The Estee Lauder Companies Inc, F2Q08 (Qtr End 12/31/07) Earnings Call Transcript

Feb. 1.08 | About: The Estée (EL)

The Estee Lauder Companies Inc. (NYSE:EL)

Q2 2008 Earnings Call

February 1, 2008 9:30 am ET

Executives

Dennis D’Andrea – IR

William Lauder – President, CEO

Richard Kunes – Exec. VP, CFO

Daniel Brestle – COO

Lynn Green – Global President of Clinique

Analysts

Justin Hott - Bear Stearns

Alice Longley – Buckingham Research

Amy Low Chasen – Goldman Sachs

William Schmitz – Deutsche Bank

Connie Maneaty – BMO Capital Markets

Lauren Lieberman - Lehman Brothers

Neely Tamminga - Piper Jaffray

John Faucher - JP Morgan

Jason Gere - Wachovia Capital Markets

[Julia Mineeva – Scabelli Company]

Operator

Good day everyone and welcome to The Estee Lauder Companies fiscal 2008 second quarter conference call. (Operator Instructions) For opening remarks and introductions I’d like to turn the call over to Vice President of Investor Relations, Mr. Dennis D’Andrea, please go ahead sir.

Dennis D’Andrea

Good morning everyone. We have on today’s call William Lauder, President and Chief Executive Officer, Richard Kunes, Executive Vice President and Chief Financial Officer. Daniel Brestle our Chief Operating Officer is here and he will be available for the Q&A. We’re also pleased to have Lynn Green, Global President of Clinique with us today to discuss recent initiatives at that brand. Since many of our remarks today contain forward-looking statements, let me refer you to our press release and our reports filed with the SEC where you’ll find factors that could cause actual results to differ materially from these forward-looking statements. I’ll turn the call over to William.

William Lauder

Good morning and thank you for joining us. Today I’d like to discuss our overall business results. Rick will provide the financial details and Lynn will discuss some of the exciting developments at our Clinique brand.

For our second quarter reported sales rose strongly up 16%. On a local currency basis sales were up 11% within the range we forecasted. Diluted earnings per share were $1.14 also on target with our guidance. The sales growth we experienced was across the board. Every product category in every region showed gains. Our robust international business fueled much of the increase and has been the catalyst for our growth for several years. We expect this trend to continue for this foreseeable future.

Asia/Pacific was our top performing region where all categories grew most by double-digits. Sales on every brand were sharply higher and our shipments rose in every country with particularly strong growth in China, Hong Kong and Korea. The regions’ retail environment strengthened from the first quarter and our distribution expanded. For example, we opened five free standing stores for five different brands in a new mall in Hong Kong. As a company we have achieved positive retail sales growth in Japan for 12 or the last 13 months. Sales of Prestige Cosmetics in Japanese department stores grew in the quarter and the category’s expected to continue to show gains. We expect our growth to outpace that of Prestige Beauty category.

Business was also healthy in Europe, The Middle East and Africa. Overall our international fundamentals and growth drivers remain in place although some markets are experiencing softness. For the second quarter in the UK Bobbi Brown and Jo Malone both saw double-digit growth and Jo Malone opened a new store in [Gilford]. Our ecommerce business nearly tripled this quarter with eight brand sites currently operating. Additionally the launch of Sean Jean Unforgivable Woman and the success of Tom Ford Beauty aided our growth. In Italy new malls are opening in the central and southern portion of the country. The Prestige sector is growing faster than the beauty markets as a whole, and we see further opportunities for expansion in Fragrance and Makeup. Tom Ford is now available in 92 more doors than last year and we took over the distribution of Darphin where sales have increased.

In Germany we had solid growth in the quarter and we believe that sales will exceed our projections for the remainder of the year. France benefited from the success of Tri-Aktilline, a terrific new product from our Good Skin labs which was launched exclusively in 536 [inaudible] doors throughout Europe. Our efforts to expand and diversity our distribution also contributed to the sales growth. Origins opened in 26 additional pharmacies and Jo Malone added two free standing stores. M A C opened both department store and free standing doors this quarter complimenting it’s dynamic like door growth.

You may recall that in the fourth quarter of fiscal 2007 and earlier this fiscal year we directed more investment dollars to support our brands in fast growing emerging markets. That spending was allocated largely to building free standing stores, introducing our brands into new doors, hiring and training employees and in advertising and promotion. I’m pleased to report that these investments are paying off. In total our emerging markets sales climbed a strong 46% in the quarter. In China retail expanded at a fast clip. Most brands had double-digit growth. Company wide we estimate that our share increased by 3% in the quarter and we are now the second largest Prestige Cosmetics group in the stores where we sell.

The majority of Prestige Beauty sales in Asia are in the skin care category but makeup is gaining traction in China and represents a strategic opportunity for many of our brands. In fact makeup comprises about 19% of Prestige Cosmetic sales in China’s department stores and is the fastest growing category in the channel. M A C and Bobbi Brown had terrific retail sales growth in the quarter and have become the top makeup artist brands in the country in their points of distribution. Retail take away for Bobbi Brown was exceptional; nearly triple that of the prior year’s quarter and shipments kept pace with that demand.

Estee Lauder and Clinique brands opened in eight Safora stores and M A C added a department store counter. We believe there is still much growth left in China. We plan to take our brands into more department stores, increase our distribution and expand beyond the 33 cities where we currently operate. While ecommerce is in its infancy in China we are evaluating the online opportunity for our brands.

Sales in another significant emerging market, Russia, were stellar. The Estee Lauder brand was a standout driven by existing and new door growth. The brand opened 177 doors in Russia in the last year bringing its total to nearly 500, part of an aggressive strategy to quickly capitalize on the growing opportunity. The company’s total life door growth in Russia was 46% this quarter compared with the prior year period.

