Estee Lauder's Sitting Pretty

In our view,

We think premium positioning has allowed Estee Lauder to develop durable brand intangible assets. Investments in advertising, promotion, and research and development (in aggregate, averaging 25% of sales over the past decade) further support the company’s retail relationships. We believe this spending will enable Estee Lauder to keep its brand equity intact as it expands its presence across a variety of channels and geographies in the high-end cosmetics category.

Estee Lauder has diversified its products’ distribution over the past few years. It has shifted its channel mix away from department stores (which we estimate now contribute slightly above 40% of sales, versus 54% in fiscal 2012) and toward the rapidly growing online, travel retail, and specialty multibrand channels that in total represent above one fourth of the company’s sales. Even some of the company’s core brands remain underpenetrated in their global distribution; for example, Mac has less than 15% of the distribution of top brands like Estee Lauder. We think this reflects the company’s prudent distribution strategy; rather than flooding its products into a new region or distribution channel, it slowly and selectively allocates brands to various channels to maximize and protect brand equity.

Estee Lauder isn’t resting on its laurels; we believe it is pursuing inorganic and organic means to support its trajectory and competitive prowess. For one, the company has pursued tie-ups (like its 2016 acquisitions of Too Faced and Becca) to broaden its reach into specialty multibrand retailers and with millennials. We think Estee Lauder’s ongoing cost-saving initiatives, which target $200 million-$300 million in annual savings, should also allow it to maintain its strong brand investments, supporting top-line growth and the intangible assets that stand behind its wide moat.

Broader Distribution Widens the Moat We have raised our moat rating to wide from narrow to reflect changes in Estee Lauder's strategy. The expansion of the company's prestige beauty brands to a broader range of distribution channels has reinforced its brand intangible assets over the past several years, bolstering our confidence that Estee Lauder will continue to generate returns on invested capital above its cost of capital over the long run. Moreover, we think the company Lauder benefits from a substantial cost advantage, as its direct operating margins, which we estimate to be around 46%, are among the highest in our household and personal care coverage. We expect this combination of brand-driven assets and cost leadership will allow Estee Lauder's economic profitability to endure for more than 20 years, in contrast to other narrow-moat household and personal care operators such as Shiseido and Beiersdorf, which derive an edge from just one moat source. Estee Lauder's robust returns on invested capital, which have averaged nearly 30% over the past 10 years (23% including goodwill), well above our 7% cost of capital estimate, are evidence of its attractive competitive positioning.

Estee Lauder owns three of the top ten global makeup brands--Clinique, Estee Lauder, and Mac--and holds a 28% share of the global prestige makeup market (15% for prestige beauty overall). We think this leading position has helped the company develop entrenched relationships with retailers that rely on its brands to drive store traffic. Estee Lauder has also committed substantial resources to R&D (averaging 1.5% of sales over the past five years) and advertising and promotion (24% of sales), enabling it to bring new products and formulations to market and increase its visibility among consumers. We think these investments have reinforced Estee Lauder’s position in retailers’ supply chains, allowing it to wield negotiating power and amass priority placement of its brands.

Estee Lauder’s substantial investments behind its brands have also allowed it to continue to take share and offset competitive headwinds, as constant-currency sales growth averaged around 6.5% between 2011 and 2016, outpacing the industry’s 5% mark. The low degree of private-label penetration in the global makeup category (which we estimate to be under 3%) bolsters the company’s pricing power. We think this indicates that consumers are willing to pay a premium for the perceived higher quality of products from prestige cosmetics brands. An element of conspicuous consumption also benefits Estee Lauder’s product portfolio, as cosmetics are often given as gifts and are a relatively affordable entry point into the luxury category. We believe consumers’ perception of prestige brands can take decades to change, allowing entrenched players to maintain longer product life cycles and, consequently, continued pricing power. Moreover, in the skin care category (38% of sales), we find consumers to be risk-averse to untested products and willing to pay more for a product they know to work, leading to strong brand recognition and hefty price gaps over private-label offerings, which we estimate to average at least 60% for the overall category.

