With US economic growth set to decelerate in the fourth quarter after an expected bounce in the third quarter and the global economy still sluggish, investors who are already positioning for 2017 and beyond might want to use the opportunity to look at stocks that could see long-term upside as the domestic and global economies recover and expand.
One such stock is The Estee Lauder Companies (NYSE:EL), which is now essentially unchanged in 2016 after having risen by much as 10% this year as economic, societal and political worries in major markets like the Middle East and Europe (particularly the UK with Brexit) caused the company to issue cautious guidance for its fiscal 2017 (which began in July).
Estee Lauder actually has a not-so-pretty dividend yield of 1.36% - or around 80-basis points lower than the 2.13% yield of the S&P 500, of which it is a component. This yield also is about 30-basis points less than that of its peer group - though it should be noted that its cohort consists of companies such as Colgate Palmolive (NYSE:CL) and Kimberly-Clark (NYSE:KMB) which aren't really direct competitors.
Consequently, investors who buy Estee Lauder shares can expect to receive a total of just $136 in dividend checks each year they hold their stock. In that sense, investors who buy it today should do so with the understanding that they're not necessarily doing it for the dividend income but rather the prospects of capital gains once the global economy recovers.
Looking ahead to fiscal 2017, Estee Lauder anticipates a 6% to 7% increase in its net sales, with currency effects expected to cause less than a 1% drag on its reported revenues - or around $0.08 less of earnings per share. Brexit has had less of an impact on the broader currency markets than anticipated so we feel confident that the currency drag on Estee Lauder's profits will be as minimal as forecasted.
That being said, with the news headlines being what they've been, Estee Lauder has every reason to worry about uncertainty - sales of its products are dependent on consumers' sense of economic well-being that, in turn, fosters a strong climate for tourism. Consequently, Estee Lauder has indicated that it expects slower growth from the United States, Europe and "some emerging markets" in the face a number of political and economic headwinds in the coming months (such as elections, terror worries, immigration concerns and crime).
Dividend and Outlook. Estee Lauder expects between 8% to 10% earnings growth on a constant currency basis in fiscal 2017. While an average of 9% earnings growth shouldn't be dismissed out of hand, it would be around 4 points slower than the 13.4% constant currency growth rate that Estee Lauder registered in fiscal 2016.
The silver lining is that Estee Lauder still expects to see "double-digit EPS growth" over the next three years. Beyond product launches and potential M&A activity - both of which are unpredictable in their success - Estee Lauder has indicated that some of this will come from reducing its operating leverage - an obvious and necessary tactic.
To illustrate: while Estee Lauder has an industry-leading gross margin of nearly 81%, its operating margin is a paltry 14.3%. This was because its operating overhead ate up 65% of its net sales. Had Estee Lauder's operating overhead been 5% lower in fiscal 2016, its earnings per share would have been $1.12 higher. Estee Lauder paid out $1.20 in dividends against earnings of $3.20 in fiscal 2016 so the same payout ratio at our higher theoretical earnings number would have meant an additional $42 cents of dividends - or another quarter's worth at the current rate.
The only issue with reducing operating overhead is that a lot of Estee Lauder's product image and branding are tied to its extensive advertising and marketing campaigns in addition to its various boutique establishments. Managing the associated costs without diminishing its brands will be a challenge - but we believe a 5% reduction is something that is easily achievable by Estee Lauder's management.
Investors who buy Estee Lauder should be encouraged by its very stable financials - across measures of liquidity and leverage, Estee Lauder is better than the industry average. What's more, the company generated free cash flow of nearly $520 million in fiscal 2016 and, to the extent that it's able to attain its targets for fiscal 2017, it is likely that it will generate between $500 to $600 million in free cash flow, enabling it to easily pay dividends worth $420 million.
Given the relative slack in its cash flow, we would not rule out EL making a 5% to 10% dividend increase - and the company is also likely to continue repurchasing stock - at current market prices, it still has around $1.6 billion worth of shares to repurchase and looking at its recent history, it is likely to repurchase half that amount.
Estee Lauder is currently trading at nearly 30-times its trailing earnings, which would put it above the S&P 500's 24.5-times earnings. If we assume that Estee Lauder will see earnings growth of 10% this year, its forward ratio dips to 25-times earnings - which is around 7 points above the S&P500's forward ratio.
In our view, most of Estee Lauder's value is still to be realized three to four years ahead, when a more economic and political environment - as well as operational right-sizing, help Estee Lauder achieve higher levels of earnings growth. This being the case, we don't see the company being worth what it is right now. Instead, we would argue that it should trade at around 25-times our forward estimate, which means a target price of $86 per share - or far less than the $103.5 consensus price target. In practical terms, this means that the stock is fairly valued today.
Considering that the overall market is highly overvalued, the consensus target is an odd one because it presumes that Estee Lauder should trade at 30-times its forecasted 2017 earnings. While it's certainly true that Estee Lauder is a low beta stock (0.83), a large market correction would still impact Estee Lauder's shares significantly, particularly if external shocks cause a hefty reduction in spending on luxuries and tourist travel. There's nothing in Estee Lauder's portfolio of prestigious products that suggests that it should be particularly immune to such developments. To be sure, there are always going to be individuals or groups that can afford Estee's prestige goods - but Estee needs broad-based rather than niche growth to satisfy its lofty multiple.
In our view, Estee Lauder's valuation is simply too rich considering the environment the company is facing as it's already acknowledged with its cautious forecasts. Consequently, we believe that it is likely to see a reduction to between 22 to 25 times its trailing earnings (from its current 30) over the coming months as its fiscal 2017 results start to be reported and recommend that patient investors use that as an opportunity to buy the stock as a long-term play.
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: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Company financial data is taken from the company’s latest SEC filings unless attributed elsewhere. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.