EUR 850.00 For Business Accounts Only

Morningstar | Coty’s Shares Surge on Solid Luxury Performance and Update on Strategy but Remain Undervalued

While no-moat Coty’s second-quarter results weren’t particularly impressive, with just 0.7% organic sales growth (paling in comparison to the roughly 9% comparable sales growth both wide-moat Estee Lauder and L’Oréal chalked up over the same period) and adjusted operating margin contracting 40 basis points to 12.8%, two developments bolstered our confidence in the firm’s long-term prospects. First, the luxury segment (41% of revenue) posted strong like-for-like sales (up 10.8%), driven by strength in the Gucci, Marc Jacobs, and Burberry brands, as well as substantial profit gains, with adjusted operating margin expanding 420 basis points to 17.4%. New CEO Pierre Laubies (who took the helm in November) provided granularity on the supply chain disruptions that have been plaguing the firm’s operations of late. While Coty remains in the middle of a turnaround, and we don’t expect the road to recovery to be a smooth one, we now expect the headwinds from these operational issues to moderate over the coming quarters.

Year to date, reported revenue  has fallen 6.8% (versus our full-year estimate of a low-single-digit decline) and gross margin has remained flat at 61.1% (comparable to our full-year estimate). As we incorporate these results, we plan to adjust our fiscal 2019 forecast to include further declines in the consumer beauty business (39% of revenue) and the $965 million asset impairment charge incurred this quarter. These changes should trim our $12.70 fair value estimate by a mid-single-digit percent. However, we’re holding the line on our longer-term outlook, which calls for around 2% sales growth and low-double-digit operating margins on average over our forecast. Despite these revisions and a more than 25% uptick on the announcement, we still view shares as providing an attractive entry point for patient investors, as we think Coty’s ongoing efforts to turn around its business will restore top-line growth and bolster profitability over the long run.

We’re encouraged by the additional detail Laubies provided on his strategic priorities, which include a heightened focus on gross margin expansion. We view this as prudent, as Coty’s gross margin in the low-60s is well below the above 70% rate we expect for L’Oréal and 80% rate we expect for Estee Lauder. We believe this can be accomplished as industrywide premiumization trends should have a favorable impact on mix and as the firm continues to extract efficiencies from its manufacturing and focuses on bringing value-added innovation (which should aid pricing) to market. Still, we don’t expect Coty to close the gap in profitability with its wide-moat peers, as we maintain it has relatively weaker pricing power and retail relationships (forming the basis for our no-moat rating). Consequently, our forecast calls for just low-single-digit sales growth and low-double-digit operating margins on average, versus mid-single-digit sales growth and high-teens operating margins for Estee Lauder and L’Oréal.

Moreover, we think Laubies’ commentary suggested that bottom-line expansion was not to come at the expense of the firm’s focus on developing innovative products and effectively marketing its offerings. This aligns with our contention that the firm will need to bolster its investments behind its brands to support top-line recovery. We forecast combined marketing and research and development expenditures amounting to nearly 26% of sales, or $2.4 billion, over the next five years, versus $1.5 billion (25% of sales) on average over the prior five years.

For additional detail on Coty’s competitive stance, please refer to our report, "Looking Beneath the Surface: Attractive Dynamics Form the Foundation of Beauty Companies' Moats."