It is easy to be attracted to companies claiming to be market leaders in their respective businesses. However, it is market share relative to competitors that matters and not absolute market share.
Coty (COTY 3.06%), is a beauty company with a portfolio of fragrances, color cosmetics and skin- and body-care products sold in over 130 countries globally. While Coty claims to be the second-largest global player in the fragrances segment, which accounts for more than half of its revenue, the global fragrances industry is fragmented with no single player accounting for more than one-tenth of market share.
Market leadership by itself has little significance
Firstly, the global fragrances market is a fragmented industry with the top five players, including Coty, possessing market share of between 7% and 9% each. As a result, Coty is unlikely to derive any cost advantages over its peers in terms of economies of scale for advertising and promotional expenses given that its competitors are generating comparable sales volumes to its own.
Secondly, unlike sodas, there is little brand loyalty or customer stickiness when it comes to perfumes. While you can count the number of soda brands on two hands, perfume brands run into the hundreds. In addition, the shelf life of fragrances tends to be short, given consumers' preference for novelty, particularly for fragrances.
Last but not least, near-term market share trends are negative. With Chanel gaining ground over Calvin Klein (Coty) in the U.S., Coty's global market share in fragrances dropped to 8.4% in 2012 compared with 8.6% in 2011.
Revenue concentrated in slower growth, developed markets
The major challenge facing many listed consumer stocks in the developed countries, including Coty, is the slower growth experienced in mature markets. Although Coty has grown its revenue from emerging markets by a 2010 through 2012 CAGR of 18%, its emerging markets' exposure stands at only 23% of fiscal 2012 revenue.
Moreover, Coty's growth strategy via acquisitions carries significant risks, and its acquisition track record is far from stellar. Coty incurred asset-impairment charges amounting to $573 million in fiscal 2012 relating to its 2010 acquisitions of philosophy and TJoy. This is a clear indication that the past acquisitions did not live up to its initial expectations in terms of financial performance.
Future outlook
Coty's financial performance for the first nine months of fiscal 2013 was less than impressive, with flat revenue growth year on year. This is in sharp contrast to full-year revenue growth of 17.3% and 12.9% in fiscal 2010 and 2011, respectively. On top of increased competitive pressure contributing to lower global market share and revenue, the weakening of the euro and the poor economic conditions in its Southern European markets were also contributing factors to the lackluster top-line performance.
I have a bearish view of Coty's future prospects. I expect competition in Coty's developed markets to intensify, which would result in either market share loss or higher advertising expenses incurred. With respect to expansion in the emerging markets, M&A will be a key driver. However, the risk of overpaying for acquisitions is high given the difficulty valuing intangible assets such as brands.
Peer comparison
Coty's peers include Estee Lauder (EL 0.80%) and Inter Parfums (IPAR 1.26%).
Estee Lauder delivered an outstanding set of results for fiscal 2013, with net sales and net earnings increasing 5% and 16%, respectively to $10.2 billion and $1.0 billion, respectively. This is the result of Estee Lauder's more favorable geographic and product mix. For example, Estee Lauder derived one-fifth of its fiscal 2013 revenue from the Asia Pacific region, which boasts of superior growth prospects. In contrast, Asia Pacific only accounted for about 10% of Coty's fiscal 2012 revenue.
In addition, Coty's gross margins of 60% pale in comparison to Estee Lauder, which sports gross profit margins of 80%. This is the result of Estee Lauder's product mix tilted toward higher-margin skincare and makeup products vis-à-vis fragrances, which represented 82% of its net sales. Taking into account the superior growth prospects of Estee Lauder, it is relatively cheaper with a 1.9 PEG compared with Coty's PEG of 2.5.
Among listed peers, Inter Parfums is the only pure-play marketer of perfumes with almost its entire sales contributed by fragrances. Historically, it has been dependent on Burberry-licensed products, which accounted for more than 50% of its revenue. With Burberry buying back its license from the company in December 2012, Inter Parfums' net sales fell 19.3% to $117.5 million for the second quarter of fiscal 2013.
In view of this, Inter Parfums has made efforts to invest in new profitable brands and it secured an exclusive 12-year worldwide license with China's leading luxury brand, Shanghai Tang, effective from July.
Looking ahead, Inter Parfums has targeted long-term organic revenue and EPS growth rates in excess of 10% and 12% to 15%, respectively. While Inter Parfums has the strongest balance sheet of the three businesses with a net-cash financial position, it is expensive, trading at a premium to Estee Lauder and Coty with a forward P/E of 25.
Conclusion
When I assess a company with leading market share as an investment candidate, I evaluate the relative market share of the company compared with its strongest competitor and the overall profitability of companies in the industry. Coty fails on both counts.
The global fragrances industry is highly competitive, with companies operating in the industry sporting lower gross margins vis-à-vis their peers in the skincare industry. Moreover, Coty is highly geared at 208% and trades at a higher PEG over its peer Estee Lauder. For the reasons mentioned above, I will not buy into Coty, despite its market leadership in the global fragrances industry.
