Estee Lauder (EL) has been an excellent steward of shareholder value in the long run, even as more recent share price developments have been somewhat disappointing. Shares have been lagging so far this year, despite some recent encouraging news including a solid outlook for the upcoming year, and a nice bolt-on deal.
While valuation multiples have come down in recent times, valuations remain elevated as the entire luxury beauty products category trades at elevated multiples. To create any reasonable margin of safety, I would be cautious and not pick up shares unless they fall back towards their mid-sixties.
Estee Lauder is a huge $11 billion beauty products conglomerate active across a range of price categories, having operations across the globe.
The company is notably strong in skin care and make-up, having a more modest presence in fragrance and hair care. In these markets, Estee is a formidable competitor to the likes of L´Oreal (OTCPK:LRLCY) and LVMH (OTCPK:LVMUY), other luxury players which trade at corresponding luxury multiples.
Estee Lauder´s products can be found at various channels, although still half of sales are derived from department stores, a channel which is clearly under pressure as of late. Besides department stores, Estee sells its goods in travel retail outlets, online, through perfumeries and through independent retail stores. Notably, the online channel and specialty retailers like Ulta Salon (NASDAQ:ULTA), are key growth drivers for the company. These changes tend to inflict some pressure on the business model, as traditional advertising is shifting towards brand ambassadors, including social media.
Despite the large size and diversified positioning, Estee Lauder has seen some slowdown as well in recent times following a very decent run over the past decade. With shares down 10% so far in 2016, and having just announced a nearly $1.5 billion bolt-on move, it is time to revisit the stance of the business.
Strong Growth Slows Down
Estee Lauder has increased its sales by roughly 60% over the past decade, with revenues increasing from $7 billion in 2006 towards +$11 billion by now. Slower organic growth and a strong dollar makes that revenues have been essentially flat for 2-3 years already.
Benefits from scale and focus on luxurious products allowed operating margins to increase from 10% of sales in 2006, towards 15% at the moment. This margin expansion, top line sales growth and the fact that Estee bought back one in every ten outstanding shares, makes that earnings per share have tripled in a ten-year time window. This earnings per share growth has been a key driver behind the multi-year momentum run witnessed in the share price.
Shares rose from levels of $20 ahead of the 2009 recession to levels just shy of $100 earlier this year, before pulling back towards a current level of $77. While shares have seen some pullback, valuation multiples remain high, even on historical standards, which combined with high margins creates a potential dangerous cocktail for investors.
Recent Developments & Valuation
Earlier in November, Estee Lauder reported results for the first quarter of its fiscal 2017 already. Reported sales were up a percent, as the strong dollar hurt revenue growth by a similar percentage. The very modest growth rates are the result of sales issues in Hong Kong, poor department sales and the strong dollar.
Problematic is that quarterly operating margins fell by 140 basis points to 14.6% of sales, resulting from a strong dollar and restructuring charges.
That said, Estee Lauder is upbeat on the prospects for the rest of the year on the back of price hikes, upcoming innovation, and easier comparables. While reported sales growth came in at just 1% in the first quarter, the company is guiding for full year revenue growth of 6-7% on the back of these drivers.
Reported earnings are seen at $3.20-$3.30 per share, for a 23-24 times earnings multiple. Adjusted earnings are seen roughly $0.16 per share higher, with the discrepancy resulting from restructuring efforts, translating into a 20-21 times multiple.
The financial condition of the business remains in excellent shape. Estee Lauder holds $1.2 billion in cash and $2.5 billion in debt. The $1.3 billion net debt load is very manageable with EBITDA running at roughly $2 billion a year.
To boost the operations and use the very strong balance sheet, Estee Lauder has agreed to buy Too Faced in a $1.45 billion deal. With the deal, net debt will more than double towards $2.7 billion, as leverage remains modest at just 1.3 times EBITDA.
Too Faced is a make-up brand which has been founded in 1998, resonates well with women and is focused on online and specialty-multi channels, as well as millennials. Key products include ¨Better than Sex¨ and ¨Melted Matte.¨
Revenues of the business are seen at +$270 million this year, yet growth is spectacular as sales growth is seen around 70%. This means that Estee is paying a 5.4 times sales multiple, more than double that sales multiple at which the company itself is trading.
This creates a risk that Estee might be overpaying, after Too Faced was reportedly valued at just $500 million last year. Risks to valuation are largely the result if strong growth turns out to be the result of a hype, which has to be seen. On the other hand, a potential billion dollar write-off, in case growth disappoints, works out to just little over $2.50 per share. While that is substantial, it surely is manageable for a company like Estee Lauder.
While the deal will add merely 2-3% to Estee Lauder´s sales, it surely has the potential to contribute greatly towards the growth profile. If Too Faced can maintain current growth rates into next year, this deal singlehandedly boosts the organic growth profile of Estee Lauder by 1-2% in the coming year.
I am in doubt with regards to Estee Lauder. Shares are down 10% so far this year and have been stagnant essentially since late 2013. Combined with modest growth, share buybacks and retained earnings, the valuation has over time become a bit more appealing. This is certainly the case as the company seems to have re-found some operational momentum again given the strong outlook for the fiscal year of 2017.
That being said, shares still trade at 21-24 times earnings, depending on if you consider adjusted earnings as realistic earnings or not. With an earnings yield of roughly 4.5%, shares are vulnerable for multiple compression just like many consumer staples businesses in recent times, certainly if interest rates continue to rise.
That being said, luxury names mostly trade at premium multiples given their pricing power, strong margins and sound growth prospects. I guess that current levels are largely fair. If one can indeed buy shares at a slight premium to market multiples, let´s say at 20 times earnings, I will start accumulating a position. That makes me a buyer if shares trade in their mid-sixties.
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.