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Here’s the entire text of the Q&A from Estee Lauder’s (ticker: EL) Q1 2006 conference call. The prepared remarks are here. We recognize that this transcript may contain inaccuracies - if you find any, please post a comment below and we’ll incorporate your corrections. And please note: this conference call transcript is a Seeking Alpha product, so feel free to link to it but reproduction is not permitted without the explicit permission of Seeking Alpha.

Questions and Answers

Operator

Thank you.

Operator Instructions Our first question today comes from Chris Ferrara of Merrill Lynch.

Q - Chris Ferrara

Hi, while the weakness is pretty-broadbased I wanted to talk about Europe, and the sluggishness there on the top line. Can you talk about how much of that related to distribution center issues, and also on travel retail? What's going on with travel retail? What was the number there, and why was it so weak?

A - William Lauder

Well, Dan is going to address the distribution issues and I will come back to talk to you about some of the top-line consumer issues.

A - Dan Brestle

Chris, this is Dan. We estimate that between the distribution center in Oevel, in our major distribution point, we lost somewhere between 10 million to $15 million of shipments in the first quarter. Some of that will be recouped with the replenishment of existing basic stock, but a lot of it was promotions that were running during that September period, and they won't come back to us.

A - William Lauder

As far as top-line issues, there are a number different issues. Let me give you the highlights: one of the highlights is our travel retail business, which currently, year-to-date, is tracking on a comp currency basis at 5%. They are projecting their year at 7. But just to give you an example, the month of October is tracking at plus 18% for travel retail. But to give you an idea, overall consumer confidence on continental Europe is not particularly strong. There are a number of reasons for that in the major markets. As well, a significant factor is that after five consecutive years of significant, strong consumer demand and growth in the UK, we are seeing a slowdown in UK demand. UK is still relatively good compared to Continental Europe, but not nearly as strong as it used to be. So I think you are seeing some of the same factors we experienced here in the United States with lack of consumer confidence. We were also experiencing those same issues in Continental Europe also in the major markets.

Q - Chris Ferrara

Okay. And then I just wanted to follow-up on the gift-with-purchase issues. I know you didn't really have success on the fall promotions, and I think you mentioned about repositioning the gifts and repackaging them and getting them back out there. What is the longer-term fix there? Obviously not as effective a piece of a business as it was at one point. What is going on in the long term, and how do you get past that?

A - William Lauder

Well, a couple of issues. The specific short-term issue in the Fall this year related to the gift-with-purchase programs, which was more acute is we made a fairly significant bet on a look which is around tweed for the Fall gift programs, and as you know, in August and September, throughout most of the United States, we experienced unusually warm weather, where the consumers were hot and sweaty just looking at tweed, let alone touching it. So those programs were not as attractive to the consumer as we would have liked or hoped. Interestingly now in the month of October which has been significantly cooler throughout North America, these same gift programs that are now running with retailers are much stronger than the same programs were a month ago. As far as the reworking is concerned, both the Estee Lauder and Clinique brands are taking different approaches to how they rework the existing gift inventories to try to recoup their business with different offers that are incentivizing the consumer to focus primarily on the more attractive of Skin Care and Makeup. The longer-term secular issue of gift-with-purchase is not insignificant. We are looking at over three-plus years of general weakness in, or declining return on investment in the gift-with-purchase programs, which is a concern for us. That being said, these programs are still much more efficient than most of the alternatives for the significant investment we might have that stimulates the top line. So while the return on investment is nowhere near where we would like it to be, and what it ought to be, and what it has historically has been, it still seems to be more efficient than alternative uses of these funds. We are looking at strategic alternatives in reallocating amongst the different communications and motivating vehicles for the consumer, but we need to do this in a manner that does not significantly affect our top line, which ultimately helps fund the productivity in a full-year basis.

A - Dan Brestle

Chris, I would like to follow up with that. That is why we have been so bullish with the Macy's National advertising program because that gives us a vehicle to reinvent gift-with-purchase. We will go to National dates for most of our major stores.

