Cotyís Turnaround Efforts Should Improve Its Profit Trajectory, but a Moat Remains Elusive
Coty’s Turnaround Efforts Should Improve Its Profit Trajectory, but a Moat Remains Elusive
Analyst Note| by Rebecca ScheunemanUpdated May 17, 2021
After reassessing Coty’s new strategic direction, and the likely impact these initiatives should have on the firm’s top line, we are revising our three-year (fiscal 2022-24) average annual organic sales growth forecast to 6% from 3%, taking our fair value estimate to $6.40 from $5.50. Sue Nabi was named Coty’s CEO in September and, under her leadership, the firm is seeking to 1) stabilize its mass beauty business; 2) accelerate its luxury fragrance core while establishing it as a key player in prestige makeup; 3) build out a skincare portfolio across prestige and mass; 4) enhance its digital capabilities; 5) expand in China; and 6) establish it as an industry leader in sustainability. These initiatives should expand Coty’s presence in high-growth markets where the firm has been minimally exposed, such as prestige makeup, skincare, e-commerce, and China. The program will be funded by the elimination of $600 million in fixed costs by fiscal 2023, which we continue to expect will lead to operating margins of over 14% by 2030 (up from 7% pre-pandemic) despite the aforementioned new investments.
Central to stabilizing Coty’s mass beauty business (45% of fiscal 2020 sales) is the turnaround of its CoverGirl brand. CoverGirl, according to Euromonitor, is the third largest mass color cosmetics brand in the United States with 10.0% share, but this share is down from 15.9% in 2011. We think Coty’s revitalization strategy is on-trend and likely to improve share trends as it is focused on clean formulations (free of harmful ingredients) and makeup/skincare hybrid products, such as anti-aging foundations. As evidence of this, in April, CoverGirl realized its first month with a market share gain in the U.S. in four years.
While we think these efforts will improve Coty’s growth and profit profile, we think it will continue to lack a moat as it remains dependent on licensed and celebrity brands that it does not fully control and whose popularity tends to ebb and flow.
Business Strategy and Outlook| by Rebecca ScheunemanUpdated May 17, 2021
Coty is the global leader in fragrance, with a portfolio of licensed brands, such as Calvin Klein and Gucci. Its prestige business (55% of fiscal 2020 sales) generally reports mid-single-digit organic growth (in line with the category). Mass (45%) has faced high-single-digit sales declines. Coty's brands (CoverGirl, Max Factor) have suffered from underinvestment while many new have brands entered the market. Collectively, Coty has not demonstrated brand strength, preferred relationships with its channel partners, or a cost advantage, thus it does not possess an economic moat. In 2020, the firm invested in the Kylie and KKW beauty brands, founded by celebrities Kylie Jenner and Kim Kardashian West, but we think it will be difficult to build sustainable brand equities as celebrity popularity tends to ebb and flow.
Coty's strategic direction has been in limbo, with three CEOs in the past two years. But we are optimistic that Sue Nabi, who took the helm Sept. 1, has the qualifications to right the ship. Nabi enjoyed a successful 20-year career at wide-moat L’Oréal, climbing the ranks and ultimately serving four years as the global president of L’Oréal Paris and another four years as the global head of Lancôme, with both brands realizing much success under her leadership. We think Nabi’s strategic priorities are on target, as she seeks to increase Coty’s exposure to high-growth markets where it has been underexposed. Specifically, she looks to 1) accelerate Coty's prestige division by expanding from its core fragrance portfolio into makeup; 2) build a skincare portfolio across mass and prestige; 3) enhance its digital capabilities; 4) further penetrate China; 5) stabilize its mass beauty business; and 6) become an industry leader in sustainability.
The fallout from the pandemic put Coty in violation of its debt covenants, but a $1 billion convertible preferred equity investment from private equity firm KKR, and the sale of a majority stake of its salon channel/retail haircare business for $2.5 billion in proceeds in fiscal 2021 should secure Coty's liquidity position, giving the firm the necessary breathing room to allow Nabi's turnaround strategy to take hold.
