COTY - Coty: The Beauty Industry's Hidden Gem

2023-10-26 08:24:25 ET

Summary

• Coty is a resilient beauty company with a diverse product line and global distribution.
• The company has made significant progress in its turnaround efforts, reducing debt and improving profitability.
• Coty has untapped growth opportunities in markets like China and Brazil, and a focus on skincare innovation for enhanced profitability.

My Value Pick of the Year: Coty

Coty ( COTY ) is a US-based beauty company that operates on a global scale, manufacturing and distributing beauty products on a global scale. The company boasts a diverse range of offerings, including fragrances, color cosmetics, and various skincare products. Coty's product line spans two core segments: Mass Market products, priced between $5 to $20, and the Premium segment, featuring products priced as high as $450 per unit.

Such a business model as Coty's is remarkably resilient. Notably, luxury sales generally tend to endure through challenging economic cycles. Moreover, the mass market beauty sector, in particular, demonstrates remarkable resilience, a phenomenon famously underscored by the "Lipstick Indicator" established by Estee Lauder's ( EL ) Leonard Lauder. This indicator highlights that mass market beauty products, like lipsticks, often experience a surge in demand during difficult economic environments, such as periods of high inflation. During these times, people tend to indulge in small luxuries, leading to substantial total revenue for companies like Coty, despite the modest per-unit cost.

This resilience has been evident in recent times of elevated inflation. Coty, despite facing higher input costs, was not only able to maintain its profitability but also successfully grew its margins and improved other crucial financial metrics. This ability to navigate challenging economic landscapes further strengthens Coty's position as a robust value choice.

Coty's portfolio comprises well-known brands acquired through licensing agreements or as fully-owned entities. Mass market brands such as Adidas and Covergirl coexist with premium labels like Chloe, Gucci, Burberry, Hugo Boss, and Calvin Klein. The company predominantly markets its products through department stores, various retailers, and duty-free outlets at international airports.

Overview

In this article, I present a compelling investment case for Coty, outlining why it stands as a top value pick at its current price. We will delve into each of these points extensively throughout this piece.

1. Strategic Turnaround Initiatives: Coty has made significant strides in its turnaround efforts, initiated amidst the chaos of the COVID-19 pandemic. Despite Wall Street's concerns about Coty's elevated debt levels, the company's new executive team has made substantial progress in reducing debt and steering operations towards overall profitability. This progress, often overlooked, renders the current valuation unwarranted.

2. Untapped Growth Opportunities: Coty recognizes vast untapped opportunities for growth over various geographics. For instance, the company is poised to expand its market share in regions like Brazil, the world's largest mass market for beauty products.

The Turnaround - Years of Poor Management and the Significance of Exceptional Leadership

To gain insight into Coty's current state and project its future trajectory and, hence, potential as a top-value investment, I believe it's essential to reflect a little bit on its past. In 2015, Coty's shares reached a peak of about $32, but over the years, mismanagement led to a gradual decline, hitting an all-time low of $2.7 in late 2020, exacerbated by the global COVID-19 pandemic.

However, COVID-19 merely exacerbated existing issues; the root cause was years of poor management decisions. These missteps included the ill-fated Procter & Gamble beauty business takeover, hesitancy in exploring vital market opportunities like China, and a lack of expansion in its lucrative prestige segment, resulting in a substantial accumulation of debt. When Sue Nabi assumed leadership at Coty in 2021, she inherited a company burdened with debt, unprofitability, and numerous challenges.

Sue Nabi , a French native, is perhaps Coty's first CEO in a long time with a genuine background in the beauty industry. Before joining Coty, she founded and successfully built a vegan skincare brand, which she later sold to Coty. Additionally, Nabi held executive roles at L'Oréal, adding to her wealth of experience in the field.

People are paramount in my assessment of a value investment. Great individuals can transform a struggling business into a thriving one, whereas inept leadership can dismantle even the most promising enterprises. In Coty's case, the company had long been a diamond in the rough, lacking the right leadership. This changed with the appointment of Sue Nabi and the backing of Coty's anchor shareholder, the German family office of the Reimann family, JAB Holding, led by the renowned investor Peter Harf . JAB Holding, occupying most board seats in Coty, brings invaluable knowledge and a vast network to the company. They were instrumental in recruiting Sue Nabi from L'Oréal and increased their total stake in Coty in 2019, holding approximately 60% in total of the shares throughout the stock's downturn.

