Earnings Call Transcript - COTY Q4 2020

Operator, Operator

Good morning, ladies and gentlemen. My name is Maria and I’ll be your conference operator today. At this time, I would like to welcome everyone to Coty’s Fourth Quarter Fiscal 2020 Results Conference Call. As a reminder, this conference is being recorded today, August 27, 2020. On today's call are Pierre-André Terisse, Chief Operating and Chief Financial Officer; Peter Harf, Coty' Founder and Executive Chairman; and Sue Nabi, Coty's appointed CEO. I would like to remind you that many of the comments today may contain forward-looking statements. Please refer to Coty’s earnings release and the reports filed with the SEC where the company lists factors that could cause actual results to differ materially from these forward-looking statements. In addition, except where noted, the discussion of our financial results and our expectations reflect certain adjustments as specified in the non-GAAP financial measures section of our release. Later, we will conduct a question-and-answer session. Thank you. It is now my pleasure to turn the call over to Pierre-André Terisse to begin. Please go ahead.

Pierre-André Terisse, CFO

Thank you, Maria, and good morning, everyone. This is Pierre-André Terisse speaking. I'll start this call with the financials and then we'll hand the call over to Peter and then to Sue. To start the financial review this time, let's have a look at the scope of reporting as there are some meaningful changes. As you know, we assigned the sale of 60% of Wella, our Professional Beauty division plus Retail Hair to KKR on June 1, 2020, with a sale not being subject to any substantial conditions as of that date. Wella is considered a discontinued operation in our GAAP. As a result, we have adjusted accounts for fiscal '19 and fiscal '20. We now present continuing operations being the former Coty less Wella revenues and direct costs, as well as directly attributable costs. The costs borne by Coty on behalf of Wella following the closing will include the invoice for transitional service agreements. We have therefore prepared the set of numbers called ongoing Coty, which better reflects what Coty ex-Wella is expected to be post-closing. Going forward, most members will refer to ongoing Coty, and I will specifically flag when I use other metrics. In terms of numbers, Coty adjusted operating income in fiscal '19 was $950 million, an 11% margin. Wella profit ex-central cost was $459 million, or after including the estimated GSA cost of $407 million. As a result, ongoing Coty operating income was $543 million, or an 8.7% operating margin. Ongoing Coty EBITDA was $875 million. Looking at fiscal '20, Total Coty adjusted operating income stands at $151 million, or 2.4% of net revenue. Wella stood at $271 million, and ongoing Coty had a negative $110 million adjusted operating income with an EBITDA of negative $226 million. Fiscal '20 variance versus '19 reflected the impact of COVID and the pressure during most of the fourth quarter across most of our sales channels, as well as some of our production sites. Coty's fourth quarter was marked by external shocks; the COVID-19 pandemic triggered a global economic and supply crisis that led to turmoil in financial markets. Indeed, Coty was hit harder than its competitors for several reasons. First, pre-crisis, the company was already experiencing weak performance. Second, Coty's category is skewed heavily towards color cosmetics and professional beauty, which were the segments most affected by COVID-19. Within these categories, Coty was still losing market share in some markets. The company is underrepresented in China, which is the market that rebounded first. Lastly, Coty is weaker than its major competitors in the digital economy. Against this backdrop, ongoing Coty net revenues were down by 50% in Q4, with Prestige being the most impacted at minus 73%. Mass was less negative, at minus 48%, as most retailers remained partially open. April was the lowest point, but every month since then has shown progress across our portfolio in both Mass and Luxury, as well as for Wella. In particular, July and our latest expectation for August showed significant progress, standing at approximately 2.5 times April levels, reflecting the reopening of numerous stores, albeit with lower traffic than usual. While many challenges remain, Q4 also reflects continued improvements with strong momentum and market share gains in e-commerce, a good performance from CoverGirl Clean Fresh and Sally Hansen's Good.Kind.Pure, and improving market share in color cosmetics in key markets, specifically the U.S. and the U.K. In terms of profit, Total Coty Q4 net revenue dropped to approximately $1.2 billion. This resulted in an operating income drop of $526 million, which is 44%. The fixed cost reductions initiated in the quarter were insufficient to offset the magnitude of the impact experienced. This was exacerbated by costs totaling approximately $50 million related to provisions from under-utilization, as well as obsolescence provisions, as we attempted a prudent approach when closing the fiscal '20 accounts. While Wella, including PSA costs, showed a minimal loss for Q4, Ongoing Coty adjusted operating income was a loss of $323 million for the quarter. As for non-recurring elements, the drop-off in our stock price led to an increase in our obligations, which was the primary driver of an impairment of approximately $400 million of our brands and goodwill. Turning to free cash flow, the negative adjusted operating income translated into a negative free cash flow of $316 million for the quarter, which was in line with our guidance of negative $300 million to $500 million, as we managed to limit CapEx and balance working capital thanks to the hard work from the procurement and finance teams. This negative free cash flow was more than offset by the first tranche of convertible preferred shares subscribed by KKR for $750 million, which resulted in net debt decreasing by $300 million from the end of March, landing at $7.8 billion despite nearly $100 million in negative foreign exchange impact. It should be noted that we received the second tranche of convertible preferred stock for $250 million at the end of July. Lastly, regarding Wella, the closure of most salons resulted in a drop in sales of 41% in Q4, but things improved from the lows in April, and both July and August confirmed strong progress with underlying trends showing negative mid-single digits. While the business is recovering, we are, of course, focused on closing the transaction, which we expect to occur by the end of calendar '20. Following this, Coty will significantly reduce its debt and leverage to a level that will support our turnaround plan. Simultaneously, Coty will maintain a 40% interest in a low-risk operation with strong potential. With that, I will hand it over to Peter.

