The Business Landscape

Estee Lauder Companies is a prominent American multinational that specializes in skincare (52% of net sales in fiscal 2023), cosmetics (28%), fragrances (16%), and hair care products (4%). Founded in New York in 1946, the company boasts a diverse portfolio of 27 global brands, including Estee Lauder, Clinique, and Jo Malone London. Estee Lauder's market presence spans 150 countries, with sales channels including their website, 1,600 standalone stores, and third-party retailers. In fiscal year 2023, sales distribution was as follows: 28% in the Americas, 33% in Asia/Pacific, and 39% in Europe, the Middle East, and Africa.

Management Insights

The company is led by CEO Fabrizio Freda, who took on the role in 2009 after serving as COO and president the previous year. With a background in Procter & Gamble, Freda has a wealth of experience, particularly in the health and beauty sector. His academic credentials include a degree in Economics and Business Administration from the University of Naples. Freda is known for his strategic focus and results-driven approach, consistently pushing for innovation and growth. Under his leadership, Estee Lauder has achieved record sales, and he remains active on boards, including that of BlackRock Inc. While his absence from Barron's top CEO list in 2022 was notable, he still ranks highly in other evaluations, indicating strong employee support.

Financial Performance

To assess the company's financial health, we begin with the return on invested capital (ROIC). Estee Lauder has shown consistent ROIC above 10% over the past decade, with the exception of the pandemic year, 2020. However, 2023 presented challenges, and while a low ROIC in 2020 is understandable, the significant drop in 2023 raises concerns. Nonetheless, there are underlying factors at play that will be explored further.

Next, we examine free cash flow, which represents the cash generated after operating expenses and capital expenditures. Estee Lauder has maintained positive free cash flow for the last ten years, but the lowest figures were recorded in 2023. A recovery in 2024 would be welcomed.

Debt Levels

An important aspect of financial analysis is understanding debt levels. By calculating the ratio of total long-term debt to current earnings, we find that Estee Lauder's debt repayment timeline extends to 7.07 years, which is higher than desirable. Contributing factors include lower earnings and the acquisition of Tom Ford. Management has emphasized a commitment to debt reduction, temporarily suspending share buybacks to prioritize this goal.

Identifying Risks

While Estee Lauder Companies is regarded as a strong investment, it faces risks. Economic downturns can significantly impact consumer spending on discretionary items, and prolonged recessions may adversely affect sales.

In addition, China presents its own set of challenges. Travel restrictions during much of fiscal 2023 led to a 34% decline in global travel retail business, particularly impacting the skincare segment. Although travel has resumed, the market is still under pressure, compounded by government crackdowns on "Daigou" sellers, who have historically purchased products abroad for resale in China.

Competition is another long-term risk, as Estee Lauder navigates a highly competitive beauty market. Key competitors include L'Oreal and Procter & Gamble, along with emerging players like e.l.f. Beauty.

Reasons to Consider Investing

Despite these challenges, there are compelling reasons to consider investing in Estee Lauder Companies. The beauty market is projected for steady growth, with estimates indicating a 5.52% increase in the global skincare market by 2028, as well as growth in makeup, fragrance, and hair care sectors.

Management has also expressed optimism regarding margin recovery, anticipating annual margin expansion greater than pre-pandemic levels. Their goal for operating margins in 2024 is between 12% and 12.5%, with long-term aspirations of reaching 20%.

Additionally, the "lipstick effect" suggests that during economic hardships, consumers tend to gravitate towards affordable luxury goods, which may bode well for Estee Lauder's performance in tougher economic climates.

Valuation Calculations

To determine the share price for Estee Lauder Companies, I utilize various calculations learned from a Phil Town seminar. The first is the Margin of Safety price, based on earnings per share (EPS), estimated growth, and future price-to-earnings ratios. Using a target EPS of 3.65, a growth rate of 8%, and a projected future P/E ratio of 16, the intrinsic value comes to $31.17. Applying a 50% margin of safety suggests a purchase target of $15.39.

The second method, Ten Cap pricing, assesses the return on investment. Due to fiscal 2023's unusual capital expenditures, I reference fiscal 2022's operating cash flow of 3,040 and capital expenditures of 1,040. After adjustments, the Ten Cap price calculated for 2022 is $113.49.

Lastly, the Payback Time price, based on free cash flow per share, indicates a price of $23.43 if one aims to recover their investment in eight years.