|Shares Out. (in M):||434||P/E||0.0x||0.0x|
|Market Cap (in M):||7,296||P/FCF||0.0x||0.0x|
|Net Debt (in M):||1,976||EBIT||0||0|
Recommendation: Short Avon Products Common Stock (AVP)
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.
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.
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.
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.
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 12th 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 10th, 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.
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%.
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.
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.
|Subject||RE: RE: Our thoughts post Q1-14|
|Entry||06/24/2014 08:25 AM|
Coty does not scare us. When coty made their initial bid, they were willing to pay 10.5x ebitda for avp with LTM ebitda of 1,240. We think current year ebitda should be around 800mm. Assuming a bid at the same multiple, avp would be worth 14.65ish. Furthermore, coty has its own issues and recently had to fully write down its chinese acquisition (T Joy - they paid 400mm for this in 2010). Coty was interested in avon to enter the brazilian market. They now have brazilian access through the recently announced collaboration. No need to buy the rest of the AVP junk and pay a control premium.
This is a stucturally problemed business, not just bad management. Avon is not in the fast growing emerging markets (China and India) and is getting disintermediated as infrastructure is being built out in brazil, Europe (western and central) and the USA.
|Entry||01/22/2015 01:10 PM|
Avon Has Been in Talks With TPG on Possible Deal:
[AVP US 8.385, +0.82 10.91%]
Avon has been having talks with TPG about a potential transaction, dealReporter said, citing 3 industry sources.
• AVP wasn’t immediately available to comment to dR; TPG declined comment
• AVP up as much as 12%, most intraday since Feb. 2013
|Entry||01/22/2015 07:11 PM|
This rumor might very well be true, as TPG purchased Avon Japan for $90mm in 2010 and I am sure still has licensing / manufacturing agreements with AVP. They probably want to make sure the company will still exist in a few years. They might also be trying to pick off a one-off country at a distressed price to add to its Japan business. Or perhaps this rumor is simply false, which tends to be the case with Dealreporter articles.
The market clearly interpreted this as a credible rumor of TPG in talks to LBO Avon given the share price reaction. We think this is highly unlikely, for a number of reasons (leaving aside the only sources were "industry experts" and the article did not give any details on what the talks were about or if they are ongoing):
1. TPG does not have the capital. Even with aggressive leverage (quoted 6.0x-6.25x in Dealreporter), the deal would still require at least $2bn of equity. TPG's 2008 fund is done, they raised a $2bn bridge fund in the interim, and are currently marketing a new $10bn fund (which could potentially close on $4bn or $5bn sometime soon, including the bridge). Given its last 2 funds have been disasters, they are telling LP's that they will get back to their "sweet spot", which is $250mm - $650mm equity checks in North American businesses. Betting $2bn on Avon given their 10 year track record and marketing pitch would be absolutely insane. They cannot LBO Avon except with a large club, which seems very unlikely. See this Reuters article for reference: http://www.reuters.com/article/2014/01/30/us-tpg-bridgefund-idUSBREA0T01L20140130
2. The math does not work. Before today's news, AVP's bonds were trading with a greater than 9% yield, with current trailing leverage ~2.5x. Levering this to 6x would require double digit interest rates. At 12%, $4bn of debt would be $480mm of annual interest expense. Even if you believe consensus EPS of 80c for 2015 (which we do not), that's $850mm of EBITDA. Cap ex is at least $150mm for maintenance, and there will be cash taxes despite the high interest expense given the geographic mismatches (all earnings outside US and cash needs to be repatriated to the US to pay debt, cap ex, and overhead expenses). We heard from the sellside / some articles today that Avon can't fix its problems as a public company - that is probably true, but they certainly can't fix any problems with $4bn+ of debt and less than 2x interest coverage either.
3. Even if you get the financing done, and even if EBITDA can bounce back above $1bn (which would require significant additional investment, which would have to be funded with equity given the high interest load, and get help from macro and FX), it is still nearly impossible to get to private equity returns in a best case scenario.
4. All of the secular / macro / company specific issues we have discussed here. We think earnings are closer to 0c than 80c consensus. In Russia, they are raising prices 10% despite the ruble depreciating 50%. The Euro has imploded. Brazil consumer confidence has gone off a cliff. 2014 earnings is massively inflated by one-time items. We could go on. Anyone who gets under the hood here is going to run as fast as they can.
5. Avon's board / largest shareholders likely won't accept a bid near the current price. That's irrational, but company boards do not sell companies at $10 or $12 when the stock was at $14 a few months ago and in the $20's 18 months ago. And paying a higher price, such as $14, just exacerbates the problems discussed above on debt load / returns.
We would also encourage those interested to read some of the sellside notes on Natura this week - Brazil is changing its tax code to close a loophole used by Avon and Natura to avoid VAT taxes. Brazil has brought 2 enforcement actions against Avon in the past decade around this issue and lost both - now they are closing the loophole. This could be very, very significant (some sell side estimates at 24% of Natura's consolidated EBITDA). Not only do the VAT tax refunds that boosted this year's EPS definitely not repeat, but this will also negatively impact Avon's revenues and EBITDA from higher VAT (100% flow through)...this could potentially be more than $100mm of EBITDA for ongoing higher VAT expense and the ~$70mm of out of period VAT benefits in 2014 will not be repeated going forward.
|Entry||03/18/2015 09:42 AM|
Great call on this one. Curious why you think it's time to take profits now?
|Subject||Re: Why exit?|
|Entry||04/27/2015 09:01 PM|
Sorry for the delayed response. We were worried they would try to sell parts of the business. I guess they may end up doing so.