Fitch Removes Avon's Ratings from Negative Watch; Assigns Stable Outlook

Fitch Ratings has removed Avon Products, Inc. and Avon Capital Corporation's (Avon Capital) ratings from Rating Watch Negative and affirmed the ratings as follows:

Avon Products, Inc. (Avon)

--Long-term Issuer Default Rating (IDR) at 'BBB-';

--Bank credit facility at 'BBB-';

--Senior unsecured notes at 'BBB-';

--Short-term IDR at 'F3';

--Commercial Paper at 'F3'.

Avon Capital Corporation with a guarantee from Avon

--Short-term IDR at 'F3';

--Commercial Paper at 'F3'.

The Rating Outlook is Stable.

Fitch's rating actions apply to Avon's approximately $2.6 billion senior unsecured notes and the $1 billion three-year bank credit facility. The bank facility supports the $1 billion commercial paper (CP) program. At March 31, 2012, $754 million of CP was outstanding.

The ratings affirmations resolve the Rating Watch Negative placed on both companies on May 10, 2012 following Coty, Inc.'s preliminary, non-binding offer to acquire Avon's outstanding shares for $24.75 per share or approximately $10.7 billion. Fitch had estimated that it was likely any accepted offer could be financed with significant amounts of debt, leaving the combined entity with weaker credit protection measures. However, Coty withdrew its proposal on May 14, 2012 and despite the almost 20% decline in Avon's share price since then, neither Coty nor any other suitor has returned with a definitive offer.

The ratings reflect the continued trends in Avon's generation of negative free cash flow (FCF, cash flow from operations minus capital expenditures and dividends) during the past two years and through the first quarter of 2012, as well as Avon's increase in leverage (total debt to operating EBITDA) to 2.7X for the last 12 months ended March 31, 2012 (LTM). The ratings also encompass operational and business model challenges to improve service levels in Brazil, manage price gaps in several categories, address working capital issues, and increase representative compensation to stem volume and market-share declines given heightened levels of competition. Fitch expects that these factors increase the probability that margins could be materially lower than 2011, leverage will increase to the 3x range, and that FCF is likely to remain negative with lower profitability during 2012.

Basis for Stable Outlook: Fitch expects that even with a lack of visibility while the new management team reviews the company's operations and sets financial and strategic goals, there are a number of clear positives, discussed below. Therefore, it is more than likely that Avon will be poised for better or more stable financial performance after 2012 although revenue growth and margins might not revert to historical levels in the medium term.

Management Focus on Cash Flow: Although both the CFO and CEO have less than six months experience with Avon, generating cash is a top priority and has also become an input in determining management's bonuses. This is a marked change from the past when sales and margin targets were the primary focus. Over the past five years ending in 2011, Avon generated a total of $88 million in FCF, compared to $1.7 billion in the previous five years ending in 2006.

Fitch views the fresh perspective that can be provided by new management with a strong operational background and the discipline involved in aligning incentives with cash generation as credit positives. Avon's CFO has experience in managing through difficult cash flow issues at Royal Ahold, N.V. The company has already started addressing inventory management by establishing clear accountability, focusing on implementing new processes to limit inventory builds, and has already taken three days out of inventory in the first quarter.

Avon Generates Cash: It is important to note that absent working capital changes, Avon consistently generated $1 billion to $1.2 billion of funds from operations (cash flow from operations less working capital) in each of the past five years. However, annual funding for working capital requirements were $400 million on average, capital expenditures averaged $312 million, and dividend payments escalated to the $400 million range. Borrowings increased to fund the FCF shortfall.

Considerable Liquidity: Avon has the ability to fund cash flow shortfalls without materially increasing debt during the 2012 transition year and beyond. The company has $1.2 billion in cash and $246 million in revolver availability after supporting $754 million in CP. Approximately $215 million of cash is trapped in Venezuela. The company can access $1 billion, though there may be added cash costs based on the amounts and tax differentials between the source country and U.S. rates. Avon has already indicated in its recent filing that in 2012 it will not indefinitely reinvest any current year earnings of its foreign subsidiaries.

