An Options Play To Protect An Estee Lauder Investment

| About: The Estée (EL)

Estée Lauder (NYSE:EL) is a company that specializes in high-end beauty products such as makeup and skin care aids. Founded in 1946 by Joseph and Estée Lauder, the New York-based company currently trades for $57.78 per share while paying out a $0.525 (.90%) dividend annually. According to the company's most recent conference call, it seems that Estée Lauder has not only enjoyed tremendous financial success in its past quarter, but it expects even higher earnings and greater growth in the near future.

In its Q1 2012 earnings call, Fabrizio Freda, the president and CEO of Estée Lauder, pointed out that the company has increased overall sales by 18% over the pervious year. Furthermore, global luxury sales are expected to climb approximately 13% this year. Meaning that companies that deal in luxury items, such as Estée Lauder, should benefit from this increase. Freda also noted that the company has made significant strides working in foreign markets, particularly in China. According to Freda, Chinese sales in the local currency grew 34%; in aggregate, sales in such emerging markets grew 23% this quarter, showing a huge jump and larger financial prospects for the company's future overseas.

In fact, the stunning growth seen by Estée Lauder in China is testament to the company's ability to operate via online marketing. Though the company only has a "physical presence" in 42 Chinese cities, according to Freda, its E-commerce platform allows for customers in 345 Chinese cities to have access to its products. Richard W. Kunes, Vice President and CFO, explained that the company's overall online business saw a 25% growth, further demonstrating the importance of online marketing and accessibility for Estée Lauder. Clinique, one of Estée Lauder's cosmetic brands, actually does most of its business outside North America, greatly assisted by a wide television and digital presence.

Lynn Greene, Global President of Clinique, discussed the brand's success during the conference call. In the United States, despite competition from Avon (NYSE:AVP) and Revlon (NYSE:REV), Clinique is the top brand of skin care products; interestingly enough, this fact also holds true in Russia. Increased television marketing for Clinique has also helped perpetuate a television and digital revolution for the brand, and Greene expects that Clinique will continue to prosper in European markets, partially due to this increased exposure.

In the same conference call, Richard Kunes reported many of the company's major financial figures. Net earnings for the company were up a startling 45% for the first quarter of 2012, totaling $281 million. In local currency, skin care sales were up 20%, complemented by a 13% increase in makeup sales. Interestingly enough, although Estée Lauder deals in high-end, luxury skin care products that could be considered unnecessary or frivolous spending, the end of 2011 placed the company in a strong financial position despite the current-albeit-recovering-negative economic climate for such businesses. Additionally, sales in Europe, the Middle East, and Africa were up 19% in local currency, proving that the company's overseas business is strong on multiple fronts.

Estée Lauder also saw decreased operating expenses this past quarter. In fact, the company saved $44 million this quarter, and, as a total figure, expects to save between $100 million and $125 million over the next year. This decrease in operating expenses was met with $81 million being spent on capital expenditure: these savings definitely bode well for the company's future prospects, as it proves that Kunes and the company's other financial operatives are able to successfully cut the unnecessary operating costs while the company grows.

As far as competition goes, Estée Lauder, while not running unopposed in the cosmetics industry, has certainly placed itself above its competitors. The aforementioned Avon has approximately one-third of the market capitalization of Estée Lauder, and it has not kept pace with Estée Lauder's rate of growth in the past year. To put things in perspective, Estée Lauder boasts a 78.4% gross margin, up from its past quarter.

Estée Lauder's stock has been a juggernaut over the last two years, more than doubling as shown below: (Click to enlarge)

The company has very expensive trailing and forward Price-to-Earnings (P/E) ratios of 30 and 23, respectively. Any whiff of bad news from the company in its upcoming earnings release on Friday, February 3, 2012 and the stock price could plummet to its previous support level in the $45 price range. An investor might consider a collar position for the company in order to provide some protection against any bad news. A collar may be entered by selling a call option against the stock and using some of the proceeds to purchase a protective put option.

Some available collar positions are shown below: (Click to enlarge)

The position in the 8th row in the table has an attractive unchanged potential return of 2.4% (51.4% annualized), an assigned potential return of 4.4% (94.5% annualized) and a maximum potential loss of 8.5% (even if the stock price goes to zero). The position may be entered by selling the 2012 February 60 call option at $1.70 and purchasing the 2012 February $52.50 put at $0.30. A profit/loss graph for one contract of the position is shown below:

If the price of the stock is equal to or greater than the $60 strike price of the call option at options expiration in February, the position will return 4.4%. If the stock price remains unchanged at $58.89 for February expiration, the position will return 2.4%. And, for a stock price less than the $52.50 put strike price, the value of the collar will remain changed with a maximum potential loss of 8.5%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.