Coty (NYSE:COTY) may be the poster child for bad M&A deals.
The company's stock is down 85% since it forged a deal with Procter & Gamble (NYSE:PG) in 2015 that gave it 43 beauty brands, including Cover Girl, for $12.5 billion. The deal saddled Coty with debt, hampered innovation and other growth initiatives, led to losses and writedowns, 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 has come under scrutiny after Forbes took Kylie Jenner off its billionaires list, as the company seemed to inflate its own sales prior to the deal with Coty.
Against that backdrop, Coty has seen sales plunge due to the COVID-19 pandemic. The company just announced its fourth CEO in four years, and made a deal with private-equity firm KKR (NYSE:KKR) that gives it some breathing room as it stares down more than $9 billion in debt and mounting losses during a global crisis. Investors cheered the news, sending the stock up 22%. Let's take a look at what these developments mean for the struggling cosmetics company and whether this is a buying opportunity.
A much-needed lifeline
Coty had announced a memorandum of understanding in May, saying that it had an agreement with KKR before finalizing that deal on Monday. Coty is forming a strategic partnership with KKR, and the private-equity firm will acquire $1 billion in convertible preferred stock, convertible at $6.24, a 20% premium above Coty's closing in price on May 8 when the agreement was initially reached.
It will also yield a 9% coupon. Separately, KKR is taking a 60% stake in Wella, Coty's professional beauty business, which services businesses like hair salons. This values Wella at $4.3 billion on a cash-free and debt-free basis, and will yield $2.5 billion in net proceeds for Coty.
The deal will help improve Coty's financial leverage, but leaves it with other challenges. The 9% dividend will mean Coty is paying KKR $90 million in interest annually as long as the stock isn't converted, and if it is, it will dilute shareholders significantly.
The Wella agreement seems less risky, as Coty's professional care business has struggled in recent years. It faces significant headwinds with the pandemic making professional hair and makeup difficult and also causing the cancellation of social events like weddings.
Management said the sale of Wella would free it up to focus on its prestige and mass market beauty brands. The company plans to eliminate $600 million of annual fixed costs over the next three years, or 25% of its total, in order to reach its goal of generating adjusted operating margins in the mid-teens and debt/EBITDA of less than 4.
The executive door revolves again
Just three months ago, Coty had named Pierre Denis as its next CEO, so the decision to make Peter Harf, Chairman of JAB Holdings, the majority owner of Coty, as the next chief represents a sudden about-face. In the announcement, Coty called Harf the person that built the modern Coty, as he was CEO of Benckiser N.V. from 1990-2001, during which time it controlled Coty. Harf went on to found JAB Holdings, which now has more than $100 billion in assets under management, including consumer-facing brands like Krispy Kreme, Panera Bread, and Keurig Dr Pepper.
That Harf is willing to take over Coty, displacing a CEO announced just three months ago, seems to reflect the difficult circumstances the cosmetics maker faces. Just last February, JAB executed a tender offer, buying stock at $11.65 a share to up its stake in the company from 40% to 60%. JAB clearly believed that Coty was undervalued at the time, but the stock has sunk since then, largely due to the effect of the pandemic, and now trades below $5.
Is Coty a value play?
With a number of well-known brands and a leadership position in categories like fragrances, Coty has turnaround potential. But the crisis caused by the pandemic presents a serious challenge for a cosmetics company already struggling to unload its debt burden, restructure its business to trim costs, and deliver meaningful growth. In the third quarter, the January-March period, organic sales fell by 20% from the year before and the company had a free cash flow loss of $318.9 million. The current quarter is likely to be worse given the shutdowns in Europe and the U.S., and the economic effects from the pandemic will last for months longer, if not years.
Coty has already suspended its dividend and faces much more uncertainty than it did a few months ago. The 9% coupon it's paying on KKR's preferred shares shows that this is a high-risk company that won't be able to borrow money easily, and may have to sell off more assets to lower its debt and make it through the crisis in good shape.
Considering those risks and challenges, Coty seems to be fairly valued today, as investors will have to endure probably several ugly quarters before potential improvements take place. Harf is clearly motivated to improve the business, but that's no guarantee of success. Investors looking for an opportunity in cosmetics may want to look at faster-growing, more fundamentally sound options like Ulta Beauty or Estee Lauder.