Turning now to the Americas, sales in the period benefit from a shift in the retail calendar that moved $40 million of shipments from the first quarter to the second which we discussed during the last call. As you know overall US holiday sales were disappointing particularly in department stores, our primary channel of distribution. Our total US department store retail sales for the quarter declined 2.5%. Some brands and products faired well and we saw mixed results from holiday gift sets. The Estee Lauder brands Blockbuster completely sold out at retail although some of its other holiday sets did not completely sell through. We had good results for holiday programs at M A C, Bobbi Brown and Jo Malone. All sold well and exceeded their prior year results. Strong sales in other channels however more than compensated for the overall slowdown in department stores. Those channels include our free standing stores, our network of hair salons and our growing ecommerce business. Their results reflect our long standing strategy of diversifying distribution. In fact in North America over the past five years, the mix of our business in alternative distribution grew by close to ten percentage points to 30%.

Our internet business has made great strides in recent years and that continued this quarter with a solid 30% growth in the US. Healthy gains came from our brand sites as well as our retailer partner sites including those run by Macy’s, Norstrom, Neiman Marcus and Safora to name a few. Online sales for most of our brands grew strong double-digits ranging from 17% to over 100%. Aside from the internet we continue to identify other ways to get our products in front on consumers whenever and wherever they choose to shop for Prestige beauty products. We have some exciting distribution concepts in the works and Lynn Green with discuss several initiatives for the Clinique brand including the recently announced collaboration with Allergan.

Now I want to briefly discuss our outlook for the second half of the year. You may remember that when we started the fiscal year, we saw weakening US business environment and expected department stores to remain soft. We now feel somewhat more cautious than we did six months ago due to growing economic uncertainty in the US. Retailers ranging from mass to luxury saw shoppers reduce their spending during the holidays. Many upscale retailers which had enjoyed unrestrained growth for years are seeing a slowdown in spending from their core consumer. We believe as many observers do that the turmoil in the housing sector, higher oil and gas prices and erratic stock market and constant talk about a possible recession will contribute to soft retail sales in the US for the balance of our fiscal year.

While we are also seeing pockets of softness in certain foreign countries we believe our international business overall will remain solid, more than compensating for slower domestic growth. Most of our brands are expected to expand for the remainder of the year. To site a few examples, La Mer and Bobbi Brown each in tend to launch in four countries. Origins plans to open in almost 80 additional [French] pharmacies. Additionally some Beauty Bank brands are expected to roll out in Australia and Good Skin is planning to sell Tri-Aktilline on DIRECTV in Korea, in limited booth stores in the UK and in the [Dougolas] chain in Germany. Good Skin and Flirt! expect to begin ecommerce in Korea shortly.

On another note I am proud to report that as of December 1, 2007 the company’s global operations division has entered into agreements to insure that all of the electricity it utilizes is generated from green sources. The Estee Lauder Companies now ranks 21st on the EPA’s list of leading Fortune 500 companies in alternative power usage. The wind, hydro and solar power we are purchasing annually equates to a carbon dioxide reduction of over 35,000 tons, about the amount produced by driving 67 million miles. We’re committed to reducing the ecological impact of our business and I believe we have made terrific progress in this area.

Another major development will be the arrival of our new President and Chief Operating Officer [Fabrizio Freda] who joined us on March 3rd. We’re thrilled to have Fabrizio help lead The Estee Lauder Companies. He is a talented global executive with the right skills, extensive experience and financial discipline that will compliment our strong leadership team. Initially he will delve into global operations, bring a fresh perspective to strategic and operational planning and assess opportunities for further growth. He will be a strong partner with me as we continue to drive our company’s growth and profitability objectives.

To conclude my remarks, I want to reiterate that although the US economy is likely to remain uncertain for at least the short term; our story is still a growth story. We fully plan to execute our strategic imperatives and make investments to enhance profitability and shareholder returns. We are prepared to keep a tight lid on expenses in order to achieve our profit objectives. As always we will remain the preeminent leader in Prestige Beauty by doing what we do best; building brands, creating cutting edge products, designing effective marketing programs, providing excellent service and speaking to consumers in a voice they can relate to no matter where they live and shop.

Now I will turn the floor over to Rick who will discuss the financial details.

Richard Kunes

Thank you William and good morning everyone. In local currencies sales this quarter were up 11% over last year. The US dollar weakened more than we anticipated adding five percentage points of growth resulted a reporting sales growth of 16% to $2.3 billion. New earnings for the quarter increased 8% to $224.4 million compared with $208.4 million last year and diluted EPS was $1.14 compared to $0.99 in the prior year quarter. Both sales and EPS results fell within our guidance ranges. A number of investments that we originally planned for last quarter happened as expected this quarter. These include new door openings for M A C, expansion in emerging countries and [AMP] investment in other international markets. During the quarter we saw robust growth in all regions and all categories. When we look at our geographic results we had a suburb quarter in Asia/Pacific which saw strong local currency sales growth in every country. Among our largest markets in the region, we are pleased with the sustained growth in Japan where nearly all brands saw increases this quarter. Korea and Australia, the second and third largest countries in Asia/Pacific grew in the mid teens. These three markets represented over half the region’s sales for the quarter. China, our largest developing market in the region jumped over 50% fueled by robust Prestige Beauty growth, expanded distribution, share gains and increased penetration of our developing brands. We are now in 81 department stores and 31 Safora stores in 33 cities across China.

