Coty: Right Business, Right People, Right Price
It is rightly said that investors make most of their money in a bear market, they just don’t know it at the time. A corollary would be that most money is lost in a bull market. Not only have there been fewer investment opportunities in the heightened equity market conditions as of late, there has also been an increased risk of a permanent loss of capital. In other words, if we make a mistake, it is less likely that we will be bailed out by a rise in the overall market.
Under these conditions, one of the stocks we chose to invest in last year was Coty, Inc. (COTY). Below, we outline the elements that attracted us to Coty, how the stock fits our investment philosophy, and why we believe our capital is safe despite the current extended bull market.
The beauty industry boasts high returns on invested capital primarily due to its low capital intensity. Limited private label penetration also allows for greater pricing power and high gross margins. In addition, it is among the fastest growing industries in consumer staples with an average 4% growth rate. Growth in emerging markets is expected to be even higher due to rising disposable income and per capita consumption.
On the other hand, the industry is relatively fragmented. Consumers have fickle tastes and they react strongly to innovation and advertising, which forces companies to constantly re-invest. Some segments, such as fragrances, are more discretionary, while others, like skin care, exhibit brand loyalty and repeat purchase behavior.
Coty is a global leader within the beauty industry. Pending the completion of its recently-announced deal with Procter & Gamble, which will more than double Coty’s size, it will become the largest player in fragrances, number three in color cosmetics and number two in the hair salon business. Over the last ten years, the company has been completely transformed thanks to a new management team, acquisitions and organic growth. Coty’s revenues tripled from 2003 to 2013, even as operating margins expanded significantly. The charts below show the company’s solid growth record.
Coty has built a core competence in acquiring and integrating brands, and developing innovations around those brands. Due to its success with this approach, the company has now become the licensee of choice for other designer and celebrity brands.
Although Coty benefits from its strong brands, distribution networks and unique technologies, its primary competitive advantage lies in its people and its entrepreneurial, creativity-driven culture. Fourteen years ago, Coty was the 31st largest beauty company in the world1. If the company completes its pending acquisition of Procter & Gamble’s beauty business, Coty will become one of the top three beauty companies.
The company’s transformation was primarily led by former CEO Bernd Beetz, who retired in 2012 after Coty decided to go public. However, current CEO and Chairman of the Board Bart Becht continues to lead the charge with the backing of Germany’s Reimann family, which has controlled the company for more than two decades and remains one of its largest shareholders. The family’s investment arm, JAB Holdings, retains 70% economic ownership and virtually all of the voting rights for Coty. Because JAB is such a large shareholder, the company has little incentive to pay heed to its minority holders, yet investors have been rewarded with share buybacks and dividends. Previously, as CEO of Reckitt Benckiser, Becht grew the company’s market capitalization almost six times over a 12-year period. Giving us further confidence in Coty’s management team was a stamp of approval from Warren Buffett, who was willing to join forces with Coty for the attempted acquisition of Avon in 2012.
Coty had been privately owned until its IPO in 2013. While we were familiar with Coty’s business and management, we rarely invest in IPOs. We patiently waited for the stock price to fall, allowing us to initiate a position at a price with which we were comfortable.
At that time, the stock traded at 10 times enterprise value-to-earnings before interest, tax, depreciation and amortization (EV/EBITDA) and had a 6% free cash flow yield, which was in line with the median free cash flow yield within the consumer staples sector. We believe this is a reasonable price to pay for a high return on capital business like beauty products, yet it is hardly a bargain. As we dug deeper in our research, we realized that our margin of safety was primarily in the quality of the business and the company culture rather than the current market price. These factors cannot be quantified, but as Albert Einstein would have pointed out, it does not mean that they do not count. Our investment case for Coty did not rest as much on the company’s current assets, earnings or stock price, but on management’s ability to manage those assets over time. As outside investors in a business, we cannot predict future events; however, we can be more confident that our interests will be protected when we partner with competent, shareholder-friendly management teams.
Although Coty’s stock price has performed well recently, we believe that there is further upside potential and that the stock will provide an attractive long-term return. Coty has a tremendous opportunity to exploit many of Procter & Gamble’s under-managed brands should the announced acquisition be completed. And, given the need for frequent innovation in this industry, there are likely to be many more opportunities for the entrepreneurial, creative teams at Coty.
Investing at all-time market highs carries obvious risks, but given our alignment of interests with Coty’s management and board and their past record of value creation, we believe our capital is in safe hands. Intrinsic value and market value can be at variance over short periods but almost always converge over long periods of time. If Coty is able to retain its people and culture, we believe its intrinsic value will continue to grow and our patience will be rewarded.
1 Source: 2013 Harvard Business School Case Study – Bernd Beetz: Creating the New Coty
Originally published on July 14, 2015
The views expressed are those of the research analyst as of July 2015, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.