Good day, everyone, and welcome to The Estee Lauder Companies Fiscal 2006 First Quarter Conference Call. Just as a reminder, today's call is being recorded and webcast. For opening remarks and introductions, I would like to turn the call over to the Vice President of Investor Relations, Mr. Dennis D'Andrea. Please go ahead, sir.
Dennis D'Andrea, VP, IR
Good morning, everyone. We have on today's call William Lauder, President and Chief Executive Officer, and Rick Kunes, Executive Vice President and Chief Financial Officer. Also with us today is Dan Brestle, our Chief Operating Officer, and he will be available for the Q&A session. Since many of our remarks today contain forward-looking statements, let me refer to our press release today, where you will find factors that could cause actual results to differ materially from these forward-looking statements.
And I will turn the call over to William now.
William Lauder, President, Chief Executive Officer
Thank you, Dennis. Good morning, and thank you for joining us. Today, I will highlight our first-quarter results, and more importantly focus on the factors that will drive our business for the next nine months and beyond. As you have seen from our press release this morning, this quarter's results were below prior year, and I am disappointed with that performance. While we are faced both internal and external challenges, we are quickly taking aggressive action on the strategic imperatives that we discussed on our last conference call. As a result, we expect to show some meaningful improvements in our performance this fiscal year and beyond. I'll talk about those actions shortly, but first, let me briefly recap this quarter's results.
For the first quarter, we reported net sales of $1.5 billion, flat with last year's first quarter, when we grew 12%. Excluding foreign currency, net sales for the quarter decreased slightly. Our sales in the Americas were affected by the planned timing of product launches, weaker store traffic with several key retailers, a lower-than-expected response to our gift-with-purchase promotions, and the impact of store closures in the areas hit by the unusually strong hurricane season.
On the International side, our businesses experienced softness in certain key International markets, coupled with start-up issues at our new European inventory center, and a tough comparison with double-digit growth last year. Our results this quarter reflect the flat sales growth, increased investment spending, spending for our strategic modernization initiatives, and incremental expenses related to stock-based compensation.
Net earnings from continuing operations for the quarter were $61.8 million, compared with 95.7 million in the prior year's quarter, and diluted earnings per share of $0.28 compared to $0.41 in the prior year's period.
Let me now discuss the quarter's product category results. In Skin Care, reported sales were flat with the prior year, coming in at $523.4 million, and declined 1% in constant dollars. Last year, Skin Care sales grew 13% in the quarter, strong sales were generated from recently launch products such as Perfectionist CP+ by Estee Lauder, and Super Defense Triple Action Moisturizers from Clinique, offset by lower sales in existing products.
Makeup sales of $604.9 million increased 3% in dollars, and also in local currency. This category grew 23% in the prior year period. Our MAC, brand generated strong growth while new and existing products from other brands also benefited the category.
The Fragrance category continues to be challenging. Sales decreased 6% to $293.2 million on both a reported basis, and excluding currency. While the current quarter benefited from the excellent growth of DKNY Be Delicious, and the recent launch of American Beauty Wonderful, they were up against stronger fragrance launches in the prior year.
Hair Care sales rose 12% this quarter to $70.4 million on a reported basis, and grew 11% in local currency. Sales benefited from the new salon distribution and growth in existing salons, as well as new and existing products.
Geographically, sales in the Americas were relatively unchanged from the prior year's quarter at $881 million. There were several factors behind these results. On the positive side, new and recently launched products were well-accepted in most major product categories, especially makeup and hair care, and most developing brands along with our Internet business, reported sales increases. Offsetting these positives, was timing of planned product launches which this year are skewed more heavily to upcoming quarters. Additionally, our fragrance category posted lower sales in this region.
While sales growth at high-end specialty stores was solid, overall our sales reflect the weakness in certain key retailers, where a greater portion of our business is done. Additionally, our Fall gift programs from the Estee Lauder and Clinique brands, did not perform to expectations. We have responded rapidly and proactively, and both Estee Lauder and Clinique are redesigning and re-promoting their gifts to recoup some of the lost sales.
