EUR 850.00 For Business Accounts Only

Morningstar | Coty's Consumer Beauty Business Continues to Falter, but Opportunities for Margin Expansion Remain

No-moat Coty concluded its fiscal year on an underwhelming note, as revenue growth that outpaced our expectations (up 23% to $9.4 billion, versus our $9.3 billion estimate) was offset by lower-than-anticipated profitability, leading to adjusted earnings per share of $0.69 (a cent below our outlook). While we view several of the headwinds facing the company (such as a supply chain disruption in the fourth quarter because of the consolidation of warehouses in North America and Europe) to be related to the integration of P&G's beauty assets and thus shorter-term in nature, we remain wary that material competition in the beauty industry will constrain Coty's top line. As evidence, the company posted organic growth of just 0.4% for the year, well below our 4% to 5% estimate for global beauty growth.

This aligns with our perspective that Coty's limited cosmetics share (we estimate below 5% globally) places it at a competitive disadvantage to wide-moat peers Estee Lauder (around 15% share of prestige category) and L'Oréal (13% share of overall cosmetics), which we view to have more entrenched relationships and negotiating power with retailers. We expect Coty's sales will grow at just 3% longer term, below the mid-single-digit rate we expect for Estee Lauder and L'Oréal. Further, we surmise Coty's portfolio has an outsize exposure to further SKU rationalization at mass retailers, given its lack of a competitive edge. In this context, we view the 4% decline in organic growth within the consumer beauty segment (45% of sales) to be evidence of heightened challenges in the mass-market landscape. As such, we expect to trim our near-term sales outlook to account for further softness in this segment, which should lower our $16.70 fair value estimate by around 10%. Shares pulled back by a low-double-digit percentage on the announcement and, even at our revised valuation, look undervalued.

However, we continue to expect strengthened profitability as Coty integrates P&G's higher-margin beauty brands into its portfolio and extracts further costs from its operations, allowing operating margin to reach a low-teens level over the next five years. The company has already made significant strides toward integrating this business, with adjusted operating margin for the year expanding 50 basis points to 10.6%, despite deleveraged costs in its consumer beauty segment. Coty also announced it plans to achieve an incremental $150 million of cost savings over the next three years (with $60 million flowing through to its bottom line and the remainder reinvested in its operations, especially in the digital and e-commerce realm), in addition to the $750 million in procurement and supply chain savings targeted following the P&G deal. In total these savings represent around 10% of fiscal 2018 cost of goods sold and selling, general, and administrative expenses. We think the firm will be able to achieve these savings without cutting into necessary investments in its brands, given substantial overlap in overhead and supply chain costs as a result of the integration of the P&G business.

While we expect the consumer beauty business (comparable full-year sales fell 4%, on top of a 10% decline the year prior) to remain challenged over the near term, we think Coty's efforts to revitalize brands like CoverGirl (which contributes a low-teens percentage of segment revenue) should restore low-single-digit top-line growth over the long run. Over the year, the company made efforts to refresh the packaging, in-store displays, and product offerings associated with the brand, and we expect the benefits from these actions will begin to materialize in fiscal 2019. However, to support this innovation, we maintain Coty will need to invest substantial resources behind its brands, in the form of advertising and research and development spending. Consequently, we model Coty's combined expenditures in these categories to remain above 25% of sales annually over our forecast, which is comparable to the rates spent by its beauty peers.