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The Estee Lauder Companies Inc. (NYSE:EL)

F3Q08 Earnings Call

May 6, 2008 9:30 am ET

Executives

Dennis D'Andrea - Vice President, Investor Relations

William P. Lauder - Chief Executive Officer, Director

Fabrizio Freda - President, Chief Operating Officer

Richard W. Kunes - Chief Financial Officer, Executive Vice President

Daniel J. Brestle - Chief Operating Officer

Analysts

William G. Schmitz - Deutsche Bank

Lauren R. Lieberman - Lehman Brothers

John Faucher - J.P. Morgan

Filippe Goossens - Credit Suisse

Ali Dibadj - Sanford Bernstein

Christopher Ferrarra - Merrill Lynch

Wendy Nicholson - City Investments

Andrew Sawyer - Goldman Sachs

Alice Longley - Buckingham Research

Constance Maneaty - BMO Capital Markets

Operator

Good day, everyone and welcome to the Estée Lauder company’s fiscal 2008 third quarter conference call. 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

Good morning. On today’s call are William Lauder, Chief Executive Officer; and Rick Kunes, Executive Vice President and Chief Financial Officer. Fabrizio Freda, President and Chief Operating Officer, is also here. Fabrizio just started with us on March 3rd and he will make some brief remarks but he will not be available for questions today. Also on the call is Dan Brestle, our Vice Chairman and President of North America. Dan will be available for the Q&A session.

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 will find factors that could cause actual results to differ materially from these forward-looking statements.

Now I’ll turn the call over to William.

William P. Lauder

Thank you, Dennis. Good morning, everyone and thank you for joining us. I want to start by welcoming Fabrizio to his very first Estée Lauder Company’s earnings call. Fabrizio joined our company two months ago and he and I have begun forging a terrific partnership. His valuable consumer products experience and financial acumen are a great addition to our management team. I look forward to working closely with him as we take the company to new heights and reinforce our position as the global leader in prestige beauty.

In our discussion this morning, I will highlight our results and global business trends. Fabrizio will discuss where he plans to initially focus his attention and Rick will walk you through the financial results.

A hallmark of our company’s strategy is the geographic and category balance that enables us to consistently generate strong sales growth. To build on our momentum and capitalize on where we see the greatest opportunities, we have made strategic investments in our international businesses, including emerging markets. We are seeing that spending pay off, as is evident by our strong international results, which have helped offset the sluggish economy in the United States.

We achieved a solid performance for the fiscal third quarter with reported sales rising 11% and local currency sales up 7%. Diluted earnings per share equaled $0.46. We again saw rapid growth in emerging markets, up nearly 30% in the quarter as a whole and good, steady expansion in most mature countries.

On a global basis, sales of our three largest brands, Estée Lauder, Clinique, and M-A-C, expanded. Estée Lauder and M-A-C had higher sales in every region. Clinique sales were lower in the Americas but rose everywhere else.

Viewing our business by region, Asia-Pacific was a standout thanks to solid like-door growth as well as continued expansion of our brands into additional markets, doors, and channels. The region’s sales climbed significantly. Sales were up in nearly every country led by China, Hong Kong, and Korea. Most countries in the region had robust double-digit gains. Every product category expanded by double-digits, driven by skincare with constant currency growth in the high teens and higher sales were recorded by virtually every brand sold in the region.

We tailor our products and marketing to specific areas and cultures and the brands are resonating with consumers. That is especially true in China where most of our brands range up double-digit increases at retail. The Estée Lauder brands like-door sales in department stores increased by one-third and the brand also expanded its distribution in department stores and Sephora. We believe that the Estée Lauder Companies is the largest prestige cosmetic group sold in our department store distribution in China and we again have gained share in this channel this fiscal year.

In Japan, sales grew in the high single digits. Department stores are our main channel of distribution in Japan and we outperformed the cosmetics category as well as the total department store business during the quarter.

As a company, retail sales of our products have climbed for 15 of the last 16 months. Clinique, our largest brand in the market, has posted higher sales in the last three years. Our skincare sales continue to show positive momentum. This year we expect the category sales will more than double last year’s growth rate.

The makeup category is also growing, led by M-A-C, which opened new doors and several successful product launches in the quarter. Aveda now sells in approximately 175 salons in Japan. 20% of them are concept salons, which sell Aveda products exclusively. While still a relatively small business, Aveda sales in Japan were up sharply in the quarter.

Our outlook for the Asia-Pacific region remains extremely upbeat.

Turning now to Europe, the Middle East, and Africa, our business in the quarter was healthy. The U.K. was up despite facing a challenging environment. M-A-C and Bobbi Brown led the growth. Sales of our A brands sold online more than doubled due to strong organic growth plus the addition of thee new brand sites for Aveda, Bobbi Brown, and La Mer.

Much of Europe’s expansion in the quarter was driven by Russia and emerging markets in Eastern Europe. The Russian economy remains robust, prestige beauty has been growing 15% to 20%, and our brands outperform the industry. In total, we posted like-door retail growth of 27% for the quarter.

Building on the momentum, Clinique ran TV ads in St. Petersburg for the first time last month. Additionally, many brands are stepping up their investment in beauty advisors since Russian consumers value advice at point of sale. It’s worth noting that some markets in Europe have begun to see pockets of softness. We believe our business will continue to grow nicely in the region but the pace should slow.

The travel retail division continued its strong performance. As a result of the size of the business and its excellent growth rate, travel retail continues to be a major contributor to the company.

General industry trends are favorable. Sales of beauty products have outperformed the entire travel retail channel. Our strength in makeup and skincare, which are our fastest growing beauty categories ahead of fragrance. Our makeup sales climbed 25% and skincare was up 22% in the third quarter.

