Description

Introduction

Avon Products (AVP) is an over-levered company facing both structural and cyclical headwinds with limited access to capital and potential impending liquidity issues. Our base case at 7x 2016 EBITDA, pro forma for additional cost cuts, is $1.00, down >70% from the current share price. We see downside to option value, or >90% from here, if FX or the macro continues to deteriorate. Earnings and EBITDA are imploding and the recent deal with Cerberus reinforces our view that the company is in distress and desperate with limited options to fix its issues and stabilize the business. After accounting for the US business transfer to Cerberus and preferred dividends, we calculate Cerberus paid 85c per share for its 16.6% as converted common equity stake in AVP vs. a current market price of $3.66, down 75% from here.

Summary Thesis

-          Avon’s business model, direct-selling cosmetics in emerging markets, faces structural headwinds from the build-out of retail infrastructure and online shopping networks in emerging markets, such as Brazil and Russia

-          Avon has under-invested for decades and requires significant investments to attempt to stabilize the top-line, well in excess of current liquidity and potential additional financing sources

-          Avon’s structural carry trade is unwinding, with 100% of revenues from outside the US (pro forma for Cerberus deal), primarily in emerging markets, and 1/3 of SG&A in USD and all debt in USD

-          Avon’s financials are overstated by Argentina, which contributed 29% of Q3 Adjusted EBIT and benefited Q3 local currency “growth” by 3%, which is now unwinding with Argentina recently de-pegging the peso and removing FX controls

-          The activist plan, to cut costs aggressively to boost margins, is not feasible as Avon lacks the capital to lay off workers and modernize its infrastructure, systems and processes and Avon has already cut low hanging fruit

-          The Cerberus deal demonstrates Avon’s lack of access to capital, as they had to give away 80% of the US business while still diluting current shareholders and are forced to use most of that capital to pay down low cost debt

-          We see significant risk to Avon being able to refinance $250mm of debt maturing in 2018 (pro forma for Cerberus deal), $350mm in 2019, and $500mm in 2020

-          Avon will likely breach covenants on its revolver this year, despite refinancing the facility 6 months ago with substantially looser covenants

-          With over 6 turns of debt leverage on our 2016 EBITDA forecast and limited liquidity / access to fresh capital, we do not think there is much if any value leftover for common shareholders and the stock should trade at option value

Overview

Avon manufactures and markets cosmetics and fashion / home products through its global network of independent sales representatives. Avon’s largest and most important markets are Brazil, Mexico, Russia, Argentina, South Africa, the Philippines and Turkey. Despite only generating 15% of sales in North America, nearly half of SG&A is in North America. Most of this overhead is allocated to the segments based on % of revenues. The strong USD over the last 18 months, along with Avon-specific and secular issues with direct-selling, has cut EBITDA in half from 2013 to 2015, leading to leverage and potential liquidity issues and pressuring them into a deal with Cerberus, a lender of last resort.

Valuation

Our base case valuation utilizes 7x EV / EBITDA, a 1x discount to peers Tupperware, Natura and Oriflame at 8x 2016 EV / EBITDA, given Avon’s higher leverage, limited liquidity, and deteriorating fundamentals. We model $100mm - $200mm of cost cuts in our analysis, which represents 3% - 6% of total SG&A (roughly half of which is fixed). Given the significant cost cuts over the past 3 years as well as the divestiture of the US business to Cerberus, we don’t see where significant cost cuts will come from. And given Avon’s liquidity position (more on this below), Avon has limited flexibility to implement wholesale changes to its operating model.

Our valuation analysis assumes current spot rates hold for the rest of 2016. However, the currency market is not expecting FX pressure to subside. The BRL, RUB, MXN, ZAR and ARS forward curves imply significant future devaluation vs. the USD over the next 12 months. Using 12 month forward deliverable rates would result in an incremental 5% headwind to revenues and $75mm hit to our base case EBITDA, half of which would impact 2016 and half in 2017. At a 7x multiple, this wipes out the remaining equity value in our base case.

Capital Structure

We only count $200mm of Avon’s reported Cash and Equivalents as liquid cash, per management guidance. On the Q3-15 call, the CFO Jim Scully stated (per Bloomberg transcript): “And when we look at the capital structure, we ended the quarter with $587 million in cash on the balance sheet. And I would view approximately $200 million of this to be cash for a liquidity cushion.” The rest of the cash is working capital required to run the business as well as cash trapped overseas in certain emerging markets where repatriation is difficult.

