Final thoughts on Estée Lauder

After looking at the financial statements of global cosmetic maker Estée Lauder (EL), I was intrigued with what I saw...

In yesterday's e-mail, I dove into the company's financials in the wake of the big pullback in its stock recently. Overall, Estée Lauder has a strong brand and operates in a solid business – which is why the company still generates a lot of cash despite being totally mismanaged.

And as I also noted yesterday:

But if the main problem is just bad management – that can be fixed (and the company's new CEO might be a sign of good things to come).

As longtime readers know, I've made massive returns dozens of times in my career by investing in the beaten-down stocks of great companies that have been mismanaged but which bring in an effective new CEO – like McDonald's (MCD), Apple (AAPL), and Chipotle Mexican Grill (CMG).

The setup I see here so far with Estée Lauder warrants an even deeper dive...

So today, that's what I'll do. I'll conclude my analysis of the company by focusing on the "soft stuff" that can't easily be quantified: brand, management, etc. – and then make a better call about what I think of the stock right now...

I'd like to give readers like Nat B. more insight – as he wrote:

I've been buying the stock the whole way down, but have to say the multiples do not give me very much confidence.

EL trades at 69x forward earnings, 31x forward [earnings before interest and taxes ("EBIT")], 20x forward [free cash flow ("FCF")], and 1.8x forward sales.

Looking forward to your deeper dive!

My response to Nat is that you can't just look at trailing or next year's consensus estimate numbers because everyone knows that Estée Lauder is struggling and profits are down, which makes the multiples look high.

Sometimes, stocks are actually the cheapest and about to skyrocket when they look the most expensive because earnings are approaching zero. In fact, they might be losing money and therefore don't even have a price-to-earnings multiple!

So when you're looking at a turnaround situation, I'm not saying to completely ignore trailing and next 12-month earnings... but I am saying that you should focus far more on the earnings potential of the business – say, five years in the future because that's what will drive the stock price over that period.

With that in mind, we need to figure out if Estée Lauder's declining financials – revenue, net income, and FCF – reflect a permanent impairment of the business (in which case, it is indeed very expensive and likely has more room to fall) or temporary issues such a slowdown in China that, when they pass, will lead to a recovery in profits – and the stock.

When this happens, savvy investors who bought anywhere near the bottom can benefit from both rising earnings and a rising multiple. It's this combination that can lead to multi-bagger returns.

As background, I wrote yesterday:

To be blunt, the recent news at the company has been terrible:

• Family infighting (this recent Wall Street Journal article has the story: Before She Quit, Jane Lauder Called for Cousin's Ouster at Estée Lauder),
• Management turnover (a new CEO, as the company announced at the end of October in this press release), and
• A terrible earnings report on October 31 that crashed the stock by a staggering 21% that day.

For insights on what's going on in the marketplace and at the company – neither of which I consider myself an expert on – I was interested to hear perspectives from my readers...

As Betty M. wrote:

Hello, Whitney! I'm [an] 86-year-old woman living in a fairly wealthy area of Coastal California. "Back in the day" (1950's, 60's, 70's) when one walked into a large gathering there was always a mixture of strong perfume fragrances. Today the scents appear to be very light; almost nonexistent. Perhaps this has to do with the price of perfume vs. a cologne or, maybe, the younger generations just aren't into perfume any longer.

Centuries ago, women used lavender pouches in their clothing to cover up the lack of bathing, then perfume was the big thing for many, many decades. Today, most people who have access to daily baths or showers, using perfumed soaps, do not see the need to cover up body odor. Just my opinion!

This trend that Betty is observing obviously doesn't bode well for Estée Lauder, which relies on fragrances for 16% of its sales.

And M. Chen added:

EL's revenue problem is chiefly linked to the following:

1) A pandemic boom that then faded after reopening;
2) EL's failure to aggressively pursue influencers and celebrities' own labels; and
3) A big bet on China, where the economy has really slowed.

Meanwhile, Dave N. is even more bearish:

Estée Lauder's moat has deteriorated beyond repair. Today's high-end target female consumer has moved on to MAC, Sofia Cosmetics etc. And in my opinion a new management cannot fix the company.

To paraphrase the great [Warren] Buffett, when a management known for brilliance takes on a company with a history of poor economics, it is the company's reputation that remains intact. I am staying away.

Thank you, dear readers!

Looking at the whole picture, there are two reasons why I wouldn't be tempted to buy the stock at today's levels...

First, my gut – and it's not much more than that – is that Dave is right when he writes "Estée Lauder's moat has deteriorated beyond repair [and] a new management cannot fix the company."

Let me put it this way: until I had definitely ruled out Dave's assertion – for example, by doing extensive surveys of Estée Lauder's and its competitors' consumers – I wouldn't touch this stock.

Second, I think Nat is right that the stock isn't that cheap – and to buy the stock of a company with this much "hair" on it, it needs to be really cheap to compensate for the many risks.

As I noted above, in situations like this, I don't pay much attention to multiples of earnings/cash flows, but I do look at price-to-sales multiples. The chart below shows Estée Lauder's multiple of enterprise value (market cap plus net debt) divided by trailing-12-month sales going back to 1996:

We can see that Estée Lauder's multiple today is down to 2.3 times (Nat cites 1.8 times above, but he's using estimated future revenue).

While that might appear cheap to the peak three years ago of 8.4 times, I think this was a silly number – based on the easing-of-the-pandemic rally, excessive bullishness on China, and a general "quality bubble" that many blue-chip companies got caught up in, which I wrote about in my August 13 e-mail.

If we look at this multiple over nearly 30 years, we can see that it was around today's level for around five years from roughly 2012 to 2017, and was well below the current level for about a decade from roughly 2002 to 2012.

So I wouldn't put Estée Lauder on my list of stocks to avoid... But given the many issues and uncertainties, I would only consider buying the stock if I was convinced it was a 50-cent dollar – and I don't think it's anywhere close to that today.

Best regards,

Whitney

P.S. I welcome your feedback – send me an e-mail by clicking here.