Estee Lauder Still Isn't Cheap Enough

In theory, there is a lot to like about the beauty, fragrance, and skin care sector. Estee Lauder's    focus on premium products plays to the return of high-end spending, while Elizabeth Arden's   fragrances have been working well this year. Meanwhile, a weak employment market should ensure that Avon Products can find representatives, and Revlon's   mass market consumer must surely be better positioned in 2014.

Moreover, an aging demographic coupled with declining marriage rates in developed markets should ensure strong demand from developed markets in the future. Meanwhile, a growing middle class in the emerging world is likely to spur prospects for years to come. On the other hand, the sector has much of this already priced into its valuation. Is there still value in the sector?

Bifurcated consumers, Elizabeth Arden and Revlon
While demographics and social trends are favoring the sector, it is not immune from economic realities. The big story in retail over the last few years has been how markets have become increasingly bifurcated. In other words, luxury goods are doing fine, and the low end has been outperforming in relative terms due to consumers trading down. However, mass market consumer products are finding life very tough.

These themes have also played out in the beauty companies. For example, Elizabeth Arden recently reported that its prestige channel sales grew 5% in its last quarter, while its mass retail sales were down mid-single digits in-line with the category. All told, its reported sales fell in the quarter.

It was a similar story with mass-market focused beauty companies like Revlon, who reported a sales decrease of 2.2% in its third quarter. Indeed, Revlon has sought to diversify its end market exposure with its $655 million acquisition of The Colomer Group, a company that sells professional beauty products to salons.

Get the Avon lady smiling again
Avon Products differs from the others in that it has a direct selling distribution model. Theoretically this makes it an attractive company in a weak employment market, because it shouldn't have difficulty in recruiting distributors. However, it hasn't quite worked out like that recently. Its core US market "continues to decline" according to its management on its recent conference call.

It gets worse. Avon has a served model transformation, or SMT, initiative with which it intends to make internal improvements to its business. Unfortunately, the pilot program in Canada led to a "steep drop in the active representative count". This is not a good sign for a company that intends to turn around its sales organization.

Estee Lauder's  focus on the premium end of the market probably makes it the most attractive company in the sector, but is it a buy?

Estee Lauder's puts and takes
As you would expect, Estee Lauder's operating performance has many things in common with its peers. 

First, the industry has had to innovate in order to stand still. Revlon's innovation has, by its own admission, had "mixed results" with its Nearly Naked face creams underperforming expectations. Similarly, Elizabeth Arden's fragrance sales suffered a slight decline in its last quarter, because these products came up against a high volume of fragrance launches last year. The lesson is that beauty companies need to keep innovating.

Unfortunately for the company, many of Estee Lauder's innovative new products for the holiday season are coming from its fragrance category. Fragrance is one of its smallest categories, and it has the lowest operating margin (10% compared to the company average of 16.8%). One concern is that Estee Lauder is investing in lower margin businesses to generate growth.

Source: company presentations

Second, the overriding lesson of retail this year has been that if you don't offer promotions you will lose market share. Indeed, Estee Lauder highlighted that the environment was "very promotional" from July to September, but its "focus was on innovation." Quoting from its recent conference call, Estee Lauder's management said:

Now we believe that our promotion, our competitiveness, during the holiday season will be dramatically improved. Our programs are much stronger, in this sense, however, we do not plan to increase promotions for the long term.

This looks like a response to tough conditions over Christmas, but will Estee Lauder be forced to promote after Christmas as well?

Finally, like Avon, Estee Lauder is undergoing a major initiative in order to improve its operational performance. Estee Lauder's strategic management initiative, or SMI, is essentially a SAP roll-out intended to improve inventory turns from two times to three times in the future. In plain English, this means it will hold less inventory in order to sell the same amount of goods.  

To be fair, the SMI is still being rolled out and it's causing disruptions to Estee Lauder's sales patterns, as retailers tend to buy in ahead of implementation. However, the plan to get the magic three multiple seems a long way away considering current trends.

Source: company presentations, author's analysis

Estee Lauder attractive but at what price?
In conclusion, theory is a wonderful thing, but reality is another. The facts are that the beauty sector is a tough market to be in right now. Avon has internal issues to deal with, Revlon is trying to diversify away from its core mass consumer market, and Elizabeth Arden is forced to innovate in order to generate growth.

Estee Lauder appears the most attractive, but it too faces concerns. Furthermore, with a P/E ratio of nearly 26 times forward earnings to June 2014, the stock is hardly a good value.

Time to Buy Some Estee Lauder?

