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New Rec: Coty Inc. (COTY: $28.67) November 15, 2015 Position: Sell Target: $20 $MM Dec-15e Mar-16e Jun-16e Sep-16e F2016e F2017e Revs 1,191 927 1,045 2,336 4,276 9,304 Adj. EPS* 0.36 0.14 0.08 0.30 1.17 1.11 Y/Y Gr -20% -20% -6% -50% 19% -5% PE na na na na 24.5x 25.8x Cnsns Rev 1,210 950 1,062 2,630 4,334 10,305 Cnsns EPS 0.38 0.20 0.11 0.34 1.28 1.26

*Adj. EPS has not been adjusted for 1x tax item in Sep-15 quarter. Shares Out: 370MM Market Cap: $10.6B FYE June Concept: 1. COTY management hopes to drive top-line growth by focusing on its “power brands,” a strategy that succeeded with household consumer goods, but is more likely to fail in fragrances. 2. In COTY’s fragrance business (44% of sales, 50% of Adj. EBIT), bulls expect Y/Y declines in organic growth to moderate and be flat in FY17, driven by increased investment in fragrance

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“power brands” at the expense of its celebrity brands. However, market share is shifting to smaller fragrance brands (such as Jo Malone, Creed, Atelier) and COTY’s “power brands” should continue to lose share. 3. Color Cosmetics revenues (~24% of sales, ~22% of Adj. EBIT) could disappoint expectations for 2%-3% growth p.a., as consumers are buying more makeup at specialty retailers (e.g. ULTA, Sephora) and less at mass channels with a higher concentration of COTY brands. 4. COTY may be supporting its stock price with buybacks to minimize the debt resulting from its merger with P&G’s Beauty brands (expected to close July 2016). Buybacks accounted for ~29% of trading volume in October. Post-merger, >50% of the float will be held by P&G shareholders, who may be eager to sell. Summary: Coty (COTY) designs, manufactures, and markets Beauty products under a variety of licensed and company owned brands. Its major competitors in third party licensing include Estée Lauder (EL), L’Oreal (OR FP), Puig (a privately-owned Spanish company), BPI (owned by Shiseido, 4911 JT), and Inter Parfums (IPAR), among others. COTY also competes with large fashion houses such as Dior, Chanel, and Hermés.

In July 2015, COTY announced an agreement to merge with some of P&G’s Beauty brands through a Reverse Morris Trust structure. The deal is expected to close in July 2016, and would roughly double the size of the company, to $9B+ in revenues and a market cap of about $22B. The deal appears likely to close. “Street” analysts are valuing COTY based on pro forma results for the combined company.

Bulls view COTY as a “management story.” They hope that COTY’s current CEO, Bart Becht, can generate mid single-digit top-line growth while improving margins. Becht was CEO of Reckitt-Benckiser (RB), the UK-based consumer goods company, from 1999-2011, when RB generated above-market sales and earnings growth by adopting a so-called “power brands” strategy.

This strategy involved redirecting marketing and R&D dollars away from

so-called “tail brands” and toward a small number of “power brands.” (This 2011 case study by INSEAD provides useful background on RB’s strategy: https://www.rb.com/documentdownload.axd?documentresourceid=9957).

Effectively, RB focused its resources on a small number of brands in niche

household categories (Calgon, Woolite, Lysol, etc.) where these brands already enjoyed dominant market share. High R&D spending allowed these brands to consistently lead the market with small improvements (a plug-in air freshener that detects when somebody enters the room, say). This, combined with heavy investment in marketing, allowed RB to create a self-reinforcing cycle of market share gains for its power brands, as profits were continually reinvested.

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Bulls hope that COTY’s CEO will successfully translate the “power brands” strategy from RB’s household products to COTY’s perfume and makeup, and expect that the impending COTY/P&G merger will provide the scale to accomplish this, just as Benckiser’s acquisition of Reckitt-Colman in 1999 jump-started RB’s own power brand strategy. This past spring, when rumors emerged that COTY was seeking to acquire the P&G Beauty assets, and that COTY’s CEO would stay on to lead the combined company, COTY’s share price jumped from $20 to $31.

Fragrance is the most important segment for the combined COTY/P&G,

accounting for 44% of pro forma FY14 sales and 50% of Adj. EBIT. Organic sales growth in fragrance at both companies has been poor in recent quarters: -8% Y/Y this past quarter for COTY, and (we estimate) negative high single-digits Y/Y for P&G, in a total fragrance market that has been roughly flat. However, COTY management has attributed the weakness mainly to declining sales of its “tail brands” (mostly celebrity brands) in fragrance, and maintains that growth in “power brands” will eventually take up the slack. The market appears to be giving COTY management the benefit of the doubt. “Street” analysts are projecting a moderation in Y/Y revenue declines for the remainder of FY16 (ending June), and flat organic growth in FY17 (implying in a flat market that COTY/P&G will stop losing market share).

Our research leaves us skeptical that the “power brands” strategy will be the

success that bulls expect. We have found that consumer tastes are shifting to smaller Beauty brands versus the large “power” brands on which COTY is focused. In fragrance, for example, much like craft beer or wine, there is a growing demand for perfumes that are perceived to be unique, “artisanal,” and possessing an authentic backstory. “Consumers are disenchanted with blockbuster brands,” one contact said. Notably, Estée Lauder appears to have taken the opposite approach from COTY, acquiring smaller Beauty brands (like Jo Malone and MAC) and growing them. As we discuss, below, high-end retailers have been allocating more shelf space to niche brands in response to this trend, and specialty retailers like Sephora appear to be following suit.

The available data appear to support this thesis. According to NPD (which

aggregates sales data from US-based retail stores and e-commerce), sales of COTY’s fragrance “power brands” in the US prestige channel have been negative Y/Y in 4 of the past 8 quarters, including the last two. Meanwhile, independent and smaller niche brands represent 19% of the US prestige sales tracked by NPD and are outgrowing the market by a wide margin.

In Color Cosmetics (~24% of pro forma sales, ~22% of Adj. EBIT), our

bearish thesis focuses primarily on the makeup business (~75% of pro forma Color Cosmetics sales, or ~18% of total sales). In makeup, COTY and P&G’s major

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brands (Rimmel, Covergirl, MaxFactor) generate most of their sales via the mass channel (drugstores, Wal-Mart, etc.), which carries a higher concentration of these “power brands.” However, our research indicates that these big brands are losing share, as customers shift their makeup spending from the mass channel to the specialty retail channel (e.g. ULTA, Sephora), which offers a better shopping experience and a much wider assortment of makeup brands, including independent brands. Perhaps in response to this trend, mass retailers like CVS and Walgreens appear to be updating their beauty departments to mimic the specialty retailers, adding more brands, including private label and exclusive brands, which would be a negative development for COTY. We discuss this point in more detail, below.

The impending merger with P&G may have created an interesting setup for

the sale of COTY shares. Under the terms of the deal, the amount of debt that COTY incurs from P&G is based on COTY’s stock price at the time the merger closes. COTY will shoulder only $1.9B of debt if its stock price is above $27.06. Below $27.06, the debt amount increases, to a maximum of $3.9B if the stock price is $22.06 or below. We estimate COTY will be carrying $5.3B of net debt once the P&G merger closes, or ~3.2x pro forma FY14 EBITDA, assuming the stock price closes above $27.06. If the stock price were under $22.06 at closing, net debt would be $7.3B, ~4.4x EBITDA.