Our slate of products made exclusively for the travel retail channel did exceptionally well and have become a critical component of the business. In addition, the number of international travelers has been growing mid-to-high single digits with an even greater percentage coming from emerging markets. Although airport stores represent the bulk of industry sales, downtown locations in Asian cities, border stores in Latin America and shops on cruise ships have shown accelerating growth.

Switching to the Americas, as you’ve seen and heard from many companies, the business environment has been challenging in the United States. Nonetheless, we increased sales for the region led by Canada, Latin America, and strength in alternative channels, including the Internet, self select distribution, and direct TV.

Our freestanding stores posted smaller gains than in past quarters, reflecting lower consumer spending. Our comparable retail sales in U.S. department stores declined 4% for the quarter as the weak economy and high gas prices affected foot traffic. However, we are working hard to bring people into department stores and we had some success. The Estée Lauder brand’s spring gift at Macy’s was considerably better than the prior year, which represents a major improvement. We added value to the gift an gave consumers a choice of products, which was well-received. As a result, the average transaction size increased by about $4.

The slowdown in U.S. department stores underscores the value of channel diversification. One example is the recent expansion of our presence on direct response television. Clinique debuted on QVC in the United States in February and the show was the largest two-hour beauty launch in the network’s history. Viewers ordered 41,000 units worth $1.5 million in sales. As we strategically planned, the QVC segment also increased sales of the products that were highlighted on the show in department stores.

Other brands with regular shows on QVC are Bobbi Brown, Ojon, Origins, and Prescriptives. Also, BeautyBank announced it will create a prestige brand to be sold exclusively on HSN starting in July.

TV retailing is one of the fastest growing channels for beauty products and it represents a global opportunity. Some of our brands have hit the airwaves in other markets. Ojon debuted on QVC in Germany during the quarter and sold out sooner than expected. Prescriptives and Bobbi Brown aired on QVC in the U.K. In Korea, Origins is sold through several television networks and Good Skin’s [Triactilene] product launched on the top home shopping channel with outstanding results.

One of our fastest growing channels is e-commerce. We now sell 18 brands across our own e-commerce sites in five countries. In North America, about three-quarters of our online sales come from our own brand sites, the balance from retailer sites. Together, these enhance our consumer shopping experience. All of our brands recorded strong double-digit gains online.

We also expanded our online operations internationally. Good Skin and Flirt began e-commerce in Korea, which was chosen because it has the highest percentage of Internet users relative to its population. This marked the first time we put our brands online without having first established them in traditional retail venues. Additionally, in April we launched a website for Clinique in France.

For the balance of this fiscal year, international markets will continue to drive our growth. As I said earlier, we expect Asia-Pacific to lead growth. Europe, the Middle East, and Africa should perform well, noting the caution I cited. But at the same time, there is no evidence in the United States pointing to an imminent turnaround in consumer confidence and spending.

We will, however, be aggressive in all regions to broaden our brands, generate buzz about products, and diversify distribution to ensure that we consistently build upon our growth.

Fabrizio joins us at an exciting time and now let’s hear from him. Fabrizio.

Fabrizio Freda

Thank you, William. Good morning to everyone. I am pleased to have the opportunity to introduce myself to you this morning and to briefly discuss a few of my observations and preliminary thoughts for the future. Before I do that, I would like to say what a pleasure it is to be here at the Estée Lauder Companies. I admire this company for its fantastic brand, highly talented people, superior creativity, history of innovation, and global reach. I have great respect and admiration for the Lauder family. They are as focused on nurturing a successful business enterprise as any I have seen. These are all factors that were foremost in my decision to join this organization.

I am thrilled to be here and I am excited to be working with William and the rest of the team to help the company build on its legacy and long heritage of success.

Let me now tell you a little about myself. I spent the last 20 years of my career with the Procter & Gamble company. My responsibilities included more than a decade in the health and beauty care division and most recently as President of Global Snacks. Prior to that, I spent some time at Gucci directing marketing and strategic planning.

At Estée Lauder, I am delighted to have several key global brands reporting to me, along with our international business, worldwide operations, packaging, and R&D. In the first few months, I am observing, listening, and learning as much as possible as fast as possible. I am working to understand how our strength can be leveraged and how to address our key opportunity.

With that in mind, I’ve done a lot of traveling in this first two months to many of our affiliates and operations to get to know our business and employees. I have also met with various customers around the world. These meetings are proving to be essential to help me determine where I can best use my experience to unlock the full potential of this company.

While I have only been here a short time, there are some key areas where I initially plan to focus my attention to determine how shareholder value can best be created in the future. Most importantly, putting the consumer first in our business model, starting from the culture created by the famous touch that Mrs. Estée Lauder always insisted upon -- the expression of warmth and genuine interest in understanding our consumers and always surpassing their expectations.

Second, leveraging at best the great creativity and innovation which is the lifeblood of our company. We must emphasize our innovation capabilities that provide the [inaudible] and results our consumer expects, as well as the service and emotions the prestige experience delivers.

Third, ensuring that we strengthen our financial discipline so that this is at the forefront of all of [our processes]. Together, we will work towards understanding how we can achieve a more competitive cost structure, for example, by leveraging scale, synergies, marketing ROI, and importantly addressing under-performing businesses. As part of this, we will benchmark internally and externally with the best-in-class.

Fourth, by continuing to drive the strategic modernization initiative that is underway to ensure a smooth implementation and maximum benefits. We will focus on how to execute with excellence to improve costs, speed to market, and inventory management.

Lastly, how to further accelerate growth in all prestige channels, our traditional ones as well as new fast-growing ones.

These areas of focus will build on the strengths inherent in the company and will further energize the passion, teamwork, leadership, and capabilities I see at every level. Working with William, we will bring our company to the next level, ensuring our place as the prominent leader in prestige beauty for years to come.