In Europe, the Middle East and Africa we again posted double-digit local currency sales gains. As has been the case for 12 consecutive quarters our travel retail business grew rapidly. The 17% sales gain this quarter was fueled by increases in international travelers, new airports, improved retail stores and expansion of new brands and products into the channel. In the rest of the region, all countries were up, with UK business growing high single-digits fueled by strong results from our Jo Malone brand, continued success of our makeup artist brand and robust sales from our ecommerce business. Travel retail and the UK affiliate represented nearly half of our sales in the region this quarter. Among our developing markets in the region, Russia once again was up sharply growing nearly 60%. Our eastern European business rose more than 40% and Turkey gained over 30%.

The relatively strong sales growth in the Americas reflected the shift in retailer orders of approximately $40 million into the second quarter due to the change in the retail calendar, as well as the inclusion of sales from the Ojan brand acquired in July. The region’s underlying growth was generated by strong sales gains in alternative channels other than US department stores. Canada and all countries in Latin America also saw growth. Taken together these areas grew more than 25% in the quarter. These factors mitigated our 2.5% retail decline in the US department store channel.

Our gross margin was unchanged compared to the prior year quarter at 74.9%. Favorable exchange rates of 20 basis points and unfavorable manufacturing variances of ten basis points were offset by an increase in obsolescence charges of 20 basis points and an increase in the level and timing of promotions of ten basis points.

Operating expenses as a percentage of sales for the quarter rose to 58.9% from 58.2% last year. As we described on our last conference call we carried over a high level of investment spending from our fiscal ’08 first quarter primarily in international markets. A few other key areas where we spent money this quarter include incremental spending for global information technology of 50 basis points and new business development activities of 40 basis points. The comparatively low operating expenses generated by our higher growth brands as well as our ongoing cost containment initiatives offset most of these increases. As a result operating income rose 11.5% to $370.5 million compared with $332.4 million last year.

Looking at operating profits by category, makeup and skin care were the primary beneficiaries of the $40 million shift in department store orders from the first quarter. Makeup results reflected strong international growth partially offset by softness in the US in some brands. Skin care profits rose due to global growth of certain core brands and contributions from La Mer. Fragrance posted a nice increase in operating income due to strong international sales. Hair care results declined reflecting amortization of intangible assets from recent acquisitions and investments to support growth in distribution. By region, operating profit decreased in the Americas but grew substantially elsewhere. In Asia/Pacific operating income increased as every country in the region achieved gains. Australia, Japan, China, Korea and Hong Kong were the largest contributors.

In Europe, the Middle East and Africa operating results primarily reflected improvements in the UK, travel retail, the Balkans and Germany. These gains were partially offset by spending in support of our continuing expansion in Russia. The decline in the Americas was primarily because of the increased spending in information technology infrastructure and new business development initiatives. In the US the benefit from the retail calendar shift was offset by ongoing challenges in the department store channel.

Regarding our net interest expense, we reported $18.3 million this quarter versus $7.7 million in last year’s second quarter. The increase is due to higher average set balances from financing our accelerated share repurchase last fiscal year. The affective tax rate for the quarter was 34.9%. Operating cash flow for the six months ended December 31, 2007 was $361.9 million as 16% increase compared with $312.7 million last year. The increase primarily reflects higher income after adding back non-cash items such depreciation, amortization, and stock-based compensation as well as improved accounts receivable collections. Our day sales outstanding improved by two days this quarter to 43 days. Inventory days increased to 174 days compared with 165 days last year. The nine day increase was due to three days resulting from the inclusion of Ojan and safety stock to support new business in emerging markets, approximately two days related to foreign currency translation and about four days from the expected growth of our business.

During the six months we repurchased approximately 1.9 million of our stock at a cost of $80 million. We spent $160.4 million for capital expenditures for the six months which includes incremental spending for counters and our company wide systems initiative. For fiscal ’08 we expect to generate between $650 million and $750 million of cash flow from operations and to use approximately $325 million for capital expenditures.

Now I’ll update you on a few assumptions for the balance of the fiscal year. For the year strong international sales will lead growth. America sales will grow slower than the company as a whole as we expect softer US sales to reflect the tough retail environment. We still expect fiscal 2008 local currency sales growth to fall within our full year guidance of about 7% to 9%. Foreign currency translation is anticipated to add approximately three and one half percentage points to growth. As always we will continue to invest in the areas that project our brands and grow our brands. However, we are prepared to adjust our spending where appropriate to protect the bottom line. At this time we estimate our affective tax rate will be approximately 36%. We reconfirm our full year EPS forecast of between $2.28 and $2.40. Looking at the third quarter our sales growth and EPS will be impacted by the soft retail sell through in the second quarter for the Americas. That said sales for the three months ending March 31, 2008 are forecasted to grow between 8% and 10% in local currency. The positive impact of foreign exchange translation should add approximately three and one half percentage points to growth.

EPS for the third quarter is expected to be between $0.43 and $0.49. When you do the math, strong EPS growth is implied for our fourth quarter. I’d like to remind you that we spent heavily in the fourth quarter of last year creating an easy comparison. This is also one of the reasons we have enjoyed such terrific sales growth this year particularly in international. That concludes my comments and now I’d like to turn it over to Lynn Green.

Lynn Green

Good morning and my pleasure to speak to you about Clinique. As you may already know Clinique is a significant part of the company’s portfolio, both in North America and internationally. In fact 60% of our sales are now outside of North America. Internationally the brand is growing double-digits with some outstanding highlights. William mentioned the Russian growth for the Estee Lauder brand; Clinique’s growth is incredibly vibrant as well, over 60% this fiscal year.

