Q1: Compare the performance of Avon stock from 1978 to 1988 with that of overall market. Explain why this has happened – i.e. evaluate Avon’s operating and financial strategies from 1979 to 1988.
Avon’s stock price has declined from $50.75 (closing) in 1978 to $24.125 (closing) in June 1988. This shows a decline of 52% while during the same period S&P 500 went up from 96.11 to 266.69 – an increase of 177%. Return on equity also declined from 31% in 1978 to 21% in 1987.
Due to changing demographics in America, Avon’s margins on sales and sales both declined in 1979-81. This forced the company to look away from their traditional beauty products business to other growing business. Avon acquired few health care/medical companies and this further weakened the cash flow. Change in Medicare policy forced Avon to divest its acquired healthcare business at loss. Then lately, due to increased focus on core beauty business and change in distribution channel Avon’s situation started improving.
Q2: Evaluate Avon’s financial condition in mid-1988. Why was Avon reducing its dividend?
By divesting healthcare business and acquiring fragrance companies, Avon has demonstrated renewed commitment to beauty business and continued investment in that business. For this purpose, Avon needed cash to. In December 1987, Avon had issued common stock in Japan and raised $218 mn. To further conserve cash the firm wanted to reduce its dividend payment.
Q3: What was the purpose of the exchange offer?
The exchange offer was designed to stop the stock price slide due to Avon’s announcement of dividend reduction. As Avon’s 46.5% shares were owned by institutional investors that expected regular stream of dividends, a cut in dividends would have caused these investors to sell their stocks and cause further share price delay. The PERCS designed by Morgan Stanley assured same dividend payment of $2.00 till Sept 1991 and an option to convert these shares into ordinary ones after that date.
Q4: As an institutional investor holding Avon stock, how would you evaluate the trade-off between accepting the new preferred and keeping the common stock?
As an institutional investor, accepting the PERCS offer is like getting a put option without downside cover for exercise price of $31.50 and exercise date of September 1, 1991. Therefore, the investors can not take advantage of the upside of the share price.
