The somewhat niche industry of high-end cosmetics has been a mixed bag for investors this year.
On the positive side, you’ve got Estee Lauder (EL) and L’Oreal (LRLCY), which are up a respective 16% and 12% year-to-date. But you’ve also got Revlon (REV), which has only been able to eke out a 3% gain, and Elizabeth Arden (RDEN), which has been hacked in half.
But there is a clear standout in the crowd: 2013 IPO Coty (COTY), which is enjoying a sizzling 50% year-to-date return, fueled in part by Thursday’s rally on fiscal fourth-quarter earnings
That’s great if you’re already in COTY stock. But the future might not be so blemish-free. Coty faces some big-time risks, and the valuation has become downright toppy.
First, let’s take a look at Coty’s Q4 results. Revenues fell by about 2% to $1.02 billion, just edging out Street estimates for $1.01 billion. Earnings flipped the script, jumping from a loss of $20.1 million in the year-ago period to a profit of $21 million. On an adjusted basis, earnings of 8 cents per share also barely managed to get past consensus expectations for 7 cents.
That drop in revenues isn’t a blip, either. Coty’s sales have suffered year-over-year declines for three consecutive quarters.
So why are investors still enthused about COTY stock?
COTY Stock: Pros and Cons
Well, there is the stable of top-notch brands (many based on licenses). The list includes adidas, Calvin Klein, Chloé, Davidoff, Marc Jacobs, OPI, philosophy, Playboy, Rimmel and Sally Hansen. Coty also boasts an extensive distribution platform that covers more than 130 countries and territories.
But the biggest potential driver for COTY stock is last month’s $13 billion acquisition of the beauty brands of Procter & Gamble (PG), including Clairol and CoverGirl. This deal is expected to add $5 billion in annual revenues to a company that has generated just $4.4 billion during the past 12 months.
Cost savings will be a key to the deal. By fiscal 2017, the COTY thinks it can get at least $270 million in cutbacks. Given that there’s likely a lot of duplication with P&G, this target doesn’t seem unreasonable, and could even be a low-ball estimate.
The problem is that the P&G assets have also been mostly flat in terms of revenue growth. True, some of the blame goes to managerial neglect as the business was not core (that’s why Procter & Gamble dumped it). But reviving tired brands is no easy feat and will likely mean more expenditures, in terms of product development and advertising. COTY also will take on $3 billion in additional debt, which will essentially double its total amount.
And COTY has never attempted a transformative acquisition; most of the dealmaking has been for much smaller companies like OPI Products and Philosophy. So there is certainly execution risk for COTY management.
Something else to consider: Back in 2012, Coty attempted to purchase Avon Products (AVP) — what would’ve been a potential disaster, if you consider that AVP’s market capitalization is currently a mere quarter of what it was at its 2012 peak.
Finally, there is the premium valuation of COTY stock, which is trading at a price-to-earnings ratio of 57. That’s high not just compared to the broader market, but also compared to the elevated valuations in the industry. Revlon trades at 44 times earnings, EL at 29x and L’Oreal at 19x.
In other words, there is not much room for error with COTY stock. But again, the P&G deal could easily result in some slip-ups, which would knock down the valuation. So for now, it’s probably best to stay away from COTY stock.
Tom Taulli runs the InvestorPlace blog IPO Playbook. He is also the author of High-Profit IPO Strategies, All About Commodities and All About Short Selling. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.
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