Estée Lauder: Cashing In On The Global Selfie Culture (Part 2)

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About: The Estée Lauder Companies Inc. (EL)
by: The Profit Hunter
Summary

Digital media enables Estee Lauder to reach millions of consumers that it never had before at a fraction of the cost of traditional advertising.

At Clinique, more than 80% of media spend is in high ROI channels like digital, influencer activations, and consume experiences, reducing the cost of customer acquisition by 30%.

In addition to influencer marketing and digital platforms, EL has 100,000 beauty advisors to help showcase its products.

Premium valuation justified by strong margins and robust category growth.

Estée Lauder is Well Positioned to Penetrate the Emerging Markets

In the second part we will analyse Estee Lauder’s penetration into emerging markets, its multi-channel distribution strategy and industry position. We will seek to value the business and explore how the prestige beauty category differs from other consumer product categories.

Estée Lauder (Estee Lauder) (NYSE:EL) has demonstrated foresight and patience in building its emerging market footprint. The company entered China, its largest emerging market, in 2002 and currently occupies leading positions in ten emerging economies. Growth across the emerging market complex has averaged 15% per annum over the last decades (over twice the rate of growth of the sector) and the area now represents 18% of total group sales. The significant investment in resources and infrastructure required to enter the Chinese market has been vindicated, with China now driving 25% of global prestige beauty growth and delivering sales growth of 40% for Estee Lauder’s China business in FY2018. The remaining emerging markets are set to drive a quarter of the industry’s growth, leaving the company well-positioned with a strong leadership position. As the company builds scale, these countries will become highly accretive to group profitability. According to management, the emerging middle class is expected to add $5 trillion of global spending power by 2028 (an increase of 50%) with China almost doubling its middle class population, adding +370m in the next decade. Growth will be driven by the emerging middle class, increased spending power amongst an ever emancipating female demographic and trading up from mass to prestige products.

Top 5 Middle Class Population Forecasts in 2028 (vs. 2018)

Population (2028)

Population (2018)

China

723m

416m

United States

345m

318m

India

183m

119m

Japan

129m

127m

Brazil

89m

75m

Source: Estee Lauder Investor Day 2018

The growing middle class in emerging and developed markets holds the promise of future growth. Many women aspire to purchase prestige beauty brands to support a more sophisticated beauty routine and a lifestyle embedded in health and wellness. Demographic shifts are favourable with the global middle class expected to expand by 600 million by 2028, which represents greater than $5 trillion in additional spending power, an increase of 50%. Growth will be driven by consumers in India, Brazil and China as well as more mature economics such as the United States. In India, for instance, the prestige beauty market is only worth $500 million (accounting for only 6% of the overall beauty market) but is expected to double in size to $1 billion by 2022. Building the brands will be driven by promotions with Bollywood actors and local influencers to drive emotional connection and engagement. Estee Lauder is well-positioned with a market share of 50% in skin care and make-up. In Brazil, the business is 90% direct-to-consumer with traffic driven by e-commerce and free-standing stores. Estee Lauder has leading positions in prestige skincare and make-up.

Annual Per Capita Spend on Prestige Beauty (Female Aged 15-64)

Country

Per Capita Spend

United States

$255

South Korea

$276

China

$23

Brazil

$21

India

$2

Source: Euromonitor

Twenty years ago Korea was an emerging economy, yet now boasts the largest per capita female spend on prestige beauty. This benchmark sets the sales growth potential in emerging nations with large addressable markets, such as India and China. Prestige beauty represents 40% of the market in the United States and 42-70% in the developed Asian markets of Japan, South Korea and Hong Kong. However, as illustrated in the table below, prestige occupies significantly less share of the total beauty market in emerging economies, which leaves ample room for growth. Given a female participation rate of 61% in China, some 500-600 basis points higher than in the United Kingdom and United States, respectively, there is great scope for women to trade up from mass to prestige beauty products over time. Indeed, of the 30 most aspirational Estee Lauder brands globally, only 15 have been launched in China to date with 10 in India and nine in Brazil. The Estee Lauder, MAC and Tom Ford brands are only available in 115, 30 and 12 cities in China, respectively. The China run-away opportunity is particularly large, given the average age of luxury consumers is just 28 versus 40 in Europe and 45 in the United States.

