A Big Beauty Industry Deal Might Be Coming Soon

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Nestle (NASDAQOTH: NSRGY), the Swiss Consumer Goods Company (CGC), identifies itself as a seller of “nutrition, health and wellness”. Nestle also owns 29.6% of L'Oreal (NASDAQOTH: LRLCY.PK), the French cosmetics champion (owner of brands such as Lancome and Georgio Armani's beauty products). Nestle has been a friendly long-term shareholder for almost 40 years and has controlled L'Oreal along the Bettencourt family (a +30% shareholder) without the usual disputes that characterize this kind of partnerships. That said, for diverse reasons, it looks like the time to sell has finally come. Let's see how you could profit from the potential sale of Nestle's stake in L'Oreal.

A great asset with a growing net cash position

L'Oreal has been a great asset to own. The company, which is growing sales organically at a 5.5% year-over-year rate, has been paying  growing cash dividends for decades (now at $3.2 per share) while accumulating cash reserves (the company's payout ratio is just below 50%). As a matter of fact, during 2013, L'Oreal has in place a plan to accumulate up to $650 million in cash. I expect L'Oreal to close 2013 with a net cash position of just over $2.7 billion. This cash proceeds could be used to buy a part of Nestle's shares in the cosmetics champion.

Timing looks right

As a part of a 10-year deal, L’Oréal has first refusal if Nestlé decides to sell its 29.6% stake in the company. This deal makes it tougher for any outside buyer to approach Nestle about its stake in the beauty products company. That said, this pact expires in April 2014, making Nestlé free to sell L'Oreal to any interested party. I think a deal might happen just around that time.

The reason? L'Oreal's valuation and the power Nestle would have to negotiate a good deal with L'Oreal, the Bettencourt family or any other interested buyer. While Nestle trades at an ex L'Oreal 2014 16 times P/E (making it 5% cheaper than Unilever for the first time in 25 years), the French cosmetics champion, which is up by 21% year-to-date, trades at 23.5 times P/E. This constitutes a huge premium to competitors such as Coty (NYSE: COTY), the second biggest fragrances company in the world, which sells for 18 times P/E. Given L'Oreal's unique market share leadership, the premium to Coty is well deserved even when Coty, the maker of Marc Jacobs fragrances and Rimmel cosmetics, is growing fast in emerging markets and solving its troubles with failed acquisitions (in 2012 Coty had +$320 million losses driven by +$570 million on write-downs from past acquisitions). That said, a sale of a non-core asset at a hefty multiple could satisfy Nestle's cash-loving shareholders.

Nestle shareholders might be very pleased

L'Oreal's market capitalization is just above $100 billion. A sale of a 29.6% stake in the company could fetch at least $30 billion. Since Nestle is not under a de-leverage strategy, the bulk of these proceeds could be returned to shareholders. The potential return could be as high as 14% of the group's market capitalization. I think selling L'Oreal could be a great opportunity for Nestle's management to focus on what they do best while boosting the pockets of their shareholders. After all, Nestle's main businesses are not related to eyebrow pencils, beauty creams and lipsticks. 

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