Why You Should Buy This Company Despite Its Lofty Valuation

| About: The Estée (EL)
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The stock of Estee Lauder Companies Inc (NYSE:EL) traded off -15% from its late April highs through August 13 as investors were concerned about the impact negative macros would have on the company's fundamentals. However, the stock is recovering well after the company reported strong Q4 results. The reported F4Q12 EPS of $0.17 was a penny ahead of the consensus estimates driven by global share gains and 60 bps of operating margin expansion. The company guided for below consensus FY13 adj. EPS of $2.44-2.56, but we are not concerned, as the company has a track record of consistently beating its initial guidance. The company continued its broad-based top line growth across all geographic regions and product categories, driven by meaningful market share gains and the continued shift from mass to prestige brands among consumers.

The cornerstone of the bear thesis on Estee Lauder has been its lofty valuation. We have already seen how the bears have often overlooked the fundamentals and lost money as they shorted companies like Amazon.com (NASDAQ:AMZN) only on the basis of high valuations. While Estee Lauder has a forward P/E of 20.34, its growth-adjusted P/E (PEG ratio) is less than 1.6x; a multiple that is actually lower than many other staples and luxury companies. Although Estee Lauder is trading at a premium to its competitors like Avon Products (NYSE:AVP) and Tupperware Brands (NYSE:TUP), it also has the highest expected growth rate. Moreover, both Avon's and Tupperware's sales depend largely on their representatives, whereas Estee Lauder products are generally sold through departmental stores, providing more stability.

The following are the key positives that make us optimistic about the company's growth prospects.

Well Positioned China Business

Doing skin business in China in reality is not that promising and easy. Companies who plan to place cosmetics on the Chinese market must apply for and obtain a hygiene license for special use cosmetics or record-keeping certificate for ordinary use cosmetics from the SFDA. Thus, there are large barriers to entry and difficulty in penetrating for skincare companies in the region. However, Estee Lauder is going strong in the region and posted double digit growth in sales. Moreover, men's skin market is rapidly expanding in China and has already surpassed North America. It is also expected to grow at 29% year over year through 2014, compared to North America at 5.7% and Europe at 7.9%. With a rapidly emerging middle-class, Estee Lauder is set to reap significant rewards going forward.

Estee Lauder should continue to gain share in Luxury Market

Luxury Category's sales are expected grow ~2x faster than the prestige beauty market in FY13, as the management guided for Luxury sales growth of 6-8%, but expect the global category to be up ~3-4% (below the 5% growth in FY12). They will continue to invest more heavily in the business (further shifting away from promotions and toward advertising), as they focus on the emerging markets, travel retail, e-commerce, US luxury, and skin care.

Who says a slowdown is bad

Estee Lauder's Chairman, Leonard Lauder identified the Lipstick index as sales across the Estee Lauder family of brands. He used the term to describe sales of cosmetics during the recession of the early 2000s. The basis behind this theory is that women substitute more expensive purchases like dresses and shoes for lipstick in times of economic distress. If that's indeed the case, we believe that the company would not only be successful in gaining market shares, but an economic slowdown might well be a blessing in disguise.

In our view, Estee represents an attractive secular growth story within the consumer space, with significant opportunities to expand in a number of geographies and distribution channels. Further, we expect the company to leverage this growth and, along with additional cost savings, deliver robust margin expansion and bottom line growth in the coming years, with a very strong balance sheet that provides ample financial flexibility. Thus, we recommend investors look beyond its high valuation to the underlying fundamentals.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This article was written by Sandeep Gupta. He has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.