Episode 3 - Stock Story: Estée Lauder

Sharpe Focus is a new podcast series featuring discussions with the Nuance Investment Team. We will be covering topics that we believe our partners will find insightful. Nuance is a boutique value manager that is 100% employee-owned.

The team focuses on buying leading business franchises with sustainable competitive positions that are trading at a discount to our internally derived fair value. We aim to outperform our primary and secondary benchmarks on an absolute and risk-adjusted basis, as measured by Sharpe ratio, over the long term.

In this episode, Portfolio Manager Adam West, CFA^®, joins Jenny McBee, CFA^® to highlight one of our October 2024 top holdings, Estée Lauder (EL).

The views expressed are those of Nuance Investments as of the date of this podcast and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as investment advice. To view the most current and standardized performance figures available click here for Nuance Mid Cap Value and here for Nuance Concentrated Value. To view the most current top holdings click here for Nuance Mid Cap Value and here or Nuance Concentrated Value.

Investing involves risk, including the possible loss of principal. For more information or a copy of our disclosure brochure, please contact client.services@nuanceinvestments.com. Past performance is not a guarantee of future results.

D. Adam West, CFA

Jenny McBee, CFA

[00:00] Jenny McBee 

Hi everyone, it’s Jenny McBee with Nuance Investments. I want to welcome you all to our latest episode of our podcast, Sharpe Focus with Nuance Investments. If you tuned into our first two episodes, we focused on opportunities that we were finding in the trucking and dental markets. 

Now in those cases, the sources of under earnings for the companies in our portfolio were causes affecting the entire industry, which is common at any given time. But at our core, we are still bottom-up stock pickers, and there will be times when company specific issues can lead to transitory under earnings. We’re seeing one such opportunity today with Estée Lauder (EL). 

So, on today’s episode, I have the pleasure of being joined by Adam West, Vice President and Portfolio Manager. Adam has been with Nuance now for 15 years and has covered the consumer and technology sectors over his career. Adam, welcome and thank you for joining me today.

[01:02] D. Adam West

Thanks, Jenny. Glad to be here.  

[01:04] Jenny McBee 

So, Estée Lauder (EL) is a company that I’m sure many listeners have some familiarity with. 

However, I was interested in learning kind of the full extent of their brands and their global reach. Can you set the stage for us today and tell us who Estée Lauder (EL) is?  

[01:20] D. Adam West

Yeah, Estée Lauder (EL) is a global leader in premium beauty products. They do skincare products, makeup and fragrances primarily. 

Everybody’s probably familiar with their flagship brand, Estée Lauder (EL), but they have several others that are pretty large, Clinique, La Mer, The Ordinary, MAC, Tom Ford. We think global beauty is a really attractive market. It typically grows much better than most consumer staples categories over time. 

It’s been seeing really good growth in emerging markets with rising income. Most of these are kind of discretionary products in nature and have better penetration in the U.S. and Europe than they do in a lot of international spots. But that’s seeing good growth over time. 

They’ve been a leader in the U.S. and Europe for a really long time, and they’ve gained a ton of market share in Asia over the past 15 years.  

[02:12] Jenny McBee 

So it sounds like they’ve been a leader for quite some time. Obviously, within our process, we put a heavy emphasis not only on the historical competitive position, but on the sustainability of it. 

So, do we think Estée Lauder (EL) will continue to be a leader going forward? 

[02:28] D. Adam West

Yeah, we do think it will remain a leader. We continuously monitor their market shares, though, and we’ll use several different sources for in-market data. And we’ll also talk to their peers and look at what their peers are reporting in terms of their sales. 

Really, there’s always going to be pockets of strength and weakness if you look at near term data, whether you’re looking at categories they compete in or different geographies. But we tend to emphasize longer term market share trends, and those have looked very sound for Estée Lauder (EL).  

[02:57] Jenny McBee 

So, once we’ve identified them as a leader in their space, we obviously wait for an opportunity to invest in them when there is some sort of transitory under-earnings. 

First, is Estée Lauder (EL) under-earning today? 