COTY, then, appears to have a strong incentive to keep its stock price above

$27.06 until the merger is complete. The company may be supporting its stock price with buybacks. In the month between Sep-30 and Nov-4, COTY repurchased $312MM worth of stock, or a full ~29% of the ~$1.1B in aggregate trading volume over that time period. However, COTY has only $232MM remaining on its current buyback authorization, and there are another ~8 months until the deal is expected to close.

If COTY’s board authorizes more buybacks, this could help support the

stock price, but at the cost of taking on additional leverage (i.e. to fund the buybacks), and with the risk that the stock price could ultimately fall below $27.06 regardless, resulting in even higher leverage once the deal is complete. It seems more likely that COTY would stop repurchasing shares once the current authorization is filled (which, at October’s pace of buying, could happen in the next few weeks), potentially removing an important source of buying support for the stock. We note that, once the merger closes, >50% of COTY’s float will be held by P&G shareholders who received the spun-off shares and may be eager to sell.

If our fundamental thesis is correct, and the “power brands” strategy fails to

succeed, then COTY might find itself in a difficult position once the P&G deal is complete. With post-merger leverage somewhere between 3x-5x EBITDA

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(depending on the set of outcomes described above), COTY would likely be constrained if it had to shift strategy and adopt the Estée Lauder playbook of acquiring small brands via M&A and growing them. We note that COTY’s competitors have far more balance sheet flexibility: Estée Lauder is currently levered only 0.5x while L’Oreal has net cash of $9B.

The “street” has an average price target on COTY of $29.50, or 23x its

FY17 EPS projection. Sell-side analysts justify applying the same multiple as EL and L’Oreal, despite COTY’s lower growth versus these peers, by citing the “strategic optionality” of existing COTY management. If our fundamental thesis is correct, and the “power brands” strategy is unsuccessful, the “halo” around COTY management is likely to fade, and with it the stock’s premium multiple.

Our price target of $20 represents 18x our FY17 EPS projection of $1.11.

The implied EV of $20.5B (assuming $5.3B of net debt) represents 12.1x our FY17 Adj. EBITDA projection of $1.7B. This 15%-20% discount to the multiples awarded to EL and L’Oreal seems justified by COTY’s long-term structural growth challenges and by its higher balance sheet risk. We also look to P&G, another consumer business with top-line growth challenges, which trades at a 17x P/E multiple on FY17 earnings.

Borrow information: COTY Supply Quantity Quantity On Loan Available to Borrow Date

14.0M 6.0M 9.6M 11.12.15 Source: Markit/Data Explorers While reasonable efforts have been made to ensure the accuracy and completeness of this data, no warranty of accuracy, completeness, appropriateness or any other kind is given by Off Wall Street, Markit/Data Explorers or their respective licensees or affiliates in relation to this data. Copyright in securities lending data: Markit/Data Explorers. All rights reserved. Background:

Coty (COTY), headquartered in New York, designs, manufactures, and markets Beauty products under a variety of licensed and company owned brands. The company traces its roots back to a fragrance house started by François Coty in Paris, in 1904. COTY is 75% owned by JAB (Johann Adam Benckiser), the investment vehicle of the billionaire Reimann family. JAB is a holding company with publicly traded debt (Bloomberg ticker: JABHOL Corp). In addition to its COTY stake, it owns 11% of Reckitt-Benckiser (RB LN), 68% of Jimmy Choo (CHOO LN), and Peet’s Coffee, among others (more information is available here:

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http://www.jabholco.com/). In 1992, JAB purchased Coty from Pfizer for $440MM. COTY completed an IPO in June 2013. COTY has two share classes. As of Nov-3, there were 85MM shares of Class A common stock, which are publicly-traded, and 262MM shares of Class B common stock. JAB owns 100% of the Class B shares and 7% of the Class A shares. The Class B shares carry 10 votes apiece. Chanel (“Mousseluxe S.à.r.l”) owns 18% of the Class A shares, which it received as consideration for COTY’s acquisition of the Bourjois cosmetics brand in June 2015. It does not appear that Chanel is restricted from selling its shares. Bart Becht is the Chairman of JAB, and also Chairman and CEO of COTY. Becht has been associated with JAB since 1995, when he became CEO of Benckiser Detergents. Benckiser completed an IPO in 1997 and acquired Reckitt-Colman (becoming Reckitt-Benckiser) in 1999. From 1999-2011, Becht was CEO of RB, where he successfully executed his “power brands” strategy. His performance at RB was widely praised by investors and the media. Over the last few years, Becht has been involved with a number of large M&A deals. When he resigned from RB in April 2011, “street” analysts speculated that his departure was due to a clash with RB’s board of directors over a big bet to merge with Colgate-Palmolive (Becht allegedly wanted the merger, the board did not). In November 2011, Becht became COTY chairman, and in April 2012 led COTY in a $24.75/share ($10.6B) bid for Avon, which was rejected (AVP shares have since fallen by -88%, to $3). In Sep-2014, COTY sacked its then-CEO, Michele Scannavini, and Becht became Interim CEO. By April 2015, it emerged that COTY was bidding for the P&G Beauty assets, and the merger deal was announced on July 9, 2015.

COTY’s major competitors in third party licensing include Estée Lauder (EL), L’Oreal (OR FP), Puig (a privately-owned Spanish company), BPI (owned by Shiseido, 4911 JT), and Inter Parfums (IPAR), among others. COTY also competes with large fashion houses such as Dior (LVMH), Chanel, and Hermés. Table 1, below, shows COTY revenues broken out by segment. Note the recent decline in Celebrity fragrance revenues, as this category has fallen out of favor with consumers (we discuss this more, below). Additional notes: Skin & Body Care revenues were boosted by the acquisitions of Tjoy (which was later discontinued in 2015) and Philosophy in FY11. Color Cosmetics-Nails was boosted by the acquisition of OPI in FY11. The Playboy brand ($175MM in FY14 revenues) was reclassified from Fragrance-Lifestyle to Skin & Body Care in FY13. Color Cosmetics-Makeup was boosted by the acquisition of Bourjois from Chanel in June 2015.

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Table 1. COTY revenues by business segment ($MM)

FYE June FY11* FY12* FY13 FY14 FY15 Fragrance 2,325 2,453 2,313 2,324 2,178 Designer 1,500 1,646 1,664 1,702 1,622 Lifestyle 507 516 321 346 325 Celebrity 319 291 325 273 233

Color Cosmetics 1,143 1,431 1,469 1,366 1,445 Nails 511 752 749 637 655 Makeup / Other 633 678 721 728 791

Skin & Body Care 618 728 868 861 772 Body care ND ND 572 574 479 Skin care ND ND 298 291 290 Total 4,086 4,611 4,649 4,552 4,395

as % of total Fragrance 57% 53% 50% 51% 50%

Designer 37% 36% 36% 37% 37% Lifestyle 12% 11% 7% 8% 7% Celebrity 8% 6% 7% 6% 5%

Color Cosmetics 28% 31% 32% 30% 33% Nails 13% 16% 16% 14% 15% Makeup / Other 16% 15% 16% 16% 18%

Skin & Body Care 15% 16% 19% 19% 18% Body care

12% 13% 11%

Skin care 6% 6% 7% Total 100% 100% 100% 100% 100%

*Figures are before reclassification of Playboy from Fragrance-Lifestyle to Skin & Body Care Source: Company filings, OWS estimates. Some figures may not sum exactly due to rounding. Table 2 shows COTY revenues broken out by geography. Note that Fragrance revenues are most heavily weighted to EMEA, as Europe constitutes the largest fragrance market globally (per capita use is higher than in N. America). Table 2. COTY revenues by geography ($MM)

