Krause Fund Research Fall 2017 Consumer Staples Coty Inc (NYSE: COTY) Recommendation: BUY November 10, 2017 Analysts Current Price $16.31 Yuchen Gao Macy Lanser [email protected] [email protected] Target Price $20-22 Mingfeng Huang Emily Phelps [email protected] [email protected] Key Investment Highlights Company Overview Coty Inc. (COTY) is a multifaceted business that • High Five-Year Sales Growth: The acquisition of P&G focuses on Luxury, Consumer, and Professional Beauty and exclusive long-term license rights of Burberry Beauty. There are 75 brands in Coty’s portfolio, Limit have generated a more diversified product portfolio, including Covergirl, Rimmel, Sally Hansen, Clairol, which will enrich the growth of Coty’s revenue stream. Gucci, Calvin Klein Fragrances, and OPI. Consumer The stock price will be affected by this high five-year sales Beauty focuses on color cosmetics, retail hair coloring, growth of approximately 13%, when the synergies of cost and styling products, body care and mass fragrances are realized. that are affordable to the everyday citizen. Luxury • High Invested Capital: Coty has a high continuing value beauty focuses on high quality fragrances, premium growth due to the large invested capital the company skincare, and premium cosmetics. Professional beauty acquired from the P&G merge. The premium between focuses on hair and nail care for salon owners and 22.6% - 34.9% over its market price is the directed result salon professionals. of prolonged value the high invested capital could bring. • Men and Women are Using More Personal Products: Stock Performance Highlights The average female uses approximately 27 products in 52 week High $20.88 her daily beauty routine, a number that has doubled in 52 week Low $14.24 the past decade. Men are also using more products in the Beta Value 0.800 past several years which has created a large growth Average Daily Volume 7.02 m opportunity. This increase in the use of products shows a growing industry that Coty is taking advantage of entirely. Share Highlights • Potential Arbitrage Opportunity: The market Cap of Market Capitalization $12.22 b Coty is 12.546B is significantly smaller than the other Shares Outstanding 749.40 m industry leader, (EL)’s 46.55B. This makes Coty Book Value per share $12.45 an “underdog” company with a high growth prospective. EPS 2017 $(0.59) Dividend Yield 3.07% One Year Stock Performance Dividend Payout Ratio -8.25% Company Performance Highlights ROA -1.87% ROE -4.28% Sales $7.65 b Financial Ratios Current Ratio 0.94 Debt to Equity 1.28 Important disclosures appear on the last page of this report. production over the next few quarters. Rapid Executive Summary employment growth and a high level of consumer confidence will continue to contribute to the GDP Our team recommends to BUY Coty Inc. for the Krause growth. The Conference Board’s Global Leading Fund. Coty is a growing business with many new product Economic Index suggests that the emerging economies lines and opportunities. We believe that they are going are picking up some speed. All major global economies to do very well these next couple years due to the new are expected to perform well in the next couple of years. trends and growing consumer demand. The growing economy is also a reason that we believe buying Coty is Interest Rates a good idea because of the businesses discretionary The Interest Rates are an important tool for the Fed to nature. achieve its monetary policy goal, due to an inverse relationship between interest rates and the unemployment rate. In addition, the lower interest rates Economic Outlook encourage people to borrow money to stimulate the economy, which would bring up the inflation Gross Domestic Product level. Investors in Consumer Staples would like to see Real GDP represents all the goods and services a country lower interest rates for this reason. produces within a specific period. The growth and decline of this economic driver could well reflect the We believe in a short term (6-month period), the Fed will production level of a country. In addition, it directly not raise the interest rates. According to the 2017 reflects the health condition of the economy in the Economic Calendar on Bloomberg, the PMI particular region. If the real GDP growth rate remains Manufacturing Index was down five tenths from July, steady or exceeds expectations, consumers normally which results in the weakest reading since June 20163. increase their consumption. In other words, the Specifically, new orders reflected more domestic Consumer Staples sector would be rewarded if GDP demand, while the export orders were flat. The Growth increases because they can . Economic Calendar on Bloomberg also shows that the unemployment rate increased one tenth, which is higher Real GDP than expected. 