Estée Lauder: Earnings Already Surpassed Pre-COVID Level, More To Come

Summary

• Despite COVID-19, EL achieved a record EBIT in Q2 FY21 (Q4 CY20), and sales were flat organically compared with an unaffected prior year.
• The strength was primarily driven by China; the U.S., Europe, and Travel Retail were still weak, meaning there is more to come in a full recovery.
• Organic sales growth is guided to 10-11% in Q3, and management are confident of returning to their long-term growth targets after COVID.
• EL shares are trading on 42.9x pre-COVID CY19 EPS, but last quarter's EPS was already 12% higher than that in CY19.
• With shares at $285.86, we expect an exit price of $349 and a total return of 26% (7.2% annualized) in 3.5 years. Buy.

Introduction

We review our Estée Lauder (NYSE:EL) investment case with Q2 FY21 (October-December) results released on February 5 and other recent developments.

We initiated a Buy rating on EL shares in April 2020 (PRO subscription required), and they have gained 76% (including dividends), more than twice the gain in the S&P 500:

Librarian Capital EL Rating History vs. Share Price Source: Seeking Alpha (28-Feb-21).

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Buy Case Recap

We initiated Buy ratings on both EL and L'Oréal (OTCPK:LRLCF) shares in March/April, after the U.S. and Europe entered COVID-related lockdowns. Our key assumptions on EL were as follows:

• The Beauty sector has a long period of strong structural growth ahead, as an aspirational category for consumers, helped by growing demand from APAC (especially China) and from premiumization (especially in Skin Care).
• Both L'Oréal and EL have strong global franchises built on leading brands, high-quality products, scale, innovation and marketing capabilities.
• Both L'Oréal and EL can grow sales faster than the market, and grow their earnings faster than sales, thanks to natural operational leverage.
• EL is smaller, more focused on the Prestige segment, has a higher exposure to Skin Care, and tends to grow sales faster (in double-digits).

We knew that EL was more vulnerable to COVID-19 disruption, as Travel Retail was 23% of its sales in FY19, and department stores were 35% (including 13% in North America):

EL Net Sales & EBIT Breakdown (FY19) (Pre-COVID) Source: EL company filings.

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While department stores were challenged even before COVID, we believed there would be at least some recovery and, even if one of EL's channels were to be impaired permanently, its competitive advantages would enable it to regain sales in other channels over time.

We reiterated our Buy rating on EL after each set of quarterly results during 2020, and maintained our expectation that double-digit EPS growth would resume eventually. As of our November update, we expected EPS to be 3.6% above its pre-COVID FY19 figure in FY21 and 16.3% above in FY22.

With recent results we now believe we were too conservative.

Record Quarter Despite COVID-19

EL's Q2 FY21 sales grew 3% year-on-year excluding currency (and were flat excluding the Dr. Jart+ acquisition), sharply accelerating from Q1 when sales were down 9% (down 12% excluding Dr. Jart+):

EL Net Sales Growth Y/Y (ex. Currency) (Since Q2 FY19) Source: EL company filings.

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Q2 FY21 adjusted EBIT was 13% higher year-on-year (10% excluding currency), exceeding the previous record quarter in Q2 FY20:

EL Adjusted EBIT (Since Q2 FY19) Source: EL company filings.

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EBIT growth was helped by 170 bps of margin expansion, including approx. 10 bps in Gross Margin and 160 bps in OpEx margin. EL has benefited from a mix shift in both products (towards Skin Care) and channel (towards online), cost containment during the outbreak, and ongoing restructuring initiatives.

Fiscal Q2 includes the holiday season and is historically the biggest quarter. Compared to Q1, sales rose 36%, EBIT rose 65% and EPS rose 81%:

EL Non-GAAP P&L (Q2 FY21) Source: EL company filings.

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Strong China, But Partial Recovery Elsewhere

The strong sales in Q2 FY21 was led by APAC, which grew 27% year-on-year (excluding currency); Americas was down 13% and EMEA (where Travel Retail sales are reported) was down 3%:

EL Net Sales Growth Y/Y by Region (ex. FX) (Since Q2 FY19) Source: EL company filings.