From a financial perspective, this shift in leadership significantly impacted Coty. The company nearly halved its net debt levels from almost $8 billion at the end of 2020 to below $4 billion as of Q4, six months into 2023.

Their economic debt, meaning to also consider liquidity and investments, would bring Coty's debt figure down even more, taking into account that Coty possesses valuable stakes in various ventures, such as the remaining >20% in Wella, valued at about $1 billion, which they intend to fully invest after they announced selling 3.6% for $150 million to IGF Wealth Management in July this year. Furthermore, they among others own a stake in SKKN, Kim Kardashian's cosmetics company, which they acquired for $200 million in 2020.

Overall, this strategic restructuring, coupled with a more focused and knowledgeable leadership team, has put Coty back on the path to stability and two straight years of profitability since FY 2022, after the Coty booked a total net loss of over $1 billion just two years ago for FY 2020.

Catalysts for Additional Growth on the Horizon

In my assessment, Coty presents significant whitespace opportunities within its product portfolio across various geographic regions. China, as previously mentioned, stands out prominently. It is a golden opportunity as the country evolves industrially, fostering a population increasingly interested in luxuries such as beauty, both big and small. Note, Coty has historically lagged in expanding its presence in China, presently, China contributes a mere 12% to Coty's total revenue mix, a fraction of its true potential.

The current low exposure in China, however, might be even more of an advantage to the company presently given recent geopolitical developments. While some of Coty's peers, such as Estée Lauder, which derives about 34% of its greatest portion of revenue from China, heavily depend on those Chinese revenue streams, Coty's limited exposure insulates it against a potential intensification of tensions between the US and China. This strategic positioning offers Coty flexibility and resilience, allowing it to still capitalize on the vast Chinese market opportunity given that tensions ease while presently mitigating risks associated with geopolitical uncertainties.

Looking beyond China, other promising markets beckon, albeit with incomparable numerical metrics, among these, Brazil shines brightly as a mass market beauty haven. Coty is already making strides in this territory, experiencing double-digit sales growth . The Brazilian market, still largely untapped for the company, provides Coty with ample room for expansion and capitalization on unexplored opportunities.

Skincare Comeback: A Gateway to Enhanced Profitability

Despite constituting a modest fraction of Coty's sales, accounting for approximately 5% and encompassing both consumer beauty and prestige lines (with Philosophy standing out as Coty's largest skincare brand), skincare represents an arena of vast potential, in my opinion. Under the vision of CEO Sue Nabi, Coty aims for a triumphant return to prominence in the skincare domain. This ambition is fueled by the rich heritage of key brands, notably Lancaster, and the groundbreaking biotechnology underpinning the Orveda brand, a venture she actually co-founded, as mentioned earlier.

I believe that what sets Coty apart in this competitive landscape might be its unique differentiators. Firstly, Coty boasts a legacy of SPF (Separation purification) technology, indicating a depth of expertise and experience that must be hard to match. And secondly, their mastery of biotech applications forms a robust foundation for their skincare products, ensuring cutting-edge formulations that deliver tangible results.

These technological advancements not only drive robust research and development capabilities but also pave the way for a slew of patents. Of particular note is Coty's ability to "vectorize" ingredients, a proprietary process that significantly enhances skincare efficacy. This technology serves as a formidable barrier to entry, especially against emerging "indie" brands, positioning Coty as an industry leader in skincare innovation.

Amid these advancements lies a substantial opportunity for Coty's profitability to soar. While their skincare segment presently represents a small share of their revenue, the strategic emphasis on technological innovation and product differentiation paints a promising future. Coty's foray into skincare is not merely a market expansion; it's a calculated move towards reshaping the industry landscape, with an eye firmly set on enhanced profitability.

Margins

In my view, Coty, overall, still has sustainable room to improve profitability, and it's also their own strategic focus that remains steadfast in that respect, focused on bolstering top-line momentum and strategic reinvestment without solely focusing on short-term margins. Historically, Coty has grappled with low margins, which are a significant concern for investors and a focal point of criticism. This challenge has been a persistent sore point for investors, leading to investor hesitation.