10 If the Federal Reserve decides to have a rate hike in the 5 next 6 months, the unemployment and inflation level are 0 going to deviate from its monetary policy goals. In the 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 % Growth -5 long run, the majority of the Federal Open Market Committee (FOMC) participants are expecting to see an -10 increasing trend of the Federal Funds Rate of 2.2% and Quarterly Annual, Average 3.0% at the midpoints of 2018 and 20194. Source: St. Louis Fed @ 2017 Inflation The above graph shows that U.S. GDP growth has leveled The Federal Reserve’s objective in conducting monetary off in the past few years after it fell in 2008. Historical policy is to achieve the inflation target of 2%. This is an evidence suggests that the Consumer Staples sector has important economic factor because the Fed is constantly been benefiting from this consistency. According to “The monitoring the price level of consumer spending. The Conference Board Economic Forecast for the U.S. FOMC Committee judges the inflation level by measuring Economy,” the U.S. GDP is expected to have a 2.6% the Personal Consumption Expenditure (PCE) growth in the second half of 20171. In addition, the index. Higher inflation rates could be beneficial for the Economist Intelligence Unit (EIU) forecasts a 2.1% and Consumer Staples Sector. A higher price level would 2.2% growth in 2018 and 20192. Business investment bring more revenue to the companies in this gained momentum last quarter, which brings investment sector. Historical data shows that the consumption level growth in line with higher levels of business confidence for Coty’s sales did not get affected by higher inflation. that have prevailed since the end of 2016. Equipment spending signals upward momentum for industrial 1 According to the Economist Intelligence Unit (EIU), the that will raise unemployment rate is pressure to increase U.S. is expected to achieve an overall inflation level of wages, which could strain the number of employees a 1.9% in 2017. In 2018 and 2019, the U.S. are predicted business can keep on. The labor force participation rate to reach an inflation rate of 2.0% and 2.2%, is expected to drop, we are forecasting a 62.7% labor respectively5. EIU agrees with the expectation of the force participation rate in the next 6 months and 61.9% FOMC in which the inflation would rise in the medium by 2020. High skill sets and use of automation in term of 2017. In 2018, the consumer price inflation is manufacturing jobs are pushing people out of the labor expected to continue an upward trend but at a slowing force, whereas before workers could find plenty of jobs pace. without the need of higher education. US Core PCE Capital Market Outlook 3 We think right now is a good time to invest in this area. 2.5 According to the forecast, the U.S. GDP is going to grow 2 in an increasing trend, which leads to a stimulation in the 1.5 U.S. consumer market. 1 0.5 In the short term (6 months), the Fed will most likely not 0 raise the interest rate due to the economic outlook that Annual YoY % Change % YoY Annual 2000 2002 2004 2006 2008 2010 2012 2014 2016 it is not affordable to have such a rate hike. If they don't Source: Bloomberg @ 2017 raise the interest rate, the unemployment rate should Unemployment and Labor Force Participation Rate decrease and inflation level should climb back up. These The unemployment rate is a measure of how many consequences would benefit the Consumer Staples eligible people are not working in the U.S. The labor force sector due to the potential increase in revenue. participation rate (LFPR) is a measure of how many persons are working or looking for work in the U.S. Both After looking at current and historical data we have of these measures are used by economists to judge the concluded that the consumer staples market will state of the American job market, but LFPR is preferred. outperform the rest of the market. Historically over the As seen by in the graph below, Consumer Staples past 10 years, the consumer staples sector has performance is negatively correlated to LFPR. We outperformed the market by 35%. As we discussed generally think that people fall back on Consumer Staples above, the outlook for consumer staples is great due to in times of hardships because they can’t afford as much the current conditions but we feel that there could be discretionary spending (cooking at home vs. eating out). growth above what we expect because of consumer demand, which is hard to predict. Labor Force Participation Rate v S&P500 Consumer Staples Price In the short term, we feel that the consumer staples 800 68 industry will outperform the market by 3.5%.