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Investment Overview for Estee Lauder (NYSE:EL)

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Estee Lauder ended fiscal 2017 by outperforming the prestige beauty industry by 2 points with a 7% y-o-y sales growth. This growth was achieved even after facing headwinds like instability in certain geographies and terrorist attacks that resulted in weak demands in many markets. Along with this, Estee Lauder also braved market specific challenges, such as a declining traffic footfall in the U.S. brick-and-mortar establishments and rising competition across the premium beauty industry. The company's impressive performance that was delivered across all its segments suggests that Estee Lauder's growth strategies are successfully steering the company as a leading player in the prestige beauty segment. In its makeup and skincare segment, Estee Lauder made acquisitions and investments in companies that appeal to millennials, the most coveted consumer segment for the beauty companies. The fragrance segment has also been boosted with a host of acquisitions made over the last couple of years. Along with this, the company has grown its presence by around 40% in the specialty-multi-retailers channel internationally, a channel which is one of the most preferred channels for millennials to make their purchases.

Estee Lauder is known for following the strategy of acquiring small and innovative brands and then expanding their reach and customer base. Last year, it acquired Too Faced and Becca Cosmetics in the makeup segments. These brands are known for their makeup products including foundations, primers, and highlighters, that suit diverse skin tones. The company's growth plans include taking advantage of its stronger products, regions, and channels to boost further growth.

Though the company faced both macroeconomic and microeconomic challenges throughout fiscal 2016, it successfully addressed those to deliver growth above the industry level. Estee Lauder's focus on generating a greater millennial user base, as well as its digital initiatives, along with its adapting to changing demand, were some of the factors that drove the company's growth. In fiscal 2016, Estee Lauder's net sales grew by 9% year-on-year on a constant currency basis. We expect Estee Lauder to continue ruling the prestige beauty market in the near future.

In FY 2016, the new products comprised of almost a quarter of its total sales marking a record high contribution. The company introduced Leading Beauty Forward — a multi-year initiative to improve efficiency, speed of market adaptability, and agility. The top growth contributor for FY 2016 was the Makeup category especially attributed by the MAC brand, the luxury brands, the Europe, Middle East and Africa regions, and the online and specialty multi channels. The two most important growth drivers for Estee Lauder were its agility and its multiple engines of growth. When the company witnessed unexpected crises in certain markets, it channeled resources to other areas with better growth opportunities. Its strength lies across 25 brands based on categories, channels, and countries which allowed the achievement of double-digit growth in some brands, channels, or markets, while balancing lower growth in other areas. For example, when Hong Kong's political unrest resulted in a dearth of incoming Chinese tourists, the brands appealing to Chinese customers started targeting the alternative key tourist attractions frequented by the Chinese.

Estee Lauder's digital and e-commerce focus have increased over the year resulting in it becoming the fastest growth channel for the company. The e-commerce and m-commerce sales exceeded $1 billion in FY 2016. The company's millennial focused initiatives yielded positive results with brands like Jo Malone, Tom Ford, Smashbox, MAC, and La Mer driving growth. In fiscal 2017, the company's broad target will be two areas: 1. expanding its reach among target users and enhancing the level of customer engagement through tools like digital marketing, in-store merchandising, creativity, and omni-channel offerings.

1. Travel Retail, Online, And Multi Retail Sales Are Expected To Keep Growing
   • The strong passenger traffic growth and the increased conversion of the passengers into buyers, especially in the emerging markets, is expected to keep the company's travel retail sales soaring for the rest of the fiscal year. It plans on boosting investments in China and other developing countries where its products are a success.
   • Estee Lauder's strong online sales were mainly driven by the third-party and retailer sites. Each of its metrics, traffic, conversions, and orders, witnessed a healthy growth. China's Tmall witnessed a surge in sales especially since the launch of its makeup brand MAC in May. MAC has further launched an online platform in South East Asia called Lazada, which is owned by the Alibaba Group. With a Tmall-like model, this store might be a further catalyst for the company's growth in the region. The company's effort to expand its online footprints continued with the launch of 100 new websites in the quarter. Around 70% of its online sales were contributed by mobile and hence this medium is a prime focus in Estee Lauder's digital initiatives.
   • Estee Lauder is also growing its position by pushing more of its brands through the specialty-multi retail channels across the world. This channel is specifically attractive to the younger beauty users, a coveted segment for most beauty companies these days. For example, even in the U.S. where the footfall decline in the brick-and-mortar stores is a concern for the company, its sales through pure play cosmetic companies such as Ulta Beauty and Sephora continued to grow.