Clinique’s strategy for all emerging markets including Russia is to build a strong foundation while accelerating door expansion on a sustainable basis. In Russia consumers view the Clinique consultants in the white lab coat as a significant symbol of the brand’s authority. To keep up with the tremendous growth in Russia we have more than doubled the number of Clinique consultants this year. The Russian consumer relates very well to our allergy tested and fragrance free points of difference. Our solid growth in the rest of Europe reflects our focus on strong Clinique fundamentals including our 3-Step Skin Care system, dynamic moisturizer category and foundations. As an example the successful launch in September of Super Moisture Foundation reinforced our number one position in the face category throughout Europe.

We are also doing very well in Asia. Clinique is experiencing double-digit growth in China and it has been accelerating every month since the beginning of the fiscal year. Our Japanese turnaround which began about a year and a half ago is continuing. It is being driven by new consumer recruitment as in indicated by 3-Step’s double-digit growth. Our acne solutions product line was successful everywhere it launched literally doubling that particular category. In Korea it ignited high double-digit growth for the entire brand since its launch at the beginning of the fiscal year.

Today I’m most excited to talk to you about some interesting initiatives in the US. As you know, Clinique ranks number one with more than a 13% share of US Prestige department stores. Our strategy is to strengthen that business which has been challenging. And at the same time reach new and lapse consumers through alternative channels. This approach should benefit the overall Clinique in the United States. Clinique announced last week that it is reinforcing its dermatological heritage through its strategic collaboration with Allergan the number one global medical aesthetics company. Together we will develop a Clinique branded skin care line that will be sold exclusively through United States physicians’ offices. The products are expected to launch this fall. This collaboration combines Clinique’s expertise in product development with Allergan’s deep understanding of the physician channel. As you know, Allergen sells Botox cosmetic, [Guviderm] and other products to dermatologists and plastic surgeons. The new Clinique skin care line will be used before and after in office cosmetic procedures such as microderm abrasions, chemical peels and laser treatments. In the last ten years, the market for non-surgical aesthetics procedures has grown nearly 750% to $4.5 billion. The Clinique Allergan initiative enhances the dermatological heritage of Clinique by adding new authority to the original positioning. This is a tremendous opportunity to tap into a growing channel while simultaneously enhancing Clinique’s brand equity. While physician’s offices are relatively small channels for skin care, at more than $230 million now, it has grown by over 18% annually during the past five years. Importantly the combination of our two industry leading companies could expand sales in the channel further.

Clinique’s positioning gives us the flexibility to pursue alternative distribution. To further articulate that point I’m excited to talk about our next new initiative, QVC which begins this month. As you may know direct response TV is a rapidly growing channel for beauty. Sales in our category on TV were close to $600 million in 2006 growing at about 13% per year. Clinique will premier on QVC for the first time on Sunday, February 17. This new channel will provide a platform to speak about the equities of core Clinique product categories such as 3-Step Foundation and Protection. We believe the positioning and price points of Clinique are completely suitable for the DIRECTV consumer. We know this channel also drives the overall department store traffic based on the experience of some of our other brands.

On QVC we will be able to articulate some of the significant Clinique points of difference, namely that all the products are allergy tested and fragrance free. In addition the ability to communicate through a personality amplifies our consultant heritage in front of 90 million households and 2.5 million active beauty buyers. We also expect to have an additional opportunity to pursue our business on QVC.com one of the largest online beauty venues. Allergan and QVC offer new opportunities for us. It is also important to enhance the customer experience in the department store, not only for the existing core consumer but for the potential new consumers that may come from these two initiatives.

Let me briefly talk about our program to improve the experience of our core consumer base in the department store where some $9 billion in Prestige beauty sales occur in the US every year. We are redefining the experience that a Clinique shopper receives in this environment. Last fall we implemented a test program in more than 70 doors that improved customer service. Clinique’s consultants were given expanded educational programs that offered them the opportunity for additional recognition and additional compensation. So far, the extra education has translated into greater sales. AT the test site sales growth is higher than it was at the same time last year and consultant turn over has been cut by a quarter, a meaningful reduction. Based on what we have learned from this test we expect to expand this program in the next 12 months. In international we’ve completed 35 doors in 14 countries with even better results. This program reinforces Clinique’s service which is one of its core values in the department store. We also feel that it is important to note that Clinique is enjoying a vibrant business with Safora. We currently sell Clinique in 169 stores in the US growing over 80%. We are excited because this validates the relevancy and desirability of Clinique with the younger consumer. Double-digit international growth. We are pleased with these results. The Allergan collaboration, the QVC environment and the enhancement of the core consumer experience, we feel these initiatives provide equity building opportunities that enhance our existing distributions while also building relevancy with the younger consumer in Safora. I am glad I had the opportunity to speak with you today and we’re happy to take your questions now.

Question-and-Answer Session

Operator

Your first question comes from Justin Hott - Bear Stearns

Justin Hott - Bear Stearns

Maybe we could start with William, maybe some of the decisions on for the management changes going on, rationale, the process and maybe of the changes we could expect to see over the next year.

William Lauder

Justin thank you, the rationale really we were talking about how we can look at our management team, look at our strengths and find a way to compliment the strengths and deep experience that our senior management team has in our industry. The average tenure in the Prestige Beauty industry of the senior executives at our company is over 20 years and that brings a great deal of benefit to our company but we also felt that there was an opportunity for us to bring a new vantage point and a new view to the way we manage our business and grow our business in the future. And so we started looking for the best talent and abilities around, we really tried to cast our net far and wide to look for the best product branding and consumer oriented talent we could with disciplines that we think would be beneficial to our company. And in the process I was fortunate to meet Fabrizio as an available executive and great leader whose mind I have a great deal of respect for and he and I clicked very well and I think he’ll be a great partner to me.

