It always amazes me how long it takes dying businesses to finally give up the ghost. And how long it takes shareholders to admit that they are going to lose every last dollar if they don’t bail out before the stock loses all of its value. We are seeing that in the retail space today as one dying brand after another bites the dust, and we are going to see it in the consumer space as well. Nostalgia is bittersweet, but investing in nostalgia is just bitter.

A sure sign that a company is in serious trouble is when it announces a restructuring plan. (See my article on TGT a few weeks ago.) An even more ominous sign is when it puffs up its chest and claims that its restructuring plan is actually something more grand rather than merely another tired attempt to fix a broken business model.

The company I’m writing about today chose the latter route by calling its desperate attempt to save itself a “Transformation Plan.” But in this stock’s case, it did more than restructure itself – it sold off its North American business (keeping a minority 19.9% position) and decided to tie its fate to the emerging markets, which have been giving it all kinds of currency and tax fits for years, and to one of the most tough-minded hedge funds in the world.

This company is no longer the master of its own fate. It now works for Cerberus Capital Management, LLC (Cerberus) and is effectively a private equity portfolio company masquerading as a public company.

As you’re about to see, that’s a huge red disaster flag (and a good short opportunity)…

Avon’s Cerberus Deal Masks Bad Numbers (And Is Bad News for Shareholders)

Avon Products, Inc. (NYSE:AVP) is one of those companies that’s been living off its reputation forever. The iconic Avon Lady reminds us of the type of beautiful woman that Don Draper would have seduced in Mad Men. But that era is gone and the idea of women selling cosmetics door-to-door is a fairy tale from a vanished past. Not only can women easily buy any cosmetic in the world over the Internet or from companies like Birchbox.com, but they are no longer sitting at home waiting for the doorbell to ring.

All Avon has to sell at this point is nostalgia. The rest of its products can be purchased more easily elsewhere.

Avon management knows this, and they’re willing to try almost anything to drum up a few extra bucks – as evidenced by their most recent “deal with the devil.” I mean that almost literally.

In March 2016, Avon sold its North American businesses into a separate company called New Avon LLC that is 80.1% owned by Cerberus, an investment firm that specializes in investing in distressed companies, and 19.9% owned by Avon. To give you an idea of Cerberus’ temper (if its name, which is based on the mythological three-headed dog that guarded the gates of Hades, doesn’t tell you enough), the company likes to own companies like gun manufacturers and military businesses. Avon, shall we say, is a bit outside its usual bailiwick. Cerberus takes no prisoners and looks out for its own interests first. And Avon’s shareholders should be on their toes because of how Cerberus structured its investment in Avon.

As part of the transaction, Avon sold $453 million of Series C Preferred Stock to Cerberus. While this provided the company with much-needed cash, it came at a steep cost to Avon’s common shareholders. The Preferred Stock ranks senior to Avon’s common stock and is convertible into 87 million shares of Avon common stock at $5.00 per share, resulting in 19.9% dilution to common shareholders upon conversion. The Preferred Stock pays a 5% annual dividend, gives Cerberus voting rights equal to 19.9% of the company’s stock (even before it is converted), the right to appoint three directors to Avon’s board, and the right to demand repayment of the Preferred Stock plus all accrued plus unpaid dividends in the event of a change of control transaction.

This is the type of capital that a troubled company raises when it has few other options and Avon paid the piper in order to raise it from one of the sharpest outfits in the business. Cerberus is now calling the shots at Avon and will do everything in its power to make sure it gets back its $453 million before shareholders get one red cent. The good news is that Cerberus brings a great deal of operational expertise to the company, though we have yet to see any meaningful operational improvement at the company; in fact, fourth quarter results showed serious backsliding in the company’s results.

Without raising the Preferred Stock from Cerberus last year, Avon’s cash and cash equivalents would have dropped by $112 million from $587.4 million at 9/30/15 to $475.4 million at 9/30/16. While the $426.3 million of net proceeds from the sale of the Preferred Stock sits on the balance sheet, it should not be considered cash available to common shareholders since Cerberus has a priority claim on these funds to repay its Preferred Stock. As such, Avon’s Current Ratio is not 1.54x but is actually a much weaker 1.27x. Accounts receivable rose from $448.0 million at 9/30/15 to $505.2 million at 9/30/16, not a particularly good sign for a company trying to get paid in a lot of emerging markets. The company also had negative net worth of -$775.5 million at 9/30/16 which would be a much worse -$1.214 billion without the Series C Preferred Stock raised from Cerberus (It was -$1.056 billion a year earlier). Cash and cash equivalents without the Preferred Stock would have fallen by $211.5 to $475.4 without the Series C Preferred from $686.9 million a year earlier as well. While the Preferred Stock is dressing up the balance sheet, it really doesn’t help common stock holders since it has to be repaid before them and is sucking out $22.65 million in dividends from the company every year.

Avon’s Problems Extend Worldwide

Avon is in the midst of another operating turnaround that stumbled in the fourth quarter of 2016, sending its shares down sharply. The fourth quarter earnings miss was attributable to continued currency pressures as well as a higher cost to service its debt. The company will continue to face currency pressures now that most of its earnings (other than its 19.9% interest in New Avon) come from abroad. Whether its direct marketing model will have a longer life outside North American, where it is clearly yesterday’s news, remains to be seen, but in a globalized world it is just a matter of time before it becomes as tired as it has in North America.

After its deal with Cerberus, the company’s ten largest markets are Brazil, Mexico, Russia, Philippines, UK, Argentina, Colombia, Turkey, Poland and South Africa. In the fourth quarter, Brazil saw a $35 million loss, there were pricing problems in Russia (where sales were down), and Egypt (not a top ten market) also was hit by a $17 million currency loss. These may have been clean up hits taken by the new Chief Financial Officer, but they illustrate the discrete issues facing a company operating in markets that suffer from currency risk and collections risk. The move out of North America increased the business risk of the company. Avon faces execution risk, currency risk and increased debt risk going forward and is still recovering from huge losses suffered in Venezuela a couple of years ago as a result of the destruction of that country’s economy and currency.

Avon has also suffered from serious governance lapses in the past. The company was prosecuted for violations of the Foreign Corrupt Practices Act in China under a deferred prosecution agreement with the U.S. Justice Department and SEC in 2014 and 2015 and paid fines and disgorgement of $135 million. It is under a monitoring agreement with the government that expires in 2018. If it violates this law again, it will face more serious consequences.

Avon stock is likely to decline further as the company struggles with its turnaround, which it has been attempting for years. There is little reason to believe that the company has suddenly found the magic bullet. If you own the stock, sell it. If you would like to profit on the short side, I suggest you buy (drum roll, please) long-dated puts. (Not at all what you were expecting to hear from me, I know.)