Previously, I looked at Dr. Michael Burry’s Scion Capital’s most recent 13F Filing with the Securities and Exchange Commission, which detailed the fund’s four equity positions. The largest of the holdings, coming in at just over one-third of the investment portfolio (13Fs exclude cash), is Coty Inc. (COTY, Financial). Should investors follow him into the stock?
A good business to buy?
Coty is a beauty products company that makes fragrances, cosmetics and skincare. It owns common cosmetic brands such as Rimmel, Sally Hansen and OPI. The company also owns skincare brands such as Lancaster and Philosophy. Until the end of August, Coty was doing very well. The company shares had doubled in nearly two and a half years and investors were paying as much as 72 times forward earnings for the stock.
However, after peaking at $30 on Aug. 15, Coty’s shares have since collapsed and are down by a quarter in the past three months. Also, Wall Street analysts have cut their 2017 earnings per share estimates from $1.08 to just 93 cents since the end of the third quarter.
Unfortunately, it looks as if the P&G acquisition is proving to be too much for Coty to handle. Fiscal first-quarter revenues fell 3% on a reported basis and operating income declined 43%. Net income fell 67% year over year. These declines were blamed on the “massive distraction” of trying to integrate the larger P&G Specialty Beauty Business into the Coty group. With such problems facing management, it seems strange that the company decided to buy the world’s premium hair straightener and appliance company and Hypermarcas beauty business during October. Maybe the company is trying to run before it can walk.
Nonetheless, despite the near-term distraction from business integration, Coty’s management is still targeting four-year cost synergies and working capital benefits of $750 million and $500 million respectively, with no change to operating costs. What is more, management remains committed to adjusted EPS of at least $1.53 for fiscal 2020. To do this, further acquisitions are expected.
If Coty can hit its target of $1.53 EPS by 2020, the shares may look attractive at their current $18.94. But with so many acquisitions going on and such disruption to the underlying business occurring while these acquisitions are integrated, the stock is not a sure thing. In fact, looking at the company right now I would steer clear. The group has grown through acquisitions during the past five years, but over this period Coty’s operating margin has bounced between 8.5% and -4.5%. Return on capital employed has bounced between 7.9% and -4.9% and free cash flow has grown less than 15% between year-end fiscal 2011 and year-end 2016 despite revenue growing at 16.5% per annum over the period and net profit jumping from $61.7 million to $215 million. At the end of fiscal 2016, Coty’s net gearing was 1,598% and gross gearing was 1,740%. Debt can be toxic to a business if not used correctly. Coty’s debt mountain and declining free cash flow are two severe red flags for any investors looking to take a stake in the business.
Strangled by debt
The Altman Z-Score is one of the most reliable and rigorous measures of bankruptcy risk. The statistical test is based on a set of balance sheet ratios and gives a score which ranks companies on a scale of 1 to 5.
Tests have shown that enterprises scoring less than 1.8 have an 80% to 90% bankruptcy risk within the next two years. Meanwhile, those companies with a score of 3 or more are generally considered safe. Coty’s Z-Score is a shocking 1.3, worse than the bankruptcy predicting line of 1.8. This high risk would be acceptable if the company’s shares traded at a deeply discounted valuation, but this is not the case. Indeed, at the time of writing, shares in Coty trade at a forward price-earnings of 18.6, price-book value of 25.2 and EV/EBITDA ratio of 23.1.
All in all, Michael Burry may like Coty for reasons known to himself, but the company looks to be too high risk for the rest of us.
Disclosure: The author does not own any share mentioned within this article.
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