Finding Future M&A Candidates

Federico is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Avon (NYSE: AVP), the makeup company, has been going through some trouble and at around 15 USD (13% down this year and 39% down in 2011) the stock price reflects the pain operations have suffered. That said, and even though with somewhat disappointing Q3 results – operating profits after taking out of the picture impairments and restructuring costs fell strongly in every region where the company operates- I believe there is upside coming from the reorganization process.

Actually, if we focus on growing markets, such as Brazil, then we see the potential coming from the brand. I do like consumer goods companies (CGCs) with good distribution networks and strong brands, both characteristics owned by AVP in Latin America. Plus, I do like CGCs even better when I believe there is going to be M&A activity.

This sector, where the likes of AVP and Revlon (NYSE: REV) are going through tough cost cutting processes, could be particularly prone to consolidation. Actually REV, which has been suffering more pain than AVP, is already increasing sales (+2.9%) and operating margins (came up to 11.6%) for Q3. Despite reporting a net loss, REV is about to come back to profitability and could also be a future M&A target.

Buyers could be found in those companies within the sector that are performing well but could use  brands and distribution networks owned by smaller competitors. Two of those potential buyers might be the French giant L'Oreal which is growing sales at double digit rates and Estee Lauder (NYSE: EL) which, trading at 22 P/E and with a 10% operating margin, is growing EPS at a 12% year on year rate and sales at a 3% rate .

Clearly the makeup market is far from being dead and some under performers own tough to replicate assets: brands and distribution networks.

Changes to Come

I do like cash dividends (see my next article at Warrentrades) but I don’t necessarily like sustainable businesses to get suicidal; the dividend was too good to be true at a 6% rate so management decided to cut it by ¾ to $0.24 a share. Tough times require tough decisions and funding a dividend with balance sheet may not be a wise course of action to take unless the business you operate is going to die, which is not AVP's case. The wise dividend cut was just one of the announcements made on Q3's presentation. Above all, the company did set some long term targets. In between those targets two are key: (i) growing sales at 5-6% a year, which is the same target set by the better performing competitor EL and (ii) ameliorating operating margins from the 6% achieved to 10-15% range through selective cost cutting – remember that REV showed an 11.6% operating margin for Q3.

Are those targets achievable? I think yes but a lot of work needs to be done. The brand has traction in Latin America; where it generates around 50% of sales, and operations in the developed world should stop generating operating losses after the heavy restructuring charges made (the company is currently making an operating loss in the US). Even timid results to proposed plans should deliver good performance for investors. Below I will work some very simple math and show what I am thinking of when I say AVP could be a god buy for any portfolio during 2013.

The Investment Case.

Great investments are those great businesses that (a) pay good sustainable cash dividends or either (b) can constitute very good M&A targets for bigger companies. If you can see a company that goes from being a total under performer to going towards (a) or (b) then you can really bat a home run. If Avon does make some changes we could be looking at one of those transformations and in a business sector (consumer goods) that validates very high valuation multiples for business winners.

Even if at first sight the company, with a P/E multiple of 18, doesn’t seem particularly cheap, we need to remember that those are static multiples while business performance, above all for those companies living through drastic transitions, is dynamic.

If in two years sales go up by just 5% compared to 2012 while operating margins go up to 10% and all the rest remains equal we would get a x10 P/E multiple. Which is cheap for a CGC and above all for a company that owns very valuable brands and distribution networks in key Emerging Markets.

All in all, AVP could be a great buy at a price below $15 if only a small part of the transformation plan proposed by management is achieved.

martinzaldua has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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