I understand that the challenges we face in the United States are substantial. That said, with the strength of our company I am confident we can overcome them. Our portfolio of brands is like no other, with strong consumer recognition and a reputation for quality. While the variety of cosmetic brands and shopping venues is abundant, I believe we can continue to differentiate our brands and further build the excitement necessary to attract and retain consumers.

In a moment of soft markets, we will continue investing in our business to further strengthen our fundamentals, positioning us well for when the market improves.

As William discussed, our company has strong international strategy. I am thrilled by the large potential in emerging markets, as well as the opportunities in more developed countries. The expansion of luxury markets across the world provides a new opportunity for our brands and we will continue to vigorously pursue this growth.

My commitment to all of you is that I will continue moving quickly to immerse myself in this business. I am gathering the proper insight that will allow me to be thoughtful in bringing my leadership to our strategy an operations. I look forward to meeting all of you in person and to begin establishing productive relationships, listening and understanding the how-to is a fundamental aspect from my introduction to this company. I eagerly await the opportunity to listen more to you as well as to gain your perspective.

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

Richard W. Kunes

Thank you, Fabrizio. Sales this quarter were up 7% over last year in local currency. The U.S. dollar weakened a bit more than we anticipated, adding four percentage points of growth, resulting in reported sales growth of 11% to $1.9 billion. Net earnings for the quarter were $90.1 million compared with $93.9 million last year and diluted EPS was $0.46 compared to $0.45 in the prior year quarter. While local currency sales growth came in slightly below our expectations, EPS was at the midpoint of our guidance range.

With 10 months of the year behind us, we are now comfortable narrowing our forecasted full year EPS toward the higher end of our range, between $2.34 and $2.40.

During the quarter, we saw outstanding sales growth internationally and in most categories. We turned in a remarkable 18% sales growth in Asia-Pacific in local currency. Among our largest markets in the region, we are pleased with a high single digit growth in Japan where nearly all brands saw increases this quarter. Korea, the second-largest country in Asia-Pacific, grew over 20%. These two markets represent nearly half of the region’s sales for the quarter.

China jumped 50%, fueled by robust prestige beauty growth, expanded distribution, and share gains. We are now in 84 department stores and 35 Sephora stores, an increase of eight doors during the quarter. Strong double-digit growth was also seen in Hong Kong, Malaysia, Taiwan, and Thailand. Conversely, while sales were up, Australia experienced slower growth reflecting some retail softness.

In Europe, the Middle East, and Africa, we posted 9% local currency sales gains. Once again, our travel retail business grew rapidly. Its 22% 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, nearly all countries saw growth. The U.K. rose mid-single digits, fueled by the continued success of our makeup artist brands, sharply higher sales from our developing e-commerce business, and strong results from the Jo Malone brand. Travel retail and the U.K. affiliate represent over 40% of our sales in the region this quarter.

Among our development markets in the region, Russia once again grew double-digits, while Turkey and our Eastern European businesses each grew about 20%.

The sales growth in the Americas reflected solid results in Canada, aided by the inclusion of sales from the Ojon brand acquired last July, and most countries in Latin America. Additionally, the region’s underlying growth was generated by sales gains in alternative channels, especially our online business fragrance sales and self-select distributions and direct TV. Taken together, these areas grew nearly 10% in the quarter. These factors mitigated our 4% retail decline in the U.S. department store channel, reflecting the soft consumer sentiment in the U.S.

Our gross margin was 74.9% for the quarter, a 10 basis point increase over the prior year quarter. Favorable exchange rates and decrease in the level and timing of promotions were partially offset by an increase in obsolescence charges and an unfavorable mix of business.

Operating expenses as a percentage of sales for the quarter rose 80 basis points to 66.3% over last year. As planned, the increase reflected about 120 basis points of higher investments in advertising, merchandising and sampling to support new product launches globally, as well as brand awareness in emerging markets. We continue to spend incrementally on global information technology, worth about 50 basis points.

These increases were partially offset by about 60 basis points for organizational costs related to the pharmacy channel in the prior year and 40 basis points in favorable exchange rate transactions.

Operating income rose 3% to $161.2 million compared to last year.

Looking at operating profit by category, skincare and makeup results each rose due to the strong international performance. Fragrance posted a wider operating loss, primarily due to spending in support of new designer launches. Hair care results declined, reflecting soft sales, investment to support growth and distribution, and higher amortization of intangible assets from recent acquisitions.

By region, operating profit decreased in the Americas but grew substantially elsewhere. In Asia-Pacific, operating income jumped primarily on the strength of sales growth in China, Japan, Korea, and Hong Kong. In Europe, the Middle East, and Africa, operating results reflected improvements in travel retail, Italy, and Spain. 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 cost for information technologies and infrastructure, higher spending on advertising, sampling, and merchandising, and activities in support of our hair care business.

Regarding our net interest expense, we reported $16.1 million this quarter versus $8.8 million in last year’s third quarter. The increase is due to higher average debt balances from financing our accelerated share repurchase last fiscal year.

The effective tax rate for the quarter was 37%.

Moving to operating cash flow, for the nine months ended March 31, 2008, we increased operating cash flow by 14% to $518.5 million, compared with $456.3 million last year. The increase primarily reflects higher income after adding back certain non-cash items, such as depreciation, amortization, and stock-based compensation, as well as the timing of payments and costs for marketing activities and employee compensation.

Our day sales outstanding rose three days to 54 this quarter, reflecting the rapid growth of our international business which carries longer trading terms. Domestic days were flat for the quarter.

Inventory days increased to 176 days compared with 168 days last year, due to additional inventory from the inclusion of Ojon and to support new business in emerging markets, foreign currency translation of our balance sheet at quarter end, and from the expected sales growth of our business in the fourth quarter.

