Estee Lauder: Pound-The-Table Buy On China Recovery And Margin Expansion

seekingalpha11-25

Estee Lauder's stock has plummeted 80%, but I believe the downturn is cyclical, not structural, presenting a pound-the-table buying opportunity.New leadership and the Profit Recovery Growth Plan aim ...

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Robert Way  Introduction Estee Lauder (NYSE:EL) is a longtime global leader in the beauty and cosmetics industry, holding one of the largest shares of the premium cosmetics market since its inception in 1946. The company operates a portfolio of 22 well-known brands, including Estee Lauder, Clinique, MAC, La Mer, and Tom Ford. Over the past decade, EL has ridden the coattails of powerful secular trends, such as the rising global middle class and the premiumization of beauty, leading to years of outperformance. At its 2021 peak, EL stock had more than 2x the returns of the S&P 500 over a 10-year period. Data by YCharts However, that narrative has since been flipped on its head. Shares of EL have plummeted over 80%, turning years of outperformance into an abysmal 8% return over the past decade. Ouch. The stock is in the same place as it was in 2014. So why am I turning bullish on a \"falling knife\" while other investors throw in the towel? First, I believe most of Estee Lauder's current headwinds are cyclical, not structural. Management's massive bet on China delivered outsized returns for years, but the recent downturn caught them way offside and exposed their overexposure. The market appears to have priced in a permanent impairment in the Chinese market. Strong secular tailwinds and demographics suggest otherwise. To me, this indicates that current weakness is merely a cyclical trough in an otherwise maturing market. That's key. Another major hurdle has been the company's profitability. EBIT margins have fallen from mid to high teens to just 7% this past year, levels not seen since the GFC. To combat this, Estee Lauder has rolled out a Profit Recovery Growth Plan (PRGP) aimed at generating $1.1 to $1.4 billion in incremental operating profit by the end of FY2026. If management is successful, this should restore operating margins back to historical averages over the medium term. Data by YCharts Finally, Estee Lauder has faced years of mismanagement and family drama behind the scenes. New leadership at the CEO and CFO spots and the absence of family members in day-to-day operations for the first time in company history should act as a key catalyst. The market doesn’t like uncertainty, and this should help ease investor concerns. All of this makes the current valuation of Estee Lauder a \"pound the table\" buying opportunity. When you view EL as a high-quality company navigating a cyclical trough, it looks pretty compelling. It's that simple. So for those who can see the forest through the trees, taking advantage of Mr. Market's impatience is a no-brainer. I initiated a position in EL earlier this week and plan to build it into a top portfolio weight in the coming months. Here's why: A Real Life Soap Opera Investing in family owned and operated businesses has historically proven to be a winning strategy. Management usually has skin in the game and because of this, they tend to have a longer-term focus. However, Estee Lauder feels more like a real-life episode of Succession. Back in August, longtime CEO Fabrizio Freda announced plans to retire at the end of FY2025. Members of the board and the Lauder family could not agree whether to choose an insider or an outsider as the new CEO during the search for his successor. On October 30th, EL announced executive Stephane de La Faverie as the new CEO. But the decision was far from drama-free. According to the Wall Street Journal, a private letter was sent by Jane Lauder to board members to criticize her cousin William Lauder for \"destroying the company.\" The following month, after finding out she would not be appointed as the next CEO, Jane announced her plans to leave the company. The Lauder family feud is nothing new. Leonard Lauder is at odds with current CEO Freda, Jane blames both William and Freda for the company's downfall, and William sides with Freda to lead the turnaround. Don't forget, there's still a $23 billion company to run… Things are different now. This marks the first time in the company's history that no member of the Lauder family holds an executive position and no member is involved in its daily operations. I view this as a massive positive. For years, many have speculated that the Lauder family became overbearing and hindered the company's ability to execute a turnaround. While de La Faverie may not exactly have a \"fresh set of eyes,\" he brings 25 years of industry experience and a proven track record of leading the Estee Lauder brand and the PRGP. Estee Lauder will also have a new CFO and a new general counsel. I believe new leadership removes a major distraction and serves as a key catalyst in the EL recovery. It's important to note that the Lauder family still controls about 84% of the outstanding voting power of common stock. Although daily operations are no longer managed by them, they still control the ship. The