Peter Harf, Founder & Executive Chairman

Thank you very much, Pierre-André. Let me start by thanking all of my colleagues. They helped us weather the storm of what has proven to be the worst economic and health crisis seen in the last 80 years. Many people in several countries gave their all to minimize the damage for the company, and I sincerely thank everybody for that effort. We have faced a very challenging quarter and a challenging year. I don't want to repeat what Pierre-André already mentioned, but I am glad to report that we are seeing improved business in fiscal '21 in the first quarter. I am pleased to say that we are going to be making money in the first quarter of '21. Although sales in fiscal '20 were significantly lower than fiscal '19, we will see a significant amount of operating income. I have been closely collaborating with the Coty management during these past three months, with the primary focus being to bring the company back on track to realize its underlying potential. From the get-go, I was aware of the concerns gripping our investors, shareholders, and the company as a whole. These concerns, specifically related to capital structure, operational underperformance, the product portfolio, and top management, have been addressed head-on with decisive actions that have ensured step changes in each of these areas. During these past few months, we have shown clear progress. Firstly, we recognized that Coty's leverage ratio is high. To lower our debt level and to strengthen our balance sheet, we entered into an agreement with KKR to sell 60% of Wella, while maintaining a 40% interest in this invaluable and highly profitable asset. This will generate approximately $2.5 billion in net cash proceeds, and we anticipate the transaction closing by the end of calendar '20. KKR has also injected cash into Remainco for convertible preferred stock. This will provide KKR with a 17% stock share of Remainco, while we maintain absolute control at 50%. Secondly, Coty has been underperforming in operating margin and efficiency. We have set rigorous objectives for fiscal '20 and '21, and we need to be profitable for the full year. We aim to achieve constant like-for-like net debt, excluding the proceeds from the divestiture, despite the ongoing impact of the COVID-19 pandemic on the beauty industry. Thirdly, we intend to simplify our business by making smart disposals to lighten the balance sheet, reducing complexity while outsourcing and expanding third-party manufacturing. We have also minimized third-party costs, personnel expenses, non-working advertising, and consumer promotion to the absolute minimum. The clear action plans and progress in these areas inspire confidence that we will deliver over one-third of the savings from our $600 million fixed cost reduction program in fiscal '21. Additionally, we realize that our portfolio has lagged in meeting new consumer demands. Thus, concrete steps have been taken to rebalance and enhance our portfolio for competitiveness regarding these changing consumer demands. We have built platforms and addressed the structural weaknesses in skincare, focusing on Asia e-commerce and direct-to-consumer by acquiring irrevocable rights to Kylie Jenner's and Kim Kardashian West's cosmetics. This initiative will facilitate further brand building and investments aimed at revitalizing our existing portfolio and leadership. Coty undertook a strategic transaction with a 20% stake in Kim Kardashian West, which secures irrevocable rights going forward for the Kim Kardashian brand value and activities. Coty will assume responsibility for portfolio development across skincare, hair care, personal care, and fragrances. The collaborations will provide us the platform to sell products in these areas globally, particularly in Northern Asia. We are also renegotiating licenses within our Prestige portfolio that do not provide sufficient profitability for Coty and are making progress on that front. Next, I recognize that Coty's culture needs to align with the first phase of significant changes in the cosmetics industry. The initiatives being implemented must indeed be pragmatic. We’re committed to restoring the agility that is part of Coty’s DNA. We have flattened the organizational structure and simplified decision-making processes, allowing a smaller group of leaders to take critical actions quickly. As of July, we resolved the critical shortcomings that have plagued Coty over the years. We also welcome beauty industry veteran Sue Nabi as our new CEO, who has the ideal qualifications to lead Coty into the future. She brings over 27 years of experience in the beauty space, having held leadership positions at L'Oreal across mass and luxury segments in color cosmetics, skincare, and fragrances, and developed key international markets. Her extensive expertise and experience, especially in skincare, e-commerce, and direct-to-consumer, will be pivotal for Coty's future. She is adept at navigating market cycles and trends and has successfully reinvigorated numerous established brands. With the changes we are making at Coty and Sue's leadership, we are becoming a powerhouse able to unlock and create significant value. I will now turn it over to Sue.