During the nine months, we repurchased approximately 2.2 million shares of our stock at a cost of $94 million. Year-to-date, we spent $250.3 million for capital expenditures, which includes incremental spending for counters and our company-wide systems initiative. For fiscal ’08, we expect to generate approximately $700 million of cash flow from operations and to use approximately $325 million for capital expenditures.

Now I’ll update you on our assumptions for the balance of the fiscal year. I would like to remind you that we spent heavily in the fourth quarter last year, creating a relatively easy comparison. The investments we made in advertising and distribution expansion have fueled the terrific sales growth we enjoy this year, primarily in international.

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 likely to add approximately four percentage points of growth. Asia-Pacific should continue to lead growth, followed by the Europe, Middle East, and Africa business. We continue to expect the Americas region to grow but be tempered by the tough retail environment in the U.S.

At this time, we estimate our effective tax rate will be approximately 36%.

As I said in my opening remarks, we are now comfortable with a full-year EPS forecast of between $2.34 and $2.40.

And that concludes my comments and we’d be happy to take your questions now.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Bill Schmitz with Deutsche Bank.

William G. Schmitz - Deutsche Bank

Good morning. Can we just talk about inventory for a little bit? Because I know you have this plan to take out a third of the inventory. I’m not sure what the timeframe is for that. Could you just remind us what the timeframe is to take out the third of inventory? And also, it continues to creep up. Is that more international growth or kind of what’s driving that?

Richard W. Kunes

Bill, our inventory certainly was higher coming into the year and remains higher year over year but we are making some progress in bringing it back towards the level that we ended last year. But we had said, if you’ll recall a couple of calls ago, that the bulk of our inventory improvement will result from the implementation of the SAP software, so that’s over the next couple of years is when most of our locations start to come online with that. We are working very diligently at bringing that number down. We have an SKU reduction program that’s underway at the moment. Actually seeing some pretty good results from the report I just looked at this morning, so we are making some progress, Bill, but the real big numbers will start to happen when we get a little better handle on it from a [inaudible] perspective. And a lot of it, don’t forget, is based on the growth of our international markets; in particular, some of our fastest growing markets where we intentionally carry more inventory because the growth is so rapid that we want to make sure we don’t miss a step and an opportunity in some of those markets.

William G. Schmitz - Deutsche Bank

Great, thanks. Can I ask one follow-up?

Richard W. Kunes

Sure.

William G. Schmitz - Deutsche Bank

Okay, great. And then as it relates to some president level departures, are you going to fill those slots with people from the inside or are you looking outside the organization as well to fill some of those seats?

William P. Lauder

Bill, we are looking to find the very best talent for our company inside or outside of our company. We believe we’ve got a great deal of talent inside of our company where we will be able to fill these slots, but Fabrizio and I are taking the opportunity with the departures of a few of our more senior level executives to look at our organizational structure and find a way to reorganize our structure for a more effective working structure, both for Fabrizio and myself and for the total company.

William G. Schmitz - Deutsche Bank

Great. Thank you very much.

Operator

Your next question comes from the line of Lauren Lieberman with Lehman Brothers.

Lauren R. Lieberman - Lehman Brothers

Thanks. Good morning. I guess the first question would be on the rate of investment in the business. I think you definitely had said coming into this quarter you expect to spend a lot to support the brands, but I feel like in the past we’ve talked about the company’s mindset of saying if the consumer is not in the store, you are not going to push on a string and spend a lot of money behind the brands at that time. And given the environment we are in in the U.S., your challenges in the U.K. and you’ve mentioned some increasing softness in Europe, what your plans are for reinvestment if the thought process around how much to invest in tough times has changed, and anything you could just share on that perspective.

William P. Lauder

Well, Lauren, you’ve touched on a number of key subjects. I think the best way -- one of the things we want to talk about is growth and share growth. And one of the things that we find is extraordinarily important is that we continue to fight wherever we can for meaningful investment for share growth and/or share preservation, that latter being more the case in markets where we have a deeper share penetration, such as North America or the U.K. But at the same time, it is very clear in markets like Europe, travel retail, and Asia-Pacific as a whole where our share penetration is lower than our relative penetration in the marketplace, we find these markets are growing and that an investment is giving us a meaningful return on investment both in market share as well as total growth.

In addition, an interesting thing that we found, and we’ve seen this before in previous consumer slowdowns, is that money properly aimed at those consumers who are shopping gain you a great deal of loyalty when they become more confident as well as becomes a pretty good investment in share preservation and/or growth.

One of the things we are currently seeing is that both the Lauder and Clinique brands stepped up some of their spending here in North America this spring in their gift with purchase programs and we actually saw some pretty meaningfully good results for the first time in five seasons. And the consumer is telling us very clearly there is not as many of her shopping, but those who are shopping they do have money to spend and if we are properly focusing our efforts, we will get a return on investment from her.

Lauren R. Lieberman - Lehman Brothers

Okay, great. I guess then just the follow-up would be in a market like the U.S., how does the relative mix change where you spend? Is it less print and more in-store?

William P. Lauder

I think it is predominantly less print and more in-store because we are going to take advantage of those who are there. That’s a key, key factor. The consumer who is already in the store already has a propensity to want to spend some money or be willing to spend money, as opposed to spending the money to hopefully drive the consumer in.

But I think you can’t miss the fact that overall on a global basis, we have reallocated most of our spending towards our international markets where we are seeing faster growth and a better return on our investment. So while we may be reallocating some of the monies we have in more established markets like North America, please don’t lose sight of the fact that we have consciously across most of our brands with a global platform, pushed our monies towards those markets where you will see greater growth in the markets as well as greater market share gains as well as profit growth.

