Estee Lauder - Valuation Is Rich, But It's Deserved

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About: Estee Lauder Companies, Inc. (The) (EL)
by: Kenra Investors
Summary

Estée Lauder has recently reported the strongest quarter in terms of growth since Q4 2014.

The company is on a solid growth path that should continue for several years, thanks to international expansion, growth in the digital business and small acquisitions.

Valuation multiples are rich but deserved in the current conditions.

A Comment On Recent Results

I have recently given a look at Estée Lauder (EL) and tried to understand if the stock is still a good long at the current levels. Q4 results were, once again, extremely strong, indicating a significant acceleration in revenue and earnings growth. Q4 2017 was the strongest quarter in terms of growth since Q4 2014, as revenue grew more than 9% and EPS grew more than 18% YoY.

EL was able to deliver outstanding results despite some economic and geopolitical volatility, terrorism and the challenging environment in the United States department stores market, which pulled down the company's performance in the region. Sales in North America rose 5% thanks to the addition of recently the acquired brands Too Faced and BECCA. Excluding the acquisitions, North American sales declined 3% due to the weak environment in department stores and, to a lesser extent, freestanding stores. Management admitted that the "biggest challenge has been in some U.S. brick-and-mortar department stores, which are struggling from falling foot traffic, especially in lower quality malls and touristic driven doors." The shift in shopping preferences to digital segments accelerated in the recent past, which resulted in declining traffic in some department stores. Fortunately, the company derives only 17% of total sales from department stores in the United States, and managed to more than offset the weakness in the segment through a solid expansion in other markets.

The exceptional results in Q4 were largely a result of the terrific strength in China, travel retail and online, as well as from some new brands. The company continues to grow at above-average rates, expanding its market share despite the fears of increased competition. In full-year 2017, sales increased 7% against an industry growth of 5% (per management). The e-commerce business accelerated, growing 33% YoY, with strong global growth, especially in Asia.

If we exclude North America, the company's performance was strong in every region. Asia-Pacific led total sales growth this quarter, with sales up 18% in constant currency, driven primarily by accelerated momentum in China, which grew more than 40% in the fourth quarter and 90% for the year. Hong Kong continued its rebound with high single-digit growth and other important Asian markets such as Japan, Korea and Indonesia delivered solid growth rates too.

In EMEA, revenue grew 12% in constant currency, led by a 20% increase in global travel retail. Markets such as Italy, France, the Nordic countries and Greece posted double-digit growth rates, while the UK and Spain grew low to mid-single-digits. The Middle East showed some improvements too, Russia was flat, while other Eastern European markets and India grew double digits.

In general, it's evident that the company has a very strong momentum everywhere with the exception of the United States, where the situation remains challenging, although the company mentioned some early signs of improvement there as well.

The only negative this quarter has been the 170 bps contraction in gross margin. On the other side, operating margin expanded 250 bps, or 80 bps in adjusted form. The negative performance on the margin side was due to unfavorable product mix, but margins are expected to improve 30-50 bps next year and 50 bps a year on average in the next three years.

Basically, all the other metrics show a strong and profitable company with a solid position. The balance sheet is strong, with a current ratio of 1.76 and a Net Debt/EBITDA of just 0.8.

E-commerce Growth Is a Tailwind

Something I would like to point out is how Estée Lauder is positioned in an extremely strong position in the changing and challenging retail environment today. Not only does the company own a huge and growing portfolio of valuable brands that guarantee a high diversification of revenue, it also manages an extremely valuable online business. A great source of strength, which is not common at all in today's environment, is in the strong margins that the company reports in its online business. This is a very important factor to consider - Estée Lauder's online business is margin-accretive. In the management's own words (emphasis added):

The online division has historically grown sales at an average annual rate of about 25% and is margin accretive to the company. In fiscal 2017, online sales accelerated, growing 33% to $1.3 billion globally. Many of our brands, in particular Estée Lauder, La Mer, MAC and Tom Ford, had an outstanding year online. Too Faced, a recently acquired brand, more than doubled its online sales when viewed on a 12-month comparable basis. And our top four online markets, e-commerce represents approximately 20% of our sales. Globally online represents 11% of total company sales, up from 4% just five years ago. […]

Okay. Let me address a lot of that. First of all, the margin is accretive to the company in total. It's accretive across our own sites and our direct-to-consumer businesses and it's accretive in our retailer business as well. So all of the components of the business is accretive to the company. Obviously, it varies by business around the world.

