OREANDA-NEWS. 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 $605 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. Net proceeds to be retained by Avon are $335 million, with the remaining $270 million contributed to Avon North America. 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 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 $435 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.