Lauren R. Lieberman - Lehman Brothers

Great. Thank you.

Operator

Your next question comes from the line of John Faucher with J.P. Morgan.

John Faucher - J.P. Morgan

Thank you very much. I wanted to follow-up on the North American profit numbers. You talked a little bit about the IT spending, marketing, and then hair care. If we look at it over the past couple of years, the operating profit has been more than cut in half and I guess as we try to model out the fourth quarter, do any of these go away as we look at the run-rate here? And should we be concerned about that fall-off in operating profit in the third quarter over the past couple of years or is it just sort of your normal quarter to quarter volatility?

Richard W. Kunes

I think it’s more a factor of the quarter to quarter volatility and you know, going into our fourth quarter, as I mentioned in my prepared remarks, we spent very heavily last quarter and even though this year we are spending at a more normalized pace, it is much less than it was last year, so you will see a change in that certainly in the fourth quarter. But the U.S. business, to William’s point, suffers somewhat when the sales slow down and in some cases our strategic decision to target some spending to gain market share and better position our brands for when hopefully the economy recovers.

John Faucher - J.P. Morgan

Okay. Thank you.

Operator

Your next question comes from the line of Filippe Goossens with Credit Suisse.

Filippe Goossens - Credit Suisse

Good morning. If I can just maybe start with a housekeeping question for Rick, and then I have a real question for William; Rick, when you exclude the positive impact of foreign currency, was operating profit still up year over year?

Richard W. Kunes

Operating profit was less -- I don’t know the operating profit without -- off the top of my head, but in the third quarter it was I would have to say relatively flat certainly at best in the third quarter. But year over year, obviously on a year-to-date basis and for the full year, our profit is up.

Filippe Goossens - Credit Suisse

Okay, and then for William, William, obviously some disappointing results last week from Elizabeth Arden on the fragrance side; also surprisingly somewhat cautious comments on the category from Procter & Gamble. Now, if we specifically look at the Estée Lauder portfolio, obviously it has not been your best category but yet longer term I think it provides one of the better opportunities. Any update you can give us based on your initial conversations with Fabrizio what he believes that the Estée Lauder company can do to really deliver on the potential that is out there within the fragrance category, both in the U.S. and particularly also in Europe? Thank you.

William P. Lauder

I’m glad you are asking that question. We are taking a number of very aggressive initiatives to find a way to make sure we bring our fragrance category performance at least up to par with our total corporate performance, if not up to par with the performance of our competitors.

One of the many steps we’ve taken is we’ve engaged Mackenzie in a benchmarking study against the industry as a whole to look at both our own performance metrics as well as the performance metrics of our competitors, and as well as we’ve engaged a number of our industrial trade partners, those with whom we do business who also do business with our competitors, to understand where we can operate more effectively and more efficiently so we can bring a better, more competitive cost structure to our brand portfolio.

That being said, and this is something we’ve talked about before, compared to our key global competitors in the fragrance arena, we believe that one of the obstacles we have is our portfolio of brands compared to their portfolio of brands. We realize this category in particular is dominated by European oriented brands and positioning, and the vast majority of our brands are North American or American oriented brands. We do have to look at that as a long-term strategic opportunity for us and I appreciate you seeing that as an opportunity for improved performance.

In addition, I don’t want to lose sight of the fact that our position as the world’s leading marketer of prestige cosmetics, fragrance is a meaningful portion of it, by all means not necessarily the single largest on a global basis, and we believe in order to maintain our leadership and channel [capacity], we must maintain a presence in this category but we must maintain this presence in the category on a competitive basis and return financial performance that is expected for something the size of this category.

Filippe Goossens - Credit Suisse

Great. Thank you very much, William.

William P. Lauder

Can I finish one thing, Filippe, so that there is no misunderstanding -- the most passionate executive on our team now for improving this performance is Fabrizio and it will put a great deal of pressure on him in the next few years to accomplish this but I have no doubt in his abilities to move our organization in that direction.

Filippe Goossens - Credit Suisse

We look forward to it, Fabrizio.

Operator

Your next question comes from the line of Ali Dibadj with Sanford Bernstein.

Ali Dibadj - Sanford Bernstein

A couple of questions; one is just trying to understand I guess in the context of the fact tat you have so many things going on, so many new things going on, going into new channels, going obviously into more geographies, as you look at your sales growth either this quarter or certainly going forward in particular, what do you think the growth rate has been between the sell-in or the initial take? So a new airport opens up, you have a new DFS place in there, how do you think of the mix between the sell-in versus kind of a steady state sales growth?

William P. Lauder

What -- are you talking about the travel retail category or are you asking this in a global question?

Ali Dibadj - Sanford Bernstein

Broadly, I just used travel retail as one small example.

William P. Lauder

Well, you know, you are asking a wonderful existential question. I mean, the reality is we are evaluated first and foremost on our abilities to sell-in to the retail channel. That is how we report our net sales. The fact is over a long-term period of time, however, sell-in is really just a function of consumer demand or retail sell-out.

So as we can improve our consumer demand, our consumer knowledge and improve how we can position and market our brands to create greater demand and therefore sell through, we will generate better sell-in results on a global basis.

If you look at it market by market, there are some quirks mainly due to history and trade structures and others that may distort these numbers somewhat. For example, in North America 95%-plus of our trade in North America is on an ADI system, whether it’s the retailer system or our system, that gives us total visibility in sell-through. And the reality is is the sell-in business in North America mirrors exactly the sell-through business. If you have a healthy sell-through, you’ll have a healthy sell-in. And it’s a fairly clean operation relative to it.