Economic Moat| by Rebecca ScheunemanUpdated May 17, 2021
Fragrance world leader Coty also has popular brands in color cosmetics, but a lack of brand equity, no strategic vendor status with its channel partners, and little evidence of a cost advantage lead us to conclude that the firm does not possess a moat. Coty has also reported economic losses in each of the past five years, as ROIC (even excluding goodwill) did not exceed our estimate of the firm's cost of capital, and as a result we are not confident that it will be able to generate excess returns over a 10-year horizon.
Fragrance is Coty's largest category, representing 56% of fiscal 2020 revenue, and according to Euromonitor, Coty is the world's largest provider of fragrances, holding 10.9% market share, ahead of number-two L'Oreal's 8.4% slice. Coty's top-selling fragrance brands in calendar 2020 were Calvin Klein, Hugo Boss, Gucci, Burberry, Marc Jacobs, adidas, and Davidoff, all licensed brands. We estimate that less than 10% of Coty's fragrance revenue stems from company-owned brands, such as Philosophy, Joop, and Escada. We are less inclined to award a firm a moat based on intangible assets from licensed brands, as the licensee does not have full control over the brand equity. Coty's average renewal term of its full licensed portfolio is approximately eight years, and there is no guarantee that Coty will be able to renew licenses. Even if Coty is able to do so, it may not be able to complete the contracts with favorable terms. For instance, in 2016 while transferring licenses as part of the acquisition of what was initially 43 beauty brands from Procter & Gamble (P&G), Coty was unable to renew the license with Dolce & Gabbana, the portfolio's second-largest fragrance brand, as the licensor opted to partner with narrow-moat Shiseido in order to capitalize on opportunities with skin care and makeup. Furthermore, the popularity of licensed brands--typically, a brand related to a fashion house or celebrity--ebbs and flows with the popularity of that fashion house or celebrity, depending on fashion cycles, the designer's ability to correctly predict fashion trends, and celebrities' career trajectories.
Even beyond fragrances, we don't think Coty's portfolio of brands has much in the way of brand equity. For one, Coty is the number-three player in global color cosmetics (31% of 2020 revenue), with 6% share in calendar 2020, following L'Oreal's 20% and Estee Lauder's 10%. Coty's major cosmetics brands are CoverGirl (the 12th largest global brand), Max Factor (14th), Rimmel (15th), and Sally Hansen (22nd). Despite these popular brands, the firm has been sustaining ongoing losses in shelf space and market share in these categories. We suspect Coty's undisciplined innovation and marketing programs led to several years of shelf space losses and decreased distribution, as products were not differentiated or superior to competitive products, and did not tout attributes consumers were seeking. In the past four fiscal years, organic constant currency revenue for the mass beauty segment declined 10%, 4%, 11%, and 23% respectively (with the most recent year severely impaired by the pandemic). But we think Coty's new strategic direction under the leadership of Sue Nabi (named CEO September 2020) should help stabilize this business. In early 2021, Coty relaunched the CoverGirl brand, with a focus on clean formulations (free of harmful ingredients) and makeup/skincare hybrid products, such as anti-aging foundations. In April, CoverGirl realized its first month of market share gains in four years. While Coty’s overall mass beauty business is still losing market share, the gap has narrowed materially and upcoming revitalization efforts for the Max Factor and Rimmel brands should further close the gap. Even so, given the highly competitive nature of the beauty market, and dominance by wide-moats L'Oreal and Estee Lauder, we think it will prove challenging for Coty to develop strong brand equities.
In January 2020, Coty purchased a 51% stake in Kylie Cosmetics, a beauty firm founded by celebrity Kylie Jenner. Five months later, Coty announced plans to take a 20% stake in KKW, the beauty brand for half-sister Kim Kardashian West. These acquisitions could help stabilize Coty's color cosmetic revenue, as Coty expands the brands globally. However, we don't think the brands offer a competitive edge by way of powerful brand equity, as we believe it is difficult to build long-term brand equity around celebrities, whose popularity tends to ebb and flow. In fact, in 2018, Coty terminated all celebrity fragrance brands (Lady Gaga, Celine Dion, Tim McGraw, and so on), as it sought to focus resources on the highest potential brands.
