Derivates and Dividend Policy
Introduction

In 1988, Chairman and CEO of Avon Products, Hicks B.
Waldron, was scheduled to propose three topics to Avon’s
board of directors on June 2nd. These three topics included:
– The public announcement that Avon would plan to sell off two of
it’s businesses that were previously acquired, which would result
in an overall book-value loss
– A reduction of the common stock dividend
– An announcement of an exchange offer that Avon’s financial
advisor proposed in which preferred stock for 25% of common
shares would be implemented.
Avon Products, Inc. Background

Soon after it’s establishment in 1886, Avon Products began to rise as one of the largest
companies to sell beauty supplies. Sales were split in two different marketing groups.
One being distributional, which is producing and selling the supplies to department
stores and other retail outlets, and the other being direct selling, or door-to-door sales.

The marketing split was heavily weighted on the direct selling side at the time.
Employees, working out of their homes and such, spoke to friends, family, and
neighbors about Avon’s beauty products. Their selling strategy boosted revenues and
made up for most of the early company profits.

The other developing industry that Avon had been investing in was Healthcare.
Examples of these businesses include Foster Medical Corporation, Mediplex Group, and
Retirement Inns of America. These healthcare groups provided new services beyond
Avon’s beauty business, which created optimism in future returns.

By 1988, Avon had about 400,000 sales reps located in the United States, and about 1.4
million worldwide.
Avon Company History
In 1981 Avon increased it’s dividend on
common stock from $2.55 up to $3.00.
 More importantly they decided to diversify
their business by entering the health care
field.

– In 1982 they acquired Mallinckrodt, a chemical
company specializing in health care.
Changing Times

A major demographic shift
started.
 Women who normally stayed at
home all day now were getting
jobs that took them out of the
home.
 This caused a loss in both their
sales force and their customers.
Changing Times

By mid 1982 they had a weakening cash
flow because of the declining business and
the $170 million Mallinckrodt acquisition.
 Avon in turn reduced their dividends from
$3 to $2/ share.
 The stock price remained steady after the
announcement because it had already
dropped from $30 to $20.375 prior to this
and investors were expecting the drop in
dividend.
Company Changes

In 1984 the new Avon CEO, Hicks
Waldron, began to redesign the company’s
beauty operations.
 Avon no longer focused on direct sales, but
rather distribution channels.
 However, they would look for other
acquisitions in case the changes to the
beauty business failed.
Company Changes
There was a possibility the public health
care policy could change from hospitalbased care to home-care.
 When Avon acquired Foster Medical
Company in May 1984 things started to
look up because they specialized in
home-care.

Company Changes

Avon also acquired Retirement Inns at the
end of 1985 and Mediplex mid 1986.
– They both managed retirement living centers.
– Mediplex also operated sub-acute health care
facilities like alcohol and drug abuse centers.

Avon sold Mallinckrodt in 1986 for $675
million to focus on provision health care.
Avon’s Reorganization
Foster Medical’s revenues primarily came
from Medicare, the largest public health
insurance programs in the US.
 A change in Medicare in 1986 cut Foster
Medical’s charges for patients by 18%

– Foster Medical did not respond well to the
change.
Avon’s Reorganization

Avon’s management
recommended it review Avon’s
commitment to the health care
industry.
– It was decided that Foster Medical,
Mediplex, and Retirement Inns
could no longer show acceptable
profit.

By 1987 Beauty Group began to
improve markedly.
Beauty Group’s strength allowed Avon to
shed the Health Care Group companies.
 It sold Foster Medical Supply in late 1987.
 Early 1988 Avon also started selling the
entire Foster Medical Corporation.

– Avon anticipated and after-tax loss of $125
million on the sale.
Avon’s Reorganization

In 1987, Avon acquired
Giorgio, Inc for $165 million
cash and Parfums stern, Inc for
$160 million.
 This added prestige fragrances,
sold through retail stores, to
Avon’s beauty line.
 It also continued Avon’s
transition away from direct
sales approach.
The Exchange Offer

Mr. Waldron recognized that the massive
reorganization of the business should be
followed by a reorganization of Avon’s
financial policies

Sufficient capital would be needed to invest
in the company to expand the beauty products
business

December 1987- Avon sold 40% of the CS of
subsidiary

The board felt that a reduction of dividends
was necessary to conserve cash flows

Reduce Dividends from $2.00-$1.00
The Exchange Offer

Mr. Waldon was worried about the
consequences of simply cutting Avon’s
dividend.

Even though the last dividend cut didn’t
result in a drop in Avon’s stock price, it
probably would this time around.

The stock price has remained steady, and the
1987 annual report stated that Avon expected
to “maintain the current dividend of 2$”

A sudden cut of the dividend would be
disastrous for Avon, as most of the major
shareholders would sell their shares.
“For five years I had been telling them that we weren’t
going to cut the dividend, and for five years they had
been telling me they didn’t believe me”
– Hicks B. Waldron
25 Largest Institutional Holders of Avon Stock
The Exchange Offer





A similar security was successfully marketed
by Americus Trust called PRIME units.

