Does Coty Pass The Smell Test?

| About: Coty Inc. (COTY)

Summary

Coty has taken a beating over the last 5 months.

A huge acquisition has led to higher and higher debt levels.

Is Coty healthy enough to persevere through it's integration struggles?

Coty (NYSE:COTY), the pure play beauty company, has taken a beating over the last five months. In August, it rallied and briefly touched the $30 mark. Since then, it has been a slow, painful bleed with the stock hitting a low of around $18. A less than stellar quarterly report in November exacerbated the move and sent the stock tumbling to further lows where it has since fluctuated between $18-20.

While I like to examine stocks near their 52 week lows looking for unnecessarily beaten down companies, I was further drawn to Coty due to the fact that Michael Burry (of The Big Short) had recently purchased a position. He has an impressive track record but is this move one that we should follow?

What's Going On?

The main driver of the price decline would seem to be the increasing debt burden related to the acquisition of P&G's specialty beauty segment specialty beauty segmentand the subsequent struggles with integration.

Growth by acquisition seems to be the status quo with Coty as they have purchased not only the P&G segment, but also Beamly, the Brazilian beauty business of Hypermarcas, Good Hair Day, and most recently a 60% stake in Younique.

There is no denying that Coty has acquired a strong set of brands across its various operating segments but have they bitten off more than they can chew? Will the focus on acquisitions eventually cede to organic growth and optimizing what they have? I can't predict the future but I can examine the current state of affairs and point out a few interesting points.

Points of Interest

As I believe the debt burden to be the most significant driver going forward, I wanted to examine the current state of Coty's health.

The first number to look at is the Altman Z-Score - a formula for the prediction of bankruptcy risk and financial distress. A Z-Score below 1.81 is the "distress" zone, between 1.81 and 2.99 is the "gray" zone, and above 2.99 is considered "Safe". Below are the results over the last 8 quarters as calculated from Coty's statements:

Qtr Ended Z Score
Dec-14 1.45
Mar-15 1.98
Jun-15 2.29
Sep-15 2.05
Dec-15 1.71
Mar-16 1.60
Jun-16 1.52
Sep-16 1.41

Since its high score of 2.29 in June 2015, Coty has seen a continuous decline and has resided in the "distress" zone for the last four quarters.

Two other ratios to examine regarding the debt are interest coverage and debt/EBITDA (TTM). The latter is important to watch going forward as it will have a direct impact on Coty's credit rating. Below are the figures:

Qtr Ended Int. Coverage Debt/EBITDA ttm
Mar-15 6.2 6.4
Jun-15 LOSS 4.8
Sep-15 5.5 4.7
Dec-15 6.0 6.6
Mar-16 0.7 8.8
Jun-16 LOSS 8.3
Sep-16 1.2 9.4

After the P&G deal, Moody's assigned a Ba1 rating to Coty's senior secured debts with a stable outlook. In the release, it states that the stable outlook reflects the view that Coty will continue to grow and generate cash flow, as well as the assumption that Coty would not attempt any additional significant transactions in order to focus on integration. Furthermore, it states that Coty could be downgraded if operating performance suffers, it has difficulties with its integration efforts, of if the debt/EBITDA ratio remains above 4x. As shown in the table above, the ratio has been and remains well above the 4x mark.

In the time since the initial October report from Moody's, Coty has spent a combined $1.11B on deals for Good Hair Day and a 60% stake in Younique to be financed through a combination of cash and existing credit facilities. Moody's has stated both deals are credit negative but would not affect the Ba1 rating.

C-Score

James Montier, a respected member of GMO's team, devised a simple scoring system to provide insight as to whether a company is potentially 'cooking the books'. A point is given for every 'yes' answer, with 6 being the highest and worst score possible. Running the test, I got a score of 2 which means there may be some minor changes being made but the company is overall not much of a manipulator. I do want to highlight a few of the findings however.

First, is there a growing difference between net income and CFO?

Cash Flow from Operation 2012 2013 2014 2015 2016
Net Income (293.3) 201.9 (64.2) 259.4 179.2
Net Cash from Operations 589.3 463.9 536.5 526.3 501.4
Difference 882.6 262 600.7 266.9 322.2

Yes, there has been from 2015 to 2016 but we can see that it is Net Income that has been unsteady. Cash flow, which is less subject to manipulation, has declined slightly but has remained fairly solid over the last five years. This is positive.

The Day's Sales Outstanding has been steadily increasing. In 2012 DSO was at 46.6 days and has increased every year since. 2016 finished at 58.0 days with the TTM data coming in at 65.2. This could mean that there is some channel stuffing occurring which has led to the increased accounts receivable despite negative sales growth. It could also simply mean that retailer sales have slowed and they are thus taking longer to pay Coty back.

Is the ratio of current assets to revenues increasing? Are there declines in depreciation relative to Gross PP&E?

2013 2014 2015 2016
Other Current Assets/Rev. 4.1% 4.4% 4.3% 4.8%
Depreciation/Gross PP&E 19.2% 18.1% 17.2% 15.2%

Other current assets can be used to as a hiding spot for items companies don't want you to see and which doesn't affect the cash conversion cycle numbers. Although there has been a slight increase, I don't think it's anything to worry about and can be ignored.

Depreciation as a percentage of Gross PP&E is showing a gradual but steady decline year over year. Companies can extend the useful lives of their hard assets to help beat quarterly numbers. I found one change, made from 2014 to 2015 where marketing furniture and fixtures were extended from a 2 to 4 year useful life to 3 to 5. This sub-category of Coty's PP&E makes up 19-20% of their gross PP&E so even a minor change could have had an impact on earnings by decreasing depreciation expense.

Where Do We Go From Here?

Coty seems to have plenty of positives going for it, but also plenty of warning signs as well. For now, I will refrain from taking a position. Acquisition integration issues and high debt levels are hard for me to overlook right now. I recommend looking closely at their next quarterly earnings release on February 2nd. If it seems like they are making progress on the integration front and seeing some positive results, I will put together a more comprehensive valuation estimate.

Just using the pro forma results from the most recent 8-K would result in a P/S ratio of .75 based on the current price ($19.41) vs. a four year average of 1.7. There's obviously room for Coty to run but it has some proving to do first.

*All financial figures are pulled either directly from the company's SEC filings or from Morningstar

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.

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