AVON PRODUCTS AVP S
January 06, 2016 - 9:31am EST by
aviclara181
2016 2017
Price: 3.66 EPS 0 0
Shares Out. (in M): 435 P/E 0 0
Market Cap (in M): 1,592 P/FCF 0 0
Net Debt (in M): 2,093 EBIT 0 0
TEV: 3,685 TEV/EBIT 0 0
Borrow Cost: Available 0-15% cost

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  • Highly Leveraged
  • Secular headwinds
  • Secular decline
  • MLM
  • Emerging Markets
  • Deteriorating Fundamentals
  • Activism
 

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

 

AVP Valuation Summary

           

$mm

               
           

2016

     

2014

2015

 

Bear

Base

Bull

Prior Year EBITDA

 

1,015

925

 

500

500

500

Gross Profit from Sales

 

(759)

(810)

 

(454)

(378)

(303)

Variable Expense

 

0

13

 

36

0

(36)

FX Impact on SG&A

 

389

505

 

221

221

221

North America Divestment

0

0

 

(50)

(50)

(50)

Argentina / VZ Devaluation

(50)

0

 

(47)

(47)

(47)

Brazil VAT

   

100

(127)

 

0

0

0

Brazil IPI Tax

 

0

(97)

 

(30)

(30)

(30)

Implied Cost Savings

 

230

92

 

100

150

200

Pro Forma EBITDA

 

925

500

 

277

366

455

                 

Multiple

         

6.0x

7.0x

8.0x

EV

         

1,660

2,563

3,644

                 

Gross Debt

         

2,314

2,314

2,314

Cash Liquidity

       

200

200

200

Net Cash from Cerberus

       

335

335

335

Net Debt

         

1,779

1,779

1,779

                 

Plus: US Business Value

       

120

120

120

Less: Cerberus Convertible Preferreds

     

435

435

435

Equity Value

       

(433)

470

1,551

Shares O/S

         

435

435

435

Share Price

 

 

 

 

($0.99)

$1.08

$3.57

                 

Gross Leverage

       

8.4x

6.3x

5.1x

Gross Leverage (incl Convertible Prefs)

   

9.9x

7.5x

6.0x

Net Leverage

       

6.4x

4.9x

3.9x

Net Leverage (incl Convertible Prefs)

     

8.0x

6.0x

4.9x

                 

Drivers

               

FX % Revenue Impact (Current Spot)

(11.5%)

(18.5%)

 

(10.0%)

(10.0%)

(10.0%)

Local Currency Growth %

0.0%

(0.5%)

 

(2.0%)

0.0%

2.0%

Total Revenues

 

(1,148)

(1,682)

 

(738)

(615)

(492)

                 

Prior Period Sales

 

9,983

8,851

 

6,152

6,152

6,152

                 

Gross Profit Margin %

 

61.8%

61.5%

 

61.5%

61.5%

61.5%

                 

Variable Expense as % of Sales

29.5%

29.5%

 

29.5%

29.5%

29.5%

                 

Prior Year Total SG&A

 

5,211

4,547

 

3,400

3,400

3,400

% in USD

   

35.0%

40.0%

 

35.0%

35.0%

35.0%

                 

Implied Cost Savings as % of SG&A

4.4%

2.0%

 

2.9%

4.4%

5.9%

                 

Earnings Build

             
           

2016

     

2014

2015

 

Bear

Base

Bull

EBITDA

   

925

500

 

277

366

455

D&A

   

193

150

 

130

130

130

EBIT

   

732

350

 

147

236

325

                 

Net Interest Expense

 

96

108

 

95

95

95

Other Expense

 

86

60

 

50

50

50

PBT

   

550

183

 

2

91

180

                 

Taxes

   

220

138

 

24

47

69

Tax Rate %

   

40.0%

75.3%

 

1386.7%

51.1%

38.2%

                 

NCI

   

(4)

(4)

 

(4)

(4)

(4)

Net Income

   

326

41

 

(26)

41

108

                 

