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  • A reopening of China will increase demand for beauty and personal care products.
  • Industry retail price increases are likely to remain sticky despite moderating input inflation.
  • Growth levers, easing currency headwinds, and debt reduction plans make this $8 billion beauty stock worth watching.

China embraced a hard-line lockdown policy to stop COVID-19’s spread. Unfortunately, it’s increasingly likely COVID is here to stay. New, more easily transmitted Covid variants have led to widespread cases despite China’s lockdowns, making the sacrifice of shuttering its economy no longer tenable. As a result, China is following the rest of the world in easing restrictions, likely boosting activity in the world’s second-largest economy.

The removal of COVID-era policies will likely increase travel and in-person work, boosting demand for consumable beauty products. For this reason, investors should consider adding beauty and personal care stocks to their watch list.

Beauty is a big market opportunity

The global market for beauty products is big, and it’s growing. This year, industry revenue should total about $571 billion, increasing by 3.8% annually through 2027, according to Statista.

Over the next five years, the industry will expand by 10.8% in the U.S. to $101.3 billion. European sales will increase to $143 billion from $132 billion, roughly 8.5% growth. That works out to be respectable but admittedly tepid annualized growth of 2.1% in the U.S. and 1.6% in Europe.

The Chinese market, however, is expected to grow more quickly. According to Action Alerts PLUS Co-Portfolio Managers Bob Lang and Chris Versace, sales in China will grow 5.4% annually over the next five years to $70 billion to $75 billion.

The return of in-person work and travel in the U.S. has been a boon to beauty product manufacturers and retailers. U.S.-centric plays, including E.L.F. Beauty  (ELF) , a beauty products company, and ULTA Beauty  (ULTA) , a national retailer, have enjoyed rapid growth and market-beating returns.

For instance, E.L.F. and ULTA’s revenue grew 33% and 17% in their most recently reported quarters. Earnings per share climbed from $0.63 during the COVID-impacted 2020 to an estimated $1.12 in E.L.F.’s current fiscal 2023. ULTA’s EPS increased from $4.64 in 2021 to an estimated $22.89 in fiscal 2023.

Given those results, it’s perhaps unsurprising that E.L.F and ULTA shares have rallied 50% and 19% since December 31, 2021, far outpacing the S&P 500’s 20% decline last year.

It may not be a stretch to think that beauty plays targeting China enjoy a similar surge in sales, profit, and returns, given the easing of COVID policies there this year.

One beauty stock to target

Action Alerts PLUS is always searching for money-making ideas to add to its watch list and, eventually, its portfolio. This week, the potential for upside revenue and returns in China led Lang and Versace to add COTY Inc  (COTY)  to their idea bullpen.

They write:

“Coty's management is targeting China as a growth source, a market that according to consulting firm McKinsey is increasingly focused on efficacy, safe or natural ingredients, and brand. This explains Coty's management leaning into clean beauty and personal care products with ingredient transparency and minimalist formulas. So far, the company launched several clean products and ranges including CK Everyone, Sally Hansen Good.Kind.Pure, COVERGIRL Clean Fresh Collection, Rimmel Kind & Free, and the Lancaster Sun Sensitive range.”

These products are part of a global strategy that should help it further drive sales in Asia Pacific, including in China, which accounted for about 4% of quarterly revenue last quarter.

While Coty offers well-known brands in its consumer line-up, including CoverGirl and Rimmel, its Prestige brands are the most profitable. Brands like Burberry, Gucci, Kylie’s (Jenner) line of products, and philosophy accounted for “62% of sales in the company's most recent quarter, but 83% of its operating income and 86% of its EBITDA,” according to Action Alerts PLUS.

Strength in premium brands, including the launch of Lancaster in the important Chinese body care market, helped Coty’s revenue grow 12% in Asia Pacific versus one year ago last quarter. That was much faster than the 5% growth reported for the Americas and slightly ahead of the 11% reported growth in Europe, the Middle East, and Africa (EMEA). About 70% of China’s beauty market is skincare, and Lancaster’s sales grew 5x in the past year at its four brick-and-mortar stores in Hainan.