When you go to Europe, on the other hand, and you get away from the U.K., where we have predominantly a department store based business and you realize that the vast majority of our distribution is a far more diffused, dispersed, and less organized -- when I say organized, chain-related distribution, sell-in and sell-through are not as closely linked functionally and the result is you will occasionally see some distortions that will come back to bite you, if you will, on one way or the other, which are either overstocks or understocks based on the accuracy or inaccuracy of information.

When you go to Asia, on the other hand, where the vast majority of our distribution is department store, they don’t hold much inventory and deliveries are done on a once, twice, or three times a week basis, you again see a very close link between sell-in and sell-through.

Ali Dibadj - Sanford Bernstein

That’s very helpful, William. Let me clarify maybe my question a tad -- how much of the current growth is opening a new store or opening a new place, a new --

William P. Lauder

Oh, you’re talking organic growth versus -- the vast majority of our growth is organic. The expansion in distribution is really not meaningful for the largest brands that contribute the vast majority of our profit.

Ali Dibadj - Sanford Bernstein

So steady state growth roughly is where we are looking at here?

William P. Lauder

That’s the vast majority of it, yes. And in certain categories, for example, travel retail, our travel retail partners are opening new doors in those markets that are growing but those businesses are largely a reflection of the success of those brands in their home markets.

Ali Dibadj - Sanford Bernstein

Okay. Could I ask a question on operating margins then? Over the past several quarters, certainly in almost the past couple of years, skincare, Asia-Pacific have really been driving your operating margin health in a certain sense. How do you see that sustainably going forward?

Daniel J. Brestle

Well, the Asian market is certainly a skincare dominated market and it is a terrific opportunity for us, both from a -- the health of the economy, the growth of the business, the growth of the prestige marketplace, so we see that as a really a long-term opportunity and a key focus, if you will, for the company going forward.

Ali Dibadj - Sanford Bernstein

So nothing diminishing so far that you guys see?

Daniel J. Brestle

Not by any means, no. We see lots of growth opportunities there for sure.

Ali Dibadj - Sanford Bernstein

And if I may just one last real quick question around -- with your balance sheet, I see clearly some inventory and AR issues, and we’ve briefly talked about. But one thing I do see also is cash building up here. Can you just tell us a little bit about your acquisition strategy going forward, if that’s getting a little bit more heated? And in particular I’m interested in understanding where on your priority list of things you think about or look at is dilution to the shareholder?

Richard W. Kunes

Well, we -- certainly -- you asked a couple of questions there, so one, on the use of cash; obviously as we’ve said many times, invest in our business, make strategic acquisitions when they make business and financial sense for us and return excess cash to shareholders. That’s sort of our priorities, if you will. We continue to buy shares. We bought shares in the quarter, as we highlighted. And to the extent that there isn’t an acquisition out there, our use of that cash that’s -- either through dividends or share repurchase return excess cash to shareholders.

The second question that you asked was -- I’m sorry, what was our strategic initiatives around acquisitions and how big a part would they play going forward?

Ali Dibadj - Sanford Bernstein

Well, in particular just when you go through your priority list of things you look at when you look at an acquisition, where does dilution to the shareholder fall?

Richard W. Kunes

We look at the longer term return of an acquisition but in our case, if an acquisition, depending on the size, smaller ones are very rarely dilutive, even in year one. Larger ones, we would accept a slight dilution initially if we saw a longer term opportunity that made sense to us.

So it’s sort of a balance, if you will, between size and opportunity.

Ali Dibadj - Sanford Bernstein

Thanks a lot, guys.

Operator

Your next question comes from the line of Christopher Ferrarra with Merrill Lynch.

Christopher Ferrarra - Merrill Lynch

I was wondering if I could ask Fabrizio, I guess, you named five initial key areas of focus and I just wanted to ask a little more about the middle one, which was strength in financial discipline. I think you used the word synergy. I just wanted to see if there’s a little more color to be had there on the integration of the brands that have run relatively independently over the last number of years.

William P. Lauder

As Fabrizio said in his statements, he is going to be more prepared to talk about a number of the different initiatives which he is looking at in our company in our fourth quarter call in the middle of August, so until then, he’s going to be still on his listening/learning tour and understanding tour.

If you will, one of the issues we always look at is the synergies between and amongst our brands and how they operate. And it’s always a delicate balancing act on a market by market basis and how much of a synergy -- how much synergies we can project into the brand in both the front of the house and the back of the house.

The tendency in our company is to create strong sibling rivalry in the front of the house in the sales and marketing areas and to generate as many synergies as possible in the back of the house so that there isn’t any duplication of effort on behalf of the brands. And we continue to focus it that way.

And one of the other things we are doing is we are looking at regional integration on a stronger basis and you now know that Dan Brestle is the President of our United States business. This is the first time we’ve brought under the leadership of one executive our very diverse portfolio of brands, which hopefully can bring even more leverage at the point of retail as well as greater coordination between and amongst the brand’s activities here in North America. And in addition, we have the same structure in place. We are just moving into the same structure in Europe and Asia. And we expect over time we will have both a stronger voice with our trade partners as well as greater, more cohesive coordination between and amongst countries and brands inside of each country, so that we have less leakage and duplicated effort.

Christopher Ferrarra - Merrill Lynch

Got it. That’s fair, and I guess an unrelated question; Rick, can you just give a quick update on where you are with respect to projected SMI costs, with some of the other initiatives I guess like additional training for consultants, stuff like that?

Richard W. Kunes

Chris, we are pretty much in line with what we anticipated when we laid out our three-year plan I guess it was a year ago March. We had talked about the next few years performance and what we were expecting. We are fairly close to that. We continue to incrementally increase our spending on the SMI initiative, and that will go on for another year-and-a-half or so and then we will start to see the benefits outweigh some of the costs that are associated with that. So that’s on track.

