Estee Lauder Companies Inc (EL): Why is the Market in Love With This Beauty Play?

To be or not to be? To buy or not to buy? That is our question with Estee Lauder Companies Inc (NYSE:EL). Whether it is nobler in the mind to suffer not buying a stock that that the market loves, or to take arms against a high valuation, revenue forecasts at the bottom end of guidance, and a management initiative that thus far isn’t quite going as planned? The good news is that unlike Shakespeare’s Hamlet not everyone is going to end up being murdered–but, being the maverick type, I favor raising arms against Estee Lauder Companies Inc (NYSE:EL)’s evaluation.

Estee Lauder’s growth prospects

I can understand why the market loves this stock and why it is willing to award it an valuation of nearly 24 times earnings to June 2014. The company has a number of attractive growth drivers:

  • An aging demographic and cultural trends that will ensure the skin care business has good long term growth.
  • Strong emerging market growth prospects.
  • On a relative basis Estee Lauder Companies Inc (NYSE:EL) has more focus on prestige brands than mass and is better placed than, say, Revlon Inc (NYSE:REV) or Avon Products, Inc. (NYSE:AVP) to benefit from the two-tier recovery whereby the high-end fares better.
  • Unlike The Procter & Gamble Company (NYSE:PG), it is a more beauty-focused company and should find it easier to innovate and react to changing consumer trends. This is incredibly important as more cultures become a bigger part of its clientele, and unlike Nu Skin Enterprises, Inc. (NYSE:NUS) it is relying on a traditional sales channels rather than multi-level marketing.
  • A strategic management initiative (SMI) is intended to considerably increase inventory management and therefore cash flow and return on investment. A key part of this is a SAP deployment.

Putting these things together creates a powerful case for the company.

On the other hand, these drivers have been known for some time. I’m not convinced that Estee Lauder Companies Inc (NYSE:EL) is a good value or is outperforming to the extent that the market is rewarding it.

Estee Lauder’s performance could be better

For brevity’s sake I should note that I covered the stock previously in an article linked here for anyone looking for a primer or background. I have three main points to make on why I think it could do better.

First, the SMI was supposed to produce significant cost savings and improve its operational metrics. This is already happening, but by some measures we could have hoped for a bit more. In the previous article I discussed how Estee Lauder Companies Inc (NYSE:EL) was hoping to increase inventory turn to 3x from 2x. In simple terms this just means it holds relatively less inventory and can decrease working capital requirements accordingly. Ultimately this would help increase cash flow.

Its performance over this issue is best expressed in a graph. These are my calculations based on company data.

I realize that I am probably being a bit harsh here – it is early in the SMI — but we are still a ways away from the 3x figure. This is a metric worth following because it will guide cash flow in the future.

Secondly, the SMI has caused some short term customer service challenges, which led to some delays and products out of stock. Management claimed that these problems were largely dealt with and were expected to have been resolved by the end of the quarter, but I note that the next wave of the SMI roll out has been delayed by six months. The SMI is not entirely going as planned.

And finally, the full year revenue guidance has now been moved to 6%, which is at the lower end of the previous guidance of 6%-8%. The reason cited for this was that the overall market is now predicted to grow 3% instead of 5%.

What the industry is saying

Revlon Inc (NYSE:REV) is more exposed to the mass market and it is suffering accordingly. While declining sales in Europe are expected, the slowdown in its Chinese sales (in line with the economy) is more disappointing. Its Asia Pacific sales declined 2% mainly due to declines in its color cosmetics in China. This is not a good sign in a market that is supposed to provide its long term growth prospects.

Similarly, The Procter & Gamble Company (NYSE:PG) recently announced a net sales decline of 2% in its beauty segment. Organic volumes and sales were down 1% each. The company cited a heavy competitive and promotional environment in hair care and skin care, although sales increased in its salon professional sub-segment. This is further evidence of a bifurcation between the prestige and mass market. In fact, The Procter & Gamble Company (NYSE:PG) faces challenges in keeping market share in all of its categories.

The last two companies are somewhat less reliable indicators. Nu Skin Enterprises, Inc. (NYSE:NUS) has been reporting strong growth but I think this company is partly reliant on keeping its distributors active and motivated. Avon Products, Inc. (NYSE:AVP) is in the middle of a restructuring program that will take time. Indeed, sales are still declining in the US and China. Avon Products, Inc. (NYSE:AVP) is more of an internal restructuring story.

It is not a positive industry score card, and near term conditions do not look great for Estee Lauder Companies Inc (NYSE:EL).

The bottom line

In conclusion, while I think the company has good long term prospects, it is hard to argue that it is a good value. Moreover its near term prospects (despite the hike in EPS guidance) appear to have gotten worse. The market is giving it the benefit of the doubt for now but, I’m not sure it’s time to follow it.

The article Why is the Market in Love With This Beauty Play? originally appeared on Fool.com.

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