FY11* FY12* FY13 FY14 FY15 Fragrance 2,325 2,453 2,313 2,324 2,178 Americas 744 785 786 720 675 EMEA 1,279 1,325 1,156 1,232 1,133 APAC 302 343 370 372 370

Color Cosmetics 1,143 1,431 1,469 1,366 1,445 Americas 606 815 837 697 723 EMEA 492 544 558 601 636 APAC 46 72 73 68 87

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Skin & Body Care 618 728 868 861 772 Americas 173 269 295 293 293 EMEA 377 357 460 474 386 APAC 68 102 113 95 93

TOTAL 4,086 4,611 4,649 4,552 4,395 Americas 1,523 1,870 1,918 1,710 1,691 EMEA 2,147 2,225 2,174 2,307 2,154 APAC 416 517 556 535 550

as % of total Fragrance 57% 53% 50% 51% 50%

Americas 18% 17% 17% 16% 15% EMEA 31% 29% 25% 27% 26% APAC 7% 7% 8% 8% 8%

Color Cosmetics 28% 31% 32% 30% 33% Americas 15% 18% 18% 15% 16% EMEA 12% 12% 12% 13% 14% APAC 1% 2% 2% 2% 2%

Skin & Body Care 15% 16% 19% 19% 18% Americas 4% 6% 6% 6% 7% EMEA 9% 8% 10% 10% 9% APAC 2% 2% 2% 2% 2%

TOTAL 100% 100% 100% 100% 100% Americas 37% 41% 41% 38% 38% EMEA 53% 48% 47% 51% 49% APAC 10% 11% 12% 12% 13%

*Figures are before reclassification of Playboy from Fragrance-Lifestyle to Skin & Body Care Source: Company filings, OWS estimates. Some figures may not sum exactly due to rounding.

According to P&G’s filings, the Beauty business generated $6.1B of revenues in FY14 (ending June) and $5.5B of revenues in FY15 (-9.5% Y/Y). According to COTY, P&G Beauty’s FY14 revenues were split across Fragrance (38%), Hair Color (43%), and Color Cosmetics (19%). Based on this disclosure, we estimate the pro forma FY14 COTY/P&G revenue mix to be as follows: Fragrance (44%), Color Cosmetics (24%), Hair Color (25%) and Skin and Body Care (8%).

COTY’s ten “power brands” include Calvin Klein, Marc Jacobs, Chloé and Davidoff (in Fragrance), Rimmel (in Color Cosmetics – Makeup), Sally Hansen and OPI (in Color Cosmetics – Nails), plus Philosophy, Playboy and Adidas (in Skin & Body Care). Key brands coming over from P&G include Gucci, Dolce & Gabbana, and Hugo Boss (in Fragrance), Covergirl and MaxFactor (in Color Cosmetics – Makeup), Wella and Clairol (in Hair Color).

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Table 3, below, shows our (rough) FY15 revenue estimates for each of

COTY’s power brands. Note especially the importance of Calvin Klein, COTY’s largest brand, which represents an estimated 17% of total FY15 revenues and 34% of Fragrance revenues (16% of pro forma COTY/P&G Fragrance revenues). In total, “power brands” represented 72% of FY15 revenues (72% of FY14 revenues), according to company disclosures. Table 3. COTY "power brand" revenue (FY15) - OWS estimates

Brand Segment Est. FY15 rev ($MM) Calvin Klein Fragrance - Designer ~$750 Marc Jacobs Fragrance - Designer ~$250 Chloé Fragrance - Designer ~$175 Davidoff Fragrance - Lifestyle ~$200 Rimmel Color Cosmetics - Makeup ~$550 Sally Hansen Color Cosmetics - Nails ~$335 OPI Color Cosmetics - Nails ~$275 Adidas Skin & Body Care ~$350 Playboy Skin & Body Care ~$165 Philosophy Skin & Body Care ~$240

Source: OWS estimates based on company disclosures 57% of COTY’s FY15 revenues were from licensed brands (60% in FY14).

We understand that typical royalty rates paid to licensees are in the neighborhood of ~5%-8%.

70% of COTY’s FY15 revenues came from products manufactured in-

house, with the remainder being supplied by contract manufacturers. COTY manufactures product in the US (primarily Sanford, SC) and in Europe (France, Spain, UK). Beauty is a high gross margin, high OpEx, business model. COTY generates ~60% gross margins overall, but spends ~20% of revenues on advertising and promotion (COTY’s total ad spend is rumored to be ~$600MM p.a.). Total (GAAP) operating margins have averaged in the low double-digits. Discussion: 1. Revenue growth in Fragrance may not improve as bulls expect. Small/niche brands are taking share from COTY’s big “power brands.” Organic sales growth in Fragrance at both COTY and P&G has been increasingly weak in recent quarters. Table 4, below, shows Y/Y% growth in Fragrance revenues at COTY (the headline numbers trail the organic growth rates due to FX). Note that organic growth at -8% Y/Y deteriorated markedly this quarter on a two-year basis, with all sub-categories negative.

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Table 4. COTY - Fragrance Y/Y% revenue growth

Organic Y/Y%* FY13 FY14 Sep-14 Dec-14 Mar-15 Jun-15 FY15 Sep-15 Total Fragrance 3% 1% -2% -1% -2% -3% -2% -8% 2Y ND 4% -1% -3% 4% -2% -1% -10%

Headline Y/Y%

Designer 1% 2% -1% -5% -9% -6% -5% -13%

Lifestyle** -3% 8% -7% 4% -18% -9% -6% -17% Celebrity 12% -16% -11% -16% -1% -32% -15% -21% Total Fragrance -6% 0% -3% -5% -9% -9% -6% -14%

*Constant FX ** FY13 figure is adjusted for Playboy reclassification Source: Company filings, OWS It appears that revenue growth from Fragrance “power brands” was also very weak this quarter. First, “power brands” make up a substantial portion of the Fragrance sub-categories that saw big declines: we estimate that “power brands” make up >70% of the “Designer” sub-category (Calvin Klein, Marc Jacobs, Chloé), >60% of the “Lifestyle” sub-category (Davidoff), but none of the “Celebrity” sub-category. Second, we understand that COTY management has told investors after this quarter’s report that, overall, “power brands” growth was in line with total company organic growth of -2% Y/Y. Given that organic growth in the Color Cosmetics and Skin & Body Care segments were better than the company total (+9% Y/Y and -1% Y/Y, respectively) and “power brands” make up a high portion of these segments’ revenues (we estimate >80% and >75%, respectively), this suggests that growth in Fragrance “power brands” must have been substantially negative (we estimate at least mid single-digits Y/Y) to make up the difference.

P&G does not break out revenues for its Fragrance business, but management did provide quarterly commentary on Y/Y% growth in volumes (not revenues) for P&G’s Prestige segment until the Jun-15 quarter. P&G Prestige consists of the big three fragrance brands being merged with COTY (D&G, Gucci and Hugo Boss) plus the SK-II skincare brand (which P&G is keeping). This commentary is broken out in Table 5, below. Note that the SK-II brand has been growing mid single-digits, so the numbers below likely overstate volume growth for the fragrance brands that COTY is acquiring. Table 5. P&G Prestige (D&G, Gucci, Hugo Boss, SK-II)

FY13 FY14 Sep-14 Dec-14 Mar-15 Jun-15 FY15 Sep-15 Volume Y/Y% +LSD -LSD -HSD -DD -HSD [N/D] -DD [N/D]

* “LSD” = Low single-digits, etc. Source: P&G quarterly earnings presentations, OWS

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Despite recent weak results, “street” analysts remain hopeful that COTY’s “power brands” strategy will gain traction, and project a moderation in Y/Y Fragrance revenue declines for the remainder of FY16 (ending June), and flat organic growth in FY17 (implying in a ~flat fragrance market that COTY/P&G will stop losing market share).