[03:09] D. Adam West

Yeah, I think they’re absolutely under-earning. If you look at their median returns on capital over time, they’ve been pretty close to 35 percent, much higher just two years ago. In 2022, the company was dramatically over-earning. 

Today, close to trough levels in the low 20 percent, and now under-earning pretty meaningfully versus what we think is the long-term opportunity. We also look at, you know, not just the company’s own history, but if you look at their peers, you can see that there’s a gap in their returns on capital that they have a pretty good opportunity to make up over time. The company earned $7.50 just in 2022. 

Consensus expects about $1.60 in the next year, and we think that normal earnings per share is closer to $5.25, so far higher than today’s level.  

[03:57] Jenny McBee 

Wow, that is significant. So, what’s causing some of this near-term uncertainty, and I guess, do we believe it is transitory?  

 [04:05] D. Adam West

Yeah, so the primary issues we’re seeing over the past couple of years, and what is the under-earning opportunity today, relate to the company’s exposure to China, and really what has happened is just kind of an inventory buildup in some of their customers. 

If you look back over the past 15 to 20 years, the business has grown meaningfully in Asia-Pacific region, and specifically in China. It was about 20 percent of sales in the mid-2000s, and it’s grown to be a much larger portion today. We see a couple of transitory issues now, primarily related to the inventory just being too high at the company’s customers. 

One is that travel retail is a primary sales outlet for the company. Travel retail or duty-free sales generally kind of skew toward premium-priced products due to the tax advantages, and this isn’t just Estée Lauder (EL) or China specifically. All of their peers have sales at travel retail outlets, and it leads to premium-priced beauty products, but also luxury apparel, electronics, sometimes premium spirits and wine. 

What had happened was the travel retail market in China had kind of developed a sort of gray market. These big purchasing groups were going into the travel retail outlets in Hainan, purchasing as much product as they were allowed to purchase, and then bringing it back to mainly in China to resell to customers. 

The Chinese government decided it wanted to crack down on that market. It had really just become a tax loophole that certain groups were profiting off of, and it had grown to be a pretty big market for Estée Lauder (EL) in particular. It had become about 15 percent of total sales just in travel retail in China, and what is happening now is that Estée Lauder (EL), along with all of its peers, had just over shipped into that end market. 

So when the demand in travel retail dried up because of these purchasing groups that are no longer allowed to do what they were doing, there was just too much inventory in that channel, and those customers didn’t need to order any more product from Estée Lauder (EL) or its peers.  

[06:16] Jenny McBee 

So, it seems like we’re hearing more about consumer weakness in China. How has that impacted their business, given they have a pretty decent exposure to China? 

[06:27] Adam West

Right. So, there have been a few issues there. This issue with China started with the travel retail issue that I just spoke about, but then the Chinese consumer started weakening more broadly. And this is not just beauty. 

You’re seeing it across things like apparel and luxury spirits as well. Estée Lauder (EL) had anticipated strong growth in China, including the travel retail market, and they had built out a supply chain and constructed a new manufacturing facility for what they thought was going to be close to double-digit growth in sales. It’s kind of a combination of poor timing and bad luck with the opening of the new manufacturing facility, but they had also just shipped too much product into that end market. 

So, now all outlets have too much inventory that needs to clear out before they can reorder more product from Estée Lauder (EL). What has happened is gross margin has declined dramatically as a result. It’s now several percentage points below the long-term median, and it hit trough levels last year. 

There’s really just too much inventory in the channels, and what it leads to is a lower level of manufacturing, and that leads to underutilization of overhead, leads to excess inventory that leads to obsolescence charges, and also it takes discounting from Estée Lauder (EL) to try and move some of the product that it has already manufactured. So really what we think needs to happen is that excess inventory needs to clear out. And once excess inventory clears out, the company can resume manufacturing and shipping toward the in-demand that’s actually going on in that market. 

And importantly, we show that Estée Lauder (EL) has not really lost market share with the in-consumer in China. It’s just the function of what their retail partners need to order. The company just shifts to a level of growth that hasn’t materialized in the near term, but retailers will need to begin ordering product again when that inventory clears out. 

[08:25] Jenny McBee 

Right. So, with more exposure to China than maybe some of their peers, how do you and the team think about just inherent risks with China? 