Diluted EPS

   

$0.75

$0.09

 

($0.06)

$0.08

$0.21

Diluted Shares O/S

 

435

435

 

435

522

522

 

 

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

 

AVP Liquidity Analysis

           

$mm

             
               

Debt Schedule

           
     

$ Face

Maturity

Rate

Interest

 

Unsecured Tranche A

 

250

Mar-18

5.75%

14

 

Unsecured Tranche B

 

250

Jul-18

4.20%

11

 

Unsecured Tranche C

 

350

Mar-19

6.50%

23

 

Unsecured Tranche D

 

500

Mar-20

4.60%

23

 

Unsecured Tranche E

 

500

Mar-23

5.00%

25

 

Unsecured Tranche F

 

250

Mar-43

6.95%

17

 

Other Debt

   

214

Various

5.00%

11

 

Revolver

   

0

Jun-20

L + 250

0

 

Total

   

2,314

   

124

 
               

Q3-15 Cash and Equivalents

587

       

Liquid Cash per Avon CFO

200

       

Cash for Working Capital

 

387

       
               

Cerberus Investment

 

435

       

Capital Infusion into North America

(100)

       

Net Cerberus Proceeds

 

335

       
               

Debt Paydown

 

(250)

       

Pro Forma Liquidity

 

285

       
               

Pro Forma Gross Debt

 

2,064

       
               
     

Q4-15

Q1-16

Q2-16

Q3-16

Q4-16

Revolver Covenant

 

5.95x

5.40x

5.00x

4.75x

4.25x

LTM EBITDA Required

 

347

382

413

434

486

               

Projected LTM EBITDA

 

500

     

366

Gross Leverage

 

4.13x

     

5.64x

               

Cash Flow Bridge

           

EBITDA

           

366

Net Interest

           

(95)

Taxes

           

(47)

Cap Ex

           

(100)

Working Capital

         

0

One-Time Expenses

         

(150)

Dividends

           

(22)

Cash Flow

           

(47)

               

Liquidity

           

238

 

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.

 

AVP Argentina Analysis

     

$mm

         
     

Q3-14

Q3-15

 

YTD

         

Total Revenues

 

6,510

5,285

 

Argentina as % of Total

 

4.0%

6.0%

 

Argentina Revenues

 

260

317

 
           

Total Adj EBIT

 

517

264

 

Argentina as % of Total

 

6.0%

17.0%

 

Argentina Adj EBIT

 

31

45

 
           

Total EBIT Margin %

 

7.9%

5.0%

 

Agentina EBIT Margin %

 

11.9%

14.2%

 
           

ARS Official Rate

 

8.0

9.0

 

Local Currency

 

2,079

2,842

 

LC Growth %

   

36.7%

 
           

Reported Local Currency

   

0.0%

 

Arg Benefit

     

1.5%

 

Ex. Arg

     

(1.5%)

 
           
     

2015

2015 PF

Change

Argentina Sales

 

435

294

(141)

EBIT

   

65

18

(47)

EBIT Margin %

 

14.9%

6.3%

 
           

Gross Margin %

 

66.0%

61.0%

 

Gross Profit

   

287

180

(108)

           

SG&A

   

222

161

(61)

           

Arg Peso

   

9.2

13.6

(32.4%)

 

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.

 

US Analysis

     

$mm

       
     

Q3-15 LTM

2015

Revenues

   

1,058

1,003

Reported Adj EBIT

 

(14)

(5)

         

Pro Forma Adj EBIT

 

22

31

Gap

   

36

36

         

D&A

   

20

20

EBITDA

   

42

51

         

Taxes

     

0

Cap Ex

     

(5)

Interest

     

0

FCF

     

46

         

Cost Cuts

     

20

Adjusted FCF

   

66

         

Cerberus Value

     

US FCF

     

66

Multiple of FCF

   

5.0x

US EV

     

332

US Net Cash

   

270

US Equity Value

   

602

Cerberus Portion

   

482

         

Cerberus Preferred Investment

 

