Wide-Moat Estee Lauder Has Been Hit Hard by Slow Travel Retail, but Long-Term Growth Intact

Senior Equity Analyst

David Swartz

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We believe Estee Lauder has earned a wide moat, based on its valuable portfolio of global leading brands, its preferred status with its channel partners in department stores, specialty beauty outlets, travel retail locations, and a scale-based cost advantage.

Although the pandemic’s aftermath is presenting challenges for Estee and its peers, we remain optimistic about its competitive position and long-term strategy. Estee has made significant investments in omnichannel, marketing, and innovations that have helped the firm deal with inflation and supply chain disruptions. We also believe the firm’s growth opportunities should persist over the long term as emerging markets (a third of sales) still spend significantly less than developed markets on prestige beauty. Per Euromonitor, average annual per capita spend on prestige beauty in 2022 was $116 in the U.S., $104 in South Korea, $19 in China, $7 in Brazil, and less than $1 in India. Estee also has significant opportunity to expand its brands geographically. We think this opportunity is particularly pronounced in the context of its brand reach, as nearly all its 30 brands are sold in the U.S., but only approximately 17 have launched in China, 11 in India, and nine in Brazil.

Despite its solid competitive standing, Estee isn’t immune to headwinds. Even prior to COVID-19, Estee had been struggling with its large exposure to global department stores as the channel faces declining traffic from consumers shifting their purchases to other outlets. However, the firm has been proactively diversifying its channel reach, developing a strong presence in e-commerce (28% of sales) and specialty beauty. In the next few years, Estee will accelerate these efforts with the implementation of its post-COVID-19 business acceleration plan. This will result in the closure of 10%-15% of freestanding stores and some unproductive department store counters, elimination of 4.5% of jobs, and realigning of the distribution network, resulting in annual savings of about $400 million, a portion of which will be reinvested in e-commerce, omnichannel, and digital marketing capabilities.

Business Strategy & Outlook

We think Estee Lauder’s strong brand equities, entrenched relationships with its retail partners, and cost edge are all durable competitive advantages that result in a wide moat for the firm.

Estee Lauder is the second-largest player in the global premium beauty market per Euromonitor, with 12.6% market share for calendar 2022, behind L’Oréal’s 17.7% and ahead of LVMH Moët Hennessy Louis Vuitton's 7.4%. Premium beauty is the only market the firm participates in, unlike many of its beauty peers, which target both premium and mass markets. Estee Lauder has broad-based leadership across geographies and categories. The firm maintains the number-one or number-two spot in prestige beauty in 40 countries, according to the firm, including many of the largest markets, such as the U.S., China, the U.K., Hong Kong, Brazil, and India. The firm also has several brands that are top 10 global premium brands (as of 2022) according to Euromonitor, such as Estee Lauder (second in skincare, sixth in makeup), Clinique (fifth in both makeup and skincare), MAC (first in makeup), Aveda (seventh in haircare), and Jo Malone London (eighth in fragrance).

We believe that Estee Lauder’s portfolio of strong brands possesses pricing power. Management has specifically stated that inflation has not had a significant impact on its operations over the last several years, as the firm has been able to lift prices and introduce new, higher-priced products to offset any cost increases. Even in the highly inflationary environment during fiscal 2022, inflation did not meaningfully impair the firm's margins (although supply chain disruptions caused some inefficiencies). Furthermore, private label is essentially non-existent in premium beauty, which we think indicates that consumers are not as price sensitive, and brands play a more important role than price for purchasing decisions. 

The Morningstar Cosmetic Brand Strength Framework (adapted from the Morningstar CPG Manufacturers Brand Strength Framework) was constructed to assess the brand strength of the various companies in the cosmetics space. It evaluates each cosmetic firm’s pricing power, market share, the importance of safety/consumers risk aversion, protection from private label, and level of conspicuous consumption. It is our belief that the strongest brands have pricing power and high market share. We think they operate in categories where consumers are more risk averse to trying unfamiliar products, and categories that have a low level of private-label penetration. Finally, we believe strong brands tend to have a high level of conspicuous consumption, as consumers are less price sensitive for items that display wealth or social status. The framework rates Estee Lauder as having a high degree of brand strength overall, with high scores for pricing power, the importance of safety/consumers risk aversion, protection from private label, and the level of conspicuous consumption. Estee receives a moderate score for market share and does not carry a low rating for any metric.

We think that Estee Lauder’s significant investments and proficiency in both marketing and R&D have been essential contributors to the firm’s brand intangible assets. Over the past five fiscal years, Estee spent an average of 23% of revenue on advertising and promotion, ahead of the 19% global beauty average, and 1.5% on research and development, slightly lagging the 2.5% industry average. Although Estee’s average R&D investment is below the industry average, we believe this is mitigated by the effectiveness of those investments. As data and analytics capabilities have become increasingly available over the years, the firm now increasingly incorporates these insights into the development process, which has significantly improved the success rate of its product launches. New products are typically about 30% of sales, significantly higher than the mid-teens target generally considered to represent a successful innovation strategy in the CPG industry. And its products seem to continue to be popular with consumers throughout their life cycles, with Estee reporting strong repeat purchase rates. In the U.S., the firm’s top-selling brands realize 45% to 60% repurchase rates, which are 25% higher than typical prestige beauty benchmarks, according to the firm.

