Coty (COTY) continues its aggressive acquisition strategy, even as the market has not really given the thumbs up for the company to pursue such a route. There are a lot of moving parts at Coty, of course driven by the purchase of Procter & Gamble´s (NYSE:PG) beauty business, a deal which closed just a few weeks ago.
Expectations have come down a lot amidst the fall in the share-price from highs of $30 this summer, to the high-teens by now. While I see risks to the 2020 earnings projection, including a reliance on aggressive synergies and struggling operating performance, appeal is certainly increasing following the slide in the share price.
If shares might potentially fall back towards the mid-teens, I would be tempted to start accumulating a position on the back of an improved risk-reward scenario at those levels.
Adding GHD, A Bolt-On Move
Coty recently announced the bolt-on deal of Good Hair Day, a UK premium brand for styling applications. The company announced no financial details other than that the deal would be accretive to earnings.
UK press reports indicate that Coty paid GBP 420 million for the business, equivalent to roughly $525 million assuming a 1.25 exchange ratio. These same reports indicate that GHD generates GBP 176 million in annual revenues, translating into a 2.4 times revenue multiple.
Financing The Deal From The P&G Benefit?
Coty believed that it had some money left after closing on the $11.6 billion acquisition of Procter & Gamble´s beauty business on the first day of October. This deal was largely an equity swap, giving investors in P&G a slight majority stake into Coty, yet shares of the company have fallen from $30 this summer, when the deal was announced, to levels in the high teens.
Another benefit is that Coty only had to assume $1.9 billion in debt, held by Procter´s businesses, instead of $2.9 billion assumed when the deal was announced. This one billion benefit will alleviate the balance sheet a bit, allowing Coty to pursue the Good Hair Day acquisition. While this looks very promising, note that it might be a reflection of deteriorating operating performance at P&G´s beauty business as well, a reason to act with some caution with regard to this unexpected benefit.
The Pro-Forma Impact, Lots Of Moving Parts
Procter´s beauty business generated $5.9 billion in revenues in 2014 and $1.15 billion in EBITDA, driven by strong brands like Wella and MaxFactor. That said, sales erosion, some divestments and non-inclusion of some brands, make that P&G´s former beauty business is set to contribute just $4.4 billion in annual revenues to Coty.
Formerly being part of a major conglomerate, means that segment EBITDA numbers can not always be relied upon. Such conglomerates often have large unallocated costs on the corporate line, while really some of these costs should be attributed to individual segments.
In a recent investor presentation, dated in September, Coty guides for a $9 billion pro-forma revenue number, comprised out of $4.6 billion in sales for Coty and $4.4 billion for P&G. Coty assumes substantial synergies on the back of actual cost savings as well as the fact that not all costs are being transferred from P&G. Based on these fairly aggressive numbers, adjusted operating margins for the whole of Coty are expected to improve from 14% at the moment, to +19% by 2020.
First Quarter Results
Coty recently posted disappointing first quarter results, a quarter ending on September 30. Revenues were down by 3% to $1.08 billion, while adjusted operating margins were down 2 percentage points to 15.4% of sales. It should be said that distraction ahead of the P&G deal closure has impacted the results a bit, as admitted by management.
This is not an encouraging start to the year, certainly seeing as no recovery is anticipated in the upcoming quarter. Based on the balance sheet, we can make an estimate about the pro-forma results. Ending the quarter with $378 million in cash, debt stands at $4.6 billion if pension related obligations are included, for a $4.2 billion net debt load. Including $1.9 billion in net debt assumed alongside the P&G deal, which closed on October 1, and accounting for the $525 million purchase in the UK, net debt currently stands at around $6.7 billion.
The September investor presentation talks about a $850 million EBITDA contribution from P&G. With first quarter adjusted EBITDA hitting $225 million for Coty, a pro-forma EBITDA is seen around $1.75 billion a year. That suggests that leverage is elevated a 3.8 times adjusted EBITDA. Leverage ratios will come down a bit over time, as the company has laid out plans to divest 6-8% of the combined sales base in the coming years.
Working Out Some 2020 Scenarios
The company will operate with 746 million shares which trade at nearly $20, for a $15 billion valuation, or $21.5 billion including net debt. Based on $9 billion in pro-forma sales, the business trades at 2.4 times revenues.
The company itself guides for adjusted margins of +19% by 2020. On a $9 billion revenue base, this yields a $1.7 billion EBIT number. After accounting for 5% interest rates on $6.5 billion in net debt and applying a 30% tax rate, earnings might come in just shy of a billion. With 746 million shares outstanding, that yields an earnings number of roughly $1.30 per share.
The company continues to target adjusted earnings of at least $1.53 per share by 2020, as this is a ¨mechanic¨ number according to executives, not requiring organic improvements, but simply being the result of the deal and consummation of anticipated synergies. That suggests that shares trade at just 13 times earnings, but these are adjusted earnings and are only projected to be reached within 4 years' time. Those earnings more closely mimic an adjusted free cash flow numbers rather than real earnings. Typical costs excluded in the adjusted metric includes restructuring, amortization and share-based compensation expenses.
One thing has to be recognized. After shares peaked at $30 this summer, they have retreated by more than a third on the back of worries about the performance of the core business and the acquired activities of Procter & Gamble. This +$10 move in the share price wiped out $8 billion in shareholder value, if the newly issued shares are included, marking a significant reset in the valuation. Note that at $30, the company traded at roughly 20 times adjusted earnings for 2020.
The reset, to the point at which shares trade at 13 times adjusted earnings by 2020, suggests that the market has priced in the risks to the optimistic guidance to a large degree. The +19% adjusted margins simply look very high even if sales come in around $10 billion. Competitor Estee Lauder (NYSE:EL) is already a well-run business which posts margins of just 14% on $11 billion in sales, as margins of Henkel and L´Oreal are rather similar in the mid-teens.
If margins of 15% are more realistic, I see operating profits of just $1.35 billion on $9 billion in sales resulting in earnings of roughly $1 by 2020. Upside to this number is obviously within reach if Coty delivers on its margin promises, and revenue growth at Procter´s activities can be reignited after being ¨neglected¨ by its former parent.
Even if I apply a rich 20 times multiple to an earnings per share number of $1 by 2020, shares are already fairly valued at these levels, suggesting no upside from current levels for the coming four years. I therefore see earnings of anywhere between $1 and $1.50 per share by 2020, which at the midpoint suggests $1.25, or $25 valuation if a 20 times multiple is attached to such a potential outcome.
Requiring a +12% rate of return, shares would have to fall back towards $16, or the performance needs to improve a great deal, before I get truly optimistic from a risk-reward stance, amidst a still leveraged balance sheet. Potential M&A rumors or consolidation by its majority shareholder should act as potential long term triggers on top of a favorable set-up if shares might retreat towards those levels.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.