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Why Coty Inc. Shares Fell as Much as 10% Today

By Anders Bylund - Jul 9, 2015 at 12:18PM

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In a massive $12.5 billion deal with Procter & Gamble, the beauty supplies specialist gets exposed to equal parts opportunity and risk.

Although we don't believe in timing the market or panicking over market movements, we do like to keep an eye on big changes -- just in case they're material to our investing thesis.>

What: Shares of beauty products manufacturer Coty (COTY -0.64%) fell as much as 10.3% in Thursday's morning trading, before recovering to a milder 5% drop by around 11:30 a.m. This morning, Coty announced that it will buy the bulk of Procter & Gamble's beauty products division in a blockbuster $12.5 billion transaction. Coty is more than doubling its annual sales with this merger, but investors are looking past the immediate business boost to focus on the difficulties in such a game-changing transaction.

So what: Coty isn't getting all of P&G's beauty business. The consumer goods titan is spinning out its hair color, fragrance, and color cosmetics product lines while holding on to related lines such as shampoos, skin creams, and soaps. Still, Coty adds powerful names like Covergirl, Clairol, and Hugo Boss to its brand portfolio. The deal has already been approved by Coty's largest shareholder, a consumer goods holding company based in Luxembourg that holds 97% of Coty's voting rights, paving the way to a quick and easy completion.

Coty's 10 "power brands," pictured here, are about to get some classy company. Image source: Coty.

Now what: The road to growth by acquisition is littered with the bodies of flawed and poorly executed deals. I can't blame Coty investors for showing nerves right now, because the risks ahead are very real.

The beauty brands on both sides of this merger have been struggling in recent years, according to Citi analyst Wendy Nicholson. Two wrongs don't necessarily make a right, even if the combination adds economies of scale and cross-selling opportunities. Moreover, Coty will shoulder some $3 billion of P&G Beauty's debt as part of this merger, which roughly doubles the company's total debt load without adding to its already slender cash reserves.

So Coty's management faces a daunting task here. The company will take two brand portfolios, both in need of an operating makeover, and attempt to work out cost savings, marketing efficiencies, and other synergies between them. All of this must be done with a supermodel-slim margin of error, given the company's limited financial resources.

And Coty shares are still priced for perfection, trading at 57 times trailing earnings. The stock has surged 43% higher year-to-date, including today's quick correction. If anything goes wrong with this ambitious deal, it's a long way down.

Anders Bylund has no position in any stocks mentioned. The Motley Fool recommends Procter & Gamble. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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