Mr. Waldron knew Avon needed to offer an
alternative to simply cutting the dividend in
order to make their stock attractive.
Americus Trusts’ sole asset was common
stock of a particular company

The board looked toward their financial
advisor, Morgan Stanley, to find a solution to
the problem.
Shareholders of the company would place
their shares in a trust and are issued 2 units: a
PRIME and a SCORE, against each share

At a predetermined date, trust would liquidate
all shares
PRIME holders would receive value of shares
up to a predetermined level
SCORE holders would receive any excess
Some investors had stated that they held
Avon stock ONLY because it paid a high
dividend.
Morgan Stanley’s answer was a relatively
new type of Preferred Stock: PERCS
(Preferred equity-redemption cumulative
stock)


Characteristics of the PERCs Shares



Avon would offer to exchange one share of a
new $2.00 PERCS for each of up to 18
million of Avon’s 7.17 million outstanding
common shares.
New preferred would pay cumulative
quarterly dividends of 50 cents
The company would be able to redeem the
preferred shares at any time according to a
declining schedule
–


Redemption price would be $34.75/share plus
accrued dividends, for the quarter starting June
1, 1988. It would decline by 25 cents per share
for EACH QUARTER thereafter.
Avon has option of redeeming the preferred
for either cash or common shares
Mandatory redemtion of the PERCS shares
on September 1,1991.
Avon Case Questions
1 + 2. Why was Avon restructuring its business? Did the changes make sense? Why is
Avon reducing its dividend?

Avon Products, Inc. restructured its business to
comply with ongoing changing market conditions.

The changes made sense and were necessary. Due to
the overwhelming demographic shift away from stay
at home mothers, a new business model was needed.
As a result of the shift, Avon’s margins on beauty
product sales declined from 1979 to 1981.



In 1984, Avon’s new CEO, Hicks B. Waldron
devised a plan to build on the beauty business
through distribution channels more than direct sales.

By 1987, distributional beauty sales began to pick up.
This lead to the transformation away from the direct
sales approach, as Mr. Waldron intended.

Under the safety of the new beauty business
revenues, Mr. Waldron then decided to sell off the
healthcare companies that were previously acquired,
including Foster Medical Corporation.

These decisions to adapt Avon Products, Inc. with
the continuously fluctuating economy created a
safety net.
The company then felt threatened. Avon started to
develop additional distribution channels and
purchasing healthcare companies in an attempt to
diversify assets and prevent loss.
After acquisitions, cash flow was very weak, and
Avon felt the need to cut dividends for shareholders
from $3.00 to $2.00 per share per year. The dividend
cut was needed in order to provide more cash to
reinvest in their new channels of business.
Avon Case Questions
3. What was the purpose of the exchange offer?

The purpose of the exchange offer was to create a safety measure to prevent investors from selling their shares as a
result of the reduction in dividends and the subsequent drop of the stock price. Investors had stated that they held
Avon stock because of the high dividend that was paid to them.

In a previous attempt at conserving cash flow in 1982, Avon reduced it’s dividend from $3.00 to $2.00 per share per
year. At that time the stock price had been steadily decreasing and investors had expected the cut in dividend price.
This expectation cut the potential negative affect upon the stock price.

Avon’s Board of Directors were worried that a further decrease in dividend would result in investors selling their
shares because the dividend reduction would drive down stock prices. CEO Mr. Waldron had stated that for five
years, shareholders were convinced the dividend would be reduced further from $2.00 to $1.00. Even though Mr.
Waldron had told them it wouldn’t, the cash situation worsened.

Avon wanted to provide incentive for the shareholders to hold the stock, so the board of directors then asked their
financial advisor, Morgan Stanley, about the situation. PERCS (preferred equity-redemption cumulative stock) were
then introduced.

The overall purpose of the exchange to $2.00 PERCS was to provide shareholder comfort, stability, and trust, which
in turn creates long-term shareholder loyalty.
Evaluation of Options
4. How would you evaluate the trade-off between accepting the new preferred and keeping the CS?
PERCS Shares







Better for an investor who requires high
dividends
Senior standing to common stock
Includes a restriction providing that Avon
could never pay a common dividend of
$1.50 or more per share per year unless it
first redeemed the preferred
No voting rights
Fixed dividend
On expiration date, the holders would
receive one common share for every
PERCS share if the price of the common
stock was less than or equal to $31.50, or
$31.50 worth of CS per PERCS share, or
the cash equivalent, if the CS was above
that price.
Gives up the call option by taking PERCS
Common Stock




CAN NOT be redeemed at any time unlike
the PERCS, which can be redeemed
according the decline schedule
More control- will not loose shares if price
jumps above $31.50
Lower dividend
Voting power
What is a fair price for the PERCs?
5. What is a fair price for the PERCs security?

PERCS = Stock + PV of Excess Dividends – Call Price with Strike of $31.50
PV of Excess Dividends = PV of the Dividends in excess of $1.25
Call Price = Value of the call option that the preferred holders forfeit

Call Price was found using an Options calculator:


–
–
–
–
–
–

K = 31. 50
S= 24.125
T= 3 Years
Volatility = 31.3%
Rf= T-Bill Rate= 8.2%
Call Price = $4.914
PV of Excess Dividends = .1875/(1.082)^3/12 + .1875/(1.082)^.5 + .1875/(1.082)^9/12 +
.1875/(1.082)^1 + .1875/(1.082)^15/12 ……… through all dividends accrued until Sept 1991
–
PV of Excess Dividends = 2.129

PERCs = 24.125 + 2.129 – 4.914 = $21.34

Therefore, a fair price for the PERCs shares would be $21.34
Summary of the Decision





The decision as to whether or not to take the PERCs shares or keep the common stock depends on the
expectation of future stock prices.
Since the shares can be redeemed for cash according to a declining schedule, if the investor expects the
price to rise above $31.50, it would be wise to keep the CS shares ever with the lower dividend payments.
If the investor expects the price of the shares to stay below the redemption prices, take the PERCs shares
in order to reap the benefits of a higher dividend payment for the three years until mandatory redemption
After three years, PERCs will be redeemed for common stock shares. The holders would receive one
common share for every PERCs share if the price of the common stock was less than or equal to $31.50
If the stock prics is above $31.50, the holder would receive $31.50 worth of CS for each PERCs share.