It's also important to know that both the DTC sites and the third-party sites are margin-accretive for the business. The simple fact that the online business is margin-accretive is great news. It means that the transition to an omnichannel environment where e-commerce's share is growing is actually a tailwind for the company.

Many Years of Growth Ahead

The online business has been the most important growth vehicle in recent times. It's clear that Estée Lauder is able to grow in spite of the challenging situation in North America, and at very healthy rates. The company's growth strategy is clear and is based on the implementation of the following plan:

  • Continue to boost growth in fast growing markets such as China and other Asian countries, exploiting both established brands and smaller brands with untapped potential. Although the recent performance (+40% YoY) is not replicable, the company expects China to continue to grow at double digit rates for many years, and expects other emerging markets to deliver similar growth rates.
  • There will be a big push on the digital business, as the online segment is an excellent growth vehicle in many regions. In 2017, online growth was fueled by both direct-to-consumer and retailer sites, which account for approximately 60% and 40% of the online business, respectively. Just in 2017, the company said it launched over 45 direct-to-consumer sites on its own platform and third-party platforms such as Tmall. We can expect this trend to continue and, although no distribution on Amazon (AMZN) has been planned, the company is trying to take advantage of some valuable third-party e-commerce platforms to expand its presence beyond its own platforms. For example, the company is planning to significantly expand its online presence in India, Middle East and Southeast Asia this year.
  • We can expect a few percentage points of the sales growth to be driven by the expansion in new brands, mainly through acquisitions. Moreover, the company intends to expand into other product categories and to push its fragrance business, which it still considers under-penetrated in the current situation, especially in the Asian markets.

Valuation and Final Thoughts

The main doubt about EL is whether the company's solid financial condition and positive growth prospects justify its rich valuation multiples. The stock is trading at 32x TTM EPS and almost 28x full-year EPS of $3.90 (using the midpoint of the management's guidance), which is not cheap for sure even considering the good growth prospects. Considering the implied EPS growth rate in the guidance (16.4% YoY), the stock is trading at 1.95x Price-to-earnings-growth, which can be too expensive for many investors.

Nonetheless, I don't think the stock is overvalued. EL has a very solid business that has shown its ability to grow at healthy rates in spite of the challenging environment in an important market such as the United States. Moreover, the increasing penetration of e-commerce at the expense of traditional stores, which is usually a strong headwind for many companies, is actually a positive contributor to margin expansion. The only concern investors could have is related to some recent increases in the promotional activity in the beauty business in the United States, mainly in department stores. I think management's comments on promotions are pretty interesting:

Yes. I'll start with - to say your question is if the consumer will get accustomed to promotion. I mean, they are - consumers are segmented, and there are certain consumers that do wait for promotional opportunities to buy and this is not new. This has always been the case. And there are other consumers that don't. But on average, I just want to make you think that the growing part of the business is the non-promoted one. And the growing - the fastest-growing channels are the channels that promote the least.

And so in total, I would say that prestige beauty is from a consumer standpoint is an industry that need a moderate amount of promotions. And then where there are excessive promotions is a short-term event that generally doesn't generate a change in consumer behaviors. And then I think Tracey will address Leading Beauty Forward.

If that is true, then the recent news that promotional activity in some department stores picked up shouldn't be a great concern.

I know that more conservative investors wouldn't be willing to invest in EL at these levels, and I admit that I see the growth prospects as fully priced at the current levels. Nonetheless, the stock could be a great performer if the current positive trend in the business remains for a few years more. EL is a market leader with an extremely solid business and is set to prosper in the new retail environment. In my opinion, it remains a hold for the long term, and I will consider buying some shares on a pullback if it will be possible.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.