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Morningstar | Mass-Market and Supply Chain Headwinds Drag on Coty’s 1Q; Trimming FVE; Shares Undervalued

No-moat Coty posted largely disappointing first-quarter results, as disruptions in its supply chain and degradation in its consumer beauty (mass-market) business led organic sales to decline nearly 8% and gross margin to contract 70 basis points to 60%. Excluding these more one-time disruptions, management still estimates organic sales fell around 2.5%. This falls materially short of our full-year expectation of roughly flat sales and nearly 62% gross margin. While we had already expected the consolidation of warehouses and planning centers in North America and Europe to negatively impact first-quarter results across all segments, the company also cited component shortages (pumps and glass bottles) from external suppliers and a September hurricane (that impacted the firm’s manufacturing and distribution operations in North Carolina) as factors that compressed sales in the luxury segment (29% of sales). Excluding these factors, the firm estimates mid-single-digit underlying growth in the segment. We plan to trim our $14.80 fair value estimate by a low-teens percentage as we lower our full-year sales outlook (primarily to incorporate greater declines in the consumer beauty segment) and reduce our gross margin expectations to incorporate deleveraging from a weaker top line, these supply chain issues, and pressures from promotional activity. However, even with these revisions, we view shares as undervalued, particularly following a 20% tumble on the release.

The consumer beauty segment (41% of sales) continued to falter, with comparable sales down 14% (high-single-digit decline excluding supply chain disruptions) due to a weaker environment for mass-market cosmetics in the U.S. and Europe as well as distribution losses. While Coty’s wide-moat peers, Estee Lauder and L’Oréal, also spoke to broader macroeconomic headwinds in these regions in their most recent quarters, we note they were still able to drive high-single-digit comparable growth over this time frame. We attribute this to their more attractive brand sets and greater ability to bolster investments behind these brands (through advertising and research and development) to prop up top-line growth (which underpins our view of their competitive edge).

Further, we remain more concerned about distribution losses, which management expects to be a headwind for the remainder of the year, following the firm’s supply chain issues. Management also suggested that heightened promotional activity was partly due to retailer penalties resulting from this disruption (as Coty may not have been able to maintain an adequate level of service), which we view as evidence of its limited negotiating power over its customers. We remain wary that further operational missteps could weigh on these relationships and reiterate our view that Coty’s lack of entrenched retail relationships has hindered its efforts to form a competitive edge.

The luxury segment remains a pocket of opportunity amid these underwhelming results, with roughly 5% underlying growth (excluding the supply chain disruptions) as high-end fragrance brands like Gucci, Tiffany, and Chloe continued a positive trajectory. This aligns with our broader outlook that ongoing premiumization trends within the cosmetics space will allow growth for higher-end fare to outpace that for mass-market offerings. Solid results in this segment, particularly in Asia, also helped fuel 5% growth (across all segments) in the ALMEA (Asia, Latin America, the Middle East, Africa, and Australia) region. However, we still note that this rate pales next to the double-digit sales growth both Estee Lauder and L’Oréal have posted in newer, developing markets as of late.