Description

Coty (COTY) $18.72

Summary

Coty (COTY) manufactures and sells beauty products including fragrance, cosmetics and hair products. On October 1, 2016, Coty doubled in size through the acquisition of Procter & Gamble’s beauty business. The opportunity exists over the next few years not only for significant cost reduction, but also to establish a scale operator that can drive revenue growth. The stock has sold off sharply over the last four months due to three factors: trading disruption around the close of the deal, concerns about revenue growth and investment and a market rotation away from consumer staples stocks. I believe that at the current price, COTY offers a reasonable reward-to-risk proposition with modest downside.

Background

Coty is controlled by JAB Holding Company (36% currently) who purchased the business from Pfizer in 1992 for $440 million and took the business public via an IPO in 2013. Although it was public, Coty was largely uninvestable to institutional clients because of the very limited float due to JAB holding 78% of the shares (prior to the PG transaction).

JAB functions as a family office with permanent capital. There is some cross-pollination between JAB and 3G Capital, with a JAB partner serving as Chairman at 3G-controlled AB InBev and with 3G investing alongside JAB in JAB’s acquisition of coffee and food brands including Peet’s and Krispy Kreme. There are some similarities in their playbooks (consumer brands, cost reduction) but also some notable differences (higher barriers to entry/greater scale advantage in food/beverage, 3G acquisitions seem more focused).

In early 2015, Proctor & Gamble was looking to divest its beauty brands business to focus more on household and personal care. It entertained bids from several parties for various parts of the business, but ultimately structured a deal with Coty as a carve out of the entire portfolio structured as a Reverse Morris Trust transaction which would be tax-free to P&G.

Coty is paying a rich price on the face of it of 2.6x FY15 revenues and 13.5x EBITDA (excluding f/x from when the deal was struck, the multiples would be 2.4x FY15 revenues and 12.6x EBITDA). The opportunity comes primarily from cost reductions with synergies of 400MM expected within four years. Adjusting for the synergies and the cost to generate them, the multiples change to 10.1x FY15 EBITDA (9.6x FY15 EBITDA excluding f/x changes since the deal was struck). In addition, Coty doubles in size which is of great advantage (but harder for outsiders to quantify) in the consumer products space.

The transaction was effected through an exchange offer whereby P&G shareholders could exchange PG shares for COTY Shares and were incented to do so via a 7% discount. Coty’s free floating shares expanded 6.5x from 74.6MM to 484.3MM. As you would expect, the arbitrage embedded in the offer combined with the limited ability to short COTY brought a very short term investor base into Coty, which promptly sold off the Coty shares received in the exchange.

On November 9th, Coty announced FQ117 (9/30) results which showed uncommonly weak top line results for a consumer staples company and proceeded to blame the results on a lack of focus during the PG transition. This seems a bit dubious and it seems more probable that Coty is starting to aggressively adjust promotional discounting in the channel – which would be beneficial long-term. The rationale of putting up the excuse eludes me however.

The Opportunity

The positive attributes of an investment in Coty are relatively straightforward:

•  It is a complex and underfollowed situation

• The P&G brands were orphaned by the parent for several years, prepared for sale and then took 16 months to close. The business has not been run optimally in years, giving Coty similar characteristics to spinoffs – previously neglected businesses that can thrive under properly motivated and attentive management

• Coty management is doing the right things: they are aggressively going after costs, rationalizing the portfolio and continuing to make fold-in acquisitions

• Expectations are very low for the remainder of fiscal 2017 (June).

• F/X trends tend to cancel out over time and the strength of the dollar in 2014-present has masked the strength of the business

• Cost synergies of $400MM/year + $500MM in working capital reduction should be attainable

• The Coty investment of $5b at market is significant to JAB

• Pruning the portfolio should set the stage for revenue growth. The market will reward revenue growth.

• Coty now has scale that it can accelerate revenue growth by acquiring smaller products and pushing them through their distribution.

