The Body Shop’s Expansion to Further Strain L’Oreal’s Margins

Acquired by L’Oreal (PINK:LRLCY) in 2006, The Body Shop range of cosmetics is well known for its products based on natural ingredients and the brand’s strong ethical commitments and fair-trade practices. The Body Shop constitutes about 4% of L’Oreal’s net sales and includes a chain of over 2,500 free standing ‘The Body Shop’ stores in over 65 countries across the globe. L’Oreal itself is the largest manufacturer of cosmetics in the world. It manufactures and sells makeup, fragrances, skin care and hair care products under popular brands such as Garnier, Maybelline, Lancome, and L’Oreal Paris.

We estimate that The Body Shop makes up around 4% of our near $23 Trefis price estimate of L’Oreal’s stock, which is around 7% below the market price. The number of The Body Shop outlets increased at an annual growth rate of over 8% from 2,000 in 2005 to around 2,550 in 2008. The number of stores remained constant in 2008-9 on account of a recessionary macroeconomic outlook, as new stores were balanced by closure of a few existing ones.

Since The Body Shop was first launched in the UK with subsequent expansion into North America and Western Europe, much of the emerging markets in Asia, Africa and Latin America remain new opportunities. At present almost two-thirds ^[1] of the stores are franchised and the remainder are company-owned, and The Body Shop is expanding rapidly in the emerging markets by franchising outlets in these markets ^[2] and by slashing prices to appeal more to the price sensitive consumer. ^[3] For instance, in less than four years The Body Shop has 55 stores across 23 cities in India and plans to increase the store count to 150 in the next four years, 100 of which are expected to come up within the next two years alone. ^[4]

While we do share L’Oreal’s optimism with regards to the sales potential in the emerging markets, we are concerned about the strain this puts on L’Oreal’s profit margins with these sales coming from franchised outlets.

Expanding via franchised outlets enables The Body Shop to quickly increase its footprint without much capital expenditure, which it would have otherwise incurred in opening company-owned stores. Franchising also limits the fixed costs such as rents, store staff salaries, and maintenance etc associated with operating a company-owned store and lends L’Oreal more flexibility to respond to the market dynamics. This however comes at a price and The Body Shop has to share sales revenue with the franchise partner, which reduces L’Oreal’s operating margins from sales coming from franchised outlets, and it has less control on its brand and positioning as it would in company owned stores.

The Body Shop already has an EBITDA margin of less than 12% compared to the company average of over 20%. Hence, with an increasing proportion of sales coming from franchised outlets in emerging markets and that too at discounted prices, we expect The Body Shop’s expansion to further strain L’Oreal’s operating margins.

We currently estimate The Body Shop’s EBITDA margin to rise gently from 11.5% in 2010 to over 12% over the next five years, predominantly due to economies of scale. If however, much of the growth comes from the franchised outlets, we can reasonably expect the EBITDA margin to decline to historical levels of below 9%, leading to a slight decline in our current $23 Trefis price estimate of L’Oreal’s stock.

You can drag the graph above to see the impact on L’Oreal’s stock price.

See our full $23 Trefis price estimate of L’Oreal’s stock.

1. The Body Shop, Franchise Opportunities [↩]
2. The Body Shop Franchise Plans to Have India in Its Top Ten Markets, Dec 16’ 2010 [↩]
3. The Body Shop lowers prices for the Indian markets, Dec 20’2010 [↩]
4. The Body Shop on retail expansion, Dec 21’2010 [↩]