Just days after Coty emerged as an unheralded bidder for Avon , Christopher Ferrara of Bank of America Merrill Lynch presented a case for the struggling cosmetics giant as being “fixable” by improving its cash flow, management and selling channels. Since the report, Avon hired McCoy, a highly respected Johnson & Johnson executive, to replace Andrea Jung, who stepped down in December amid the company’s underperformance and bribery allegations. Ferrara’s report could serve as a guide for shareholders to hold McCoy and recently hired CFO Kimberly Ross accountable for a turnaround.
“[We] continue to believe that a significant step in AVP’s improvement process will be improving incentives throughout the organization for employees to drive the measures that drive shareholder value,” wrote Ferrara in his April 5 note to clients. “Working capital improvement will be predicated upon addressing the underlying operational issues and returning to growth, which will take time.”
Others agree, even if a turnaround may take longer than shareholders would want. “We agree that Avon is fixable, however we believe Avon’s board and shareholders missed a good opportunity to be acquired by Coty,” wrote UBS analyst Nik Modi in a Tuesday note to clients. “While Sheri McCoy and Kimberly Ross seem like capable executives, we believe the issues at Avon will take time and lots of money to fix: In fact, given our view on Avon’s issues, we believe it may take two to three years to sustainably fix.”
New York-based Avon Products shares are off nearly 40 percent in the last 12 months. This month, Fitch Ratings and Standard & Poor’s downgraded Avon Products’ credit to near “junk” status, citing weaker-than-expected earnings and questions on how quickly a turnaround can be executed.
Avon is the world’s largest door-to-door cosmetics merchant, which made it a compelling takeover candidate for Coty, but the company’s size also comes with a host of accounting and management challenges.
The biggest issue for Avon Products to fix, according to Ferrara, is its persistent cash shortfall when comparing the company’s net income to its reported free cash flow. From 2009 through 2011, Ferrara calculates that there is a $1 billion gap between the company’s $2.3 billion in pro-forma net income and its $1.3 billion in reported free cash flow.
“We believe the most challenging issue for investors to gain comfort with is the persistent gap between Avon’s ex-charges net income and free cash flow,” the analyst wrote. A discrepancy in the company’s capital expenditure to its depreciation, amortization, and inventory accounted for 81 percent of Avon’s free cash flow gap, calculates Ferrara.
While Avon Products has reported slowing sales and profitability, Ferrara noted that in recent analyst calls Ross has recognized a lack of accountability throughout the company. Ross has also targeted improving the timeliness of fulfilling orders, the forecasting input costs and inventories, and bolstering the non-U.S. processes. Still, Avon’s first-quarter earnings fell short of Ross’s forecasts, signaling a continued need for improvement.
In Ross’s prior role as CFO of privately owned foods giant Ahold, the company posted growth in its cash management metrics. “Ms. Ross has been no stranger to turnarounds, overseeing numerous structural/fundamental changes at Ahold,” adds Ferrara.
Meanwhile, aside from improving purely financial metrics, McCoy needs to address accountability within the organization and misaligned compensation, while improving the company’s direct sales performance, which has lagged peers.
“A common critique of Avon centers around the direct-selling channel. While Avon’s performance has been poor, particularly in the U.S. and Brazil, others have thrived,” writes Ferrara. Were Avon to improve its comparative performance, it might benefit from overall direct sales market share gains from retailer channels, especially among personal care and cosmetics consumers. Ferrara calculates that the percentage of global beauty and personal care sales through direct selling has grown steadily from 10.4 percent in 2005 to 11.7 percent in 2010.
McCoy can also fix the company’s compensation policies, which drew shareholder ire under former CEO Andrea Jung. Despite underperformance in earnings and cash flow growth relative to peers, and even relative to management forecasts, Avon Products executives were paid in line with the industry. Those pay practices also rewarded rank-and-file sales representatives with pay rewards that were in excess of their performance, analysts contend.
Bloomberg calculates a takeover of Avon Products would have been the largest M&A in the cosmetics sector since Procter & Gamble’s $57.3 billion takeover of Gillette in 2005.
But the deal wasn’t meant to be, and that leaves Avon’s new C-suite with the task of proving that they are going to make big fixes.
“Avon’s new management is now on the hook, fair or not. Whether or not Avon believed that the Coty offer would survive diligence, the market will remember a $24.75 offer. The next step still seems to be a due diligence, but by Sheri McCoy, rather than Bart Becht [Coty’s chairman],” writes Ferrara in a May 15 note.
—By TheStreet.com’s Antoine Gara
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