Toward the end of the first quarter, it became clear that retail weakness and the soft gift programs, would negatively impact our planned sales by approximately $35 million and was the major reason we previously lowered our first half expectations. To a lesser extent, we also felt the effects of store closures in the hurricane-affected southern region of the U.S. Approximately 25 stores were affected, and 11 stores remain closed. The loss of sales from these stores in the quarter including returns, was approximately $5 million.
We also believe sales are reflecting lower foot traffic, due to consumer reaction to higher energy prices. In Europe, the Middle East, and Africa, sales decreased 1% over the prior year's quarter to $417.5 million, and declined 1% on a local currency basis. In local currency, sales were weaker in Spain, the U.K., Italy and Austria. This region of sales grew 29% in the prior year's quarter.
Our northern European inventory center came online during the first quarter; however, the start-up was slower and more problematic than anticipated which caused a backlog in shipments. We are now shipping to our normal business profile, and we expect them to be operating as originally planned by the end of our fiscal second quarter. Partially offsetting these results were higher sales in Germany, and the Company's travel retail and distributor businesses.
In Asia-Pacific, sales this quarter grew 5% over the prior year quarter to $198.6 million. In local currency, sales this quarter were up 2%. Our business in China continued its momentum, once again generating high double-digit growth. The local currency increase also reflects double-digit growth in Hong Kong, and good growth in Taiwan.
Now, let's talk about our expectations for the remainder of fiscal 2006. We have a lot of activity to fuel growth, including a full slate of terrific product launches throughout our brands. We are excited about the opportunities that emerging markets and expanded geographic penetration presents, along with leveraging our business in alternative distribution channels. Let me give you some details.
In the Americas region for the full year, we have taken up our forecast for the Tom Ford Estee Lauder collection, due to strong buyer demand. We expect the buzz generated by the launch will fuel excitement for the Estee Lauder brand. We will continue to develop our new brands in Kohl's, adding stores as Kohl's expands throughout the year, and executing our first full-fledged holiday program.
Additionally, our other channels, freestanding stores, salons, and the Internet are performing quite well. We are likely to see a continuation of faster growth at the high-end specialty retailers, which make up about 20% of our U.S. department store business, while prestige department stores may be more challenged for the reasons cited earlier. However, since our press release of September 19, the consumer spending environment in the U.S. has deteriorated, and we also now believe that Federated will move more quickly on their planned post-merger store closures. We had previously expected closures to begin in March, and take place over time with only a handful of closings this fiscal year.
Our assumption now is that Federated will simultaneously close in early calendar 2006 more than half of the 82 announced stores. This will affect our full-year sales, as we will take inventory returns for all of the stores, and lose a considerable portion of their sales for the remainder of our fiscal year. The good news is, that we should get approximately half of the pain out of the way, and see less of a pinch in fiscal 2007.
While we have had on-going discussions with our largest customer to attempt to mitigate the disruptions at some stores, Federated has stated that they expect disruptions and weakness to continue for some period of time. The estimated impact of these closures and potential disruption in fiscal 2006 full-year sales is a reduction of $50 million, which equates to approximately 80 basis points of growth. As we have said before, store closures should be a long-term positive, as less disruption equates to more productivity per mall, and therefore higher profitability.
In addition to Federated store closures, our revised outlook considers stores in the Gulf Coast region that remain closed. We also expect to take returns of damaged goods. The combination of store closures and returns are expected to adversely impact full-year sales by about 20 to 25 million.
Additionally, higher energy costs are starting to be felt beyond the gas pump, and many consumer products and services companies are passing on their higher costs to their consumers, which is reflected in the steep drop in the consumer confidence index. The internal and external factors that I have discussed in the aggregate, are negatively impacting our full-year sales by over $100 million.
