Is Coty a value or a value trap?
Coty (NYSE: COTY) can be the poster child for bad M&A deals.
The company’s shares are down 85% since entering into a deal with Procter & Gamble (NYSE: PG) in 2015, it earned her 43 beauty brands, including Cover Girl, for $ 12.5 billion. The deal put Coty in debt, hampered innovation and other growth initiatives, resulted in losses and write-downs, and caused the company to vastly underperform most of its peers.
More recently, Coty’s deal last November to buy a 51% stake in Kylie Cosmetics came under surveillance after Forbes took Kylie Jenner off her billionaire list because the company appeared to be pumping up its own sales ahead of the Coty deal.
In this context, Coty saw its sales fall due to the Covid pandemic19. The company just announced its fourth CEO in four years and has struck a deal with a private equity firm KKR (NYSE: KKR) it gives him some breathing space as he faces over $ 9 billion in debt and mounting losses in a global crisis. Investors applauded the news, sending the stock up to 22%. Let’s see what these developments mean for the struggling cosmetics business, and whether it is a buying opportunity.
An essential lifeline
Coty announced a memorandum of understanding in May, saying he had a deal with KKR before finalizing that deal on Monday. Coty forms a strategic partnership with KKR, and the private equity firm will acquire $ 1 billion of convertible, convertible preferred stock at $ 6.24, a 20% premium over Coty’s closing price on May 8 when the agreement was initially concluded.
It will also earn a coupon of 9%. In addition, KKR takes a 60% stake in Wella, Coty’s professional beauty business, which serves businesses such as hair salons. This values Wella at $ 4.3 billion on a cashless and debt-free basis, and will bring Coty $ 2.5 billion in net proceeds.
The deal will help improve Coty’s financial leverage, but leaves it with other challenges. The 9% dividend will mean Coty will pay KKR 90million in interest per year until the stock is converted, and if it does, it will dilute shareholders considerably.
The Wella deal looks less risky, as Coty’s professional care industry has struggled in recent years. It is facing significant headwinds with the pandemic making it difficult for professional hair and make-up and also causing the cancellation of social events like weddings.
Management said the sale of Wella would allow it to focus on its prestige and mass beauty brands. The company plans to eliminate $ 600 million in annual fixed costs over the next three years, or 25% of its total, in order to meet its goal of generating adjusted operating margins in mid-teens and a debt / EBITDA less than 4.
The executive door turns again
Just three months ago, Coty appointed Pierre Denis as the next CEO, so the decision to make Peter Harf, chairman of JAB Holdings, the majority owner of Coty, as the next boss represents a sudden turnaround. In the ad, Coty referred to Harf as the person who built the modern Coty, as he was CEO of Benckiser NV from 1990 to 2001, during which time he controlled Coty. Harf went on to found JAB Holdings, which now manages more than $ 100 billion in assets, including consumer brands like Krispy Kreme, Panera Bread and Keurig Dr Pepper.
The fact that Harf is ready to take over Coty, replacing a CEO announced just three months ago, seems to reflect the difficult circumstances facing the cosmetics maker. Last February, JAB executed a takeover bid, buying shares at $ 11.65 per share to increase its stake in the company from 40% to 60%. JAB clearly believed Coty to be undervalued at the time, but the stock has since sunk, largely due to the effect of the pandemic, and is now trading below $ 5.
Is Coty a game of value?
With a number of well-known brands and a leading position in categories like fragrances, Coty has turnaround potential. But the crisis caused by the pandemic presents a serious challenge for a cosmetics company that is already struggling to unload its debt burden, restructure its business to reduce costs and generate significant growth. In the third quarter, the January-March period, organic sales fell 20% from the previous year and the company recorded a free cash flow loss of $ 318.9 million. The current quarter is expected to be worse given the closures in Europe and the United States, and the economic effects of the pandemic will last for months longer, if not years.
Coty has already suspended its dividend and faces a lot more uncertainty than a few months ago. The 9% coupon it pays on KKR preferred stock shows that this is a high risk company that will not be able to borrow money easily and may have to sell more assets to reduce your debt and get through the crisis in good shape.
Given these risks and challenges, Coty appears to be quite valued today, as investors will likely have to endure several difficult quarters before any potential improvements occur. Harf is clearly motivated to improve the business, but that is no guarantee of success. Investors looking for an opportunity in cosmetics may want to consider faster growing and more fundamentally healthy options, such as Ulta Beauty Where Estee Lauder.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.