It’s pretty much business as we had planned, but we are formulating around some of the areas I think that were a part of Fabrizio’s comments. We are formulating some strategies on some possibly opportunities for more aggressive cost savings in certain areas.

Christopher Ferrarra - Merrill Lynch

Got it. Thanks a lot, guys.

Operator

Your next question comes from the line of Wendy Nicholson with City Investments.

Wendy Nicholson - City Investments

My first quick question is just a follow-up to the discussion of Mackenzie -- what’s the timing on that? Are they taking six months, nine months in order to give you feedback on the benchmarking stuff?

William P. Lauder

We’ve already had a number of presentations and very in-depth discussions with them. They’ve given us some very enlightening material and they’ve given us a great deal of general roadmap and the benchmarks of where we can improve and ought to improve. Now comes the much harder work, which is the internal identification and, if you will, digestion of this information to see where and how we can begin to improve our performance benchmarks versus our competition.

A lot of it has to do with the very historical practices of our company and a lot of it has to do with basically saying okay, just because we’ve done it this way for 40 years doesn’t mean we have to continue to do it. It’s time to stop, press the restart button and start again with a new way of doing business that is more competitive.

Wendy Nicholson - City Investments

Terrific, that sounds exciting but my bigger picture question is actually on the European operating margin, and we’ve seen sort of a steady trickling down kind of going back four or five years on the margin in Europe. And I know, or I think, some of that has got to be all the investment spending in Eastern Europe and in India. But I also wondered at some point, do we get to kind of a floor in the European margins and markets like Russia start to turn profitable, so that -- you know, how low do those margins go? Is that an ongoing phenomenon and is there some issue with mix there that I’m not thinking of, or is it really just the investment spending? Thanks.

Richard W. Kunes

Wendy, you hit upon it I think in your comments, which is it is really a mix by affiliate more than anything else. And in particular, the spending that we are doing in Russia and in Eastern Europe to grow those markets, so there is a -- it will continue to trickle down. It’s part of our plans. There’s a little bit of a flat lining, if you will, in the operating margins in Europe but as those markets begin to mature, you will see that profitability start to improve.

Wendy Nicholson - City Investments

And has there been any degradation or deterioration in the operating margin of the travel retail segment? Because that’s such a high margin business and that’s growing so rapidly, I would have thought that that would have offset some of the negative mix from the other stuff.

Richard W. Kunes

There’s been a very small deterioration in the level of profitability but that was intentional because of some of the spending we are doing to grow that business. And we’ve been driving some of that great growth by some of the -- a little bit of spending in certain areas, like some of the stores in certain airport venues and things like that. So we’ve intentionally let that slip just a little bit but it is really nothing that’s systemic, if you will.

Wendy Nicholson - City Investments

Got it. Thank you.

Operator

Your next question comes from the line of Andrew Sawyer with Goldman Sachs.

Andrew Sawyer - Goldman Sachs

I guess I was going to ask quickly on just the broad resource allocation question, and I look at year-to-date and your margin in the Americas, I suppose, including some of the IT spending is down call it 250 basis points and you’ve gotten call it 3% local sales growth. And if you look at Asia, spending levels aren’t quite as high relative to the revenue growth. And I was kind of wondering how we should think about the type of spending you are putting against the Americas market without quite as high a sales return versus what we see in Asia, and if you can kind of compare and contrast the two. Thanks.

William P. Lauder

Well, it’s a very good question and I appreciate you segregating out the corporate infrastructure spend, if you will, which resides predominantly here in North America versus our market spend, which is a little more comparable market to market.

You have to realize, of course, that the United States is a very fully developed, very sophisticated market and a very, very competitive market. That’s not to diminish the level of competition we experienced in Asia. The fact of the matter is that if you remember your high school physics or maybe even college physics, the principals of an object in motion remains in motion and an object at rest remains at rest.

The fact of the matter is that our market share growth that we are seeing and the total market growth that we are seeing in Asia dictates a certain level of investment and a return on investment that’s resulting of that, as well as the mix of business, as we’ve talked about, which is predominantly in the skincare sector, which has traditionally a higher gross margin structure and a higher -- hopefully a higher operating margin structure.

North America is a far more competitive business. It’s a far more, unfortunately, stagnant total market business, with far greater share penetration, which results in the fact that you have a more stagnant business, which requires a somewhat greater investment on a very large volume and infrastructure costs to make sure we can move these businesses along.

We cannot continue to allow our business in North America to remain stagnant. We must find ways to continue to maintain that momentum and growth because it is our fortress market, it is our largest share, it is the market in which we would call our home and it is extraordinarily important for our global success for our brands to continue to be successful in our home markets.

Andrew Sawyer - Goldman Sachs

And just kind of a -- maybe just building a little on the Americas comments -- how would you characterize the margin pressure as being defensive within your department stores or offensive versus driving your alternative brands and channels?

William P. Lauder

You know, that’s a very interesting question. It’s a -- a lot of it is scale related, if I can put it that way. Our investment in alternative channels, we find very attractive but the fact of the matter is that most of our alternative channel investments, while giving us a very good return on investment, and we find that there are cross synergies, cross channel synergies, the fact of the matter is that the majority of our alternative channel investment strategies, while profitable on a discrete basis are not necessarily as large in scale as our traditional channel distribution, so that the absolute values are different. They will move the needle on the margin but until they start getting real critical mass and scale, they are just that -- they are good alternative businesses but of a significantly smaller scale than our traditional channel.

Andrew Sawyer - Goldman Sachs

Thank you.

Operator

Your next question comes from the line of Alice Longley from Buckingham.

Alice Longley - Buckingham Research

My question is on travel retail -- could you just repeat how much it was up? And then could you tell us how much it was up in local currencies, and then how much of travel retail is in Western Europe versus the rest of the world? And the final piece of that is how much is travel retail up in Western Europe in local currencies? Thank you.