• This type of business is generally stable, generates lots of cash and the dividend ($0.50/yr) protects the downside

The bear case can be summarized as:

• Coty (JAB) pays rich prices for a disparate collection of subpar assets

• The stock is not exceptionally cheap

• FY17 will stink, making the thesis more backend loaded

• Integration risks are significant

• Share repurchase is greatly restricted (and a takeover of Coty impossible) until 10/18 due to tax restrictions resulting from the Reverse Morris Trust transaction

• The acquired PG brands have been starved of investment and if they can be restored, much additional capital will be required

• These businesses will never generate organic growth

• JAB’s goals may not be in line with shareholders’ goals and their controlling interest precludes any takeover

Coty is a complex situation where the returns are going to be back-end loaded. My expectation is that Coty is likely to trade with some volatility over 2017 as results confirm (or question) the thesis. In addition, if the economy does accelerate and the market continues to rally, consumer staples will likely be sold off in pursuit of greater growth. Downside should be protected by the dividend which was recently increased to $0.50/year, payable quarterly. The stock currently yields 2.7% and would yield 3% at $16.67 (-11%) and 3.25% $15.38 (-18%).

Coty has experience in cutting costs and has been managing the current portfolio for cash conversion. Their co-investors at 3G also have some experience at this. I have high confidence that they will be able to achieve their cost synergy targets.

Perhaps because of their focus on cost-cutting, Coty is accused of being unable to drive top line growth. I think this is an unfair assessment. First, the beauty industry has been struggling with low organic growth and has responded by growing through acquisition. This is not unlike beverages where young brands attract a following and are snapped up by larger players and brought to market in scale. There is nothing inherently bad about this strategy and while the acquisition prices paid look rich on trailing numbers (the sellers are capturing some of the prospective scale gains) this can be an effective strategy for a disciplined acquirer in a low growth market that rewards scale.

Second, I believe that both PG & Coty have a few brands that are in sharp decline that in aggregate are masking underlying market-pacing performance of the healthy brands. They have a celebrity fragrance business that is in decline. It is probably generating modestly positive EBITDA with no reinvestment. Pruning these brands sets the stage for revenue growth without a significant penalty to profits. In addition, they may well be able to monetize these brands by selling it off as a cigar butt to strategic or financial buyers. Revlon purchased Elizabeth Arden (which had a similar business) in September for 0.8x trailing revenues. This can be a win for both parties. The buyer may get a decent return out of buying some struggling brands on the cheap and the seller can focus on their core brands while monetizing the pruned brands.

Coty has announced the intent to cull 6-8% of revenues or $500MM - $700MM in underperforming brand revenues. My expectation is that they will fill in the income gap with acquisitions. Shortly after closing the P&G deal, they announced the acquisition of Good Hair Day which bolsters the professional salon portfolio and fills $120MM of revenues that have been growing at 60%+ p.a.  for the last 3 years. Selling off barely profitable revenue that is declining and purchasing currently low profitable revenue that is growing rapidly is a reasonable strategy to reposition the portfolio without adversely impacting profits and loading the portfolio up with growth options that the company should be able to monetize on scale expansion.

The timing of important events that should be catalysts for the stock going forward are:

• FQ217 results reported on 2/4/17. Expectations are for a lousy quarter. Stock will trade on outlook for 2H17

• FQ317 results reported in early May, 2017. Progress on pruning and cost synergies will be key.

• FQ417 results reported in August, 2017. Outlook for FY18 issued.

• Management expects to host an investor day in Fall, 2017

• FQ118 results reported in November, 2017  

The Data

Coty has a current enterprise value of $19.7b and a market capitalization of $14.0b.

Consensus estimates are pretty scattered for Coty because of all the necessary adjustments for synergies, cost of synergies, pruning, etc. The consensus does reflect management’s guidance for revenue growth and cash flow growth beginning in FY18 and accelerating sharply in FY19. Currently, the market is greatly discounting this guidance.

Investors won’t know the underlying health of the core business until the pruning has been complete. I expect that the Company will give additional color on the next few earnings calls, but it may well maintain some opacity on the matter until the brands targeted for pruning can be monetized. However, here is an illustration on how the core business could return to growth once the pruning has commenced.