435

Cerberus NA Investment

   

170

Total

     

605

         

Preferred Coupon

   

22

NPV

     

50

         

Implied Value of Common

   

73

Cerberus Shares

   

87

Implied Value per Share

   

$0.85

 

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.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

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

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    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

     

    AVP Valuation Summary

               

    $mm

                   
               

    2016

         

    2014

    2015

     

    Bear

    Base

    Bull

    Prior Year EBITDA

     

    1,015

    925

     

    500

    500

    500

    Gross Profit from Sales

     

    (759)

    (810)

     

    (454)

    (378)

    (303)

    Variable Expense

     

    0

    13

     

    36

    0

    (36)

    FX Impact on SG&A

     

    389

    505

     

    221

    221

    221

    North America Divestment

    0

    0

     

    (50)

    (50)

    (50)

    Argentina / VZ Devaluation

    (50)

    0

     

    (47)

    (47)

    (47)

    Brazil VAT

       

    100

    (127)

     

    0

    0

    0

    Brazil IPI Tax

     

    0

    (97)

     

    (30)

    (30)

    (30)

    Implied Cost Savings

     

    230

    92

     

    100

    150

    200

    Pro Forma EBITDA

     

    925

    500

     

    277

    366

    455

                     

    Multiple

             

    6.0x

    7.0x

    8.0x

    EV

             

    1,660

    2,563

    3,644

                     

    Gross Debt

             

    2,314

    2,314

    2,314

    Cash Liquidity

           

    200

    200

    200

    Net Cash from Cerberus

           

    335

    335

    335

    Net Debt

             

    1,779

    1,779

    1,779

                     

    Plus: US Business Value

           

    120

    120

    120

    Less: Cerberus Convertible Preferreds

         

    435

    435

    435

    Equity Value

           

    (433)

    470

    1,551

    Shares O/S

             

    435

    435

    435

    Share Price

     

     

     

     

    ($0.99)

    $1.08

    $3.57

                     

    Gross Leverage

           

    8.4x

    6.3x

    5.1x

    Gross Leverage (incl Convertible Prefs)

       

    9.9x

    7.5x

    6.0x

    Net Leverage

           

    6.4x

    4.9x

    3.9x

    Net Leverage (incl Convertible Prefs)

         

    8.0x

    6.0x

    4.9x

                     

    Drivers

                   

    FX % Revenue Impact (Current Spot)

    (11.5%)

    (18.5%)

     

    (10.0%)

    (10.0%)

    (10.0%)

    Local Currency Growth %

    0.0%

    (0.5%)

     

    (2.0%)

    0.0%

    2.0%

    Total Revenues

     

    (1,148)

    (1,682)

     

    (738)

    (615)

    (492)

                     

    Prior Period Sales

     

    9,983

    8,851

     

    6,152

    6,152

    6,152

                     

    Gross Profit Margin %

     

    61.8%

    61.5%

     

    61.5%

    61.5%

    61.5%

                     

    Variable Expense as % of Sales

    29.5%

    29.5%

     

    29.5%

    29.5%

    29.5%

                     

    Prior Year Total SG&A

     

    5,211

    4,547

     

    3,400

    3,400

    3,400

    % in USD

       

    35.0%

    40.0%

     

    35.0%

    35.0%

    35.0%

                     

    Implied Cost Savings as % of SG&A

    4.4%

    2.0%

     

    2.9%

    4.4%

    5.9%

                     

    Earnings Build

                 
               

    2016

         

    2014

    2015

     

    Bear

    Base

    Bull

    EBITDA

       

    925

    500

     

    277

    366

    455

    D&A

       

    193

    150

     

    130

    130

    130

    EBIT

       

    732

    350

     

    147

    236

    325

                     

    Net Interest Expense

     

    96

    108

     

    95

    95

    95

    Other Expense

     

    86

    60

     

    50

    50

    50

    PBT

       

    550

    183

     

    2

    91

    180

                     

    Taxes

       

    220

    138

     

