BalkansCat
The Estée Lauder Companies Inc. (NYSE:EL) manufactures, markets, and sells skin care, makeup, fragrance, and hair care products worldwide. We have started coverage on the company in February this year, with an initial hold rating.
The primary reasons for our neutral outlook have been the:
- softer demand for EL's products - reflected in the weaker sales and net profit figures
- potential positive impact of the reopening of China
- potential positive impact of the improving macroeconomic environment, including consumer confidence and inflation
- overvaluation based on a set of traditional price multiples
Rating history (Author)
Since our last writing, the firm's stock price has declined by 37%, significantly underperforming the broader market, which has gained almost 7% in the same period.
Today, we have decided to revisit our case on EL, and give an updated view on both the macro- and company-specific factors that may shape the firm's financial performance in the coming months and quarters.
Macroeconomic environment
Since our last writing, the macroeconomic environment has meaningfully improved, at least in the United States. Consumer sentiment has improved, inflation has moderated while the FX environment has stayed relatively stable.
Inflation rate
Inflation rate in the United States has dropped by ~0.7% since February, which is a meaningful improvement compared to the data seen during the last two years.
Core inflation rate (tradingeconomics.com)
In our view, this disinflation is likely to have a positive impact on EL's expenses, which eventually may lead to improved margins and better bottomline results in the coming quarters. As the Fed remains committed to fighting inflation by still raising the interest rates, we do not believe that inflation is going to start increasing again in the near term.
Consumer confidence
Consumer confidence - or consumer sentiment - is often treated as a leading economic indicator, which can be used to gauge the changes in the spending behaviour of the consumer. Better sentiment or higher confidence levels indicate that people are more optimistic about their financial outlook and the overall state of the economy in general and therefore are more willing to spend on non-essential, discretionary items, like the ones EL is selling.
U.S. Consumer confidence (tradingeconomics.com)
Since our last article, consumer confidence in the United States has significantly improved. In our view, this development may lead to higher demand for EL's products in the coming quarters, positively impacting the sales figures of the company. Further, if the inflation continues to decline, sentiment is likely to improve further in the near term.
Management has also reflected on these developments in the firm's latest earnings report. While sales have been and forecasted to be keep trending down, it is mainly driven by the Asia travel retail in Hainan and Korea. This negative factor has been partially offset by growth in almost each region from Asia/Pacific to Europe, the Middle East & Africa. Until now, the North American market has continued to be relative weak with soft demand. Important to note here that not only EL has experienced weak demand in the U.S., but also other luxury brands, including Farfetch (FTCH) and LVMH Moët Hennessy - Louis Vuitton, Société Européenne (OTCPK:LVMHF).
FX environment
EL is generating a meaningful portion of its revenue outside of the United States, therefore the FX environment plays a significant role in the financial performance.
USD Index (investing.com)
Despite the volatility in the past months, the USD index is about at the same level as it was in February. Looking forward, we do not expect the USD index to reach its previous highs that we have seen in late 2022. The following table shows how EL's operating expenses have changed from fiscal 2022 to fiscal 2023. Foreign exchange transactions had a minimal, but positive impact on the expenses.
Operating expenses (EL)
All in all, based on the improving macroeconomic environment, we have an optimistic outlook on EL.
Company specific factors
Inventory levels
In our previous article, we have raised our concerns about the high, rising level of inventories. This issue has not been resolved since. Our concerns have been revolving around excess and potentially obsolete inventory. How will the firm be able to "get rid of" these products? If significant discounting needs to be applied, it may lead to a negative development of the margins.
In the most recent earnings report the negative impact of the excess inventory on the gross margins has been explicitly mentioned:
The unfavorable impact from obsolescence charges is primarily due to excess inventory on hand and increased levels of inventory destruction and reserves driven by lower demand that resulted in lower product shipments.
When comparing fiscal 2023 with fiscal 2022, we can see that the gross margin has contracted by as much as 440 bps year-over-year, from which obsolescence charges made up 100 bps.
Gross margin (EL)
On the other hand, we have to mention that inventory levels have only increased marginally in fiscal 2023 vs. fiscal 2022, which is a good sign.
Balance sheet (EL)
China risk
A substantial portion of the firm's sales are generated in the Asia Pacific region. The economic recovery of the region, especially the recovery of China has not been as fast as expected. How the economic situation will develop in China in the near future also remains quite uncertain.
A stagnating Chinese economy may lead to softer demand for EL's products, hurting the business overall. Several analysts have been, for this reason, cautious about their outlooks on the company. Their primary arguments have been related to lower guidance and longer headwinds from destocking:
We expect below consensus initial FY'24 guidance. While that is somewhat anticipated by the market, we don’t believe investors will view low guidance as conservative given large cuts over the last two years.
The softer demand has been also largely confirmed by the latest financial results and comments:
During the fiscal year ended June 30, 2023, the operating environment continued to be disrupted by the impact of the COVID-19 pandemic. Most notably, the pace of recovery in Asia travel retail and mainland China was slower than anticipated. In Hainan, prolonged store closures initially presented a headwind and, thereafter, low levels of conversion occurred when travel resumed. This was compounded by inventory tightening by certain retailers.
In our view, investors must be aware of the firm's dependency on China before making an investment in the stock.
Hack
In the recent past, it has been in the headlines that EL has suffered a cyberattack. The company has made the following statement about the incident:
The incident has caused, and is expected to continue to cause, disruption to parts of the company’s business operations, [...]
This has been especially painful for the firm because as a result it has caught some further downgrades, namely from Barclays. Barclays has noted several times that there is under-investment in CAPEX, including technology.
BARC can't help but worry that these issues are broader & more systematic than it originally described, [...]
As a result, we believe that increased CAPEX spending on technology may be on the horizon. It is good from one perspective, but it will have a negative impact on the margins and on the bottom-line results. If we combine this with the worries over the demand in Asia, the picture looks even worse.
Conclusions
The macroeconomic environment in the United States has improved substantially since our last writing, which may lead to lower costs and higher revenue for EL.
On the other hand, the firm is still carrying significant amount of inventory, which may be difficult to sell, especially as the demand in China does not seem to be picking up as initially expected.
The recent cyberattack is also making it difficult to justify a bullish view on the firm.
From a valuation point of view, based on a set of traditional price multiples, EL's stock still does not appear attractive.
Valuation (Seeking Alpha)
For these reasons, we maintain our neutral outlook and reiterate or "hold" rating.