Our research leaves us skeptical that the “power brands” strategy will be the

success that bulls expect. This position is supported by conversations with industry participants, and store visits, in both the US and Europe. First, the anecdotal evidence we have collected makes clear that consumer tastes are shifting to prefer smaller, niche fragrance brands, and that monolithic “power brands” are falling out of favor. Industry participants note that fragrance is a highly personal, almost emotional purchase, and therefore very different from RB’s household cleaners, which are high volume purchases for which consumers feel little personal connection, and where consumers are generally trying to minimize their cognitive load (“Does it work well? Is this brand reliable? Then I’ll buy it.”)

According to our contacts, the shift to smaller brands is about the “juice”

itself (“Consumers no longer want to smell like everyone else,” and are seeking to express their individuality through scent), and it is about flaunting a lesser-known brand name when asked, “What perfume are you wearing?”

This trend appears to be well advanced at the higher end of the market, and

moving downward. One industry participant suggested that perfumes with ASP >$100/bottle have been growing at a “20%+ CAGR over the past 3-4 years,” driven by niche brands. For example, a brand like Creed (which retails for $185-$750/bottle) has been growing revenues ~25% Y/Y in recent quarters, according to NPD data. Further down the price spectrum, in prestige fragrance (i.e. brands that retail for roughly $50-$100/bottle), fast growing brands include Nest, Diptyque, Atelier, Commodity, and Jo Malone (owned by Estée Lauder). Notably, brands like Jo Malone and Commodity utilize a “layering” concept, whereby consumers can create a unique, individual perfume by combining different scents (tapping into the “individualization” theme).

High-end retailers (Saks, Neiman Marcus, Galeries Lafayette, etc.) have

been allocating more floor space to niche brands in response to this trend. We estimate nearly 50% of floor space at the high end US department stores we visited was devoted to niche brands. Figure 1, below, illustrates the floor space allocated to niche brands like Jo Malone, Nest, and Creed, at Saks Fifth Avenue.

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Figure 1. Niche fragrance brands at Saks Fifth Avenue (Jo Malone, Nest, Creed)

Source: OWS

Similarly, at Galeries Lafayette in Paris (which is a major tourist

destination), we estimate that nearly 50% of the floor space in fragrance was devoted to niche brands. Figure 2, below, shows examples. Our observations regarding floor space were similar when we visited Globus, a high-end department store in Geneva.

Figure 2. Niche fragrance brands at Galeries Lafayette, Paris (Tom Ford, Byredo, Annick Goutal)

Source: OWS

Specialty retailers and mid-range department stores appear to be following suit. We estimate that smaller brands (e.g. Thierry Mugler, Paco Rabanne, etc.) were allocated roughly ~30-40% of shelf space at the Dillard’s and Macy’s we visited, and a similar proportion at ULTA. We estimate small brands accounted for nearly 50% of shelf space at the Sephora stores we visited in the US, and included niche brands like Tom Ford, Nest, Replica, etc.

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Interestingly, Sephora has just added a separate “Niche Fragrances” section to its US website (see here: http://www.sephora.com/fragrance), featuring a large number of niche brands like Commodity, Nest, Atelier, Juliette Has a Gun, Clean, Etat Libre D’Orange, etc. This is a new development for the holiday season: the “niche” section was not on Sephora’s website a few weeks ago.

It appears that retailers are increasingly eager to sign exclusive distribution

deals with smaller fragrance brands. Multiple industry participants noted that Sephora’s exclusive distribution agreement with Atelier Cologne has been a “huge success.” Our contacts say that other retailers are now looking to copy this model: for example, Dillard’s has just introduced an exclusive fragrance product under the Daniel Cremieux brand. When we asked for a recommendation at Saks this week, we were directed to the new Azzedine Alaïa fragrance, exclusive to Saks, which was introduced only very recently.

It appears the purpose of this exclusive distribution strategy is to help the

retailer stand out as a unique shopping destination in a market where a Google search for a “power brand” like D&G’s Light Blue, for example, turns up dozens of online purchasing options (n.b. the Light Blue eau de toilette that sells for $74 at Sephora is currently priced at $39.99 on Amazon).

Several industry participants suggested that COTY could struggle to grow its

fragrance “power brands” unless it can make customers perceive them as more exclusive. This should be difficult, these contacts suggest, because COTY has already allowed the distribution of its “power brands” to expand into non-prestige channels, and the resulting damage to these brands is hard to reverse.

On Sep-25, the Wall Street Journal published an article

(http://www.wsj.com/articles/luxury-perfume-makers-turn-to-wal-mart-target-1443226316) noting that prestige perfumes from Calvin Klein, Davidoff, D&G and Hugo Boss were appearing at Wal-Mart, CVS and Overstock.com at heavily discounted prices, through the “gray market” distribution channel. In our store visits, we observed substantial inventory of Marc Jacobs perfumes at TJ Maxx (Figure 3, below).

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Figure 3. Marc Jacobs perfumes (Lola and Honey) at TJ Maxx

Source: OWS

Meanwhile, it appears that the pace of new fragrance launches continues to increase, suggesting that competition for COTY’s target market is intensifying (see Table 6, below).

Table 6. New fragrance launches, total and by selected category

1992 2002 . . 2011 2012 2013 2014 Total 101 464

1,220 1,330 1,610 1,620

Feminine 53 270

841 968 925 Masculine 35 130

307 328 353

Unisex 13 64

182 314 342

"Limited editions" 0 41

228 206 245 263 Flankers* 11 68

253 245 275

Celebrity 3 12

74 52 58 79

Niche 21 100

276 331 540 448 * “Flankers” are offshoots of larger brands, and are typically seasonal. For example, COTY’s CK One – Summer would be considered a “flanker” for CK One. Source: Michael Edwards, www.fragrancesoftheworld.info, OWS

According to industry participants, fashion houses and other brands remain eager to enter the fragrance market despite this heavy competition. This is mainly because they view fragrance as a relatively low-price entry point for the brand (e.g.

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a customer might first become acquainted with the Comme des Garçons brand by buying a $100 bottle of perfume, then later graduate to a $500 dress). For an illustration, we are told that Rag & Bone, Christian Louboutin, Prouenza Schouler, and Moschino may be planning to enter the fragrance market soon. The available data appears to support our thesis that niche brands are taking share. According to our analysis of NPD data (which tracks spending across most US prestige retailers and e-commerce), COTY’s fragrance “power brands” have generated negative sales growth in 4 of the last 8 quarters, including the last two. P&G fragrance revenue growth has been negative for the past 8 quarters, according to NPD. Meanwhile, “Other” brands (mostly smaller, niche brands) constitute 19% of the market that NPD tracks (making them, in aggregate, larger than either L’Oreal or Estée Lauder, which each account for 16%), and have been growing in the mid to high single-digits, taking share.