Mass versus Prestige Share of Beauty Market

Country

Mass

Prestige

Hong Kong

30%

70%

South Korea

50%

50%

Japan

58%

42%

US

60%

40%

Germany

72%

28%

China

74%

26%

Turkey

90%

10%

India

94%

6%

Brazil

95%

5%

Source: Investor Day 2018

Positioned for Multi-Channel Growth

In recent years Estee Lauder has increased its direct-to-consumer channel reach through e-commerce platforms, such as Tao Bao in China. This has allowed the group to develop a one-to-one relationship with its customers by collecting data on their demographics, purchase frequency and preferences. The group has information on 69 million consumers worldwide. This data and customer insights, in turn, facilitates targeted promotions, oftentimes through digital-first story-telling. The firm’s digitally-enabled capabilities create a strong foundation for building new power brands paired through a consumer’s lense. Estee Lauder’s superior customer retention rate (25% higher than prestige beauty benchmarks) is a credit to its service-driven approach and strong product quality and innovation which drives high loyalty. Given retaining a customer costs 64% less than recruiting a new customer, the costs incurred in driving customer loyalty create long-term value by maximising the group’s return on customer acquisition.

The business is driven by data-powered insights. This is best illustrated by the lipstick sub-category, which the company has grown to dominate in the prestige arena. A decade ago the average woman used 2-5 lipsticks in her daily routine. This has increased today to 5-10 lipsticks. Lipstick is usually the first product a woman purchases in the beauty realm and provides a broad recruitment vehicle to lift consumers from mass to prestige beauty products. The MAC brand is the market leader in prestige lipstick, selling nearly 1.5 million lipsticks every second of each day. Using data and creativity, MAC collections are tailored to individual markets oftentimes collaborating with top Chinese fashion photographers, engagement platforms and influencers activated online and in-stores.

Estee Lauder engages strategically with over 100,000 beauty advisers and make-up artists, social media influencers (ranging from celebrities to micro influencers) and media platforms to activate brands and trends in beauty. The company can reach target consumers by brand, by geography and channel. Key channels include online, travel retail and free-standing store formats, of which Estee has become a leader in travel retail and digital. With steadily growing passenger volumes, the travel channel is an ideal way to build brand power and in 2018 Estee Lauder surpassed the number two player to become market leader in global travel retail prestige beauty with a 21.5% share. Travel retail represents not just a sales channel, but a brand-building opportunity. Given its presence, for instance, in Heathrow Terminal 5, Estee Lauder is able to reach 30 million consumers each year, of which 30-40% of consumers come from cities where Estee Lauder is not distributed through physical stores. Whilst core brands Estee Lauder and Clinique are 90% penetrated in existing locations, other brands like MAC, La Mer and Bobbi Brown are only in 15%, Tom Ford is in 8% and Becca and Le Labo are in 3%. Management suggests 59% of prestige beauty shoppers purchased their first beauty products at an airport hence the long-term opportunity to convert new shoppers into life-long customers.

In 2015, department stores accounted for 74% of total sales and have since declined to around 50% with the company’s 1,500 free-standing retail stores and 300 brand websites driving growth. Estee Lauder was the first prestige beauty company to launch an e-commerce capability with Clinique.com which was introduced over twenty years ago. Today, the group generates approximately $2.8 billion in net sales from e-commerce and has over 300 dedicated brand websites which serve as media platforms. E-commerce business generated on its own captive sites eliminates having to share the profit stream with a middle-man. Intuitively, it is realistic to foresee customers purchasing Jo Malone or Estee Lauder’s Advanced Night Repair through their respective dedicated sites, given strong brand equity and periodic replenishment cycles. Yet it is hard to imagine the same buying behaviour applying to the purchase of lower ticket items, such as washing detergent or soft drinks.