Avon has no secured debt outside of its revolving credit facility, which they refinanced in June 2015 and currently have no borrowings on. The revolver’s governing covenant is based on Gross Leverage and steps down dramatically through 2016. Based on our analysis, they will breach the covenants and therefore lose access to the revolver sometime over the next few quarters. This would leave Avon with a little over $200mm of liquidity, with significant debt maturities in 2017, 2018 and 2019. Given the significant macro uncertainty, this liquidity cushion seems very thin and prevents Avon management from investing in the business to try and stabilize the top-line.

Fundamentals

Avon’s deteriorating fundamentals are, ironically, masked by the significant FX pressures it has experienced. In markets like Russia, Brazil and Argentina, which are experiencing high rates of inflation, Avon is raising prices, although generally not even close to enough to offset the FX decline vs. USD. YTD through Q3-15, Avon reported local currency sales as flat. However, units were -4% and price / mix was +4%. Hyper-inflation in Argentina alone added 1.5% by our calculations, with the rest driven by price increases, mostly in Brazil and Russia. Units are much more telling and indicative of the long term health of the brand, in our view.

This misconception distorts investor views of the fundamentals and the ability of Avon to stabilize sales once FX pressure subsides. For example, in 2017, which has no FX impact as the sell-side analysts model using spot rates, consensus calls for 3% revenue growth. We have no idea how this is achievable given continued rep declines and units -4% YTD, -5% in 2014, and -5% in 2013, unless there are significant investments in systems, recruiting, marketing, and product innovation.

Avon management has not been forthright about these and other issues, claiming time and again that they are “making progress” and downplaying fundamental issues and relying on accounting gimmicks. For example, when out of period VAT credits in Brazil were significantly boosting EBIT and margins in 2014, Avon did not back this out of their adjusted non-GAAP metrics or adequately explain the magnitude and tenure of these credits. Now that this is hurting year over year comparisons in 2015, they are providing disclosure breaking out the impact. In addition, on the Q3-15 earnings call for the first time Avon discussed “ending rep count” as an important measure, saying it had improved, but providing no disclosure or reasoning behind this change. Avon has historically used active rep count, which measures the number of reps who placed an order during the quarter, instead of the number who could theoretically place an order at the end of a given quarter.

Argentina, until late December, pegged the ARS to the USD. There was a significant disconnect between the official rate (around 9 pesos per USD) and the black market rate (15 pesos per USD). Similar to the situation in Venezuela a few years ago, Avon has been translating results at the official rate while raising prices aggressively in line with local inflation, which was reflected in the significant devaluation of the black market rate. In addition, many cost inputs were fixed (such as energy prices) leading to huge margins well above corporate average. These large price increases boosted “local currency growth” by 1.5% YTD. Argentina represented 29% of Q3 Adjusted EBIT and 17% of Adjusted EBIT in Q3-15 YTD. On December 17, the newly elected government in Argentina allowed the ARS to float freely and it has devalued to 13.6 pesos per USD. We estimate this is a $47mm negative impact to Adjusted EBIT for Avon on a full year basis, and have built this into our base case.

Cerberus Deal

Avon announced on 12/17/15 a deal with Cerberus with two parts. Under the terms of the agreement, Cerberus will invest $435mm in convertible perpetual preferred stock with a conversion price of $5.00 with a 5% annual dividend, payable in cash or shares under certain circumstances. On a fully converted basis, this represents 16.6% of common shares outstanding. In conjunction with the equity investment, Cerberus is contributing $170mm to a newly formed, privately owned company in return for an 80% ownership stake in NewCo. Avon will own the remaining 20% of NewCo and is contributing its North America business, $100mm of cash and $230mm of liabilities, primarily the US pension, as well as tax assets. Cerberus will receive 3 Avon board seats, including the Chairman, and name 2 additional directors in conjunction with Avon, for a total of 5 of the 11 total remaining seats (roughly half the current board resigned).  Avon also announced suspension of its dividend. Cerberus will control the board of NewCo.

We believe this deal is evidence of Avon’s dire situation. Avon will not receive the $170mm of cash Cerberus paid for control of the North America business – instead that is an equity investment in NewCo. This is not well understood by investors and almost all of the sell-side notes on the deal got this wrong. After contributing $100mm of cash into NewCo, Avon will net $335mm of cash proceeds pre fees. They stated they would use $250mm to pay down near-term debt, leaving $85mm for reinvestment in the business and restructuring cash expenses. We believe this is a fraction of the capital that Avon requires to have any hope of turning its business around.