Coty's brands have not demonstrated pricing power, which provides further evidence of a lack of brand equity. While explaining why the firm's gross margins are about 10 points below that of peers, former CEO Pierre Laubies stated that operational complexity has led to resources being spread too thin, which had led to a lack of pricing power. Management has also suggested that a product's margins tend to decline as it matures, implying a need to rely on promotional activity and discounting to support volumes, which we surmise speaks to the firm's inability to carve out a brand-based intangible asset moat.
We constructed the Morningstar Cosmetic Brand Strength Framework (adapted from the Morningstar CPG Manufacturers Brand Strength Framework) to assess the brand strength of the various companies in the cosmetics space. It evaluates each cosmetic firm's pricing power, market share, the importance of safety and consumers' risk aversion, protection from private label, and level of conspicuous consumption. It is our belief that the strongest brands have pricing power and high market share. We think they operate in categories where consumers are more averse to trying unfamiliar products, and categories that have a low level of private-label penetration. Finally, we believe strong brands tend to have a high level of conspicuous consumption, as consumers are less price sensitive for items that display wealth or social status. The framework rates Coty as having a moderate degree of brand strength overall, with a high score for protection from private label, moderate scores for market share and the level of conspicuous consumption, and low scores for pricing power and the importance of safety and consumers' risk aversion.
Coty's lack of brand equity has precluded the firm from maintaining preferred status with its channel partners. Coty's primary distribution channels are food-drug-mass, department stores, specialty beauty stores such as Sephora and Ulta, and travel retail. E-commerce (a high-teens percent of revenue in fiscal 2021's third quarter) is also an increasingly important channel for all of Coty's businesses. While Coty is the world's largest provider of fragrance, we suspect that the firm's limited presence in prestige skin care and makeup constrains Coty's ability to reach preferred vendor status with department stores and travel retail operators. According to GlobalData, department stores' beauty business is about 50% skin care, 30% makeup, and 20% fragrance. We believe the mix is similar for travel retail, limiting Coty's clout in these channels. For Coty's other significant channels, food-drug-mass and specialty beauty, Coty has been losing significant shelf space in these channels for the reasons cited above, namely undisciplined innovation and marketing, with products that fail to resonate with consumers. While beauty overall is an important category for food, drug and mass channels, as the business boasts attractive growth rates, growth has been driven by the higher end of the category, where Coty lacks a significant presence.
We believe that Coty's brand investments have not been as material or effective as the firm's peers. In the past three years, Coty spent 24.6% of revenue on marketing, slightly ahead of the 22.4% beauty pure-play average. However, we deem these investments not as effective as their competitors'. For one, Coty has acknowledged that their shift to digital has lagged peers, although CFO Pierre-Andre Terisse said that the firm is beginning to close the gap. Coty is also lagging peers regarding its e-commerce efforts, as a high-teens percent of Coty's revenue is captured online, compared with 22% for Estee Lauder and 16% for L'Oreal. Furthermore, Coty has underinvested in R&D as compared with its peers, spending an average of 1.9% of revenue over the past three years, compared with the 2.8% peer average. However, we expect the firm to close the gap in the next few years. Unless those investments are spent on high-ROI projects, though, we do not expect the investments to improve brand equities.
Coty does not appear to have a cost advantage, either. In order to gauge a firm's cost advantage, we look at direct operating margin, which adjusts for costs not directly related to production and distribution: discretionary costs such as advertising, and research and development. For fiscal 2019 (the most recent fiscal year not disrupted by the pandemic) Coty's direct operating margin was 39.3%, below the 40.8% average for all global beauty companies under Morningstar coverage, and well below L'Oreal's 56.0% and Estee Lauder's 45.8%, other cost-advantaged pure-play beauty companies. Coty's metric also falls below Shiseido's 41.3%, another firm viewed as lacking a cost advantage.
Prior to the fiscal 2017 acquisition of Procter & Gamble beauty business, Coty generally reported economic profits, with ROICs ranging from 12.7% to 22.1% excluding goodwill and between 6.5% and 12.5% including goodwill, compared with our 7.3% estimate of the firm's cost of capital. However, since the acquisition, the firm has failed to report an economic profit, with ROIC excluding goodwill ranging from 6.9% to negative 5.1%, and 3.6% to negative 2.5% including goodwill. In our view, this provides further evidence of a lack of a competitive edge.
