Estee Lauder (NYSE:EL) makes premium personal care products such as color cosmetics, skin crèmes, hair care products and fragrances, and sells them through high street department stores, upscale perfumeries, prestige salons and spas, basically any place which carries an image of luxury and offers the consumer a sense of exclusivity, befitting the premium pricing of these products. With brands like Aramis, Clinique, La Mer, Bobbi Brown, Estee Lauder competes with companies such as L’Oreal (PINK:LRLCY), Revlon (NYSE:REV), Avon (NYSE;AVP), LVMH Moet Hennessey and Shiseido Company.

Estee Lauder’s stock price has risen by almost 48% from around $55 in September 2010 to its current levels of over $80. Estee Lauder is currently trading at over a 50% premium to our $53 Trefis price estimate of its stock. In an attempt to explain the trend in Estee Lauder’s stock price, we explore what factors could lead to an upside to our current estimation of Estee Lauder’s stock.

The much needed improvements in Fragrances’ profit margins

In 2009, Estee Lauder’s Fragrance segment had an EBITDA margin (a measure of profitability) of about 4% of net sales, much lower than the industry average of about 13% and Estee Lauder’s company-wide EBITDA margin of over 14%. Hence, in spite of contributing 16% to total Estee Lauder revenue, the fragrance segment contributes close to 5% to its stock price.^[1] We currently forecast a moderate rise in Fragrance’s EBITDA margin to about 6.3% over the next five years. However, we believe there is much scope for improvement in fragrances’ EBITDA margins by pursuing cost reduction programs such as focused promotional spending on higher-margin recent launches and designer fragrances and by directing advertising budgets to selective markets, which exhibit the greatest potential. Restoring fragrances’ EBITDA margins to 13% over the next 5 years could lead to a 7% potential upside to our current Trefis price estimates of Estee Lauder’s stock.

Gain in skin care segment’s market share

Estee Lauder’s range of premium skin crèmes constitutes over 6.2% of the global skin care market. We estimate that skin care constitutes over 52% of Estee Lauder’s stock and we believe Estee Lauder with its rich portfolio of anti-aging skin care is well placed to further strengthen its position, reaching 8% over the next five years leading to a 7% potential upside to our current Trefis price estimate of Estee Lauder’s stock.

Greater presence in the booming emerging markets

Despite a global presence, about 47% of Estee Lauder’s net sales come from the US, with Europe, Middle East and Africa contributing 35% and Asia-Pacific constituting the remaining 18%. However, the consumer markets in emerging economies have been growing in double-digits compared to the developed economies which have been struggling with close to a 4% growth rate. If Estee Lauder increases its presence in emerging economies by opening more outlets, we can reasonably expect further market share gains across product segments, contributing a 6% upside to Estee Lauder’s stock.

Tapping the Chinese Market

China’s appetite for luxury products

The luxury goods market in China has grown by over 23% over the last year, led by watches at ~35%, suitcases and handbags at ~20% – 25%, and cosmetics, perfumes and personal care products growing at ~20%. Estee Lauder ranks amongst the Top 5 beauty care brands and is poised for much growth on account of China’s expanding middle class and rising affluence in Tier 2/3 cities beyond mega cities like Beijing, Shanghai, Guangzhou and Shenzhen.^[2]

Chinese male’s appetite for skin care products

The Chinese men’s skin care market is expected to grow at 29% year-on-year through 2014 compared to North America at 5.7% and Europe at 7.9%, reaching $270 million in 2011, exceeding North America at $227 million.While Asians have always been patrons of skin care products, men’s skin care products have recently struck it big with the Chinese male and this presents an excellent opportunity for growth to Estee Lauder.^[3]

Given the rising affluence of the Chinese and their preference for luxury cosmetics along with the Chinese male getting increasingly involved in skin care, we see a window of opportunity for Estee Lauder. L’Oreal is currently leading personal care in China but if Estee Lauder were to strengthen its portfolio with more customized product offering, marketing and advertising communication, we can expect a 4% potential upside to Estee Lauder’s stock price for every 1% incremental gain in skin care segment’s market share.

Even if Estee Lauder were to exploit all the above opportunities, we only foresee a 20% potential upside to our $53 Trefis price estimate, still leaving 30% gap to the current market price.

You can see a detailed analysis of our $53 Trefis price estimate of Estee Lauder’s stock here.

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