    24

    47

    69

    Tax Rate %

       

    40.0%

    75.3%

     

    1386.7%

    51.1%

    38.2%

                     

    NCI

       

    (4)

    (4)

     

    (4)

    (4)

    (4)

    Net Income

       

    326

    41

     

    (26)

    41

    108

                     

    Diluted EPS

       

    $0.75

    $0.09

     

    ($0.06)

    $0.08

    $0.21

    Diluted Shares O/S

     

    435

    435

     

    435

    522

    522

     

     

    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

     

    AVP Liquidity Analysis

               

    $mm

                 
                   

    Debt Schedule

               
         

    $ Face

    Maturity

    Rate

    Interest

     

    Unsecured Tranche A

     

    250

    Mar-18

    5.75%

    14

     

    Unsecured Tranche B

     

    250

    Jul-18

    4.20%

    11

     

    Unsecured Tranche C

     

    350

    Mar-19

    6.50%

    23

     

    Unsecured Tranche D

     

    500

    Mar-20

    4.60%

    23

     

    Unsecured Tranche E

     

    500

    Mar-23

    5.00%

    25

     

    Unsecured Tranche F

     

    250

    Mar-43

    6.95%

    17

     

    Other Debt

       

    214

    Various

    5.00%

    11

     

    Revolver

       

    0

    Jun-20

    L + 250

    0

     

    Total

       

    2,314

       

    124

     
                   

    Q3-15 Cash and Equivalents

    587

           

    Liquid Cash per Avon CFO

    200

           

    Cash for Working Capital

     

    387

           
                   

    Cerberus Investment

     

    435

           

    Capital Infusion into North America

    (100)

           

    Net Cerberus Proceeds

     

    335

           
                   

    Debt Paydown

     

    (250)

           

    Pro Forma Liquidity

     

    285

           
                   

    Pro Forma Gross Debt

     

    2,064

           
                   
         

    Q4-15

    Q1-16

    Q2-16

    Q3-16

    Q4-16

    Revolver Covenant

     

    5.95x

    5.40x

    5.00x

    4.75x

    4.25x

    LTM EBITDA Required

     

    347

    382

    413

    434

    486

                   

    Projected LTM EBITDA

     

    500

         

    366

    Gross Leverage

     

    4.13x

         

    5.64x

                   

    Cash Flow Bridge

               

    EBITDA

               

    366

    Net Interest

               

    (95)

    Taxes

               

    (47)

    Cap Ex

               

    (100)

    Working Capital

             

    0

    One-Time Expenses

             

    (150)

    Dividends

               

    (22)

    Cash Flow

               

    (47)

                   

    Liquidity

               

    238

     

    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.

     

    AVP Argentina Analysis

         

    $mm

             
         

    Q3-14

    Q3-15

     

    YTD

             

    Total Revenues

     

    6,510

    5,285

     

    Argentina as % of Total

     

    4.0%

    6.0%

     

    Argentina Revenues

     

    260

    317

     
               

    Total Adj EBIT

     

    517

    264

     

    Argentina as % of Total

     

    6.0%

    17.0%

     

    Argentina Adj EBIT

     

    31

    45

     
               

    Total EBIT Margin %

     

    7.9%

    5.0%

     

    Agentina EBIT Margin %

     

    11.9%

    14.2%

     
               

    ARS Official Rate

     

    8.0

    9.0

     

    Local Currency

     

    2,079

    2,842

     

    LC Growth %

       

    36.7%

     
               

    Reported Local Currency

       

    0.0%

     

    Arg Benefit

         

    1.5%

     

    Ex. Arg

         

    (1.5%)

     
               
         

    2015

    2015 PF

    Change

    Argentina Sales

     

    435

    294

    (141)

    EBIT

       

    65

    18

    (47)

    EBIT Margin %

     

    14.9%

    6.3%

     
               

    Gross Margin %

     

    66.0%

    61.0%

     

    Gross Profit

       

    287

    180

    (108)

               

    SG&A

       

    222

    161

    (61)

               

    Arg Peso

       

    9.2

    13.6

    (32.4%)

     

    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.