Sue Nabi, CEO

Thank you very much, Peter, ladies and gentlemen. This is an exciting moment for me to join Coty. Although my official start date is in five days, I am eager to share my strong conviction in a bright future for Coty. First, I want to thank Peter for steering the company towards a new direction and implementing the necessary changes to establish a solid foundation for me to build upon. With over 25 years in the industry, I have learned what makes a beauty business successful. Assessing Coty’s potential, I quickly recognized it as a diamond in the rough. Coty is transforming, and we are on the verge of something new and exciting, modern indeed. Today, stakeholders are seeking something meaningful; they appreciate great comebacks and success stories they can be part of. I aim to create a nimble and successful New Coty with all our dedicated teams. The building blocks of this modern Coty are already in place. We have two key and well-positioned operating franchises reflecting the beauty industry and a new continent to be explored. Modern beauty groups simplify their organizations for clarity, often establishing a luxury franchise alongside a mainstream mass franchise. Coty is uniquely positioned to explore the potential of the direct-to-consumer business model, featuring personality-led beauty with strong social media followings. The new Coty will thrive on three key factors. First, the Mass franchise is essential, especially in these uncertain times characterized by economic difficulty. As the COVID-19 crisis wanes, this will remain a crucial avenue for many to access the latest trends and innovations, with affordable quality, and likely where many will first discover the beauty market. Secondly, our luxury franchise serves as an entry point for customers seeking iconic fashion brands at an accessible price, providing them a glimpse of the world of couture. Lastly, the new continent of DTC personality-led beauty, evidenced by Kylie and Kim Kardashian West brands, is bursting with potential. This segment is not merely focused on celebrity fragrances but provides brands with access to a vast and engaged audience that can be directly leveraged for data and insights, making it among the most profitable retail models available. It will enable us to adapt quickly to trends and make real-time corrections. Importantly, we will showcase that Coty can formulate top-quality skincare products with a comprehensive mapping of the market based on positioning, pricing, technology, and psychological appeal. Coty possesses an exceptional portfolio of beloved brands, including CoverGirl, Rimmel, and Bourjois, each deeply rooted in American, British, or French culture. This is unique, precious, and powerful—an excellent foundation for a new chapter in these brands' stories. Our brands carry significant responsibility; they must act flawlessly and serve as role models in the beauty industry. The magic of a brand begins at the product level. Brands like CoverGirl have pioneered innovations in beauty, leading the way for modern longwear and clean beauty products. The introduction of CoverGirl's Clean Fresh foundation, the top launch this spring, underscores this commitment to excellence. Coty's luxury division boasts an impressive portfolio that includes trendsetting fashion brands, such as Gucci and Burberry, poised to excel in cosmetics and fragrances. Each brand should champion something distinctive, which is central to Coty's philosophy. For these reasons, I firmly believe in Coty’s bright future. As French writer Victor Hugo said, "There is nothing more powerful than an idea whose time has come." I would add that the time for the new Coty has arrived. I look forward to starting my role as CEO and sharing more specific plans at the next earnings session. Thank you very much.