From Cerberus’ perspective, they invested a total of $605mm for a preferred stake in Avon and majority ownership of Avon North America (NewCo). NewCo will be capitalized with $270mm of cash and will generate ~$50mm of EBITDA in 2015 on a pro forma basis. Avon reports segment Adjusted EBIT by region, however, this reporting embeds allocated corporate overhead, which we estimate at ~$50mm. Avon disclosed $22mm of Adjusted EBIT LTM pro forma vs. -$14mm reported, which excludes allocated expenses (which will be stranded at Avon) but layers on some transition services arrangements expenses. Cap ex was less than $5mm in 2014 in North America and Avon is also contributing deferred tax assets, given large US tax losses we believe these tax assets could have significant value. Therefore, Cerberus now owns 80% of a business generating ~$45mm of FCF pro forma, capitalized with $270mm of cash. If they can cut $20mm of costs (middle management, essentially) and assuming 5x FCF = $600mm of enterprise value, which they own 80% of, or $482mm. They will collect $22mm of dividends annually from AVP, assuming a few years of dividends discounted back is roughly $50mm. This leaves an implied value of roughly $75mm for their 87mm shares after conversion, or 85c per share.

Similar to other Cerberus situations, they took control of a valuable asset at a steep discount and put much less capital at risk than it would appear. They protected their downside by taking the US business basically for free and took a flyer on some sort of turnaround working at the parent. We believe this deal demonstrates that Avon desperately needed capital and this was their only option.

Activist Plan

An investor group led by Barington Capital, collectively owning 3% of shares outstanding, sent a letter to Avon on 12/3/15 calling for new senior leadership, a large restructuring program and arguing against the sale of the North America business / a stake to private equity, which had been reported as in the works by the WSJ a few days prior. Barington proposed annual cost savings of $500mm-$700mm which could result in 90c of EPS and a $14.40 share price by their calculations, assuming 2015 revenues remain flat, which ignores the significant FX deterioration.

We think the Barington plan does not make any sense. While we concur with Barington that the management team and the Board have done a terrible job managing the company for many years, we disagree with Avon’s ability to cut anywhere close to that magnitude of expenses no matter who is in charge. The fact that they don’t think that Avon needed capital / should have cut its dividend calls into question their understanding of the business and capital structure. Their plan leaves out one critical piece – even assuming these cost savings opportunities exist without impacting revenues (we are highly skeptical), Avon does not have the capital required to implement them.

In addition, a significant portion of these cost savings opportunities are in the US, which is now only 20% owned by Avon. By our calculations, in 2014 Avon was able to cut $230mm of costs, or roughly 4.4% of prior year SG&A, and $92mm in 2015, representing 2.0% of prior year SG&A. Pro forma for giving away the US business to Cerberus, SG&A is roughly $3.4bn for 2015. Even assuming they can cut 4.4% of this expense base, that is only $150mm, which we give Avon credit for in our base case.

Even more of an issue is Avon has had roughly dollar for dollar one-time restructuring charges to achieve cost savings over the last several years. In addition, the employees fired by Avon need to be replaced with modern IT, systems and processes – which also would require significant capital to implement. We agree with Barington that Avon’s systems and processes are too manual and out of date. Reps send in orders by hand via snail mail. Avon’s time to delivery is roughly 2 weeks in Brazil vs. Natura at 2 days. Employees in New York design brochures for reps in Brazil. Clearly, this doesn’t make any sense.

However, there is no easy answer and Avon has underinvested for decades. Avon tried to implement a SAP system in Canada in 2013 and eventually abandoned the project, citing poor returns on investment and disruption for the reps, which led to higher attrition. Total cost of the project was $125mm. From 2011-2015, Natura (Avon’s largest direct selling competitor in Brazil) spent $200mm more in cap ex cumulatively than Avon despite maintaining 25% of the sales base of Avon and having the vast majority of its operations only in Brazil. Natura now has an integrated online social media / ordering platform for reps (Rede Natura) fully functional, and is rolling out retail locations in Brazil.

We estimate that it would take more than $1bn to try and fix / turn around Avon’s business globally. Avon does not have any way of raising this capital or they would not have done this deal with Cerberus. In order to raise dilutive capital from Cerberus, they had to give back $100mm and 80% of their North America business, which generates significant positive FCF. Avon needs additional cost cuts just to fill the holes created by the North America divestment, Argentina devaluation, and continued FX impact on revenues given the cost mismatches.

Conclusion

Avon has an analyst day scheduled for January 21. Similar to past CAGNY presentations, we don’t think the company will have a credible plan to present. We think that a real turnaround plan will require capital that the company does not have access to and given its liquidity situation cannot make the investments required to stabilize the business. We think it is too late for Cerberus or activist investors to right the ship here and see little, if any value in the equity at this point.

Catalyst

-          Continued deterioration in fundamentals

-          Further devaluation of EM currencies vs. the USD

-          Additional disclosure on the impact of Argentina devaluation

-          Breach of covenants on the revolver