Q - Chris Ferrara

You are confident that is the right move to stay with gift-with-purchase and sort of reinvent it, rather than find another way of executing things?

A - Dan Brestle

Well, part of the reinvention is a different way to execute different promotional vehicles to support it, but as William said it is a large part of the three major brands in the United States business, and we can't walk away from it. We have to reallocate funds to other areas, but we still have to make it successful.

Q - Chris Ferrara

Thanks.

Operator

We will go next to Amy Chasen of Merrill Lynch.

Q - Amy Chasen

Actually Goldman Sachs. In terms of the Belgium logistic problems. You quantified it, and that was great, but can you walk us through what the issues were there. Your confidence in getting this fixed by the end of the second quarter, and I am wondering whether that's the reason, sort of the fact that your longer-term cost reduction programs are taking longer to implement, is the reason that you are stepping up your short-term cost reduction program. I am sorry to make this a long question, but could you also, William, maybe flesh out a little bit more your short-term cost reduction plan? I understood the indirect expense focus. I wasn't sure about the rest of it, and you talked about potentially having to take a charge. I am not sure why there would be a charge associated with that. Sorry that is such a long question.

A - William Lauder

Well, there are multiple parts of that. I will let Dan answer the first part of your question about the Belgian distribution center.

A - Dan Brestle

Amy, let me give you, it is a two-part issue. Part one our distribution center in Oevel. We went into a new building with a new system, and we did not anticipate the complexity of the start-up problems we had. Our direct shipments to customers in four major markets were impacted tremendously during the August-September period. Compounding the issue we have a major contract with DHL, who supplies all of our facilities and major distribution centers throughout Europe, and got dramatically behind in the August timeframe, and did not recover in time for the quarter. That is being addressed, and we think that will be fixed, and is fixed as we speak. Our Oevel distribution center is fixed, in terms of meeting our everyday shipping needs, it is not running as efficiently as we want, but we are confident by the end of the quarter it will give us the efficiencies that we would expect.

A - William Lauder

As far as the short-term initiatives are concerned Amy, there are a number of different initiatives that we are taking, that we are very aggressively going after a number of the opportunities, and as you may have caught in the text of my message, there is really two main focuses. One is an activity-based approach toward our processes, which looks to rationalize on an economic basis our activities, and make sure that all the activities we are pursuing, are in truth accretive to the needs of the total company, and to eliminate those activities which seem to be perhaps marginal at best, given the new realities of the current business environment around the world.

Q - Amy Chasen

Are you talking marketing spend, or can you just give an example?

A - William Lauder

Well, it is not, you know marketing spend comes as a tail which is created by the dog, which is all about program creation and initiatives, and what other forecasted returns on these marketing programs. The general theme that we are emphasizing very emphatically with the brands is spend more on fewer programs, but make each of those programs more impactful. So rather than promoting a dozen programs throughout the season, we are going to ask them to focus on 6 to 8 programs, and make more noise and more impact with those 6 to 8, rather than the 12 different programs. And that manifests itself in an emphasis in the creation of fewer programs, an emphasis on the reduction of the expenses associated with the creation, and instead a reallocation of these funds, towards advertising and promotional vehicles which will drive those fewer programs to greater success. The second part of that is, a more efficient, more focused look at indirect spending and coordinated indirect spending, between and amongst the brands so there isn't any duplicative efforts and perhaps less efficient use of total corporate funds and, again, the focus on improved productivity, and doing more with less for more impact.

Q - Amy Chasen

So William, what's the one-time cost associated with these two programs? Because these seem like they are pretty straightforward, and you just sort of drive them internally through really sitting down and fleshing this out with the different managers.