We note that Estée Lauder has been outgrowing COTY/P&G by a wide margin (+12% constant currency in the September quarter, including some small acquisitions), but this growth has been driven by the niche brands Jo Malone and Tom Ford. Over the past year, Estée Lauder has acquired two additional, fast-growing niche brands: Le Labo and Frederic Malle. 2. Customers appear to be moving away from mass beauty channels, which have a high concentration of COTY/P&G brands, and to specialty retailers, like ULTA/Sephora, which carry a much wider variety of brands. Consensus expectations for 2%-3% p.a. revenue growth in Color Cosmetics may be too high. ULTA and Sephora are growing rapidly in the US and taking market share. Sephora now has more than 360 standalone units in the US, plus 485 stores-within-a-store located at JC Penney. JCP has told investors that it intends to add Sephora store-within-a-store locations to the remainder of the JCP store base, which would roughly double the current number, and it expects the Sephora expansion to drive $1B+ in revenue growth between now and 2017. Both LVMH (which owns Sephora) and JCP have indicated that SSS at US Sephora locations has been in the “double digits” recently and is accelerating. We estimate Sephora is generating roughly $2B-$2.5B in US revenues and also commands a 30%-40% market share in France, where it has 325 stores.

ULTA had 817 stores as of last quarter, up +100 Y/Y (+14%). SSS has ranged from 8%-11% Y/Y over the past 5 years, and has accelerated to 10%-11% Y/Y in the last 3 quarters. Total revenues at ULTA were $3.5B over the TTM period.

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Our field research indicates that MAC-branded retail stores (MAC is a $2B+ cosmetics brand owned by Estée Lauder) are also becoming an extremely popular destination for cosmetics. These sell only MAC branded product. A recent “street” survey of US teens indicates that the shift from mass to specialty retail may be accelerating (Table 7, below). The survey results accord with the anecdotal evidence we gathered during our recent store visits. Table 7. "Street" teen survey

Preferred beauty destinations (upper-income females)

Rank Fall 2014 Spring 2015 Fall 2015 1 Sephora 22% Target 19% Sephora 38% 2 Target 21% Sephora 19% ULTA 19% 3 CVS 13% ULTA 18% Target 14% 4 ULTA 13% CVS 14% CVS 6% 5 Wal-Mart 7% Wal-Mart 9% MAC 3% 6 Walgreens 3% Walgreens 5% Wal-Mart 3% 7 Macy's 2% MAC 2% Macy's 3% 8 Nordstrom 2% Macy's 2% Nordstrom 2% 9 Online 2% Nordstrom 2% Walgreens 2%

10 MAC 2% Online 1% Rite-Aid 1%

Sephora + ULTA + MAC 37%

Sephora + ULTA + MAC 39%

Sephora + ULTA + MAC 60%

Preferred beauty destinations (average-income females) Rank Fall 2014 Spring 2015 Fall 2015

1 Wal-Mart 24% Wal-Mart 21% Sephora 24% 2 Target 16% Target 16% ULTA 23% 3 ULTA 13% ULTA 15% Wal-Mart 14% 4 Sephora 12% Sephora 14% Target 10% 5 Walgreens 5% Walgreens 6% MAC 6% 6 CVS 4% MAC 4% Walgreens 4% 7 MAC 3% CVS 3% Macy's 2% 8 Macy's 2% Macy's 2% CVS 2% 9 B&BW 2% Online 2% Sally B. 2%

10 Mall 2% B&BW 2% Dillard's 1%

Sephora + ULTA + MAC 28%

Sephora + ULTA + MAC 33%

Sephora + ULTA + MAC 53%

Source: “Street” survey of US teens, average age =16, N=9,400. Published Oct-19-2015. We think this channel shift is happening mainly because specialty retailers, like Sephora/ULTA, offer a much wider array of brands and SKUs than mass retailers. Figure 4, below, illustrates the typical brand selection at a mass retailer

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(in this example, a Wal-Mart Neighborhood Market). The mass channel usually offers ~10-15 makeup brands, with a high concentration of “power brands” from COTY/P&G (i.e. Rimmel, Covergirl, MaxFactor). Figure 4. Makeup brands at mass retailer (Wal-Mart Neighborhood Market)

Source: OWS

By comparison, ULTA now carries >500 brands in a typical ~10K sq. ft.

store, up +25% from ~400 brands a few years ago. Sephora carries >200 different brands in a full sized store (~5,500 sq. ft.).

The wide selection of brands is important because, according to our field

work, there appears to be a kind of “Forever 21 effect” taking hold in beauty. In other words, consumers, especially younger women, appear to be purchasing a larger number of items, from a wider variety of brands, with each transaction.

This phenomenon is illustrated by the growing popularity of “haul” videos

on YouTube (examples): https://www.youtube.com/results?search_query=ulta+haul). These are 10-15 minute videos in which teenage girls display a big shopping bag from ULTA or Sephora (the “haul”) and discuss/review each item. The more popular “haul” stars generate 200k-1M views per video.

Such video bloggers (or “vloggers”) appear to hold increasing sway in

promoting independent or lesser-known brands. For example, Too Faced, a fast-growing makeup brand at ULTA, was initially “discovered” and promoted by teenage vloggers. The increasing use of social media also appears to have boosted major independent brands like Urban Decay and Smashbox. While neither of these

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brands has an advertising budget remotely close to that of a “power brand” like Covergirl, both command substantial floor space at the specialty retailers.

The specialty retailers are clearly moving to accommodate this trend. In

August 2015, Sephora introduced a “Scouted by Sephora” program (http://www.sephora.com/scouted-by-sephora), in which it “curates” products from lesser-known brands. Also in August 2015, Sephora introduced a subscription box service (http://www.sephora.com/play), where customers receive a box each month with a variety of products, curated mostly from niche brands. In a clear imitation of the “haul” videos on YouTube, Sephora produces an “unboxing” video on its website (the October 2015 unboxing is here: http://www.sephora.com/play-october-2015?mediaId=30800024).

So, aided by social media, there appears to be a proliferation of makeup

brands, and a growing desire by consumers to purchase a wider array of brands, including “newly discovered” ones. This trend would seem to work against COTY’s strategy of focusing on a handful of large “power brands.”

Meanwhile, the mass retailers appear to be responding to their market share

losses by trying to become more like their specialty retail competitors. This primarily means adding more brands, including exclusive and private-label ones, a development that should be negative for COTY/P&G’s “power brands,” which have historically commanded a large share of the shelf space at these stores.

For example, in June 2015 CVS noted that it plans to respond to market

share losses by adding “new and exclusive beauty brands” to its stores, which it will detail at its upcoming investor day on Dec-16. Walgreens has been adding the Boots private label beauty brand (No7) to pilot stores in Phoenix and New York, and is expected to roll this out nationwide. In Feb-2015, Walgreens also launched an exclusive “masstige” beauty brand called Circa.

“Street” analysts are modeling 2%-3% organic growth in Color Cosmetics

revenues for the combined COTY/P&G business for FY17. Given the issues discussed above, this might be too optimistic. While organic growth in COTY’s Color Cosmetics segment was an impressive +9% Y/Y this quarter, this was against an easy three-year comp (growth was +10% Y/Y in Sep-14 but negative -10% Y/Y in Sep-13, for a 3-year CAGR of 3%).

We note also that COTY has benefited from the huge success over the past

12-18 months of the Sally Hansen “Miracle Gel” nail product. In the markets tracked by NPD data, Sally Hansen sales almost doubled, from ~$5MM/month to >$9MM/month, starting in April 2015, following the expanded distribution of this product. However, NPD data shows that Sally Hansen sales have since leveled out

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in the $9MM/month range, and so the growth benefit from this product should anniversary in April 2016.

Based on our research, we think nails represent the strongest part of COTY’s

business (and the category where a “power brands” strategy has the greatest chance of success, given that nails are more driven by product innovation than the other categories). However, we note that the P&G merger will dilute the contribution of nails to the total business: once the merger is complete, nail care will decline from 15% of standalone COTY revenues to only ~7% of revenues for the pro forma combined business (~25% of Color Cosmetics revenues). 4. The impending merger with P&G may have created an interesting setup for the sale of COTY shares.

