Thesis

Shorting Avon Products represents a compelling opportunity to bet against a broken business model incorrectly valued in line with peers. I estimate that shorting the common stock should generate a return of approximately 30% relatively uncorrelated to the market.

Business Model

Avon Products, Inc. (NYSE:AVP) is an international manufacturer and distributor of beauty, household, and personal care products. Unlike most competitors, Avon’s business is conducted via a direct selling platform that partners with over 6 million active independent representatives. Representatives are not Avon employees, yet reserve the right to purchase products at a discount to the published ‘brochure’ price in order to sell to consumers. This business model offloads Avon’s need to work with third-party retail establishments and incentivizes active representatives to market Avon products. Both Avon employees and independent contractors conduct the recruitment of further active representatives. Avon has no arrangements with the end user beyond the Representative and no single representative accounts for more than 10% of net sales.

Avon Products growth is predominately predicated on its ability to maintain and enhance its image, further its distribution network (add more active representatives), and enhance margins in currently underperforming geographic regions.

I believe that these competitive advantages will slowly turn into competitive disadvantages as Avon loses more active representatives, translating in poorer YoY Sales and decreasing margins.

Brief History

Founded in 1886, Avon is currently the second largest direct selling company. Nonetheless, poor recent performance has tanked the stock price increasing speculation that investors can buy shares at a discount. Having dismissed a $10.7 billion bid from Coty Inc. in May 2012, Avon is currently in the midst of an operational restructuring, led by J&J exec Sherilyn McCoy as CEO.

Macroeconomic Factors

Beauty Industry: From 2012 to 2017, the beauty industry is expected to grow by 7% per year. However, developing nations, where Avon generates most of its sales, is expected to grow by 12%. This further emphasizes Avon’s problem as they have been able to pick up minimal growth even with such positive market headwinds.

Direct Selling Industry: The global direct selling industry has grown from $118 billion to $154 billion from 2009 to 2011. This 14% CAGR has failed to matriculate to Avon’s topline which has been stagnant over the same period.

Investment Paradigm

Though much of the street believes that the new management team can turnaround Avon Products. I believe, instead, that Avon is an attractive short for the following reasons:

Three Prong Decline: Following AVP’s 3Q earnings announcement, the company’s organic sales, volumes, and active representatives have all decreased significantly. This trend has severely affected the company’s free cash flow generation performance in North America and Asia Pacific.

Avon’s greatest strength is the 6 million active sales representatives that are incentivized to market and sell Avon products. Unfortunately, many of these active representatives have become disenchanted with the ability to profit from selling Avon products. This slippery slope has dramatic effects on volumes and organic sales of Avon. In order for Avon to right the ship, they must reinvigorate active representatives. Instead, I believe that Avon will truly begin to hemorrhage active representatives as Avon’s brand image further disintegrates.

Future Avon growth is highly levered to the company’s ability to continue growth in Latin America, namely in Brazil and Venezuela. Nonetheless, unsustainable trends in almost every other region in the world has forced Avon to diverts its attention from growth to cost cutting. For a company that is dependent on its image, future cost cutting in promotion and marketing will backfire on Avon’s growth prospects. Nonetheless, Avon is in the midst of a catch 22 where large pockets of business are barely profitable, implying a need to cost cut.

As shown by the figure above, North America & Asia Pacific generate no profit for Avon.

Currently, Avon’s “$400 million Cost Saving Initiative” include reducing global headcount and exiting from South Korea, Vietnam and France markets.

Update: As of December 12^th 2013, Avon has taken a $125M charge due to the failed rollout of an SAP-based order management software system. Supposedly, the new system was disruptive to active representatives instead of simplifying the process. The new SAP system was part of the original $400 million cost saving initiative.

FCPA Risk: Detailed in City of Brockton’s Retirement class action lawsuit against in Avon, much of the Foreign Corrupt Practices Act (FCPA) story has yet to be properly discussed by Avon. In recent conference calls, management has refused to discuss the case and provide transparency on the timeline before the issue is settled. Nonetheless, Avon has spent over $300 million on the issue and has recently been rejected by the SEC for proposing a $12 million settlement. Furthermore, the lawsuit implies that Avon’s practices in many of the developing nations is built upon a foundation of malpractice. Debra Hennelly, former Avon Executive Director of Global Ethics and Compliance, stated in the lawsuit that senior officials asked her “to avoid being inundated with what would likely be uncovered if Avon started doing a broader review of all of its vendors in Latin America.” She was fired shortly after.