And we hold that Estee has excelled at marketing as well as R&D. The firm focuses its marketing investments on its best-selling “hero” products. We believe these investments are an important driver of the growth of these products, which boast 2 to 3 times the pace of gains as compared with the industry growth rate. Estee has also been quick to adapt its marketing investments to changing consumer habits. Today, about 75% of Estee’s marketing dollars are spent on digital, up from about 22% five years ago. Remarkably, the firm gathers 200,000 consumer data points every day on its brand.com sites, which stands to further improve its ability to target its consumer base. The firm is making good use of this data, by increasing the precision of its target marketing and in-market execution. For example, phrasing on digital ads is adapted to best resonate with a consumer of a given demographic group. For example, the print of a La Mer ad will read “Fresh & Flawless” for a Latina consumer, “Radiant Coverage, Healing Hydration” for an Asian shopper, and “Radiant in an Instant” for a millennial. Estee is also using its vast database to ensure each store location has a locally relevant product selection for the neighborhood in which it is based. For instance, Chicagoland has been converted from one designated market area to smaller neighborhoods using over 10 catchments, or areas with various demographic classifications.

We think Estee’s digital capabilities also helped to stabilize the business during the pandemic. The firm hosted over 1 million virtual makeup try-on sessions, expanded AI-driven product recommendations, hosted live streaming events with makeup artists and skin care experts, and offered video consultations. These tools drove higher conversion rates across the firm’s sites and led to larger average order values. Estee is also investing in omnichannel capabilities such as buy online-pickup in store and same-day delivery. We think these efforts will allow it to compete effectively in an evolving marketplace.

We hold that Estee’s status as a preferred vendor is another facet of its competitive moat. Before the pandemic, Estee’s largest channel was department stores, at 39% of sales (15% North American, 24% international), although this is down from 56% in 2009. As a global leader in prestige beauty, Estee is a very important partner for department stores. Clinique is the #1 premium beauty brand in the U.S. and remarkably, 25% of all beauty products purchased at no-moat Macy’s are a Clinique product. Although challenged at present, travel retail is another significant channel, which has reported compelling growth rates, increasing to 29% of 2021 company sales from 7% in 2009. Estee Lauder and wide-moat L’Oréal are essentially tied for the top spot, making both firms valuable partners. A third important channel for Estee is specialty-multi, specialty beauty stores that carry many different brands. The two most significant retailers in this channel are wide-moat LVMH’s Sephora (premium only) and narrow-moat Ulta Beauty (premium and mass). Estee’s 2016 acquisition of Too Faced makes the firm an even more important partner in this channel, as this makeup brand has significant exposure in specialty-multi. In addition to the firm’s dominance in global prestige beauty, Estee also adds value to its retail partners by periodically launching new products exclusively with a specific retailer, to drive excitement and traffic for the retailer and the brand.

We believe that Estee’s cost advantages also help to solidify its competitive edge. Given the firm’s position as the dominant player in prestige beauty, we think it is afforded scale-based advantages related to procurement, manufacturing, and logistics. One of Estee’s most significant expenses is advertising, and Estee is one of the world’s largest advertisers. As such, the firm should be able to procure the related products and services at a lower rate than its smaller peers. Furthermore, we believe its vast resources enable it to respond to evolving consumer trends more effectively, and to help it to recover more quickly and cost-effectively if it were to miss a trend. 

Estee Lauder has reported average ROIC including goodwill of 22% over the past 10 years, or 29% excluding goodwill, both of which are significantly higher than our 7% estimate of the firm’s cost of capital. In our view, this points to further evidence that the firm maintains a competitive advantage. Furthermore, the returns have been consistent, ranging from 17% to 25% including goodwill and 23% to 36% excluding goodwill, and we have confidence that it will be able to generate excess returns over the course of the next two decades.

Wide

Economic Moat

Estee Lauder

Aveda is a company founded by Horst Rechelbacher, now owned by Estée Lauder Companies, headquartered in the Minneapolis suburb of Blaine, Minnesota. Aveda manufactures skin and body care, cosmetics, perfume, hair color, hair care products, and trains students in cosmetology, massage and esthiology at the Aveda Institutes in Minneapolis, New York City, Des Moines, Washington, DC, Maryland, Vancouver, Calgary, Orlando, Denver, Toronto and many other cities.

Aveda

Clinique is an American manufacturer of skincare, cosmetics, toiletries and fragrances, usually sold in high end department stores. It is a subsidiary of the Estée Lauder Companies.

Clinique

The Estée Lauder Companies, Inc. engages in the manufacture of skin care, makeup, fragrance and hair care products. It sells products under the following brand names: Estée Lauder, Clinique, Origins, MAC, Bobbi Brown, La Mer, Jo Malone London, Aveda and Too Faced. Its channels consist of department stores, multi-brand retailers, upscale perfumeries and pharmacies, and prestige salons and spas. The company was founded by Estee Lauder and Joseph Lauder in 1946 and is headquartered in New York, NY.

Earnings data Q2 2023

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Shares of Estee Lauder continue to fall as the company continues to cut the guidance. The operational weakness is prolonged and severe, making me very cautious. Current performance does not provide fundamental support, and with shares still looking expensive based on 2022 peak earnings, I am very cautious.

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