In March, Barron's online posted an article about Avon Products (NYSE:AVP), and mentioned that fans of the stock believed it to be cheap because of a relatively low P/E ratio and a nice stockpile of cash. When the article was posted, Avon had a P/E below 10, which was trading at half its average P/E for the last five years, and was lower than the double-digit P/Es of rivals Estee Lauder (NYSE:EL) and Alberto Culver (NYSE:ACV). The article suggested that Avon's stock price could double in the next 12 months. There's no way of telling if it will, but I think it's a good exercise to discuss Avon's pros and cons before taking the plunge.
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CEO Andrea Jung has been in charge since November 1999. In that time, sales and earnings before interest and taxes (EBIT) have grown 100% and 145% respectively. In November 2005, Avon undertook a restructuring plan that would take several years to complete. Three specific initiatives of the restructuring included simplifying its product line by providing a smaller range of products with greater profitability, lowering costs by sourcing globally rather than locally and instituting a zero overhead growth policy to ensure productivity gains are equal to or greater than inflation. In February, Avon announced it was embarking on a second restructuring program (in addition to the original which began in 2005) to streamline operations, cutting as many as 3,000 jobs worldwide.
The Associated Press reported in February that the company's chief finance officer (CFO), Charles Cramb, said that when the two programs are complete in 2012, the restructuring will provide Avon with $1.1 billion in annual savings. Judging by 2008's results, it appears the restructuring may be working. Revenues were $10.6 billion and EBIT earnings $1.24 billion, both higher than in 2005, before the turnaround began. (For further reading, see Evaluating A Company's Management.)
I have three specific issues with Avon management that I'll address in order of severity. First is corporate cost cutting. Back in February, I wrote an article about companies like NuStar Energy L.P. (NYSE:NS) that avoid layoffs at all costs in order to maintain employee morale and productivity. This is especially important during a recession because companies that refrain from job cuts tend to bounce back faster once the economy improves. I'm afraid that in the quest for bigger profits, Avon is cutting off more than it should.
My second issue is with the Avon CEO's compensation. According to the DEF 14A, Jung made $11.055 million in total comensation in 2008. Compensation at this level is unbelievable when you consider A.G. Lafley, CEO of Procter & Gamble (NYSE:PG), considered by many to be one of America's finest executives, was paid approximately double Jung's total compensation in 2008, yet ran a company with eight times the revenue and 13 times EBIT. One of these executives is overpaid and it's not Lafley.
Lastly, is Avon's use of cash to repurchase $1.2 billion in stock between 2006 and 2008. Not one share was bought on the open market in the fourth quarter of last year when the stock fell from $42.50 to a low of $18.38, despite Avon holding $1.1 billion in cash and having $1.8 billion left on its $2 billion repurchase program that started December 17, 2007. In February, the company completed an $850 million bond offering, selling long-term notes that pay rates of interest between 5.625% and 6.5%. $500 million of the proceeds went to repaying all of its short-term commercial paper outstanding and the rest went to general corporate purposes. The net effect, total debt went from $2.49 billion at the end of 2008 to $2.84 billion after the offering.
Avon is clearly not a bad company. However, I would have a hard time buying its stock given management's use of cash. Warren Buffett believes companies should only buyback stock below intrinsic value. Though intrinsic value is anybody's guess, I'd be inclined to say it's closer to $20 than in the mid-$30s where it traded for most of 2008. I'll be looking closely at the first-quarter report to see if share repurchases are accelerating with a lower stock price. If not, I'd pass. (For more, see Investment Valuation Ratios.)