good news is that the family has already voiced their continued commitment to the company over the long term. This is key, as it avoids the massive selling pressure that could have weighed on the stock in the near term. China and Asia Travel Retail Since taking the helm in 2009, CEO Fabrizio Freda's key focus has been increasing Estee Lauder's international business. One of his first goals was to generate >60% of the company's revenue from international markets. The big bet on global expansion proved highly successful over the years. From FY2018 to FY2021, China's % of total revenue soared from 13% to 36%. Estee Lauder Investor Relations, Author's Work The company's exposure to China became so pronounced that, at its peak, Estee Lauder highlighted this in its FY2022 10-K filing: \"Our largest customer in fiscal 2022 sells products primarily in China travel retail and accounted for 13% of our consolidated net sales for fiscal 2022.\" In FY2022, 31% of net sales originated from the Asia Pacific region. This means that a single customer in China was responsible for 42% of sales in the region. It doesn't take a genius to recognize the inherent risk through this overexposure. Estee Lauder's exposure to the Chinese market reminds me of the infamous quote from former Citigroup CEO Charles Prince: \"As long as the music is playing, you've got to get up and dance.\" And for years, Estee Lauder kept dancing. But in FY2023, the music was turned off. Net sales dropped 10% during FY2023, followed by a 2% drop in FY2024. In Q1 FY2025, EL saw double-digit declines across mainland China, Hong Kong, and Asia travel retail markets, forcing management to pull its full-year guidance already. Estee Lauder's challenges in the region are far from unique. Industry peers such as Coty (COTY), Shiseido (OTCPK:SSDOY), and L'Oréal (OTCPK:LRLCF) have all felt the same pain. Looking at a YTD performance chart of these companies paints the picture well. Of course, this isn't exactly rational. The point is that this is far from being just an Estee Lauder issue… Data by YCharts I see three key reasons why the current weakness in the Chinese and broader Asian travel retail markets is cyclical rather than structural. Outbound travel recovery: Estee Lauder has long benefited from the boom in international travel over the years. The eye-catching displays in travel retail channels drive key revenue and profitability, as they yield higher sales per square foot and benefit from the favorable tax advantages of duty-free locations. However, the sluggish recovery of Chinese outbound travel has been a major headwind for the segment. Statista Chinese outbound travel is expected to only reach 130 million in 2024 and is still well below pre-pandemic levels of 155 million. However, industry experts remain quite bullish, with projections of 200 million Chinese outbound travelers by 2028. Besides the rising middle class and increased disposable income, a key driver of this growth is the fact that only 10% of Chinese citizens currently hold passports. While China has the second-largest economy, it ranks 63rd globally for passport access rates. The Chinese passport grants access to just 83 countries and territories, compared to 187 by the U.S. passport. A key driver of increased passport adoption rates will be more visa free agreements with other countries. As more countries lift visa requirements, outbound travel, and as a result, travel retail traffic should rebound. Improving consumer trends: Although it is still very early, we are beginning to see improvements in Chinese consumer sentiment. For example, October retail sales in China grew by 4.8%, well ahead of consensus expectations of 3.8%. Most importantly, cosmetic sales surged by 40.1% YoY, reversing months of negative growth. Another key highlight was 2024 Singles' Day, which saw a strong 26.6% YoY increase in overall sales. The strong results led to JD CEO Sandy Xu claiming that \"Overall consumer sentiment continued to brighten.\" Music to my ears. I'll be keeping an eye on these figures in the near term as sustained strength in sentiment will be key. But overall, early indications continue to lean positive. Organization for Economic Co-operation and Development Chinese stimulus: While the Chinese gov. has already introduced some macro policies, many analysts have speculated that a consumer facing \"bazooka\" stimulus package is on the table. Since Trump became U.S. president, anticipation has grown. This comes mostly in response to the potential U.S. tariffs and their implications for the Chinese economy. While EL management acknowledged in the Q1 report that Chinese stimulus will be a key driver in the medium to long term, near-term benefits are more subdued. For those with an extended investment horizon, this is all you need to hear. Now the question becomes when will the market return to growth? Management had previously signaled that they expect the Chinese market to stabilize in 2025, followed by MSD growth in 2026. L'Oreal CEO Nicolas Hieronimus even went as far as to say, \"What we see today is indeed a market that would go back to the growth rhythms of the pre-COVID growth rhythms.