QUESTION
We will cover the Avon Products case. In preparing your memo, be sure to cover the following points:
– Evaluation of Avon’s historical capital budgeting, investment and dividend-payout policies during the previous decade. In other words, how did Avon get into the mess it finds itself in 1988?
– Evaluation of Avon’s restructuring decision. You should perform a DuPont analysis of the performance of Avon’s major lines of business over the 1982-1987 period in support of your recommendation regarding any divestitures. This involves calculating ROA and decomposing it into profit margin and asset turnover.
– Evaluation of Avon’s dividend policy going forward. Should Avon accept Morgan Stanley’s recommendation regarding the proposed dividend cut and PERC issuance? Be sure to tie your recommendation to the three major theories of dividend policy.
ANSWER
Capital Budgeting Decision
The capital budgeting decisions taken by the Avon in the past decade was mostly related to the foray of company into healthcare sector. The company made three large investment in the healthcare sector in past five six years. The first one was in Mallinckrodt and the investment in it was about $710 million and was sold for $675 million in the year 1986. Assuming all the pre-tax earnings of segment healthcare are in actual cash flow from Mallinckrodt business of Avon, it gives us an IRR of 8.26%, which is very less than the RoE of 23.6% of the year 1981. Along with that Mallinckrodt, Avon acquired two more healthcare companies, Foster Medical and Retirement Inns in the year 1985 and 1986 respectively but later had to sell them at an after-tax loss of $125 million. The decision foraying into healthcare segment is a bad capital budgeting as well as strategic decision. The company was not able to forecast the things about to happen in the particular industry (government policy) and thus lost badly.
Avon made investment in other period also, which gave company extraordinary returns. That means there was no problem with the capital budgeting decision but the problem was company foraying into an unknown territory of healthcare sector.
Dividend Policy
|
Year |
Closing Stock Price |
Dividend |
Percentage of Dividend Paid to Closing Price |
|
1978 |
50.75 |
2.55 |
5.02% |
|
1979 |
39.38 |
2.75 |
6.98% |
|
1980 |
34.25 |
2.95 |
8.61% |
|
1981 |
30.00 |
3.00 |
10.00% |
|
1982 |
26.75 |
2.50 |
9.35% |
|
1983 |
25.13 |
2.00 |
7.96% |
|
1984 |
21.88 |
2.00 |
9.14% |
|
1985 |
27.63 |
2.00 |
7.24% |
|
1986 |
27.00 |
2.00 |
7.41% |
|
1987 |
25.75 |
2.00 |
7.77% |
The dividend policy of the company has been quite strange. In the initial years the company tried to increase the dividend at a constant term, but once the dividend started putting burden on the cash position of the company started reducing the dividend to $2 per share. But keeping at $2 was not at all the right strategy for the company. On and all the dividend raises some serious question, they are giving on an average 8-9% of the closing price in the form of dividend which according to the industry standards is pretty high. In 1978, the dividend was 5% of the closing share price which is decent enough, but they should have maintained this range of 5%, but instead of that the went on started increase the dollar value of dividend without keeping in mind the share price of the company.
DuPont Analysis
|
Particulars |
Cosmetics |
Fashion jewellery |
Health Care |
Misc. |
Overall |
|
|
1982 |
Return on Asset |
28.85% |
33.46% |
7.39% |
5.73% |
18.60% |
|
Net Profit Margin |
14.00% |
18.30% |
15.47% |
6.45% |
13.84% |
|
|
Asset Turnover Ratio |
2.06 |
1.83 |
0.48 |
0.89 |
1.34 |
|
|
1983 |
Return on Asset |
23.24% |
26.09% |
8.51% |
3.38% |
14.93% |
|
Net Profit Margin |
11.66% |
13.17% |
15.81% |
3.76% |
11.38% |
|
|
Asset Turnover Ratio |
1.99 |
1.98 |
0.54 |
0.90 |
1.31 |
|
|
1984 |
Return on Asset |
25.43% |
27.32% |
9.54% |
-2.34% |
15.42% |
|
Net Profit Margin |
12.95% |
15.67% |
16.89% |
-1.93% |
11.97% |
|
|
Asset Turnover Ratio |
1.96 |
1.74 |
0.56 |
1.21 |
1.29 |
|
|
1985 |
Return on Asset |
19.96% |
17.32% |
16.22% |
-4.11% |
11.11% |
|
Net Profit Margin |
11.95% |
10.73% |
19.67% |
-15.29% |
10.30% |
|
|
Asset Turnover Ratio |
1.67 |
1.61 |
0.82 |
0.27 |
1.08 |
|
|
1986 |
Return on Asset |
21.74% |
22.05% |
8.88% |
-10.36% |
13.88% |
|
Net Profit Margin |
12.31% |
14.52% |
15.05% |
-12.92% |
11.05% |
|
|
Asset Turnover Ratio |
1.77 |
1.52 |
0.59 |
0.80 |
1.26 |
|
|
1987 |
Return on Asset |
18.14% |
19.26% |
2.55% |
14.34% |
15.02% |
|
Net Profit Margin |
13.90% |
12.18% |
6.04% |
18.77% |
13.92% |
|
|
Asset Turnover Ratio |
1.30 |
1.58 |
0.42 |
0.76 |
1.08 |
|
Over the years, one thing that can be said about the company is their heavy investment in Healthcare sector. Healthcare sector has good net profit margin, better than cosmetic segment in almost all the years. But the problem with healthcare segment is the asset turnover ratio. This ratio is below par when compared to other two major segments of the company and below the company average also. This means that the company was not able to generate sufficient sales in healthcare segment. If the company was able to generate sufficient sales in this segment, this segment would have performed better than other segments of the company. There could be a number of reason for this, but the most probable reason is lack of expertise of the company in this particular segment.
The Future
The company needs a complete overhaul of its dividend policy. As stated earlier the dividend policy of the company was not at all right as they paying quite high dividend for quite a low price. Also, looking at the historical trend the irrelevance theory is not at all applicable. This can be said because the shares of the company started falling in anticipation of lower dividend announcement by the company. Also, going into the future the board believes that the large shareholders of the company will sell the shares if the company reduces the dividend. Therefore, this simply beats the basic assumption of the irrelevance theory. The most applicable theory in this particular case is the residual theory, this is because company is going through an internal reconstruction and thus all the money if invested back in the company will earn higher return. And thus, giving the shareholders only residual dividend. Moreover, as per the tax preference theory investors tend to prefer capital gain over dividend because of reduced tax burden.
Therefore, the company should accept the Morgan Stanley proposal and offer the shareholders who wants dividend preference shareholders and those who don’t want dividend can stick to common shareholders and should reduce the common dividend drastically to $.50 per share. This will help the company to reinvest the money back into the operations.
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