Estee Lauder: A Promising Corporate Workout Situation

seekingalpha11-21

Estee Lauder faces challenges with declining demand in Asia and market share losses in the West, leading to a significant drop in stock value.Despite operational issues, there is potential for ...

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Baloncici  Estee Lauder (NYSE:EL) owns some of the most prestigious personal care brands in the world. Despite its leading position, the business has faced challenges as of late, due to declining demand in Asia and market share losses in the West. Estee Lauder stock has now fallen to a 10-year low and trades at a record discount to L'Oréal (OTCPK:LRLCF), its principal competitor. At this point, when market valuations seem high and geopolitical uncertainty elevated, we do prefer to increase allocation to corporate workout situations as this, since their returns are largely uncorrelated with the market. While Estee Lauder faces operational challenges, we believe there is significant potential for improvement under the new management team. Estee Lauder, despite being cyclical, remains a resilient business, bolstered by its strong brand equity built over many years of consistent marketing investment. Estee Lauder is under-earning currently The operating profit margin of Estee Lauder group fell to ~7% during FY2024, down from about 17% during FY2019. A recovery to these pre-pandemic profit margin levels could boost the profitability and the value of Estee Lauder shares considerably. EL stock is down 50%+ compared to 2019. Estee Lauder is also under-earning as compared to its principal peers. L'Oréal has generated a ~19.5% operating profit margin as of late, even though its product line and geographic sales footprint are similar. L'Oréal also has a large Asian business but has been able to navigate the market issues better. There are several underlying reasons for this weaker performance of Estee Lauder:  Weaker travel channel and mainland China performance due to economic woes; Weaker presence in digital distribution channels; Supply chain disruption as demand fell rapidly; Higher priced product mix as compared to L'Oréal.  Estee Lauder has invested heavily in the cyclical travel retail distribution channel with its premium brands. When consumer confidence in China declined, both travel and demand for premium products weakened. As a result, Estee Lauder, being more sensitive to economic cycles than L'Oréal, has underperformed due to the deterioration in consumer sentiment. Having said that, Estee Lauder management could have done a better job at responding to changes in demand patterns. The supply chain of the business was also apparently too inflexible and the online distribution presence too small. Estee Lauder’s gross margins have now begun to recover as excess inventory is being cleared. The company now needs to wait for a rebound in Chinese consumer confidence, which would drive renewed demand for its core premium brands and travel retail distribution channel. Skincare is the main profit center of Estee Lauder Estee Lauder has been growing their skincare sales up until about FY2022. During the COVID lockdowns, skincare sales received a significant boost as consumers, spending more time at home, prioritized self-care routines. This trend benefited both Estee Lauder and L'Oréal, with their skincare sales increasing by approximately 50% during this period.   Estee Lauder Skincare ($ million) FY2019 FY2020 FY2021 FY2022 FY2023 FY2024 Cagr, %                     Sales 6,551 7,382 9,484 9,902 8,249 7,908 4%   Operating Profit 1,925 2,125 3,036 2,776 1,277 735     Margin, % 29% 29% 32% 28% 15% 9%                       L'Oréal Skincare sales 10,453 11,051 12,982 15,334 16,447   12%                     Click to enlarge During the lockdowns, consumers have accumulated extra savings and become a lot more willing to splurge on premium-priced “masstige” brands. This development favored the strategic positioning of Estee Lauder, which generates most of its sales from premium products. The brands (Estee Lauder) However, the skincare division of Estee ran into issues in the second half of FY2022 as consumer sentiment decreased in America, Europe, and China. Rising inflation, limited product availability, and economic uncertainty have prompted consumers to prioritize saving. Value brands started outperforming in this environment. On top of this, the Chinese economic woes have had a major impact on consumer sentiment in the country and the demand in the cyclical travel channel did not recover as rapidly as was expected. While consumer sentiment in the West has now recovered, China continues to struggle and sales are continuing to decline there. Chinese consuner sentiment (FRED) China and the Asian travel retail are among Estee Lauder’s most important markets, and the company continues to face challenges as sales in these markets decline. Net sales in mainland China, as well as net sales from travel retail locations, in fiscal 2024, 2023, and 2022 were approximately 26%, 28%, and 34% of consolidated net sales, respectively. The market volatility also seems to have uncovered the operational issues at Estee Lauder, as management has failed to predict this market sentiment change over-produced the premium brands, and over-invested in premium brand marketing. Despite this unprecedented volatility over the past five years, Estee Lauder has managed to grow sales in Asia while they have lost some market share in the West.    Estee Lauder Geo Data ($ million)  FY2019 FY2020 FY2021 FY2022 FY2023 FY2024 Cagr, %                     Net sales:                 The Americas 4,741 3,794 3,797 4,623 4,518 4,581 -1%   Europe, the Middle East & Africa 6,452 6,262 6,946 7,681 6,225 6,140 -1%   Asia/Pacific 3,673 4,238 5,486 5,437 5,194 4,888 6%                     Click to enlarge Estee Lauder financials Sales return to growth in the Americas and Europe During the quarter ending September, the sales of Estee Lauder in the Americas, as well as Europe, have remained sluggish, declining by ~2% as compared to the same period last year. The sales in Asia fell 11% on the other hand. Overall, reported net sales decreased by ~5%, driven by a decrease from volume of ~8%, partially offsetting this decrease was an increase from pricing of ~3%. This performance has underwhelmed the markets and the share price of EL fell ~25% after the announcement. The poor performance as compared to L'Oréal also must have spooked the investors. During the quarter ending September, L'Oréal grew sales in Europe and North America by 5%, while North Asian sales declined by only ~6%. L'Oréal has outperformed Estee Lauder by a considerable margin. Also, quite interestingly, the premium