Beauty product maker Avon Products (AVP) is starting to look, well, quite beautiful to activist investors. Over the last month, the stock has fallen 16.7% amidst a scandal over international bribery and floundering fundamentals. During the same time, competitor Estee Lauder (EL) is up by more than 19.2%. Measured also from a 3 month, 6 month, 1 year, 5 year, and 10 year period, Avon has significantly underperformed peers - often negative, while others were positive. The stock is now at an exceptionally low multiple, despite its strong brand name and diverse product offerings. Thus, the case for a value gap certainly exists, as I argue below.
From a multiples perspective, Avon is cheaper than all of its competitors. It trades at a respective 10.7x and 10x past and forward earnings. For comparison, Estee Lauder trades at a respective 29.3x and 23.2x past and forward earnings. In addition, Avon also offers a significantly high dividend yield of 5.05%. While in normal circumstances, this might preclude an activist campaign, in the instance of Avon, this is not the case. The reason why the high dividend yield does not preclude an activist campaign for Avon is because there remain significant concerns over the sustainability of the distributions. Net debt currently stands at $2.2B, or 28.5% of market value, and free cash flow generation is struggling more than some competitors with lower yields. A greater limitation to an activist campaign would be its mid-cap valuation. Although billionaire investor Ronald Perelman has taken a bit of a break from his activist days, now would, in my view, an opportune time to rattle cages and take over Avon. Not to mention Revlon (REV) could benefit from the revenue and cost synergies of a merger…
At the recent third quarter earnings call, Avon's Chairman & CEO, Andrea Jung, noted the disappointing results:
We had a challenging Brazil ERP implementation, which caused greater disruption than we had anticipated, and that was the significant impact on Avon's top and bottom-line.
We have an increased macroeconomic volatility, which further pressured our third quarter revenue results. Though it's not yet reflected in our financial results, we are making some tangible strategic progress, most notably in North America, and I'll talk about that. But given the current operating environment, we no longer expect to achieve mid-single-digit sales growth and 50 to 70 basis points of operating margin expansion in 2011. We're fully assessing our long-range business plan and targeting an operational and financial update to investors in the first quarter of 2012.
The EPS of $0.38 being far below consensus estimates of $0.46, coupled with the FCPA investigation and a significantly depressed valuation, is perfect fodder for any activist investor. But perhaps the most significant activist attractant was what was not mentioned on the call: guidance for next year or the following. Management suggests that it is more concerned with "exploring strategies" for long-term value creation - an argument that now rings disingenuous to many investors. Over the years, Avon has supposedly undertaken cost and operational restructuring to little result. Much of the reason why analysts rate the stock a "hold", despite low multiples, is explicitly because management has failed to perform. Estee Lauder, with its much higher multiples and lower dividend yield, is currently rated a "buy".
Regardless, if an activist campaign ever takes place at Avon, the firm is still an attractive value play. In my view, issues concerning fundamentals have been slightly overblown by emotions. Earnings are normalizing in Brazil below what some may have hoped and declines in China are upsetting, but I believe new product offerings can accelerate demand despite past failure. In addition, the firm stands to significantly benefit from a macro recovery with leading positions in emerging markets. The possibility that the firm is safer than what meets the eye only serves to make it a further activist target. Shareholder activists are, ultimately, more aggressive value investors that similarly care about a margin of safety, especially considering the cost of a proxy campaign.
As for value creation, I anticipate ROIC declining from around 27.6% in 2010 to around 23.8% in 2013 - much better than other analyst expectations. In addition, operating margins are forecasted to contract to around 10.7%. With slower growth in cosmetics and fragrances in Brazil and restructuring failing to add meaningful growth to North America, a case for changing corporate governance can certainly be made. In the event of an activist campaign, splitting the role of Chairman and CEO will likely be considered.
Consensus estimates for EPS are that it will decline by 0.6% to $1.79 in 2011 and then increase by 2.2% and 11.5% in the following years. Of the 16 revisions to EPS estimates, 15 have gone down. Assuming a multiple of 15x - still well below peer levels - and a conservative 2012 EPS estimate of $1.81 yields a rough intrinsic value of $27.15. That represents nearly a 50% margin of safety and one compelling reason to launch an activist campaign. It is only a matter of time until the value gap - which has lingered for several years now - is closed, but an activist's entrance would catalyze this process.