Estée Lauder: Strong Business But Not At The Right Price (NYSE:EL)

Some opening remarks

First I would like to start by repeating the following phrase once again: Estée Lauder (EL) is a high quality business. I would only briefly touch upon this point in the next paragraph since this statement is not very hard to justify.

However, there are two dimensions to making a successful investment:

  • investing in high-quality businesses with sustainable competitive advantages
  • not overpaying for these businesses

The first part is relatively easier to establish (although not always that straightforward), but the second one is much more contentious and open to interpretations. That’s why in this article I will spend much more time on the company’s valuation and why I believe that although EL deserves to be priced at a significant premium to its peers there are limits to the amount that one should be willing to overpay for a good quality business.

Estée Lauder is a high-quality business

The company has some of the best operational performance metrics within the industry and by pivoting towards the right category of the beauty business – skin care, has managed to emerge as the best company to own in the space.

Source: Yahoo! Finance

Estée Lauder was by far the best-performing beauty business within the peer group, returning more than 400% over the past decade and followed by the other two strong names in the sector L’Oréal (OTCPK:LRLCF) and Shiseido Company (OTCPK:SSDOY). The rest of the peers had a rather disappointing performance over the period.

Estée Lauder alongside L’Oreal also stands out from the crowd with high and stable Return on Invested Capital, while many of the peers in the sector are struggling to achieve profitability alone.

Source: morningstar.com

Gross profitability driven by some of the strongest brands in the space is another area where EL excels.

Source: author’s calculations based on data from annual reports.

Estée Lauder alongside L’Oreal are two leaders in the half a trillion industry by a large margin to their peers.

Source: author’s calculations based on data from annual and quarterly reports

Such a disparity in such a big industry would naturally result in the leaders being priced at a significant premium to the rest, while perhaps the laggards being priced overly conservatively due to their struggles to achieve consistent profitability.

Finally, the company has relied much more on organic growth when compared to most of its peers. Becoming one of the largest and highest returning companies in the space without going on an acquisition spree is yet another important feature of EL.

Source: author’s calculations based on data from annual and quarterly reports

Share price disconnect from fundamentals

As I said earlier, no matter how good a business is, one should always have a limit on the price that is willing to pay. Even though the notion of overpricing is somehow elusive and up for interpretation, in my view, EL is reaching the upper limits of its premium valuation.

To start with, Return on Equity and market premium on book value of equity are almost always in a strong positive relationship, especially in a stable industry such as consumer staples.

In the case of EL, last three years have been significantly out of sync, with P/B hovering significantly above what the achieved ROE would suggest.

Source: author’s calculations based on data from annual and quarterly reports and Yahoo! Finance

On a time-series basis, EL now trades at an all-time premium relative to its operating profitability. As we could see down below, historically, P/S multiple has been relatively consistent with operating profitability.

Source: author’s calculations based on data from annual and quarterly reports and Yahoo! Finance

This margin-P/S relationship was broken in 2019 and became even more distorted during the past twelve months.

With the high level of advertising and promotions necessary to fuel the growth, fixed costs have been relatively stable over the past decade. Thus, the company’s operating profitability has been fairly consistent with gross margins, driven by the significant price premium achieved for Estée Lauder’s products.

Source: author’s calculations based on data from annual and quarterly reports

Nevertheless, last two years once again stand out from the fairly stable historical relationship. EL has managed to keep its operating profitability stable, in spite of the significant fall in gross margins, which suggests cost-cutting of SG&A expenses.

As we could see below, one of the actions taken to tackle the declining gross profitability has been to reduce advertising, merchandising, sampling, promotion and product development costs as share of sales which has widened the gap with EL’s main competitor – L’Oreal.

Source: author’s calculations based on data from annual and quarterly reports

Although this is not necessarily a huge risk, investors should be wary of too extreme cost-cutting measures in order to achieve higher valuations. More importantly in the case of EL, the company’s ability to further cut advertising & promotion costs, without sacrificing growth, seems limited.

Skin Care doing the heavy lifting

EL’s leading role in the skin care segment has been crucial for the company’s well-being. The segment’s already high margins in 2005 expanded significantly over the past 15 years as EL delivered some of the most popular premium products in the space. Compared to the company’s other three product segments, skin care appears to be doing the heavy lifting in terms of operating profitability with a significant gap to makeup, fragrance and hair care.

Source: author’s calculations based on data from annual and quarterly reports

On top of higher margins, over the reviewed period the revenue share of the high margin skin care unit increased from 38% in 2005 to 48% during the last twelve months, while the low margin fragrance stagnated from 20% to 12%.

Source: author’s calculations based on data from annual and quarterly reports

In comparison, L’Oreal has a more balanced segment exposure while at the same time achieves higher operating profitability than EL. This suggests that L’Oreal is executing much better than EL outside of the Skin Care segment.

Source: L’Oreal CAGNY 2020 Presentation

As a result of EL’s increased share in the skin care category, operating profitability improved significantly over the 15-year period, from 11.6% in FY 2006 to 16.1% in last twelve months.

Not only has EL capitalized on its strong brands in the skin care segment but it also benefited heavily from the premiumisation of the category.

The premiumisation phenomenon is not just a preserve of the East. Skin care now accounts for 22% of global prestige beauty sales with a value growth of 6%, according to the NPD Group, and super premium and natural and healthy lifestyle brands are leading the way.