Justin Hott - Bear Stearns

Can you tell us a little about his background, what you found particularly compelling in his background?

William Lauder

He’s got a broad background based primarily in, his career was predominantly with P&G, however he did spend some time with the Gucci Group in Italy. He’s been both a country manager for P&G as well as a category manager. Has had some exposure to the luxury good sector at P&G and I thought his strategic thought process, the way he builds an argument and a thought process as well as the disciplines he takes to building his business I thought would be very compatible and would add a great deal to what our company is all about.

Justin Hott - Bear Stearns

Okay thanks.

Operator

Your next question comes from Alice Longley - Buckingham Research

Alice Longley – Buckingham Research

Can you detail a little bit what you’re planning to do with costs in the Americas to offset the weakening sales, what kind of plans are you cutting back on for the year?

Richard Kunes

We’re experiencing what everyone is experiencing. I think that as everyone’s describing it’s going to be a rough road. There’s not going to be a lot of cut back. The cores of our business, continue supporting our promotional program, continue supporting our demonstration which is our people behind the counters, they’ll all stay in place. And we’ll be smarter in some of the discretionary expenses we have but we really aren’t going to walk away from the market. We’re going to continue to participate. Sometimes in bad times there’s more opportunity than the good times, so we’re looking forward to it.

Alice Longley – Buckingham Research

Should I assume a margin decline in the Americas despite these costs for the year?

William Lauder

I think you should assume that, you know our business is a little soft in the US certainly and it will put pressure on our margin but we try to manage our business globally and we try to manage our business to meet our financial obligations and commitments to you the investment community and I think we’re doing a pretty good job of that and you know we’re using our strength in international to not only fund investments in international but to also offset some of the toughness that we have in the US.

Richard Kunes

Let me give a little bit of clarification on my statement, when we talk about softer businesses we look at the productivity of our makeup artist, beauty advisor, consultant, you name it, and we will adjust that staff versus that productivity. So if traffic is down we naturally adjust the staff to that so we maintain a selling cost. So it’s not business as normal, we’re adjusting our staffing based on the environment.

Alice Longley – Buckingham Research

And you’re adjusting the staffing at retail; you’re basically supporting fewer people or supporting them less?

Richard Kunes

Yes, we won’t fill openings as quickly if we don’t have the productivity from the existing counters. Each of our beauty advisors, each of our brands, have a certain benchmark and whether its $200,000 per person or $150,000 per person, we expect to get that from every employee at the counter. And we adjust that up and down based on the business.

Alice Longley – Buckingham Research

Thank you very much.

Operator

Your next question comes from Amy Chasen - Goldman Sachs

Amy Chasen - Goldman Sachs

Obviously it sounds like in the third quarter you expect your US business to slow pretty materially given some of these excess inventory levels, but when you look at the second half of the year do you expect that to be substantially slower than the first half? I’m just trying to get a sense of how much of this slowing is related to the excess inventory versus your comments about the weaker consumer.

William Lauder

I think Amy for the second half of the year you’ll see our sales in the US will obviously be the slowest growing region. I don’t think you’ll see quite the softness in the fourth quarter that we’re going to see in the third quarter but so that’s sort of an answer to your question. The third quarter’s really being impacted by what was sold in the second quarter which didn’t totally sell through. So the reorders are a little bit softer but it’s not disastrous for us. And we mentioned during the call that by the way everything other than US department stores in the Americas region grew by 25% in the second quarter and that trend we expect to continue.

Amy Chasen - Goldman Sachs

Let me just ask, it sounds like in the third quarter that your US sales are actually going to be down, but you’re saying that the fourth quarter growth will not be as bad as the third quarter growth? Does that mean that for the fourth quarter we can expect that sales will be up?

William Lauder

Our third quarter’s sales growth rate will be down, but our sales will not be down in the third quarter versus prior years. And our fourth quarter growth rate will be more in line with the first and second quarter.

Amy Chasen - Goldman Sachs

The average of the first and second quarter.

William Lauder

Yes.

Amy Chasen - Goldman Sachs

Great, thank you.

Operator

Your next question comes from William Schmitz - Deutsche Bank

William Schmitz - Deutsche Bank

Can you just talk a little bit about where the margin leverage is coming from, the model because you said that that $40 million calendar shift was about a 70% margin? I know there’s a big fix cost base and there’s also reinvestment, and so I know it’s a pretty broad question, but can you kind of talk about why given such strong organic growth that you’re not getting more volume leverage off of it and I know there is some reinvestment, but when does that kind of taper off?

Richard Kunes

Bill you remember that in the first quarter we exceeded what our guidance because we had not spent all of the money that we anticipated and in particular in some of the international markets and so we said that that spending would carry over into our third quarter and obviously in the guidance that we gave for the second quarter we knew about the $40 million shift from the first quarter to the second quarter so that was all sort of built in. We’re investing heavily internationally, our business is doing terrific, you know some of those investments are markets where the profitability is still developing if you will. So China and to some extent Russia, where we’re making heavy investments but they’re not, they don’t generate the same profitability level but it certainly drives share growth, it drives sales and it positions us well for the future. So I think our story has been fairly consistent in that nature and that we think we’re doing a reasonable job at it.

William Schmitz - Deutsche Bank

Okay good and just a follow-up sort of related, it looks like accounts receivable only increased about 9.5% year over year but sales were up 16%, does that mean that sales slowed down toward the back end of the quarter?

Richard Kunes

I’m sorry Bill, the first part of your….