In Asia-Pacific, we expect to see a continuation of exceptional growth in China, fueled by growth in prestige beauty, and expansion of our brands. In Japan, Clinique is starting to see a pickup, driven in part by a focus on locally-relevant product introductions. And Aveda is developing its salon business. Korea is beginning to show signs of life, despite weak consumer confidence, while the rest of the Asian countries, are expected to produce sales growth in the mid to high single digits.
The European region is expected to rise on travel retail growth, on middle Eastern business, and the expansion of our emerging business in India, which has gotten off to an impressive start, and is trending well above our plan. From a product category perspective, in Makeup, Clinique started off the year with several strong launches, and we have high expectations that those products, along with new Colour Surge eye shadow extensions, will generate continuous repeat business.
The Estee Lauder brand is launching new lip products under its Double Wear and Pure Color lines. MAC has a robust holiday program, along with the Catherine Deneuve collection, and Bobbi Brown has a very strong Spring program. In skin care, Clinique is undertaking a major Spring relaunch of its 3-Step program which by comparison is larger than many cosmetic brands. For the first time the brand is supporting the launch with television ads. Resilient Lift by Estee Lauder is the #1 lifting moisturizer in U.S. prestige distribution, and the brand is launching Resilience Lift Extreme this December.
Origins is in the process of launching its first products under Dr. Andrew Weil umbrella. You may have seen Dr. Weil on the cover of Time magaziner's October 17 edition, where he expounded on his secrets for Aging Well.
In fragrance, we are supporting the 10-year anniversary of Pleasures, with new advertising featuring Gwyneth Paltrow, in both print and TV. We are excited that Tom Ford has reinterpreted the Youth Dew fragrance, as part of the new Amber Nude collection for holiday. We are looking forward to the December launch of Unforgivable from Sean John, as well as the Spring launch of Missoni products.
In hair care, continued comp store growth as well as select new points of distribution for Aveda and Bumble & bumble, are expected to boost sales. While our efforts to drive sales growth are critical to the health of our business, we are aggressively moving to improve our bottom line.
The first action behind our strategic imperative of portfolio management is the disposition of the Stila brand. Our portfolio currently contained two top makeup artist brands, MAC and Bobbi Brown, which are both fast-growing and highly profitable. It makes more sense for us to focus corporate resources behind brands, categories and regions which provide a superior return, while finding a buyer for Stila that can continue the brand's growth path.
We are also accelerating some actions behind the strategic imperative of operational and cost excellence. Specifically we are driving two significant incremental cost reduction programs this fiscal year. First, we are implementing value analysis reviews of our processes and organizations, and second, we are accelerating indirect purchasing and noncritical spending savings. We are tackling overhead costs by streamlining the organization and processes to match our portfolio objectives in both the support functions and within the brands. We have initiated an intensive pilot around several corporate support functions and underperforming brands.
In the support functions, we look for activities that are not contributing significantly to growth, or to the effective management of our operations. In the brands, we will seek to optimize performance by better understanding the economics of its various components, including sales and marketing functions and product lines to allocate investment to those activities with the highest returns.
Additionally, we are going to accelerate our efforts to reduce our indirect purchasing costs, beyond the initiative we announced in August. We are starting with a review of our spending with our top 20 vendors by brand and by corporate department, to ensure we are properly leveraging the breadth of our business in negotiations.
We will also be examining the organizational model for indirect purchasing, including looking for opportunities to create a more centralized structure and greater coordination between the brands. Coupled with this, we have undertaken some serious belt tightening by aggressively identifying projects and costs that do not critically need to take place this fiscal year.
We will re-evaluate the need for these projects in our fiscal 2007 budgets. We have a fundamental commitment to cost reduction for both the near term and the long term. These initiatives are expected to deliver between 40 million and $45 million in incremental savings this fiscal year, and improve our profitability going forward.
To summarize my discussion and put it into focus, for the full year, we now expect sales growth to be between 3 and 4% in constant currency. Foreign currency translation is estimated to negatively impact full-year sales by approximately 1.5%. Our EPS from continuing operations is now expected to be $1.87 to $1.94.
