Overview -- U.S.-based Avon's operating performance continues to be weaker than expected and credit metrics remain weak. -- We are revising the 'BBB-' rating outlook on Avon to negative from stable. -- The negative outlook reflects our expectation that the company's operating performance will continue to be weak and leverage will be above 3.5x, unless the company reduces debt levels. Rating Action As Standard & Poor's Ratings Services previously announced, on Nov. 1, 2012, we affirmed our 'BBB-' corporate credit rating on New York City-based Avon Products Inc. and revised the rating outlook to negative from stable. In addition, we affirmed our 'BBB-' issue-level ratings on the Avon's senior unsecured debt and 'A-3' commercial paper rating. Rationale The negative outlook reflects Avon's continuing poor operating results and weak credit metrics. We estimate adjusted leverage continues to be above 3.5x as of the recent September quarter compared with 2.5x in the September 2011 quarter. We have also revised our financial risk profile to "significant" from "intermediate," supported by weaker credit metrics and our change in our assessment of the company's liquidity to "adequate" from "strong." Financial ratios indicative of a significant financial risk profile include ratios of adjusted total debt to EBITDA between 3x and 4x, funds from operations (FFO) to total debt between 20% and 30%, and adjusted total debt to capital between 45% and 50%. Avon's credit metrics are weaker mainly because of declining profitability and higher debt. Its ratio of total debt to EBITDA for the September 2012 quarter remained elevated above 3.5x, an increase from 2.7x at 2011 year-end and historical levels of 1.7x. We attribute the increase primarily to the debt-funded acquisition of Silpada Designs Inc. in July 2010. Though we had expected leverage to increase above 3.5x, we now expect it will be difficult for the company to materially lower leverage through improved operating results, as slow operating turnaround and weak operating performance could persist into next year (though we believe the company could lower leverage by reducing debt). Additionally, although the company has reduced its outstanding commercial paper and cut its dividend by about 75%, the company's cash flow generation has decreased and the company has financial covenants, with cushion estimated to be below 30%. The company also has about $375 million of debt maturing in 2013, which we expect the company will address. Our Avon ratings also reflect our view that the company's business risk profile will remain "satisfactory." Avon continues to sustain its good market share in the direct sales channel. It has also sustained a broad international presence, generating more than 75% of the company's revenue outside North America. Additionally, the Avon brand continues to exhibit brand strength. Our assessment of the business risk also includes the inherent risks of operating with channel concentration as a direct sales company (including potential difficulties with its sales force and participation in the highly competitive cosmetic industry). Our assumptions for Avon include a slow operating turnaround. Although the company has resolved the issues related to the Enterprise Resource Planning systems implementation in key-market Brazil, operating improvement continues to be slow, and sales and profitability remain pressured. The company continues to face soft overall top-line growth against foreign exchange headwinds and margin pressure from higher input costs, increased investment in its "representative value proposition" (RVP; a broad-based recruitment and reward platform), and other expenses (such as for the ongoing investigation under the Foreign Corrupt Practices Act ). We expect the company will need to make investments to improve operating efficiencies, and it may take time before the company begins to benefit from the new management's operating turnaround strategy. Our assumptions over the next year include the following: -- Weak sales growth, which could include mid- to high-single digit percentage sales declines for this year, as we expect negative foreign exchange and softness to continue in some of its key markets. -- Margin pressure persists from higher commodity costs, labor costs, and operating expenses related to continued investment spending in its sales representatives. -- Relatively flat capital expenditures of about $260 million to $280 million for this year and possibly increasing beyond 2012, as the company may make investments as part of its operating turnaround strategy. -- Dividends cut to about $100 million. 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 declining and is below its peers', contracting about 500 basis points since 2008 to about 10%. Avon continues to have large scale and geographic diversity, which can generally compensate for regional weaknesses, if the company is operating efficiently. Its diverse operating base also helps offset the effect 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 important to Avon's long-term growth strategy. Liquidity Avon currently has adequate liquidity, with sources of cash that are likely to exceed uses for the next 12 months. We expect the company's substantial cash balances, cash flow generation, and access to capital markets will support its operating needs and debt maturities over the next couple of years. The next debt maturity is about $375 million in 2013. Our view of the company's liquidity profile incorporates the following expectation: -- We expect cash sources to cover uses of cash by at least 1.2x in the next 12 months. -- We expect net sources would be positive, even with a 15% drop in EBITDA. -- Cash sources include existing cash balances of $1.1 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. On Sept. 30, 2012, there was nothing outstanding on the revolving credit facility and about $69 million outstanding under the commercial paper program. The company has indicated it does not plan to reinvest its 2012 foreign earnings. The company may further reduce its reliance on its outstanding commercial paper by year end. -- We expect cash uses to include some investment in working capital, about $260 million to $280 million in capital spending, and about $100 million in dividends. -- The company has leverage and interest coverage covenants on the new $550 million term loan, as well as a minimum interest coverage covenant on its private placement notes. The company currently has about 20% cushion on its tightest covenant and we expect the company would remain compliant even with a 15% drop in EBITDA. Outlook The outlook is negative. Operating performance has been poor and we expect progress towards stabilizing the business to be slow over the next 2 years. We would consider lowering the rating if credit metrics do not begin to improve, including leverage decreasing to about 3.5x by year end and towards the low 3x area over the next year. The company could possibly achieve this through debt reduction and we would also expect some progress towards improved operating results, including increased profitability, next year. If we lower the long-term rating to speculative grade, we would lower the short-term rating to 'B'. Although unlikely in the next 12 to 18 months, we could consider revising the outlook to stable if the company improves operating results, particularly in Brazil, and increases profitability, leading to improved credit metrics on a sustained basis, including leverage in the low 3x area. Related Criteria And Research -- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012 -- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 Ratings List Ratings affirmed; Outlook Revised To From Avon Products Inc. Corporate credit rating BBB-/Negative/A-3 BBB-/Stable/A-3 Ratings Affirmed Avon Products Inc. Senior unsecured BBB- Commercial paper A-3 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.