Healthy Business Model in Developing Markets: The direct selling model is healthy, particularly in developing markets. The World Federation of Direct Selling Associations reported that in 2010 there were 88 million direct selling representatives selling products and services with a retail value of $132 billion. That is up from $34 million and $82 million, respectively, in 1998. Thirty-six percent of the $132 billion encompasses the cosmetics, fragrances and toiletries (CF&T) category in which Avon competes. The category and channel are very robust in many developing markets. Euromonitor International, Inc. reports that the CF&T market in Brazil, Avon's key market, has grown at a seven-year CAGR of 13.4%. More important, 27% of all CF&T sales in Brazil go through the direct selling channel.

Rating Movements:

Downgrade/Negative Outlook: Fitch would consider a Negative Outlook or downgrade if the company maintains the $400 million dividend beyond 2012 without generating meaningful FCF or if Avon does not have a clear and credible plan for a turnaround. Given the poor first quarter and guidance for more of the same in the second quarter, it is likely that FFO will be under $1 billion during 2012, increasing the potential that the company will have to draw on cash on hand in order to avoid borrowing to fund the dividend. While liquidity is solid in the near term it has lessened markedly since 2010, as discussed below.

Additionally, a significant decrease in working capital usage and/or material increases in margins could take longer to realize which may continue to pressure FCF and the ratings. Meaningful positive surprises from working capital improvement and profitability increases would clearly provide more room for discretionary activities.

Another factor to be considered in a potential Negative Outlook or downgrade is the impact on Avon's covenants if material declines in profitability continue. Avon's $1 billion credit agreement and the $535 million in privately placed notes require interest coverage of at least 4x. At the end of 2011 it was approximately 9x but after the poor first quarter it was 6.9x. Fitch will be monitoring this covenant closely.

Upgrade: An upgrade is not likely in the short term. However, Fitch would consider an upgrade if Avon generates and is able to sustain FCF in the $100 million range, and management is committed to maintaining leverage under 2.5x after achieving stability in its business and operations. Resolution of the Foreign Corrupt Practices Act investigation given the high cost (near the $100 million range) has also been a drag on cash flow and would also be viewed positively. The ongoing cost of compliance would remain but is likely to be lower.

Financial Performance:

For the first quarter ended March 31, 2012, Avon's operating performance deteriorated substantially. Commodity and wage inflation pressured margins by 220 basis points (bps), in addition to 170bps of additional spending against the representatives and brochures, and 220bps in other items including negative mix and additional bad debt expense. As a result, the EBIT margin (excluding restructuring charges) declined by 610 bps to 4.3%.

Debt increased from year end by $74 million to $3.4 billion to partially fund $178 million in negative FCF in the first quarter. Avon used some of its cash on hand to fund the remainder. Fitch does not expect debt levels to increase materially given Avon's intention to repatriate international cash balances if needed. LTM Leverage (Debt/EBITDA) increased to 2.7x from 2.3x at Dec. 31, 2011 with the decline in profitability during the first quarter.

Liquidity:

Much of Avon's healthy liquidity is derived from maintaining more than $1 billion in cash. Avon's liquidity of almost $1.5 billion at the quarter-end, however, is down from almost $2.5 billion at the end of 2010. Debt maturities are very modest in 2012 at just $17 million; however, $250 million 4.8% notes are due in March 2013 and $125 million 4.625% notes are due in May 2013. The $1 billion revolver terminates in November 2013 as well. Fitch expects that these will be refinanced or renegotiated.

Additional information is available at 'www.fitchratings.com'. The ratings above were unsolicited and have been provided by Fitch as a service to investors.

Applicable Criteria and Related Research:

--'Corporate Rating Methodology' (Aug. 11, 2012);

--Fitch Place Avon's Ratings on Watch Negative Following Coty Bid', (May 10, 2012);

--'Fitch Downgrades Avon's IDRS to 'BBB-/F3'; Outlook Stable; (May 8, 2012);

--'FBT and Consumer - FCF Efficiency Leaders and Laggards (July 28, 2011);

--'Foreign Corrupt Practices Act - No Minor Matter' (June 1, 2010).

Applicable Criteria and Related Research:

Foreign Corrupt Practices Act -- No Minor Matter

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=526965

FBT and Consumer -- FCF Efficiency Leaders and Laggards

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=638784

Corporate Rating Methodology

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=647229

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