.
- Have implemented numerous restructuring initiatives that haven't resulted in much restructuring. They are currently undergoing another strategic review in conjunction with recent hiring of their new CEO, Sheri McCoy, who came from Johnson & Johnson, unfortunately another company in the news recently with consumer-related misteps. Shareholder patience has clearly worn thin...
- Legal overhang with FCPA and Reg FD. FCPA is basically a magnet for AVP's direct-selling/internationally-levered business model.
- The street may have some doubts that the company can maintain is current dividend in light of the payout ratio.
- Perception that management isn't acting in best interests of shareholders. They were recently in the news for essentially ignoring a credible (at least perceived by the market) offer from a competitor in the mid-$20s per share. The cynic in me wants to point out that most management options strike in the low $30s.
Here's some background/timeline on that last bullet point:
- On March 7th, a competitor named Coty submitted an unsolicited indication to purchase AVP for $22.25 per share. Coty went public with an increased offer on April 2nd of $23.25 per share, which AVP ultimately rejected as "opportunistic".
- On April 16th, Coty reaffirmed its offer and provided highly confident letters on financing (addressing one of the drawbacks cited by AVP in its initial rejection). Coty also specifically outlined areas they wanted to study further that could impact value +/-.
- On May 10th, Coty again increased its indication to $24.75 per share and disclosed Berkshire as one of the select equity sources of financing. This last offer valued AVP at ~$10.7bn. Coty gave them a few days to consider before withdrawing their offer.
- On May 15th, Coty withdrew its offer citing a complete lack of engagement by AVP, even though AVP publicly announced that they would review the offer.
- Coty shortly thereafter filed an S-1 to go public, indicating that they wanted to move on to other strategic initiatives. It was reported in the press that another competitor, Richmont, was considering a bid for all or part of AVP and that discussions had been held in the past to no success. So far, nothing has materialized further with either company that the public is aware of.
I merely submit that a lot of the above is currently priced into the company's historically low valuation.
The business is pretty straightfoward. More detailed information can be found on their website or financial reports.
- They do direct-selling of primarily beauty products (versus selling through a retail outlet).
- Their product lines are beauty (~70% of sales), fashion (~20% of sales), and home (~10% of sales). These ratios have been pretty consistent over the last several years.
- It's a fairly decentralized organization with only marketing, sales, and supply chain being centralized.
- They generate 70-80% of their sales from international markets, so there's an emerging markets angle here. Not surprisingly, consumption per capita is much lower in developing markets. Latin America (particularly Brazil) have been the biggest drivers of revenue/cash flow.
It's probably worth a brief discussion of the direct-selling business model. Basically, AVP manufactures their products, sells them at a discounted price to third-party/independent contractor representatives, who then sells the product on to end-users at a marked-up prices. So AVP gets to their customers mainly through the representative, which is an important distinction. Not surprisingly, turnover and competition for representatives is quite high, so the company's always looking at ways to better incentivise their representatives. This is probably a partial explanation why G&A costs have ballooned over the past several years.
ECONOMICS / EARNINGS POWER:
AVP has generally consistent revenue generation, attractive margins "potential", low and consistent capex requirements, and healthy free cash flow.
- The company did around $11bn in revenue in 2011, which has grown around 8% per year on a per share basis over the last 10 years. In terms of long-term revenue drivers, there's a wide divergence between the spending patterns of emerging and developed economy consumers, especially on beauty products. Regardless of your position on these economies, they will eventual become more developed, and the gap will close.
- EBIT margins are currently depressed at all time lows for a variety of reasons, but have averaged 13% over an extended period of time (20+ years) with a high of around 16%. The company has clearly lost control of its G&A.
- Aggregate earnings have essentially been flat over the last 10 years (slight decline compounded actually). They've averaged $1.50 per share in earnings over the last 10 years and consensus for 2012 is around $1.00 per share. Earnings potential feels well in excess of 2012 consensus.
- Given the stability of gross margins (which have actually increased over the last 10 years), the ratio of EBIT-to-gross profit is an interesting way to look at true or adjusted profitability. On this metric, AVP currently shakes out in the mid-teens but has averaged in excess of 20% over the past 10 years.
- I suspect earnings will continue to be bumpy in the near-term as the company continues its transition/adjusts under its new CEO, but over an extended period of time, tailwinds in emerging economies along with buybacks and cost control should increase per share earnings to more normalized/potential levels.
- The company operates a fairly asset-light business model with capex/sales averaging around 2.5% over the last 10 years with not a ton of variation.
- Working capital management has been sub-par, particularly as it relates to inventory management/efficiency.
MANAGEMENT / CAPITAL ALLOCATION:
- The company pays a $0.23 per share quarterly dividend. The record date is 5/17/12. This implies a 5.9% dividend yield at the current price. The payout ratio on earnings is essentially 100%. There's clearly some risk to the dividend.
- They've reduced shares ~12% over the last 10 years in aggregate. But they don't repurchase many shares really. Most excess cash goes to the dividend because it has to in order to maintain it...They do have a $2bn buyback plan in place, most of which has been unused.
- Management seems decently incentived. They get paid if performance targets are met (revenue and operating margins). Wish they'd incorporate returns on capital which would have them better focus on working capital.
- It's tough to say how capital allocation will evolve over time. They recently hired a new CEO, Sheri McCoy, from Johnson & Johnson. She was recently passed over for the CEO spot over there so jumped ship. It's early goings in her time there, so I've purposely avoiding a broader discussion on her. Nonetheless, she seems pretty qualified and has a fair bit of consumer experience at J&J, which may not be saying much.
- The old CEO, Andrea Jung, is hanging around the hoop a little more than I'd like. It'll be interesting to see how her and McCoy coexist.
The company is pretty cheap on an absolute and relative basis.
- Given that per share earnings have been inconsistent in the recent past, EV/revenue is probably a better, more stable metric. The company has averaged 1.8x, 1.4x, and 1.3x revenue in the past 10, 5, and 3 year periods. That compares to the current level of 0.85x. My metric is burdened by the pension so the historical multiples I pulled from CapIQ probably bias higher. The lowest the company ever traded was 0.75x in early 2009 when everyone thought the world was ending. AVP is clearly trading at a trough valuation on this metric. Valuation doesn't look as favorable on metrics like EBITDA, EBIT, or EPS. But that's only relevant if you don't believe the reversion to the mean thesis. The company has to grow/revert into a more reasonable cash flow valuation.
- AVP doesn't have a perfect comparable but most consumer products companies trade well in excess of 1x revenue.
- I peg normalized EBIT and unlevered free cash flow (taxed EBIT plus depreciation less capex) at ~$1.5bn and ~$950mm, respectively. That implies a normalized EBIT multiple of 6.5x and a 10% FCF yield. That seems too cheap for a (admittedly bruised) brand like AVP.
- Clearly there's been third-party interest out there with a recent Berkshire-supported bid of ~$25 per share. This becomes less relevant over time, especially if earnings quality deteriorates, but it's notable nonetheless.
- FCPA/Reg FD overhang
- Perpetual restructuring with limited results
- Dividend cut
- Operational turnaround and buybacks.
- Potential M&A / strategic transaction.
|Entry||06/05/2012 10:23 PM|
How do you distinguish (if at alll) Avon from other multi-level marketing companies such as NUS, HLF, USNA, etc? Are the AVP distributors also getting rippped off?