Innovation Drives Estee Lauder's Momentum

We believe Estee Lauder EL remains acutely focused on developing products that resonate with specific consumer tastes, diversifying the channels and countries in which it sells its offerings, and supporting execution through sustained investments behind its brands, the funds for which have been freed up by ongoing cost-saving programs. In combination, we think these efforts support Estee’s leading competitive edge. We see significant opportunities for growth in developing markets and the digital channel, which we expect to play an increasingly large role in the beauty consumer’s path to purchase.

These dynamics have already been incorporated into our longer-term outlook for the company, which calls for 6% average sales growth and high teens operating margins. We think investors have flocked to the cosmetics sector as growth across the broader consumer goods landscape remains muted, leading to few discounts across the space. While Estee Lauder shares currently trade above our fair value estimate, we think they are worth keeping an eye on, as we’d find them compelling at a wider margin of safety.

Developing Markets Key to Sales Trajectory In our recent conversations with Estee Lauder's management team, the theme that stood out the most was the company's commitment to taking a more precise, customized approach to each of its geographies, ranging from developing markets to the United States. We appreciate this strategy, given the varying consumer attributes in each of the company's regions. We see the most attractive opportunities in Asia-Pacific (22% of sales), given broader macroeconomic trends that should lift consumer spending on beauty as well as an affinity for prestige fare that should spur further premiumization in the region.

We think per capita GDP growth coupled with an increase in consumers trading up from mass-market to premium beauty fare should help per capita beauty spending in developing regions begin to close the gap with that in more established markets, supporting industrywide cosmetics growth slightly above 4% over the next five years. We have found a positive relationship between per capita GDP and per capita spending on beauty (in this case, defined to encompass the makeup, skincare, haircare, and fragrance categories) in the top 30 beauty markets around the world. In our view, this indicates that rising global wealth should sustain industrywide beauty growth.

Beauty expenditures relative to wealth are especially elevated in several Asian regions, including Japan, South Korea, and Hong Kong. We estimate their per capita spending on beauty amounts to $213, $192, and $247, respectively, versus around $156 in the U.S. We attribute this to a greater preference for premium cosmetics offerings in these markets, which stands to bolster Estee’s trajectory, given the company’s exclusive focus on this segment of the market.

The rise in per capita beauty expenditures relative to per capita GDP has been steeper in Asian markets than in the U.S., with a particularly strong responsiveness to additional wealth in South Korea and Japan. While China still remains at the low end of both measures (GDP per capita and beauty spending per capita), we expect it to follow a trajectory similar to its geographic peers as individual wealth expands. This makes Estee Lauder’s performance in China, the second-largest beauty market at present, an increasingly important determinant of its prospects. China’s per capita beauty spending has more than doubled over the last decade (from $16 in 2008 to $34 in 2017, by our estimates) but still remains less than a fourth of that in the U.S. ($156 in 2017, growing 20% over 2008) and less than a fifth of that in more developed Asian markets like Japan ($213) and South Korea ($192).

In our view, premiumization trends should be especially noticeable in China, given the bent toward higher-end fare in the country and the Asia-Pacific region more broadly. According to a 2017 McKinsey study, Chinese consumers have been contributing an increasing proportion of the global luxury goods market, hovering around a one-third share in recent years versus just 12% in 2008; they are expected to account for 36% of global luxury sales by 2020.

Asian consumers’ thirst for luxury offerings extends to the beauty category. In a 2016 survey conducted by McKinsey, 20% of cosmetics consumers who had changed their purchasing behavior over the past year opted for a more expensive brand, while just 10% traded down to a less expensive alternative. This stands in contrast to the behavior seen across all categories, where global consumers were roughly as likely to trade up as they were to trade down (which is logical, given that we assume consumers are reallocating their budgets toward categories in which they prioritize a premium brand and trimming their spending on less differentiated categories). Put differently, on average, cosmetics consumers across the globe are about twice as likely to trade up as they are to trade down.

This propensity to trade up in the cosmetics category is even more pronounced in China and developed Asian markets. Cosmetics consumers in mainland China were 11 times as likely to trade up as they were to trade down, substantially exceeding the likelihood of trading up even in developed Asian markets (4 times as likely as trading down) and the global average. In this context, Estee Lauder’s management estimates that per capita spending on prestige beauty increased 36% in the U.S. versus 123% in China between 2009 and 2017.