Recent reports emphasized Coty's nuanced approach within their guided EBITDA margin expansion of 10bps to 30bps . Amidst this margin expansion, considerable savings are earmarked for strategic reinvestments. These funds are channeled back into the company to power innovation as well as strengthen influencer partnerships, as one example. I will imply my assumptions about Coty's margin development later in the validation section.

Valuation: Unraveling the Investment Potential

Having explored some of the catalytic factors that could shape Coty's future, let’s delve into the heart of valuation. Understanding the potential of these catalysts and translating it into tangible numbers is crucial in evaluating the wisdom of an investment. As a value investor, I rely on the time-tested method of discounted cash flow ((DCF)) analysis. Discounting the value of future cash flow in order to derive a present (equity) value for a company might sound simple on first sight, however, it involves predicting the future, a task impossible for most of us. To err on the side of caution, I tend to opt for pessimistic or modest assumptions in my models. If, with modest assumptions, a company's calculated equity value offers a significant discount to its current market cap, it might be a good value pick.

Upon thorough analysis, our DCF model suggests a price target of approximately $15. This valuation represents an upside of roughly 60% based on Coty's current share price of $9.6 at the time of writing this article.

Furthermore, let's examine this relative approach to analyzing Coty, considering the famous P/E ratio and comparing it to several of its peers.

In essence, both analysis underscore the promising investment opportunity Coty presents. By cautiously estimating future cash flows and accounting for various catalysts, Coty emerges as a compelling value proposition. It's not merely a story or vision; it's a numerical affirmation of the company's potential.

Risks and Considerations:

While Coty Inc. emerges as a compelling value pick, there are several risks and challenges that potential investors should carefully consider. These are the most significant ones I consider presently:

1. Market Volatility and Economic Uncertainty: Coty operates in a dynamic market influenced by global economic factors. Economic downturns or recessions can impact consumer spending habits, affecting Coty's revenue and profitability. Additionally, market volatility can lead to fluctuations in Coty's stock price, posing challenges for investors.

2. Competition and Changing Consumer Preferences: The beauty industry is highly competitive, with evolving consumer preferences and trends. Coty faces competition from established players and emerging brands. Adapting to changing consumer demands and staying ahead of trends is vital for sustaining market share and profitability.

3. Execution of Turnaround Strategies: While Coty has made significant strides in its turnaround efforts, successful execution of strategies is crucial. Any missteps or delays in implementing planned initiatives, including debt reduction and market expansion, could impact investor confidence and stock performance.

Conclusion: Seizing the Undervalued Opportunity

Coty Inc., a beacon of resilience and strategic prowess in the beauty industry, stands as a remarkable value proposition for astute investors. Despite the challenges faced in recent years, the company has weathered storms, overcoming adversities through sound management, strategic initiatives, and a keen understanding of market dynamics. Presenting a robust portfolio that spans both mass market and premium segments, Coty not only endures economic fluctuations but also thrives amidst adversity.

The market, however, seems to have undervalued Coty, presenting a unique opportunity for investors. Trading significantly below their recently announced guidance revision and outperforming Q4 & Full-Year expectations, Coty's current stock price does not accurately reflect its intrinsic value and growth potential. The company's resilience in the face of economic uncertainties, coupled with its strategic initiatives and leadership vision, positions it for substantial future gains.

Investors recognizing the untapped potential within Coty's business model and its strategic trajectory have an opportunity to capitalize on a compelling investment prospect. The convergence of innovative products, geographical expansion, and a prudent approach to financial management positions Coty as an undervalued gem in the market. As the company navigates the ever-changing landscape of the beauty industry, it remains poised for sustainable growth and profitability, making it an attractive addition to any investor's portfolio.

In summary, my view is that Coty's current market position represents an ideal entry point for investors seeking long-term value and robust returns. By recognizing the company's intrinsic strengths and its ability to exceed market expectations, investors can align their strategies with a promising future, reaping the rewards of Coty's upward trajectory in the beauty industry.

Editor's Note: This article was submitted as part of Seeking Alpha's Best Value Idea investment competition , which runs through October 25. With cash prizes, this competition -- open to all contributors -- is one you don't want to miss. If you are interested in becoming a contributor and taking part in the competition, click here to find out more and submit your article today!

For further details see: