The Estee Lauder Investment Thesis
In my previous article on this company, I wrote about The Estée Lauder Companies Inc.’s (NYSE:EL) temporary troubles. However, I underestimated how long these issues would last. I still think the brands are intact and, therefore, EL can command a premium valuation, but the margin situation needs to be addressed. And the makeup division in particular is the headache.
In my opinion, a spinoff of the makeup segment could create shareholder value, allowing EL to focus on the much more profitable fragrance and skin care segments.
Estee Lauder Fiscal Q2 2024 Earnings Review
On February 5, EL reported its fiscal Q2 earnings and announced that the dividend would be the same as last quarter, $0.66. Results were mixed, beating revenue guidance by $40 million but still down 7.4% year over year. However, the forward guidance is a bit more positive, with 3% to 5% growth in the next quarter and perhaps a return to very small growth for the full year in FY24.
Unfortunately, the slowdown in mainland China and the pressure on Asian travel remain. However, the outlook is for both to return to growth in the near future. And, right now, if we look at Asia-Pacific excluding mainland China, revenue growth is in the double digits and EMEA is in the mid-single digits. So EL is still growing nicely if you take out travel and China.
In addition, EL gained some market share in China in its most important segment, skin care, as well as in fragrances. In addition, with the new factory in Asia, the supply chain will be shorter and the China Innovation Lab will hopefully find products that are perfectly aligned with the market.
And if we zoom out and look at the period from 2018 to 2023, we can see that Asia Pacific still has a strong growth rate, despite the recent struggles. But we can also see that EL is really dependent on that region in terms of future growth, as the Americas are declining and EMEA is only growing marginally.
In my opinion, EL has missed the boat when it comes to using social media, especially TikTok. Companies like e.l.f Beauty (ELF) have shown how successful it can be to respond quickly to social media trends and engage with audiences. EL needs to modernize its approach.
The international share of sales is approximately 75%, with the majority of the travel-retail business in EMEA. In addition, approximately 70% of sales are made through bricks and mortar stores, so there is still a lot of room for growth in the online market.
And if we look over the same period to see which categories are underperforming, we can clearly see that makeup is the category of concern. All the other categories are growing, and skin care in particular is extremely strong. And, if we look at the most recent EL 10-Q and the operating income margins, the problem gets even bigger.
If we look at the 6M operating income margins for 2022 and 2023, we get the following results:
- Skin Care: 11.85% in 23 and 21.35% in 22
- Makeup: Negative in both years
- Fragrance: 17.33% in 23 and 20.83% in 22
- Hair Care: Negative in both years
- Other: 43.55% in 23 and negative in 22.
And the last time makeup had a positive adjusted operating income margin was in FY22 with ~2.7%, while skin care had 28% and fragrance 17.7%. And makeup has this weak performance while MAC is still probably the biggest prestige makeup brand in the world. So, their second largest category is declining and has the worst margins. So, spinning off this category could create value for shareholders because it would immediately improve EL margins and multiples.
So, without the makeup department, EL would be much more attractive and would have healthy margins again. This one department is dragging the whole margin down. But I think EL will address this with the profit recovery plan 25/26 as they improve the channel mix and focus on the more profitable brands and segments.
While skin care margins have also almost been halved, I expect them to recover as growth in China picks up, probably later this year.
EL’s Balance Sheet and Debt
Estee Lauder’s balance sheet is quite strong, as most of its debt does not mature for several years. After the 2% Senior Notes due December 2024, the company’s next debt maturities are in March 2027 and May 2028.
However, the trend in long-term debt is still not pretty. From $1.9 billion in June 2016 to $6.6 billion in the last report is not a pleasant development. Especially since net income did not increase that much during this period. The peak was $2.8 billion in June 2021 and is only $467 million TTM. The starting point in 2016 was $1.1 billion. But normalized net income should hover around the $2 billion mark, which is still below the debt growth rate, but sufficient since debt will then be less than 3 times net income.
Estee Lauder’s Valuation
With margins down so much, EL looks very expensive at first glance. A 109x P/E multiple is just too much for such low growth. But, in this case, we have to look at normalized earnings, because I am quite sure that EL will be able to turn the wheel.
If EL gets back to $1.5 billion in net income and we take the 360 million shares outstanding, we get EPS of $4.17, which at the current price of $140 is a 33x multiple, roughly in line with the 10-year median of 36x.
Personally, I think EL can get back to $2.5 billion in net income in FY2027, which would lead to EPS of about $6.9. If we then apply a multiple of 30x, which is realistic given the brand and pricing power, we would have a share price of $207 and an upside of about 50%. A realistic target, I think.
However, if EL were to return to its all-time high net income of nearly $2.9 billion, we would be talking about EPS of $8, which could catapult the stock to $240 if the multiple is at its historical median.
If EL manages to turn around, it could provide investors with a strong return. Therefore, I am holding my position and waiting to see how they handle the situation, but I am not buying yet. I will wait for the next quarterly results and further developments. If the margins improve, especially in the makeup division, I will think about buying more.
Estee Lauders Capital Allocation
Over the past 10 years, EL has been one of the best-managed companies in the world, as evidenced by its 10Y median ROIC of 19%. The investment in Tom Ford, in particular the fragrances and the new license agreement with BALMAIN for BALMAIN Beauty, should continue to pay off in the future. I still think ROIC will go back up. Because the sentiment towards EL is too negative. As the products and brands are still in demand and the problems should be temporary, though unfortunately longer than I thought.
Dividend payments, which will be approximately $948 million in FY24, represent a growth rate of nearly 13% over the past 10 years. Should this trend continue, it would be an attractive entry point for dividend growth investors.
They have also used some money to buy back shares, but relatively little. But they have shown a willingness to return money to shareholders in the form of a growing dividend and some buybacks, and that is likely to continue after the profit recovery plan is completed.
Estee Lauder’s Reverse DCF
The guidance for FY24 diluted EPS is $2.08 to $2.23 or $2.04 to $2.20 adjusted, so I used $2.15 as the basis for my reverse discounted cash flow, or DCF, to see what is priced into the stock right now. In this case, the stock has priced in an EPS CAGR of 20% over the next 10 years. A feat that only a few companies can achieve.
But if we normalize to $4.00 EPS, we get the following situation. Now the stock is only pricing in a 12% CAGR, which is also the LT plan for EL. They want EPS back to double digit growth. So I think the situation is this: if they can get margins back to where they were, the stock is fairly valued, but if they cannot, it is overvalued.
A 12% CAGR in this situation is definitely possible, a 20% CAGR over the next 10 years probably not. The key will be to improve makeup margins or to focus even more on skin care and fragrances. And my suggestion would be to divest the makeup business or parts of it.
Risks For EL
Clinique, Estee Lauder, Tom Ford and many others are still luxury brands and therefore have pricing power and a loyal customer base. But the rise of dupes in the beauty industry and their large social media followings pose a risk. There are many websites where customers can search for the best dupes through a dupe finder that even gives them a dupe match score and suggestions on which product to buy.
And, unfortunately, some of the success of other brands in social media can be attributed to EL because their competitors saw the potential earlier and responded faster.
But the biggest risk now is that they will not regain their old strength and that net profit margins will remain in the single digits. And the margin decline is a combination of several factors including COVID, travel restrictions and increased competition. COVID and travel restrictions will soon be forgotten, but what about competition? This is where EL needs to show how it will be using social media to compete with the young brands.
For now, I’m sticking with my Hold rating for The Estée Lauder Companies Inc. because I think they have a good chance of returning to being more profitable and thus outperforming the S&P 500 (SP500) over the long term from today’s starting point. However, in order for me to upgrade the EL rating to Buy, I would need to see significant improvements in the makeup division in the next quarterly reports, or for skin care to return to 20%+ operating income margins.
If The Estée Lauder Companies Inc. consisted only of the skin care and fragrance businesses, there would be no doubt in my mind that it would continue to grow strongly with excellent margins.
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