Estee Lauder Stock: Price Really Matters

Estee Lauder sells $15 billion worth of beauty products per year, with approximately half of the revenues coming from makeup and half coming from skin care. It has increased in value from $1,000 in 1946 to $58 billion today, for an annual compounding rate of 24.7%. You would have been better off finding Estee and Joseph Lauder a year after WWII ended and demanding that you could join them as an investor in their company than you’d have been finding Warren Buffett at any point in his life and demanding the same.

The reason why great fortunes can be made in the beauty sector is because the profit margins are extreme once a desirable brand is created. As you know, the purpose of a successful is that you can create pricing power for yourself to charge more for a chemical combination of elements X, Y, and Z because of the particular mindshare that you are able to evoke such that it’s not merely about the combination of ingredients, and this is especially true when human vanity is the driver of the buy impulse.

The financial side of the beauty industry is about spending a dollar to make $20. It’s similar to the sugary soda industry in that the highest expense is actually the bottle and the ingredients themselves are a mere fraction of the final retail price.

You better believe I regard Louis Vuitton as one of the twenty-five best businesses in the world. Have you looked at the ingredient costs for its $250 perfume? On a bulk/high volume basis, that perfume costs $3 to manufacture, plus $5 to transport,  and it sells it for 31x the cost. Putting that LV stamp on a bottle turns $8 to $250. No wonder Bernard Arnault is passing Warren Buffett in overall wealth.

Although its brands are not as strong as Louis Vuitton’s, it does own Estee Lauder, Clinique, Aramis, Prescriptives, Origins, M.A.C., Bobbi Brown essentials, Aveda, and Tommy Hilfiger fragrances and cosmetics. These brands are enormous cash-generating machines. In particular, the Tommy Hilfiger line of fragrances isn’t actually manufactured by Estee Lauder, but it licenses the brands out to several manufacturers for the right to use the brand in exchange for payment and certain quality assurance guarantees.

These strong-brand licensing agreements are the golden goose of investing because you get to collect cash every month without doing anything–no manufacturing, distribution, or retailing costs. The monthly payments are premised upon you allowing other manufacturers to borrow your intellectual property because they believe they can charge a higher price for a Tommy Hilfiger fragrance than a generic alternative.

This is my way of saying that Estee Lauder is an excellent long-term investment if purchased at the right price. The problem? The stock is trading at literally its highest valuation ever. It earns $5 per share in profits but trades at $161. That is 32x earnings for a business that traded at 18-22x earnings for all of the 1980s, 1990s, and early 2000s. The business model hasn’t changed substantially, and it is not a primary beneficiary of lower domestic tax rates as most of its sales occur abroad, but yet, the valuation continues to creep upwards.

This is only something that can occur when you have not seen a recession in a decade. In 2008-2009, Estee Lauder cut its prices by 35% and saw its profits fall in half. The valuation fell to 14x earnings. If the 2008-2009 recession were to repeat, the profits would fall to $2.50 per share and at a valuation of 14x earnings, the stock would trade at $35. For comparison, the stock fell from $27 to $9 during the actual 2008-2009 recession, but the starting valuation was only a little over 20x earnings so the amount of P/E contraction was not nearly as significant.

I am not making a prediction that Estee Lauder will fall to this level, but I am saying that this stock’s cyclical nature and high valuation make it particularly exposed to the doubly whammy of declining profits and a contracting P/E ratio if a recession were to strike. It’s on the short list of “excellent companies that could fall the hardest” if an adverse economy were to materialize.

Overall, I think Estee Lauder shareholders will do well over the super long-term. The core earnings power of the firm is set for 10% or greater earnings per share over a multi-decade holding period. But this is the worst time to get in on a great company. My medium-term view is that shareholder returns over the next five to ten years will significantly lag the earnings per share growth rate of the firm. And in a worst-case scenario? I think this stock could fall very hard, and some of it deservedly so due to its bloated valuation, when the next recession arrives. Cyclical stocks trading at lofty valuations ten years into an economic expansion rarely qualify as optimal candidates for investment.

Originally posted 2019-03-21 13:12:33.

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