[08:35] D. Adam West

Yeah. So first of all, all of its peers are exposed to China in some way. 

It has become a meaningful growth market for beauty products in general. Estée Lauder (EL) just has slightly more exposure than companies like L’Oreal (OR.PA) or Beiersdorf (BDRFY) for Unilever (UL) or Procter & Gamble (PG). And its focus on premium products also kind of exposes it more to those travel retail issues than some of its peers. 

In terms of how we assess the risks in a market like China, we utilize all resources and estimates that we can find for in-market consumption, just focusing on the actual consumer. And we also look at what their peers are reporting. And by all accounts, Estée Lauder (EL) isn’t losing share with the end consumer in China. 

Their peers all mention the same dynamics, which is a shift from travel retail to traditional retail and generally a weakening consumer. But we also realize that there are risks in China due to the government. The government has power over spending regulations and general attitudes toward tariffs that create risks for us. 

What we’ve done is run some scenario analysis on the valuations of different geographies based on our level of normal earnings. And with the stock trading below $70, we think the market is ascribing essentially zero value to the Chinese business, if not negative. And we don’t believe those assets are worthless. 

And I think that they should generate normal returns over a long period of time. So, at the end of October, with the stock trading in the mid-60s, it was trading around 12 times our normalized earnings. We believe it should trade closer to 21 times, which is actually below what the company has traded in the past, but in line with some of the high-quality consumer staples companies. 

[10:18] Jenny McBee 

Clients will probably notice that we recently took Estée Lauder (EL) to a top-five position in the portfolio towards the end of October. Obviously, they had a very difficult earnings announcement. They cut their dividend. 

Did anything in this report actually concern you? 

[10:35] D. Adam West

So, the report didn’t really change our view of the company. And in these situations, what we do is first confirm the competitive position. Is there any reason to believe that the competitive position, the market share positions have changed or longer term are structurally disadvantaged in some way? In this case, the company’s commentary and the results were all in line with peers. 

Again, Estée Lauder (EL) just has relatively more exposure to China and those travel retail outlets. The inventory just needs to clear out to resume manufacturing and shipping at normal levels. After that, we check the returns on capital and confirm what we believe to be a transitory under-earning issue. 

That didn’t change with this report. Then we double check any changes to the balance sheet or capital allocation. The dividend cut really isn’t ideal, but we had actually identified that as a risk prior to the announcement, and it doesn’t really change our long-term fundamental valuation of the company. 

The valuation is based on the earning assets, in our opinion. The quarterly announcement obviously came as a surprise to a lot of investors. What we believe might be happening here is there’s been a change in management, the retirement of the prior CEO and the announcement of a new CEO that has been a president of the company. 

He’s worked very high up and close with the retiring CEO. So, they withdrew guidance and cut the dividend. I think that just gives the new management a clean slate and more flexibility going forward. 

In this case, we saw no reason to change our long-term view of Estée Lauder (EL), which is that it’s a leader within attractive categories, dramatically under-earning its long-term potential, relatively strong balance sheet. There are near-term challenges that have led to an attractive valuation. If you look back just a couple of years ago, the stock was trading at just north of $350. 

We thought it was over-earning and over-valued at the time, more than 60 times our normal earnings estimates. And for a long time, we believed this company was a solid market share leading business, but an expensive stock, so we didn’t own it. These recent challenges have given us an opportunity to invest in what we think is an exciting opportunity. 

And it’s a stock that is trading at a price it hasn’t traded at in more than a decade, and meaningfully below our fair value and our opinion.  

[12:59] Jenny McBee 

Well, thank you so much for joining me today, Adam, and walking us through what we believe, like you said, is a unique opportunity today in Estée Lauder (EL). And to our listeners, I want to thank you all for tuning in today, and we would welcome any feedback or follow-up you might have. 

Disclosure 

The views expressed are those of Nuance Investments as of the date of this presentation and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as investment advice. Past performance is not a guarantee of future results. 

Investing involves risk, including the possible loss of principal. For more information or a copy of our disclosure brochure, please contact client.services@nuanceInvestments.com