Coty, Inc.: Winning A Fight Against Online Luxury Sales (Is A Positive)

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About: Coty Inc. (COTY), Includes: AMZN, EBAY
by: Willow Street Investments
Summary

The company is fighting a decade long battle against European online sales of its luxury brands in its effort to protect the prestige of its luxury brands.

The company, along with many of its competitors that support its fight, argues that it wants choose its distributors or ban online sales of its luxury brands.

The company is concerned about protecting the luxury image of its luxury brands such as Marc Jacobs, Calvin Klein and Chloe.

A European court advisor, in a non-binding opinion, found that companies should be able to block retailers from reselling their products on online platforms.

The company aims to transform by strengthening global brands, focusing on higher growth brands, stabilizing remaining brands and expanding its geographic reach.

Our eyes are focused on Coty, Inc.'s (NYSE:COTY) next earnings report, which is set for late August 2017. Until such time, we tend to look out for any additional factors that support our decision to invest in the company shares. As we have noted multiple times, the company's shares first came to our attention after multiple insiders purchased significant amounts of COTY shares near 52-week lows in the first half of 2017. We saw such insider purchases as an indication of such insiders' confidence in COTY's transformation primarily involving its integration of three personal products businesses (make-up, fragrance and hair care) acquired from Procter & Gamble (NYSE:PG). In the near-term, COTY's shares slid from 52-week highs of about $30 due to adverse effects from higher-than-anticipated inventory levels in the acquired PG beauty business, competitive pressures in its consumer beauty division and the distraction associated with its merger integration efforts. Next, we highlighted the Chinese market as a potential market for growth for the company as Chinese millennials are becoming the "world's biggest beauty queens" given the power of the Internet. With respect to the Chinese market, we then noted COTY's entrance into such market through the Chinese retail giant Tmall, a business-to-consumer marketplace owned by Alibaba (NYSE:BABA).

Although COTY transformative efforts represent a self-described "multi-year effort," the company did exceed its revenue/earnings estimates in its latest quarterly report due to strong demand for its Calvin Klein brand and its recently acquired brands, ghd and Younique. (See our article highlighting COTY's most recent earnings report.) With such investor data points in mind, we would like to discuss a major battle being fought by COTY that, if the company wins, is another data point supporting an investment in the company's shares. COTY is in a battle against online sales of its luxury brands in its effort to "protect its luxury brands." The company, along with many of its competitors that support its fight, argues that it wants choose its distributors or ban online sales of its luxury brands. European online retailers say, however, that online luxury brand sale bans are anti-competitive. COTY's battle also involves two countries on either side of the issue: 1) Germany, an economic power of efficiency and thrift, argues that innovative online distribution networks should not be blocked; and 2) France, a country where many of the world's most iconic luxury brands were born, argues that online sales diminishes the prestige of a brands' luxury image.

The German business division of COTY argues that luxury brand distribution policies do not serve as an outright ban on luxury online sales, but it is concerned about protecting the luxury image of its luxury brands such as Marc Jacobs, Calvin Klein and Chloe. COTY's German business is involved in an ongoing landmark litigation that could determine whether luxury goods companies can prevent retailers from selling their products via online marketplaces such as Amazon (NASDAQ:AMZN) or eBay (NASDAQ:EBAY). Luxury brand owners have long argued that it is their right to choose their distributors to protect their image and exclusivity. Online companies counter such argument by stating that such curbs are anti-competitive and adversely affect small businesses. COTY's battle on its own behalf (and in effect for all luxury brand companies) is significant given that the European market represents 70 percent of global luxury sales. In late July 2017, COTY received some good news when a European court advisor found that companies such as COTY should be able to block retailers from reselling their products on online platforms such as EBAY and AMZN. In particular, the Advocate General to the European Union Court (in a non-binding opinion) found that luxury brand owners would not be breaking antitrust rules if the prestige image of their products requires them to be sold in selected stores and if those retailers are chosen in a fair way.

The European Union Court of Justice typically follows at least part of an Advocate General's non-binding opinion, and, as such, such opinion is likely a positive sign for COTY and other luxury brand owners. The results of COTY's case may adversely affect multiple antitrust investigations across Europe due to what regulators see as unjustified contracts between manufacturers and retailers to set limits on the geographic extent of sales and the pricing of goods. As such, the upcoming decision in the COTY case could settle years of legal battles over what online retailers call "blanket bans" or "unjustified selective distribution agreements" in violation of European Union ("EU") competition rules. Ultimately, the upcoming EU decision will answer the question of "How far can luxury brand owners go to stop retailers from reselling their products on platforms?" Arguments against luxury brand online sales include the idea that "Consumers will remain deprived of greater choice and price competition while for many sellers an important online distribution channel will remain effectively closed." Over the years, luxury-goods makers influenced lawmakers by successfully lobbying the EU to give luxury brand owners more power over how online retailers sell their products to prevent the degradation of image of their luxury products.

