After sustaining a stock market drubbing throughout much of 2018 and into early 2019, Coty, Inc. (COTY -2.91%) seems to be catching its breath -- and heading into the early stages of a rebound -- thanks to its recently implemented turnaround plan. Its Luxury Division is providing good returns, compensating for the Consumer Division's rather wobbly performance. Now, Coty has announced a deal to acquire a controlling interest in the Kylie Beauty celebrity brand, in a bold but possibly risky move to access the as-yet-untapped Generation Z cosmetics market.

Coty's turnaround plan

During 2018, Coty's performance slumped and its stock market performance followed suit. Weighed down by a pricey acquisition and a weak e-commerce presence, in January 2019 the company appointed a new CFO, a Chief Global Supply Officer, and a COO for the Consumer Beauty Division to set itself back on the path to growth. 

Company leadership developed a turnaround plan to centralize management, invest in its most successful brands, optimize its supply chain to cut costs, and restructure itself to remove bureaucracy. By 2023, Coty's plan aims to pay down debt, boost cash flow to approximately $1 billion, and reach an operating margin of 14% to 16%.

Fiscal Q2 2020 results indicate Coty's turnaround plan is successful so far. Its luxury division posted the strongest results, seeing 1.3% growth and accounting for 43% of the company's Q2 revenues. The smaller Professional Beauty division grew 2.2%, while Consumer Beauty shrank 6.7%.

A woman holding a tube of pink lipstick.

Image source: Getty Images

While the quarter still produced a net loss, it was far smaller than last year's. Meanwhile, operating income turned dramatically positive, cash flow surged, and the company spent far less on capital expenditures:

Metric Fiscal Q2 2020 Fiscal Q2 2019 Year-Over-Year Change
Net Loss ($21 million) ($960 million) (97.8%)
Net Loss Per Share ($0.03) ($1.28) (97.6%)
Operating Income or (Loss) $35.4 million ($804.6 million) N/A
Operating Cash Flow $422.1 million $319.6 million 32%
Capital Expenditure or Capex $58.6 million $125.7 million (53.3%)
Free Cash Flow $363.5 million $193.6 million 87.7%

Amid this dramatic improvement in Coty's fortunes, will its planned Kylie Beauty investment help the turnaround, or prove as costly a stumbling block as the company's previous brand purchases?

Buying a controlling stake in Kylie Beauty

Kylie Beauty, encompassing subdivisions Kylie Cosmetic and Kylie Skin, was launched in 2015 by reality TV personality and model Kylie Jenner.  Last November, Coty announced it would buy a controlling stake of 51% in Kylie Beauty for $600 million, with the other 49% held by founder Kylie Jenner. The deal is slated to close in Q3 2020, and Jenner will stay on as the lead designer.

In a November conference call after the deal's announcement, Coty CFO Pierre Andre Terrise stressed Kylie Beauty's strong outreach to Generation Z through the appeal of Jenner herself, a television and online personality with 270 million social media followers. He cited figures claiming that 75% of those followers are between 18 and 24 years old, a demographic with which Coty has no direct marketing contact.

In the 12 months leading up to the November 2019 deal, Terrise said Kylie Beauty generated revenue of $177 million -- a 40% increase over its sales from January through December of 2018. According to one of the slides accompanying the presentation, Coty expects Kylie Beauty to add 1% growth or more to its core business revenue annually. The projections also claim the deal will have no effect on earnings per share in the first year, but provide "substantial" (though unspecified) benefits by year three. 

Potential downsides to the Kylie deal

This isn't Coty's first attempt at improving its fortunes through a brand acquisition. Back in 2016, the company purchased Max Factor, Clairol, CoverGirl, and other cosmetics and perfume brands from Procter & Gamble Company (PG -0.13%) for a whopping $12 billion. On July 1, 2019, it announced a $3 billion writedown in the brands' value, causing its shares to tumble 14% in a single day.

While Terrise painted a rosy picture of the Kylie Beauty deal, some analysts appear less enamored. Coty paid a nearly 3.4x revenue multiple to acquire a brand consisting of little more than a few cosmetics formulas and a celebrity's personal Instagram following. Rakuten Intelligence, a company analyzing online sales, claimed that only 40% of online purchasers over the past three years bought Kylie products more than once, while reporting a 62% plunge in online sales year over year between May 2018 and May 2019.

Additionally, the unpredictable purchasing trends of Generation Z could potentially affect the long-term viability of Kylie. Surveys indicate that the number of Gen Z women using cosmetics every day in the 18 to 24 age group Kylie Beauty aims at is declining, from 50% in 2015 to 38% in 2019.

Coty's deal still looks like a good move

Despite all the warning notes and the bad outcome of its Procter & Gamble brand acquisitions, it's possible Coty's Kylie deal will boost its recovery strategy's momentum.

Coty is risking a substantial but not catastrophic amount of cash on a purchase that could potentially reap major near-future benefits. Kylie Beauty is profitable and focuses on the luxury personal-care product niche where Coty's performance shines. Even if Gen Z buys fewer cosmetics than previous generations, Coty has effectively zero marketing to this demographic, so the deal can only improve its access to millions of potential young customers.

The deal is a maneuver with a strictly limited, survivable downside if it fails, balanced against significant growth and value if it succeeds, amplifying the effects of the company's other turnaround strategies. While it's a risk, it seems to be a calculated one, making Coty a stock worth watching in the coming year for those investing in consumer discretionary stocks.