Avon Case

1
Avon Case

• Week 12 April 6, 2006

2
Avons 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)
• Sold Mallinckrodt in 1986 for 675 million
• Bought fashion and scents
• Giorgio, Inc. for 165 million cash (1987)
• Parfums Stern for 160 million cash (1987)

3
Avon Cash Flows and Ratios
4
Avon and Finance Theory

• What has been the relationship between Avons
  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 Avons business strategy?

5
Performance of Business Lines
6
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 gt 46.5
• About 1/6 shares desired cash yield

7
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

8
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)

9
PERCS versus Avon Common
1 Share
2
Dividend ()
1
2
4
3
5
1.25
1 Share
Dividend ()
1
2
4
3
5
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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

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PERCS

• Receives higher dividend but has a limit on
  upside gain to stock
• If P5 gt 31.50, receive 31.50 in stock value
• If P5 lt 31.50, receive share value

31.50
Lost Profit on Stock
12
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.

13
Valuation of PERCs

• Value of PERCS composed of value of stock, value
  of extra dividends, minus value of call
• Valuation issues then are the appropriate
  discount rate on extra dividends and value of call

14
Avon Case Summary and Issues

• What has been the rationale behind Avons
  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 Avons management?
• Do the PERCS satisfy investor expectations so
  that Avon will achieve desired outcome?