Why this Costmetic Company Should Accept its Fate

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

Avon Products (NYSE: AVP), the largest direct-selling cosmetics manufacturer in the US, made headlines again with more bad news. 2012 has been a year of bad omens for the company--declining sales, hiking costs, bribery investigations, faltering interest of active representatives, quarter after quarter of earnings misses, executives resigning, the CEO stepping down, and now structural changes under the new leadership.

The company has announced that it will be exiting two of its Asian markets, South Korea and Vietnam, and is cutting 1,500 jobs as part of its restructuring plans that were announced in the latest third quarter earnings call. These initial steps will help Avon achieve only 20% of the targeted savings of $400 million, which are intended to be fully achieved by 2015. However, the savings come with strings attached, in that Avon will have to face a charge of $80 million to $90 million in order to implement these actions.

Bad news keeps hitting this company, but it keeps staggering ahead. Increasing SG&A expenses are now its biggest concern, as they are growing at a higher rate despite declining revenues. Bear in mind, SG&A expenses are typically under more management control than costs of sales or non-operating expenses like taxes or interest. If I were to put it in other words, Avon has serious managerial inefficiency problems. 

Another problem is the company's reliance on its direct-selling model. Former CEO, Andrea Jung, was a marketing expert, but Sheri McCoy has no former experience of door-to-door selling. Additionally, as CEO McCoy rightly puts it, "advice from friends and word of mouth" are the two most powerful drivers of Avon's business. But with a weak brand image and little long-term desirability amongst women, the business can't grow on just word of mouth anymore. Formal advertising and celebrity endorsements are becoming inevitable now. A proof of this is the declining number of Active Reps around the world, which in the latest quarter was down 1%, largely due to double-digit declines in two of its big markets--North America and Asia. Latin America, or more specifically Brazil, is Avon's strongest market. Russia, Turkey, and South Africa also showed growth in the latest quarter, yet overall results remained disappointing.

Amid all the doom and gloom, it is hard to believe that Avon's management refused a lucrative takeover offer from Coty Inc. earlier this year for as high as $24.75 per share. AVP's downward spiral that followed is proof of the fact that shareholders disliked management's hubris. Nonetheless, rumors are now making rounds that Coty could be bringing its offer back to the acquisition table once again. Would this acquisition still make sense? Yes. 

Fragrance is the largest category in Avon's 'Beauty' portfolio. McCoy herself acknowledged in the latest quarter that, although the segment has performed well, the company is still seeing weakening in some areas now. Coty, on the other hand, is known for its profitable fragrance line of famous brands--Marc Jacobs, Guess, Playboy, Calvin Klein, Beyonce, Madonna, and now a newly announced collaboration with Katy Perry, amongst a dozen others. A merger of the two would boost Avon's business. Avon's skincare and makeup line is a little more developed than Coty's. Adding Avon to its cosmetics brands--Rimmel and Sally Hansen, etc., would synergize Coty's business. It's a win-win.

So what are some of the possible ways this can work out? A merger wouldn't work because Coty likely wants Avon's management to go. Coty has also denounced the possibility of a hostile takeover. So would a bear hug work? If Coty now comes back with the same offer of $24.75 per share, it will be more than a 75% premium to the last close price of a little over $14. This should give management a huge incentive to sell off their positions and honorably retire. Yet another way could be an open tender offer by Coty to Avon's shareholders. 

Avon's management recently cut dividends from $0.23 down to $0.06, and has indicated that another dividend cut is expected soon. Competition in the industry is getting fiercer by the minute. Big companies like Estee Lauder (NYSE: EL) and Revlon (NYSE: REV) already posed a serious threat, and now plastic storage containers company Tupperware (NYSE: TUP) have acquired smaller cosmetics brands. All three have better financials, and with a better revenue growth are fast eroding Avon's market share.  

<img src="http://media.ycharts.com/charts/8754fcf993e8f4bc633658b1ecfa4f6a.png" />

AVP Revenue Quarterly YoY Growth data by YCharts

Additionally, the rising popularity of LOreal's (NASDAQOTH: LRLCY) Garnier brand and cosmetics by Mac and Maybelline amongst women of all ages further scares industry players. If Sheri McCoy cannot turn around the company's fate in another 6 months, this cat will be out of lives and in a desperate need of Coty's bear hug.

PalwashaS has no positions in the stocks mentioned above. The Motley Fool owns shares of Tupperware Brands. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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