     

    US Analysis

         

    $mm

           
         

    Q3-15 LTM

    2015

    Revenues

       

    1,058

    1,003

    Reported Adj EBIT

     

    (14)

    (5)

             

    Pro Forma Adj EBIT

     

    22

    31

    Gap

       

    36

    36

             

    D&A

       

    20

    20

    EBITDA

       

    42

    51

             

    Taxes

         

    0

    Cap Ex

         

    (5)

    Interest

         

    0

    FCF

         

    46

             

    Cost Cuts

         

    20

    Adjusted FCF

       

    66

             

    Cerberus Value

         

    US FCF

         

    66

    Multiple of FCF

       

    5.0x

    US EV

         

    332

    US Net Cash

       

    270

    US Equity Value

       

    602

    Cerberus Portion

       

    482

             

    Cerberus Preferred Investment

     

    435

    Cerberus NA Investment

       

    170

    Total

         

    605

             

    Preferred Coupon

       

    22

    NPV

         

    50

             

    Implied Value of Common

       

    73

    Cerberus Shares

       

    87

    Implied Value per Share

       

    $0.85

     

    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.

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise do not hold a material investment in the issuer's securities.

    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

    Messages


    SubjectUnderstatement of the year
    Entry01/06/2016 10:01 AM
    Memberjgalt

    >Avon management has not been forthright about these and other issues, claiming time and again that they are “making progress” 

     

    Sheri McCoy is easily one of the most delusional CEOs I've ever seen.


    SubjectAVP cost savings announced
    Entry01/07/2016 05:31 PM
    Memberaviclara181

    Avon just announced a partnership with HPE to "lead [its] hybrid infrastructure transformation". Concurrent with that release, they announced cost savings associated with this implementation in an 8-K. They are spending $30mm in cash in the near term to achieve $10-$15mm of annualized savings starting in 2019. This is a 5 year payback. The cash expense to annualized savings is greater than 2 to 1. This is even worse than our assumptions, which are 1 for 1 cash expense to annualized savings and flow-through immediately. This reinforces our view that there are limited cost savings opportunities remaining and drastic changes are impossible given the liquidity situation / limited capital available for restructuring.

    Relevant text from 8-K below:

    On December 31, 2015, Avon Products, Inc. (the “Company”) approved actions primarily consisting of global headcount reductions relating to an information technology infrastructure outsourcing initiative. These actions are expected to be substantially completed by December 31, 2016.
    The Company expects to record total charges related to these actions of approximately $30 million before taxes. Approximately $20 million of these charges are expected to be recorded in the fourth quarter of 2015, with the majority of the remaining expected charges to be recorded by December 31, 2016.
     
    These charges are expected to be comprised primarily of employee-related costs and professional fees, and substantially all of the charges will result in future cash expenditures. After an initial period of transition, the Company expects to begin to realize savings in 2018 and expects to achieve annualized pre-tax savings of approximately $10-15 million beginning in 2019.

    http://www.sec.gov/Archives/edgar/data/8868/000000886816000088/item205it.htm 


    SubjectQ4 results
    Entry02/11/2016 09:37 AM
    MemberRSJ

    Looks like your thesis is playing out Aviclara, numbers are terrible....especially top line decline and margin pressure. Mgmt is citing US$ strength as the source of all their problems.....understand that is part of the thesis but any updated thoughts on underlying trends? worse than expected it seems given share loss. Also, any thoughts on the bonds? wondering if the 18s are a decent short...unclear as they appear to have sufficient near term liquidity.


    SubjectCerberus Implied Value Calc
    Entry08/04/2016 07:07 PM
    Memberthecafe

    Aviclara - why are you excluding the pension liabilities transferred to North America from your equity calculation? Thanks.


    SubjectUpdate
    Entry08/11/2016 08:05 PM
    Memberthecafe

    Separately, anyone following and have an updated view on the name?

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