What Management's Thinking Around Coty's Bid For Avon

| About: Avon Products, (AVP)

Avon (AVP) made headlines yesterday by rejecting a buyout offer at a 20%+ premium to the stock price. The rejection by Avon is the latest in a series of newsworthy events, as the company attempts to emerge from a turbulent past couple years. Below is a 5 day chart for Avon showing the 20% move Monday morning after privately owned Coty offered $23.25 a share for all AVP shares, which Avon's management promptly rejected.

Click to enlarge.

Avon stock reacts to buyout offer
Source: Yahoo Finance.

I always like to evaluate companies that reject offers at a material premium on the chance that an attractive short term trade presents itself. Generally I will evaluate the situation from 2 perspectives and invest if both yield positive results. First I look at the chance of a higher offer being made, and secondly I look at the attractiveness of the underlying asset as a margin of safety in case there is no other offer.

The best case scenario here is that Coty or another company will make a higher offer, and investors will have made a wide margin in a short period of time. This requires evaluating how attractive Avon is to a company like Coty in order to determine the chance that Coty will raise the offer. In this case I believe that a higher offer is at least somewhat likely because Coty has been on a buying spree over the past couple of years, and Avon's presence in emerging markets would fit well with Coty's business. Coty prides itself on finding synergy yielding acquisitions, and on a surface level AVP looks like a prime candidate.

It is also important to consider if Avon would still be an attractive investment in absence of an increased offer. By offering $23.25 a share, Coty has indicted that it believes Avon is worth more than $23.25 a share, and by rejecting the offer Avon has signaled the same. Avon's management released the following statement on Monday morning:

The Avon Board believes Coty's indication of interest, which offers Avon shareholders only a 20% premium over the Company's closing share price on March 30, 2012, does not reflect the fundamental value of Avon and its global beauty care franchise. Indeed, the indication of interest represents a multiple of only 1.1 times Avon's net revenue for the fiscal year ended December 31, 2011 and 8.7 times 2011 EBITDA. This is significantly below multiples that the Board of Directors believes an iconic consumer company is worth in a change of control transaction.

This offers support for the notion that Avon shares might be undervalued at any price less than $23.25, but is by no means sufficient evidence. After analyzing the terms of the offer and Avon's global situation, it is my opinion that Avon is not undervalued and certainly not an attractive investment opportunity. I believe that Avon is not an attractive stock at its current valuation because growth will be limited for the foreseeable future.

Avon's earnings have been below estimates for several quarters, and the company is plagued by a series of operational issues in addition to low growth. I also examined the company's historical revenue to see what was driving the limited growth and found that Latin America and Western Europe accounted for essentially all of the growth (as can be seen in the table below). Other regions have seen flat to lower revenues, which is especially troubling for a beauty and fashion company. I worry that the underlying products Avon is selling are no longer trendy (something I would know nothing about). When this trend is combined with the other business factors, it does not present a bright picture of the company.

Geographical Revenue Breakdown - AVP
Revenue by region by year 2011 2010 2009
Latin America $5,116.0 $4,589.5 $4,103.2
North America $2,110.4 $2,244.0 $2,293
Central & Eastern Europe $1,580.6 $1,585.8 $1,500.1
W. Europe, ME, & Africa $1,542.2 $1,462.1 $1,277.8
Asia Pacific $942.4 $981.4 $1,030.7

Clearly Avon is not growing fast enough to justify its valuation at 19 times P/E, and management does not seem to have a coherent strategy to return to growth. In addition to the various issues discussed below, Avon has a payout rate of 78%, and thus is only reinvesting 22% into growing the business. By only reinvesting such a small portion of earnings, Avon is inherently hindering its growth in the future.

Avon has publicly announced that it is looking for a new CEO to replace Princeton-educated Andrea Jung, who has been with the company since 1993 and served as CEO since 1999. Many analysts blame Jung for the troubles of the company, but this could be misdirected scapegoating. Jung was widely praised as a success for the first years of her tenure as CEO, and she currently serves on the boards of both GE (NYSE:GE) and Apple (NASDAQ:AAPL), and has received numerous awards and honors.

Regardless of Jung's role in the troubles of the company, I believe that Avon will suffer from the loss of Jung, and her replacement will not be able to increase growth in the immediate future. It will take time before a new CEO can have a meaningful impact on the direction of the company. Avon has indicated it is looking externally for a replacement, which also makes me question the aptitude of its current management team without Jung. In order for the negative growth trend to be fixed in the near future it will require someone who knows the company, and not an outsider.

Additionally, Avon is currently implementing 2 restructuring programs (from 2005 and 2009) as a means to reduce costs associated with employees and pension plans. To date these programs have cost the company over $750m (2011 net income of $513m) and will continue for the foreseeable future. These types of liabilities are notoriously difficult to quantify with any sort of accuracy, and thus makes me very wary of investing in Avon. Avon's business model relies heavily on the firm's relationship with its employees, so ultimately the restructuring plans could have a negative impact on future earnings by deteriorating that relationship.

Furthermore, a close look at Avon's balance sheet shows that in 2011 $500m of the company's debt matured and was essentially repaid by issuing short term notes with an interest rate of 10.9%. Until the company refinances or repays this short-term debt, the situation seems too uncertain. Management has not provided adequate communication surrounding their recent use of commercial paper.

Ultimately all of these factors work together to yield my recommendation that Avon is not an attractive buy at this price (nor was it before the 20% pop). Other articles regarding the buyout offer have not mentioned what I see as a key detail in the press release from management this morning that could explain the situation:

Coty's indication of interest does not constitute a real offer: Coty's indication of interest is non-binding and, by its own terms, subject to numerous conditions such as financing, due diligence and the negotiation of a definitive agreement. Coty's letter to Avon dated March 30 alludes to the possibility that, following diligence, Coty reserves the right to raise or lower its price to acquire Avon. In the final analysis, Coty is attempting to obtain a "free look" at Avon in the absence of any commitment whatsoever to close a transaction at any price.

Certainly if Coty were just attempting to get a "free look," then it would perfectly explain the behavior of management for both companies. I believe that given their current troubles, Avon's management would almost certainly accept any binding offer at a modest premium. It would also explain why they would reject a non-binding offer if they knew that Coty would not follow through after a closer look at Avon's books.

The variant view here is that the Coty offer is serious. The billionaire owner of Coty, Joh Benchiser, has been furiously pursuing deals in the past several years and has also indicated frustration that the talks between Coty and Avon have not materialize into a deal. My opinion is that Benchiser is not going to make an offer before he is able to get a closer look at the company, and that seems unlikely at this point. I imagine that if Coty is serious about the offer, they will come back with a higher offer in the coming week, but otherwise I believe that speaks very negatively to Avon's prospects for the future.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in AVP over the next 72 hours.

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