As a result of its sizable population, relatively low per capita spending on beauty, and penchant for premium fare, we expect the Chinese beauty market to be a key driver of industrywide growth in the years ahead. Estee Lauder’s management expects China to contribute roughly one fourth of growth in prestige cosmetics (which account for only 26% of the Chinese beauty market versus 40% in the U.S. and 47% on average in Asian developed markets) in the coming years. We think the extent to which Estee Lauder is able to develop products that resonate with local consumer tastes will determine its success in these fast-growing developing markets.

We think the company is doing a commendable job of this by tackling product innovation on a regional basis, rather than relying on a one-size-fits-all approach. For example, relative to the U.S., skincare is a significantly larger proportion of cosmetics sales in Asia, as consumers in the region have historically preferred establishing a skincare routine over wearing color cosmetics, though the latter has started to gain more traction with Asian consumers. Around 70% of Chinese consumers’ expenditures on cosmetics in 2017 went toward skincare versus just 36% in the U.S. and 42% globally. This is comparable with the proportion of spending on skincare in Japan (60%) and South Korea (67%). Fragrances are much less important in China, accounting for just 2% of sales versus 15% globally.

New products like Estee Lauder Micro Essence Sakura, which was developed in Asia based on one of the most popular local skincare offerings and is formulated for Asian skin using Asian ingredients, are evidence that the company is relying on its local leadership teams to better understand the unique consumer needs within a region.

Chinese consumers are also important to Estee Lauder’s travel retail business (around 18% of sales and experiencing low teens compound sales growth over the last three years) as management estimates Chinese travelers will account for roughly one fifth of 2019 air traffic (with emerging-market travelers in aggregate accounting for just over 50%). In our view, travel retail can be used to strengthen brand loyalty, drive incremental spending, and reach new cosmetics consumers, particularly in less developed markets. According to management, around 30%-40% of travelers in these channels come from cities in which Estee Lauder lacks physical distribution, and 59% of prestige beauty consumers first purchase a high-end product in the travel retail channel.

In our view, Estee Lauder has done a commendable job of driving conversions from browsers to buyers in this highly profitable channel by engaging customers before they reach the point of sale. Since around two thirds of purchase decisions are still made before consumers travel, the company has also expanded the role of “pre-tailing” (in regions where it has a more limited physical footprint, this occurs via the digital channel) to increase consumer engagement with its brands before travel. For example, customers can pick up purchases that they have ordered in advance online at airport counters or even have their purchases delivered to them at their gate or airline seat. Further, Estee Lauder has launched a wide array of products (expected to exceed 200 in fiscal 2019 alone) exclusively through the travel retail channel.

China contributed around 13% of Estee Lauder’s sales in fiscal 2018 versus 9% the year prior. Although this proportion is not consistently reported, we expect the broader Asia-Pacific region (22% of sales in fiscal 2018 versus 18% a decade prior) will remain an important piece of Estee Lauder’s story, and we forecast low teens average sales growth in this segment over the next five years. This implies that the Asia-Pacific region will contribute more than 30% of sales by fiscal 2023, comparable with the contribution from the Americas. We don’t expect this growth to be margin-dilutive as the Asia-Pacific segment’s operating margin has averaged 16% over the past five years, on par with the company’s margin on a consolidated basis. Moreover, a higher proportion of skincare in these regions and a shift toward the online channel (which already accounts for nearly 30% of sales in China, with just under a third of the company’s brands in this channel currently) should be accretive to profitability.

Customization and Channel Diversification Can Boost U.S. Performance We appreciate that the company's focus on locally relevant products extends beyond international markets and into the U.S. (around one third of sales, including travel retail). By approaching North America as a "granular emerging market," management should be able to maintain growth in this region (offsetting pressures from weak department store traffic) and ensure that it defends its share from niche competitors, in our opinion. This more targeted approach has informed both product development and marketing.

