Don't Shy Away From This High PE Stock

Neha is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Estée Lauder (NYSE: EL) manufactures and markets prestige cosmetics and other beauty products, with a product portfolio of well-known company-owned brands (including Aramis, Aveda, Bobbi Brown, Clinique, Estée Lauder, La Mer, M•A•C, and Origins) and global fragrance and cosmetics licenses (including Coach, Tommy Hilfiger, Sean John, Donna Karan, and Michael Kors). The company’s sales are primarily concentrated in the skin care (42.2% of sales) and makeup (38.2% of sales) categories, but the company also competes in fragrances and hair care. The company is a pure-play prestige business, with little exposure to the mass market. Estée Lauder has significant exposure to international markets (62.5% of sales) and a small but growing exposure to developing and emerging (D&E) markets. The company has a deep and experienced management team that I view as one of the best among beauty and personal care companies. The team manages the business on a long-term basis and has demonstrated exceptional execution of its strategy since the 2008 recession.

The company is going strong in China, a region that other skin care companies have had great difficulty in penetrating due to large barriers to entry. For instance, in order to enter the Chinese market, cosmetics companies are required to apply for and obtain a hygiene license for special use cosmetics or record-keeping certificate for ordinary use cosmetics from the SFDA. Moreover, the men's skin market is expanding swiftly in China (it has already surpassed North America) and is expected to grow at 29% annually through 2014 (compared to North America at 5.7% and Europe at 7.9%). With a rapidly emerging middle-class, Estee Lauder is set to reap significant rewards going forward.

Estee continues to capitalize on the secular growth of prestige beauty despite macroeconomic weakness in some of its core regions. Prestige continues to outgrow mass, and Estee continues to outgrow prestige beauty, guiding FY13 revenue growth to 6%-8%, or 2x the category growth rate. From a valuation standpoint, Estee might look expensive at first when compared to its peers like Avon Products (NYSE: AVP) and Tupperware Brands (NYSE: TUP). However, the company also has best-in-class expected growth rate to support its premium valuation. Estee Lauder holds a competitive edge over Avon and Tupperware in key emerging markets like China. Moreover, Estee Lauder has a more stable revenue base as its products are generally sold through departmental stores, whereas both Avon and Tupperware are largely dependent on their representatives. Let’s look at the profit margins of these three companies.

<table> <tbody> <tr> <td> <p>Company</p> </td> <td> <p>Avon</p> </td> <td> <p>Tupperware</p> </td> <td> <p>Estee Lauder</p> </td> </tr> <tr> <td> <p>Profit Margin (ttm)</p> </td> <td> <p>-0.40%</p> </td> <td> <p>7.47%</p> </td> <td> <p>9.30%</p> </td> </tr> <tr> <td> <p>Operating Margin (ttm)</p> </td> <td> <p>6.46%</p> </td> <td> <p>15.40%</p> </td> <td> <p>15.03%</p> </td> </tr> </tbody> </table>

We can see that Estee Lauder has the best-in-class profit margin. Tupperware also has a decent profit margin of 7.47%, while Avon's already-thin profit margins have declined more than 25% in the past two years. I think the investors should clearly stay away from Avon, as the company has seen a 1% drop in its revenues in the recent quarter, and a consistent level of earnings growth does not look sustainable.

Going forward, Estee Lauder's organic sales growth might moderate in the next few years from unsustainable recession-recovery growth rates, but should still progress at mid to high single digits as management strategically invests in the fastest-growing parts of the beauty industry: the travel retail channel and D&E markets, including China and Brazil. D&E markets (currently about 15% of sales) should provide sales growth opportunities through brand whitespace expansion, tailoring products to local markets, and ongoing strong market growth, driven by new consumers becoming more affluent. Moreover, I see substantial operating margin expansion opportunities with the ongoing implementation of management’s strategic modernization initiative (SMI), a shift toward higher-margin categories, and sales leverage through overhead controls, among other projects.

The company also exhibits recession-proof characteristics. Estee Lauder's Chairman, Leonard Lauder, identified the Lipstick index (sales across the Estee Lauder family of brands) and used it to describe the sales of cosmetics products during the recession of early 2000s. What he noticed is that the company’s sales are inversely proportional to the overall state of the economy. One possible reason behind this observation can be that women substitute expensive purchases for lipstick in times of economic stress. Thus, the company looks relatively immune to the overall macro environment.

To sum up, I consider Estee Lauder to be a terrific long-term growth story, given its potential to both expand its profit margins and drive strong revenue growth. Moreover, strong free cash flow should provide the opportunity for additional dividend increases, modest share repurchases, and the opportunity for new license agreements or strategic acquisitions. Therefore, I rate it as a buy.


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