It appears that COTY’s earnings power is, to some extent, leveraged to its stock price. Under the terms of the P&G deal, the amount of debt that COTY incurs from P&G is based on COTY’s stock price at the time the merger closes, with a collar between $27.06 and $22.06. Table 8, below, shows various stock price scenarios, along with the resulting debt that would be incurred from P&G, and the associated interest burden (because the terms of the P&G credit agreement are not disclosed, we assume the P&G credit agreement enjoys the same terms as COTY’s existing revolver). The difference between a COTY stock price of $27 and $22 at closing equates to $0.04/share in additional interest costs, or just over 3% of the “street’s” FY17 earnings projection.

Table 8. P&G debt incurred under various COTY stock price scenarios

COTY stock price

Debt incurred ($MM)

Annual interest ($MM)

Per share (net of tax)

$27 1,892 39.9 $0.04 $26 2,305 48.6 $0.05 $25 2,718 57.3 $0.06 $24 3,131 66.1 $0.07 $23 3,544 74.8 $0.07 $22 3,933 83.0 $0.08

*Net of tax Source: COTY/P&G merger agreement, OWS

We note also that COTY’s existing revolver and its $1.75B term loan are floating rate debt, with the spread to LIBOR based on COTY’s leverage to Adjusted EBITDA. Table 9, below, shows our estimates for COTY’s overall debt and leverage following the close of the P&G merger. If leverage exceeds 4x EBITDA (which appears possible under a scenario in which COTY incurs the full $3.9B debt from P&G), COTY’s borrowing costs on its floating rate debt would increase by +25bps, to LIBOR + 175bps (or 2.11% at the current LIBOR rate). We

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estimate the additional interest expense would reduce COTY’s earnings by another $0.02/share. Table 9. COTY leverage scenarios

COTY net debt as of Sep-30-2015 2,293 - CFFO through Jun-30-2016 (OWS est.) -484 + CapEx through Jun-30-2016 (OWS est.) 130 + Dividends 87 + Share buybacks 544 + Required principal paydown on term loans 50 + Debt incurred for Hypermarcas acq. 1,000 COTY net debt before P&G merger 3,620

P&G merger debt -- minimum 1,868 P&G merger debt -- maximum 3,933

COTY net debt after P&G merger -- best case 5,488 COTY net debt after P&G merger -- worst case 7,553

FY17 adj. EBITDA (OWS estimate) 1,697 FY17 adj. EBITDA ("Street" estimate) 1,941

Leverage vs. OWS EBITDA (best case) 3.2x Leverage vs. OWS EBITDA (worst case) 4.4x

Leverage vs. Street EBITDA (best case) 2.8x Leverage vs. Street EBITDA (worst case) 3.9x

Source: OWS

The point is that COTY appears to have an incentive to keep its stock price above $27.06 until the merger is complete.

The company may be supporting its stock price with buybacks. In the month

between Sep-30 and Nov-4, COTY repurchased $312MM worth of stock, or a full ~29% of the ~$1.1B in aggregate trading volume over that time period. However, COTY had only $232MM remaining on its buyback authorization as of Nov-5, and there are another ~8 months until the P&G deal is expected to close.

If COTY’s board authorizes more buybacks, this might help support the

stock price, but at the cost of taking on additional leverage (the present $700MM buyback program represents ~0.4x turns of FY17 EBITDA, by our estimate), and with the risk that the stock price could ultimately fall below $27.06 regardless, resulting in even higher leverage once the deal is complete.

It seems more likely that COTY would stop repurchasing shares once the

current authorization is filled (which, at October’s pace of buying, could happen in

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the next few weeks). Given that buybacks have accounted for nearly a third of trading volume in recent weeks, this could potentially remove an important source of buying support for the stock.

We note that, once the merger closes, >50% of COTY’s float will be held by

P&G shareholders who received the spun-off shares. We think many of these shareholders may be eager to, or even forced to, sell. First, several of P&G’s largest holders are S&P 500 trackers, and would likely be forced to sell COTY as it is not a member of the index.

Second, it appears that some of P&G’s largest (actively managed)

shareholders are income-oriented mutual funds (P&G sports a 3.6% dividend yield). COTY management has stated that it intends to increase its annual dividend to $0.50/share following completion of the P&G merger, which implies a 1.7% dividend yield at the current stock price of $28.67. This may prove inadequate for some mutual funds that require high dividend yields.

Third, P&G is a $200B market cap company, while the new COTY, at

current prices, would be a $22B market cap, and may fall below the size parameters of some P&G holders with a mandate to purchase very large cap stocks.

COTY’s decision to lever up for the P&G merger might ultimately leave the

company in a difficult position. If our fundamental thesis is correct, and the “power brands” strategy proves unsuccessful, then COTY might find itself having to change tack, and might choose to pursue the Estée Lauder strategy of acquiring small brands via M&A and growing them. (Multiple industry participants opined that COTY would ultimately need to abandon its “power brands” strategy and start acquiring brands).

However, COTY’s balance sheet constraints could make it more difficult to

engage in M&A if the “power brands” strategy doesn’t work out. It also appears to be a seller’s market: we are told that fast-growing niche perfume brands, for example, have been getting acquired at 10x or higher sales multiples (though we haven’t been able to confirm this independently). Even assuming a 5x sales multiple, to acquire niche brands representing ~1% of its revenues, or $90MM, the combined COTY/P&G would have to spend $450MM on M&A, ~0.25x turns of leverage or approximately 50% of our projected FY17 free cash flow.

We note that COTY’s competitors have far more balance sheet flexibility:

Estée Lauder is currently levered only 0.5x while L’Oreal has net cash of $9B. 5. Recent results

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COTY shares fell as much as -8% intraday after the company reported results for the September quarter (Q1 FY16) on November 5. Total revenues of $1,112MM missed consensus expectations of $1,133MM. Adj. EPS of $0.30 (after backing out a 1x tax benefit) essentially matched consensus of $0.295. It appears that weaker than expected results in the Fragrance segment may have disappointed COTY bulls last quarter. Organic Fragrance revenues fell by -8% Y/Y, against a -2% Y/Y comp (“street” analysts appeared to be modeling a low single-digit decline in organic growth). Further, management sounded a cautious tone in the earnings release and conference call, noting that revenues from “tail brands” in Fragrance were declining sharply, but that growth from the “power brands” (CK, Marc Jacobs, Chloé, Davidoff) disappointed and failed to take up the slack from declining “tail brands.”

Management also tried to moderate expectations for a major near-term recovery in Fragrance revenue growth, stating that it needed time to clean up a fragrance portfolio marked by “unsustainable historical launches” in tail brands. In response, “street” analysts have started taking down their organic growth projections for FY17, from an average of 2%-3% Y/Y before the call, to roughly flat following the call (one leading bullish analyst is still modeling 3% Y/Y).

Organic growth in Color Cosmetics was +9% Y/Y, against a +10% Y/Y

comp last year but versus a -10% Y/Y comp two years ago. This was higher than “street” expectations for mid single-digit growth. Management attributed this to Sally Hansen (while noting that COTY will soon anniversary the launch of “Miracle Gel,” as we discuss, above), and also noted positive growth from Rimmel.

In Skin & Body Care, organic growth was -1% Y/Y against a -2% Y/Y

comp, slightly below consensus expectations. COTY’s margin performance this quarter was generally better than the

“street” expected, allowing it to meet consensus EPS estimates despite a top-line miss.