Estee Lauder’s efforts to diversify its products’ distribution competitive positioning bolsters our updated perspective. The company has expanded into a variety of channels (including specialty stores, freestanding stores, travel retail, and e-commerce sites) and geographies (with 64% of sales outside the United States), lessening its reliance on U.S. department store dynamics. Its largest customer, Macy’s, accounted for just 8% of sales in fiscal 2017, compared with 14% in fiscal 2007. Estee Lauder has also expanded its reach to the fast-growing specialty beauty channel (penetration increased 40% in 2017), which includes retailers like Sephora and Ulta. This channel has been gaining share from department stores over the past decade and now accounts for 20% of all North American makeup sales, versus the 19% held by department stores. Still, we believe Estee Lauder has been able to maintain its brand equity and prestige positioning as it expands into new channels through selective distribution arrangements and consistent pricing across all channels (for example, a Mac product at Ulta will sell at the same price as in a department store or freestanding boutique). Management has emphasized that only certain brands are sold through specialty beauty channels to maintain the exclusivity of its overall brand portfolio. Estee Lauder has also strengthened its digital presence; online sales have grown at roughly a 25% compound annual rate over the past five years and e-commerce now accounts for 11% of revenue, compared with just 4% five years ago. This includes investments in social media and high-touch online services (for example, beauty advisors who provide advice through an online chatroom), which should enhance brand loyalty among its customer base. In addition, the company has acquired brands that are primarily distributed in these higher-growth channels (specialty and online), such as Too Faced and Becca, ensuring a positive trajectory for its brand assets.

Estee Lauder’s cost structure augments its competitive edge, in our opinion. We estimate its direct operating margin to be around 46%, second only to L’Oreal (which has direct operating margin around 54%) in our household and personal care coverage, despite having less than half of its revenue base. We think this is partly attributable to the company’s manufacturing strategy; its major facilities largely manufacture just one product category (that is, makeup, skin care, and so on) for its key brands. Given that its manufacturing lines need to be changed to produce different colors or formulations of the same product, we think this strategy of producing a specific product’s inventory in one location allows for greater fixed-cost leverage than decentralized production. We think Estee Lauder’s scale relative to smaller prestige beauty players allows for greater purchasing power over suppliers, helping it procure inputs like custom packaging and specialty chemicals at more favorable prices.

Less Dependent on Department Stores, but Channel's Still a Risk We think further competition in the global cosmetics market and softness in the U.S. department store landscape pose a moderate degree of risk to Estee Lauder. The company's position exclusively within the prestige segment of the cosmetics market ties its fate to discretionary spending and global macroeconomic conditions. We believe its customers are brand-loyal and unlikely to trade down to cheaper alternatives in these conditions, but they may use less product or purchase smaller sizes, particularly in the more cyclical fragrance category, which could slow the company's sales. Further, U.S. department stores (where traffic erosion persists) contribute roughly a sixth of the company's sales. While we think Estee Lauder has done an admirable job reducing its reliance on this channel over the past several years, further store closures are still likely to weigh on the top and bottom lines as inventory is either sold at a discount or, more commonly, repurchased by the company to defend its brand equity. We think the company's ability to weather these challenges will depend on its brand spending, which would help ensure its products remain visible and relevant to consumers. If Estee Lauder were unable to maintain its investments in advertising or new product development, it could lose share to more innovative or on-trend offerings, particularly as distribution through specialty multibrand and e-commerce channels (where niche competitors can more easily secure distribution) grows. These investments, when combined, have averaged one fourth of sales over the past five years, and Estee Lauder's cost-saving plan should allow the company to continue to invest at this rate. However, an inability to extract these savings could prove detrimental to the company's positioning. Last, Estee Lauder generates roughly two thirds of its sales outside the U.S., and foreign exchange headwinds could dent reported sales and profits from time to time.

We think Estee Lauder is financially healthy. While we believe the company is likely to pursue bolt-on acquisitions to expand its reach in the prestige beauty space, which could increase its debt load, we expect its free cash flows to strengthen (averaging above 11% of sales over the next decade) as its cost-saving efforts materialize, providing its balance sheet with the financial flexibility to support these deals. Given the uncertainty around the timing and scale of any future deals, we model excess cash to be returned to shareholders through share repurchases and dividends over our 10-year forecast. We estimate the Lauder’s dividend payout ratio will average 40% over our forecast, a touch higher than the 36% ratio over the past five years, which suggests dividend growth averaging above 10% over this frame. During this period, we forecast annual share repurchases averaging above 1.5% of shares outstanding.