A - William Lauder

Well, there is a number of different one-time costs that would be associated with that. It may be termination of contracts with suppliers who are not as cost effective as other competitive suppliers, as other divisions as example. It may entail one-time cost with reductions in force in areas that are not as effective or efficient, or return on investments. Those are examples. In addition the most important things about one-time costs is, you are saying, hey, look, we are going to be lowering the absolute levels of spending not this year so it comes back next year. We will be lowering the absolute level of spending this year, and in the following years for good.

Operator

We will move next to Wendy Nicholson of Citigroup.

Q - Wendy Nicholson

My first question has to do with the Skin Care business. Would it be fair to say that the promotional issues, would have affected Makeup more than Skin Care. I am wondering why the Skin Care business was so weak, whether it is a market share issue, and how confident you feel about a pickup in that category specifically?

A - William Lauder

Wendy, if you look at it, you are mostly right in what you say, but not entirely right. The Skin Care weakness that we saw in the first quarter was largely related to the weakness in the promotional programming, and also, as you may have heard us say, also related to the sequencing of our shipments, and our focus in programs in Skin Care this year versus last year. So if the weaker gift-with-purchase programs in the first quarter, you saw weaker Skin Care, because total sell-through was weaker because of the gift-with-purchase programming. In addition to that the launch programming associated with that was less skewed to Skin Care this year versus last year. That effects most of the weakness and we expect to recover most of that going forward.

Q - Wendy Nicholson

Why would the tweed program sounds more like a shade statement or color statement to me. What in there would be Skin Care related?

A - William Lauder

Well, there is nothing specifically Skin Care-related about the gift in and of itself, but one of the major attractive programs of the gift itself is a bag. And unbuyable bag where the consumer gets not only in the gift with purchase a number of products, but the bag it comes in, and the emphasis of that bag was in the tweed program. So it wasn't about a color story per se, it was literally about was the bag itself attractive to the consumer?

Operator

Next from Deutsche Bank, we will hear from Bill Schmitz.

Q - Bill Schmitz

Good morning. If I could I want to keep this kind of broad here. What do you think about the long-term top and bottom-line growth targets you have set out, 5 to 6% top line growth, the 13 to 13.5% operating margin, and 12 to 15% EPS growth?

A - William Lauder

Well, certainly if you look at it, we need to continue to hit our numbers each year, to be able to achieve our long-term growth. We have confidence in the fundamentals, given what our current visibility is today over the long-term, what we see as opportunities around the world in our key categories. We have confidence not only in our own ability to achieve that, but also in the strength of our brands, very unique and attractive positions within their markets to our consumers and to the retailers, as well as in the abilities of these brands to achieve individually their goals, which means we roll it up to a total company, we believe in our total abilities to invest those objectives. The obvious issues that could be obstacles going forward will be any longer-term secular disruptions, like we have seen in the recent couple of months, that extend on a broader basis for a more sustained period of time. And I wish I had some control over that, but unfortunately those factors, especially the weather, are out of our control.

Q - Bill Schmitz

Okay. That's fair. And then just a follow-up. Can you talk a little bit about your SAP implementation, and whether or not you think that the tools you have are forecasting now are, you know, below par, and should we see a marked improvement in that, as you move forward on this system integration?

A - Rick Kunes

Sure, certainly, Bill. The tools that we have today are nowheres near as good as the tools we will have under SAP. So we are anticipating a much better forecasting capability with the implementation of SAP, which as you know is a couple of years away, but that is one of the driving reasons that we are implementing it, the ability to forecast better, and also the benefits it will bring to the supply chain, and some of the processes and the way we run our business.

Operator

We will move next to Linda Bolton Weiser of Oppenheimer.

Q - Linda Bolton Weiser

Thanks. Just had a question again on the gift-with-purchase programs. I guess one of the other negatives would be that that kind of thing could encourage consumer pantry loading. Do you have any method of monitoring that? And what do you think the current consumer inventory levels are of your products?

