Beauty and the Beast?

12/27/2011 11:11 am EST


The cosmetics and beauty sector usually weathers tough economic times fairly well, but one iconic company is having a tough time getting its act together, and Wall Street is very interested in how this situation plays out, writes Jim Fink of Investing Daily.

I’m a strong supporter of women in business, and applaud the 18 US companies in the Fortune 500 and the 27 Canadian companies in the Financial Post 500 which have female CEOs. Women are just as capable as men, including the ability to screw things up.

Take, for example, Avon Products (AVP) CEO Andrea Jung, who until last week was the longest-serving female CEO of a Fortune 500 company (12 years). Jung’s record pales in comparison to the 21-year tenure of Christie Hefner as CEO of Playboy Enterprises, but that arguably involved nepotism, so it doesn’t count.

In analyzing the performance of cosmetics direct-seller Avon during Jung’s 12-year rule, one has to question why the board of directors hadn’t fired her earlier. By almost any comparison, and certainly against cosmetic competitors Elizabeth Arden (RDEN) and Estee Lauder (EL), Avon has been a dog of a stock.

If I were an Avon shareholder and observed shareholders of Avon’s two main competitors earning between 5% and 11% more per year than I was, I would be calling for the CEO’s head. It’s no wonder that 24/7 Wall St. recently named Avon the worst-run company in America, which is quite an ignominious achievement given the stiff competition from Research in Motion (RIMM), Yahoo (YHOO), Hewlett-Packard (HPQ), Groupon (GRPN), and Eastman Kodak (EK).

The Story of Jung's Ouster
Better late than never, Avon announced last week that Jung will be stepping down (i.e., ousted) from the CEO post in 2012 once a successor has been found. An unusual wrinkle is that Jung will remain with the company as chairman of the board for another two years.

Investors were so glad that Jung had been ousted that on December 14 they bid up Avon shares intraday by 11%—its largest gain in more than three years. But the stock fell back at the close, once investors realized that Jung wasn’t leaving the company entirely.

Jung may be the sixth most powerful woman in business, but power doesn’t equal competence. Jung came from a marketing background and had none of the operational expertise needed to run an international company like Avon.

The implementation of enterprise resource planning (ERP) software to handle customer relations in Brazil has been an utter disaster, and poor inventory management has left too little cash flow to pay the company’s dividend, resulting in increased debt to cover the gap. Cash flow has lagged behind reported earnings for several years, which is a bad sign of aggressive accounting practices and poor capital allocation.

Splitting the roles of CEO and chairman of the board is a good idea that improves corporate governance. But keeping a former CEO like Jung as chairman is a bad idea for many reasons.

Most egregiously, a former CEO is paid much more than an outside chairman would receive. Jung will get a huge $1 million annual salary as chairman. She is also entitled to receive up to an additional $1 million annual bonus and $4 million per year in long-term incentive payments. This is outrageous compensation for a failed CEO, and even more outrageous for a board chairman.

Being a board chairman does not involve a big time commitment because boards don’t meet that often. Granted, Avon’s board met 11 times in 2010, but the unusually large number is related to the problems Jung was responsible for.

Recent History of Avon’s Troubles
The number and severity of problems Avon faces is staggering.

In February 2011, there was a management shakeup after an “awful” fourth-quarter earnings report that caused the male chief financial officer (CFO) to become the interim CFO, and a search for a new CFO began. A new female CFO from a Dutch supermarket chain was named in May.

The last straw occurred in October when the company released a “wretched” third-quarter earnings report and a 10-Q filing disclosing two SEC investigations of the company. Jung also announced that the company would miss 2011 revenue and profit goals:

The results of the quarter reflect a challenging ERP implementation in Brazil which caused greater disruptions than we anticipated. This significantly impacted our top and bottom line results.

Given the current operating environment, the company no longer expects to achieve the stated targets of mid-single-digit revenue growth and 50 to 70 basis points of operating margin improvement in 2011. In light of the changing landscape, we are assessing our long-range business plan and are targeting an operational and financial update at an investor meeting in the first quarter of 2012.

The two SEC investigations the company is subject to involve:

  • violation of the Foreign Corrupt Practices Act (i.e., illegal bribing of Chinese government officials to win business)

  • violation of the SEC’s regulation FD (fair disclosure).

Avon has also spent millions of dollars on its own three-year internal investigation of bribery allegations, and last May fired four executives in the company’s China unit for bribing Chinese officials (scapegoats?). Reports are that China was not the only country involved—millions of dollars in bribes were also made to government officials in Brazil, Mexico, Argentina, India, and Japan.

Analysts were in shock, which made for a very interesting Q&A in the post-earnings conference call. Stifel Nicolaus analyst Mark Astrachan said:

Why should investors believe management and the board have any control over the business at this point? Andrea, you’re chairman. Given an average board tenure of over ten years, how long can the status quo here remain? I mean, I just don’t know what to say at this point.

Citigroup analyst Wendy Nicholson (a central figure in the Regulation FD violation) made the following comment:

It strikes me that you guys need to do a tremendous amount of work, probably change a bunch of people in management, probably change your capital structure, maybe take another restructuring charge, maybe exit a market like what you did in Japan. Have you thought about the idea—go back and hire McKinsey again. Go back and really go to the drawing board. Think about taking the company private? I mean, it strikes me that you guys are so totally screwed up in so many ways.

It was devastating comments like these that finally got the entrenched and comatose Avon board to finally summon the courage to kick out Jung from the CEO office.

But the board couldn’t finish the job by kicking her out of the company entirely, and she will have two years to continue her meddling. In an internal corporate memo Jung wrote to all US employees and global managers, she stated: "I am not going anywhere. I will remain very close to the business, defining the company’s strategy and brand positioning."

Jung’s refusal to leave has some former Avon CEOs upset. James Preston, who led Avon from 1989 to 1998, wrote to the board that Jung should leave now: "I have long held the belief that once a CEO leaves that position, he or she should make a “clean break” and not question or second-guess the actions of his successor. I have become increasingly concerned—and saddened—by the declining fortunes of the company."

Similarly, former Avon CEO David Mitchell (1975-83) said in an interview that Jung staying on as chairman was a “stupid arrangement” that will greatly complicate the board’s ability to find a quality successor.

No CEO worth his or her salt would want to join a company that included a former CEO being paid millions of dollars to look over her shoulder and nix innovative restructuring ideas. Make no mistake about it—Avon needs a radical overhaul, and Jung’s continued presence will just make the overhaul more difficult to implement.

Lack of Succession Planning and Sexism Are Other Legacies
This entire mess could have been prevented if Avon had put into place a succession plan. But Liz Smith, Avon’s former president and the best qualified successor to Jung, was unceremoniously left hanging in the wind for so long that she quit in 2009 and took a job as CEO of Outback Steakhouse. Smith was never replaced, and Jung just assumed more power.

Jung has been quoted as saying that the board will appoint a male CEO “over her dead body,” which would eliminate highly qualified candidates such as Herbalife (HLF) CEO Michael Johnson—so let’s add illegal sex discrimination to her serious flaws.

Bottom line: Avon remains profitable, and its debt load is heavy, but manageable. The company is fixable and could shine once again, but a new CEO won’t be enough change to convince me to buy the stock.

The only thing that will get me interested is news that Jung is gone—and I mean completely gone.

Read more from Investing Daily here...

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