The Allure Of Estee Lauder

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One of the world's largest manufacturers and marketers of skin-care, makeup, and fragrance products, the Estee Lauder Companies (EL: $42) is well positioned, in our view, to benefit from ongoing global growth in consumer discretionary spending and increasing focus by both men and women on skin care and appearance.



In the June, 2007, fiscal year, sales from outside the Americas region grew faster than in the Americas region. Within the Americas region, sales growth was better in the nondepartment-store channels, including single-brand, freestanding stores that the company owns and operates, than in the traditional department-store channel. We expect these trends to continue in fiscal 2008 as well. However, we believe investors have focused on the U.S. traditional department-store channel, in which sales have been adversely affected by store closures, store name conversions, and, more recently, weak consumer support.



Also of concern to investors, by our analysis, has been the company's decision in early 2007 to accelerate and increase its investments in its strategic initiatives program, which has pressured margins in some quarters. We forecast that the investments will help drive future sales growth and that the dollar levels involved will moderate in late fiscal 2008 and fiscal 2009.



Our 5 STARS [strong buy] opinion reflects what we see as Estee Lauder's favorable growth prospects and its compelling valuation.We believe the company eventually will prevail over challenging conditions in the U.S. market that have been brought on by consolidation and closures of department stores and exacerbated by the slowdown in the U.S. economy. We also expect that the expenses the company is incurring for its strategic initiatives program will help drive future sales growth. With potential upside of about 22% from current levels, we recommend purchasing the shares.



Company Profile

The company, founded in 1946 by Estee and Joseph Lauder, has grown into one of the world's largest manufacturers and marketers of skin-care, makeup, and fragrance products, sold in more than 135 countries and territories worldwide. Historically it has been a dominant player in the high-end fragrance and cosmetic categories, with brand names such as Estee Lauder, Clinique, Aramis, Prescriptives, Origins, MAC, Bobbi Brown, La Mer, Aveda, Stila, Jo Malone, and Bumble and Bumble. The company is also the global licensee for fragrances and cosmetics sold under the Tommy Hilfiger, Donna Karan, and Michael Kors brands. Each brand is distinctly positioned within the cosmetics market, according to the company.



The company's most significant operating region is the Americas, accounting for 51% of sales and 45% of profits in fiscal 2007 [June]. Other regions include Europe, the Middle East, and Africa [35% of sales and 43% of profits] and Asia-Pacific [14% and 12%].



The skin-care division [37% of fiscal 2007 net sales] addresses various skin-care needs of women and men. Products include moisturizers, creams, lotions, cleansers, sunscreens, and self-tanning products. The makeup division [39%] manufactures, markets, and sells a full array of makeup products, including lipsticks, mascaras, foundations, eye shadows, nail polishes, and powders. The fragrance division [18%] offers a variety of fragrance products, including eau de parfum sprays and colognes, as well as lotions, powders, creams, and soaps that are based on a particular fragrance. The products of the hair-care division [5%] are offered mainly in salons and freestanding retail stores and include styling products, shampoos, conditioners, and finishing sprays. Other products account for less than 1% of net sales.



As is customary in the cosmetics industry, Estee Lauder accepts returns of its products from retailers under certain conditions. In recognition of this practice and in accordance with generally accepted accounting principles, the company reports sales on a net basis, which is computed by deducting the amount of actual returns received and an amount established for anticipated returns from gross sales. As a percentage of gross sales, returns were 4.2% in fiscal 2007, 5% in fiscal 2006, and 4.6% in fiscal 2005.



In fiscal 2007, Macy's (M) accounted for 12% of Estee Lauder's accounts receivable and 14% of consolidated net sales.



Cosmetics Makers Seek New Outlets

Upscale cosmetics makers including Estee Lauder are coping with a changing retail landscape for beauty products. The 2005 purchase of May Department Stores by larger rival Federated Department Stores [now Macy's] created the largest U.S. department-store operator and led to the closing of about 80 duplicative outlets nationwide. Federated also sold May's 48-store Lord & Taylor department-store chain to a private investment group.



At the same time, consumers are finding new places to buy their makeup. Sephora [a unit of France's LVMH Mot Hennessy Louis Vuitton] is an upscale specialty store offering makeup and beauty products; it often features smaller, less well-known cosmetic brands, including philosophy and Bare Escentuals, in addition to some larger brands, such as Estee Lauder's Clinique. Since entering the market in 1998, Sephora has grown to over 200 outlets in the U.S.



With the decline of the importance of the department-store channel as a seller of cosmetics, beauty companies are seeking alternatives. Estee Lauder is opening more of its own stores, featuring its MAC, Aveda, or Origins brand products, and has over 500 single-brand, freestanding stores worldwide as well as 86 multibrand stores. The company expects 29% of its sales will come through North American department stores by 2010, down from 46% in 2002. It anticipates that more products will be sold through specialty retailers and international department stores.



Estee Lauder and other cosmetics companies are also turning to emerging markets, where consumers have more disposable income to spend than in the past. The company projects that 51% of its sales will come from outside the Americas region by 2010, up from 39% in 2002. Overall for the industry, cosmetic sales rose 10.7% in Latin America and Eastern Europe in 2006, compared with growth of just 3% in the U.S., according to Euromonitor International, a global market research firm.



Upscale cosmetic brands are also turning to home-shopping channels such as QVC. The channels, once seen as marketing inferior goods to middle- and lower-income consumers, now attract upscale brands, including Bobbi Brown, Elizabeth Arden, and Shiseido. Estee Lauder's Clinique line appeared for the first time on QVC in February, 2008.



Business through the Internet has also become more important for the beauty companies. Estee Lauder reported that its Internet business grew 30% in the December, 2007, quarter, with healthy gains from its own brand sites as well as retailer partner sites including those run by Macy's, Nordstrom (JWN), Neiman Marcus, and Sephora.



Finally, Estee Lauder announced in January, 2008, that Clinique will develop a new upscale skin-care line to be marketed exclusively through physicians, a strategy reflecting the increasing importance of sales through doctors' offices. The new line will be marketed by Allergan (AGN), best known as the manufacturer of Botox, but which is also involved in the Prevage MD, M.D. Forte, and Vivite physician-dispensed skin-care products.



Valuation

Our discounted cash flow [DCF] model derives a $52 value for the stock. Our historical analysis suggests a value of $55. Our peer analysis values the stock at $49. Our 12-month target price of $52 is a blend of our DCF valuation and our historical and relative analyses.



Corporate Governance

The Estee Lauder Companies has a number of corporate practices that are not particularly shareholder-friendly, in our view, including two classes of stock, which allows insiders to maintain voting control, and a three-class board of directors. Insiders, including Lauder family members and a director who is a trustee of one or more Lauder family trusts, occupy 5 of the 12 directors' positions.



The company does separate the chairman and the CEO positions, although both are currently occupied by Lauder family members. However, in November, 2007, the company announced the appointment of Fabrizio Freda as president and chief operating officer, effective Mar. 3, 2008. It also announced there is a succession plan that anticipates Freda becoming CEO within 24 months. Freda's most recent position was president for global snacks at Procter & Gamble (PG), but he spent a decade in P&G'sHealth & Beauty Care division and also worked at Gucci.



Investment Risks

Risks to our recommendation and target price include a greater-than-expected pullback in consumer spending that could hurt the company's retail business, unfavorable foreign currency translation, changes in regulations governing cosmetics, and difficulties in the global rollout of the company's Strategic Modernization Initiative, which started in May, 2007, and is expected to be implemented in a majority of locations by the end of fiscal 2010.