2. Acquisitions and investments will help fuel growth
   • In June 2017, the company announced that it will invest in Deciem, a company which like Estee Lauder's latest acquisitions, focuses mostly on millennial beauty users and diverse skin tones. Deciem's unique products are massively popular and further expanding its global presence can help Estee Lauder capitalize on this popularity and seize a bigger chunk of the global skincare market. So far, Deciem has launched 10 brands among which The Ordinary is an internationally popular brand of skincare treatment and NIOD is a skincare brand focusing on the root causes of aging. Deciem offers a wide range of products at different price points and sells them through its own multi-brand stores, department stores, e-commerce, TV shopping networks, and select retailers. It is mainly available in the U.S., the U.K., and Canada. The products are a big hit with millennials and the diverse consumers who look for functional products that are formulated based on science.
   • Towards the end of 2016, Estee Lauder signed an agreement to acquire Becca Cosmetics for $200 million and Too Faced for $1.45 billion. These two prestige makeup brands are known for being two of the most rapidly growing entities in the makeup segment. Their massive popularity with the millennial consumers and in the multi-retail channels benefited Estee Lauder. When Too Faced came under the Estee Lauder umbrella last December, the brand was launching its Sweet Peach collection. This launch turned out to be Too Faced's most successful launch till date with the collection attracting around 100,000 consumers online, who waited for hours to get their hands on the products.
   • Estee Lauder announced a string of acquisitions in the span of two months between October and December, 2014. The company’s last acquisition prior to these was in May 2010, when it acquired Smashbox Beauty Cosmetics. The acquisitions are: GLAMGLOW, a prestige skincare brand specializing in facial mask treatments, Le Labo, the high-end fragrance and sensory lifestyle brand, Editions de Parfums Frédéric Malle, the storied fragrance brand established by the iconic perfumer Frédéric Malle, and RODIN olio lusso, a luxury skin care brand, offering a selection of luxury skincare oils.
   • Luxury brands are a key growth driver for the company: its luxury brands like La Mer, Jo Malone, and Tom Ford have been delivering double digit growth for several years. Hence, the recent acquisitions, of all premium and luxury brands, are best seen in this light.
   • Skincare is the most important segment in Estee Lauder's portfolio. Consumers are currently demanding products such as masks and oils beyond the traditional skincare formulations like moisturizers and serums. Estee Lauder possesses a strong research and development arm. The recent acquisitions in the beautifying mask and oil-based treatment categories might satisfy the changing demands.

3. Partnership With South Korean Dr. Jart+
   • In October 2015, Estee Lauder bought a stake in Have & Be Co. Ltd., the South Korean company which owns skin care brands such as Dr. Jart+ and Do The Right Thing. The deal is expected to be completed by the end of 2015. The company aims to build a strong presence in the local beauty market through these alliances. It also wants to introduce the Korean innovative beauty products into its portfolio of offerings to complement novelty with its own brand appeal. The company plans to bolster its long-term growth strategy in Asia through this move.

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Skin Care

Estee Lauder's Skin Care Market Share: Estee Lauder's Skin Care Market Share expanded from 6.6% in 2008 to 8% in 2014. However, its share declined to ~7% in 2015 and 2016, partly due to cannibalization of its older products, and partly due to a shift in order realizations following its SMI implementation. However, we currently forecast Estee Lauder's skin care product market share is expected to gradually grow to over 10% by the end of our forecast period. There could be a marginal downside to our price estimate, if the market share were to remain flat throughout the forecast horizon.

Estee Lauder's Skin Care EBITDA margin: Estee Lauder's Skin Care EBITDA Margin increased from 20% in 2008 to 26.2% in 2012, before declining to 25.7% in 2013. The EBITDA margin grew to ~27% in 2014 and remained at almost the same level in 2015 before increasing to around 29% in 2016. We expect margins to remain near 28% by end of our forecast period. There could be almost 15% downside to our price estimate, if margins were to decline to the 2008 levels of 20% over our forecast period.

Makeup

Estee Lauder's Makeup Market Share: We currently forecast Estee Lauder to gain share in the global makeup market from 14% in 2016 to reach almost 24% by the end of our forecast period. There could be a marginal downside if Estee Lauder fails to gain market share over our forecast period.

Estee Lauder's Makeup EBITDA margin: Estee Lauder's Makeup EBITDA Margin increased from 19% in 2008, to 22% in 2016, and we expect it to gradually increase to 25% going forward. There could be close to 10% downside to our price estimate if margins were to decline to the 2008 levels of 19%.

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Estee Lauder manufactures and markets premium makeup, skin care, fragrance, and hair care products in the personal and beauty care segment of the market. Estee Lauder's main competitors consist of cosmetics companies such as L’Oreal, Shiseido Company, LVMH Moet Hennessey Louis Vuitton, Revlon, Coty, and Procter & Gamble Company. 