We are confident that our business fundamentals, strategic direction, and the actions we discussed with you in August and today, should create a lot of opportunities to enhance our top and bottom-line growth. We are committed to taking the appropriate steps to foster healthy sales growth while keeping a keen eye on the bottom line.
Now I would like to hand it over to Rick Kunes, our Chief Financial Officer, to take you through the financial details.
Rick Kunes, EVP, Chief Financial Officer
Thank you, William, and good morning, everyone. My discussions today will also focus on our results from continuing operations. The Company achieved first-quarter operating income of $105.1 million compared with $156.3 million last year. This reflects a decrease in operating margin of 350 basis points to 7%, primarily due to flat sales during the quarter.
Our gross margin of 72% for the quarter decreased 60 basis points over last year's 72.6%, reflecting an increase in obsolescence charges of approximately 60 basis points, proportionate to the change in inventory, as well as unfavorable changes in exchange rates and promotional activities of approximately 50 basis points. Partially offsetting these increases was the net change in the mix of our business within geographic regions and product categories of approximately 50 basis points.
Operating expenses as a percentage of sales for the quarter increased 290 basis points to 65% from 62.1% last year. The increase reflects the absence of sales growth leverage during the quarter. Operating expenses also increased approximately 90 basis points, due to the recognition of stock-based compensation of about 20 basis points, and about 20 basis points for costs related to our strategic modernization initiatives.
Looking at operating profits by category, skin care decreased $26 million to $38.8 million, due to soft sales, particularly in Europe, while our spending to support this business continued. Makeup was down $5.3 million to $60.5 million, as slightly higher sales were more than offset by increased investment spending. We also anniversaried the prior year shipments of our Beauty Bank brand, where makeup represents a large portion of the product mix. Fragrance fell $23.3 million to a loss of $1 million, due to the lower sales, which reflect the continued difficult fragrance business in the U.S., coupled with higher product support spending.
In hair care, operating income increased $2.5 million to $5.3 million, primarily reflecting improved results domestically, as well as result of comp store growth and expanded points of distribution. By region, operating profits in the Americas declined $28.1 million to $80.4 million, due to the sales weakness William described, and cost related to stock-based compensation, and our strategic modernization initiative.
In Europe, Middle East and Africa, operating results decreased $19.6 million to $22.4 million. Global results were experienced in certain key markets like Spain, the U.K., our travel retail and distributor businesses, and Italy. The shortfall on product shipments in certain continental and European countries, that occurred as a result of this start-up of our new regional inventory center, also negatively impacted our operating results. Improved results were posted in France and Germany.
Asia-Pacific operating income decreased 3.5 million to 2.3 million, reflecting lower results in Hong Kong, Taiwan, Malaysia, and Thailand. China's results were also down, as we continued to investment in infrastructure in China to support future business opportunities. Solid improvement in Australia, and a modest increase in Japan, partially offset these results.
Regarding our interest cost. Net interest expense of $5.6 million this quarter versus $4.1 million last year. The increase is primarily due to outstanding Commercial paper during the current quarter. The effective income tax rate for the quarter was 36% versus 37% in the prior year. This decrease is primarily because of the tax effect of the Company's foreign operations, a decrease in state and local income tax expense, and an increase in tax credits.
At this time, we expect our effective tax rate will be approximately 36% throughout fiscal 2006. For the fiscal first quarter, net earnings from continuing operations was $61.8 million, compared with $95.7 million last year, while diluted earnings per share were $0.28 versus $0.41 for the three months of last year.
Switching to our financial position, the Company's cash balance was $390 million at September 30, 2005, which was comparable to last year. For the quarter, net cash flow is used for operating activities, were $62 million versus 98 million in the prior year period. These outflows reflect seasonal working capital levels, and should improve in the coming quarters.
For the full fiscal year, we expect net cash flow from operating activities of approximately 600 to 625 million, reflecting lower sales, but expected improvements from our savings initiatives, and working capital over the next nine months. Our higher inventory level, primarily reflects lower-than-expected sales growth, the safety stock in our new regional inventory center in Europe, and increased sourcing from the Far East.
