Coty Makes Offer For Avon, Smelling “Blood in the Water” – Analyst

Coty envisions “an iconic beauty company” to emerge from its proposed acquisition of Avon; however, the direct seller’s management has dismissed the offer as “opportunistic” and not in shareholders’ best interest. Coty is now appealing directly to shareholders, highlighting the firms’ complementary product portfolios and geographical strengths. Meanwhile, Avon seems intent on finding growth and profitability on its own.

In theory, [Avon Products Inc.]’s acquisition by [Coty Inc.] could recuperate the former’s hamstrung business and round out the latter’s fragrance-heavy portfolio, but analysts question whether a deal will ever materialize, and if one should at all.

Coty made a bid for Avon April 2, offering $23.35 per share in cash for the fellow New York-based beauty firm, amounting to a roughly $10 billion proposal.

Avon rebuffed the offer – the third such offer in recent weeks – calling it “opportunistic and not in the best interest of Avon’s shareholders.”

Coty begs to differ. Its proposal represents a “very substantial” premium of 27% to the three month volume-weighted average price for Avon shares, the firm says, maintaining that “Avon’s shareholders would want their board to explore with us the benefits to shareholders of a transaction.”

It adds that if Avon can produce non-public information that demonstrates greater value, Coty will consider increasing its offer.

The proposed pair-up would not prove beneficial to the world’s largest direct seller of beauty products, as the differences between Coty’s traditional wholesale/retail model and Avon’s representative-based model are just too “vast.” – Morningstar analyst R.J. Hottovy

At least one Avon investor agrees that Coty’s proposal merits a more considered look, reportedly filing suit in New York State Supreme Court for Avon’s alleged refusal to engage in negotiations.

According to Coty’s April 2 release in which it appeals to Avon shareholders, the firm has no intention of pursuing a hostile takeover. Rather, “our objective is to engage in discussions with Avon and conduct due diligence so that we and Avon can together determine if there is a basis for a transaction,” Coty says.

In making its case, Coty says the proposed acquisition would create “an iconic beauty company” with new growth opportunities that can “benefit consumers by providing greater access to innovative, quality and branded beauty products across multiple distribution channels.”

The suitor acknowledges that there are “substantial uncertainties concerning Avon’s business and liabilities.” Such liabilities include weak earnings over a string of quarters and an ongoing SEC investigation into alleged violations of the Foreign Corrupt Practices Act. In a February earnings call, Avon designated 2012 a “transitional” year and outlined plans for cutting costs and restoring growth.

Coty says it expects that “a very material part” of the cost synergies generated by its proposed acquisition would have to be reinvested to address Avon’s operational issues. Improving systems and supply service levels and enhancing programs to support sales representatives would be priorities, it says.

Avon maintains that Coty merely wants a “free look” at its books.

“The board of directors remains confident in the company’s stand-alone prospects,” Avon states.

Analysts Are Skeptical

Analysts also have questions about Coty’s motivation, the fairness of its offer and the likelihood of a deal going forward.

“Coty just smelled blood in the water and decided to make an offer,” said Morningstar’s R. J. Hottovy, director of global consumer equity research, in an April 3 conversation with “The Rose Sheet.”

Hottovy agrees with Avon management that the unsolicited offer “substantially undervalues the firm,” representing a multiple of 1.1 times trailing 12-month revenue and 8.7 times trailing 12-month EBITDA, according to his April 2 note.

Moreover, while “Avon faces a perfect storm of problems at the moment,” the proposed pair-up will not prove beneficial to the world’s largest direct seller of beauty products, according to Hottovy. The differences between Coty’s traditional wholesale/retail model and Avon’s representative-based model are just too “vast,” he said.

“Say you’re an Avon representative and all of a sudden you see the products you’re selling in a shelf at a department store?” he said. “You’d be fairly upset.”

UBS Analyst Nik Modi believes the viability of a deal is more a question of price than compatibility, although in an April 3 note he acknowledges that Coty will be “constrained by the fact that any synergies would likely get reinvested in order to heal Avon’s woes.”

Modi believes the “best case” scenario for Avon shareholders would be a bid of “as high as $27,” although it’s questionable if Coty would put out such bait and if Avon would bite.

Hungry For Skin Care

Avon would be another jewel in Coty’s crown following acquisitions over the last two years including Chinese skin-care firm TJoy Holdings, German cosmetics company Dr. Scheller Cosmetics AG and the Philosophy skin-care brand.

Those purchases filled gaps in Coty’s product offering and strengthened its overall skin-care business, “one of our key strategic objectives,” Coty CEO Bernd Beetz said in November 2010 (Also see "Coty's Philosophy: Expand Portfolio With Higher-Growth Skin Care" - HBW Insight, 29 Nov, 2010.).

Coty has achieved growth with nail care of late. New products from Sally Hansen, picked up in the firm’s 2007 acquisition of Del Laboratories, have helped grow the brand’s sales 22% over the past year. The company has also benefitted from its November 2010 acquisition of nail color marketer OPI Products Inc., as well as a general resurgence of market demand for nail color.

According to data from SymphonyIRI, the mass nail-color category more than doubled from 2008 to 2011. Meanwhile, Sally Hansen sales grew from $100 million in 2008 to $223 million in 2011, according to Coty (Also see "Coty Growth Driven By On-Trend New Products" - HBW Insight, 19 Mar, 2012.).

UBS analyst Nik Modi believes that Coty is “serious about acquiring Avon,” and if Avon isn’t receptive, no other suitors are likely to come forward, he says.

Overall, Coty’s portfolio remains stacked on the fragrance side, with sales driven by celebrity scents from luminaries including Beyonce, Faith Hill, Halle Berry and, soon, Lady Gaga. Overall, fragrances accounted for 57% of the firm’s 2011 revenues.