Estee Lauder's major brands include Estee Lauder, Aramis, Clinique, M-A-C, Bobbi Brown, La Mer, and Aveda, along with fragrance and cosmetics sold under brands such as Donna Karan, Tommy Hilfiger, Micheal Kors, and Sean John.

Premium priced products that are not branded, yet relatively expensive, are sold through limited distribution channels consisting primarily of upscale department stores, specialty retailers, upscale perfumeries, pharmacies, prestige salons and spas, free standing company owned stores and spas, company websites, authorized retailer websites, stores on cruise ships, direct response television, and in-flight and duty free shops.

Despite a global presence, about 40% of Estee Lauder's net sales come from the Americas, with Europe, Middle East and Africa contributing 38%, and Asia-Pacific constituting the remaining 22%. The company's increased focus on the Asia-Pacific market is expected to further increase in the future.

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The Skin Care and Makeup segments have the highest contributions to Estee Lauder's value. Skin Care forms the priority category for the company, contributing ~50% of Estee Lauder's stock value, and Makeup contributes around 40%. The Skin Care segment is also the most profitable of all its beauty products, generating an EBITDA margin of 27%, compared to the company average of around 24%.

Market sizes and market shares in Skin Care Vs Makeup

The Skin Care market grew by 7.4% in 2014, and 5% in 2015 and 2016. The Skin Care market is currently valued close to $120 billion and could cross $170 billion in the next five years.

In the Makeup category, Estee Lauder had a higher market share of around 14% in 2016 (that increased from 12% in 2010), but the overall market size of the Makeup segment is about half of skin-care. The overall Makeup market is currently valued around $65 billion and could exceed $80 billion by the end of our forecast period.

Higher margins in Skin Care compared to Makeup

We estimate that Estee Lauder's skin care EBITDA margin was around 27% in 2016, compared to 24% for the Makeup business.

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Strong prestige beauty sales growth in 2016

Global growth of the prestige beauty segment is outpacing growth in the mass beauty segment. We expect this to benefit Estee Lauder's premium brands which earn the company higher profit margins. The U.S. prestige beauty industry reached $16 billion in 2016, growing 7% in dollar sales, compared to 2015, according to the global information company The NPD Group. At 13%, the makeup segment experienced the healthiest growth, while fragrance grew 4%, and skincare increased by 3%. (Link)

Booming Skin Care due to anti-aging creams

Anti-aging creams and anti-cellulite skin care products are in high demand among aging populations in developed countries notably Japan (oldest demographic), the US, and Western Europe. Half of Estee Lauder's skin-care business comes from anti-aging products. The anti-aging market comprises of those products that can treat multiple signs of skin aging at one time, and is a fast-growing segment under the anti-aging beauty products. Estée Lauder launched its first global anti-aging cream in Europe in February 2012 and a China specific skin care brand Osiao in October 2012.

Growth of natural products categories and "Masstige" segment, as well as male product lines

There is a growing demand for natural / organic products in most countries, a trend led by the developed markets in the US and Western Europe. Additionally, there is an increased preference for less synthetic, eco-friendly, and more natural products and packaging.

There is a growing trend towards the so-called "Masstige," or premium brands sold at lower prices through mass distribution. In addition, beauty care products focused on men is the latest niche being targeted by most players globally. In developed markets, particularly in the US and Western Europe, the introduction and extension of the men’s product lines is a major source of growth.

Focus on travel retail

Estee Lauder has capitalized on the strong growth in its travel retail channel to capture the attention of travelers from emerging markets, who either buy in the channel, in stores at their destination, or when they return to their homes. The channel has performed particularly well for Estee Lauder within Europe, Asia-Pacific, Middle East & Africa, generating double-digit net sales growth in fiscal 2015 and 2016. The main drivers to the travel retail segment growth were: the launch of new initiatives, an expanded distribution network, an increase in global airline passenger traffic, and accelerated orders.

In 2014, the global travel retail market was valued at ~64 billion and is estimated to reach at around $85 billion in 2020.(Link) Global travel retail has quickly become the fastest-growing retail channel for beauty, fashion, and accessory products. The market is driven by expanding passenger volumes, especially in emerging markets. Global Airport Retailing information for 2012 reveals that the Asia-Pacific airport retail spending stood at $12.2 billion, while spending in Europe was $10.6 billion and for the Americas $7 billion. By 2016, it is expected that the spending will reach $23.2 billion for Asia Pacific, whereas for the Americas and Europe the figures will be $10.1 billion and $12.4 billion, respectively.

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