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Morningstar | Coty Posts Solid Operating Margin Expansion in 3Q Despite Top-Line Woes; Shares Not a Bargain

No-moat Coty's top line continued to languish in its third quarter, with organic sales declining 3.7% as the consumer beauty segment (42% of sales) remains hampered by share losses, lingering headwinds from the supply chain disruptions that began in the fourth quarter of 2018, and industrywide softness in the U.S. and Europe (a sentiment both wide-moat Estee Lauder and L'Oréal have echoed lately). This marked the third quarter in a row of sales declines (on a reported basis) amid a global beauty market that we estimate is expanding by a mid-single-digit clip; year to date, reported sales have fallen 8% (tracking below our full-year estimate for a 5% decline).

Still, we contend these results highlighted two reasons to be optimistic about the firm's longer-term trajectory. First, management indicated that its supply chain headwinds (primarily related to the capacity of its distribution centers and an inadequate supply of certain product components) have largely abated; it estimates the total impact for fiscal 2019 will be $150 million in lost sales and $100 million in lost profit. While we expect a lingering impact from these issues on Coty's retail relationships over the next year, we posit the firm will be able to regain some footing with these customers longer term.

Second, profitability is trending in the right direction, with adjusted operating margin expanding 120 basis points to 11.5%. Most notably, adjusted operating margin in the Luxury segment (37% of sales) increased 400 basis points to 17.3%, nearing the high-teens level for Estee Lauder and low-20s level for L'Oréal's luxury beauty business. We don't anticipate a material change to our $12.10 fair value estimate or longer-term outlook (low-single-digit sales growth and operating margin above 10% on average over our forecast) as we incorporate these results. As such, we'd suggest investors wait for a larger margin of safety, despite a mid-single-digit decline on the announcement.

We remain encouraged by management's commitment to strengthening profitability by focusing on higher-velocity, higher-margin brands as well as extracting further costs from its operations. However, we plan to keep a close eye on the extent to which management reinvests a portion of these savings into product development and marketing, as we surmise the firm has historically underinvested in its brand set, hindering its sales performance. In this context, we expect the firm will spend more than 25% of sales on marketing and research and development each year over our forecast, on par with the average level we expect for its peer set.

Additionally, we were pleased to see Coty's free cash flow strengthen (amounting to $142.1 million in the quarter, up $347.5 million from the prior year period) and think management's target of positive free cash flow generation in fiscal 2019 is feasible (we model roughly $200 million for the year). This supported modest debt reduction, with net debt to adjusted EBITDA standing at 5.7 times (versus 5.8 times at the end of the second quarter), matching our full-year expectation. We expect this metric to fall toward the firm's 4 times target over the next five years.