Description

I recommend going long Estee Lauder (“EL). Estee Lauder is not a cheap stock; but it is a high-quality business with a strong competitive position in an attractive and growing global industry. The business has the potential to deliver solid and consistent low-mid teens earnings growth over the long-term, making this a long-term compounder.

            Estee Lauder manufacturers, markets, and distributes, skincare products, make-up, and fragrances, around the world. Estee Lauder’s brand portfolio includes iconic beauty franchises, such as M.A.C. Cosmetics, Jo Malone, Estee Lauder, Clinique, Bobbi Brown, Tom Ford, and Le Mer. The Company also owns a collection of high-growth emerging brands, including Too Faced Cosmetics, Becca, Le Labo, Smashbox and GlamGlow. In 2018, Estee Lauder will generate $13.6B in sales.

            Estee Lauder operates at the high-end of the beauty market, which enjoys wonderful economics. The Company generates 80% gross margins and +20% returns on net tangible assets, producing strong free cash flow. In the premium segment of the beauty market, customer loyalty is strong and demand is resilient through economic cycles. People want to look and feel good, even in a tough economy.

            In addition to the attractive business and industry fundamentals, Estee Lauder is experiencing three areas of accelerating revenue growth that should translate into sustainably higher earnings over the next several years.

            First, Estee Lauder’s business in China is booming. The emerging Chinese consumer class is hard-core beauty product enthusiasts, who place a premium on luxury brands. Unlike their mothers, who were mainly interested in skin care products, young Chinese women are voracious buyers of make-up and cosmetics, which provide instant results for selfies. Estee Lauder’s premium portfolio in China, mainly consisting of core Estee Lauder, Clinique, Le Mer, and M.A.C., is uniquely positioned to benefit. Chinese consumers trust these brands and associate them with quality. In 2018, Estee Lauder should do about $1.3B in revenue in China. The Company should be able to compound its Chinese sales at 20% annually for the foreseeable future. Over the long-term, China could become Estee Lauder’s largest market. I believe this is still the early stage of EL’s Chinese growth. 

            Second, Estee Lauder has established a dominant position in the growing travel retail channel. Beauty products are one of the most popular categories in airports and duty-free shops around the world. Not only are customers enticed by the deals, they are also willing to spend on high-end brands as a vacation indulgence. Estee Lauder’s premium brand portfolio, combined with its global distribution capabilities, allows the company to create unique product and packaging formulations, specifically designed for the travel channel. Approximately one billion travelers pass through airports each year, with this figure expected to grow by 5% annually, driven by route expansion, and airport growth. This growing passenger traffic establishes a captive customer base hungry for Estee Lauder’s quality beauty products.  

            Lastly, the global proliferation of e-commerce is a boon for Estee Lauder. In the past, people who did not live in close geographic proximity to an upscale department store or beauty products retailer did not have easy access to premium beauty products. This problem was particularly acute in international markets with less developed physical retail infrastructure. The demand to look and feel good was present, but the distribution required to conveniently and reliably satisfy this demand was lacking.

            The Internet solves this problem by opening up access to Estee Lauder’s products to consumers all over the world. The numbers are starting to show: in 2017, Estee Lauder’s online sales grew 33% to $1.3B globally. This represented 11% of total sales, up from 4% only five years prior. Estee Lauder has built a team of 700 people to oversee the Company’s online business in over 40 countries, operating 800 websites. In 2017 alone, Estee Lauder doubled its online sales in key developing markets Russia, Turkey, and South Africa. In China, 77% of online customers for the ultra-premium Le Mer brand were under the age of 35. The expansion of e-commerce channels, particularly mobile commerce, will sustain a strong tailwind for Estee Lauder’s business for many years to come.

            In addition to the revenue growth drivers, Estee Lauder posses a valuable intangible asset that is overlooked by the market but provides a key competitive advantage: entrepreneurs in the beauty industry want to sell their company to Estee Lauder. The beauty industry is full of up-start, new companies with innovative products, led by creative and bold founders. Social media, and direct online-selling, have flattened the barriers to entry in the beauty business in the United States because new companies don’t have to rely on physical retail distribution, or expensive national media buying, to sell and promote products.

            However, while the barriers to entry are lower than they have ever been, the barriers to scale a profitable and durable beauty business on a global basis remain extremely high. To become a global beauty company, a business must have the relationships, capital, and know-how that are required to manufacture and distribute beauty products across a multitude of retail channels and categories, as well as market the products across media platforms in every country in the world. Estee Lauder has spent decades developing the financial and organizational resources necessary to execute on these objectives, making Estee Lauder a desirable home for any beauty entrepreneur seeking longevity and global relevance. This dynamic ensures that at least every few years, Estee Lauder is likely to add a high-growth, dynamic beauty business to its brand portfolio. 

            Through a combination of 8-10% revenue growth, margin expansion, and consistent share repurchases, Estee Lauder can compound earnings per share growth at 12-15% per year over the long-term, which should approximate the compound rate of return in the stock. Large acquisitions, or faster than anticipated revenue growth in international markets, could provide additional upside. For reference, Estee Lauder’s only real comparable company is the European beauty behemoth L'Oreal, which generates $30B in revenue and is valued  ~$130B. With solid execution, I see no reason why Estee Lauder cannot reach these heights given the effective global dupoloy in high-end beauty enjoyed by Estee Lauder and L’Oreal.

Catalyst

Accelerating growth in China/Asia Pacific; Acquisitions; Market share gains