Avon Products, Inc.

On June 1, 1988, Hicks B. Waldron, chairman and chief executive officer of Avon Products, Inc., was reviewing a package
of proposals that he and his financial advisors were to present to the Avon board of directors for final approval the
following day. These proposals included (1) a public announcement that Avon would explore plans to divest two of its
businesses, probably at a considerable book loss; (2) a reduction of the dividend on Avon’s common stock; and (3) an
exchange offer under which Avon would issue an unusual preferred stock in exchange for up to 25% of its common shares.

Background
Avon Products, Inc., founded in 1886, was one of the world’s largest manufacturers and marketers of beauty products.
The company was famous for its direct selling beauty business, in which a sales force of independent contractors
purchased products from Avon and then resold them door-to-door, largely to their friends and neighbors. In addition, by
the mid-1980s, the company was an important national provider of sub-acute health care services.

Avon’s Beauty Group produced and sold cosmetics, fragrances, toiletries, and fashion jewelry and accessories; it also sold
gift and decorative products. While it sold several fragrances through retail establishments, most of the Beauty Group’s
revenues were from its direct sales operations. In 1988 Avon had 1.4 million active sales representatives worldwide,
including 400,000 in the United States. Avon’s other principal business group was its Health Care Group, which comprised
Foster Medical Corporation, the Mediplex Group, and Retirement Inns of America. They provided home health care,
operated retirement living facilities, and provided certain sub-acute health care services. Exhibit 1 gives a 10-year review
of Avon’s financial performance, and Exhibit 2 gives data by lines of business for the period 1982-1987. Exhibit 3 shows
balance sheets for 1986 and 1987, and Exhibit 4 gives an historical perspective on Avon’s stock price.

Recent Company History

As a result of its strong cash flow, Avon was able to increase its dividend regularly in the late 1970s while aggressively
seeking acquisitions. By 1981 Avon had raised the dividend on its common stock to $3.00, up from $2.55 in 1978. But more
important, in the early 1980s, Avon made the major strategic decision to diversify its business by entering the health care
field. Its first acquisition in that field was in January 1982, when Avon acquired Mallinckrodt, Inc., a specialty chemical
company whose sales were largely to the health care industry.

However, during this same period, an important demographic shift was beginning to threaten Avon’s Beauty Group. The
majority of Avon’s sales representatives and their customers had traditionally been women who spent much of the day at
home. But increasingly these women were entering occupations that required them to be away from home during the
day. Therefore Avon was losing both its sales force and its customers. From 1979 to 1981, Avon’s margins on beauty
product sales declined as the company broadened its direct-sales product line and offered increasingly generous sales
incentives, and by 1982 beauty product sales began to decline as well.

By mid-1982, Avon suddenly found itself in a weakening cash flow position as a result of the declining beauty business and
the $710 million Mallinckrodt acquisition. Strapped for cash, the company reduced its dividend in August 1982 from $3.00
to $2.00 per share per year. Avon’s stock price hardly moved when the company made the dividend announcement. but
the Wall Street Journal reported at the time that observers had expected the dividend reduction. In any event, Avon’s
stock price had dropped from $30 per share at the end of 1981 to $20.375 per share immediately before the dividend
announcement.

In 1984, having just become Avon’s CEO, Mr. Waldron began to reshape the company’s beauty operations. Instead of
remaining primarily a direct sales company, he decided, Avon would broaden its approach to the beauty business by
developing additional distribution channels. The company also continued to look for acquisitions in the health care area,
so that Avon could remain viable in the event the changes it was making to its beauty business failed.

In May 1984, Avon acquired Foster Medical Company in a share exchange. Foster Medical seemed a particularly attractive
acquisition because of the possibility that public health care policy would change to encourage a shift from expensive,
hospital-based care to the less expensive home care, which was a major part of Foster’s business. Avon also acquired
Retirement Inns of America in November 1985 and the Mediplex Group in April 1986. Mediplex operated sub-acute health
care facilities such as alcohol and drug abuse treatment centers, nursing homes, and psychiatric hospitals. Mediplex and
Retirement Inns both managed retirement living centers of various types. Consistent with this increasing focus on the
provision of health care, Avon sold Mallinckrodt in 1986 for $675 million.

Although Mediplex and Retirement Inns served patients who paid for care themselves or through private insurers, Foster
Medical’s revenues came primarily from Medicare, the largest public health insurance program in the United States. A
change in Medicare in 1986 effectively cut Foster Medical’s charges for Medicare patients by 18%. Foster Medical was not
able to respond successfully to this change, and in 1987, Avon’s management recommended to the board that it review
Avon’s commitment to the health care industry. The board concluded that Foster Medical, Mediplex, and Retirement Inns
could no longer grow at an attractive rate and still show acceptable profits. In addition, by 1987 the performance of the
Beauty Group had begun to improve markedly. The board decided that the Beauty Group’s strength permitted Avon to
shed the Health Care Group companies. It started by selling Foster Medical Supply, a distribution company, in November
1987. Early in 1988, Avon also began the process of selling the entire Foster Medical Corporation. Avon anticipated an
after-tax loss of $125 million on the sale.

