Fitch: Avon Lays Out Roadmap; Execution Risks Remain

NEW YORK–(BUSINESS WIRE)–Fitch Ratings gained more insight into Avon’s turnaround plan at its
Investor Day on Jan. 21, 2016. Many aspects were positive; however,
significant execution risks remain given continued questions around the
business model longer term as well as recession risks in several of its
largest markets, excluding North America.

Avon’s goal is to operate profitably as a smaller, $6 billion company
with modest top-line growth. Avon reported that its business excluding
North America generated 2015 sales of $6 billion, and estimates adjusted
EBITDA of nearly $575 million. Separating out the North American
business – which had LTM sales of $731 million and estimated EBITDA of
$4 million – to Cerberus Capital removes a drag on both operating trends
and on management’s time, and the cash infusion and dividend suspension
will provide a meaningful boost to Avon’s liquidity.

With the oversight and operational capabilities of its strategic partner
Cerberus Capital Management, the company plans to reduce its overhead by
$350 million and reinvest those funds in growth initiatives such as new
products, IT, and its representatives (reps), around a tightly focused
group of Top 10 countries. The company will also look to exit smaller
sub-scale markets which are a drag on profitability.

Competition and Recession in Top 10 Markets

Avon reported that its Top 10 markets accounted for nearly 70% of 2015’s
revenues after excluding the impact of VAT and IPI taxes in Brazil.
Fitch anticipates that the company’s long-term growth plans of
mid-single-digit revenue growth and low-single-digit rep growth could be
difficult given that key markets are in recession. In addition, there is
an intense level of competition in the Top 10 markets.

Most important, three key markets, Argentina, Brazil and Russia, are in
recession. While rep count typically increases as more people look to
make additional money when jobs are scarce, generating sales is more
difficult. For example, Avon’s Latin America region is its largest
geography. The region includes four of the Top 10 markets and generated
almost 55% of revenues and adjusted operating profits (excluding North
America) through the nine months ended Sept. 30, 2015. However the
region has also seen negative volumes (-4%) and rep declines (-2%) in
the same time period.

Avon reported that it generated 1% rep growth in 2015 and 3% organic
sales (excluding North America). However, based on the nine months, rep
count improvements are likely driven by EMEA only, and much of the
company’s organic growth is pricing to recover currencies rather than
volume-driven.

The Top 10 markets have also experienced accelerating levels of
competition in the past decade as large beauty multinationals entered in
search of growth. Taking or gaining share in some of these markets,
where large deep-pocketed beauty marketers such as L’Oreal and P&G
innovate as a matter of course, may be difficult.

Cost Cuts and Small Exits to Provide Funds to Invest

Cerberus’s operational skills and focus at the board level and in Avon’s
new project management group is supportive to achieving the targeted
$350 million in cost savings over the next three years. Avon’s current
cost structure was scaled to a much larger organization. Fitch views the
company’s investment in IT and focus on directing marketing efforts
toward the Top 10 countries positively. Plans to exit sub-scale
geographies should also benefit margins modestly over the medium term
and also demonstrate a commitment to better performance as a much
smaller $6 billion enterprise.

Liquidity Buffered by Cerberus Preferreds and Dividend Suspension

Avon’s international subsidiaries have long provided the bulk of the
company’s profits and cash flows. Through the nine months Avon North
America recorded a $12 million operating loss.

Avon has taken steps to address and add to its financial flexibility and
liquidity with the suspension of its nearly $110 million annual dividend
and its expectation of receiving net proceeds of approximately $505
million from transactions with Cerberus. The transactions involving
purchasing a majority stake in Avon North America ($170 million inflow)
and a separate capital injection to Avon in the form of $435 million 5%
preferred notes should close this spring. The proceeds and additional
cash flow should ably fund reinvestment in the business and allow the
company to reduce debt by $250 million.

The $435 million preferred equity is being reviewed to ascertain if
there is an equity component. In the interim, if viewed solely as debt,
pro forma leverage in 2016 is expected to be almost 5x before declining
to 4.3x in 2017.

Furthermore, the transaction should provide a better matching of
revenues and costs in similar currencies, and the hard currency needs of
the North American operation will be meaningfully reduced. Avon
announced that it would also look at hedging translation. This would be
one of the first personal care companies to do so. While hedging could
limit currency volatility, there may be modest additional costs added to
overhead but the amounts and timing are unclear at this juncture.

KEY ASSUMPTIONS

–The proposed transactions with Cerberus purchasing 80.1% of Avon North
America and buying $535 million in preferred shares from Avon closes in
spring 2016 as anticipated;

–Organic revenue growth of 4% to 5% in the next two years on flat
volume as Avon now begins to price consistently to inflation with
flat-to-slightly positive growth over the next two years. However,
negative F/X completely offsets 2016’s organic growth.

–EBITDA of approximately $500 million in 2016 and $565 million in 2017;

–Free cash flow (FCF) of $85 million in 2016 and $100 million in 2017.

RATING SENSITIVITIES

Future developments that may, individually or collectively, lead to a
positive rating action:

Stabilization of the Outlook is based on sustaining flat-to-modestly
positive rep growth as well as low-single-digit organic growth. While
pricing may drive the bulk of organic growth in the near term, Fitch
expects positive volume to also be a contributor.

Negative:

Future developments that may, individually or collectively, lead to a
negative rating action:

–Continued sales declines, which would be exemplified by active reps
and volume turning negative and being sustained in the low-single-digit
range;

–Significant EBITDA contraction to a level below $500 million after
2016;

–Negative FCF being sustained. While the company has ample liquidity
and can fund cash shortfalls with cash on hand, negative FCF would be of
concern.

–Sustained increases in leverage over 5x.

–Currency controls in significant markets such as Brazil and Russia.
Avon’s debt is dollar-based and cash flow for debt service over the
intermediate term would be based on offshore cash generation.

Fitch currently rates Avon as follows:

–Issuer Default Rating (IDR) ‘B+’;

–Senior unsecured notes ‘B+/RR4’;

–Short-term IDR ‘B’.

The Rating Outlook is Negative.

Additional information is available at www.fitchratings.com.

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Contacts

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