Avon Case

Week 12 – April 6, 2006

J. K. Dietrich - FBE 532 – Spring 2006

 Avon’s Strategy since 1982
 Bought health care firms
– Mallinckrodt for $710 million (1982)
– Foster Medical Care with shares (1984)
– Retirement Inns of America (1985)
– Mediplex (1986)
 SoldMallinckrodt in 1986 for $675 million
 Bought fashion and scents
– Giorgio, Inc. for $165 million cash (1987)
– Parfums Stern for $160 million cash (1987)

J. K. Dietrich - FBE 532 – Spring 2006

 Avon: Cash Flows and Ratios

Cash Inflow or Outflow 1981 1982 1983 1984 1985 1986 1987
Net Income 219.90 196.60 164.40 181.70 -59.90 158.70 159.10
Borrowings LT Debt 2.20 292.50 21.10 122.10 177.30 91.40 107.20
- Cash Spent on Dividends -180.45 -178.65 -148.98 -167.68 -158.70 -143.30 -143.30
- Cash Spent Increasing Assets 3.60 -665.40 -52.60 -151.90 148.70 -7.30 -262.90
Difference 45.25 -354.95 -16.08 -15.78 107.40 99.50 -139.90
1981 1982 1983 1984 1985 1986 1987
Debt-Equity Ratio 0.01 0.24 0.26 0.38 0.67 1.04 1.08
Equity to Total Assets Ratio 0.60 0.55 0.53 0.47 0.40 0.30 0.30

J. K. Dietrich - FBE 532 – Spring 2006

 Avon and Finance Theory
 What has been the relationship between
Avon’s strategy and its need for cash?
 How has dividend policy fit into its
financial strategy?
 What financial considerations does theory
suggest should be made concerning
business strategy and dividend policy?
 How do you evaluate Avon’s business
strategy?
J. K. Dietrich - FBE 532 – Spring 2006
 Performance of Business Lines
Margin on; 1982 1983 1984 1985 1986 1987
Cosmetics, fragrances, 14.00% 11.66% 12.95% 11.95% 12.31% 13.90%
Health care 15.47% 15.81% 16.89% 19.67% 15.05% 6.04%
Return on Assets for:
Cosmetics, fragrances, 28.85% 23.24% 25.43% 19.96% 21.74% 18.14%
Health care 7.39% 8.51% 9.54% 16.22% 8.88% 2.55%

J. K. Dietrich - FBE 532 – Spring 2006

 Avon in 1988
 Cash needed for restructuring
– Winding down of Mediplex and Retirement
Inns
– Rebuilding and expanding beauty product
business
 Dividends $143 million/year
 Concerns about investor clientele
– Institutional ownership > 46.5%
– About 1/6 shares desired cash yield
J. K. Dietrich - FBE 532 – Spring 2006
 Morgan Stanley Proposal
 Avon offer to exchange up to 18 million
common shares for $2.00 preferred equity-
redemption cumulative stock (PERCS)
 After five years, PERCS redeemed with


common shares
 Dividend on remaining common shares
reduced from $2.00 to $1.00
 Cash saved  $1  (73.8  18)  $56 million

J. K. Dietrich - FBE 532 – Spring 2006

 PERCs versus Common (no deal)
 PERCs must have same value as common if
PERCs were not issued
 If PERCs not issued, to achieve same cash
flow effect, dividend on common would be
reduced to $1.25 because $1.25 dividend to
all common shares is same cash flow as
$2.00 to PERCS (25% of total) and $1.00 to
non-converting common (75% of total)

J. K. Dietrich - FBE 532 – Spring 2006

 PERCS versus Avon Common
$2 + 1 Share

1 2 3 4 5

$1.25 + 1 Share

1 2 3 4 5
J. K. Dietrich - FBE 532 – Spring 2006
 Concept
 Shareholders wanting cash yield will
convert to PERCs
– Receive higher dividend
– No profit from share value above $31.50
 Other shareholders will be content to hold
(lower dividend yielding) Avon common
 At margin, value of the two securities
(common and PERCS) must be equivalent
to common if PERCS not issued at all
J. K. Dietrich - FBE 532 – Spring 2006
 PERCS
 Receives higher dividend but has a limit on
upside gain to stock
– If P+5 > $31.50, receive $31.50 in stock value
– If P+5 < $ 31.50, receive share value

$31.50

J. K. Dietrich - FBE 532 – Spring 2006

 Value of PERCS
 Value of PERCS is present value of
dividends plus value of common minus
value of call option written
 Value of common and value of PERCS
(with the assumption of no issuance of
PERCS) must be equal
 Common priced at $24.125, before
announcement of exchange offer.

J. K. Dietrich - FBE 532 – Spring 2006

 Valuation of PERCs
 Value of PERCS composed of value of
stock, value of extra dividends, minus value
of call:
PE  PS  PVXD  Value of Call
 Valuation issues then are the appropriate
discount rate on extra dividends and value
of call

J. K. Dietrich - FBE 532 – Spring 2006

 Avon Case: Summary and Issues
 What has been the rationale behind Avon’s
strategy and how does its current situation
relate to its past dividend policy?
 What are the key factors in the success of
the PERCS proposal and what contribution
does it make towards the goals of Avon’s
management?
 Do the PERCS satisfy investor expectations
so that Avon will achieve desired outcome?
J. K. Dietrich - FBE 532 – Spring 2006