To be or not to be? To buy or not to buy? That is our question with The Estee Lauder Companies . Whether it is nobler in the mind to suffer not buying a stock that that the market loves, or to take arms against a high valuation, revenue forecasts at the bottom end of guidance, and a management initiative that thus far isn’t quite going as planned? The good news is that unlike Shakespeare’s Hamlet not everyone is going to end up being murdered--but, being the maverick type, I favor raising arms against Estee Lauder's evaluation.

Estee Lauder’s growth prospects

I can understand why the market loves this stock and why it is willing to award it an valuation of nearly 24 times earnings to June 2014. The company has a number of attractive growth drivers:

• An aging demographic and cultural trends that will ensure the skin care business has good long term growth.

• Strong emerging market growth prospects.

• On a relative basis Estee Lauder has more focus on prestige brands than mass and is better placed than, say, Revlon  or Avon Products to benefit from the two-tier recovery whereby the high-end fares better.

• Unlike Procter & Gamble , it is a more beauty-focused company and should find it easier to innovate and react to changing consumer trends. This is incredibly important as more cultures become a bigger part of its clientele, and unlike Nu Skin Enterprises it is relying on a traditional sales channels rather than multi-level marketing.

• A strategic management initiative (SMI) is intended to considerably increase inventory management and therefore cash flow and return on investment. A key part of this is a SAP deployment.

Putting these things together creates a powerful case for the company.

On the other hand, these drivers have been known for some time. I’m not convinced that Estee Lauder is a good value or is outperforming to the extent that the market is rewarding it.

Estee Lauder’s performance could be better

For brevity’s sake I should note that I covered the stock previously in an article linked here for anyone looking for a primer or background. I have three main points to make on why I think it could do better.

First, the SMI was supposed to produce significant cost savings and improve its operational metrics. This is already happening, but by some measures we could have hoped for a bit more. In the previous article I discussed how Estee Lauder was hoping to increase inventory turn to 3x from 2x. In simple terms this just means it holds relatively less inventory and can decrease working capital requirements accordingly. Ultimately this would help increase cash flow.

Its performance over this issue is best expressed in a graph. These are my calculations based on company data.

I realize that I am probably being a bit harsh here – it is early in the SMI -- but we are still a ways away from the 3x figure. This is a metric worth following because it will guide cash flow in the future.

Secondly, the SMI has caused some short term customer service challenges, which led to some delays and products out of stock. Management claimed that these problems were largely dealt with and were expected to have been resolved by the end of the quarter, but I note that the next wave of the SMI roll out has been delayed by six months. The SMI is not entirely going as planned.

And finally, the full year revenue guidance has now been moved to 6%, which is at the lower end of the previous guidance of 6%-8%. The reason cited for this was that the overall market is now predicted to grow 3% instead of 5%.

What the industry is saying

Revlon is more exposed to the mass market and it is suffering accordingly. While declining sales in Europe are expected, the slowdown in its Chinese sales (in line with the economy) is more disappointing. Its Asia Pacific sales declined 2% mainly due to declines in its color cosmetics in China. This is not a good sign in a market that is supposed to provide its long term growth prospects.

Similarly, Procter & Gamble recently announced a net sales decline of 2% in its beauty segment. Organic volumes and sales were down 1% each. The company cited a heavy competitive and promotional environment in hair care and skin care, although sales increased in its salon professional sub-segment. This is further evidence of a bifurcation between the prestige and mass market. In fact, Procter & Gamble faces challenges in keeping market share in all of its categories.

The last two companies are somewhat less reliable indicators. Nu Skin has been reporting strong growth but I think this company is partly reliant on keeping its distributors active and motivated. Avon is in the middle of a restructuring program that will take time. Indeed, sales are still declining in the US and China. Avon is more of an internal restructuring story.

It is not a positive industry score card, and near term conditions do not look great for Estee Lauder.

The bottom line

In conclusion, while I think the company has good long term prospects, it is hard to argue that it is a good value. Moreover its near term prospects (despite the hike in EPS guidance) appear to have gotten worse. The market is giving it the benefit of the doubt for now but, I’m not sure it's time to follow it.

Is Tupperware a Good Stock to Buy on Emerging Market Prospects Alone?

Tupperware is an interesting emerging market growth stock. It offers a curious mix of significant exposure to high growth emerging markets, a secular growth story with its direct distribution model and, a relatively recession resistant business model. On the downside, currency fluctuations play a major role in dictating profitability and their established markets appear to be low growth. I’ll try to outline these points in turn.