Fair Value and Profit Drivers| by Rebecca ScheunemanUpdated May 17, 2021
We are increasing our fair value estimate for Coty to $6.40 from $5.50 after the firm's third-quarter report. While the quarter was largely as expected, we now expect a more robust post-pandemic sales recovery, given the firm's brand revitalization efforts and expansion into high-growth markets (skincare, prestige makeup, China, e-commerce), taking our three-year forward average annual organic sales estimate to 6% from 3%. We also incorporate our view that the U.S. corporate tax rate will increase to 26% beginning in 2022, from 21%, leading us to increase Coty’s total tax rate by 150 basis points to 26%, although this did not materially impact our valuation. Our updated valuation implies fiscal 2021 enterprise value/adjusted EBITDA of 18 times.
In the prestige segment, after fiscal 2020's pandemic-driven 25% drop in organic sales, we expect organic sales will recover 1% and 12% in fiscals 2021 and 2022, respectively, as stores reopen. In fiscal 2023 and thereafter, we expect 3%-4% annual sales growth, in line with Coty's weighted exposure to global prestige beauty categories (mostly fragrance with some cosmetics and skincare). In the mass segment, after fiscal 2020's 23% organic sales drop, we think sales will continue to slide 9% in fiscal 2021 as mask-wearing pressures makeup sales, with recoveries of 5% and 8% in fiscals 2022 and 2023, respectively. Over the long term, we forecast 2%-4% annual growth, as rebranding efforts, in conjunction with investments in innovation and marketing, help the business maintain market share. In fact, the segment held market share in the first quarter for the first time in five years, as new products resonated with consumers.
Over the past three years Coty's gross margin has averaged 60%, excluding the Wella divestiture, and we expect this will improve to 61% over the next 10 years driven by SKU rationalization, supply chain efficiencies, and procurement savings. Coty's restructuring plan should also generate $600 million in SG&A savings, which should decline to 13% of sales over the next decade, down from the three-year 16% average excluding Wella. We expect the firm to maintain advertising and promotion investments at 25% of sales, while R&D investments climb to 2.6% over the long term, from last year's 2.0%. The net effect is operating margins improving to 14.6% in 2030, up from 7% the two fiscal years before the pandemic.
Risk and Uncertainty| by Rebecca ScheunemanUpdated May 17, 2021
We assign Coty a high uncertainty rating.
Given the magnitude of changes occurring at Coty (yet another CEO as of Sept. 1, integrating acquisitions, divesting a material portion of the business, while working to reignite a stagnant brand mix and deal with a global pandemic), there is meaningful risk for executional missteps. Coty is making significant investments to expand into high-growth markets where it has historically been underexposed, such as skincare, prestige cosmetics, China, and e-commerce. There is no guarantee that these investments will be well-received by consumers or will generate sufficient returns for stakeholders.
Coty's net debt/adjusted EBITDA stood at an alarming 22 times at the end of fiscal 2020, well above the 5.95 times limit imposed by its debt covenants. Coty received a waiver in its obligation to meet this requirement through March 31, 2021, at which time it was in compliance, as it reduced debt with the $2.5 billion in proceeds from the sale of a 60% stake in its professional and retail hair care businesses. We think Coty will remain in compliance moving forward, with leverage expected to average 3.8 times over the next five years.
Coty faces several environmental, social, and governance risks, such as significant use of fresh water, potential harmful ingredients in products (which can lead to recalls or litigation), pushback on animal testing, and insufficient governance which has allowed a series of value-destroying acquisitions. The governance issue is the most material and probable risk in our view, which we think is appropriately captured in our high uncertainty rating.
Capital Allocation| by Rebecca ScheunemanUpdated May 17, 2021
We assign Coty a Poor capital allocation rating, given a weak balance sheet and a track record of value-destroying acquisitions, partially offset by appropriate shareholder distributions.
