10 November 2016 Americas/Brazil Equity Research General Merchandise Stores Natura Cosméticos S.A. (NATU3) Rating (from NEUTRAL) UNDERPERFORM Price (10-Nov-16,R$) 26.15 DOWNGRADE RATING Target price (R$) (from 35.00) 26.00 52-week price range 33.71 - 21.18 Market cap (R$ m) 11,276.91 More Heavy Lifting Ahead; Downgrading to Enterprise value (R$ m) 13,389.22 *Stock ratings are relative to the coverage universe in each Underperform analyst's or each team's respective sector. ¹Target price is for 12 months. ■ Progress much slower than expected. More heavy lifting required. We Research Analysts have been bears regarding Natura for a long time but decided to become Tobias Stingelin, CFA more constructive, and hence upgraded the stock to Neutral on July 2016, as 5511 3701 6301 we thought that gradually the different initiatives that management was [email protected] implementing to stabilize the business in Brazil were gaining traction. Bruno Zanotta Unfortunately, however, the outlook is much more challenging than we 55 11 3701 6314 initially thought, and we believe that the sudden and unexpected resignation [email protected] of the company's CEO just highlight the complexity of the situation. We still Mariana Hernandes believe that some initiatives [i.e. investments in technology, the segmentation 55 11 3701 6306 [email protected] of its direct sales force, the sale of its products in the drugstore channel, e- Antonio Gonzalez, CFA commerce (B2C and Rede Natura], its entrance in the traditional retail and, a 52 55 5283 8921 tight grip on expenses) that have been implemented over the last few [email protected] quarters are steps in the right direction; however, in hindsight, and after a another very poor set of results, these initiatives are simply evolving too slowly. Productivity levels also remain too erratic, which combined with the long-lasting challenge in growing the consultant base evidences that activating the channel has been very tough, signaling outstanding issues with product & value proposition and innovation amidst a very difficult competitive environment. We believe there is still a lot of heavy lifting to stabilize the domestic operation and that the recovery will take longer than thought. ■ Downgrading to Underperform from Neutral on limited visibility and valuation grounds. We believe that earnings visibility is very low, but are cutting our 2016 and 2017 earnings by sizable 40% and 26%, respectively, to reflect a much tougher outlook, and as we believe that NATU3 will have to be more aggressive (i.e. prices, product portfolio, innovation, marketing, store openings, etc.) to stabilize market share. Our new blended target price is now R$26.0 (from R$35.0), which supports our downgrade to Underperform (from Neutral). We see the stock trading at 22.9x 2017e P/E. Share price performance Financial and valuation metrics 3 5 Year 12/15A 12/16E 12/17E 12/18E Revenue (R$ m) 7,899.0 7,840.3 7,939.9 8,910.1 3 0 EBITDA (R$ m) 1,495.9 1,322.8 1,374.8 1,600.9 2 5 EBIT (R$ m) 1,256.7 1,058.2 1,096.0 1,299.1 2 0 Net Income (R$ m) 513.4 257.8 492.4 557.0 1 5 EPS (CS adj.) (R$) 1.19 0.60 1.14 1.29 Jan - 1 6 A p r - 1 6 Ju l- 1 6 O ct - 1 6 Prev. EPS (R$) - 0.99 1.53 2.05 Dividend yield (%) 6.1 1.1 1.3 2.6 N A T U3 .SA SA O PA ULO SE BO VESPA IN D EX P/E (x) 22.0 43.7 22.9 20.2 On 10-Nov-2016 the SAO PAULO SE BOVESPA INDEX EV/EBITDA 9.4 10.1 9.5 8.1 closed at 61779.97752 P/B (x) 10.97 10.50 7.93 6.70 Daily Nov11, 2015 - Nov10, 2016, 11/11/15 = R$23.75 ROE stated-return on equity 47.7 24.5 39.4 35.9 Quarterly EPS Q1 Q2 Q3 Q4 ROIC (%) 19.59 20.95 22.83 26.59 2015A 0.28 0.27 0.31 0.34 Net debt (R$ m) 2,752 2,112 1,817 1,682 2016E -0.16 0.21 0.17 0.38 Net debt/EBITDA (12/15E, %) 255.4 188.5 123.6 97.2 2017E Capex (R$ m) -383 -301 -318 -356 Source: Company data, Thomson Reuters, Credit Suisse estimates DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, LEGAL ENTITY DISCLOSURE AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. 