A - William Lauder

You know, it is very hard to judge about what the consumer inventory levels are. When I visit friends' homes do I not look in their drawers to see how many extra lipsticks and eye shadows they have. My hope is they have lots of them, and they are all our brands, certainly. If I use a proxy for that, as an example last night I was looking on E-Bay of how many items were for sale for our different brands, and you look at 8,000 to 10,000 items offered for sale of the Estee Lauder brand, or the Clinique brand, or some 5,000 to 7,000 for the MAC brand, being offered by consumers on E-Bay, and I use that as a proxy, if you will, a consumer interest, if you will, a different level. Saying there is a lot of product out there, but there is still plenty more for consumer to want to spend money on. Over time, one of the things that we've seen happen is, let's use the Los Angeles Southern California market as an example. 10 years ago, there were five major different retailers who offered our brands in the region. So each season the consumer had, for both the Clinique and Lauder brands five different gift-with-purchase offers in any given season. So ten weeks out of the season, she was being offered from one the retailers a gift-with-purchase from the Estee Lauder or the Clinique brand. Today those five retailers are now two. So she now has a choice, not of five different gift-with-purchase which she could shop for at her favorite brand amongst her different local stores. She now has the choice of two. Does that create a greater incentive for her to pick each one if she was, in fact, a gift shopper, versus a loyal Macy's shopper, or loyal Nordstrom shopper? Perhaps. But I don't believe you are going to see stockpiling in our category of merchandise, much like you would see in other categories, primarily because we don't believe the consumer is extremely price sensitive, one. And two, there is an instant gratification associated with the purchase of our category of merchandise, that may not be associated with others, and I don't believe the consumer buys 3s, 4s and 5s, with one exception, when their favorite color is discontinued for one reason or another, usually their sales associate in the store will tell them, and call them up and say your favorite color is being discontinued. Then the consumer stockpiles it, because she doesn't want to not have her favorite color.

Q - Linda Bolton Weiser

Okay. Thanks, William, that's helpful.

Operator

Operator Instructions Again, please limit yourself to one question and a related follow-up. We will go next to John Faucher of J.P. Morgan.

Q - John Faucher

I would say that is a new pronunciation. I want to just follow up on the guidance issue, which related to the significant sequential improvement you are expecting, can you talk about sort of how we should view discontinued ops in that, versus what we had previously modeled before, and then, you know, as we look at the problems with the distribution center in Belgium, you know, short-term execution probably will remain a bit of a concern, and how comfortable can we feel in the short-term cost saves, given some of the execution issues we have seen over the past couple of quarters. Thanks.

A - Rick Kunes

Sure. John, regarding discontinued operations, I mean obviously the reason that we are discontinuing operations is we think it benefits us. Not so much on the performance that we in a sense move aside from Stila, but the fact that we now have resources that we can invest into other brands that will give us a better return. Regarding the cost savings initiatives, most of those kick in the second half, obviously it is almost November now, and most of those benefits of those programs that William outlined, are going to benefit our second half. So that's really contributing, if you will, to the sequential improvement that we see for the second half of the year. Regarding the distribution centers, Dan pointed out most of the issues that we have with the distribution centers have been resolved at the moment. It is not running as efficiently as we would like it to be, but it is certainly operating as we would have expected it to operate from the beginning. And by the end of the second quarter, we think we will have all the issues sorted out with that.

Q - John Faucher

Rick, are you guys giving a number on the discontinued Ops side, so that we can track that through and plan accordingly?

A - Rick Kunes

I think it will certainly be part of our Q, so you will see the numbers that and you will see it reported that way. For the year of the benefit, John, I want to state benefit is probably $0.03 or so, $0.02 to $0.03.

Q - John Faucher

Okay. Most of benefit already coming through in this quarter then, probably.

A - Rick Kunes

A lot of it coming through in this quarter, yes.

Q - John Faucher

Okay. Thank you very much.

Operator

We will move next to Connie Maneaty of Prudential.

Q - Connie Maneaty

If we can go back to travel retail for a second. You explained how sales were growing, but why did operating profit decline in the first quarter?