Heading into the pandemic, Coty had tight liquidity, given its $600 million January 2020 investment in Kylie Cosmetics, and limited ability to secure debt, as it was pushing against the 5.95 times maximum net debt/adjusted EBITDA imposed by its debt covenants. Given the pandemic-induced plunge in EBITDA, Coty closed fiscal 2020 with leverage at 22 times, but negotiated waivers with lenders, avoiding a default. The $2.5 billion sale of a majority stake in its Wella business allowed the firm to reduce debt, coming back into compliance, which we expect to persist. Leverage should fall below 4 times in fiscal 2023, and Coty will need to tap debt markets that year to refinance $3.8 billion in maturities.
The firm has destroyed significant shareholder value as it has overpaid for and poorly integrated various deals. In October 2016, Coty purchased 41 cosmetics, fragrance, and hair care brands from Procter & Gamble for $14.8 billion. Since the closing of the deal, the business has suffered from steep revenue declines, which we attribute to underinvestment in the brands by Procter & Gamble during the yearlong deal approval process, Coty’s inability to effectively integrate the business, and management’s lack of appreciation of the severity of the problems, which delayed resolution. In fiscal 2019, Coty took a $3.7 billion impairment noncash charge on the assets.
Although the firm had its hands full with a complicated integration of these assets, Coty continued to make acquisitions, purchasing GHD (a manufacturer of hair styling appliances) for $512 million in November 2016, and taking a 60% stake in Younique, an online multi-level marketing beauty company, for $600 million in February 2017. In 2019, Coty sold its Younique stake for $50 millon plus a $28 million promissory note, confirming a significant destruction of shareholder capital.
In 2012, Coty offered to buy Avon Products for $11 billion, although Avon’s board, which had recently hired a new CEO to turn the business around, declined the offer. In December 2015, when Avon was split into two businesses with one portion privatizing, Avon was valued at $1.8 billion. While Coty’s shareholders were spared from this loss, we think the example is relevant to current and prospective Coty shareholders, as it demonstrates the board’s willingness to chase growth without regard for the standing of the business.
In 2020, Coty bought a 51% stake of Kylie Jenner’s Kylie Cosmetics for $600 million and announced a 20% stake in Kim Kardashian West's KKW for $200 million. As celebrity popularity tends to ebb and flow, we think building long-term strength for celebrity brands can be especially challenging. It is too early to conclude if these transactions will add shareholder value, but the Kylie deal at 6.7 times trailing sales and 26 times EBITDA, looks rich. (KKW metrics not disclosed.)
We view Coty's shareholder distributions as appropriate. Coty prudently suspended its dividend in May 2020, given the pandemic and tight liquidity. We think Coty will reinstate it in fiscal 2023, and average a 30%-40% payout ratio. We expect Coty to refrain from repurchasing shares the next three years, as it focuses on debt reductions, and we think buybacks will resume in 2024, absent acquisitions.
Coty’s chairman is Peter Harf, managing partner at JAB who served as Coty’s CEO from 1993 to 2001. Harf has been a vocal advocate of the benefits of growing by acquisition. In fact, Harf’s long-term JAB partner, Bart Becht, advocated for a halt in acquisitions as he believed Coty's active acquisition strategy was complicating operations and harming the business. The widely publicized dispute culminated in Becht's abrupt departure from JAB. As JAB controls the board and shareholder votes, minority shareholders have little opportunity to effect change in our view. While in theory shareholder interests should be aligned with JAB's (to maximize shareholder return), JAB's history of overpaying for businesses impairs our confidence in the firm's ability to be a wise steward of shareholder capital.
On Sept. 1 Sue Nabi stepped in as CEO. Nabi enjoyed a successful 20-year career at wide-moat L’Oréal, climbing the ranks and ultimately serving four years as the global president of L’Oréal Paris and another four years as the global head of Lancôme. The brands realized much success under her leadership, and we are optimistic her experience will help her stabilize Coty's business. Nabi plans to stabilize the mass beauty business by developing superior products and brands that represent a clear purpose, accelerate the luxury unit by expanding into makeup, skin care, and Asia, and build Coty’s e-commerce and digital marketing capabilities, using Kylie and KKW as a foundation, leveraging the brands’ strong social media followings.