Transcript Class 2 - University of Southern California

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)
 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)
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
Debt-Equity Ratio
Equity to Total Assets Ratio
J. K. Dietrich - FBE 532 – Spring 2006
1981
0.01
0.60
1982
0.24
0.55
1983
0.26
0.53
1984
0.38
0.47
1985
0.67
0.40
1986
1.04
0.30
1987
1.08
0.30
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;
Cosmetics, fragrances,
Health care
Return on Assets for:
Cosmetics, fragrances,
Health care
J. K. Dietrich - FBE 532 – Spring 2006
1982
14.00%
15.47%
1983
11.66%
15.81%
1984
12.95%
16.89%
1985
11.95%
19.67%
1986
12.31%
15.05%
1987
13.90%
6.04%
28.85%
7.39%
23.24%
8.51%
25.43%
9.54%
19.96%
16.22%
21.74%
8.88%
18.14%
2.55%
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 equityredemption 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
+ 1 Share
$2
1
2
3
4
5
$1.25
+ 1 Share
1
J. K. Dietrich - FBE 532 – Spring 2006
2
3
4
5
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  Valueof 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