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APAC's strength was primarily driven by mainland China, which saw double-digit sales growth in physical stores; sales growth was also double-digits when including online. Korea and a number of smaller markets also contributed.

Online sales were up 60% year-on-year, growing "double or triple digits in every brand, every region, every channel". This helped partially offset COVID-related restrictions that were imposed in the U.S. and Europe in the winter.

Travel Retail grew single-digits, driven by strong results in Asia, particularly in Hainan, an increasingly popular destination for Chinese domestic tourism.

By category, sales growth was again led by Skin Care, where year-on-year growth accelerated to 27% (excluding currency) in Q2 FY21 (from 10% in Q1). Fragrance growth turned positive (to 5%) for the first time since the start of COVID-19. Makeup sales were down 26% and Hair Care down 6%:

EL Net Sales Growth Y/Y by Category (ex. FX) (Since Q2 FY19) NB. Skin Care growth included contribution of +6% in Q1 FY21 and +7% in Q2 from the Dr. Jart+ acquisition. Source: EL company filings.

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COVID-19 was still a significant negative, even in China where it reduced Makeup sales due to mask-wearing. As EL's CEO explained:

Makeup is completely correlated to the occasion of usage. In China, because of the good control of COVID ... makeup is in better shape ... (but) there is very disciplined mask-wearing, and mask-wearing also is a reason for less usage of makeup. So stronger than the rest of the world, but still not as strong as it will be after COVID."

Fabrizio Freda, EL CEO (Q2 FY21 earnings call)

We believe demand for beauty products was still suppressed by COVID-19 during the quarter, and there is sizeable further potential to come in a full recovery.

FY21 Outlook

For Q3 FY21, EL expects year-on-year growth of 10-11% in net sales and 26-38% in EPS (excluding currency). Currency is expected to add 3% to sales growth and 4% to EPS growth:

EL Q3 FY21 Outlook Source: EL results release (Q2 FY21).

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We believe the growth rates are achievable. The prior-year quarter saw sales declined by 9% (11% excluding Dr. Jart+) as much of the U.S. and Europe entered lockdowns, and sales in Americas were down by as much as 23%.

For FY21, EL is again not providing guidance due to continuing uncertainty. Management still expect a "sequential quarterly sales growth improvement", but less than before due to the unanticipated second wave of COVID-19. Dr. Jart+ will add 2% to full-year sales, while the termination of some third-party and EL's own stores will subtract 1-2% (but with some recoverable elsewhere). EL also expects some of the normal costs cut during the outbreak to return, and for the usual investment costs in Q4 that appear every year.

Eventual Return to Double-Digit EPS Growth

Management expressed confidence in eventually returning to EL's long-term growth and margin targets, which include a 6-8% ex-currency sales growth, a 50 bps EBIT margin expansion, and double-digit EPS growth each year:

EL FY20-22 Outlook (Before COVID-19) Source: EL presentation at Bernstein conference (May-19).

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Specifically, EL's long-term growth drivers in increasing Skin Care demand, rising beauty penetration in China and growing Travel Retail are all intact:

"The key drivers for us - let's go one by one - Skin Care, very sustainable ... The potential of China as we explained very well in our Investor Day is for the long term ... In TR (Travel Retail) ... in the future the domestic travel acceleration within China will continue, but the international travel will be restated, and so this will be a further acceleration in the long term when COVID will abate. So, all our key drivers are really here for the long term ... we are very positive, in summary, on the continued strength post-COVID of our drivers."

Fabrizio Freda, EL CEO (Q2 FY21 earnings call)

While there was some margin benefit from the mix shift to higher-margin online channels during the outbreak, EL is working to retain online sales by investing in value-add services such as Virtual Try-On. EL's CFO predicted that margin expansion will continue:

"We are very comfortable that we have margin progression ahead of us once the pandemic is behind us in a more sustainable way."