Also in 1987, Avon acquired Giorgio, Inc. for $165 million in cash and Parfums Stern, Inc. for $160 million. These
acquisitions not only added prestige fragrances, sold through retail stores, to Avon’s beauty line, but also continued Avon’s
transition away from the direct sales approach to the beauty business.

The Exchange Offer

Mr. Waldron felt that at the same time that Avon was reorganizing its business, it should also reconsider its financial
policies, including its dividend policy. The company was about to begin the last phase of its exit from the health care
business with the sale of Mediplex and Retirement Inns. In addition, Mr. Waldron and the board agreed that Avon should
redouble its commitment to its core beauty products business, whose recent results were encouraging. Among other
things, this implied that Avon would continue to invest significant additional capital in that business.

In December 1987, Avon raised additional capital by selling 40% of the common stock of its wholly-owned Japanese
subsidiary, Avon Products Company Limited, in a public offering in Japan that raised $218 million. The price was over six
times book value and around 50 times earnings. Avon booked an after-tax gain of $121.1 million, or $1.72 per share, on
the sale.

The board also felt that Avon should conserve cash flow by reducing its dividend from $2.00 to $1.00 per share, but Mr.
Waldron worried about the consequences of simply cutting Avon’s dividend. Avon had maintained its dividend at $2.00
per share per year since the dividend cut in August 1982. Although that reduction had not resulted in any sudden drop in
Avon’s stock price, Avon’s stock had been falling for some time in advance of the cut. This time might be different. Avon’s
1987 annual report had stated that the firm expected to maintain the current annual $2.00 dividend, and Avon’s stock
price had remained fairly steady during 1988.

Exhibit 5 lists the 25 largest institutional holders of Avon stock. Many of those investors might sell their Avon shares quickly
if Avon simply reduced its dividend. As Mr. Waldron put it, “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.” Some investors had stated that
they held Avon stock because it paid a high dividend. Avon’s board asked its financial advisor, Morgan Stanley and Co.,
what steps the company could take to avoid having the dividend reduction drive down the stock price. The exchange offer
was one element of the solution.
Morgan Stanley proposed that Avon offer to exchange one share of a new $2.00 preferred equity-redemption cumulative
stock (PERCS) for each of up to 18 million of Avon’s 7.17 million outstanding common shares. The new preferred would
pay, on the same dividend dates as its common stock, cumulative quarterly dividends of 50 cents ($2.00 a year) accrued
from September 1, 1988 to September 1, 1991.1 Although the company would be able to redeem the preferred shares at
any time before September 1, 1991, according to a declining schedule,2 the important provisions concerned mandatory
redemption of the PERCS shares in September 1, 1991.

On that date the PERCS shares would expire. Their 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 common stock per PERCS share if the
common stock was above that price.

As was usual with preferred stock, Avon would not be able to pay its common dividend at any time its preferred dividend
was in arrears. In addition, this preferred stock included 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.

1 Short-term U.S. Treasury notes were paying about 8.2% per year at the time.
2 The redemption price would be $34.75 per share, plus accrued dividends, for the quarter starting
June 1, 1988.
It would decline by 25 cents per share for each quarter thereafter through the quarter beginning
March 1, 1991.
The redemption price would fall to $31.75 per share on June 1, 1991, and then to $31.50 per share on
June 1, 1991.
The company would have the option of redeeming the preferred for either cash or common shares.

Mr. Waldron felt confident that the financial markets would understand the new security. Third-party issuers had
successfully marketed at least one product similar to the PERCS, Americus Trust PRIME units. An Americus Trust was a
corporation whose sole asset was common stock of a particular company. The basic idea was that shareholders of that
company placed their shares in the trust, which issued two units, called a PRIME and a SCORE, against each share. The
PRIME units received all the dividends the stock earned; the SCORE units received no dividends. At a predetermined
terminal date, the trust would liquidate the shares it held. The PRIME holders would receive the value of the shares up to
a certain predetermined level, and the SCORE holders would receive any excess. The PERCS might appeal to investors who
would buy PRIMEs.

Mr. Waldron realized that he would need to convince his colleagues on the board that the terms of the offer would be fair
to all the company’s shareholders and also appealing to those who especially desired high dividends. Avon’s stock closed
at $24.125 per share on June 1, 1988. Exhibit 6 gives the June 1 closing prices of options on Avon’s stock which were listed
on the Chicago Board Options Exchange.
1. Evaluate Avon's investments and financing decisions in the 1980s.
2. Why was Avon restructuring its business in 1988?
3. Did the changes make sense?
4. As an institutional investor holding Avon stock, how would you evaluate the trade-off between accepting the new
preferred and keeping the common stock?
5. Might you just sell the common stock and ignore the offer altogether?
6. Evaluate Avon's financial condition in mid-1988. Why was Avon reducing its dividends?
7. What was the purpose of exchange offer?