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
Groups Recommendations
Particulars Total Shares(mn) Dividend per share Total Dividend Paid
Common Stock 7.17 $2 14.34
PERCS:
Preference Stock (25%) 18 $2 35.85
Common Stock (75%) 54 $1 53.78