Tracey Thomas Travis, EL CFO (Q2 FY21 earnings call)

Valuation

At $285.95, on last-twelve-month (CY20) financials, EL shares are trading at a 65.3x P/E and a 2.2% Free Cash Flow ("FCF") Yield; on pre-COVID CY19 financials, they are trading at a 47.9x P/E and a 1.4% FCF Yield:

EL Earnings, Cashflows & Valuation (FY18-CY20) Source: EL company filings.

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EPS was much lower in CY20 than CY19, due to COVID's impact on earnings, but FCF was much higher due to working capital improvement.

With Q2 FY21 EPS actually 12% higher than the prior-year', we believe current "normalized" earnings are 10-20% above those in CY19. This means EL is likely to be trading at a "normalised" P/E in the 40-45x range when measured on current earnings, compared to 47.9x on CY19 earnings.

The Dividend Yield is 0.8% ($2.12 per share), with the dividend having been maintained through the outbreak and raised 10% at Q1 FY21 results.

EL expects to reinstate share repurchases during H2 FY21.

As of Q2 FY21, EL had $5.55bn of gross cash, giving it a small net cash of $162m. Subsequently, on February 23, EL spent $1bn to raise its stake in DECIEM Beauty from 29% to 76%.

Illustrative Return Forecasts

EL's H1 FY21 EPS of $4.05 is substantially higher than our previous forecast of $2.97. We now forecast Q3 FY21 EPS to be at the mid-point of the outlook, and Q4 EPS to be flat from FY19 (due to pre-recovery investments). This gives us a new FY21 EPS of $5.84 (was $5.15), 9.4% higher than the FY19 figure:

Near-Term EL EPS Estimates NB. Red denotes forecasts. Source: Librarian Capital estimates.

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We update the rest of our forecast assumptions as follows:

• FY22 Net Income of $2.51bn (was $2.26bn), representing a full recovery
• FY23 and FY24 Net Income growth of 11.0% (was 10.5%), representing a return to long-term growth targets
• Share count to fall by 0.3% in FY21 (new) and by 1% each year thereafter (unchanged)
• Dividends to grow with EPS at a 40% pay-out ratio from FY22 (unchanged)
• P/E to be at 40x at FY24, de-rating from the present (unchanged)

The 11.0% Net Income growth rate represents the outcome from the high-end of management's 6-8% sales growth and 50 bps margin expansion targets.

Our new FY24 EPS of $8.72 is 13% higher than our previous forecast ($7.73).

With shares at $285.86, we expect an exit price of $349 and a total return of 26% (7.2% annualized) in 3.5 years:

Illustrative EL Return Forecasts Source: Librarian Capital estimates.

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While the 7.2% annualized return figure is lower than the 10% we typically require, we believe that the high quality of EL earnings (both in terms of resilience and long-term growth) means this is still an attractive investment.

In addition, the forecasted annualized return is below 10% partly as a result of the relatively short period we evaluate, and will be higher for longer periods. Ultimately, if EL's EPS CAGR were to continue to be above 10%, the long-term annualized return would also trend towards this; it is lower for the period up to FY24 because EPS CAGR there is dragged down by the lower growth during the COVID-impacted FY20-21, and because the effect of the small de-rating is larger over a smaller number of years.

On the same EPS and dividend forecasts, EL shares would achieve a 10% annualized return if the exit P/E were to be 43.7x.

Conclusion

Despite COVID-19, EL achieved a record EBIT in Q2 FY21 (Q4 CY20), and sales was flat organically compared with an unaffected prior year.

The strength was primarily driven by China; the U.S., Europe and Travel Retail were still weak, meaning there is more to come in a full recovery.

Organic sales growth is guided to 10-11% in Q3, and management are confident of returning to their long-term growth targets after COVID.

EL shares are trading at 42.9x pre-COVID CY19 EPS, but last quarter's EPS was already 12% higher than that in CY19.

With shares at $285.86, we expect an exit price of $349 and a total return of 26% (7.2% annualized) in 3.5 years. Buy.

We reiterated our Buy rating on Estée Lauder stock.

Note: A track record of my past recommendations can be found here.

Analyst’s Disclosure: I am/we are long EL, LRLCF. 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.