During the quarter, we aggressively repurchased 1.9 million shares of stock for a total of $71 million. This brought the total shares repurchased under our program to approximately 29 million shares, and to-date we have returned over $1 billion in cash back to stockholders. We continue to buy an additional 3.7 million shares during the first week of October. We anticipate capital expenditures of approximately $300 million in fiscal '06, increasing versus fiscal '05 due to our company-wide systems initiative.
Let me briefly update you on our working capital. September 30, 2005, inventory was 815 million, an increase of 102 million versus last September. Inventory days were 186 at the end of the quarter versus 171 days last year. This increase includes 7, 4, and 4 days respectively, attributable to the sales shortfall, the new European distribution center backlogs, and business building activities. Regarding receivables, our DSOs of 55 days at September 30, 2005 were relatively unchanged compared to a year ago.
Let me now update you on a few assumptions for fiscal 2006, which includes the accounting rule change regarding expensing of stock-based compensation, the revised potential impact of the Federated/May merger, and the impact of our incremental cost savings initiatives. For the full year, as William said, we anticipate sales growth of approximately 3 to 4% in constant currency. And we expect foreign currency translations to negatively impact reported results by approximately 1.5%. We expect gross margin to decrease slightly for the fiscal year, with supply chain savings offset by the impact of the unfavorable gift program, pressure on our costs resulting from higher energy prices, negative foreign exchange, and potentially higher obsolescence cost. Combined, the expensing of options and Federated/May merger will have a minimal negative impact on our gross margin.
Regarding expensing of stock-based compensation, as a result of the changes in our stock price and our equity-based compensation plan, the expected impact to our full-year operating income is now approximately $35 million. This translates into a EPS impact of $0.12 compared to the slightly more than $0.14 we have previously forecasted. The impact on our first quarter was $0.04, and we expect $0.07 for the half.
Additionally, we now expect the Federated/May merger impact in fiscal 2006 will reduce our reported EPS by $0.09 to $0.10. Earlier William described some incremental cost savings opportunities we have identified this fiscal year. We are pursuing these savings with vigor, but expect to realize the majority of the savings in the second half of our fiscal year. Associated with these projected savings may be certain yet to be determined one-time costs, that we will record as incurred, which we expect will benefit the current and future fiscal years.
We now anticipate operating expenses to increase 20 to 40 basis points, excluding any one-time charges. This will include the positive effect of our stepped-up cost savings, offset by lower sales growth, and approximately 50 basis point negative impact of stock-based compensation expense. Operating expenses also include approximately $23 million of spending related to our SMI project.
As a result, our operating margin is expected to range between a 20 to 60 basis point decline. Therefore, our reported diluted EPS from continuing operations is now expected to be between $1.87 and $1.94, which again, includes approximately $0.22 per share impact from expensing stock-based compensation, and potential impact of Federated/May. Our expectations also include the effect of the additional cost savings of approximately $0.12, but does not include any one-time costs associated with these savings initiatives.
Separately, subject to the final negotiated sales price, we may report a gain or loss on disposal of Stila, which would be included as a component of discontinued operations.
Regarding the fiscal '06 first half, we expect sales to grow between 3 and 4% in constant currency, and anticipate approximately 1% negative impact of foreign exchange. We expect a gross margin decrease of 90 to 110 basis points. Operating expenses are expected to increase 130 to 150 basis points, primarily as a result of slower sales growth, and stock-based compensation expenses. Diluted earnings per share from continuing operations for the first half are expected to be between $0.83 and $0.88. We expect the effect of the Federated/May merger to impact our first-half results by $0.04.
Let me remind you that we run our business on an annual basis, and we experience volatility in our quarterly results. In particular, this year we will be impacted by the expensing of stock-based compensation, the timing of product launches and investment spending, implementation of our cost-savings initiatives, and the pace and implementation of retailer consolidation activities.
This concludes my comments for today, and we are happy to take your questions now.
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