William Schmitz - Deutsche Bank

If you look at accounts receivable it was only up about 9.5% year over year but sales were up 16% and so I’m wondering if sales slowed as the quarter kind of progressed because you would assume that you know if it was evenly split that sales and accounts receivable should grow at the same rate.

Richard Kunes

Bill only a little bit to some extent in the US, that would be a true statement, but other than that it’s just, it’s a pattern of our collections and you know our DSOs did go down by a couple of days and that’s just really a mix of business. There’s no particular item that stands out as to why we did a better job collecting our receivables in this quarter than the same quarter of last year. So the only thing where your statement holds true to some extent is in the Americas where we started to see that slowdown of reordering towards the end of our second quarter and now it’ll carry over into the third quarter.

William Schmitz - Deutsche Bank

Great, thank you.

Operator

Your next question comes from Connie Maneaty - BMO Capital Markets

Connie Maneaty – BMO Capital Markets

I was hoping you could explain a little bit more the decline in Americas operating profit because there’s almost a 26 point spread between sales growth of 9% and the profit decline of 17%. You had positive currency from Canada and Latin America I imagine in the profits. So what accounts for that decline?

Richard Kunes

A couple of things Connie, there was some carry of expenses although most of it was internationally related, there was some carry over from quarter one into quarter two in the Americas. We also spent fairly heavily in particular in this quarter on IT related spending including or SMI initiative and a lot of those expenses were, there was about $7 million I think of incremental expense in the second quarter versus history. The third thing was that there was some amortization of intangible assets related to some recent acquisition that impacted our second quarter to some extent a little bit more so than it will normally happen because we did some adjustments to our first quarter results. They weren’t substantial but it just increased the number if you will in the second quarter so I think those are really the three major items that are out there.

Connie Maneaty - BMO Capital Markets

Okay and as a follow-up with inventory days continuing to go up do you envision at some point having to take an inventory write down?

Richard Kunes

No you know if at the end of the first quarter I think Connie our inventory days were up, I want to say 19 days year over year and at the end of this quarter they’re up nine days year over year so we’re actually beginning to get our inventory back in line. We don’t anticipate anything unusual. We did mention that there was about a 20 basis point impact I think or a ten basis point impact due to obsolescence and that’s a charge for reserve in case there are any issues with the inventory. So I think from an accounting perspective we’re not seeing anything from a major adjustment or write off due to inventory.

Connie Maneaty - BMO Capital Markets

Is that ten to 20 basis point impact due to obsolescence, is that a new feature in cost of goods and should we be putting it in our models going forward?

Richard Kunes

No it’s just a reflection you know, there’s always provision for obsolescence that goes into any of our financial results. It’s just incrementally it’s a little higher because of our higher inventory position in this particular quarter.

Connie Maneaty - BMO Capital Markets

Okay, thank you.

Operator

Your next question comes from Lauren Lieberman - Lehman Brothers

Lauren Lieberman - Lehman Brothers

I just wanted to see if you could talk a little about the UK market in particular. I know you said that it was, you actually called it out as being particularly strong this quarter but in terms of the outlook, the news coming out of the UK doesn’t seem to be terribly encouraging from a consumer standpoint just like it isn’t in the US, so if you can talk about the business over there a little bit.

William Lauder

Sure Lauren, our business in the UK continues to be a very robust and healthy business. It is our largest business outside of the US; it’s the second largest country in the world. We have the second greatest share, our share in North America is greater, but our UK business is extremely healthy and extremely good. Our comp growth quarter, the comp growth in the second quarter in the UK was 8% which is very healthy relative to our growth in North America but for the UK market that was the first time in about three or four quarter for them where they did not grow on a double-digit rate. You’re correct, everything that you read and I read about the overall health of the economy in the UK would indicate that they will follow a pattern like the US, however we’ve tended to see in our business that that does not follow lock step with the US. But I would expect that there will be some continued softness in the UK. But we’re not seeing that yet and as I mentioned in my prepared remarks they launched their internet business in the fall of this year and was extraordinary strong relative to the size of the total market and we were very impressed and we continue to see strong demand for a number of our brands across the country.

Lauren Lieberman - Lehman Brothers

Does continued softness though, because you said for you guys right now 8% versus double-digit is considered soft, so are you expecting that level or a deceleration ….

William Lauder

Lauren, let’s put it in perspective. In a very mature market 8% growth everyone ought to be very happy with and we are very pleased with 8%. If you will for a group that’s used to double-digit they’re not as pleased with 8% as they would be with 10%, 12% or 15% as I think most of us would. But we’re pleased with a business that’s over $500 million or some number greater than that to be growing at 8% and we hope that they’ll continue.

Lauren Lieberman - Lehman Brothers

Okay, thank you.

Operator

Your next question comes from Neely Tamminga - Piper Jaffray

Neely Tamminga - Piper Jaffray

With respect to the US consumer, not to beat a dead horse on all these conference calls during Q4, but I would think that the department stores would be looking for some partnership with respect to PWPs or GWPs, are you getting that sense from them and should we be factoring that in our models in the second half?

Daniel Brestle

They’ll looking obviously for us to step up and do whatever we can to help generate sales and this is from the most, there are up scales, especially stores all the way through the basic department store, but we can’t move as quickly and we don’t have the mechanism to move much quicker than what we have sort of laying around in inventories, so we have great programs. I think all of our retail partners have looked at our spring programs and I think they’re stronger in every division. They are happy, they’re walking away saying that we are primed for a good season if the consumer cooperates so, it’s not a matter of extra and excess and more programs its matter of better executing the programs we have.

Neely Tamminga - Piper Jaffray

I guess related to that if Lynn could speak if she’s still around on the direct mail initiatives I think Clinique has had in place to reignite and reengage some of their former customers, is that playing into some of your plans for the March and June quarters?

