NTCO - Natura: Multiple Positives Reiterate Buy

2023-11-21 00:34:03 ET

Summary

• Natura &Co posted resilient Q3 results with steady growth in Latin America and operational improvements in its Natura brand.
• The sale of The Body Shop removes a key overhang and cash drag on the company, allowing it to focus on its core business.
• Natura &Co trades at a dirt cheap valuation, providing a favorable risk-reward opportunity.

Investment Thesis

In continuation with our coverage on Natura &Co ( NTCO ), we had ascribed a Buy rating on the stock due to 1) visible signs of a turnaround in Avon international 2) strength in its LatAm business driving operational improvements 3) potential sale of underperforming assets which can remove an overhang on the stock and 4) relative undervaluation compared to its peers and its long term average. The company posted resilient Q3 results driven by strength in its Natura brand driving operational improvements while Avon initiatives also have been yielding results with robust operating margin expansion despite challenging macro. In addition, the sale of The Body Shop to Aurelis likely removes a key overhang and a cash drag on the company which has limited overlap from its core business in Direct selling. Reiterate Buy as a result of multiple positives and significant undervaluation.

Resilient Q3 Results

The company reported a resilient Q3 despite a challenging macro environment with consolidated sales down 0.7% in constant currency terms (down 11% in BRL terms) driven by steady growth in Latin America, particularly in Brazil, partially offset by continued weakness in The Body Shop segment. Natura Brazil reported a solid 10% growth YoY despite operational headwinds related to commercial integration which affected sales temporarily. Performance in Hispanic LatAm continues to improve with NTCO reporting a 3% decline in BRL amid persistent macro pressures (single-digit jump in cc terms excluding Argentina). This resulted in Natura & Co LatAm segment reporting a 2.5% growth in cc terms and 9.4% decline in BRL terms.

Avon brand in Brazil and Hispanic LatAm reported a 25% and 19% topline decline respectively, as anticipated, reflecting the continued optimization of its product portfolio within Fashion and Home along with lower representatives in Hispanic markets due to rollout of Wave II. Despite the revenue decline, there have been continued productivity improvements within its core beauty segment as reflected over several quarters due to pricing and product mix. Avon International reported a 12% decline in revenues (2% in cc terms) which came in below expectations. The decline was largely driven by contraction in Fashion & Home categories due to portfolio rationalization, lower number of representatives (down 12% YoY) along geographic optimization. This was partially offset by 1.8% growth in the Beauty segment driven by strong growth in the fragrance segment.

Consolidated Gross margin continues to report an upward trend, up 310 bps YoY, at 65.3% driven by pricing actions and product mix optimization along with favorable commodity costs outpacing the Fx headwinds. Gross margins within Natura&Co LatAm expanded by 320 bps YoY driven by pricing and product mix. Gross margins in Avon International expanded by 490 bps YoY to 64.5% driven by price increases and product mix offsetting cost pressures. Consolidated Adj. EBITDA came in at R$751 mn with margins up 190 bps YoY at 10.0% driven by robust gross margin expansion along with strict cost control and SG&A leverage. Adj. EBITDA margin for Natura LatAm expanded by 100 bps YoY driven by strong gross margin expansion partially offset by increased investments in marketing and R&D expenses within Natura brand. Adj. EBITDA margin in Avon International expanded by 440 bps YoY at 8.0% driven by gross margin expansion and lower selling expenses (down 20% YoY) partially offset by G&A deleverage.

Balance sheet position improved significantly as the company used the proceeds from the sale of Aesop to prepay more than half of its debt outstanding, creating a strong capital structure and financial flexibility. Net Debt/ EBITDA came in at -0.7x (excluding IFRS 16) compared to 4.2x previously, demonstrating a resilient and flexible balance sheet to drive growth.

The Body Shop Maneuver

The Body Shop reported a 15% decline YoY (13% decline in cc terms) in revenues amidst continued macro pressures with sales from its core distribution channels (stores, e-commerce, and franchise) down high single digits in cc terms, worse than Q2 2023. The decline was largely expected amidst 111 store closures compared to the previous period along with portfolio rationalization in a challenging macro backdrop. Gross margins came in up 30 bps YoY driven by pricing/ product mix while Adj. EBITDA margins came in at 140 bps up YoY driven by gross margin expansion and SG&A leverage as a result of staff restructuring and cost control initiatives.

NTCO reported a binding agreement to sell The Body Shop ((TBS)) to European Private Equity firm, Aurelis for a consideration of £207 mn (~US$260 mn) including earnout potential of ~US$112 mn. This translates to an implied EV/ Trailing 12M EBITDA of 2.7x (excluding the rental expenses in Adj. EBITDA and excl. earnouts) and an EV/ Trailing 12M EBITDA of 3.9x including earnouts. The valuation is significantly below the valuation in which it acquired (EUR 1bn) from L'Oreal in 2017 and incurred losses in the transaction which is likely to lower the tax burden from the capital gains incurred in the Aesop sale. We believe TBS has limited overlap from NTCO's core business focused on direct selling and relationship sales and has been cash drag and a distraction for the management from its core business and focusing on ramping Avon integration. We believe this likely removes a key overhang and allows NTCO to grow organically in its core business and is a key positive. In addition, the company is net cash positive as reported in the current quarter post the deleverage and the sale proceeds from TBS could likely lead to additional dividends.

Valuation

Post the deleverage, NTCO trades at a dirt cheap valuation of under 6x below its long-term average of 12x as well as relatively undervalued compared to its peers (including L'Oréal which trades at roughly 15x EV/ forward EBITDA) as the Street continues to be pessimistic about fire sale of TBS business along with macro headwinds squeezing discretionary purchases. We believe this provides a favorable risk reward at current levels driven by its focus on core segment of Direct selling post-TBS sale along with strength in Natura &Co LatAm business and visible signs of turnaround initiatives in Avon International. In addition, its strong balance sheet flexibility post-deleveraging and the possibility of extraordinary dividends from the proceeds of TBS sale makes us believe the risk reward is favorable. Reiterate Buy with a target price of $10 at 9.5x (ascribing a 20% discount to reflect the current macro slowdown and uncertainties).

Risks to Rating

1) NTCO has been impacted by persistent macro headwinds and a worsening macro scenario could push back recovery within its Avon brand as well as have an adverse impact on its Natura brand

2) The company relies primarily on direct selling and its inability to have its consultants sell to its customers can have a material impact on the business

3) Its operations in LatAm, particularly within emerging economies such as Brazil, Peru, Chile, and Argentina, are subject to significant political, Fx, and regulatory risks and have historically faced political instability which can be detrimental to its operations

Final Thoughts

We believe NTCO is perfectly positioned to grow organically as the macro pressures subside and has reported substantial operational improvements driven by continued strength in its Natura brand and turnaround initiatives bearing fruit within Avon. The sale of TBS removes a key overhang which has been a cash drag and a distraction for the management. We believe there are multiple positives currently along with a cheap valuation that provides a favorable risk reward. Reiterate Buy with a target price of $10.

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