Emerging Markets Becoming More Important to Tupperware

Firstly, here is how segmental profits have developed over the years and note how the profit mix is shifting towards Asia/Pacific…

	Percentage Share of Segmental Profits
	2005	2006	2007	2008	2009	Rolling to Q3 2010
Europe	76.68%	52.83%	45.68%	45.56%	43.18%	40.20%
Asia Pacific	13.50%	20.79%	21.40%	23.81%	23.68%	25.54%
TW N Amer	0.33%	4.77%	8.77%	10.20%	11.48%	12.90%
Beauty N A	9.22%	8.01%	27.28%	22.27%	15.73%	14.34%
Beauty Int	0.26%	13.60%	-3.13%	-1.84%	5.94%	7.01%

It's worth noting that 'Europe' includes areas such as South Africa, Russia and Turkey, which have been high growth areas for them.  They are doing well in emerging markets but there appears to be a consolidated decline within established markets.

However, the situation is somewhat affected by executive issues at Beauty North America (BeautiControl) of which, they appear to have stabilized. The latter issue is somewhat embarrassing given that the CEO Rick Goings is a former US head of Avon Products.

Developed Markets Stabilizing and Restructuring in Place

Here are the sales numbers for the divisions on a five year basis...

	2005	2006	2007	2008	2009	Rolling to Q3 2010
Total Sales	1279	1743	1981	2161.8	2127	2271
Europe	602.5	615.9	688.2	769.6	749.6	788.6
Asia Pacific	204.5	239.7	292.4	336.1	385	440
TW N Am	253.6	255.5	289.8	303.3	292.3	316.3
Beauty N A	146.7	150	461.5	460.7	391.6	400.6
Beauty Int	72	482.6	249.5	292.1	309	325.9

The issues with Beauty North America are well expressed here, but they seem to have stablized to low growth. However as noted above, this division only contributes 14% of profits. Furthermore, if we look at segmental profits...

	2005	2006	2007	2008	2009	Rolling to Q3 2010
Europe	116.4	96.3	111	123.8	143.3	153.6
Asia Pacific	20.5	37.9	52	64.7	78.6	97.6
TW Nor A	0.5	8.7	21.3	27.7	38.1	49.3
Beauty N A	14	14.6	66.3	60.5	52.2	54.8
Beauty Int	0.4	24.8	-7.6	-5	19.7	26.8

...we see that the situation has been turned around. Nevertheless, the trend of slower growth in North America (Tupperware and Beauty) appears to be established.

A Recession Resistant Business Model?

 However, as noted in the initial paragraph, although this is slower growth it is relatively recession resistant. This is because when a recession bites, Tupperware will find it easier to recruit direct sales people to go out and sell their products on a part time basis. We can see that here...

<><><><><><><><><><><><>

Active Sales Force by Segment
	2007	2008	2009	Q3 2010
Europe	97192	100,660	106,645	91,358
Asia Pacific	41361	47,370	62,419	72,726
TW Nor A	67204	75,927	86,832	88,548
Beauty N A	341,875	338,315	326,251	341,140
Beauty Int	239,802	240,758	232,137	234,029

The sales force in Europe and North America expanded dramatically during the recession. However, within Asia Pacific, an even more dramatic expansion took place.

Asia Pacific has another, more secular, profit driver. Not only is consumer discretionary picking up there, but Tupperware's direct distribution model works well in allowing women to generate part time income. A similar growth story is occurring with Avon Products, Revlon and Estee Lauder who are all, doing well within emerging markets.

Conclusions: Is Tupperware a Good Buy?

I confess to having a few concerns here. Tupperware North America appears to be set for low growth and I am also very concerned about a slowdown in developed Europe. I think increasing Sovereign Debt fears will reduce growth prospects for mainstream Europe in 2011. However, I note that this should result in an increased sales force, albeit with lower sales per person.

The emerging market growth story is compelling and, I believe, offers a cyclical (consumerisation) and secular (expansion of business model) growth story. Moreover, I expect emerging market profit contribution to be greater than that of North America by end 2011. The company already states that 60% of their sales are to emerging markets. In addition, this is including weak performance in Russia thanks to an accounting error and some one-off operational issues. Hopefully, these will be resolved.

Ultimately, I like prospects here and the way this stock will perform within a portfolio. It offers interesting and diversified profit drivers. Admittedly, it will not like strong US Dollar, but then again I am not a US resident.

 Analysts have it on an EPS of $3.62 and $4.17 for 2010 and 2011 respectively. At a share price of $47.68 this gives a PE ratio for Tupperware of 13.2x and 11.4x respectively. Furthermore, I have it on a current free cash flow yield of 5.7% which is good, considering they look set to grow earnings in the mid teens. I'll pick some up.

Source:

Tupperware Q3 Results

Interview with Rick Goings