Source: link

Estée Lauder and La Mer brands are leading in the premium skin care segment, while Clinique is one of the strongest US beauty brands.

Source: gartner.com

Even though strong brands are hard to replicate competitive advantages that often provide both volume and price premium, competition in the space seems to be intensifying. On one hand, a large number of newly emerging small companies based around more natural products are entering the space.

The market is highly competitive with large multinational companies dominating it. However, over the past few years, numerous smaller companies have gained share in this market on account of increasing consumer interest in natural beauty products, particularly in Europe and North America

Source: grandviewresearch.com

To stop the emerging competition, many of these brands have been acquired by large cap beauty companies, sometimes at very high price tags. EL has also been very active in acquiring smaller beauty and skin care brands, benefiting from the ultra-low interest rate environment.

Lured by the high returns on capital, new large cap players are also entering the space.

Source: forbes.com

In a surprising move, Colgate-Palmolive entered the space with two acquisitions of PCA Skin and EltaMD in 2017, betting on its expertise in selling products through the professional channel.

The company then went on with one of its largest acquisitions ever of the French Skin-Care Brand Laboratoires Filorga Cosmétiques for the hefty price tag of $1.69 billion.

Source: filorga.com

Although this move was one of my reasons to abandon CL for the time-being, the company is ready to invest heavily in the space and is yet another deep-pocket, large-cap peer entering the space and trying to steal EL’s lunch.

Although not in skin care, Unilever has also been pivoting towards the beauty space with some of its acquisitions, such as Hourglass.

Source: fashionnetwork.com

KKR has also entered the space with its deal with COTY, while the Brazilian giant Natura & Co. has become the fourth-largest beauty group with its acquisitions of Avon and The Body Shop.

Even though the hegemony in the beauty space of Estée Lauder and L’Oreal will be hard to challenge, the two companies will likely see an increased competition in the future, especially in the most lucrative space – skin care.

Free Cash Flow perspective

As a stable and predictable business, EL’s share price has been closely following the company’s free cash flow. Not surprisingly then the large free cash flow jump in FY 2018 coincided with EL’s share price going from a range of around $140 to $200.

Source: author’s calculations based on data from annual and quarterly reports and Yahoo! Finance

This just highlights the importance of fundamentals, such as free cash flow for EL’s share price performance.

Going back to margins, operating profitability has been in an invert relationship with free cash flow yield, which shows how important margins are for the company’s free cash flow generation ability.

Source: author’s calculations based on data from annual and quarterly reports and Yahoo! Finance

Thus EL’s share price has been driven up by the absolute increase in FCF alongside FCF yield repricing, prompted by higher operating profitability. Therefore, in order to keep its premium valuation, EL will have to at the very least retain its high operating profitability and fend off any emerging competition in the skin care space.

On a discounted cash flow basis, EL also appears to be valued too favorably.

During the past 10 years, FCF grew at 10.9% annually, going up from $686m in 2010 to $1,935m in the last twelve months. Although I highly doubt that such a spectacular growth in FCF will be achieved during the next 10 years, I will assume the same growth rate for that period and somehow higher than the normal rate of inflation growth rate of 3% after that.

Applying cost of equity of 7.7%, based on beta of 0.79, normalized risk-free rate of 3.0% and equity risk premium of 6.0%.

Thus, if EL manages to sustain its free cash flow growth rate of the past decade over at least 10 more years, the company’s implied share price is $219, or merely 5% above the current share price of $205.

However, there are a number of important points that need to be kept in mind:

  • Firstly, this is just an illustrative DCF model aiming to show the kind of growth rate that investors should expect in order to justify the current price.
  • Secondly, investors should be mindful of the risks for EL’s profitability and free cash flow generation going forward.
  • Finally, there is a good reason why EL’s share price might continue to be detached from the company’s fundamentals, but I consider this scenario as way too speculative.

On the last point, this does not appear a very unlikely scenario given the poor condition that many of EL’s peers are currently in. This could usually lead to competitors at the bottom becoming even more conservatively priced, while leaders achieving even higher premiums to their fundamentals.

Although I do recognize that this is a real opportunity, especially in the current challenged economic environment, relying on such a scenario is based purely on speculation and I would not consider it as a basis for investment.

Conclusion

Estée Lauder is without a doubt one of the strongest companies in the beauty and cosmetics space. The company has many features of a strong business and those skillful enough (or lucky enough) to have spotted the opportunity post the 2009 crisis have enjoyed the largest returns in the large cap beauty sector.

However, as prices could overshoot on the downside when bad things happen, the same could happen on the upside and at the moment EL appears to be in that spot. The company’s current share price appears to be detached from its fundamentals, while at the same time more competition is entering the space and threatening EL’s exceptional profitability in the skin care segment.

Bearing these two conflicting points in mind, my best point of action at this point is the following;

  • I keep EL on my radar as one of the best companies in the space, but will await better valuations in order to pull the trigger.
  • If I were owning the shares and sitting on some profits, I would consider trimming the position down a bit, taking some profits and waiting for valuations to reverse back to fundamentals once again.
  • I would never think of shorting the stock.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author’s opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies’ SEC filings. Any opinions or estimates constitute the author’s best judgment as of the date of publication, and are subject to change without notice.

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