Shares of Estee Lauder (NYSE:EL) have been a significant underperformer over the past year, losing nearly half of their value as its challenges in Asia have continued and Western consumers have pulled back on discretionary spending. I last covered Estee Lauder in May, reiterating shares as a “sell,” and since that recommendation, the stock has continued to struggle, losing 37% even as the market has rallied over 9%. I have been concerned that EL would see a very slow recovery, which was not factored into its valuation, given a ~30x forward P/E several months ago. Given how much shares have deflated, now is a good time to revisit EL.
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In the company’s fiscal fourth quarter reported on August 19th, Estee Lauder earned $0.64, beating consensus by $0.39. However, its forward guidance was very weak. Back in May, I saw no more than $4-4.25 in fiscal 2025 earnings growth given 0-4% organic growth. Instead, Estee Lauder expects to earn $2.78-$2.98 with sales down 1% to up 2%, as operating margins will be 11-11.5%.
Even the company in its press release described 2025 guidance as “disappointing.” It is struggling with a US consumer that is pulling back on discretionary spending as well as structural problems in its China business, pressures that appear set to continue. In fact alongside results in August, the company announced its CEO, Fabrizio Freda, would retire by the end of fiscal 2025.
The company has not announced a successor yet, which makes me believe EL is likely to look outside the company for new leadership, which may be a positive given sluggish sales in recent years. Still, this will be a long transition, leaving the company with “lame duck” leadership for a year. Announcing his retirement before a successor is appointed alongside these results speaks, in my view, to the Board’s justified frustration in Estee Lauder’s financial performance.
For the full year in fiscal 2024, organic net sales declined by 2%, though there was some sequential improvement. In Q4, EL had 8% of organic net sales growth. Skincare revenue was the standout with organic growth of 15% and sales of $2.03 billion. Makeup, fragrance, and fair care generated just 1% organic growth. Much of this growth was due to favorable comparisons in Europe and the Middle East, which grew by 32%. In the Americas, organic growth was down 5%. Asia was down 4% due to weakness in China, even as Japan and emerging markets are growing.
Recently this September, Estee Lauder reiterated it continues to see “softness” in China. Its products in this market are particularly dependent on travel activity, which continues to be sluggish. It is expecting further declines in China, given weak consumer sentiment in that country, amid ongoing sluggishness in the real estate market, which is a critical transmission mechanism to household wealth.
Chinese consumption has been weak, but it is also noteworthy that many iconic American brands, including General Motors (GM), Nike (NKE), Starbucks (SBUX), alongside Estee Lauder have reported significant challenges here. Even Tesla (TSLA) has seen increased pressure from local firms. Many Hollywood films are similarly earning a fraction of what they once did. There are likely several factors in play, which make me believe that this weakness may prove to be more structural.
First, US-China relations have deteriorated significantly over the past decade, as a growing Great Party rivalry builds. It is plausible in my view that increased geopolitical tensions is playing a role in souring Chinese consumers’ views towards US brands, weakening their relative market position. Additionally, President Xi has focused on developing domestic businesses, rather than being a purely export-driven economy.
This effort has coincided with China’s movement from a low-income to a middle-income country. In early stage emerging countries, it is natural for Western brands to be aspirational and highly sought after. However, as an economy develops, it will be able to build its iconic firms and brands, creating more natural competition to imported brands, even holding geopolitical tensions aside.
Given these factors, it is increasingly my view that the Chinese market is structurally different than even several years ago. As such, sales are likely permanently impaired relative to their prior trend. China is still growing, so EL can still grow here, but its market share is likely to face more persistent pressure, greatly limiting the recovery potential. Additionally, in my view, a further deterioration in US-China relations (particularly given Taiwan) is more likely in my view in coming years than a new era of rapprochement.
Because it expects weakness in China, the company is doing destocking in Q1, which will leader to weaker sales. In Q1, organic growth is expected to be down 3% to 5%. Organic growth is forecast to be down 1% to up 2% in 2025 with volumes likely flat to slightly down. It expects industry growth of 2-3% in 2025, due to strength in EM, offset by weakness in China and slower growth in the US. It expects to underperform the industry, given its China exposure. Additionally, North America has been difficult. While Estee Lauder expects to flip to growth in North America, growth will be muted. I see challenges here.
EL has faced “company-specific” challenges in the US, particularly due to slower traffic at department stores, which have also been aggressively controlling their inventory. As a result, it has been focusing more distribution through Amazon (AMZN). While this may boost sales, that is likely to lead to some pressure on margins in my view. More broadly, it has also faced a general slowdown in spending.
As you can see, the personal savings rate is down below 3%, well below pre-COVID levels, a reason we have seen a pullback in discretionary spending. Now with the Federal Reserve set to cut rates next week and strong home equity values, I do expect consumer spending to stay positive. A US recession is not my base case, but given the current level of spending, growth is likely to be tepid.
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Additionally, we have seen a full recovery in the travel and “going out” economy, with spending back to pre-COVID trends. There is not a reason to believe consumers are “under spending” on the activities associated with EL purchases, likely limiting growth. In fact, lower interest rates could shift consumer spending back towards debt-financed sectors, like housing, home improvement, and autos, creating more competition for spending dollars and weighing on EL’s growth.
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Given this backdrop, EL has taken action to focus spending, and it believes it is still on track for its $1.1-$1.4 billion cost cut plan, aiming to get half realized over the next year. As such, margins should expand about 100bps from its 10.2% margin in 2024. This is more tepid than originally hoped, due to the weaker macro backdrop. We are seeing some signs of this program taking effect with SG&A up just 1%.
EL is also carrying just $2.2 billion of inventory from $3 billion last year, and after Q1, it should have inventory in a health place. Its balance sheet also remains strong with $3.4 billion of cash and just $7.8 billion of debt. The business is also still cash generative with $1.4 billion of free cash flow last year. These factors mean its 3.1% dividend yield is secure.
Guiding to flattish organic growth in this environment is credible. There is not a clear reason to expect China and the US to decline, absent a recession, but also not a clear catalyst for acceleration. Having reduced inventories, throughput and contained SG&A, some modest margin expansion is also credible in my view. As such, I do see ~$2.90 in fiscal 2025 EPS as achievable.
With shares at $85, the stock is still nearly 30x earnings, which points to markets assuming a material recovery beyond 2025. Now, as benefits from its restructuring are fully ramped in, there could be an additional $0.90-$1.20 in EPS, pointing to longer-term EPS potential of about $4. Absent a meaningful acceleration in China, I struggle to formulate a case for much earnings power beyond that.
EL has an excellent balance sheet and valuable brands, which can support a higher multiple, but 20x is a full multiple for what is likely a low growth business, facing another difficult year. Shares are down 58% since I first covered EL, rating it a sell. While valuation is not cheap, it no longer is so high as to make it a clear sell. There is also the potential for the company under new leadership, to sell brands, focus operations, and repurchase stock. Finally, further deterioration in sales does not seem like the central case.
Not wanting to be “greedy” and stick with a trade beyond its expiration date, I am moving shares to a “hold.” I would not rush to buy the dip or call a bottom, but at about 20x run-rate earnings, EL is no longer a compelling sell and is more likely to trade flattish in my view. I would not rush to buy yet and can see shares staying the $80-$90 range for some time, but most of the losses have likely run their course.