In FY16, Coty closed acquisitions of Hypermarcas’ beauty business in Brazil in February and in FY17, Coty closed the GHD acquisition in November. Starting with the pro-forma FY2016 revenue numbers, pruning -7% of declining brands, adjusting for the recent non-P&G acquisitions and assuming a modest 0.25% growth on the core, results in PFFY17E revenues down -1.3%. The revenues shown differ greatly from consensus, because consensus estimates are likely reflecting that P&G will only be owned for 9 months in FY17.

Hypermarcas provides Coty with more than just brand exposure in Brazil. It also provides a manufacturing plant and distribution network. It’s expected that this platform will be used to greatly expand in Brazil and Coty should be able to distribute a selection of its other brands through this platform. I have estimated revenue growth for Hypermarcas at 8% off a relatively low base.

GHD sells hard goods into the salon market like hair dryers and curling irons. The attraction was threefold: first, it bolsters Coty’s salon offerings in addition to Wella and OPI; second, GHD is growing at 60%+ for the last 3 years and finally, GHD is UK based and Coty could take advantage of the depreciation of the Pound (although a rich price was paid on trailing earnings, regardless). I have estimated growth at 50%, 40%, 25% and 15% in FY17, FY18, FY19 and FY20, respectively.

I’ve made the modest assumption that the core base brands grow at a modest (and well under 2% market) growth of 0.25%, 0.50%, 0.75% and 1.00% in FY17, FY18, FY19 and FY20, respectively. This results in revenue growth of -1.3%, 1.6%, 1.7% and 1.7% in FY17, FY18, FY19 and FY20, respectively, without the assumption of any further acquisition activity – which seems highly improbable. My point is simply that returning to revenue growth may be easier than most investors think. If they can swiftly clear out the brands that have been exceptionally weak, it would not take much to restore revenue growth. Furthermore, they retain the option of further boosting growth through additional acquisitions and it may be that the ability to drive growth through Hypermarcas is even greater than estimated.

Revenue growth and the pruning of weak brands making little profit contribution should drive EBITDA margins into the low 20s by FY19. There is upside to these metrics with additional acquisitions or more rapid debt reduction.

Premier peers like L’Oreal and Estee Lauder typically trade at 15x EV/EBITDA and 25x P/FCF. They are afforded these high multiples primarily because of the stability of the underlying business. Consumer beauty staples tend to be very recession resistant and stable growers. The FCF multiples are high because while the businesses generate healthy cash flow, there is often a good bit reinvested for growth.

Coty does not deserve multiples at this level because it does not really have exposure at the higher end of the beauty business, it has lesser scale, and it has a lower growth profile. However, it does deserve a valuation of 12x EV/EBITDA and 21x P/FCF, which would equate to a price north of $28 in FY19 and north of $31 in FY20. I believe there is additional upside to these levels contingent on additional organic and acquired growth.

My most probable downside case is that the integration of P&G and the rationalization of the brands extends deeper into FY18 and continues to mask any underlying revenue growth. In this scenario, I believe the dividend offers protection (and may, in fact, be part of the rationale behind raising the dividend in conjunction with the P&G deal). Currently, the $0.50 annual dividend yields 2.7%, compared to 2.1% for the S&P 500. If Coty is delayed in driving growth, the stock could be dead money yielding 3% - 3.25% for a period of time. The dividend is safe for the foreseeable future given the solid cash generation, moderate leverage and the reputational risk to JAB – in fact, I would not be surprised to see dividend increases going forward.

With base upside 51% to $28.30 and reasonable downside of -14% to $16 over a two year horizon, COTY offers a highly asymmetric reward to risk ratio in excess of 3.6:1. I recommend purchase of COTY at current prices and an increased position on price weakness relating to volatility relating to the pace of integration over the next few months.

My opinion would adversely change if there is evidence that the underlying core business is markedly weaker than expected.

Catalyst

The primary catalysts are successfully executing on cost synergies, pruning (and monetizing) brand portfolio and a resumption of revenue growth.