I believe that Avon’s management team has been extremely irresponsible in sharing its FCPA problems. Though arguments can go either way in terms of FCPA dialogue influencing active representatives, uncertainty remains regarding Avon’s business model itself and their ability to enter second/third world countries using questionable tactics. Finally, one may also reasonably question why Avon’s geographic spread differs greatly from the overall market. Specifically why is a company of Avon’s size so invested in questionable geographies like Venezuela, while the North American business remains unprofitable.

Update: On December 10^th, investors in Avon Products filed a lawsuit against certain directors and officers of Avon. Early statements claim that the lawsuit could cost the company over $330 million.

Free Cash Flow Generation: The current free cash flow profile of Avon does not allow investors to get ‘paid to wait’ or ‘de-risk’ the operational turnaround. I believe that Avon is valued at approximately 18.45x 2015 EPS (of $0.94) and 9.22x EBITDA. Concurrently, Avon is set to product a levered FCF yield of 6.14% in 2015, up from the current 4.37% for 2013. This increase is primarily based on conservative WC assumptions in line with what management optimistically believes is feasible. Avon has generated over negative $400m of WC per year on average from 2008 to 2013. Going forward, I assume this decreased to under $200m per year.

Note: high end luxury retailers with significantly better growth prospects such as Revlon trades at over 10x EBITDA currently. This is about a turn higher than Avon right now. I believe that this multiple difference is completely justified by the case presented and if anything should increase.

Turnaround stories often lead to large market dislocations and provide opportunities for investors to profit. My experience has told me that the best turnaround stories (most recently HPQ and BBY) are often accompanied by extremely high FCF yields that allow investors to get paid to wait. Avon’s multiples are currently still that of a high end cosmetics/beauty company and its FCF generation is extremely poor. This is not a turnaround I would feel confident about. I believe this provides a margin of safety (on the short end) in that Avon is still extremely overvalued.

History of Poor Capital Allocation – Case Study of Silpada Designs

Though related to earlier management, a study on Avon’s background with Silpada (a direct seller of high-end sterling silver jewelry) still warrants discussion. In 2010, to diversify its product offering, Avon purchased Silpada from the company’s founders for $650 million. In 2011 and 2012, Avon wrote down the value of the intangible asset by $263 and $209 million, respectively. AVP announced on February 12, 2013 that it was exploring “strategic alternatives” and over the summer announced a sale to Rhinestone Holdings, Inc. for $85 million. This lends further credence that in order to inorganically grow Avon, they may instead accelerate value destruction by overpaying for non-core assets.

Rhinestone Holding is a newly formed entity owned by Silpada’s founders.

Competitive Advantages / Disadvantages:

Advantages: 1) Avon still has an iconic brand with high levels of awareness. The companies storied past should be able to buy management some time while it tries to restructure its core operations. 2) With a network of over 6 million active representatives, Avon implicitly has over 6 million ‘free’ marketing personnel who are highly incentive to bolster Avon’s image. 3) The direct selling platform is highly accretive to sales in second/third world countries.

Disadvantages: 1) Ability for retail sellers to build out infrastructure in developing markets and put pressure on direct selling platform. 2) Loss of enthusiasm in active representatives. This could disenchant Avon’s core selling channel and turn a competitive advantage into a competitive disadvantage. 3) Lasting corruption investigation forces Avon to constantly bleed $100 in cash per year and cause upper level management to focus on a non-core problem.

Currency Risk

With the revenue mix bias towards the Latin American region, Avon is constantly under pressure from FX fluctuations. It is estimated that a 5% change in the USD versus Avon’s revenue mix would impact 2014 EPS by 7%.

Valuation

Decaying businesses are always difficult to model. Individuals who shorted HPQ or BBY 2 years ago couldn’t have possibly said that there price target was 3x or 4x NTM EPS but they would have actually been right. Nonetheless, I would admit the best way to value this is to ask what FCF yield one would warrant for holding Avon equity.

In that spirit, I believe Avon deserves at least a 9% yield for its 2015E FCF of $463m. This implies an equity value of $5,148m and $11.85 per share.

Conclusion

If the new management team is able to turnaround the underlying performance of the company, mitigate the FCPA issue, and continue to harvest profits from Latin America, Avon is currently fairly valued. Nonetheless, I find that these events happening unlikely and short sellers can receive downside exposure with limited loss. Furthermore, management targets for 2016 are extremely aggressive (they even admit so) and I believe there is a material difference between their targets and reality.

A Personal Aside

In a market some admit fully valued, Avon is a perfect way to hedge a market pull back without taking on the risk of some of the ‘go-go’ tech stocks in the market. I’d always short a bad business model at an expensive price than a solid business model at a ludicrous price.