L'Oreal Did Not Decline Enough To Make It An Investment

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L'Oreal reported solid first half results for fiscal 2024.The company might continue to grow with a high pace - due to the lipstick effect even during a potential recession.But even with high growth ...

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(OTCPK:LRLCF). And while we are certainly talking about a great business with a wide economic moat, I did not see the stock as a good investment and in my last article published in March 2024, I argued that the stock is overvalued. In my last article I wrote: In my opinion, L’Oréal is not a “Buy” and certainly not a bargain. Especially when looking at the technical picture in combination with the high valuation multiples (and the stock being rather overvalued), I don’t think L’Oréal is the best investment we can make right now. Since the article was published, the stock declined about 15%, raising the question if it is a good investment now. We are looking at the company and stock once again to answer that question. It seems unlikely it is a good investment at this time. Of course, a lot can happen in seven months, and I also might have made a mistake in my last article by being too pessimistic. But usually, a 15% decline is not enough to make the shift from overvaluation to good investment. Half-year Results Let’s start by looking at the last results L’Oréal reported – the half-year results for fiscal 2024 – and the results were certainly solid. Net sales increased from €20,574 million in the first half of fiscal 2023 to €22,121 million in the first half of fiscal 2024. While this is resulting in 7.5% year-over-year top line growth, operating income grew even 8.0% YoY from $4,259 million in the same timeframe last year to €4,599 million in the first half of 2024. And diluted earnings per share increased from €6.25 in H1/23 to €6.82 in H1/24 – resulting in 9.1% YoY bottom-line growth. L'Oreal H1/24 Presentation While reported growth was 7.5% in H1/24, like-for-like growth was 7.3%. And that growth stemmed from 2.6% volume growth, 3.3% price increase and 1.4% product mix. And when looking only at the second quarter and not the first half of 2024, reported growth was 6.7% and like-for-like growth was 5.3% and therefore growth rates seem to slow down a little bit. L'Oreal H1/24 Presentation We can also look at the different regions and while North America grew 7.8% year-over-year in the first half of 2024, Europe grew 11.1% and emerging markets grew even 14.7%. The top 3 growth contributors were the United States, Mexico and the DACH region (Germany, Austria and Switzerland). Only one region was struggling – North Asia, which declined 1.7% year-over-year. L'Oreal H1/24 Presentation Looking at the different segments, the two most important segments are still Consumer Products (responsible for 38% of total revenue) and Luxe (responsible for 34% of total revenue). And while Luxe reported only like-for-like growth of 2.3% year-over-year, Consumer Products reported like-for-like growth of 8.9%. The third segment is Professional Products, which grew 5.7% like-for-like. The fourth and final segment is Dermatological Beauty, which is already responsible for 17% of total revenue and did not only grow with the highest pace (16.4% like-for-like growth) but is also reporting the highest operating margin (28.9%) of all four segments. L'Oreal H1/24 Presentation Mainland China Similar to many other companies, L’Oréal is also struggling in China, and the Asia region is the only region in which L’Oréal had to report negative numbers. Recently, I have written about Apple, which is also struggling in China, but I have also written about the possibility of sentiment changing in China. In the last few weeks, many Chinese stocks jumped higher, and although we already saw a correction again (which is a normal and how stock markets work) I remain long-term optimistic about China. A more positive (or more bullish) sentiment is at first visible in the stock market – simply due to the real-time data we have for the stock market. However, a more positive sentiment can not only push stock prices higher, but it can – and will – also have an impact on consumer buying decisions, for example. And over the long run, China might be an important market for L’Oréal, with above-average growth rates. McKinsey & Company McKinsey was projecting in 2023 that China will be a huge contributor to growth for the beauty market and is expecting growth rates of 8% annually till 2027. And while Africa and the Middle East are expected to grow at a higher pace, China is the bigger and much more important market. Expectations and Growth When talking about the growth potential and what to expect, we have to differentiate between the short-to-mid-term and the long-term expectations. For the long run, I am quite optimistic that L’Oréal can continue to grow with a solid pace. For starters, the beauty market will probably continue to grow with a solid pace and outpace overall GDP growth. In 2023, the beauty market grew 8% and for 2024, expectations are still around 4.5%. L'Oreal H1/24 Presentation Additionally, L’Oréal is not only the world leader in beauty, and being number one sometimes has advantages. L’Oréal also demonstrated it can grow with a higher pace than the beauty market from year to year. And of course, we should not just extrapolate past data into the future, but a business consistently outperforming will most likely also continue to do so in the future. L'Oreal H1/24 Presentation L’Oréal itself is projecting the market to grow from €280 billion in 2023 to €380 billion in 2030 – resulting in a CAGR of 4.46% for the years to come. Other studies are even more optimistic and assume growth rates of 7.7% for the years from 2024 to 2030 or even 9.8% between 2024 and 2032. McKinsey & Company And McKinsey – in the above-mentioned study – is expecting the global beauty market to grow with a CAGR of 6% until 2027. Recession and the Lipstick Effect When focusing on the long-term and bigger picture, I am quite confident that L’Oréal will continue to keep its leading position in the market and its wide economic moat will enable above-average growth rates for the business. However, we also must look at the next few quarters and how L’Oréal might perform during a potential recession. And while some European countries are already struggling – especially in Germany the word recession already seems appropriate – the situation also might get worse in the United States in the coming quarters. However, when talking about a cosmetics company and recession, we should also mention the lipstick effect. And while during recessions the spending for many non-essential products is declining, economists observed a different pattern for lipsticks. In Boosting Beauty in an Economic Decline: Mating, Spending, and the Lipstick Effect the authors are stating: Economists have established that recessions are reliably associated with increased spending on two types of products: traditional inferior goods (e.g., spending more on tuna rather than salmon because of budgetary constraints) and morale boosters (e.g., going to see a Charlie Chaplin film in the Great Depression). Although the lipstick effect has garnered some anecdotal lore, the present research suggests that women’s spending on beauty products may be the third indicator of economic recessions—an indicator that may be rooted in our ancestral psychology. And this effect is well documented for many major recessions – including the Great Depression and the Great Financial Crisis. Especially, women spend much more on attractiveness products during recessions. There have been several ways to explain the lipstick effect, including the following: We turn to the final explanation – that the lipstick effect is driven by a desire to “treat” oneself more frugally by spending less on clothes or jewelry and purchasing new cosmetics products instead. We provide evidence showing that during the Great Recession, younger women reduced expenditure shares in several categories, even as they increased their expenditure share on cosmetics. In the next potential recession – and it is coming in my opinion – L’Oréal might profit from the lipstick effect once again and maybe perform quite well even in challenging times. Intrinsic Value Calculation One of the major issues I already mentioned in my previous articles is the high valuation multiples L’Oréal is trading for. As argued above, L’Oréal is certainly a great business with long-term growth potential and due to the lipstick effect, the company also might perform well in a potential recession. Nevertheless, I don’t think the current stock price is justified. And although L’Oréal moved a bit away from the extreme valuation multiples of the last few quarters, the stock still seems rather expensive. Data by YCharts At the time of writing, L’Oréal is still trading for 33 times earnings, as well as 35.5 times free cash flow. And although it is sometimes possible to justify valuation multiples between 30 and 40 with extremely high-growth rates, we should be rather cautious. To get a clearer picture what intrinsic value might be reasonable or justified for L’Oréal, we will once again use a discount cash flow calculation. As basis for our calculation, we take the free cash flow of the last four quarters, which was €6,005 million and the last number of reported shares outstanding was 536.4 million. When calculating with these assumptions, L’Oréal must grow its free cash flow 15% annually for the next 10 years, followed by a growth rate of 4% into perpetuity. And although we can be optimistic that L’Oréal will be able to grow with a high pace in the years to come and even when being a little more optimistic that L’Oréal will also be able to perform great during a potential recession due to the lipstick effect, I think it is hard to argue for 15% annualized growth in the next 10 years. Of course, we can look at the last three years in which the company reported a CAGR of 22% for the bottom line, but the last three years are probably not representative for the long-term growth potential of the business. When looking at the last ten years, the company grew its bottom line with a CAGR of 9% and that number seems more realistic. We can also ask what a more realistic growth rate might be, and I would not calculate with a higher growth rate than 10% in the next ten years (which is already optimistic). With all other assumptions being the same, this would lead to an intrinsic value of €279 for L’Oréal and to be honest, I would not even think about L’Oréal for a higher price (of course that price will change in the future as the business progresses). Bottom Line L’Oréal is certainly a great business and might even be recession-resilient and even perform well during an economic bust. But even when being very optimistic about China returning to growth and L’Oréal continuing to grow with a high pace, the growth rates which are necessary to make the stock fairly valued at this point are just unrealistic and L’Oréal remains a 'Hold' at best.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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