L'Oreal Faces Beauty Market Setback In China: Here's Why I'm Holding

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L’Oréal's sales in North Asia fell 3.1% in H1 2024, with China being the main driver due to weakening in consumer spending.Luxury beauty brands like Lancôme are struggling in China, with travel retail...

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Management is shifting towards more affordable products in this region.I believe that the stock is fairly priced compared to its five-year average, limiting upside potential.I rate the stock a Hold, mainly due to concerns about North Asia's continued weak performance, even after the release of the massive stimulus pack.   Robert Way L'Oreal SA (OTCPK:LRLCY) has been facing headwinds in the North Asian region, with sales declining 3.1% YoY in the first half of the year, despite double digit growth in almost all other geographical regions.  With China being in the spotlight due to the decline in consumer spending and the recent announcement of the massive stimulus pack to reignite the economy, investors are speculating about the impact of these macroeconomic trends on L'Oreal's share price. Therefore, in this article, I considered reviewing the recent financial performance of the company, with an emphasis on the headwinds that the company is experiencing, particularly in China.  In the outlook section, I will present the rationale behind my Hold rating for this stock, including a deep dive into the fundamentals of the company and a simple valuation analysis.  For now, I would like to start with a brief company overview section for those readers new to this stock.  Company Overview L'Oréal is a global beauty company based in France that sells skincare, makeup, haircare, and fragrances. The company has a portfolio of 37 international brands, including L'Oréal Paris, Maybelline, Garnier, and Lancôme.  I like how they distribute their products, not just through online sales and stores, but also in professional salons. If you've ever been to a women's hair salon, you've probably noticed their products all over the place. Maybe, you also noticed the wide range of prices for these products. This is because L'Oréal serves different consumer segments, from mass market to luxury.  The company organizes its operations into four business segments. I considered including below a breakdown of total revenue per segment and region from the latest earnings report. Please note that the figures are in Euros (€). press release | L'Oreal As a side note, SAPMENA-SSA, includes South Asia Pacific, Middle East, North Africa, and Sub-Saharan Africa. In regards to the ownership of the company, there are two main owners: The Bettencourt Meyers family, who owns 34.7% of the company, and the Swiss multinational, Nestlé, who owns 20.12%.  market screener Headwinds in China Sales in North Asia during the first half of the year declined by 3.1%. Even after excluding the effects of any new business activities, acquisitions, or store closures, their sales in that region decreased by 1.7%.  The reason I am sweating about this decline is due to the weight of the North Asian region in the total revenue of the company. In H1 2024, this region accounted for 25% of total sales, a figure very close to the North American region.  Mainland China seems to be the driver for this decline. As a matter of fact, L’Oréal faced a 2-3% contraction in the beauty market, with luxury beauty suffering from high single digit declines.  If you are up to date with the latest news, the decline in consumer spending in China should not be a surprise to you. In the face of an economic slowdown and a job market that is under pressure, the Chinese government is expected to announce a massive stimulus to boost domestic spending.  L'Oréal is not oblivious to this fact. As a matter of fact, the company has had to adapt to this decline in China by emphasizing more affordable products. More premium brands, like Lancôme and Yves Saint Laurent, face difficulties in this region due to weakened demand for luxury fragrances and skincare products, which seem to perform better in more stable economic environments. Another pressure from China comes from continued weakness in travel retail, particularly in Hainan, where sales declined by 30% during the first half of the year.  Moving on to other headwinds, margins are still pressured by high operating costs. In the first half of the year, the company spent €427 million more than in H1 2023 on brand support, particularly for new product launches and innovations. SG&A also increased in the first half of the year by 80 bps. Additionally, the consolidation of Aesop had a negative impact of 35 basis points at the group level. However, despite the increase in expenses, gross margins improved slightly, reaching 74.8%. Outlook I'd like to start with price action.  A quick look at the daily chart below shows the share price trading sideways since the beginning of 2023, bouncing between $80 and $100.  trading view In my view, the $100 resistance and $80 support seem to be reliable, as the share price has bounced multiple times on these levels.  Moving on to the income statement, total annual revenue has increased since the pandemic, with a double digit growth in 2023.  trading view Additionally, in the last 7 semesters, total revenue increased YoY, mostly in the double digits.  trading view Moving on to profitability, operating income has been increasing in the double digits over the last three semesters. Net income has been following this trend, with just one growth decline in H2 2022.  trading view In regards to the cash flow statement, things don't look promising in H1 2024, with a 5% YoY decline in free cash flow.  trading view The decline in free cash flow is disappointing, considering the 8.86% increase in net income.  Among the contributing factors, the latest earnings report mentions an increase in working capital due to the phasing of net sales. Additionally, Capex increased to €781 million, representing 3.5% of sales.  Finally, a quick look at the balance sheet shows a significant increase in the net debt of the company.  trading view Additionally, total debt has remained relatively flat since H1 2023, while cash & equivalents have been declining ever since.  trading view Moving now to valuation, a quick glance at some of the valuation metrics shows that the company is overvalued when compared to the consumer staples sector.  However, I believe that a more accurate comparison would be with its own five-year average. When doing so, the valuation metrics show a different picture, where the company is undervalued, compared to its five-year average.  An example is EV/EBITDA, which is 10% below this average. Forward price to sales shows a similar picture, being 11% below its average.  In my view, paying 28x cash flow seems quite fair for this company. I don't expect the price to cash ratio to go down to 25x, as it was in June 2022.  seeking alpha Looking at EV/EBITDA in the same period, the 23x ratio seems quite attractive, considering that in June 2022 it was trading at 21x. seeking alpha However, my investment style looks for big discounts to the fair value. In the case of L'Oreal, it seems that shares are priced fairly.  Conclusion To wrap up, I believe the strongest headwind that the company has been facing in the Chinese region is priced in. Between June and September, the share price went from the $100 resistance level down to the $80 support.  Additionally, I believe the massive stimulus announced by the Chinese government on September 24 is also priced in, although it seems that investors are relatively pessimistic with the outlook of luxury brands, and travel-related sales in this region. The main reason I believe so is because shares went up to $92 after the announcement, and now (just a few weeks later) shares are down to $86.  On the positive side, profits are still growing, and gross margins look slightly better than in H1 2023.  From a valuation perspective, the company appears fairly priced, despite some metrics suggesting it is slightly undervalued compared to its own performance. That said, I don’t see the kind of significant discount I typically seek in an investment. Considering these factors, I rate this stock as a Hold for now. I recommend keeping a close eye on the growth (or decline) in the North Asian region in the next earnings release.   Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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