Luxe product range was the main sales growth driver of L'Oréal, outperforming Estee Lauder in its core premium segment. We suspect that this recent underperformance is mainly related to differences in distribution channels and potentially strategic planning and operational management issues. We were pleased to learn that the previous CEO is now being replaced. We look forward to the improved operating performance from the new management team. Even though EL is underperforming L'Oréal operationally across the board, the Travel Retail distribution channel is still a significant drag on performance. Excluding travel, the sales of Estee Lauder grew 1% in the quarter. Organic sales decreased 5% at the low end of the expected range, driven by double-digit declines in mainland China, global travel retail primarily owned to Asia, and Hong Kong SAR. Excluding these three areas, sales in the rest of our global business rose 1% both on a reported and organic basis. Valuation compared to L'Oréal While Estee Lauder is still struggling, most analysts believe that the business will manage to recover its operating margins and grow earnings strongly over the next few years. Estee Lauder is currently generating about $15.5 in revenue. Assuming that they can return to the 15%+ historic group operating margin level, the business should be able to generate ~$2.3+ billion of operating profits within the next few years. At his margin level, ~$4.2 of EPS should be achievable. Most analysts expect Estee Lauder to return to this level sometime during 2027-2028. EPS Estimates (Seeking Alpha) Even though L'Oréal does appear to be a better-quality business, Estee Lauder is trading at an all-time discount to its main peer when looking at the Enterprise Value to Revenue multiple. valuation multiples (TIKR Terminal) Estee Lauder is trading at ~15X four-year forward earnings, as compared to ~20x four-year forward PE for L'Oréal. Estee Lauder does not seem as cheap when looking from this perspective. After all, L'Oréal is a better company and does deserve a larger valuation multiple. For this reason, we believe it is necessary to time the purchase of Estee Lauder correctly, as it is not cheap enough to just buy and hold. Financial and operational developments to follow  At this point, there are a lot of moving parts, and forecasting Estee Lauder's profit margins over the next few quarters will be challenging as the company is continuing to lose market share in the U.S. and Asian sales are still falling. Estee Lauder could do a better job at reducing inventory levels and speed to market, which would allow the business to respond to changing market trends a lot faster. The inventory turnover of L'Oréal, for example, is almost twice as fast. Inventory turnover (TIKR Terminal) During this ongoing Asian and travel retail downturn, the gross margin of Estee Lauder declined from ~ 76% to ~72% as the company had to sell out excessive inventories at reduced prices. In the first quarter of this financial year, gross margin has already started recovering. Our gross margin expanded 310 basis points compared to last year, largely due to a reduction in obsolescence charges as we better aligned our inventory on hand with our shipments throughout last year. We also better capitalized on our strategic pricing initiatives by reducing discounts related to excess production and promotions. Even though inventory levels have now been reduced, negative sales trends are still making it difficult to improve profit margins as the cost base is largely fixed. This negative effect has largely offset the gross margin improvement benefits. Operating expenses increased 190 basis points as a percent of sales during the quarter primarily driven by selling expense deleverage and advertising to support new product launches. During the first quarter, Estee Lauder generated a 4% operating margin and is still far off its mid-teens historic profitability. The gross margins are now improving, but sales declines are preventing them from achieving stronger profitability. But even excluding Travel retail and China, Estee Lauder grew sales by only 1%. Chinese recovery would help the business considerably, having said that, they also need to work on initiatives to re-energize growth initiatives in the West. In an inflationary environment, growth is needed to drive fixed-cost leverage and improve margins. Cost structure (Estee Lauder) In the worst-case scenario, Estee Lauder could also right-size the organization by selling underperforming divisions and brands. In this case, a mid-teens margin could be reached but on a smaller revenue base. Topline needs to be stabilized before profitability can be improved The decline in sales volumes must be addressed before operational improvement programs can be effective. Estee Lauder presents an intriguing investment opportunity, primarily due to its potential to recover profit margins to historical levels. However, achieving margin improvement will be challenging as long as sales volumes continue to decline. Our strategy is to wait until Estee Lauder stabilizes its sales volumes before initiating a position. The company forecasts an organic net sales decline of 6-8% in the second quarter compared to the same period last year, with operating profit margins also expected to decrease. This would represent a sequential slowdown in sales, following a ~5% decline in the first quarter. While it may still be premature to invest in Estée Lauder, we plan to enter the position once the company demonstrates quarter-to-quarter sales stability. The Bottom Line  Despite its challenges, Estee Lauder appears undervalued. The company is grappling with weak sales in its travel retail channel and China. Stabilized Chinese demand, even at lower levels, could improve planning and support profit margin recovery. While Estee Lauder has lost market share, its strong premium brands should help restore historic margins, even if future revenue growth remains uncertain. Currently trading at 10-year lows and a record discount to L'Oréal, the stock offers an attractive valuation. However, with Asian sales still declining and profitability expected to weaken in the second quarter, it may be too early to invest. We plan to enter a position once sales stabilize The risk  Estée Lauder risks continuing to lose market share in Western markets, which could result in below-average profitability for an extended period. A recovery in Chinese demand may take several years, prolonging the company’s sales challenges. Potential corporate governance issues as the L'Oréal family control ~80% of the voting power.   Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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