Shift To Thicker Margin Products Should Drive Top Line For L’Oréal

Shares of L’Oréal SA (OTC:LRLCY) jumped 7% on February 10, driven by an announcement regarding the much anticipated buyback of Nestlé’s stake. However, shares ebbed back by 5.5% the following day due to a lackluster performance in 2013 from the company. The group’s total sales reached approximately €23 billion (~$30.5 billion), up from €22.5 billion (~$28.9 billion). Revenue growth rate on a like-for-like basis for the group’s core business was approximately 5% while acquisitions resulted in a 1% addition to total top line. However, weak global currencies contributed to a 3.7% decline in revenue growth rate in 2013, resulting in a 2.3% growth in overall reported revenues for the company.

Gross margins expanded by 60 basis points in 2013, supported by better cost and product mix in its portfolio. L’Oréal continued to increase its Research and Development (R&D) spending to boost its top line through products that are innovative. The company’s total operating expenses stood at $16.6 billion compared to $15.6 billion from a year ago, with increases in R&D and G&D spending. However, the company’s shift to digital marketing compared to traditional marketing partially offset this increase in operating expense. The group’s operating margin expanded from 16.5% in 2012 to 16.9% in 2013 due to lower cost of sales and S&M expenses. These activities facilitated a 7% expansion in the company’s net income for 2013, from $3.7 billion in 2012.

In its earnings release, L’Oréal announced its plans to buyback 8% of its share capital from Nestlé. ^[1] To finance this transaction, the company will be selling its entire stake in the Galderma joint venture between Nestlé and L’Oréal. Below, we present key takeaways from the company’s recently concluded earnings and shed light on the stake sale transaction.

We have a $33 Trefis price estimate for L’Oréal and are in the process of incorporating the company’s Q4 earnings into our model.

View our detailed analysis for L’Oréal here

A Look At The Nestlé – L’Oréal Announcement

In December 2013, Nestlé offloaded its 10% stake in French fragrance manufacturer Givaudan for approximately 1.15 million Swiss Francs (~$1.27 billion). ^[2] The Swiss consumer product manufacturer has been stripping out and selling its non-core businesses to streamline its operations and clean up its balance sheet. This deal sparked interest among investors, who eyed the 29.5% holding Nestlé has in L’Oréal. In addition to Nestlé being a major shareholder, L’Oréal’s founding family, the Bettencourt Myers, hold 30.6% in L’Oréal. Nestlé and the Bettencourt Myers family struck an agreement 40 years ago with Nestle to sell the company roughly half of its stake to prevent the nationalization of the L’Oréal group when the Socialists came to power.

The Bettencourt Myers family also has a right of first refusal agreement in place with Nestlé that expires on April 29, 2014. A right of first refusal contract gives the holder the right to enter into a transaction with the owner of a business before the owner is entitled to enter into a transaction with a third party. This agreement with Nestlé is limiting the company’s potential to sell the stake to L’Oréal which is the third party in the transaction. As of date, Nestlé’s 29.5% stake in L’Oréal is valued at approximately $32.1 billion. A sale of this stake would lend massive support to the company’s ongoing business streamlining activities.

Prior to its H2FY13 earnings call, L’Oréal announced that it would be buying back approximately 48.5 million shares (27.12% of Nestlé’s stake in L’Oréal) at €124.48 per share from Nestlé. The share buyback would decrease Nestlé’s stake to 23.29% and also increase the Bettencourt Myers family’s holding in L’Oréal to 33.31%. According to the agreement between the Bettencourt Myers and Nestlé, the family has a ceiling at 33.33% stake in L’Oréal and any additional share capital should be offered back to L’Oréal. The presence of a ceiling on the Bettencourt Myers family holding is a major factor in L’Oréal offering to buy only 8% of its share capital.

The share buyback would cost about €603 billion (~$8.23 billion) for L’Oréal, which the company intends to finance, as follows: it will contribute its 50% interest in the Galderma joint venture with Nestlé,  at an equity value of €2.64 billion and an Enterprise Value of €3.14 billion.  And it will fund the remaining  €3.40 billion with cash, financed in part by commercial paper.  The enterprise value of L’Oréal’s 50% stake in Galderma is approximately €3.13 billion (~$4.27 billion). Removing Galderma’s €500 million debt to L’Oréal leaves an equity value of €2.64 billion (~$3.6 billion) for the 50% stake. By selling this equity stake in Galderma, L’Oréal would be left with a net payment of approximately $4.63 billion to Nestlé.

This remaining amount would be financed through the company’s cash-and-cash equivalents balance, and the issue of commercial paper as short term debt. As of December 31, 2013, the company had a cash position of approximately $3.6 billion and a working capital requirement of $671 million. For FY14, we expect the company to have a working capital requirement of approximately $314 million. This leaves approximately $3.2 billion in cash that could be used by L’Oréal for financing the stake buyback, which should result in an issue of approximately $1.4-$1.5 billion in commercial paper in FY14.

Margins Should Improve Due To Shift In Product Mix

According to our calculations, Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA) margins for L’Oréal’s cosmetics division improved from 20.2% in 2012 to 21.4% in 2013. This strong expansion in margins is a result of the company’s shift in focus from professional products to consumer and prestige products, where the company has a lot more pricing power due to its market leadership position. In 2013, operating margins for the company’s Professional Products division remained fairly steady at 20.5% from a year ago. However, margins across all the other divisions such as Consumer Products, L’Oréal Luxe and Active Cosmetics increased by 0.8% on average to reach 20%, 20% and 21.2% respectively.

We expect margins in these divisions to further expand going forward due to L’Oréal’s rising investments into R&D, to provide customers with innovative and regionally diverse products. With increasing disposable incomes and given its market leadership position globally, we expect the company to pass on additional R&D costs onto the consumer through higher pricing, which should lead to an expansion in margins. Additionally, the company is increasing its focus on prestige products to drive higher sales. The new travel retail division that the company announced in November 2013 should support an increase in sale of luxury products across brands such as Lancôme and Giorgio Armani that resonate well with growing passenger traffic globally.

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1. Strategic Transaction Approved by Boards of Nestlé and L’Oréal, L’Oréal IR, February 2014 [↩]
2. Nestlé selling Givaudan shares, Nestlé Pressroom, December 2013 [↩]