Pierre-André Terisse, CFO

Thank you. We are now ready to take some questions.

Operator, Operator

Our first question comes from Faiza Alwy of Deutsche Bank.

Faiza Alwy, Analyst

So my question is, first of all, congratulations. It's great to hear you on the call. I wanted to hear more from you about what you think Coty needs to do over the next couple of years to reach the goals you have in mind. You mentioned skincare and a few other areas, as well as this transformation. Can you discuss the necessary investments or actions needed, and what you would like to see happen over the next couple of years to achieve your vision?

Sue Nabi, CEO

I think for the next few years, my roadmap entails repairing and correcting what has been going wrong, particularly with the makeup brands. We’ve been diligently working on this throughout July and August, even though I officially join in five days. We are keen on strengthening the brands and enhancing their brand equities. First, I aim to bolster the makeup portfolio and consumer beauty sector. Second, I want us to accelerate progress in the luxury division. Third, I believe we need to capitalize on the promising, profitable, and dreamy direct-to-consumer beauty brands. So these represent three clear ideas I have in mind. Of course, this acceleration will occur across all categories: repairing makeup brands, ensuring they align with the evolving beauty needs of consumers today and tomorrow. In fragrance, we need to explore new ways of selling that leverage our online capabilities to reach consumers directly. Finally, in skincare, it’s essential to build an in-house expertise supported by the right talents, research, and a portfolio that ranges from accessible products to high-end offerings.

Operator, Operator

Our next question comes from Olivia Tong of Bank of America.

Olivia Tong, Analyst

Sue, this question is sort of a bit of a follow-up to the first one. It's great to hear your perspective on beauty and what you believe is important for Coty's recovery path. But it sounds like you're mostly aligned with decisions the company has already made such as partnerships on social media brands, etc. Can you talk a little bit about where you differ in view versus prior decisions? And then Pierre-André, just one quick one for you: can you just talk about the key drivers of that first $200 million of cost savings that you're expecting for fiscal '21? Thank you very much.

Pierre-André Terisse, CFO

Yes. I will take the second part first. What is very much the same as what we had already shared in May and June. Fundamentally, the work done during the summer under Peter's leadership has been to initiate the implementation of these plans to ensure that clear action steps are embedded within management. We know that the $600 million plan touches on many areas, including supply chain, and the immediate actions are strongly linked to the Oxygen project, which we've discussed in past quarters, focusing on execution and expeditious implementation. Additionally, we are keen on non-people cost reductions, implementing new rules to significantly minimize IT, finance, HR, and the various costs that introduce complexity into our business. We are pursuing many different avenues of action, but the primary source of cost reductions this year will come from the two areas I mentioned, which we estimate at north of $200 million. I will let Sue address the other part of your question regarding her differing views versus what has previously been done.

Sue Nabi, CEO

In terms of differing perspectives, I would summarize it simply: we must focus on products. We need to emerge as the best creators of beauty products, and that’s something that has been lacking in the past. I envision this company becoming product-driven and product-centric, which is my passion and expertise. At the end of the day, customer connection begins in the bathroom, where users engage with the product, whether they are male or female. If the product is not the best on the market or tailored to users, it will not succeed. Finally, sustainability is also crucial; customers should feel good about the products they use.

Operator, Operator

Our next question comes from Steph Wissink with Jefferies.

Steph Wissink, Analyst

I also have a follow-up question for you, Sue. Based on your comments about products, if you could help us consider how the company has invested its R&D dollars and the changes you would make to emphasize product development. You also mentioned a commitment to formulating top-quality skincare, and you provided an example of CoverGirl's Clean Fresh products, which falls within color cosmetics. Could you discuss skincare development and your focus for R&D in that area, as well as how you see the financial implications over the next couple of years? Thank you.