\" While this optimism is great to hear, all we need is MSD growth to make the stock work. So, while impatient investors continue to rush for the exits and label China as \"uninvestable,\" long-term investors recognize that these things play out in cycles. Remember: History may not repeat, but it often rhymes. That's the name of the game here. Profit Recovery Growth Plan One of the biggest drivers of pessimism surrounding Estee Lauder has been the continued erosion of profitability. While EBIT margins have had a solid rebound from last year's trough of 7%, they are still meaningfully below the five-year average of 15%. This has begged the question: Can EL ever return to pre-pandemic margins? I, and the company, see no reasons why operating margins do not expand from here. To do this, management introduced a profit recovery plan in November 2023, which has since been renamed the \"Profit Recovery Growth Plan\" (PRGP). The plan aims to deliver $1.1 to $1.4 billion of incremental operating profits by FY2026 through cost savings measures and operational improvements. In FY2025, the PRGP will deliver ~80% of cost savings from gross margin improvements and 20% from reduced operating expenses. By FY2026, cost savings are expected to be more evenly split between the two. EL has also announced that it will reduce its global workforce by 3% to 5% (~3000 jobs). Data by YCharts The decline in profitability starts at the top with gross margins, which shrank by more than 500 basis points from peak to trough. This contraction was largely the result of excess inventory the company accumulated during the pandemic-driven boom, particularly in the Chinese and Asia travel retail channels. Estee Lauder over expanded and oversaturated distribution channels, leading to an 84% increase in inventories from FY2018 to FY2023. As demand began to slow, the company responded with heavy discounting to move excess stock. This also resulted in $75 million of inventory write-offs in FY2023 and another $103 million in FY2024. Data by YCharts To make matters worse, sales in the Asia Pacific region are heavily skewed to the Skincare segment. Skincare represents more than 51% of EL's total sales and is by far the company's most profitable segment, contributing over 75% of operating income in FY2024. As demand slowed, this led to a disproportionate impact on overall profitability. The good news is that management has already made solid progress executing the PRGP. Easy comps helped deliver 310 basis points of gross margin expansion during Q1 FY2025. A $700 million reduction in inventories from the peak reached in FY2023 and a meaningful reduction in obsolescence charges drove this improvement. Beyond inventory management and pricing improvements, another lever is improvements in distribution and manufacturing. When Estee Lauder's supply chain was constructed, nearly 90% of sales were generated in North America. Today, the company's sales mix looks a lot different. 29% of sales from the Americas, 40% from EMEA, and 31% from Asia Pacific. Although this massive shift occurred, the supply chain never adjusted. This has caused years of higher freight costs and long lead times, and created overall inefficiencies. However, management has finally invested in a new manufacturing facility in Japan and two new distribution centers in China, which should lead to dramatically lower freight costs and shorter lead times. This regional manufacturing strategy will also help prevent the excess inventories that plagued the company during this past downturn. At the same time, Estee Lauder has begun intentionally reducing its exposure to traditional North American department stores. In the past, department stores accounted for nearly 60% of U.S. revenue. Today, management has reduced this figure to 40%. The company has also cut its freestanding retail location footprint by 10% to 15% in recent years, shifting to more profitable digital channels. Digital sales now account for 28% of total revenue and continue to generate strong double-digit sales growth in the U.S. This shift should help meaningfully lower the SG&A cost base over time. Before management pulled its annual guidance in the most recent quarter, the company had forecasted annual adjusted operating margins of 11% to 11.5%. If management successfully executes the PRGP, it can generate a midpoint of $1.25 billion in incremental operating profits by FY2026. Using the $1.58 billion operating income from FY2024 as a baseline, this would imply total operating income in the ballpark of $2.8 billion in FY2026. If zero revenue growth occurs over the next two years, this will bring operating margins back to around 17%. This implies that EL currently trades at just 9x projected EBIT. If EL can sustain these operating margins into FY2027, and we begin to see some top-line acceleration, EPS could top $6 (assuming historically average interest expenses and tax rate). From there, the question becomes whether we assign a peak or trough multiple to the earnings? Either approach suggests at least a double from current levels, providing investors with a solid MOS at the current valuation. The market consensus is really pricing in about $3.61 in EPS for FY2027. My