These Two Scenarios Can Dampen Estee Lauder’s Valuation

Estee Lauder (NYSE:EL) has recently released its Q4 FY2015 earnings results (fiscal year ends in June). The company’s sales have been severely dampened by a slowdown in travel retail, a weak performance by its bigger skincare brands, and currency headwinds. We expect Estee Lauder’s Asia-focused travel retail sales to remain slow in the short-run, on account of the economic problems in countries such as China and South Korea. Also, since 70% of Asia’s sales come from skincare, especially from the bigger brands, the revival of these brands might also take some time. The skincare business accounts for about 50% of Estee Lauder’s value, as per our estimates. In this article, we discuss how the delayed revival of its travel retail and flagship brands might lower the company’s valuation.

Our price estimate of $84 for Estee Lauder is slightly above the current market price.

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Travel Retail Might Trouble Estee Lauder In The Short Run (~5% Downside)

Travel retail is one of the major growth drivers for Estee Lauder. Estee Lauder’s travel retail channel has been built with a focus on Asia. Its Q4 FY2015 results demonstrated weak performance from this channel due to factors such as the economic slowdown in China and the MERS virus attack in Korea. Along with this, the economic slowdown in Europe and Brazil also slowed down travel and hence the sales through the travel retail channels. However, Estee Lauder’s management claimed that the growth trend has been solid even till the third quarter ^[1] and we also think that travel retail can be a primary catalyst for the company’s growth in the long run. However, in the short run, the economic slowdown in most of its key business regions might keep Estee Lauder’s travel retail under pressure.

In 2014, China’s GDP growth rate hit a 24-year low and is expected to continue growing at an even slower pace in 2015. ^[2] South Korea’s economic growth softened towards the latter half of 2014, and the country’s central bank expects the economy to slow down further in 2015, on account of lower inflation and weak consumer spending. ^[3] Hence, Asia doesn’t look too promising for travel retail right now.

Similarly, the UK which is globally the fourth largest duty-free and travel retail market (source: Generation Research), witnessed a growth in passenger traffic, but a decline in visitor spending, in the first half of 2015. According to International Passenger Survey conducted by the tourism body Visit Britain, overseas visitor spending declined by 1% to $14.6 billion, even though the number of visitors increased by 3% to 16.8 million. According to Visit Britain, spending in the first half of 2015 was impacted by the adverse exchange rate movements, notably, the strong sterling as compared to the euro. ^[4]

A major challenge with the travel retail channel is that it is more unpredictable than a company’s domestic business. According to Vincent Boinay, Managing Director of L’Oréal Travel Retail, the most important reason for this uncertainty is the lack of data sharing among the market participants. ^[5]

We have forecasted Estee Lauder’s skincare EBITDA margin to rise from around 25% in 2014 to cross 26% by the end of our forecast period. However, if the declining trend in travel retail persists for some more time, and the EBITDA margin falls to around 24%, then there can be a 5% downside to our price estimates for Estee Lauder.

Declining Demand For Its Flagship Brands (~5% Downside)

Over the last few quarters, there has been a declining demand trend for Estee Lauder’s skincare brands. In its fiscal 2014 year-end discussion, Estee Lauder’s management admitted that the skincare growth was slow in its most important region, the U.S. (U.S. contributes to roughly 50% of the company’s net sales). The US consumers expected  innovative products, across newer skincare categories, such as masks and oils. ^[6] Hence its recent acquisitions in the beautifying mask (GLAMGLOW) and oil based treatment (RODIN olio lusso) categories provided some solution to the skincare demand and supply gap.

However, in its Q4 FY15 performance, it was observed that though Estee Lauder’s mid and smaller sized brands experienced double-digit growth, its flagship Estee Lauder brand and Clinique had been lagging behind. The Lauder and Clinique brands are much bigger in size with a broader distribution channel, whereas the smaller brands are targeted at specific consumer segments and hence the growth can be achieved more easily. ^[1] The revival of these big brands is of utmost importance for the sustainable growth of Estee Lauder’s overall skincare segment.

The company is undertaking revival measures such as launching new products, more aggressive marketing, and social media spread for these brands. However, these initiatives might take some time to have a significant impact on the company’s sales. Also, given the fact that a significant portion of these brands’ sales take place through the travel retail channels, and in the Asian markets where skincare contributes to almost 70% of beauty sales, and given the slowdown of these markets, Estee Lauder’s flagship brands might take some more time to recover.

We have forecasted Estee Lauder’s skincare market share to rise from around 8% in 2014, to almost 9% by the end of our forecast period. However, if the deceleration in its skincare sales persist for some more time, and the market share remains almost flat, then there can be a 5% downside to our price estimates for Estee Lauder.

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1. Q4 Fiscal 2015 Earnings Conference Call, Estee Lauder, August 17, 2015 [↩] [↩]
2. China’s 2014 economic growth misses target, hits 24-year low, Reuters, Jan  20 2015 [↩]
3. South Korea GDP Growth at Nearly 1-1/2 Year Low, Trading Economics, Jan 22 2015 [↩]
4. Strong pound hits spending, not UK visits, The Travel Retail Business, August 21, 2015 [↩]
5. L’Oréal’s Boinay: why travel retail is not a step ahead, The Travel Retail Business, May 20, 2015 [↩]
6. Estee Lauder’s Q1 2015 Earnings Transcript, Seeking Alpha, November 2014 [↩]