TEXT-S&P cuts Avon Products Inc

Fri Mar 16, 2012 2:48pm EDT

Overview	
     -- Global cosmetics company Avon Products Inc.'s operating results 	
continue to be weak and credit metrics have deteriorated over the past year.	
     -- We are lowering our corporate credit rating on Avon to 'BBB' from 	
'BBB+'.	
     -- The outlook is negative, reflecting our concern that weak operating 	
results may persist in light of continued operating disruptions in Avon's 	
major markets. These may be further exacerbated by the uncertainty caused by a 	
longer-term company strategy that is on hold until a new CEO is placed, and by 	
potential management distractions from the ongoing SEC investigation.	
	
Rating Action	
On March 16, 2012, Standard & Poor's Ratings Services lowered its corporate 	
credit rating on Avon Products Inc. to 'BBB' from 'BBB+'. The rating outlook 	
is negative. At the same time, we lowered our ratings on the company's senior 	
unsecured notes to 'BBB' from 'BBB+'.	
	
The 'A-2' short-term rating remains unchanged. We believe the company's strong 	
liquidity and good access to capital markets support the short-term rating.	
	
Rationale	
Today's rating action reflects the company's weak operating results, and 	
credit metrics deterioration amid persistent soft global economic conditions 	
and continued operating disruptions in Brazil. Brazil is a key market for the 	
company. Service delays related to the implementation of Enterprise Resource 	
Planning systems pressured sales and profitability in Brazil.	
	
The rating action also reflects our expectations for some margin erosion in 	
2012 due to higher operating expenses related to increased investment in the 	
company's "representative value proposition" (RVP) broad-based recruitment and 	
reward platform, rising commodity costs, and expenses related to the ongoing 	
investigation under the Foreign Corrupt Practices Act (FCPA), all will 	
contribute to lower margins and earnings. We believe an operating turnaround 	
could be more difficult to manage than previously expected. 	
	
In December the company announced that it is seeking to replace its CEO, and 	
longer-term company strategy will depend on the new CEO. Without a clear 	
longer-term strategy in place, we are uncertain about the company's ability to 	
execute an operating turnaround over the next year. 	
	
The SEC's formal investigation related to the company's possible violations of 	
the FCPA and Regulation FD adds additional risk. The bribery investigation and 	
potential disclosure violation could be a distraction for management and could 	
lead to fines and other regulatory action against the company.	
	
Our ratings on U.S.-based cosmetics company Avon Products incorporates our 	
view that the company's business risk profile continues to be "satisfactory" 	
and its financial risk profile as "intermediate", as our criteria define these 	
terms. Avon has sustained its good market share in the direct sales channel. 	
It has also sustained a broad international presence, with more than 75% of 	
the company's revenue generated outside North America. Additionally, the Avon 	
brand continues to exhibit brand strength. However, we believe the risks of 	
direct sales distribution and near-term operating difficulties, especially in 	
its Brazil, Russia, and North American businesses, somewhat offset the 	
company's strengths. 	
	
Avon's intermediate financial risk profile is supported by its continuing 	
strong liquidity and credit measures, which, despite the deterioration, remain 	
in line with the indicative financial ratios for the "intermediate" 	
descriptor. This includes adjusted leverage from 2x to 3x. Credit metrics have 	
weakened as a result of declining profitability and higher debt levels. The 	
ratio of total debt to EBITDA for fiscal year 2011 increased to about 2.7x. 	
This compares with 2.6x leverage in the prior year and historical levels of 	
1.7x, with the leverage increase primarily attributable to the debt-funded 	
acquisition of Silpada Designs Inc. in July 2010. We believe credit measures 	
could further deteriorate if the company is not able to improve operating 	
results over the next year.   	
	
Avon's operating performance has declined significantly since 2009, despite 	
various restructuring programs that generated significant annual cost savings. 	
The company's EBITDA margin has been on a declining trend and is below its 	
peers, contracting about 60 basis points from the prior year, to about 13% at 	
fiscal 2011, and nearly 300 basis points since 2008. 	
	