Lynn Green

I’m glad you asked about that, yes. We have had nice success with the recruitment that we have done on the lapsed consumers. Most especially some of the lapse consumers from some of the merger and we will indeed continue that and I think that even is relevant on the gift with purchase promotions as well that that lapse consumer we made sure on some of these last promotions that we’ve done that she receive the proper notification of the promotions that were happening.

Neely Tamminga - Piper Jaffray

Great thanks, good luck.

Operator

Your next question comes from John Faucher - JP Morgan

John Faucher - JP Morgan

I guess I’m looking at the guidance for the back half of the year and as I look at this I’m just trying to figure out why if we look at the mid point of the range here, why given the affect of the spending comps seems to be relatively high, the SG&A was up a lot in both the third and the fourth quarter why we’re seeing it looks like a slightly lower number for the third quarter and a higher number for the fourth quarter, can you talk about the programs, the spending, what have you, given the fact that the spending comps don’t look dramatically different for either quarter.

Richard Kunes

In our third quarter we actually, there is a disproportionate spend if you will, on new product launches and on expanding our newer brands internationally as well as in new and growing markets. We have some TV advertising that we don’t do a great deal of but there’s a couple of TV campaigns, one in France one in China in particular, that’s happening in the third quarter. And we do continue to spend quite heavily to drive that top line growth especially in these developing markets like China and Russia. M A C is also opening quite a few free standing stores in the third quarter and again that’s based on the timing of us being able to take occupancy of those stores to make sure that that spending happens in the third quarter. So we are investing quite a bit in the third quarter and relative to last year, in the fourth quarter our spending is not as high by any means. So we think, and again it’s sort of proven out if you will John that we invest our money where we see opportunities to grow. We invested in the fourth quarter of last year and the first quarter of this year, we’ve driven tremendous growth internationally. That trend is really helping us. We’re gaining market share and we have to spend when we think we have the competitive opportunity and not so much worried about the quarter by quarter results. We just try to give you guys a heads up on what we’re going to do.

John Faucher - JP Morgan

Okay, thank you very much.

Operator

Your next question comes from [Julia Mineeva – Scabelli Company]

[Julia Mineeva – Scabelli Company]

I wanted to ask if you have raised your prices in the recent quarter and also if you’re planning to raise them in the future and especially in Asia and Japan.

Daniel Brestle

We didn’t take any unplanned increases. We have some selective brands we’ll raise prices in some countries. I think we have two price increases, one in March and one in July, but nothing unplanned like some of our competitors have been announcing.

[Julia Mineeva – Scabelli Company]

What about Japan in particular?

Daniel Brestle

I don’t know Japan sitting here, I’m not aware of any increase in Japan but Dennis can get back to you if we misspoke.

Richard Kunes

Generally you would not see in our business any meaningful moves on the total for our companies in price increases because we normally take them at a very marginal basis, they’re usually very incremental and given the broad number of SKUs we actually offer to the consumer around the world, that’s usually not a meaningful driver.

[Julia Mineeva – Scabelli Company]

Thank you.

Operator

Your next question comes from Connie Maneaty - BMO Capital Markets

Connie Maneaty - BMO Capital Markets

I’ve got a couple of follow-up questions for Lynn, what do you size the opportunity on QVC to be and before these initiatives that you announced today, what have the sales growth rate for Clinique been in the US say over the last three years?

Lynn Green

Let me talk about the QVC opportunity and the rationale for that QVC opportunity. The two pronged approach that you saw to our strategy which was QVC and also Allergan are really two strategic moves that not only are valuable in and of themselves for equity building purposes, but also drive the overall growth of the core consumer. We think that those two initiatives can recruit lapse consumers as an example and also new consumers. I think it is important to note that Clinique in some recent consumer research has a 92% awareness factor in the US in the Prestige arenas and we think that QVC can be an excellent conversion to buy opportunity both there and in the overall department store.

Connie Maneaty - BMO Capital Markets

You mentioned that there would be a personality, did you mean that there would be a spokeswoman who is known to viewers or did you mean something else by that?

Lynn Green

Actually the spokesperson will be the Senior Vice President of Development for Clinique and she has developed the new product for Clinique for a significant amount of time and we feel that she will be an excellent representative for the brand.

William Lauder

Connie as a follow-up to that part of the question, we’ve seen a pattern of success for DIRECTV where it’s not just about product that’s being presented but it’s actually the personality of the person presenting the product that makes a difference for the consumer who watches this media and shops this media and this channel that makes a brand successful.

Connie Maneaty - BMO Capital Markets

Does the Allergan brand have a name and who’s going to market it to physician’s offices?

Lynn Green

The Allergan brand does have a name, but we have not announced it yet and we will use the outstanding creditability of the Allergan Company to call on the physician channel.

Connie Maneaty - BMO Capital Markets

So that means you must have some, is a sale then profit sharing arrangement with them or how does the venture work?

Lynn Green

And we haven’t disclosed the financial terms at all.

Connie Maneaty - BMO Capital Markets

Okay and which of these two ventures do you think has the most upside QVC or, I mean which do you think will be bigger, QVC or Allergan?

Lynn Green

I actually put them in a tie. I think that they both have the opportunity to drive new consumers and to recruit lapse consumers and I wouldn’t give more to one or the other.

Connie Maneaty - BMO Capital Markets

Okay, thanks.

Operator

Your next question comes from Jason Gere - Wachovia Capital Markets

Jason Gere - Wachovia Capital Markets

I was wondering if you could give us an update on SMI and then secondly can you talk a little bit about some of the brands in the portfolio that are under performing, how you’re looking at potential divestures and also the acquisition outlook as well.