While COTY fights its battle in EU courts to protect the distribution of its luxury brands in the EU, it appears brand owners are seeking to protect their brands in the U.S. as well. In recent weeks, the CEO of Birkenstock USA ("BK" - ironically a German company) harshly denounced the online sale of its products on AMZN. BK's complaints arise during an increasing battle between smaller retailers and Internet behemoth AMZN. In a brutal email, BK's CEO chastised AMZN for contacting shop owners and offering to buy BK's products at full price. BK, earlier in 2017, had stopped selling its products on AMZN due to an increase of counterfeit BK products and unauthorized sellers. AMZN, for its part, has been contacting tens of thousands of U.S. retailers, asking them to sell their products directly to AMZN. BK, in its own policy with retailers, prohibits shop owners from selling, distributing or shipping its products to resellers. In the recent email of BK's CEO, he stated that "any authorized retailer" who sells BK products to companies such as AMZN "will be closed FOREVER." In addition to the BK CEO's threats towards retailers that sell its products, the company is also considering legal action against AMZN for knowingly encouraging a breach of our policy. BK, in a sentiment similar to COTY, indicates that allowing AMZN to sell its iconic cork-and-leather sandals could tarnish its brand and reputation.

BK, also similar to COTY, believes that it should control how and where its products are sold. The control of how COTY (and BK's products) luxury products is not an issue to be underestimated, but investors should focus on the company's current integration and cost cutting efforts involving its acquisitions of more than 40 brands from PG. The company also acquired the personal care/beauty business of Brazil's Hypermarcas SA, a majority stake in online cosmetics retailer Younique and a high-end hair styling appliance brand, ghd. While such acquisitions should drive revenue/earnings growth long term, the company is experiencing near-term adverse effects from such acquisitions. For example, COTY has lost shelf space at retail stores for certain PG brands and expects such lost shelf space will continue until COTY's marketing efforts reverse the effects on such brands being "abandoned" by PG. With this in mind, the company is focused on driving growth by: 1) strengthening/nurturing its global brands in its consumer beauty, luxury and professional beauty businesses; 2) cultivating smaller brands with higher growth potential; 3) stabilizing its remaining brands; and 4) expanding the geographical reach of its portfolio and leveraging its global distribution footprint.

COTY's strategy to drive growth also includes mergers and acquisitions. With the company's strong cash flow and balance sheet, it intends to add businesses that improve its growth profile while remaining disciplined on valuation. The company also continues to target total four-year synergies and working capital benefits of $750 million and $500 million, respectively, with no change to the operating costs to realize both. With the above-noted efforts to drive revenue/earnings growth in mind, we believe that COTY has significant long-term growth potential given its iconic and emerging brands, Chinese market opportunities, a potential improved control over the distribution of its luxury products and its detailed strategy to drive sustained profitable growth over time. We strongly believe in the company's transformational efforts, and, given this, we recommend that investors consider the company's shares on any overall market weakness.

Our view

COTY is transforming on multiple fronts while also attempting to protect its European luxury business from online retail sales. As noted above, a non-binding advisory opinion is likely to lead to a positive EU decision that would allow it to sell its luxury products in the channels it chooses. Our COTY investment thesis is supported by our confidence in the transformational rewards from the company's integration of PG's beauty business along with the other acquisitions noted above. Although the company considers its transformation as a multi-year effort to drive more consistent revenue/earnings growth, we expect initial positive signs from such transformational efforts over the next year. Despite COTY experiencing uncertainty given difficult market conditions exacerbated by acquisition and cost synergy uncertainties, it is working to overcome such adverse conditions by: 1) strengthening its global brands; 2) shifting more of its resources to fuel the growth of its brands with higher growth potential; 3) stabilizing its remaining brands; and 4) continuing to expand the geographic reach of its strong brand portfolio. The company is also likely to achieve its $750 million cost synergy target by fiscal 2020. Further, COTY's initial efforts to acquire market share in the coveted Chinese millennial market are an additional signal of the company's focus on expanding its global market opportunities in addition to its U.S./European focused transformational efforts.

COTY's efforts to transform will also expand its operating margins/improve cash flow generation. The company plans to further develop its power brands, expand its presence in emerging markets and increase its distribution. COTY will also work to drive growth through acquisitions. The company is taking aggressive steps to stabilize its businesses and turn around its consumer beauty business. Despite such adversities, COTY has a significant opportunity to transform the PG brands it acquired. COTY's forward price-to-earnings ratio is about 27.35 based on fiscal 2017 earnings estimates of $0.75, and about 22.50 based on fiscal 2018 earnings estimates of $0.91. Estimates for both fiscal 2017 and 2018 have decreased modestly in recent months. We believe that investors should follow the extensive multiple insider purchases in the first half of 2017 and consider the company's shares on any overall market weakness. Over the long term, investors will benefit from share price appreciation and dividend increases as the company drives revenue/earnings growth from the integration of its recent acquisitions, internal product pipeline innovation, product portfolio management, its e-commerce push into Chinese markets and acquisitions and its efforts to protect the prestige of its luxury brands.

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Disclosure: I am/we are long COTY, PG. 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.