Sue Nabi, CEO

As you can imagine, it’s a bit early for me to articulate a full strategy or provide comprehensive details regarding R&D investments. However, I can tell you that key trends will focus on health and digitalization, which will be essential inputs across all of our portfolio. These trends represent priorities that we are currently working on: health and digital enhancements.

Operator, Operator

Our next question comes from Javier Escalante at Evercore ISI.

Javier Escalante, Analyst

I have a question for Pierre and one for Sue. Pierre, could you revisit Q4? It feels like destocking was an issue, at least in the U.S. We see that U.S. sales in tracked channels were down 20%, but you're reporting that loss as much more significant. Could you help us understand the gap between retail sales and reorder? To what extent does that contribute to refilling the pipeline, and is that expected to swing profitability in Q1? Also, could you explain the outsourcing aspect? I understand you want to divest manufacturing plants and set up third-party manufacturing. And for Sue, given the situation we're in, what can you do regarding makeup? I've been impressed with what Caring is doing with Gucci beauty; they are investing significantly in innovation. Shouldn't Coty also prioritize this investment in China? What challenges are preventing that from happening?

Pierre-André Terisse, CFO

Yes. I will address the first part of the question. In terms of Q4 performance, April was certainly very challenging, and March already showed difficulty. We faced considerable struggles in various channels due to closures, such as travel retail and department stores. As Peter mentioned earlier, we are under-indexed in e-commerce, which exacerbated our situation. Thus, we saw considerable drops: April was particularly challenging with negative 67%, and May gradually improved, followed by June. July and August have shown significant progress, and although there was some reloading in Q4, it reflects retail confidence. Retailers are no longer nervous; they see consumers returning and have started to replenish their inventory. This trend was consistent across Mass, Luxury, and Wella as well, with hairdressers adapting to the new normal. Our overall outlook is cautious, but we are optimistic about the positive start we see in Q1.

Sue Nabi, CEO

Regarding your inquiry related to the makeup brands, we are focusing on three areas: reinforcing the core values of brands like CoverGirl, enhancing the products themselves, and addressing retail dynamics, whether in brick-and-mortar locations or e-commerce. In terms of products, our recent success with CoverGirl's Clean Fresh foundation, which emerged as the top launch this spring, demonstrates our commitment to modern, clean makeup that aligns with consumer interests today. Additionally, we are pursuing further trends beyond those we have already addressed with my team, and we aim to surprise the market with innovative new launches.

Operator, Operator

Our next question comes from Joe Lachky of Wells Fargo Securities.

Joe Lachky, Analyst

Congratulations to Sue. Welcome aboard. Pierre-André, I wanted to ask a question on leverage. Your leverage appears elevated as we exit fiscal year '20. Given the downward pressure on earnings, could you share how we should think of leverage evolving moving forward? I understand you aren't providing specific guidance, but could you share your thoughts on where you see leverage being at this time next year? Will you use all proceeds from the Wella transaction to pay down debt? Long term, do you see yourself achieving your medium-term leverage ratio target of 4x, and how long do you anticipate it will take?

Pierre-André Terisse, CFO

Yes. I won't offer any specific guidance as you correctly noted. However, I can share that the dynamics surrounding this are as follows: KKR's $1 billion investment is now in the bank. We concluded the fiscal quarter with a net debt of $7.8 billion, which we recognize as too high. Nevertheless, we've effectively managed to deliver a commendable performance given our modest revenues, showing a negative cash flow of only $320 million for the quarter. We are keen to stabilize cash flow for fiscal '21, particularly before factoring in any proceeds from Wella. We are prioritizing this area and are committed to improving performance from our end, as we expect to close the Wella transaction by the end of calendar '20, with no substantial conditions hindering progress. Hence, we are optimistic about our overall performance, especially considering the steady recovery of Wella's business as well.

Operator, Operator

Our next question comes from Andrea Teixeira of JPMorgan.

Andrea Teixeira, Analyst

I wanted to congratulate and welcome you as well. I have a question for Sue regarding the recent M&A with Kylie and Kim. How will this impact the brand attributes and sustainability you've mentioned? For Pierre-André, if my math is correct, Kylie only contributed a few million dollars in the fourth quarter, and I understand that this was due to disruptions in your third-party manufacturing and consumption issues. What is the negotiation status with the third-party manufacturer, and should we expect an announcement soon? Additionally, how does this relate to KKD? Should we see this announcement before KKD closure, or will there potentially be delays? A clarification for Pierre: regarding the Wella deal, is there a chance of valuation changes given that trends in professional hair have worsened since the spring?

