Coty: Too Early To Celebrate, Still Much Work To Be Done

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About: Coty Inc. (COTY)
by: Zvika Finkelstein
Summary

Coty posted its FQ2 2019 earnings last Friday, beating both on top and bottom lines. In response, shares soared by 32% to what I believe was a relief rally.

Despite resolving critical supply chain issues, management has much work to do in order to deserve its credibility.

At current levels, I consider shares to be fairly valued and see no reason to alter the neutral stance until any meaningful progress is done.

Coty (COTY) posted its FQ2 2019 earnings last Friday. The results were above expectations, beating both on top and bottom lines. The company posted EPS of USD 0.24 vs. consensus estimates of USD 0.22, although still reflecting a 25% decline vs. the same period last year. The actual revenue amounted at $2,511 M vs. analysts' estimated $2,473 M (-5% YOY). In response, shares soared by 32%. While I truly understand investors' relief, I believe there is still a long way to go before Coty will deserve higher valuations.

According to management, the reasons for the better than expected revenues are mainly related to a moderation in supply chain headwinds, a shift in US hurricane-related shipments into Q2 and a solid e-commerce momentum in luxury brands, all supported by easier comparables in the prior year.

It seems like the most vulnerable segment right now is Consumer Beauty, down 15% in revenues vs. the prior year. While holding for almost 40% of total revenue, that might be a big issue for Coty, which focuses heavily on that middle-end segment.

In the press release, CEO Pierre Laubies mentioned that "while we are confident we can return Coty to a path of growth, we are also realistic that it will take some time." Considering that he stepped into his role only a few months ago, he should earn his 100 days of grace, although the burden of proof lays on his hands.

Coty's Story

The story of Coty is quite simple: the company manufactures, markets, distributes, and sells beauty products worldwide. The company offers its products through various retailers under a wide range of brands. Among them are Alexander McQueen, Burberry, Calvin Klein, Cavalli, Davidoff, Escada, Gucci, Hugo Boss and Stella McCartney. It operates in three segments: Luxury, Consumer Beauty, and Professional Beauty, while selling its products to third-party distributors, as well as through direct-to-consumer, third party-operated, and own branded Websites.

Coty has lost half of its value during the past year, mainly resulting from a decline in revenues and margin compression while holding a huge debt burden after purchasing the beauty business of Procter & Gamble (NYSE:PG) back in 2016 in a massive $11 B deal. As of the date of this article, the company's long-term debt amounts at $7.5 B vs. only $593 M in operating free cash flow expected in FY19, which derives an adjusted coverage ratio of 13 years! That's a very big issue to attack.

Looking into its historical financial results, Coty's top line looks quite good with a 5-year revenue CAGR of 18%, although the company has not managed to transfer its revenue into the bottom line, while its EPS has been decreasing at an average rate of 3% during the last 5 years. Its operating margins have decreased from 12.1% of revenue in FY15 to only 6.9% of revenue in FY18.

This underperformance is not something to write home about and new management has lots of work to do in order to turn back to growth mode. The good news is that this leaves a great room for operational improvements and lots of opportunities for a turnaround in the business. Looking at the CEO comments as published on Friday, it seems like management knows which steps should be taken going forward:

From a financial standpoint, gross margin improvement will become our key area of focus. Gross margin is the lifeblood of the business and we recognize that we must close the gap we have here versus our beauty peers. That means managing revenue and costs, improving product mix and range, simplifying our portfolio and formulations, and systemically deploying lean-inspired methodologies in our manufacturing and logistics operations.

It seems like the whole beauty market is enjoying a bullish sentiment after companies like Estee Lauder (NYSE:EL) and L'Oreal (OTCPK:LRLCF) both have presented strong sales in their recent earnings reports. However, there are still some headwinds in the market, among them are a heavy reliance on China and escalating marketing costs, as has recently been noted by The Wall Street Journal's Carol Ryan.

Valuation

As of this date, Coty is trading for $9.33 per share and considering FY2019 EPS of $0.66 (non-GAAP), we derive a forward price to earnings multiple of 14.2x, which is well below industry leaders like L'Oréal (30x) and Estée Lauder (28x), but in line with smaller peers like E.L.F Beauty (15x).

Trying to discount future cash flows by using some optimistic assumptions of forward 5-year revenue CAGR of 2% and operating margin of 11% of total revenue, we derive an intrinsic value of $8.5 per share, which is 8% lower than the last closing price ($9.3). Presented below is a DCF analysis as derived by using a 9% discount rate, followed by a sensitivity table.

Bottom line

While I truly understand investors' relief after last earnings results, I believe shares are fairly valued and see no reason to alter the neutral stance until any meaningful progress is done. The company still faces some heavy challenges, among them are supply chain disruptions, low margins and a huge debt burden. While last earnings results were above expectations and new management's comments provide some place for optimism, additional progress needs to be delivered upon to drive appeal from here.

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.