Our assumptions for Avon over the next year include the following:	
	
     -- Low-single-digit revenue growth, as we expect softness will persist in 	
some of its key markets.	
     -- EBITDA margin between 12% and 13%, as margin pressure from higher 	
commodity costs, labor costs, and operating expenses related to investment 	
spending continues. 	
     -- Flat capital expenditures of about $275 million.	
     -- Dividends of about $400 million to be funded with cash flow generation.	
	
Under these base case assumptions, we expect the company's credit metrics will 	
remain near its current levels, which includes adjusted leverage in the 	
high-2x area in fiscal 2012. We forecast the ratio of funds from operations to 	
total adjusted debt will be about 30%, and free operating cash flow to be $400 	
million to $500 million over the next year. 	
	
Avon continues to have large scale and geographic diversity, which can 	
generally compensate for regional weaknesses. Its diverse operating base also 	
helps offset the impact of foreign currency fluctuations in regional markets. 	
Developing markets remain a significant portion of the company's sales, and we 	
expect them to continue to be an important component of Avon's long-term 	
growth strategy.	
	
Liquidity	
Avon has "strong" liquidity (as defined in our liquidity criteria), with 	
sources of cash that are likely to exceed uses for the next 12 to 24 months. 	
We expect the company's substantial cash balances, cash flow generation, and 	
access to capital markets to be more than adequate to support its operating 	
needs and debt maturities over the next couple years. The next debt maturity 	
is in 2013.	
	
Our view of the company's liquidity profile incorporates the following 	
expectations:	
	
     -- We expect coverage of uses of cash to exceed 1.5x in the next year and 	
1.0x in the next 24 months.	
     -- Cash sources include existing cash balances of $1.3 billion (of which 	
a significant portion is held overseas) and a $1 billion commercial paper 	
program backed by a $1 billion revolving credit facility that is due in 2013. 	
At the end of fiscal year 2011, there was nothing outstanding on the revolving 	
credit facility and $709 million outstanding under the commercial paper 	
program.	
     -- We expect cash uses to include some investment in working capital, 	
about $275 million in capital spending, and about $400 million in dividends.	
     -- We expect net sources of cash would be positive even with a 30% drop 	
in EBITDA.	
     -- The company has a minimum interest coverage covenant, which we expect 	
the company will maintain sufficient covenant cushion on.	
     -- We expect Avon could likely absorb low-probability shocks based on its 	
positive cash flow and current cash balances.	
	
Outlook	
Our rating outlook on Avon is negative, given the continued operating issues 	
in Brazil and softness in other key markets, including Russia. Furthermore, we 	
are uncertain as to whether the company will be able to execute an operating 	
turnaround and improve credit metrics over the next year, given the lack of 	
clear strategy without a new CEO in place and the ongoing SEC investigation, 	
which could be a further distraction and adds some risk to the company's 	
reputation. We also expect higher investment spending on representatives, 	
rising commodity costs, and global economic conditions will continue to affect 	
the company's sales base and margins. We would contemplate lowering the rating 	
if the company is not able to improve its operating results, or if the bribery 	
and FD regulation investigations lead to additional costs and result in 	
further deterioration of credit metrics, such that leverage increases to above 	
3x. Leverage could rise to this level if debt increased 11% to $4.4 billion, 	
or if EBITDA fell 10% (assuming debt levels remain unchanged). If we lower the 	
long-term rating to 'BBB-', we would lower the short-term rating to 'A-3' 	
based on our criteria.	
 	
	
Alternatively, we could consider a stable outlook if the company is able to 	
resolve some its operating issues in its key markets and stabilize its 	
operating results, such that leverage is lowered and sustained near 2.5x. This 	
could occur if EBITDA increases 8% (assuming debt levels remain unchanged). 	
	
Ratings List	
Downgraded; Short-Term Rating Unchanged	
                           To                From	
Avon Products Inc.	
 Corporate credit rating   BBB/Negative/A-2  BBB+/Negative/A-2	
 Senior unsecured          BBB               BBB+ 	
	
Rating Unchanged	
Avon Capital Corp.	
 Commercial paper          A-2
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