Gross margin of 60.1% expanded by +90bps compared to 59.2% in 1Q15,

and +20bps versus the 59.9% GPM attained in 1Q14. We note that COTY recently closed its Phoenix manufacturing plant (laying off 205 workers), which was inherited with the Philosophy acquisition in 2011, and consolidated these operations into its Sanford, NC facility. This appears to have helped boost gross margin performance in the quarter.

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On a GAAP basis, SG&A represented 43.5% of sales last quarter, down -50bps Y/Y (but up +20bps compared to 1Q14). We estimate the SG&A leverage was attained primarily by cutting advertising expenses this quarter (advertising represents ~22% of revenues). Management’s comments on the conference call support this notion, as it indicated that ad spending was down meaningfully Y/Y, in part due to a reduced number of big fragrance launches this quarter versus last year. However, notably, starting with this past quarter’s 10-Q, COTY has stopped disclosing it’s advertising spend on a quarterly basis.

Total Adj. OPM was 15.6% this quarter, up +150bps Y/Y, but down -20bps

versus 1Q14. By segment, Adj. OPM in Fragrance was 19.9%, up +110bps Y/Y but down from 22.1% in 1Q14. In Color Cosmetics, Adj. OPM was 14.8% versus 12.0% last year and 11.8% in 1Q14 (which was a notably weak quarter on the top line). In Skin & Body Care, Adj. OPM of 3.9% compares to 2.7% in 1Q15 and 1.7% in 1Q14, with this quarter’s margin expansion being helped by the discontinuation of COTY’s underperforming TJoy brand in China. 6. Financial assumptions In line with the majority of “street” analysts, our model assumes the COTY/P&G merger is completed in July 2016, and our FY17 projections reflect the results of the combined company.

Note that the FY17 consensus numbers on Bloomberg are too low, because several “street” analysts are not including P&G in their projections. The consensus numbers cited in our report use an average of the analysts who include P&G.

We project total COTY revenues of $4,276MM in FY16 (vs. consensus

$4,334MM) and $9,304MM in FY17 (vs. $10,305MM). Our Adj. EPS projections are $1.17 in FY16 (vs. consensus $1.28) and $1.11 for FY17 (v. $1.26). Note that the FY16 projections include the $0.29/share benefit that COTY received from a one-time tax item this past quarter.

The difference between our revenue projections and the “street” is

attributable to our lower than consensus projections for the Fragrance and Color Cosmetics segments. Excluding P&G, we project organic revenue declines in Fragrance of -8% Y/Y in FY16 and -6% Y/Y in FY17. This compares to “street” projections of -6% Y/Y and flat, respectively.

Across the Fragrance “power brands,” we model that, in a flat fragrance

market, Calvin Klein and Davidoff revenues decline in the mid to high single-digits organically in both FY16 and FY17, while Marc Jacobs and Chloé, combined, are roughly flat in FY16, and down low single-digits in FY17. We

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assume that designer and lifestyle “tail brands,” along with COTY’s celebrity brands, decline by low double-digit percentages in FY16 and FY17, as COTY redirects investment away from these brands. For the P&G Fragrance business, we project organic revenue declines in the mid single-digits for both FY16 and FY17.

In Color Cosmetics, for standalone COTY, we project organic revenue

growth of 5% Y/Y in FY16 and negative -2% Y/Y in FY17. This compares to “street” expectations of 6% Y/Y and 2% Y/Y, respectively. Our projections assume that the growth contribution from Sally Hansen is reduced once the “Miracle Gel” launch anniversaries, around April 2016, and that organic sales growth at Rimmel declines in low single digits, due to the channel shift to specialty retail, discussed above. For P&G (whose Color Cosmetics business is driven by the Covergirl and MaxFactor makeup brands), we project low single-digit declines in organic Color Cosmetics revenue growth in both FY16 and FY17.

We project (GAAP) gross margins of 60.7% in FY16 and 64.8% in FY17

(note that P&G has higher gross margins, but higher SG&A, compared to standalone COTY, so the FY17 projection is impacted by mix). On the standalone COTY business, we project that gross margins will be slightly up in FY16 and flat in FY17, with cost cuts largely offset by lack of volume leverage and a mix shift away from the higher-GPM Fragrance segment. For P&G, we assume that FY17 gross margins expand by +100bps from FY15 levels, despite declining revenues, as COTY begins to realize its targeted $150MM in synergies (equating to roughly 3% of standalone P&G sales) by consolidating P&G’s manufacturing footprint.

We project Adj. OPM of 13.0% in FY16 (vs. the “street’s” 13.2%) and

14.3% in FY17 (vs. 14.5%). Our model assumes that standalone COTY reduces SG&A spend by a low single-digits percentage (after adjusting for FX), driven by reduced advertising and payroll & other costs. We assume that SG&A as a % of P&G sales declines by -20bps from FY15 levels, again despite declining revenues, as COTY cuts costs. 7. Valuation “Street” analysts and investors value COTY on the assumption that the P&G merger will close in July 2016. Once the merger closes, we estimate there will be 760MM shares outstanding for the combined entity. At COTY’s current share price of $28.67, or 23x the “street’s” FY17 EPS projection of $1.26, this implies a market value of $21.8B.

COTY’s net debt as of Sep-30 was $2.4B, and it will borrow another $1B to fund the acquisition of Hypermarcas. Assuming that COTY incurs the minimum $1.9B in debt from P&G, that results in total net debt of $5.3B, for an implied,

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post-merger enterprise value of $27.1B. This represents a 14.3x multiple on the “street’s” FY17 adj. EBITDA projection of $1.9B.

At current multiples to FY17 EPS and EBITDA (23x and 14x, respectively),

COTY is trading in line with peers EL and L’Oreal: EL currently trades at 23x FY17 EPS and 13x EBITDA, while L’Oreal (OR FP) trades at 24x and 14x, respectively. However, consensus expectations for growth at EL and L’Oreal are higher than for COTY, in part because these larger peers are much less indexed than COTY is to Fragrance (which is generally viewed as an unattractive market within Beauty) and are more indexed to skin and facial care (which is viewed as the most attractive). Analysts project revenue growth in the mid single-digits for both EL and L’Oreal, but only low single-digits for the combined COTY/P&G.

The “street” has an average price target on COTY of $29.50, or 23x its

FY17 EPS projection. Sell-side analysts justify applying the same multiple as EL and L’Oreal, despite COTY’s lower growth versus these peers, by citing the “strategic optionality” of existing COTY management. If our fundamental thesis is correct, and the “power brands” strategy is unsuccessful, the “halo” around COTY management is likely to diminish, and with it the stock’s premium multiple.

Our price target of $20 represents 18x our FY17 EPS projection of $1.11.

The implied EV of $20.5B (assuming $5.3B of net debt) represents 12.1x our FY17 Adj. EBITDA projection of $1.7B. This 15%-20% discount to the multiples awarded to EL and L’Oreal is justified, we think, by COTY’s long-term structural growth challenges and higher balance sheet risk (with leverage >3x versus 0.5x for EL and net cash of $9B for L’Oreal).

By comparison, we also look to P&G, another consumer business facing

top-line growth challenges, which trades at 17x FY17 earnings and 12x FY17 EBITDA, despite offering a 3.6% dividend yield. If our thesis is correct, we would expect the market to treat COTY similarly. 8. Risks The biggest risk is that margins could be higher than we project. COTY’s management team has a reputation for having skilled operators and adeptness at cost-cutting. We have tried to be conservative in projecting margins (modeling a +230bps expansion in Adj. OPM between FY15 and FY17, despite our projection for negative revenue growth), to take this into account. It is also possible that management could announce that it expects higher synergies from the P&G merger than previously estimated.

