By Siddharth Sharma (UCL), Michael Lipsky (NYU), Mark Blekherman (The Wharton School), Alex Ha (Ivey Business School)
Summary
COVID-19 has changed our lives completely: the way we work, communicate, consume and shop. As retail chains continue to suffer due to respective lockdown policies implemented by governments, brands such as JCPenney, Hertz, GNC, and Brooks Brothers have filed for chapter 11 bankruptcy due to their inability to generate revenue from stores to pay off debt obligations and rents. Coty, a luxury cosmetics brand, is in similar trouble, recording a 23.2% decline in revenue year-over-year. The drop in revenue and profitability, combined with the company’s significant debt obligation of USD 14.3 billion in long-term debt, was threatening their solvency.
Meanwhile, KKR, one of the leading global private equity investment firms (USD 218 billion AUM) , has made numerous investments since in April, deploying over USD 70 billion to complete acquisitions (PAI Group, J.B Pharma, Global Atlantic, Greencollar, etc). This includes purchasing a majority stake of Coty’s professional brands. Prior to this, Coty was on the verge of bankruptcy as its share price fell over 60% from the beginning of the year, allowing KKR to purchase world leading professional brands Wella, O.P.I, ghd and Clairol at a steep discount.
A similar strategy was employed by Sycamore Partners through their attempt to acquire a majority stake of Victoria Secret, one of the largest North American retailers for USD 525 million. The deal was called off because of Victoria’s failing brand image and accumulated unsold inventories. KKR pursued Coty because of its dominant market position in the professional beauty space, in addition to a strong cultural fit between the two pertaining to their sustainability-driven governance practices.
In recent years, environmental, social, and governance (ESG) has become one of KKR’s key acquisition mandates. Post-acquisition, KKR has introduced two new executives at Coty to help push ESG development for its portfolio.
Bidder Company Overview - KKR
Kohlberg, Kravis Roberts & Co (“KKR”) is a global investment firm headquartered in New York City. KKR has since completed over 280 private equity investments and has USD 218 billion of Assets Under Management. KKR is most well-known for their leveraged buyout of RJR Nabisco and TXU, the largest ever leveraged buyout to that point. KKR pursues four main strategies: private markets, public markets, capital markets, and principal activities.
Founded in 1976 by Henry Kravis, George Roberts and Jerome Kohlberg
Presidents: Henry R. Kravis and George R. Roberts
Number of employees: 1184
Key shareholders: Vanguard Group (8.76%), ValueAct Capital Management (8.06%), Vulcan Value Partners (4.98%), Principal Global Investors (4.17%).
Market Cap: USD 29.32 billion
EV: USD 53.27 billion
LTM Revenue(LTM 12/31/19): USD 7.9 billion
LTM EBITDA (LTM 12/31/19): USD 1.31 billion
EV/REV: 15.9x
EV/EBITDA: 6.0x
Target Company Overview - Coty
Coty is engaged in the manufacturing, marketing and distribution of branded beauty products. It operates in three business segments: Consumer Beauty, Luxury, and Professional Beauty. With over 52 brands including Gucci, MiuMiu, Adidas, Calvin Klein etc. Coty offers a variety of color cosmetics, retail hair coloring and styling products, body care, and mass fragrances. Coty’s fiscal year ends June 30.
Founded by François Coty in 1922, IPO in 2013
CEO/Chairman: Sue Y Nabi/Peter Harf
Number of employees: 19,000
Key shareholders: JAB Holdings (60%)
Market cap: USD 2.88 billion
EV: USD 11.67 billion
LTM Revenue USD 7.93 billion
LTM EBITDA: USD 1.14 billion
LTM EV/Revenue: 1.47x
LTM EV/EBITDA: 9.1x
Deal Overview
Kohlberg Karvis Roberts & Co. (KKR) announced a strategic transaction agreement with Coty Inc, purchasing 60% stakes of Coty’s Professional and Consumer Beauty Brands
On June 1, 2020, KKR announced publicly a USD 2.3 billion deal for four consumer and professional brands including Wella, Clairol, OPI and ghd brands(See Figure 1). KKR is financing the transaction on an all-cash basis. KKR is going to invest an additional $1B into the business by issuing new convertible preferred shares in order to improve Coty’s leveraged profile, reducing Coty’s net debt/adjusted EBITDA from 5.6x to 4.5x.
As of December 31, 2019, Coty had not realized positive earnings for 18 months and operating cash flow had halved in 2020 due to the demand shock on retail through the COVID pandemic. Coty has been under significant financial pressure as capital expenditure and previous acquisitions were mostly financed by debt. As of Q3, 2020 Coty had accumulated USD 9.4 billion in debt obligations.
