Skin Care Product Sales Weaken, Margins Could See Pressure In The Future For Estee Lauder

Estée Lauder (NYSE:EL) reported its Q2FY14 results on February 05, 2014. The company’s top line grew 4% on a year-on-year basis, compared to 5.7% in CY12, to reach $10.4 billion approximately in CY13. Sales for Estee Lauder’s make up products gained momentum during the year, growing 5.3% to reach $4 billion. However, skin care product sales failed to out-pace industry level growth with a year-on-year growth rate of 2.7% during CY13, due to a larger-than-expected extent of cannibalization of older, recognized products. This was the driving factor for a slowdown in top line growth during the year for the company.

The company’s EBITDA margins took a slight hit during the year due to its implementation of its Strategic Modernization Initiative (SMI). In the earnings call, the company stated that the SMI had resulted in an acceleration in orders to the quarter before the SMI rollout (Q2FY13). This lowered the top line by approximately $94 million and the operating profit by approximately $78 million in Q2FY14 alone. ^[1]

According to our calculations,the  EBITDA margin for the company contracted from 22.5% in CY12 to 20.0% in CY13. However, GAAP operating profit margins benefited from lower D&A expenses through the SMI implementation and were 20 basis points higher compared to CY12. Furthermore, the company’s bottom line witnessed an 8% expansion on a per-share basis, from $2.34 in CY12 to $2.55 in CY13. In the current earnings note, we present our key takeaways from Estée Lauder’s Q2FY14 earnings.

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Strong Demand From EMEA Offsets Asia/Pacific Slowdown

During CY13, revenues from the Asia/Pacific region stood at $2,116 million compared to $2,109 million a year ago. This represents a meager 0.3% growth in sales from the region, compared to 7.2% the previous year. The slowdown in the Chinese economy has impacted luxury product sales from tier 1 cities in China, although tier 2 and tier 3 cities are continuing to perform strongly due to the burgeoning middle class in the region. In addition to the slowdown in China, the recent unrest in Thailand has impacted sales for the company, with a (-5%) growth rate during Q2FY14. ^[1] However, this weakness was offset by strong sales in the Europe, the Middle-East & Africa (EMEA) region, with double digit growth in Russia, South Africa and Turkey.

The region’s revenues were approximately $3,900 million in CY13, compared to $3,630 million in CY12. Growth in sales from the region were also double of what they were in CY12, marking a revival in prestige product sales from the EMEA region. The U.K was the top performer within the EMEA market, with a growth rate of 9% during Q2FY14. Demand for brands such as M-A-C, Jo Malone, Bobbi Brown and Aveda in the U.K. market  continued to show strength. This was driven by constant product launches and new product campaigns, resulting in strong revenue growth. Furthermore, southern European economies of France and Italy lent support to the overall growth with a revival in demand.

We expect the Asia/Pacific region to remain fairly weak in the near-term, mainly due to conditions in China and other South-East Asian economies such as Thailand and Indonesia. However, a recovery in developed markets should more than offset for the slowdown in sales from the region.

New E-Commerce Platform Should Further Expand Margins

In addition to rolling out its SMI initiative and realigning its inventory management system, Estée Lauder plans to expand into tier 2 and tier 3 cities in China to tap into the vast potential of the growing middle class in the region by building brick-and-mortar outlets selling a variety of products, with an objective to expand its margins. ^[1] Furthermore, Estée Lauder’s e-commerce platform has seen strong growth in the last three years. Sales from the channel have doubled in the past three years, and the company expects further strengthening in sales from its e-commerce platform, especially in the North American market. Platform rollouts in the EMEA and Latin America regions, such as Israel and Brazil, are also expected to support strong growth going forward. ^[1]

However, the deceleration in skin sales growth for the company is a cause for concern. Skin care products amount to approximately 44% of the company’s revenues, and a slowdown in revenue growth from the division leads to a decline in our price estimate. We are reviewing our price estimate to $77 for Estée Lauder in light of its recent Q2FY14 results.

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1. The Estée Lauder Companies Management Discusses Q2 2014 Results – Earnings Call Transcript, Seeking Alpha, February 2014 [↩] [↩] [↩] [↩]