In recent years, an oversaturation of celebrity scents has diluted the market and compromised the profitability of such ventures.

“If you compare the dollar volume being generated by any celebrity fragrance today, on average, it is about 30% of what a celebrity fragrance was generating in 2002,” The NPD Group’s Karen Grant, senior global beauty analyst, noted during a December 2011 panel organized by the Fragrance Foundation (Also see "The New Deal: Optimizing Investment In Celebrity Fragrance" - HBW Insight, 2 Jan, 2012.).

Skin care, on the other hand, continues to thrive, and its high margins to entice.

Avon released its Anew Genics skin-care range in the fourth quarter of 2011, heralding it as “the first [Avon launch] to market youth gene technology” and citing its “very, very attractive growth margins” (Also see "Avon Struggles In U.S. Market, Unveils Plan To Get Back On Track" - HBW Insight, 8 Aug, 2011.).

At the same time, Avon announced it was “recalibrating” its product mix, aiming to have beauty products make up 55% of its overall portfolio and non-beauty – including jewelry and fashion items – the remaining 45%.

Other key products in Avon’s anti-aging skin-care portfolio include Anew Clinical Advanced Wrinkle Corrector, which “immediately plumps out the look of wrinkles and fine lines,” and Anew Platinum Day Cream SPF 25, formulated with patented Paxillium Technology “to help restore youthful cell shape” and Radiescent Microspheres “to immediately counteract dullness and restore radiant skin,” according to the firm’s website.

Eyeing Avon’s Emerging Market Footprint

Much of Avon’s appeal consists in its emerging market access. Avon currently derives 70% of its profits from sales in developing regions, according to UBS.

Of the direct seller’s $11.3 billion in revenues in 2011, 81.5% came from outside of North America. Of Coty’s $4.1 billion in net sales last year, 63% came from outside the Americas.

While Avon has had problems with execution, it does boast manpower in 100 countries, including centers of explosive beauty growth such as Brazil and China. Avon’s asset-light representative-based model has enabled the company to enter developing markets early and with relatively little investment in infrastructure.

Supporting its representatives with effective web-based tools and efficient supply-chain management has proven the challenge, Morningstar noted in a November 2011 report, adding that without knowing “how well Avon can put these operational pieces in place,” analysts have “little visibility as to when meaningful improvement will take hold.”

Morningstar questions whether Avon’s door-to-door sales reps in emerging markets would benefit from having Coty’s celebrity scents added to their basket, given that the fragrance category is “fairly volatile” and celebrities do not necessarily resonate from one market to the next.

Making foreign market considerations even more complex, Avon is the target of an SEC probe into allegations linking Avon to bribes made to government officials in China.

In connection with the company’s own internal investigation into the alleged FCPA violations, former Avon Vice Chairman and CFO Charles Cramb was dismissed earlier this year (Also see "Avon Clearing the Decks: Firm Ousts Cramb Amid Ongoing Investigation" - HBW Insight, 6 Feb, 2012.).

At the time, Deutsche Bank Equity Research analyst Bill Schmitz called Cramb's departure a sign that Avon is “taking steps to right its wrongs and inject accountability into the business.”

In an October 2011 note, Schmitz characterized Avon’s situation as “so bad it’s good” (Also see "Avon Under SEC Probe; Outlook “So Bad It’s Good,” Analyst Says" - HBW Insight, 31 Oct, 2011.).

Any Other Takers?

UBS’ Modi believes that Coty is “serious about acquiring Avon,” and if Avon isn’t receptive, no other suitors are likely to come forward, he says.

According to Modi, Avon is “too large for existing publicly-traded direct sellers to acquire.” Direct-sales firms including Tupperware International, , Natura Cosmetics and Nu Skin would be hard-pressed to afford and successfully integrate Avon’s business, he suggested.

On the other hand, traditional consumer product goods companies have concerns about the long term “viability” of the direct-selling channel, he says in his note.

Procter & Gamble Co. has its own expansive plans for emerging market growth, which don’t include Avon, L'Oreal SA management has a “negative view on direct selling” and [Estee Lauder Companies Inc.] is committed to its “100% prestige portfolio,” Modi says.

Expectation of a large acquisition by Coty has been growing. In January 2011, Berkshire Partners LLC, a Boston-based private equity firm, and Rhone, a private equity firm with offices in New York and London, both made minority investments in the firm following its acquisitions of OPI, Tjoy, Philosophy and Dr. Scheller. Since then, Coty has not made any other sizable acquisitions.

"This mutually beneficial agreement allows Coty to continue its accelerated growth path organically and externally around the globe," Beetz said of the capital boost in January. "By bringing these partners on board, Coty will be in a stronger position to prepare for future and larger acquisitions," he added.

While Avon professedly is committed to it’s “publicly stated path of completing the CEO search and executing against what it believes are strong long-term prospects,” per the firm’s April 2 release, undeniably “there is a need for stronger management,” Morningstar’s Hottovy says.

Avon announced April 2 that it has elected former Campbell Soup Co. CEO Douglas R. Conant as a board director, replacing Paul S. Pressler, partner at Clayton, Dubilier & Rice, Inc., who has chosen to step down (see related brief, p.14).

In light of its recent strategic moves, Avon “seems pretty committed to turning around the business themselves,” Hottovy said.

However, he noted, “there’s a price for everything.”

Coty, along with Reckitt Benckiser and luxury goods firm Labelux Group GmbH, is privately owned by German holding company . With regard to the proposed transaction, Avon says it has worked with BDT & Company, LLC to arrange equity financing, which will be provided by the Joh. A Benckiser and BDT Capital Partners, along with selected limited partners in the BDT Capital Funds.  Coty worked with J.P. Morgan Securities LLC to obtain debt financing for the transaction.