Course: FM-II | Group: 2G | Case Brief

Case: Avon Products Inc. | Protagonist: Hicks B. Waldron (CEO, Avon)

Background:
Established in 1886, Avon was one of the worlds largest manufacturers and marketers of
beauty products. Avons was famous for its direct sales beauty business, which was also the
key source of their revenues. In 1988, Avon had about 1.4 million active sales representatives
worldwide.
Apart from the beauty sector, Avons other principal business group was its Health Care
Group, which comprised Foster Medical Corporation, the Mediplex Group, and Retirement
Inns of America. Due to optimistic future returns in the Health Care Group, Avon continued
their investments in this sector. Thus Avon took the strategic decision to acquire Mallinckrodt
Inc. $710 million in 1982, Foster Medical Company in a share exchange in 1984, Retirement
Inns of America in 1985 and the Mediplex Group in 1986.

Demographic Shift & Changing Times:

In 1982, a major demographic shift began to threaten Avons Beauty Group. Women were
increasingly entering occupations that required them to stay away from home during the day.
However, the majority of Avons sales representatives and customers had been women that
spent most of their time at home. Therefore, Avon was losing both its customers and sales
representatives.
Also, contradictory to the predictions, the Health Care segment was not as profitable for
Avon. After Medicare (the largest public insurance program in the US) cut Foster Medicals
charges by 18%, the management recommended the board to review Avons commitment to
Health Care industry. The board concluded that acquisitions could no longer grow at
attractive rate and still show acceptable profits.
Exhibit 2 in the case clearly shows the declining earnings from the Health care business.
Year Net Sales Pre-Tax Earnings Identifiable Assets
1984 542.9 91.7 961.3
1985 260.3 51.2 315.6
1986 431.8 65 731.9
1987 167.1 10.1 396.5

From the above data, we observe that even though the sales in 1986 were about 1.5 times the
sales in 1985, the pre-tax earnings increased only marginally, showing the expenses of the
segment had gone too high.
By 1987, the performance of Beauty Group had improved considerably which is why Avon
decided to focus on this segment and exit the Health Care Group. Avon began the process of
selling the Foster Medical Corporation anticipating an after tax loss of $125 million. Also
they sold Mallinckrodt Inc. suffering a loss of approximately $35 million. Also, Avon
acquired various perfume producers in 1987 which helped in their transition from direct sales
approach to retail outlet approach along with diversification of product line. Avon raised
capital by selling 40% of common stock in Japan subsidiary for an after tax gain of $121.1
million. These actions implied that Avon would continue to invest significant capital in the
business. The board thus suggested that Avon should conserve cash flow by reducing
dividends.

Dividend Policy of Avon:

1978-81
By 1981, Avon had raised the dividend on its common stock to $3 up from $2.55 in 1978.
1982-87
In this period, Avon was strapped for money for which it reduced the dividend from $3 per
share to $2 per share. As it can be seen in the Exhibit 4, the price of the share had reduced,
although not significantly to cause tension in the firm. The yearly high in 1982 is extremely
close to year low in 1981, showing the dividend reduction had affected the stock prices.
Year High Low Closing
1980 40.75 31.125 34.125
1981 42.375 28.125 30
1982 30.5 19.375 26.75
1983 36.875 21.25 25.125

1987:
The board suggested that Avon should conserve cash flow by reducing its dividend to $1 per
share, but Mr. Waldron worries that simply cutting the dividend would lead to a steep drop in
the stock prices because some investors had stated that they held Avon stock because it paid a
high dividend. Also, the largest institutional investor for Avon, Delaware Management Co.s
primary investment objective is Yield of the share (Exhibit 5). Hence, simply cutting the
dividend can lead to drastic consequences this time.

Morgan Stanleys proposed solution:

The board of Avon consulted Morgan Stanley, their financial advisor for an alternative
solution. Morgan Stanley proposed a new type of preferred stock: Preferred Equity
Redemption Cumulative Stock (PERCS).
Features of the Exchange Offer:
An exchange of one share of the new PERCS for each up to 18 million of Avons 7.17
million shares
The new preferred stock would pay cumulative quarterly dividends of 50 cents ($2
annually) accrued from September 1988 to September 1991
Granted mandatory redemption of the PERCS share in September 1991
Avon could never pay a common dividend of $1.50 or more per share per year unless
it first redeemed the preferred
Redemption price would decline by 25 cents per share for each quarter, beginning
March 1991
 Avond_2G.xlsx

Groups Analysis & Recommendations

Dividend per Total Dividend Paid
Particulars Total Shares (Millions)
share ($) ($)
Scenario I PERCS Employed
$
Preference Stock (25%) 18 $ 2.00
3,60,00,000.00
$
Common Stock (75%) 54 $ 1.00
5,40,00,000.00
Scenario II Maintain Dividend Policy
$
Common Stock 71.7 $ 2.00
14,34,00,000.00
Scenario III Reduce Dividends
$
Common Stock 71.7 $ 1.00
7,17,00,000.00

The three scenarios listed here gives a picture for the potential revenue distribution for Avon
Products:
1) Scenario 1: About 25.25% shareholders would be interested in PERCS as
per the Exhibit 5 since they can obtain an assured gain of $5.87/share for
this exchange. Also this would retain about $53.4 Million in earnings with
dividends averaging $1.25/share. (Our Proposal is to go for this,
taking positive action on all the three options on the case)
2) Scenario 2: About $143.4 Millions would be required for keeping
shareholders content.
3) Scenario 3: About $71.7 Millions would be retained as earnings to be
reinvested in the company however, this would result in a falling of price
from ~$24 to ~$12/share.

Notes Amount
Current Price of Common Stock $ 24.13
Dividend Discount for PERCS
Year
1988 Q3 (Now) $ 30.13
1988 Q4 $ 0.50
1989 Q1 $ 0.50
1989 Q2 $ 0.50
1989 Q3 $ 0.50
1989 Q4 $ 0.50
1990 Q1 $ 0.50
1990 Q2 $ 0.50
1990 Q3 $ 0.50
1990 Q4 $ 0.50
1991 Q1 $ 0.50
1991 Q2 $ 0.50
1991 Q3 $ 32.00
Benefit/Share to the shareholders opting for PERCS $ 6.00
Stock prices for $2 Dividend $ 24.39
Stock prices for $1 Dividend $ 12.20
Assumed Dividend Growth 5%
US Treasury Notes 8.20%
Price if Current Dividend (@$2) $ 65.63
Price if Current Dividend (@$1) $ 32.81