Consumers made 500 million visits to brand sites in 2018, spending an average of 9.5 minutes per visit. The sites collect over 200,000 data points daily which is used to understand trends, consumer preferences and design marketing delivery. The e-commerce business is present in over 50 countries with brands present in over 1,600 retailer e-sites.

The dedication to e-commerce is paying off. Customer acquisitions are lower which drives high return on investment. Management expects consistent double-digit growth over the next three years and channel penetration to continue to climb towards upwards of 33% by 2021. Driven by its dedicated brand sites and partnerships with third-party platforms such as Alibaba’s (NYSE:BABA) T-Mall, e-commerce comprises 30% of sales in its top six markets. China has been growing at 30% per annum in the last five years – a function of T-Mall’s ability to reach 600 million consumers across 650 cities and the 45 million direct followers Estee has cultivated across its Chinese social media accounts. Indeed, on Singles Day in China sales reached $150 million driven by sales of 850,000 MAC lipsticks. By virtue of the way Chinese consumers have embraced e-commerce, Estee Lauder does not require physical distribution through stores in every city in China. Beyond China there is significant runway for e-commerce growth in under-penetrated markets, such as Japan, Brazil, Korea, Russia and Thailand.

Net Sales by Distribution Channel

Sales

Bricks & Mortar

51%

Travel Retail

18%

Online

13%

Freestanding Stores

11%

Source: Estee Lauder Investor Day 2018

Capital allocation has been a core strength. Over the last decade the group has generated $16 billion in operating cash flow and $1 billion from stock option proceeds and forex gain. Of this total, $5 billion has been invested back in the business in new product development and entering new markets, $2 billion has been spent on acquisitions and the balance of $10 billion has been returned to shareholders through a mix of dividends and share buy-backs.

Estee Dominates the Prestige Beauty Category

Estee Lauder is a market leader in the prestige beauty category with a 14.5% market share of the global prestige beauty market. As illustrated in the graph below, this share has consistently expanded over the last decade.

Estee Lauder’s Share of Global Prestige Market

Source: Company Reports

With over 70% of sales generated outside the United States, the group has grown to become market leader in over forty countries as depicted in the table below.

Estee Lauder’s Market Leadership Positions

Americas

Europe

Africa

Asia

Australasia

US

UK

Tunisia

Pakistan

Australia

Canada

Sweden

Cote D’Ivoire

India

New Zealand

Mexico

Finland

Ethiopia

China

Guatemala

Czech Republic

Nigeria

Thailand

Costa Rica

Austria

Ghana

Hong Kong

Panama

Greece

Angola

Taiwan

Columbia

Hungary

Kenya

Myanmar

Peru

Bulgaria

Tanzania

Philippines

Brazil

Poland

South Africa

Vietnam

Chile

Turkey

Indonesia

Malaysia

Source: Estee Lauder Investor Day 2018

However, in spite of its strong global presence, there is significant runway to increase the penetration of smaller brands by launching them in new markets, in particular Asia-Pacific which is expected to house two-thirds of the world’s population by 2025 and accounts for 30% of the prestige beauty market. China has become the largest beauty market in the world. Chinese consumers are the leading buyers of beauty products in the world and spent over $25 billion on prestige beauty products in 2018. Chinese travellers are driving industry growth globally and the proportion of Chinese citizens holding passports (currently 9% of the population) is set to double by the end of 2020. Fledgling brands such as La Mer, Origins, Darphin, Aveda, Too Faced, Becca, Bumble & bumble, Kilian, Frederic Malle and Rodin are poised to expand across new territories in coming years.