math suggests this implies 12% to 13% EBIT margins for FY2027. Clearly, the market doesn't believe managements projections. I expect this to change rather quickly. Balance Sheet and Capital Allocation Investors can take comfort in Estee Lauder's sound balance sheet, with approximately $7.8 billion in total debt and $2.4 billion in cash on hand. Solvency risk is certainly not a concern here. The company's debt is pretty well-structured with the following maturity schedule: Estee Lauder Investor Relations Estee Lauder's free cash flow relative to market cap has been very impressive. The company historically generates mid-teens percent of sales in free cash flow and peaked at over 18 percent in FY2021. FCF has since declined to 9% of sales in FY2024, mostly due to a step-up in cap ex to complete new manufacturing and distribution facilities. Going forward, I expect cap ex spend to compress to nearly all maintenance (~4% of net sales). This will lead to a substantial uptick in free cash flow, likely pushing annual FCF north of $2 billion. Over the next four years, I have forecasted FCF as a % of net sales to gradually increase to 8%, 10%, 12%, and 14%, still below the pre-pandemic mid-teens percentage. This suggests a five-year cumulative FCF exceeding 36% of Estee Lauder's entire market cap. But remember, strong ROIC and FCF only take you so far. Capital allocation is what really moves the needle. Author's Work In the Q1 report, management surprised many investors and analysts when they announced a dividend cut of nearly 50%. The decision comes after an average annual dividend increase of about 9% over the past five years. While the yield still remains a solid 2.14%, it was more the timing that spooked investors. Management claimed the decision was more about adjusting the payout ratio to reflect the subdued operational performance, while at the same time giving new management greater financial flexibility. Given the lack of liquidity concerns, I wouldn't read too much into this. Prior to the dividend cut, management had already suspended the share repurchase program back in December 2022. While the company has a long track record of share repurchases (5% reduction over the last 10 years), the timing of repurchases has been suspect. From 2021 to 2022, management used nearly $3.2 billion to repurchase shares. Looking at the chart below, you can see that this decision turned out to be a less-than-ideal. Stock Charts Moving forward, I wouldn't expect to see dividend growth similar to what was seen in recent years. The payout ratio is still extremely elevated (~100%) and until FCF ramps back up, the dividend will likely remain flat. As for repurchases, I expect only enough to offset annual dilution. Valuation Author's Work On the surface, EL's current valuation looks fairly pricey. However, this assumes profitability remains at GFC level troughs. I, and the company, do not expect this to be the case. Starting with top-line sales, I forecasted -3%/3%/5% for '25/'26/'27. This assumes stabilization in China and Asia travel retail, with reacceleration to MSD by '27. For adj. operating margins, I forecasted 10%/14%/17% for '25/'26/'27, in line with management's Profit Recovery Growth Plan. Depreciation and amortization have averaged ~4.5% of sales over the past four years. Cash and cash equivalents are estimated using the prior FCF model, assuming annual capex spend declines to 4% of sales. This model also assumes management pays down its $500 million in maturing debt in 2024 and another $500 million in 2027. I opted to keep shares outstanding flat, assuming share repurchases offset annual dilution. With a 15x EV/EBITDA multiple, well below EL's five-year average of 25x and L'Oreal's 23x, this model suggests a FY2027 price target of $136. This implies a double from current levels using a relatively conservative multiple. If EL earns a multiple more in line with its historic average, the stock could return to over $200. Either way you slice it, the stock works. Risks While I'm bullish on the EL turnaround, it's important to acknowledge risks with any investment. Some include:  Slower recovery in China: While management has made an effort to reduce exposure to the Chinese and Asia travel retail market, 26% of total sales still come from China. A prolonged downturn in consumer sentiment and discretionary spending could delay the recovery. Failure to execute PRGP: The success of the EL turnaround hinges on restoring operating margins to pre-pandemic levels. If some of these cost savings are sales-dependent and management is unable to re-accelerate growth, margin expansion may be in jeopardy.  Bottom Line  Beauty and cosmetics have become a basic necessity. People have worn makeup for the past 7000 years. This is unlikely to change this year, next year, or in the next 100 years. So, after closely following EL for years, investors finally have the chance to acquire a stake during a cyclical trough. Short-term hiccups and macro headwinds have led to impatient investors viewing EL as a show-me story. Zooming out paints a different picture. This is just too good an opportunity to pass up. 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