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Avon Facing Downgrade Regardless of Coty Bid: Corporate Finance

Avon Facing Downgrade Regardless of Coty Bid
A downgrade would raise New York-based Avon’s borrowing costs, limiting its ability to fund a turnaround after three years of declining profit. Photographer: Scott Eells/Bloomberg

Avon Products Inc. is probably due for a ratings cut whether or not it’s bought by Coty Inc., complicating efforts by the world’s largest door-to-door cosmetics seller to restore profitability and stay independent.

Even before Avon turned down a $10 billion bid from Coty, the maker of perfumes by Heidi Klum and Beyoncé Knowles, credit-default swap traders were treating the company as junk, according to Moody’s Corp.’s capital markets research group. Swaps linked to the target’s debt jumped more than 10 percent after the Coty offer was made public on April 2. Moody’s Investors Service rates Avon A3, while Standard & Poor’s has it two levels lower at BBB. Both maintain “negative” outlooks.

A downgrade would raise New York-based Avon’s borrowing costs, limiting its ability to fund a turnaround after three years of declining profit. The company hired a new chief executive and is investigating potentially improper overseas practices. Coty plans to finance part of the purchase with debt, putting pressure on Avon’s ratings if the deal goes through.

“Every single piece of the business is uncertain,” said Jody Lurie, a corporate-credit analyst at Janney Montgomery Scott LLC in Philadelphia. “The bond market sees this increased level of risk based on this uncertainty with the Coty transaction and with the investigation and the new CEO.”

Avon has $2.26 billion of bonds outstanding, $875 million of which will mature in the next two years. Coty Chairman Bart Becht said in an April 16 letter to Andrea Jung, Avon’s chairwoman, that his company had equity commitments for its offer of more than $5 billion. He said Coty was working with JPMorgan Chase & Co. to raise debt financing.

‘Pretty Chronic’

Jennifer Vargas, an Avon spokeswoman, didn’t respond to a voicemail seeking comment.

Avon’s problems are “pretty chronic,” according to Bonnie Baha, head of the global developed credit group at DoubleLine Capital LP in Los Angeles, where she helps oversee $32 billion.

“Any way you slice it, the credit metrics for Avon are deteriorating,” Baha said in a telephone interview. “So many things have conspired against them: shifting demographics, Internet retailing. The direct sales model is a thing of the past. The fact they do have a majority of their sales in developing markets is good and it’s sort of kept things afloat for a while, but the strong dollar worked against them.”

Narrowing Margin

Avon was started in 1886 as the California Perfume Co. when salesman David McConnell hired women to sell his products house-to-house after discovering that his free “door opener” fragrance samples were more popular than the books he peddled. Over the years, U.S. sellers transitioned from home visits, to workplaces, to online.

The company’s net income margin narrowed to 4.55 percent in 2011, from 5.58 the year before and 6.13 in 2009, according to data compiled by Bloomberg. Avon, which had $1.25 billion of cash and equivalents at the end of last year, down from $1.3 billion on Dec. 31, 2009, lacks the capital needed to mount a takeover defense, so it would have to issue debt, Baha said.

Credit-default swaps tied to Avon, which typically rise as investor confidence deteriorates, have surged to 264 basis points from less than 100 in October, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market. A basis point equals $1,000 annually on a contract protecting $10 million of debt. The swaps fell to 258.5 as of 12:27 p.m. in New York, CMA data show.

‘Paying Attention’

The contracts have climbed to levels implying the debt should be rated Ba1, the highest step of speculative grade, according to Moody’s data. The swaps last signaled the company should be rated investment grade on March 26. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt.

Investment-grade bonds are rated above Baa3 by Moody’s and BBB- by S&P. Yields on bonds at the bottom of that category average 4.04 percent, while the highest-rated speculative-grade debt pays 7.64 percent, according to Bank of America Merrill Lynch index data.

“The fact that Moody’s still has it at A3 tells me no one is really paying attention to this,” Baha said.

Moody’s analysts Janice Hofferber and Peter Abdill wrote in a note dated April 3 that the Coty offer “is a credit negative” although they didn’t change the rating. “Credit and event risk has increased at a time when Avon’s operating and financial profile is under pressure,” they wrote.

Avon’s “turnaround could be delayed” by management distraction, an inability to recruit new representatives or a postponement of its restructuring resulting from the Coty offer, they wrote.

Equity, Debt Financing

BDT Capital Partners LLC, an investment firm run by former Goldman Sachs Group Inc. executive Byron Trott, and Coty’s majority owner, Joh A. Benckiser SE, have committed equity financing totaling more than $5 billion, and the perfume company has a “highly confident” letter from JPMorgan for debt financing, Becht said in the April 16 letter. Coty intends to structure financing in a way that preserves Avon’s investment-grade rating, according to the letter.

“The numbers don’t tell that story to us, not even with $5 billion in equity financing,” Carol Levenson of Chicago-based Gimme Credit LLC, wrote in a report the same day. Even if Coty coaxes ratings companies to give it the benefit of the doubt, “this would still be a major downgrade for Avon, by the way, which currently carries ratings well above the minimal investment grade level,” she wrote.

Founded in Paris

Coty, founded in 1904 in Paris by Corsican-born Francois Coty, helped develop perfume into a mass product, with 36 million consumers two decades later. The New York-based company’s bid of $23.25 a share “reflects what we know about Avon based on public information as well as our concerns with what we do not know,” Becht said in the letter.

There are “significant items materially impacting the value of Avon,” Becht wrote. Coty can’t determine the best price because it hasn’t been invited to perform due diligence, and doesn’t know the extent of Avon’s legal issues concerning an investigation related to the Foreign Corrupt Practices Act, he said. Avon began a probe into its Chinese operations in 2008, centering on the bribery of foreign officials that led to the firing of executives.

Avon responded to say that Coty’s offer is “opportunistic and does not reflect the fundamental value of the company and its global beauty care and direct selling franchise.” The shares ended at $19.36 on March 30, the day before the offer, and closed yesterday at $21.85, down 23 percent from a high of $46.14 on June 30, 2004.

‘Challenging Business Model’

Sherilyn McCoy was appointed as Avon’s chief executive officer on April 9. McCoy previously served as vice chairman of the pharmaceutical, consumer corporate office of science and technology and information technology divisions at Johnson & Johnson. Coty and Avon had discussed McCoy running a combined company, and Becht said in an April 2 interview that it “would not be helpful” for Avon to hire a new CEO in light of the bid.

Avon has a “challenging business model, certainly relative to the 50s,” according to Jason Brady, who manages bonds at Thornburg Investment Management in Santa Fe, New Mexico, which oversees $73 billion.

“The market probably has this one a little more right,” Brady said in an interview. “The rating is lagging.”

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