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Morningstar | Coty's Turnaround Plans Evidence Rocky Path to Recovery; Lowering FVE, but Shares Not a Bargain

No-moat Coty's shares fell around 14% after management detailed its plans to turn around its languishing consumer beauty segment (42% of sales) and announced that it expects an impairment charge of about $3 billion in fiscal 2019 in conjunction with its restructuring initiatives. We view management's fiscal 2023 targets of 14%-16% operating margin (versus an adjusted operating margin slightly below 11% in fiscal 2018), around $1 billion in free cash flow (versus our pre-announcement estimate for roughly $850 million), and below 4 times net debt/EBITDA as somewhat aggressive, but still expect meaningful operational improvement after evaluating the additional detail management provided on its long-term strategy. We intend to reassess our long-term assumptions (flat sales growth and high-single-digit operating margin on average over the next five years) in light of management's updated outlook, and expect to trim our $12.10 fair value estimate by 10%-15%, as the impact of the impairment charge should be partly mitigated by a more optimistic long-term margin outlook. Even with this planned revision, we'd suggest investors wait for a more attractive risk/reward opportunity.

Coty has faced myriad struggles with the beauty brands it acquired from Procter & Gamble in October 2016, and management admitted that the integration has been "longer and more complex" that it originally imagined. However, we think management is taking several steps in the right direction to improve performance. Most importantly, the decision to remove complexity throughout the business is prudent. Management plans to heighten its focus on priority brands (approximately 25% of the firm's number of brands) and priority brand/country combinations (roughly 60% of sales), and strengthen its investments in these areas (moving the proportion of brand/country combinations supported "at scale" to 60% by fiscal 2023 versus around 20% at present), which we think will support sales.

Secondly, management plans to shift its product assortment toward the higher end of the mass cosmetics category and rationalize lower-margin items. It estimates that "premium mass" cosmetics have experienced 11% compound growth over the last two years in the U.S. (roughly 30% of sales), while value-priced mass offerings have declined by 17%. We think these actions should support both profitability and product velocities and help the firm shore up its relationships with retailers, which we believe were impaired by the supply chain disruptions the firm faced toward the end of fiscal 2018.

Finally, we appreciate management's plan to increase spending on research and development to 2.3% of sales by fiscal 2023 (versus 1.9% in fiscal 2018), as we have long maintained that Coty will need to bolster investments behind its brands (in the form of marketing and R&D) to restore top-line growth. We think this will be essential for management's goal of moving its gross margin closer to those of its peers, as we think heightened spending on new product development will help the firm more quickly bring value-added innovation (that consumers are willing to pay up for) to market. Coty's gross margin stood around 62% in fiscal 2018, versus 73% and 79%, respectively, for wide-moat peers L'Oréal and Estee Lauder. While we don't expect Coty to entirely close this gap, we think modest gross margin expansion is achievable as the firm shifts its focus to higher-margin, higher-velocity offerings and simplifies its cost structure.

Still, we expect the firm's top-line trajectory will be constrained by its exposure to the mass-market beauty segment longer term, given industrywide premiumization trends. According to Coty's management, global mass beauty grew just 0.9% in fiscal 2017 and declined 0.7% in fiscal 2018, and while the firm's weak sell-out performance (declining nearly 5% and 7%, respectively) highlights the magnitude of its share losses, this industry-level performance remains well below the mid-single-digit lift in the global cosmetics market in recent years. Sales in the consumer beauty segment fell 18% in the first nine months of fiscal 2019, and our pre-announcement estimate for the segment incorporated a full-year decline around this level.