10 November 2016 Substantially Cutting Earnings Estimates We are updating our earnings estimates to reflect: (1) NATU3's 3Q16 poor results, (2) new macro-economic assumptions and, (3) our new business assumptions. As a result of these changes, we are cutting our 2016 earnings estimates by sizable 40% and our 2017 estimates by another 26%. We are now 20% below Reuter's consensus for 2016 and 15% for 2017. We believe, however, that earnings visibility is extremely low, not only because of the still very challenging sales environment in Brazil, but also because of volatility in net interest expenses. Figure 1: NATU3 — Changes to Projections R$ in millions, unless otherwise stated 2016 2017 ∆ 16/15 ∆ 17/16 New Old % Chg. New Old % Chg. Net Revenues 7,840 8,264 -5.1% 7,940 9,219 -13.9% -0.7% 1.3% Gross Profit 5,461 5,755 -5.1% 5,555 6,436 -13.7% -0.4% 1.7% Gross Margin (%) 69.7% 69.6% 1 bps 70.0% 69.8% 15 bps 24 bps 31 bps EBITDA 1,323 1,417 -6.6% 1,375 1,621 -15.2% -11.6% 3.9% EBITDA Margin (%) 16.9% 17.1% -27 bps 17.3% 17.6% -27 bps -207 bps 44 bps Net Income 258 428 -39.7% 492 661 -25.6% -49.8% 91.0% Net Margin (%) 3.3% 5.2% -189 bps 6.2% 7.2% -97 bps -321 bps 291 bps EPS 0.60 0.99 -39.7% 1.14 1.53 -25.6% -49.8% 91.0% Source: Company data, Credit Suisse estimates On a high level basis, the economic environment for 2016 has proved to be more challenging than expected and has not yet shown any clear trend of improvement at this stage. Needless to say that the macro situation has contributed to impose another burden on Natura's top line growth, but it is clearly not the only reason. We believe that the company has once more lost market share recently, albeit there are no official numbers available. Figure 2 shows sales trends for both Natura and Avon (AVP) since 1Q12 and they evidence the tough overall sales environment. We thought that Natura was on the right direction to stabilize and then gradually improve sales from 2Q16 onwards, but a very poor sales performance in 3Q16 indicates that the situation is more challenging and that the turnaround is evolving much more slowly than expected. Figure 2: Modest Sales Uplift in 2Q16 Reverted in 3Q16 Strongly R$ in millions, unless otherwise stated Notes: since 1Q12 we use Avon’s Beauty segment to compare with Natura’s sales in Brazil. Based on net sales for Natura and constant currency sales for Avon. Sources: company reports and Credit Suisse estimates. Natura Cosméticos S.A. (NATU3)2 10 November 2016 As we look into 2017, the economy might be less of a headwind, but the recovery will be only gradual and household consumption should remain under pressure. The competitive environment will not improve any time soon. More importantly, however, we believe that management will have to be meaningfully accelerating the "transformation" underway. The company's new CEO, Mr. João Paulo Ferreira, is a company veteran and from what he mentioned in the company's 3Q16 earnings call, Natura's current strategy will not radically change. The company will only strengthen some projects (the same message was conveyed by one of the company's controlling shareholders, Mr. Pedro Passos) and we expect to see more news on that front on the company's investor day on November 17. Reigniting Productivity and the Channel are Key Overall, we believe that the company will continue working to revitalize its direct sales channel (crucial) through new credit policies, a more robust digital platform, consultant segmentation, stronger innovation, changes in its product portfolio and value preposition (i.e. product positioning), etc. In our view, (1) another round of poor results, (2) the substantial cut in dividends (R$123 million YTD16 vs. R$686 million YTD15), (3) growing indebtness, (4) ongoing market share losses and, more recently, (4) the departure of the company's previous CEO, signal that sense of urgency to de facto transform the company accelerated once more at the shareholder level. Unfortunately, however, there is no easy fix as indicated by the company's erratic performance despite Natura's strong brand. We believe that the company will have to be much more aggressive in innovating, in offering a more attractive value preposition to its consultants and customers, mainly considering the economic and competitive environment. The expansion into traditional retail will eventually have to be accelerated and Natura will have to develop new competencies that it does not yet master.