Avon's 40% Upside Invites Activism, Estee Lauder Shines

Includes: AVP, EL
by: Takeover Analyst

Slightly more than a month ago, I argued here that an activist ought to shake up management at Avon Product (NYSE:AVP). The company has consistently underperformed the competition due more to missteps than anything else. Bribery charges, poor execution, and a major miss in the third quarter all provide perfect fodder for an activist investor. One of the corporate governance reforms that I proposed was splitting the role of Chairman and CEO. The company recently announced that it will do just that: Andrea Jung will become just the Chairman while an external review will find a new CEO.

At the third-quarter earnings call, Andrea Jung noted dismal performance:

"When I look at the lion's share of the top-line mix, it was in Latin America, and that mix was driven by Brazil. Latin America growth fell below double digits for the first time in over 10 quarters. Latin America growth in constant dollars was 6% in this third quarter, and that was driven by an unanticipated sales decline in Brazil of negative 3% in constant dollars.

In Brazil, the ERP implementation created greater than anticipated service disruption. Despite extensive pre-implementation testing, we had greater than anticipated implementation challenges in the go-live. Significantly higher business complexity in this market contributed to a greater than expected level of disruption, as I said, when we went to the go-live environment. Brazil, as a reminder, has 2x to 3x more volume in SKUs than the other ERP markets where we've implemented. The market has 2x more interfaces and legacy systems".

Third quarter EPS of $0.38 was well below the $0.46 consensus due largely to the supply chain fiasco. The new CEO may offer some hope, but there is no quick fix to working capital issues, negative FX effects, and floundering fundamentals in cosmetics and fragrances. One analyst even suggested that the new CEO could cut the dividend yield, which would only further incentivize an activist's entrance. Avon's multiple is at the absolute low-end of peers and a shareholder representative would, in my view, best catalyze value.

Consensus estimates for Avon's EPS are that it will be relatively flat over the next three years. Assuming a multiple of 13x and a conservative 2012 EPS of $1.73, the rough intrinsic value of the stock is $22.49, implying 36.6% upside. Whether or not this potential will be unlocked, however remains to be seen.

All of this activist speculation falls into context when you consider the success of Estee Lauder (NYSE:EL), which is off to a strong start for the fiscal year. First-quarter EPS of $1.41 was well above the consensus of $1.18, SG&A spending declined, and gross margins expanded by 170 bps. Revenue also grew in the double digits and management guided for 6% higher 2012 EPS than it did previously. The $4.25 - $4.45 guidance is ultimately too low, but will help limit the downside.

Estee Lauder has also excelled in the marketplace. Its Coach Poppy Flower was the #1 new fragrance for the holidays and DKNY Golden Delicious and Estee Lauder Sensuous Nude have been welcomed with rave reviews. I believe that the fragrance segment is in the process of a successful turnaround story that has yet to be fully appreciated by the market.

Consensus estimates for Estee Lauder's EPS are that it will grow by 22.8% to $4.53 in 2012 and then by 13.9% and 17.1% more in the following two years. Assuming a multiple of 23.5x and a conservative 2012 EPS of $5.11, the rough intrinsic value of the stock is $120.09, implying 11.7% upside. If the multiple were to decline to 20x and 2012 EPS turns out to be 5.4% below the consensus, the stock would fall by 9.2%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.