Consumers recognise and trust the value of Estee Lauder’s brand portfolio which manifests in strong pricing power. Indeed, price increases represent 20-25% of net sales growth. Unlike more expensive prestige goods, Estee’s products lie within the affordable luxury category. As such, growth has proven resilient during economic downturns. This is partly because of the company’s purposeful diversification strategy across brands, channels, geography, segments and price points. Aside from brand strength, Estee Lauder has clear competitive strengths in distribution and holds an extensive patent portfolio in skincare which anchors high-end products.

Is the Premium Valuation Justified?

Management has guided to 6-8% net sales growth in constant currency terms with 2% from price/mix and the balance from new distribution (2%), volume (2-3%) and acquisitions (1%). In the case of the latter, the company has enjoyed a successful M&A history with management emphasising a 21% return on invested capital in brands acquired since 1994. Management expects to post 150 basis points of margin improvement by FY2022, driven by gross margin leverage of 50 basis points in constant currency terms through investments in supply chain and procurement benefits; 50 basis points of selling expense leverage through efficiencies and expanding in channels which require less direct selling and better systems and processes to reduce store selling costs by better aligning store traffic and staffing hours; and 80 basis points in G&A expense leverage through initiatives involving shared services and lower indirect procurement costs. A portion of these improvements – expected to be around 30 basis points – will be reinvested in supply chain, technology and sustainability initiatives whilst management will continue to support long-term initiatives centred on organic business growth and strategic acquisitions to strengthen the category and brand portfolio. Management forecasts the business to deliver $2.5-3.0bn of free cash flow by FY2022 which puts the firm on a three-year forward free cash flow multiple of 20-24x. Is such a premium valuation justified? Given the company’s moat is widening and is expected to gain share across the prestige beauty category for many years to come as brands are rolled out in new markets and the effectiveness of marketing improves, it is by no means unreasonable. Moreover, Estee Lauder generates sustainably strong returns as proxied by return on equity, return on assets and return on invested capital.

Estee Lauder’s ROE, ROA and ROIC (2012-18)

Source: Company Reports

What are the Risks?

Key risks reside in advertising claims (there is debate as to whether the products deliver the stated benefits) and an economic slowdown in China on account of tariff measures or boycotts. In addition, given the products are highly discretionary there is sensitivity to a general global macro-economic slowdown, particularly if high income consumers are impacted.

The Future Looks Bright for Estee Lauder

By virtue of its one-on-one connections with its audience and digital technological prowess, Estee Lauder engenders strong consumer loyalty and pricing power. As many consumer categories face competitive threats from private label, prestige beauty will continue to remain insulated thanks to its brand-centric appeal and positioning in the mindset of consumers. Estee Lauder has built a strong culture of collaboration and empowerment where brand managers are provided with the resources and scope to drive innovation and expand their customer base across new channels and markets. Through investments in digital, acquired brands and new channels, management has allocated capital pragmatically in a dynamic global environment. Digital media enables Estee Lauder to reach millions of consumers that it never had before at a fraction of the cost of traditional advertising. Sales growth has consistently exceeded the overall prestige beauty market, driven by emerging markets and a multi-channel strategy, notably travel retail, online and speciality multi-channel.

It is difficult to conceive of a company so geared to many of the world’s most powerful trends – rising affluence across emerging markets, ageing demographics in the west, the importance of instant beauty and aesthetics for the ‘selfie’ generation and the ability to build one-to-one relationships with customers through digital connections, whether through social media influencers or online make-up tutorials. Indeed, with over 90 million selfies sent per day globally, the rapid rise of social media apps has created a cultural shift which elevates the importance of skincare and make-up products. Unlike other consumer categories which face disruption from private label or Amazon (NASDAQ:AMZN), with its focus on craftsmanship, artistry and individuality, Estee Lauder’s brand portfolio is well entrenched in the mindset of consumers for its quality, authenticity and prestige and as consumer buying behaviour evolves, the multi-channel approach to sales minimises the dependency on a single distribution channel. The business is spearheaded by the Lauder family which has created a strong culture and is managed for the long term. Accordingly, shares of the company are recommended for purchase.

Disclosure: I am/we are long EL. 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.