Pierre-André Terisse, CFO

Firstly, regarding the Wella deal, the answer is no—the valuation remains intact. When we first agreed on the transaction in May, we were already fully aware of the implications, as we had passed through the worst month in April. The situation has indeed improved. We secured a fixed price agreement, with no question of adjusting the valuation, neither upward nor downward, thus eliminating any concern on that front. On Kylie and Kim, to clarify, Kylie represents $600 million or 51%, and we have already paid that in January 2020. You can find reference to it on our cash flow statements. For Kylie, we recognize the need to resolve current challenges, and I won't comment on the specifics of potential partnerships just yet. However, we have been actively working alongside Kylie to enhance her brand, particularly in skincare, which lacked considerable focus when we first invested. We're developing it swiftly, expanding distribution, particularly in Europe and DTC, and have been successfully following our planned trajectory. With Kim, we are looking at a 20% stake that should come through at the beginning of calendar '21, so we anticipate a positive roll out in early 2021.

Sue Nabi, CEO

To address the sustainability of influencer-led beauty businesses, I find the possibilities surrounding brands like Kylie and Kim to be particularly appealing. Personality brands come with robust social media followings, providing extensive data which enables us to better tailor our products to their preferences. Additionally, we place significant emphasis on establishing strong skincare ranges for both brands. The skincare segment generally garners higher consumer loyalty than cosmetic products, which is favorable. Furthermore, both Kylie and Kim's brands sit within the fast-growing, mid-range skincare category. In essence, consumers will initially buy because they trust and love Kim and Kylie; they will continue to repurchase due to their enjoyment of our quality products.

Operator, Operator

Our next question comes from Mark Astrachan of Stifel.

Mark Astrachan, Analyst

I wanted to start by clarifying some details. Reviewing the comments from July and August, it seems that if you extrapolate sales averages, they would indicate a decline of high single digits year-on-year for those months. I wanted to ensure that I'm interpreting this correctly. Additionally, from a broader perspective for Sue, could you elaborate on the necessary steps to revitalize CoverGirl and Max Factor, given that both have seen multiple relaunches in recent years? What could lead to a different outcome this time? In light of that, how do you view EBIT margins as you attempt to grow sales while also making effective investments in those brands?

Pierre-André Terisse, CFO

Yes. To address the first part, I think your interpretation of the charts is slightly skewed because you currently see only Q3 data. As I mentioned, we faced steep declines from approximately minus 67%, followed by minus 50%, and then minus 40% in Q4. Presently, we are seeing significant improvements with July and August nearing minus 20, reflecting a notable recovery. It’s important to note that travel retail, which accounted for about 9% of our net revenues, has been substantially affected by a lack of traffic. However, as Peter attests, the remaining segments are demonstrating a strong recovery relative to Q4 despite residual challenges. Our key focus is not only on revenue recovery but also restoring improved cash flow and profitability while we implement new cost structures.

Sue Nabi, CEO

To address the relevance of brands such as CoverGirl and Sally Hansen, we first need to reinforce the essence and purpose of these brands to elevate visibility and messaging targeted towards modern consumers. CoverGirl is significantly more beloved than many competitors, which is a key advantage. I firmly believe we need to offer new and superior products that outshine the competition. Our strategy will focus on emphasizing key products that can shift the fate of the brands, and we'll also employ strict SKU management to ensure our innovations stand out in-store. Additionally, we're looking to harness digital and social media effectively for this messaging and explore avenues to transition these brands further into a DTC model.

Pierre-André Terisse, CFO

Thank you all for your questions and for your attention. As Peter mentioned, we are eager about this new chapter. We recognize there is a lot of work ahead, but we remain enthusiastic about the opportunities to come. We look forward to interacting with you on the road. Thank you.

Sue Nabi, CEO

Thank you.

Operator, Operator

Thank you, everyone. This concludes today's conference call. You may now disconnect.