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9. Financial projections Annual projections

(FYE June) FY13 FY14 FY15 FY16E FY17E Revenue 4,649 4,552 4,395 4,276 9,304 COGS 1,860 1,866 1,757 1,679 3,279 Gross profit 2,789 2,686 2,638 2,597 6,024 SG&A 2,261 2,151 2,086 1,979 4,622 Amortization 90 86 75 76 76 Restructuring & other 43 423 82 105 64 GAAP EBIT 394 26 395 438 1,262 Interest expense 77 69 73 96 177 Other expense (income) -1 1 89 0 0 EBT 319 -44 233 342 1,085 Income taxes 117 20 -26 -3 271 GAAP tax rate 36.6% -45.6% -11.2% -0.9% 25.0% GAAP net income 202 -64 259 346 814 NCI 34 33 27 28 28 GAAP net inc. to COTY 168 -97 233 317 786 GAAP EPS (FD) $0.42 -$0.26 $0.64 $0.82 $1.03 FD shares 396 382 363 347 760

Non-GAAP adjustment GAAP EBIT 394 26 395 416 1,262

Adjustments 179 475 134 139 69 Adj. EBIT 573 501 529 555 1,331 Interest expense 77 69 73 96 177 Adj. EBT 496 432 456 460 1,155 Adj. income tax 140 81 68 6 289 Adj. tax rate 28.2% 18.8% 15.0% 1.3% 25.0% Adj. net income 356 351 388 453 866 NCI 34 33 28 28 20 Adj. net income to COTY 322 318 360 425 846 Adj. EPS (FD) $0.81 $0.83 $0.99 $1.17 $1.11

% of sales Revenue 100.0% 100.0% 100.0% 100.0% 100.0%

COGS 40.0% 41.0% 40.0% 39.3% 35.2% Gross profit 60.0% 59.0% 60.0% 60.7% 64.8% SG&A 48.6% 47.3% 47.5% 46.3% 49.7% GAAP EBIT 8.5% 0.6% 9.0% 10.2% 13.6% Adj. EBIT 12.3% 11.0% 12.0% 13.0% 14.3% EBT 6.9% -1.0% 5.3% 8.0% 11.7% GAAP net income 4.3% -1.4% 5.9% 8.1% 8.8% NCI 0.7% 0.7% 0.6% 0.7% 0.3% GAAP net inc. to COTY 3.6% -2.1% 5.3% 7.4% 8.4% Adj. net income to COTY 6.9% 7.0% 8.2% 9.9% 9.1%

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Y/Y% Revenue 0.8% -2.1% -3.4% -2.7% 117.6%

COGS 2.0% 0.3% -5.8% -4.5% 95.3% Gross profit 0.1% -3.7% -1.8% -1.6% 131.9% SG&A -1.1% -4.9% -3.0% -5.2% 133.6% GAAP EBIT NM -93.5% 1437.4% 10.8% 188.2% Adj. EBIT 6.9% -12.6% 5.7% 4.9% 139.9% EBT NM NM NM 46.8% 217.0% GAAP net income NM NM NM 33.3% 135.5% NCI 9.0% -2.1% -19.0% 5.6% -1.4% GAAP net inc. to COTY NM NM NM 36.5% 147.7% Adj. net income to COTY 7.3% -1.5% 13.2% 18.2% 99.1% Adj. EPS 4.3% 1.7% 19.6% 18.5% -5.1% FD shares 3.1% -3.7% -4.9% -4.4% 118.9%

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Quarterly projections

Jun-15 Sep-15 Dec-15E Mar-16E Jun-16E Revenue 1,020 1,112 1,191 927 1,045 COGS 414 444 457 365 414 Gross profit 605 669 734 563 632 SG&A 559 484 507 442 546 Amortization 19 19 19 19 19 Restructuring & other 51 84 14 14 14 GAAP EBIT -23 81 194 88 53 Interest expense 17 16 25 27 27 Other expense (income) 0 0 0 0 0 EBT -40 66 169 61 26 Income taxes -66 -67 42 15 6 GAAP tax rate 163.5% -102.3% 25.0% 25.0% 25.0% GAAP net income 26 133 127 45 19 NCI 5 7 9 7 5 GAAP net inc. to COTY 21 125 118 38 14 GAAP EPS (FD) $0.06 $0.34 $0.33 $0.11 $0.04 FD shares 369 370 359 347 347

Non-GAAP adjustment GAAP EBIT -23 81 194 88 53

Adjustments 83 92 16 16 16 Adj. EBIT 60 173 210 103 68 Interest expense 17 16 25 27 27 Adj. EBT 43 157 185 76 41 Adj. income tax 9 -69 46 19 10 Adj. tax rate 20.3% -44.1% 25.0% 25.0% 25.0% Adj. net income 35 227 138 57 31 NCI 5 7 9 7 5 Adj. net income to COTY 30 219 129 50 26 Adj. EPS (FD) $0.08 $0.59 $0.36 $0.14 $0.08

% of sales Revenue 100.0% 100.0% 100.0% 100.0% 100.0%

COGS 40.6% 39.9% 38.4% 39.3% 39.6% Gross profit 59.4% 60.1% 61.6% 60.7% 60.4% SG&A 54.8% 43.5% 42.5% 47.6% 52.2% GAAP EBIT -2.3% 7.3% 16.3% 9.5% 5.0% Adj. EBIT 5.9% 15.6% 17.6% 11.2% 6.5% EBT -4.0% 5.9% 14.2% 6.5% 2.5% GAAP net income 2.5% 11.9% 10.6% 4.9% 1.9% NCI 0.5% 0.7% 0.8% 0.8% 0.5% GAAP net inc. to COTY 2.1% 11.3% 9.9% 4.1% 1.4% Adj. net income to COTY 2.9% 19.7% 10.9% 5.4% 2.5%

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Y/Y% Revenue -2.1% -5.9% -5.4% -0.7% 2.5%

COGS -7.7% -8.0% -10.2% 3.6% -0.1% Gross profit 2.1% -4.5% -2.2% -3.3% 4.3% SG&A 7.0% -6.9% -5.6% -5.0% -2.4% GAAP EBIT NM -32.3% 5.8% -23.4% NM Adj. EBIT 20.5% 3.8% 4.5% 2.5% 13.8% EBT NM NM NM NM NM GAAP net income NM NM NM NM NM NCI -37.0% 21.3% -5.3% 4.5% 8.7% GAAP net inc. to COTY NM NM NM NM NM Adj. net income to COTY 202.0% 113.6% -20.7% -21.3% -12.1% Adj. EPS 211.8% 110.7% -19.9% -19.5% -6.5% FD shares -3.8% 1.5% -1.0% -2.2% -6.1%

Financial metrics

Price $28.67

Shares* 760 MV $21,789

Net debt* $5,245 EV $27,034

Book value $875 TBV -$2,543

FYE Jun-30 FY15 FY16E FY17E* Adj. EBIT 529 555 1,331 Adj. EBITDA 760 789 1,697 SCF (NI + D&A - CapEx) 303 355 862 CFFO 526 601 1,263 CapEx -171 -203 -318

EV/EBITDA 35.6x 34.3x 15.9x EV/(EBITDA - CapEx) 45.9x 46.1x 19.6x

*Assumes completion of P&G merger, July 2016. Assumes COTY takes on minimum $1.9B P&G debt.