In summary, I think there are attractive reasons to hold Estee Lauder $EL but on a risk/reward basis the stock is hardly a good value. That may seem a glib observation and, it doesn’t take much to look at a stock on a PE of 28 and say it's ‘overvalued, but that shouldn’t detract from the subtle complexity of the underlying profit drivers here. Many of which could appeal to some investors.
In this article, I want to focus in three issues: the weighting of product growth towards skin care which has strong long term prospects, the strategic shift that the company underwent to chase emerging market growth, and the Strategic Modernization Initiative (SMI) by which management is making operational changes in order to generate step changes in performance.
Estee Lauder’s Q3 Results
This was a tricky quarter for Estee Lauder as it was up against tough comparables brought on by the timing of SAP launches across geographic regions. Last year, a launch took place in April which caused orders to be accelerated beforehand in Q3 (thus making Q3 last year seasonally stronger) whilst this year, a launch took place in January which had the effect of pulling orders ahead into Q2 of 2012. No matter, adjusting for these effects saw constant currency sales growth coming in at a respectable 9%.
Its products are tailored more towards the prestige end of the cosmetics industry rather than the mass market of a company like Avon $AVP or even Revlon $REV Whilst advertising spending was up, management was keen to state that sales growth wasn't driven by promotions.
However, 9% growth isn’t enough for a stock on a rich evaluation. Analysts queried the growth outlook and, of particular concern was the note of caution over China in the results.
Excluding the order shift impact, reported sales in the Americas, EMEA and Asia/Pacific would have increased 5%, 9% and 9% respectively. In isolation, management stated that in China constant currency growth was up 14%. The results in Europe were particularly strong, but investors need to recall that a lot of sales are increasingly coming from Asian travel shoppers who are on vacation. Furthermore, this quarter contained the Chinese lunar year holiday.
Turning to guidance, operating margins are predicted to increase 120bp this year with EPS of $2.21-2.26 and free cash flow (FCF) of $675m (operating cash flow-capital expenditures). Given a share price $60.72 and Enterprise Value (EV) of $23.6bn this puts the stock on a forward PE of 27.1x and a FCF/EV yield of 2.9%. Even if we normalise capital expenditures to, say a $300m depreciation assumption, the FCF Yield is still around 3.4%.
It’s not a cheap stock.
Skin in the Game?
A quick look at the composition of sales to the nine months of 2012.
Note that revenue appears to be pretty evenly spread, but the real earnings driver is coming from skin care. Not only is this the fastest growing category in revenue terms (16%) but it is also where the profit growth is coming from.
Indeed, skin care is a hot industry right now and it looks set for continued growth. An aging demographic and a heightened awareness of grooming products within an increasingly urbanized population, suggests that long term prospects look good.
Companies like Nu Skin Enterprises $NUS and Beiersdorf (Nivea) are seeing continued strong growth. Another two companies worth mentioning in the context of Estee Lauder are International Flavors & Fragrances $IFF and Germany’s Symrise. Both are exposed to the scent market and the kind of growth rates achieved by Estee Lauder in fragrances is not signaling good news.
An Emerging Market Growth Story?
What characterises Estee Lauder is that it expanded aggressively within emerging markets. However, within this remit there are a variety of trends emerging. Within China it appears that the rate of growth in the major cities is slowing and the real acceleration is shifting towards the second tier cities. In a sense, this is completely natural because it reflects shifting growth patterns in China. However, I am concerned that there is a property bubble which is just about to deflate in China. Even if this does not result in a slowdown in absolute sales to China, this stock is priced for strong growth rather than a moderation in China.
Similarly, although Brazil is the fastest growing market for the company, there is a strong case to be made that Brazil is largely a play on China. A lot of Brazil’s marginal growth comes from the exportation of huge quantities of both hard and soft commodities. If you are sanguine about the risk with emerging markets this year, than you will see this exposure as a potential benefit. If, like me, you are increasingly cautious then it would be dangerous to price too much optimism in.
Estee Lauder’s Operational Initiative
The company is in the middle of implementing the previously mentioned SMI. It is a program of heavy investment intended to produce $700-750m in savings by the end of 2013. The cost of which, will see its heaviest outlays coming in 2012-13. Essentially, it is an SAP roll out which will enable the company to globally integrate processes and management functions. The end result should create greater efficiencies in things like inventory management, distribution, advertising return on investment (ROI) and warehousing requirements.
Quantifying the end result will be difficul,t but a good example was given by the management in terms of inventory turn. Estee Lauder believes it can reduce inventory turn from 3x to around 2x in the future, with the changes made via the SMI. To put this into context, last year the cost of revenue was $1.94bn with average inventory through the year of around $911m. In other words a ratio of 1.94/.911=2.1x now if the company can get this ratio to 3x it implies inventory of only $645m or a saving of $266m in working capital requirements.
All of which is impressive and when analysts start pencilling in some assumptions with improvements from the SMI, suddenly the current evaluation does not look so exorbitant.
What's Next for Estee Lauder?
On one hand, the stock offers a compelling mix of emerging market growth, a top quality skin care division and the potential for a re-rating based on operational improvements from the internal SMI. On the other hand, it is really only skin care that is growing strongly and the reliance on emerging market growth may well prove problematic in the future. In addition, in the results to Q3, EMEA made up 46.9% of income, with the Americas and Asia/Pacific at 27.2% and 25.9% respectively. It is clear that Estee Lauder cannot rely on the Americas region to save the day should Europe and China start to weaken. Throw in the expensive evaluation and this is not a stock I would be chasing.
A soft landing in China coupled with a successful resumption to growth in the Euro Zone in the second half would be a big plus, but there are likely to be cheaper ways to take risk on these themes than Estee Lauder at the moment.