Interactive Investor

Stockwatch: A good looking rally but will it last?

23rd August 2019 11:41

Edmond Jackson from interactive investor

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A 35% share price rise in six months catches the eye, but will this cosmetics group run out of puff?

The Estée Lauder Companies Inc

Full-year results to the end of June from Estée Lauder Companies (NYSE:EL) are indeed a pretty face.

The key numbers show an 11% advance in net group sales at constant currency to $14.9 billion (£12.3 billion), with skincare – the biggest and most profitable segment – accelerating 20% to $6.6 billion, and Asia Pacific including China as the geographic dynamo with sales up 25%.

Beyond that first impression there's some mixed performance where investors are quite left guessing as to whether investment in product and promotion will yield beneficial results, or whether Estée Lauder is chiefly riding on a boom in skincare.

And what if trade tensions intensify such that the Chinese government tells its people not to buy American products? 

At around $203, the NYSE stock is up over 35% from $150 last February when I drew attention to its buying merits: on a social basis, how a global epidemic of narcissism is boosting luxury cosmetics to beautify personas and prop up egos; and geographically how China and Asia Pacific is the fastest-growing region for "aspirational" middle class folk.

Offsetting this is a risk over how premium-value cosmetics could be affected by lower discretionary spending. Estée Lauder management reckons people will continue to make small repeat purchases of such items – i.e. for fans, such products are addictive.  

How high a rating before risk overtakes reward? 

EL's trailing price/earnings multiple is now in the low 40s versus low 30s earlier this year, its yield sub-1%. Polar opposites like this show how Estée Lauder is being revered as an international growth stock, amid heightened uncertainty for many industries and services.

On an "all-time" chart view however, it's looking spiky of late – as if momentum money could also be involved. 

One way of rationalising this is to concur EL stock has run up fast which exposes it to profit-taking should the wider bull market falter. Yet there's a bigger story underneath by way of social trends supporting long-term demand for such products.

Stock traders might want to be alert for profit taking but investors continue to hold and with fresh money use drops to accumulate.

In last autumn's sell-off, for example, EL was down a maximum 15% versus plenty of technology stocks off more; and that proved a buying opportunity for 2019. Underlying performance has advanced but then so has the stock rating, making it vital to appreciate risks.

How dependable are skincare sales?

My chief concerns are financial growth weighted towards skincare, which is good while the sector booms although other products are less exciting financially – especially in operating profit terms.

I've picked out a "results by product categories" table within the results to illustrate how skincare products are racing ahead: operating profit up 27% offsetting 20% falls in makeup and fragrance, the next best categories.

A 39% slide in hair care profit shows further polarisation, though is only 1.5% of group total. If EL's growth is becoming skewed towards skincare, how dependable is it? 

Skincare sales were led by The Estée Lauder and La Mer brands across most global regions, due to continued strength in core products but also successful innovations.

I recall consumer studies going back quite some years, how skincare in general is seeing growth – not just due to wealth/aspiration factors increasing personal grooming but also the growth e.g. in skin cancer and dermatitis leading to greater public awareness of skin health.

However, the likes of Estée Lauder products are more like pampering than basic health; as if narcissism – not to be under-estimated – is probably the chief factor.  Social factors are important to appreciate given it may only need a modest change in skincare sales' growth rate to be accentuated in EL's group earnings. 

Other products affected chiefly by promotional spend

Make-up was the next best segment with 7% growth at constant currency – primarily driven by The Estée Lauder and MAC brands – especially in the Far/ Middle East and in travel retail sales. Other brands fared less well, for example lower sales for Clinique and Smashbox.  Operating profit fell 20% "due to planned investments" and also $90 million worth of goodwill/intangibles impairment.

It's a similar story for Fragrances which saw higher overall sales due to luxury brands, while some "designer" fragrances trended lower. This division's operating profit also fell 20%, which was again due to marketing spend in advertising and store operations targeting wider consumers.

And Hair Care edged sales ahead 4% at constant currency with most brands showing growth bar one in the US; but operating profit has slumped 39% due to advertising spend.  

Where I start to baulk is whether this "investment" is broadly to prop up sales in modestly-performing products, without which they might lose market share, or can we expect to see growth invigorated which then swings the losses to profit?

In fairness, management has previously invested heavily in skincare as more people latch onto serums, toners and face masks. Whether that capitalises on the real trend while other products consolidate only time will tell.  

Estee Lauder - results by product categories                
Year ended 30 June                
$ millions   Net Sales   Percent change   Operating income   Percent
    2018 2019 reported constant 2018 2019 change
        basis currency     rptd basis
                 
Skin Care   5,595 6,551 17% 20% 1,514 1,925 27%
Makeup   5,633 5,860 4 7 549 438 -20
Fragrance   1,826 1,802 -1 1 176 140 -20
Hair Care   570 584 2 4 64 39 -39
Other   67 69 3 4 9 12 33
Subtotal   13,691 14,866 9 11 2,312 2,554 10
                 
Exceptional charges   -8 -3     -257 -241  
                 
Total   13,683 14,863 9% 11% 2,055 2,313 13%

Contrasting geographic fortunes

Given skincare sales are booming and US consumer spending is three times that of China, EL's geographic disparity is remarkable. US sales have eased 5% to $4.7 billion and a $211 million operating profit reversed to a $194 million loss, explained by "strategic investments in technology and capabilities" but also lower net sales – i.e. operational gearing – and impairments to goodwill/intangibles.

This appears to relate to soft sales e.g. by department stores in the US (like in the UK) though it would have been preferable to see better reassurance in the outlook statement about how US performance can be turned around. 

Overall, management says strong consumer demand for high-quality products should mean "global prestige beauty" increases by 6-7% this fiscal year so EL can grow ahead of the industry and also expand global market share.

That assumes no fresh new risks materialising beyond an escalation in US/China trade tensions, protests in Hong Kong shopping areas and Brexit, already taken into account.

In Europe, the Middle East and Africa (EMEA), net sales at constant currency soared 18% to $6.5 billion helped by travel retail, online and emerging markets. Such growth chiefly comes from the Middle East, Russia and India, while Benelux and UK sales declined.

As if attempting to justify "strategic investment" spending, this is said to have helped sales while those lower in the UK are blamed on Brexit and department store closures. Operating profit 32% higher (operational gearing again) at $2billion is said to reflect strong growth in travel retail and emerging markets.

Asia Pacific is the growth leader with $3.7 billion sales, up 25% and translating into a 27% advance in operating profit at $729 million albeit with a relatively smaller sales constituent – up from 22% to 25% of group total.

Within the geographic areas, travel retail sales are an important theme e.g. EMEA reporting 16% operating profit growth to $1.6 billion from this segment – i.e. 80% of total regional profit. Therefore, a disruption to global travel would be an issue although terrorism appears to have abated.

Shifting overall stance to "Hold"

On a near-term trading view I think there are reasons to bank profits after this year's rise.

This reflects the stock's now racy valuation despite various underlying risk factors, in the context of risks also to the US economy and stock market.

However, on a medium to longer-term investment outlook I think EL can continue to gain from the global consumer trend to high-premium skincare especially, and as regards the US stock market President Trump is likely also to encourage stimulus ahead of an election year.

On current evidence "buy the drops" if they happen again, assuming performance in the other beauty products can improve. For now, at around $203: Hold.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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