Estee Lauder: We Are Optimistic, But The Price Is Too High (NYSE:EL)
The Estée Lauder Companies Inc. (NYSE:EL) manufactures, markets, and sells skin care, makeup, fragrance, and hair care products worldwide.
In today’s article we will be discussing the firm’s latest earnings results, along with a set of profitability and efficiency measures. We will also comment on the change of these measures over the past 5 years, and our outlook for the coming quarters.
Let us start by looking at the return on equity (ROE).
Return on equity
Return on equity is a popular measure to gauge a firm’s ability to generate profits from shareholders’ equity. Over the past 5 years, EL’s ROE measure has been extremely volatile, ranging from 12% in 2020 to more than 50% in 2021. In the recent quarters however, the measure has been gradually declining, reaching about 25%, close to the pre-pandemic levels.
To understand what is behind these changes, we will be decomposing the ROE into three parts, namely the net profit margin, the asset turnover and the equity multiplier.
Net profit margin
The net profit margin is a commonly used profitability measure and it indicates the percentage of revenue that a company keeps as profit after accounting for fixed and variable costs. While the current net profit margin is still slightly above pre-pandemic levels, it has declined substantially from its highs reached in early 2022.
Looking at the latest earnings results gives us an idea, what has been driving the decline in the past quarters.
While sales have substantially declined year-over-year, the cost of sales has remained about constant, resulting in a significant gross margin contraction. Total operating expenses have also remained comparable to the previous year’s, however, in Q2 fiscal 2023, a $207 million impairment charge has been also part of the costs.
All together, these items have had a substantial negative impact on the firm’s bottom line.
Looking forward, there are several considerations to take into account. First of all, the macroeconomic environment appears to be improving. Consumer confidence in the United States has sharply rebounded from its 2022 lows. Energy prices and raw material prices appear to be moderating. Inflation also appears to be slowing. And last, but not least, the reopening of China after the strict Covid lockdowns could also be a material factor. In our opinion, all these developments are likely to have positive impacts on EL’s financial performance in the coming quarters. Decreasing costs, along with increasing demand may lead to improving sales and profitability in the second half of 2023.
On the other hand, we have to look at some company specific measures as well. Inventory management has been in the focus for many retailers in 2022. Often times, firms had to use significant promotional activity and discounting to reduce their excess inventories, leading to contracting margins. Over the past years, EL’s inventories have also been growing rapidly.
The largest change in Q2 can be seen in the raw materials category, followed by finished goods.
All in all, we would like to see inventory levels decreasing or at least the growth slowing. Although we do not believe that EL is going to have problems with inventory becoming obsolete (and therefore margins are not likely to be further negatively impacted), having lower levels of inventory could improve the company’s liquidity position and financial flexibility.
Asset turnover, or sometimes called asset utilisation, is an efficiency measure. It indicates, how effective the firm is generating sales using its assets.
The current levels of asset turnover is well below pre-pandemic levels, which has been driven by the sharp drop in 2020.
The following chart shows that while sales have plummeted in 2020, the firm’s asset base has kept on gradually growing.
So what do we expect going forward? The latest earnings report summarized the firm’s sales by geographic area. We can see in the following table that about 2/3 of EL’s sales are generated outside of the U.S. and Asia/Pacific is a substantial contributor.
This data is important for two reasons:
1.) The reopening of China could fuel demand for EL’s products in the coming quarter, which could lead to a significant revenue increase, positively impacting the asset turnover ratio.
2.) The USD has been relatively strong compared to other currencies in 2022. The dollar index however appears to have peaked already and has declined substantially. A weaker USD compared to other currencies may also have a positive impact on the sales figures going forward.
All in all, we expect asset turnover to improve in the coming quarters.
Last, but not least, let us look at the equity multiplier. This measure shows the ratio between the total assets of the company to the amount on which equity holders have a claim. The reading is currently well above the pre-pandemic levels, however it has been decreasing gradually in the past quarters.
The main reason for the increase has been the sharp increase in gross PP&E in 2019.
Our final take
While the firm’s profitability has been quite volatile in the past years, but we believe that due to the improving macroeconomic environment, this measure may start improving again in the coming quarters. China’s reopening, the weakling dollar, the improving consumer confidence can all have a positive impact on the firm’s financial performance.
On the other hand, the firm is trading at a significant premium compared to both the sector median and the company’s own 5Y average. The following table summaries a set of valuation measures.
We believe that the valuation is simply not justified. While we are optimistic about the coming quarters, uncertainties exist. The macroeconomic environment may not improve as we foresee it. For this reason, we believe it is not the right time to start a new position or add to an existing one.
For these reasons, we rate the stock as “hold”.