For example, Clinique iD moisturizer, launched in November 2018, builds on Clinique’s entrenched position in this subcategory (with a retention rate above 40% and Clinique moisturizers accounting for around one fourth of prestige moisturizer sales) but has a more customized approach. To match customers with the right Clinique iD moisturizer (with 15 possible combinations), a virtual diagnostic tool evaluates skin type to identify the optimal product. From a marketing perspective, the company has shifted from looking at a city as a whole to subdividing a region into catchments (2,600 in total across the U.S.) that can more precisely identify consumer demographics in an area. For example, Chicago had previously been viewed as one market, but it is now segmented into more than 10 catchments with different demographic characteristics and shopping trends. In turn, a product’s merchandising and advertising can now vary depending on the attributes that are most likely to resonate with consumers in a given catchment.

We believe ongoing channel diversification will help the company reach a wider range of consumers in the U.S. and abroad as well. One of CEO Fabrizio Freda’s primary accomplishments, in our view, has been reducing Estee Lauder’s exposure to North American department stores while expanding its reach in faster-growing channels like travel retail, online, and specialty multibrand (which account for more than a third of sales in aggregate). This is especially prudent as management estimates that in North America, 80% of consumers now shop in more than five channels and omnichannel consumers can generate up to 3 times the value of consumers who shop in one channel. We think the company may further diversify its channel exposure through acquisitions, as it did when it bought Too Faced in 2016 (for slightly above 5 times sales, by our estimate) to gain traction in the domestic specialty multibrand channel, which accounted for above 80% of Too Faced distribution.

We estimate U.S. department store traffic has eroded by a low-single-digit rate on average over the last decade, and we appreciate Estee Lauder’s management’s efforts to reduce exposure to this channel. The company derived approximately 15% of sales from North American department stores in fiscal 2018, which is roughly half the level from a decade prior.

In particular, Estee Lauder’s e-commerce business continues to expand at a rapid rate--nearly 30% compound growth over the past five years. While we expect e-commerce to pressure pricing (by increasing price transparency) in many areas of the consumer goods space, we don’t view this as a meaningful threat to Estee Lauder, since beauty consumers tend to be price inelastic and averse to new, untested product formulations. Additionally, we estimate that the vast majority of beauty purchases (both for replenishment and trying new products) still occur within the store. As a result, we view e-commerce to be an area of opportunity rather than a threat for beauty companies. This channel has allowed consumers to interact with brand content at any point of the day, engage with the community around a brand (with 40% of Estee Lauder’s brand content user-generated), and still receive the high-touch services (such as virtual try-on or online beauty advisors) they would at a traditional beauty counter. Moreover, a growing e-commerce business provides the company with a vast amount of consumer data, with over 200,000 data points received daily from “brand.com” sites, and is accretive to profitability as well, given lower customer acquisition costs and return rates.

Innovation Should Support Above-Average Growth We maintain that Estee Lauder's ability to bring value-added innovation to market and selectively expand the distribution of its brands should allow it to outpace industry growth while keeping intact the brand equity that underscores its competitive edge. Management estimates that new product innovation accounted for nearly 30% of sales in the first half of fiscal 2019, ahead of the 20%-25% rate it has seen historically. Moreover, pricing continues to account for 20%-25% of annual sales growth, suggesting that these new offerings have still provided a compelling value proposition to consumers. We expect these efforts will support around 6% average sales growth (versus the roughly 4% we expect for the broader global beauty industry and 5% management expects for global prestige beauty) in the years ahead.

Further, we expect strengthened profitability as the benefits from improved pricing and better-leveraged selling, general, and administrative costs fall through to the company’s bottom line. Estee Lauder embarked on a multiyear cost-saving initiative in 2016, Leading Beauty Forward. At the end of fiscal 2018, it updated the annual pretax benefits it expects to receive when the program is completed in fiscal 2021 to $350 million-$450 million (up from $200 million-$300 million previously). This represents 3%-4% of fiscal 2018 cost of goods sold and operating expenses, excluding depreciation and amortization; we model the company reaching the midpoint of this range in fiscal 2021. These savings should support adjusted operating margin expanding 170 basis points by fiscal 2022, to above 18%.

We believe Estee will need to maintain significant investments behind its brands in order to support its top-line trajectory; we model the company reinvesting around half of these savings in its business in the form of marketing and research and development. We expect combined spending on these categories to hover around one fourth of sales over our forecast (amounting to nearly $3.8 billion in fiscal 2019), which is comparable with both the level it has spent historically as well as the proportion of sales its peers invest behind their brands.