Vincent Besnault
Disclaimer: Estee Lauder reports in June. FY refers to its fiscal year. For comparison with peers, CY (calendar years) are used.
The Beauty Sector’s Liar’s Poker
I have covered Olaplex Holdings, Inc. (OLPX), Coty Inc. (COTY), and Inter Parfums, Inc. (IPAR) in the beauty segment so far. All are Estée Lauder’s direct competitors. During their latest earnings calls, most claimed having gained market share in their respective segments – at least for some of their brands. Most also claimed that they will grow revenues at high one-digit percentage rates in CY 2023.
Valuations are similar except for L’Oréal S.A. (OTCPK:LRLCY) and The Estée Lauder Companies Inc. (NYSE:EL), who both operate a diversified portfolio of brands and products and are considered industry leaders. The other main players are less diversified, which justifies lower valuations. However, valuations among all major players have remained fairly stable.
Each of them claiming growth and market share capture during a slowdown in consumer spending and a sluggish recovery of the Asian market is questionable. In my opinion, Estee Lauder is the weakest link, and we will discuss why here below.
Sector Valuation And Peers
The below charts demonstrate that Estée Lauder and L’Oréal are valued similarly on both P/S and P/E, which implies that they will perform equally in the future. But as discussed in this investment thesis, numerous factors indicate such valuation could be revisited in the near future.
P/S ratios splits the industry into two groups, with Estée Lauder and L’Oréal (5.069x and 5.180x, respectively) leading, and the remaining competition between 1.341x and 3.197x. L’Oréal has a slight edge over Estee Lauder.
Price to Earnings ratios display more curiosities, which can be explained by Coty and Shiseido returning to profitability recently. The small denominator thus causes the ratio to be high, but in this context this is not an anomaly. Here, Estée Lauder has an edge over L’Oréal by 5.16 points (40.24x and 25.08x, respectively).
EV/EBITDA is comparable to the P/E ratios, with Estée Lauder edging L’Oréal by 4.3 points. Shiseido’s ratio is offset for the aforementioned reason.
Incurred Sales Drop In 2022 & Operating Efficiency
Although valuations seem fairly stable across the industry across all metrics, a recent development casts doubts on Estée Lauder’s leadership.
While its peers have grown revenues in CY 2022, Estée Lauder’s revenue dropped -9.53% in Q2 and -10.52% in Q3, now only up 1.52% YTD. Also, management acknowledged a considerable inventory tightening, which resulted in a 15% increase in inventories YoY. Combined with the remarkable sales drop, it is clear Estee Lauder’s inventory turnover ratio will suffer in 2022, which impacts operational efficiency negatively. This could obviously be offset by aggressive promotions during the holiday season, but probably at the expense of the operating income margin.
Investment (Selling) Thesis
Persisting Margin Pressures
Estée Lauder’s SG&A expenses historically fluctuated around USD 2.3 billion. The latest earnings call does not indicate any evidence pointing to initiatives towards a reduction of those costs in Q4-2022. While Estée Lauder generated USD 661 million operating profit in Q3-2022, its operating income contracted -45.71% YoY and -29.61% YoY in Q2 and Q3-2022, respectively. In comparison, as I assessed in my previous articles on Coty and Inter Parfums, the industry overall does not seem to witness such violent sales and margin pressures (so far).
Management Guidance On Earnings & Cost Management
Estee Lauder already downgraded its earnings guidance by -57.03% for FQ2-2023. Analysts also priced a 112.85% YoY rebound in earnings for FQ4-2023. EPS have been historically volatile and cyclical. The management team highlighted that its “flexibility to manage its margins is intact”. Nevertheless, the growing SG&A costs in both absolute and relative terms suggests the exact opposite.
Skepticism over Growth Levers
Estee Lauder counts on China as a major growth lever for its products. In 2022, roughly 21% of its operating income came from APAC . It expects China to rebound in Q4-2022. Unfortunately, recent unrests and a surge in COVID cases have failed to accelerate Chinese consumer spending. In addition, recession fears and high inflation across Europe and the US also represent headwinds for sales & earnings growth at this moment.
Catalysts For A Revaluation
Surprising Earnings Results
Estée Lauder will report earnings for the holiday season 2022 on February 2nd, 2023. This will be a critical moment to watch, and although the company has a track record of “underpromise – overdeliver” for earnings, the gap has been closing. The question here is whether analysts improve their estimations’ accuracy or if management has less room to play with. Given the numbers presented above, I tend to think the latter holds, and the risks of an unpleasant surprise have increased. Such surprise could affect the share price adversely.
Competition’s Performance
L’Oréal grew revenues by 19.7% for the year as of CY Q3-2022 (8.1% are reported to be linked to FX-fluctuations, thus a net 11.6% sales growth). L’Oréal’s next earnings report is scheduled Feb 9th, 2023. While this is after Estée Lauder’s quarterly earnings reporting date, it will remain interesting to see how both companies have performed during the critical holiday season. Should L’Oréal outperform Estée Lauder significantly, this could be another catalyst for a decrease in its share price.
Risks
Estee Lauder has traditionally been valued similarly to its peers
Valuation metrics (P/E, P/S, EV/EBITDA) have remained comparable despite Estee Lauder’s poor sales and earnings performance throughout 2022 compared to its peers. This could be caused by mispricing and reverse. On the other hand, it could also persist in the future because the market’s faith that Estee Lauder persists on its growth trajectory. Hence, continuous monitoring will remain critical.
Conclusion
Estée Lauder is the first of the major players in the beauty industry whose revenues shrank drastically in Q2 and Q3 of CY2022. Management blames the missing reopening of the Chinese market being the main driver behind the sales loss, yet all companies faced this headwind. Despite these headwinds, L’Oréal managed to further grow its revenues over the same time frame. In my opinion, this indicates that Estée Lauder is losing market share to its competitors and is the (relative) weakest link in the sector. It is a strong, profitable company with a diversified set of products. Nevertheless, its valuation remains relatively unchanged compared to L’Oréal, despite Estée Lauder’s poor performance.
While the two companies might perform well in the mid and long rung, Estée Lauder exhibits serious risks in the foreseeable future. As a result, I consider The Estée Lauder Companies Inc. stock risky and would rather sell than hold it.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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