The acquisition of Coty’s professional and consumer brand is driven by two main factors: Coty’s solvency resolvement and value proposition relocation
With KKR’s capital injections, Coty can deleverage from its significant debt obligations, reducing Coty’s net debt/adjusted EBITDA from 5.6x to 4.5x. Given that consumer demand for beauty products has been heavily susceptible to COVID-19, due to physical store closures and social distancing practices, Coty’s slowing financial performance has signified its difficulty in generating free cash flow to pay down debts. Thus, the USD 3.3 billion capital injection will allow Coty to pay off its debt without adding more leverage, improving the company’s financial risk profile. Coty is going to pay down USD 1.2 billion of debt obligations and the remaining USD 2.1 billion will be used to prevent Coty from liquidity issues and will allow Coty to invest into operations & sales.
Building on a 51% stake in Kylie Jenner’s beauty brands acquired for USD 600 million in January 2020, Coty also purchased 20% ownership in Kim Kardashian West's beauty business KKW for USD 200 million. These acquisitions represent Coty’s strategic shift towards its mass beauty segment. With more than 300 million followers across her personal and brand social media channels, Kardashian West will help Coty publicize all creative efforts and reach a global audience. Subsequently, Coty will use its deep industry knowledge and go-to-market expertise to grow the direct-to-consumer beauty brand.
There are three reasons why KKR is specifically interested in Coty’s professional brands over other distressed retail giants: dominant position, purchase discounts and ESG practice similarities.
The acquired brands are highly similar in that they possess strong brand presence and possess formidable market penetration into the beauty market. All four brands are well-established with over 100 years of experience and each brand has held dominant positions in their respective product markets. Coty Professional Beauty is ranked the #2 salon professional company after Nioxin.
Despite the valuations of these four specific brands being undisclosed, the precedent purchase price for them are well above USD 2.3 billion. Assuming the valuation of Clairol, GHD and OPI remained the same from when Coty made the acquisitions, a 60% stake of these three companies would total USD 3.552 billion, which excludes Wella. This implies that KKR did not pay a premium for Coty’s brands; instead, they benefited from a steep discount due to Coty’s recent financial performance.
Another rationale is Coty and KKR’s shared vision of ESG. KKR’s 103 private portfolio companies have achieved over 460 ESG-related awards relating to their sustainability practices. Coty is also actively working towards reducing their carbon emission by 30% by 2030 and achieving gender equality in leadership positions. This means that Coty fits into KKR’s ESG investment strategy.
Short-term outlook
De-Leveraged Capital Structure
The effects of Covid-19 has caused professional beauty revenue to slip 12%, luxury operations to decline 26% and the consumer division to fall 17%, incentivizing Coty to de-leverage and simplify its portfolio in order to focus on its core businesses: Luxury Consumption.
As mentioned earlier, one of the largest upsides from Coty’s divestment of Wella along with KKR’s financing is that Coty’s debt burden will fall. This additional liquidity will allow Coty to invest in innovation and e-commerce developments for its Prestige business. Coty’s investment in fragrance innovation will solidify its place as a leader in the USD 31.4 billion global perfume market. Coty will also reinvest in its key mass beauty brands (Sally Hansen, Rimmel, CoverGirl, and Max Factor) in priority markets, to expand the presence of these brands and to improve revenues.
Coty’s divestment of Wella aligns with their previous divestiture of Younique in 2019 as Consumer Beauty revenues declined 28.3% when adjusting for Younique’s revenue. Coty sold Younique, in part, to bring focus back to and to further improve the performance of their core businesses. Coty sold the 60% stake of Younique they acquired for USD 600 million in 2017 back to the company’s founders; the terms of the deal weren’t disclosed.
Coty looks to further improve business fundamentals over the course of the next three years by reducing fixed costs by USD 600 million. Coty’s adjusted business plan has major upside, as 2019 net revenue would have been USD 5.9 billion greater if they had solely focused on their core businesses. Also, FY19 EBITDA would have been USD 1 billion after removing the USD 160 million in costs associated with Professional and Retail Hair.
Revenue
The effects of Covid-19 have impacted Q3 (12/31/19 - 3/31/20) net revenues across Luxury, Consumer Beauty, and Professional Beauty. Coty reported $1.528B of net revenues, a 23.2% decrease year-over-year.
Due to the forced closure of department stores and specialty retailers filing for bankruptcy, Luxury saw net revenues of USD 563.9 million, a decrease of 22.75%. Consumer Beauty net revenue of USD 602.7 million represented a decline of 28.3% year over year, and was the segment that was hit hardest. Consumer Beauty’s decrease in revenue can be attributed to the inclusion of Younique’s revenue from the prior year and a drastic decline in consumer traffic towards retailers. With salons forced to close due to social distancing laws, Professional Beauty saw net revenues of USD 361.4 million, a decline of 14.2%. As global COVID cases begin to slow in various regions, traffic has slowly begun to shift back from essential personal care to color cosmetics and the Professional Beauty segment will see better performance out of its hair and nail product lines providing upside for Q4.