Richard W. Kunes

I don’t know if we have all of those pieces, quite honestly, Alice, but in the third quarter on a comparable currency basis, travel retail was up 23%. For the nine months, it’s up 21%, so our business is quite strong year over year. And on a reported basis, third quarter was around 25% and nine months, about 22%.

Alice Longley - Buckingham Research

And how much is Western Europe versus the rest of the world?

Richard W. Kunes

Well, the two biggest opportunities -- our biggest travel retail market is certainly Europe, followed by Asia, smaller in the Americas but I don’t [have it] by region by travel retail.

Alice Longley - Buckingham Research

Is Europe maybe 60% of it?

William P. Lauder

I don’t think so, no. It’s probably lower than that but --

Richard W. Kunes

Dennis can certainly give you that level of detail if you want after the call.

Alice Longley - Buckingham Research

Thank you.

Operator

We have a follow-up question from the line of Lauren Lieberman with Lehman Brothers.

Lauren R. Lieberman - Lehman Brothers

Great, thanks. I’ve actually got two. First thing was on hair care, just been growing at a 15% to 20% rate for like two years now and the growth sort of disappeared. I know that specifically in the press release, you guys mentioned the Bumble and Bumble hotel program but I can’t imagine that’s it. Was one of the changes that you did not acquire any distributors in the quarter? And if so, is that an important part of the growth algorithm going forward?

Richard W. Kunes

If you look at the hair care growth on a year-to-date basis, it’s about 12%. The quarter was affected by a couple of things. There was a launch last year by Aveda, which generated some strong growth in last year’s quarter. That wasn’t anniversaried this quarter. We did have that hotel amenities program that you referenced, and that did have quite a big impact and also our -- you know, the hairdresser are feeling the same economic pressures, if you will, that we see in the U.S. department stores, so that is affecting their business somewhat.

So those are the things that affected the quarter specifically but on a year-to-date basis, it is our fastest growing category. We expect it to remain that way for the year and as I said, through the nine months, it’s up on a comp basis about 12%, on a reported basis about 14%.

Lauren R. Lieberman - Lehman Brothers

Okay, but my question on the distribution acquisition -- I mean, is that part of it and do you expect it to reaccelerate next quarter, or --

Richard W. Kunes

You know, when we acquire a distributor, it adds to sales certainly but I don’t think it’s a material impact on this particular quarter.

Lauren R. Lieberman - Lehman Brothers

Okay, great. And then the other thing was I was surprised to hear that Clinique was down in the Americas. Lyn Green of the spotlight last quarter, it sounds like everything has really been quite good, and with the QVC, so I was surprised. Can you maybe talk a little bit about that?

Richard W. Kunes

I think Dan can.

Daniel J. Brestle

Yes, we talked about on the last call, Lauren, and we made note that there was a shift in the Clinique gift with purchase business. The Clinique business is healthy. It is down somewhat but on a general statement, all of our brands are trending much better than our retail partners. We are absolutely somewhat amazed at the gift with purchase programs and how the response was this quarter. It is -- Clinique had a terrific April with the Macy’s gift. Estée Lauder had a terrific March with the Estée Lauder gift.

So Clinique is very healthy. It is down a couple of points but it is very healthy going forward and I think we are going to have a good Mother’s Day.

Lauren R. Lieberman - Lehman Brothers

Okay, and then was the Clinique gift in the first quarter last year, so is that part of what you were getting at?

Daniel J. Brestle

It was the first quarter last year, moved to the second quarter, so --

Lauren R. Lieberman - Lehman Brothers

That’s what I meant, yeah, okay. Perfect.

Daniel J. Brestle

And this year we moved out of the third quarter into the fourth quarter, so --

Lauren R. Lieberman - Lehman Brothers

I’m sorry, I meant --

(Multiple Speakers)

We’re on the same page. It’s okay.

Daniel J. Brestle

Our third into fourth, yes.

Lauren R. Lieberman - Lehman Brothers

Yes, that’s what I meant. Sorry.

Daniel J. Brestle

Yeah, you’ll see the Clinique number come back in April.

Operator

And our final question comes from Constance Maneaty with BMO.

Constance Maneaty - BMO Capital Markets

Good morning. Still on the Americas, you mentioned that department store sales were down 4% and that you were starting to see some weakness in some of your own stores. What in -- how much was the U.S. -- how big was the U.S. decline for all the parts of the U.S. business?

Richard W. Kunes

Well, our total outside of department stores, for all those other channels of distribution in the Americas region were up 10% for the quarter, and I think the number was 70% of our sales comes from U.S. department stores in the Americas region, so I think there is a mathematical equation in there somewhere, Connie, that you could come to your answer. I don’t have it off the top of my head.

Constance Maneaty - BMO Capital Markets

Okay, and as a follow-up, what’s your latest read on the Clinique pilot program? How is that going in Dillard’s and Macy’s?

Daniel J. Brestle

The early reads are terrific. We continue to see the turnover of our beauty advisors, or in Clinique’s case, the consultant, decrease. We are getting tremendous enthusiasm. The average unit sale in the transactions are going up, I think it is camouflaged somewhat with the general state of the economy but we are very happy with it and we continue to roll it out in more and more markets.

Constance Maneaty - BMO Capital Markets

How many doors is it in right now?

Daniel J. Brestle

I don’t have that, Connie. I can’t tell you.

Constance Maneaty - BMO Capital Markets

Okay. Thanks very much.

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 May 18th. To hear a recording of the call, please dial 1-800-642-1687, pass code number 37735167. That concludes today’s Estée Lauder conference call. I would like to thank you all for your participation and wish you all a good day.

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