A - William Lauder

There's any number of reasons why operating profits declined in the first quarter, and the relation is not necessarily to travel retail in particular. I will remind you of what we've said before about the travel retail business specifically. Travel retail has a lower gross margin than our standard business model, but a higher operating profit, because of lower operating expenses than our standard business model, but I will remind that you travel retail is reported through our European region, even though this business is dollar denominated on a global basis.

A - Rick Kunes

Connie, part of it is the timing. You know we do activities related to travel retail. But in general, our operating expenses are lower. We do occasionally some activities as we open new airports, and we do in-airport, if you will, certain activities to help drive longer-term growth, and some of that is affecting our first quarter as well.

Q - Connie Maneaty

You are saying there was investment in travel retail that caused its particular operating profit to decline, because the sales are growing faster than the overall average?

A - William Lauder

The answer to that is yes.

Q - Connie Maneaty

Could also ask a question on inventory. As inventories have been growing faster than sales for quite a while now, and I was happy to get the breakdown of the different days and their sources, but what is the long-term target here, and how do you get there?

A - William Lauder

Well, longer term, we had talked earlier about the benefits of the improved forecasting systems from SAP are going to bring us, and one of those benefits will be better forecasting so better supply chain production of goods, and better inventory management tools, so that's the end gain is that when we have SAP fully implemented, we will have tools that will allow us to do a much better job of managing our inventory than we have today. Because of the length of our supply chain, when we have a sales result like we had in the first quarter, unfortunately, that leads to driving our inventory numbers up, and that was the, as you said there were 7 days increase versus last year in our inventory numbers, related to unfortunately the flat sales in the first quarter. So longer term, we turn our inventory now twice, a little more than twice a year, and our objective is to get that to closer to 3 times by the time we have SAP implemented. Shorter term, we wanted to get back by the end of this fiscal year to an inventory in terms of days, similar to where we were at the end of fiscal '04. But you know, we announced a program recently about reducing a number of points of distribution going from 50 points of distribution, to down to slightly below 30. That is obviously going to help benefit us as well. So, I mean, we are working on it. It is just, you know, because of the length of supply chain it takes a little longer.

Q - Connie Maneaty

Given the current sales environment, do you think you can get to the fiscal '04 day number?

A - William Lauder

It is certainly going to be tougher, no question about it, Connie. That is still our objective. Will we get all the way there by the end of the year, we will see, it is possible we may not, but we are working hard to try to get there by the end of this fiscal year.

Operator

Sandhya Beebee with HSBC has our next question.

Q - Sandhya Beebee

I have a question in terms of the top-line growth guidance for the first half. It does sound like you look for a sequential pickup between Q1 and Q2 that is fairly significant to get to 3 to 4% constant currency sales growth. I was wondering what was going to really be different in this quarter outside of the promotional problems not reoccurring hopefully again, that would get you there, and also I guess as sort of an auxiliary question to that, on the market share of Clinique and the Estee Lauder brands, is there anything that you are seeing outside of what happened on the promotional problems in the first quarter, that would make you feel like the rate of decline in the shares of those brands have accelerated somehow versus what we have seen in previous years?

A - William Lauder

Well, you know, the gift-with-purchase business represents 35% approximately for both the Clinique and Lauder brands of their total sales. So 35% of your business is weak, obviously you have to strengthen your business the other times. And one of the things we are seeing which gives us some confidence and more than some confidence is that basic business, nonpromotional business is quite strong for these brands. Literally from one day to the next, from a day you are going against the promotion, to a day you are going against the basic business, we are seeing a significant pickup in that business. So we have some confidence from a share point, much of the issues in share erosion are primarily related to the gift-with-purchase programming. And let's not forget that the absolute value related to their total market share, because of the promotional spending is quite significant to the total business that these brands experience, as well as the average productivity per door that they are able to enjoy because of all the promotional spending. Secondly, we do have some confidence in Christmas. We have got stronger Christmas programs. Christmas programs so far that are early in the stores seem to have nicer sell through. We have confidence both in the Tom Ford for the Estee Lauder program. As we mentioned before, we have Sean John launching in the November time period. And we are expecting that Europe will be approximately up 10% or so for the holiday season, because of a number of different programs, as well as some other recoveries.