Coty Leadership
While operations in the short-term will remain unchanged, there has been turnover of management at Coty, with a mix of youth and experience focusing more on sustainability. The appointment of KKR executive Gordon Von Bretten, taking the role as a CTO, is an example of how KKR is deploying their leaders to provide better governance through improvements to company efficiency and strategy. Coty’s new strategy will be forged in tandem with new CEO Sue Nabi. Her entrepreneurial background, demonstrated after launching the green, clean and vegan skincare brand Orveda, coupled with her undeniable commitment to making beauty for the many, embodies how a Coty, with new management both externally and from KKR, will focus on sustainability.
The fact that KKR has no apparel or beauty products within its portfolio suggests there will be no supply and distribution chain cost synergies. Instead, it appears this new leadership team couples KKR business leaders, who will ensure basic fundamentals are being followed, with industry knowledge and creativity, provided through experienced leaders such as Peter Harf and new blood such Sue Nabi, to drive growth.
Long-term outlook
The beauty industry has a positive outlook with three factors likely to facilitate future growth: increased inclusivity, slow beauty, and mens beauty.
Increased inclusivity of beauty is another key trend that will drive industry growth. The beauty industry has been guilty of only targeting young white customers. For instance, 40% of women in the 50 year plus category don’t feel seen by the beauty industry, according to L’Oreal Paris. Equality of choice for both race and age will allow the industry to cater to a new set of consumers. Whether by increasing foundation ranges for a variety of skin tones or skincare for menopausal women, the diversity conversation within beauty will play a significant role in driving growth. Coty should be able to capture this growth with new leaders such as CEO Nabi having experience in reaching more demographics.
Another key driver is the growth of slow beauty. This is the idea that consumers will adopt a ‘skinimilast’ approach and reduce the number of beauty products they use. This is in part driven by the sustainability fears and skin detox for health reasons. As a result, the demand for sustainable multi use products, with typically higher profit margins, increases as this new sub sector develops. Not only does this growing sector provide a new product area to target, but it also fits in with the ESG values at the core of Coty’s new leadership team.
Men's beauty is a key driver in the growth of the industry as a whole. With Gen-Z, there has been a shift in the notions of masculinity and the relationship with skincare and beauty. Male instagram influencers have helped lead this paradigm shift. This has opened up a new and growing set of consumers for beauty brands to target. Men’s beauty is deemed to grow with a CAGR of 5.5%, with the market being worth USD 166 billion by 2022, according to Allied Market Research. Similar growth rates can be seen in the beauty industry as a whole with a CAGR of 5.1% expected, with the total market expected to be worth USD 438.4 billion in 2026.
Coty believes influencer marketing & e-commerce are going to replace retail stores as the new norm. Coty realizes the effect of influencer and social media marketing, resulting in their investments in celebrity brands instead of traditional luxury brands. Their long term outlook will be, to some degree, reliant on the future value of the Kylie catalyst and other partnerships. Taking majority stakes in King Kylie as well as a minority interest in Kim Kardashian West’s beauty business, Coty demonstrated its renewed emphasis on beauty by reducing their current reliance on their physical fragrance branches. Coty is aiming to decrease their fixed costs through removing the margins taken from brick and mortar stores and leveraging the cost advantage from making direct to consumer sales. This is in line with retail industry trends of movement to online, which the beauty industry has been slow to do with 85% of sales being in store (See Figure 5). Coty can, and will, aim to adapt to the new normal by investing in ecommerce as well as through partnerships with influencers such as Kylie Jenner and Kim Kardashian to market to younger generations.
Risk & Uncertainties
Numbers and revenue figures aside, Coty has weaker bargaining power against KKR given its need to deleverage and the struggling state of the retail industry. KKR’s acquisition of Coty’s professional and retail hair businesses is much needed and will allow Coty to focus on its lucrative mass beauty segment. Meanwhile, the relatively unregulated nature of the retail industry - primarily due to its competitive landscape and lack of technology and IP controversies - will streamline the closure of the deal. Moreover, Coty’s experience with M&A, from its merger with P&G’s RMT Brands to its acquisition of Kylie Cosmetics, may prove to be valuable as it is no stranger to scaling via a larger entity.
Covid-19 will have immediate and lasting effects on Coty’s brands: Luxury, Consumer Beauty, and Professional Beauty. With strict social distancing laws and consumer traffic dropping drastically, causing retailers to shut down, Coty saw a decrease in net revenue from USD 2.51 billion to USD 2.35 billion. With continued increases of new cases in North America, it is less likely that the economy will recover to pre-pandemic levels within a year or two. Coty’s Luxury and Consumer Goods, which are sold primarily through retailers, will continue to struggle as social distancing measures impede the reopening of stores. Similarly, Coty’s Professional Beauty faces a rough road ahead as many states have either yet to reopen, or have shut back down salons, almost entirely halting sales.