Estée Lauder Earnings Preview: Fragrance Products To Boost Sales In Q2FY14

Estée Lauder (NYSE:EL) is expected to report its fiscal second quarter results on February 05 before markets open. (Fiscal years end with June.)  The company’s earnings have been strong throughout the last year. In the past three quarters, Estée Lauder posted top line numbers that were roughly in-line with analyst estimates. But the company finished each quarter beating consensus estimates on the bottom-line. This strong performance resulted in the stock gaining over 30% last calendar year, 2% lower than the annual gain in the S&P 500 index.

Second quarter of the fiscal year marks the addition of holiday season sales for this manufacturer of luxury cosmetics and accounts for approximately 29% of full revenues, indicating its importance for overall fiscal performance. Revenues for Q2FY13 were 15% higher on a quarter-on-quarter basis. We expect this trend to continue for the forthcoming quarter, driven by higher quarterly sales in luxury fragrance sales. Additionally, operating profit margins should see considerable expansion during the quarter, as fixed SG&A expense is posted against significantly higher revenues. For example, as a percentage of revenues, SG&A expenses for Q2FY13 and Q2FY12 were 58%. In comparison, SG&A expenses as percentage of revenues during Q4FY12 and Q4FY13 were much higher at 76% and 73% respectively.

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Fragrance Sales To Provide Q2FY14 Revenue Boost

The contribution of fragrances to overall revenues has seen a consistent decline for the company, from 19% of total revenues in 2007 to 13% by 2012, driven by higher skin care product demand globally. During the same period, skin care revenue share increased from 37% to 44% by 2012. The skin care product market worldwide reached $100 billion in 2012, growing at an annualized rate of 4.1% between 2007 and 2012 while the worldwide fragrance market reached $37 billion. ^{[1] [2]} Although these markets had similar growth rates during the period, the larger size of the skin care market meant higher revenue growth potential for the company, leading to a shift in product mix.

However, despite its declining share, the fragrance division witnesses a strong growth rate in Q2, supported by holiday season spending on luxury fragrance products. The fragrance division registered a 32% growth in revenues during Q2FY13 while other divisions such as skin care, hair care and make up registered growth rates of 15%, 16% and 9% respectively. Premium fragrance brands such as Jo Malone, Modern Muse and Tom Ford have historically been strong drivers for divisional revenues. Furthermore, the company launched various limited edition fragrance products exclusively for the holiday season which could boost revenues. We expect another quarter of strong performance from the company’s fragrance division. In addition to strong fragrance division performance, skin care products should continue their impressive growth trajectory.

SMI Initiatives To Boost Operational Efficiency

The Strategic Modernization Initiative (SMI) implemented to better forecast demand for Estée Lauder products has resulted in a gradual increase in operating profit margins, as well as positive working capital growth. Developed by German software maker SAP AG (NYSE:SAP), this SMI software package has been implemented in three waves across many of Estée Lauder’s business divisions. The company expects to roll out the final wave of SMI in July 2014, which is the first quarter of fiscal 2015.

Since the implementation of the SMI, working capital for the company has seen consistent growth. According to our calculations, Estée Lauder finished 2012 with a working capital level of $1.3 billion and a working capital ratio of 1.76. With complete integration of the SMI initiative, we should see a softening in the working capital ratio going forward, with lower inventory levels and reduced accounts receivables due to a faster order processing system. For 2013, we expect a working capital ratio of 1.68 despite an increase in absolute working capital to $1.4 billion.

Furthermore, cash flow from operations have increased from $847 million in CY2010 to $1,129 million and $1,171 million during CY2011 and CY2012 respectively. The increase in cash flow from operations is a result of lower working capital requirements, lower receivables and collectibles and a faster cash conversion cycle. This increase in operational efficiency not only boosts its cash position, but also results in an expansion in margins, with more cash available for reinvesting into its operations. We expect the company’s operating profit margins to continue expanding steadily going forward.

We will update our price estimate of $77 for Estée Lauder after the company files its financials with the SEC.

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1. Skin Care Market Radiant for Foreseeable Future, GCI Magazine, September 2012 [↩]
2. Better Days for Global Fragrances, Euromonitor Blog, August 2011 [↩]