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Morningstar | Coty’s Turnaround Efforts Should Help Stabilize Its Top Line, but Road to Recovery Won't Be Smooth

In October 2016, Coty acquired Procter & Gamble’s specialty beauty business, which doubled its revenue base and made it the foremost player in the global fragrance market. This acquisition was a watershed moment for the firm, in our view, as it also bolstered its presence in the color cosmetics and haircare categories and should provide substantial benefits to Coty’s bottom line over the long term. However, even with these assets, we think Coty has fallen short of securing an economic moat, as we see little to suggest that it has developed the brand intangible assets and entrenched retail relationships needed to establish a competitive edge.While Coty owns several well-known brands, such as CoverGirl, Sally Hansen, and Marc Jacobs fragrances, we believe it lacks the capacity to exert pricing power, as evidenced by our estimate of flat price/mix over the past five years. Further, the margins on its products tend to erode with maturity, suggesting that the firm relies on discounting to drive volume in its legacy offerings and has possibly struggled to develop new products that resonate with evolving consumer preferences. We also don’t think Coty’s material exposure to the fragrance category (37% of revenue) confers it with defensible brand assets, as this category is characterized by substantial competition, and the popularity of a fragrance is often linked to its underlying designer or celebrity.We had expected Coty’s operations to improve as the company integrated the higher-margin assets acquired from P&G, but the firm faced several integration headwinds, including supply chain disruptions toward the end of fiscal 2018. Management has outlined several ambitious targets for fiscal 2023, including 14% to 16% adjusted operating margin (versus slightly below 11% in fiscal 2018), around $1 billion in free cash flow, and a net debt/EBITDA ratio below 4 times. While we think these goals are aggressive, we expect the firm's performance stands to materially improve as it removes complexity from its business, focuses on higher-margin and higher-velocity brands, and simplifies its cost structure over the next few years.