William Lauder

Let me answer the second question first for you, we’ve obviously in any portfolio company, we will have brands that are performing at or about your standards and brands that are not performing at your standards. A number of those brands that are performing at or above our standards we’re pushing them to continue their performance and enhance their performance and contribution to the company and using them strategically to grow our business in key markets around the world as well as to contribute financially. Brands that are not performing at our standard, we’re looking to find ways to make sure that they improve their performance as well as to minimize their under performance in one way, shape or form, if they are key and strategic different responsibilities. There’s a number of different brands which we believe have key strategic positions which are important to us as a key channel commander on a global basis and we continue to push them to improve their performance.

As far as the acquisition landscape, we’re continually looking at opportunities that would compliment our portfolio and enhance our long term strategic priorities. We’re primarily focusing in on category approaches and channel approaches and markets outside of North America; those are the three scenes we’re looking at. And we are also overriding throughout all of these scenes are brands that we feel we can successfully plug in to our deep creditability and knowledge of the channel in our network around the world.

As far as pricing is concerned, you know the ratios that are being paid out there and we know those ratios too and we will be reasonable and rational in our acquisition approach.

Jason Gere - Wachovia Capital Markets

And in terms of I guess some of those brands that you might consider to be under performing can you quantify what are tail brands or is that a small percentage of the portfolio?

William Lauder

It’s a small percentage of the portfolio. We’re continually pushing and like I say we feel that virtually every one of the brands in our portfolio has a reason for being and a reason for existence and if we didn’t feel they had a reason for being for existence they probably wouldn’t be in our portfolio any more.

Jason Gere - Wachovia Capital Markets

Okay and then can you just give the update and SMI and how should we look at in terms of the roll out?

Richard Kunes

Sure and we did if you heard earlier, we mentioned we are spending fairly heavily that it did drive an additional $7 million of spending in our second quarter. You know that [Deveta] is live, or you may know that we’re going, should go live with our first manufacturing facility later this calendar year as well as the financial backbone here in North America and we’re developing a model affiliate sort of concept testing and laying the groundwork for our first affiliate installation. Our hopes is that once that happens, we will then start to accelerate the pace because we will have really touched every single model that we have as a company and we will then begin multiple stream implementations and pick up the pace on it.

Operator

Your final question comes from William Schmitz - Deutsche Bank

William Schmitz - Deutsche Bank

…market’s growth which is great and very robust, can you just talk about kind of the economics of expanding there, does it work the same way. Is the inventory recourse, I mean do you accept returns, are you paying for half the fixtures, are you paying the commissions to the sales people, or the Estee Lauder employees, I know it’s kind of a broad question, but just trying to figure out how the margin mix plays out as you invest.

William Lauder

Hey Bill, we missed the first part of your question when we didn’t hear you start until you say markets, are you….

William Schmitz - Deutsche Bank

I was talking about developing markets and just the dynamics and how that kind of differs from the US and when the big sort of heavy up investment is going to be done but also the subtleties of that, of going there.

William Lauder

Well let’s talk, I’ll compare and contrast our two largest and fastest growing markets in the emerging markets category right now, China and Russia, and try to compare and contrast them. They each quite obviously have dramatically different dynamics to each other and each relates if you will to the region in which they are a part of. China being an Asian market is more a department store oriented market, it’s entirely department store oriented market. Russia being at the far end or the eastern end of Europe is really a perfumery oriented market and we’re seeing dynamics develop similar to their total regions. And as a result what you see in China is I think we may have quoted to you before the number of doors in the number of cities which are all based on concentration and productivity concentration in a department store model and basis where we do partner with the retailer in different expenses to driving the business in those marketplaces for the installation and others.

In Russia the comparison would be it’s mostly perfumeries. It’s primarily with two or three different perfumery partners as well as a handful of department stores and most especially the perfumery partners are very aggressively opening doors on an average of one or two a week in Russia. But these are perfumery doors, these are smaller doors that are not producing as much each but are going far deeper into more neighborhoods and we are now expanding our presence outside of the two major cosmopolitan cities of Moscow and St. Petersburg. The investment dynamics for each are very different but just to give you an idea; our emerging markets as we classify them combined are growing at 43%. The economics of these markets are similar, we expect they are both in profitability for total affiliates and certain brands within those are meaningfully profitable and are beginning to approach, or we see them beginning to approach the norms for those brands in the international arena and that’s what we expect over the longer period of time.

William Schmitz - Deutsche Bank

Okay so when does the mix stop being negative, have you kind of modeled that out?

William Lauder

I don’t want to make any prediction and tell you that on July 1, 2021 it’s going to be a certain number.

William Schmitz - Deutsche Bank

I hope it’s not that long.

William Lauder

Here’s the reality Bill and it’s an interesting number to look at. We want to look at, I mentioned earlier the UK which is our most developed market, it was the first international market we launched as a corporation and it was back in 1959 or 1960 and we want to look at relative penetration to the total population and disposable income and what those growth opportunities are. We have said in the past that for example China, a rapidly growing economy, a very large population with a certain level of wealth and that’s growing, you shouldn’t want us to stop investing or to reduce our investment until we begin approaching the penetrations that we have in the rest of the region relative to disposable income, luxury spending, retail channels and profitability and scale.

William Schmitz - Deutsche Bank

Okay that’s fair.

Operator

That concludes today’s question and answer session. If you were unable to join for the entire call a playback will be available at 12:00 noon Eastern time today through February 12. To hear a recording of the call please dial 800-642-1687 pass code number 29427240. 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.

William Lauder

Thank you.

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