By Joseph Hogue, CFA
Avon (AVP) recently released its third quarter results on October 27th. Earnings per share of $0.38 missed the consensus estimate of $0.46 per share. The company withdrew its yearly guidance and said it was reviewing its operations. Though management is seen as fairly weak and restructuring efforts are not moving quickly, the real impetus to the day’s 18% stock decline was the announcement that the Securities & Exchange Commission (SEC) was investigating the company under the Foreign Corrupt Practices Act (FCPA) and for its communications with analysts.
Even if the recent price action does not attract a buyer, as suggested in a recent Bloomberg article, strong fundamentals and an impressive share in emerging markets should help the company meet revenue targets. The most constructive support for the shares lies in a study of settlements to the FCPA and possible outcomes for the company.
The company has approximately 430.8 million shares outstanding with a market capitalization of $7.98 billion. After the mayhem on October 27th, Avon trades for a price to earnings ratio of 10.0 times its annualized average earnings per share of $1.84 over the last eight quarters. Despite weak management and problems relating to the SEC investigation, analysts surveyed by E*Trade have a consensus estimate for earnings of $1.80 per share over the next four quarters.
The company’s current ratio, a key measure of solvency, is 1.44 times. This, combined with $988 million in cash on its balance sheet, means that the company should be able to meet any short-term liabilities including settlement decisions. The stock pays a very strong dividend yield of 5.0%, or $0.92 per share. Investors should not make their decision based solely on the dividend yield as the current payout represents a cash outflow of $398 million per year and may need to be reduced in the event of a large settlement.
Strong Growth in Emerging Markets
As expected, GDP growth rates are decreasing for Europe and the United States, while emerging markets continue to see strong economic growth and a rising middle class. According to World Bank data, growth in household consumption expenditures over the last five years to 2009 has averaged 7.7% in the BRICs compared to only 1.3% across the OECD members.
Despite a high level of market penetration within emerging markets, Avon continues to experience an increase in the number of representatives averaging 4% in 2010, including 8% in Latin America. The company currently employs about 6.5 million independent representatives globally. High rates of unemployment and a lower workforce participation rate by women provides a large supply of labor in emerging markets. Sales for the company are geographically diversified within North America (21%); Latin America (42%); Western Europe, Middle East, and Africa (13%); Central and Eastern Europe (15%), Asia/Pacific (7%), and China (2%).
Industry sales have rebounded quickly from the recession, and both Estee Lauder (EL) and Elizabeth Arden (RDEN) have topped estimates with recent quarterly reports. The Personal Products industry trades for an average of 15.0 times trailing earnings per share. Revlon (REV) trades for 12.1 times its annualized average earnings per share over the last eight quarters while Estee Lauder trades for more than 33.6 times earnings.
Foreign Corrupt Practices Act
The Foreign Corrupt Practices Act of 1977 is a federal law primarily used to prosecute accounting transparency requirements under the SEC and bribery of foreign officials. Any U.S. or foreign corporation that has registered securities with the SEC can be prosecuted under the act. The Department of Justice (DOJ) boasts that 32 cases were prosecuted in 2010.
Though it is hard to estimate the final price effect on the stock from a settlement with the SEC and the Department of Justice, previous precedents can help put a range on possible settlement expenses. The online blog of the FCPA lists the top ten settlements under the act and details for each. These range from $800 million for Siemens (SI) in 2008 to $48.1 million for Royal Dutch Shell (RDS) in 2010. Most of these settlements include a large criminal fine along with a civil disgorgement of profits.
A more appropriate precedent may be available through the BAE Systems/Armor Holdings (BAESY.PK) settlement this year. The company was accused under both the anti-bribery and accounting provisions of the Foreign Corrupt Practices Act for setting up a sham consulting agreement with a third party to bribe a U.N. official. The company cooperated with DOJ and SEC investigators and was able to reach a non-prosecution agreement for $5.7 million. This amount pales in comparison to some of the larger settlements, especially those including criminal fines, but reflects the level of cooperation involved in the case.
In light of this, Avon’s cooperation with the government’s investigation is particularly important. The company started an investigation into its Chinese operation’s compliance with the FCPA in 2008 and shortly thereafter voluntarily contacted the SEC and DOJ. Since that time, Avon has fully cooperated with the two bodies in the investigation. Note 5 of Avon’s most recent Consolidated Financial Statements (10-Q) describes the extent of the investigation with:
Compliance reviews are focused on reviewing certain expenses and books and records processes, including, but not limited to, travel, entertainment, gifts, use of third party vendors and consultants and related due diligence, joint ventures and acquisitions, and payments to third-party agents and others, in connection with our business dealings, directly or indirectly, with foreign governments and their employees.
This use of third party consultants in connection with foreign governments is similar to the investigation into Armor Holdings.
Trading in the shares had hovered around $30 for the two years prior to July 2011 but have since fallen 41.4% from their 52-week high. The stock plunged 18% on October 27th as the news was released of the SEC investigation. This loss from $23.01 to $18.52 wiped out nearly $1.9 billion of equity value in the shares. Given prior precedents, this loss of value seems grossly overstated. While a dollar estimate on a possible settlement is difficult, even the highest settlement to date ($800 million) would mean the shares are oversold by approximately $2.55 per share. The actual settlement will almost certainly be much less due to the company’s cooperation with officials.
A return to the sector P/E average of around 15 times and forward earnings for the company of $1.80 would put the shares at $27.00 over the next year. This would still be significantly under the 52-week high of $30.33 on May 3rd. Standard & Poor’s has a twelve-month target of $21 on the stock. Barring some form of a buyout or acquisition, a more conservative estimate that puts the price-earnings ratio close to competitor Revlon would put the twelve-month target around $21.60 per share, a 16.8% increase over Friday’s close.