History of performing post-recession

Rate increases designed to slow inflation by reining in economic activity could cause a recession this year. However, beauty is somewhat insulated against a recession because of its disposable nature. Also, industry leaders, including Coty, rebounded quickly following past economic downturns.

Lang and Versace write:

“Given concerns over a potential recession in the coming quarters, we examined how revenues at Coty, as well as its competitors Estee Lauder (EL) and Inter Parfums (IPAR), performed during the 2008-2009 period.

On a calendarized basis, Coty's revenue shrank 4.8% in 2009 and rebounded 10.4% in 2010 along with the economy and consumer spending, while those at Estee Lauder fell roughly 1% in 2009 before increasing almost 10% the following year. Revenue at Inter Parfums fell 8.2% in 2009 and rebounded by double digits in 2010. We chalk that performance up to the consumable nature of beauty and personal care products, which has made them recession-resistant in the past.”

Of course, there’s no guarantee that it will play out the same this time, but history often rhymes, to paraphrase Twain. If so, any dip in demand caused by recession could be temporary.

For now, Action Alerts PLUS isn’t buying Coty shares yet. However, Lang and Versace will look for opportunities to add it to the portfolio if it backfills recent gains. They write:

“Like several other names in the AAP portfolio, it had a strong run since early November and that move has now placed the shares in overbought territory. In the near to medium term, we can see the shares being worth $10-$11, which offers just over 10% potential upside from current levels. On the downside, the shares have support at much lower levels. That along with the risk we outlined above associated with the current Covid wave in China has us waiting for COTY to pull back at levels that offer more favorable upside and less downside risk.”

As you can see in the following chart, shares have run up a lot since last fall. It could be worth picking up shares if shares drop back toward support levels (the red line).

CHART-S&P-500-JS-011123

The Smart Play

One big concern with Coty is its high debt load. However, the company is reducing those obligations, which should improve net income over time.

Last quarter, Coty’s gross margin improved by 0.70% to 64.1%, while its operating margin improved by 3.4% to 18%. The company is kicking off solid free cash flow, allowing it to pay down debt.

Rising interest rates negatively impact interest expenses, but 90% of Coty’s debt is fixed or hedged. It expects interest expense will be in the mid-$200 million range this fiscal year, but that could fall in future years thanks to cost-cutting. Coty anticipates expense reduction will save it $170 million in fiscal 2023, providing additional financial wiggle room. Currently, its leverage is 4.5x, but it’s targeting 3x exiting 2023 and 2x exiting 2025.

The strong Dollar was a drag on its top line last year, but the negative impact should be easing, given the Dollar has been losing ground to the Euro and other currencies since September. Last quarter, currency conversion reduced reported sales by 7%. That prompted management to guide fiscal Q2 currency headwinds of 7% to 9% to sales in fiscal Q2 and 6% to 8% in fiscal 2023.

This year, management’s guidance is for 9% to 11% top-line growth, excluding its exit from Russia because of the War in Ukraine. Adjusted EPS should grow mid-teens to $0.32 to $0.33, with earnings accelerating thanks to its debt and cost-savings plans in 2024. If the Dollar weakness continues, management may readjust their outlook higher.

It’s also notable that Coty has been raising its prices faster than its input costs have increased, which is why its margin is improving. It took a mid-single-digit increase last quarter, and it plans to increase prices by another mid-single-digit percentage soon. If inflation continues slowing, I suspect Coty’s pricing will remain sticky, potentially resulting in an even better margin later this year.

Given Coty is a global company; it’s already benefiting from rebounding beauty and personal care product demand in Western markets as back-to-work and travel trends return to pre-COVID levels. The opening up of China provides a cherry on top of that rebounding demand, potentially providing multi-year growth from new product launches and expanding distribution.

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