See, I told you so. About 5 months ago here, I argued that Avon Products (AVP) was both an activist and buyout target. My point was that since the company's mid-cap valuation more or less precludes an actual activist campaign, a takeover was likely to close the discount to intrinsic value. I argued further that the company would split the roles of Chairman & CEO. Not only did Avon split the roles, they also received a takeover offer.
But, wait, there is more that I was correct about. I pitched Avon's intrinsic value at $22.49 - roughly where it is trading at now. Buyout bids should be at a premium to intrinsic value, since they most account for the realization of revenue and cost synergies. In short, my thesis was confirmed by what ensued over the next five months.
In this article, I will run you through my DCF model on Avon and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to firms specialized in consumer goods. For fun, we will compare this beauty company to toy maker Mattel (MAT) and a tobacco company, Altria (MO). I find that Avon has reached its intrinsic value and that investors looking for exposure in consumer goods should now look elsewhere in the industry.
First, let's begin with an assumption about the top line. Avon finished FY2011 with $11.3B in revenue, which represented a 4% gain off of the preceding. I model revenue trending from 10% to 5% over the next half decade or so.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 37% of revenue versus 52% for SG&A and 2.6% of capex. Taxes are estimated at 32% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital. I forecast this not having a meaningful impact in one direction or the other over the explicitly projected period.
Taking a perpetual growth rate of 2.5% and discounting backward by a WACC of 9% yields a fair value figure of $23.56 - virtually in-line with what the market currently assesses.
All of this falls within the context of a battered management team:
Since joining Avon, I've had the opportunity to meet many associates, visit our largest market, Brazil, and begin to identify our strengths, as well as some of our challenges.
Some of these challenges have been self-inflicted and have been well-documented by our management team on previous calls and meetings. Addressing the issues we face requires us to take a fresh appraisal of what we have that works well and what we need to adapt and revamp so we can achieve our full strategic and financial potential.
"Self-inflicted"? That can't be good. From a multiples perspective, Avon is no longer as cheap as it used to be. It trades at a respective 19.8x and 14x past and forward earnings versus 15.5x and 12.8x for Mattel and 19.2x and 13.3x for Altria. If we are looking for a company that is cheap by multiples, Avon is not looking too hot among consumer goods.
With that said, the thing that attracts to me all three of these firms is that they offer excellent dividend yields. Altria offers a dividend yield of 5.2%, trumping Avon's by around 130 basis points. Consensus estimates for Altria's EPS forecast that it will grow by 7.3% to $2.20 in 2012 and then by 7.3% and 6.8% in the following two years. Assuming a multiple of 17x and a conservative 2013 EPS of $2.33, the stock would hit $39.61 for 25.8% upside. Investors looking for both a high dividend yield and strong upside should thus opt for Altria over Avon. The stock is much safer and has significantly greater reward.
Ditto for Mattel over Avon. Mattel offers a dividend yield of 3.6%. Consensus estimate for Mattel's EPS forecast that it will grow by 11% to $2.42 in 2012 and then by 10.3% and 5.6% in the following two years. Assuming a multiple of 17x and a conservative 2013 EPS of $2.61, the stock would hit $44.37 for 30% upside. As the economy nears full employment, parents will be more willing to purchase gifts for children.
Unlike tobacco customers, toy customers (ie. parents) do not have a very inelastic time-insensitive demand for the products they are purchasing. This will make the toy industry a substantial beneficiary of greater consumer expenditures. The same case could be made for Avon, but the upside is not going to be substantial after the buyout bid.