Wednesday, June 29
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Melvin Capital’s Demise Presents a Beauty of an Opportunity

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In the current bear market, selling for non-fundamental reasons can often provide an opportunity to buy a bargain.

This past week, Melvin Capital, an embattled $7 billion hedge fund, announced it’s closing down after steep losses over the past year and a half. Recall, Melvin was the prime target of a short-squeeze in GameStop (GME) and a handful of other stocks they were known to be short.

Melvin Capital ran a concentrated portfolio and was the top holder in several companies. These positions have been liquidated in the past month in anticipation of closing the fund. The selling in their list of stocks into an already weak market has exacerbated the downdraft in those names.

Sifting through Melvin’s portfolio for a buying opportunity uncovers Coty (COTY) , the multinational beauty company. The soon-to-be-defunct hedge fund owned 48.7 million shares earlier in the year, almost a 6% stake. Coty’s shares are down 40% year to date to $6.25; Melvin’s abrupt liquidation undoubtedly contributed to the weakness.

In early May, Coty reported decent earnings, raising EPS guidance but guiding EBITDA to the low end. As many other multinational companies, Coty’s results were impacted by the lockdowns in China and exiting its business in Russia. The company, however, showed progress deleveraging its balance sheet after levering up to acquire Procter & Gamble’s (PG) specialty beauty business in 2016.

RBC analyst Nik Modi is bullish with a $14 target based on Coty’s fundamentals improving and strong management execution. Modi found positives in Coty’s Prestige business: “Prestige segment posted an impressive beat on both the top and bottom lines. LFL growth of +25% was over 10pts ahead of our/consensus estimates of ~14%. EBIT margins of ~17% came in more than ~600bps ahead of our/consensus estimates closer to 11%, driving both the top-line and profit beats. Plus, all geographies post double-digit growth.”

The Coty story does have some hair, and Modi points out some challenges: “1) Consumer segment results missed expectations. LFL growth of +10% was short of our estimate of +13% and even further below the aggressive consensus estimate of +16%. Profit for the segment was negative at -2.1% vs. our/consensus estimates of closer to 3%. Management cited being short on capacity in its Covergirl brand, as demand has been stronger than plan, and continued investment in various initiatives (Rimmel, Bourjois, and Max Factor brand repositionings). 2) Russia exit will impact FH1’23. Management lowered its CY’22 outlook of ~$1bn to ~$950mm as it exits Russia, which tends to weigh more heavily toward Prestige and FH1. The exit will result in about ~$50mm of lost EBITDA from FH1’23.”

Morgan Stanley lowered their price target after earnings but likes the setup; “Guidance does look fairly conservative to us, albeit with a lot of moving pieces. We remain Equal-Weight here, but are intrigued by relatively low valuation vs a clearly improved internal execution story, offset by macro risk factors. Post Q3, we are lowering our PT to $9 from $12 based on an 11x times FY23 EV/EBITDA multiple.”

JAB Holding, the German conglomerate, owns 55% of Coty. Recent post-earnings insider buying by a director of 50K shares gives some confidence of a good investment opportunity.

Overall, Coty is improving fundamentally with familiar macro headwinds in the current environment. Nonetheless, the shares are down 40% this year to a multi-year low not seen since the pandemic. Economic uncertainties are a factor in Coty’s decline. Still, market-related stock liquidations have depressed the shares to an attractive entry point, setting up the stock for a meaningful rebound over time.


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