Q - Sandhya Beebee

Okay. Then I just had one other question that related to some of the comments you made earlier, and that was really talking about how the newer products were performing pretty well. It is the base business that is suffering. Something that you guys need to do to maybe step up your innovation rate, or pick up the R&D spending. So it is what the customer wants, you can maybe cater to that more?

A - William Lauder

Well, it seems over the long-term, Sandy, what we have seen pretty consistently, is that approximately 30% of our business comes from product launch within the last three years. And 70% of our business continues to come from product launched more than three years ago. And this has been pretty consistent now over the last 10 to 12 years. The difference is that the 70% that is coming in basic, is coming in a less concentrated manner than it has before, which relates to the inventory question, where it is taking more SKUs to make up that 70% of the basic business at three years old, as it did before. If you will, some of the basics of the traditional 80/20 roll, where 80% of your sales were made up of 20% of your SKUs are changing somewhat. The consumer response to the innovation rate and the success of our new product launches, continues to be a pretty consistent basis. The real question is about the new product launches is their sustainability in years 2, 3, and beyond, and the consistent contribution that these new products bring to the table.

Operator

We have time for one more question today. And that comes from Alice Longley of Fulcrum.

Q - Alice Longley

Hi, good morning. Just so I can understand your guidance better. Can you tell us where on the P&L, the 40 million to $45 million in savings, will show up and how much of that is in cost goods sold, and how much of that is in operating expenses?

A - William Lauder

Probably about 80% of that number will show up in operating expenses. There will be some benefit in cost of sales, but the vast majority will be operating expense related.

Q - Alice Longley

Okay. And then can you give us an update on what the ratio of advertising to sales is going to look like year-over-year for the year?

A - William Lauder

You know, it's somewhat sensitive as you know. Somewhat sensitive to the level of sales growth that we have overall as the Company. We were forecasting that number to start to come down as a percentage of sales. I still believe that that will in true for the year, but, again, it depends where our sales come within the range of the 3 to 4% guidance that we have given you.

Q - Alice Longley

All right, thank you.

A - Rick Kunes

Don't forget when you are looking at the advertising ratio, our two largest brands, the Estee Lauder and Clinique brands are the biggest advertisers yet, our fastest-growing brands have significantly lower advertising rates as a total of their sales. So as our mix of business changes, and our faster-growing brands that are not as dependent on advertising for their growth begin to contribute a larger portion of the total, while our actual voices and page rates, and all the other GRP measurement points of advertising voice for the existing brands, Lauder and Clinique in particular don't change, the mix changes on its own, because of the growth in brands that are not as advertising-dependent.

Q - Alice Longley

Can I ask a question about that for the brands not as advertising intensive, whatever advertising you do, is that intensity going up? In other words, is the ad-to-sales ratio for the smaller brands likely to intensify as they become bigger brands, and more established brands?

A - William Lauder

Well, in actual fact what we are finding is, that these brands are able to stimulate their top line quite effectively, with a very consistent marketing message that is a very different mix, than more traditionally advertising-driven brands. And they are not looking towards increasing their voice to accelerate their growth, because they are finding that the different means and methods to which they accelerate their growth, are not necessarily dependent on advertising.

Q - Alice Longley

All right, thank you.

Operator

Thank you. If you were unable to join us for the entire call, a playback will be available between 12:00 noon Eastern time today through Wednesday, November 2. To hear a recording of the call, please dial in to 888-203-1112, and reference passcode number 8413888. That concludes today’s Estee Lauder conference call, I would like to thank you all for your participation, and wish you all a good day. You may now disconnect.

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