Temporary Travel Retail Woes Should Not Derail Estee Lauder’s Long-Term Beauty Prospects

Equity Analyst

Dan Su

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As a leading provider of premium beauty products, Estee Lauder has reinforced its competitive standing with category-leading brands in skin care, cosmetics, and fragrances, in addition to retaining a preferred vendor status across brick-and-mortar and digital channels. These attributes, coupled with scale-based cost advantages, should augur a long-term competitive edge that enables the firm to deliver excess returns for more than 20 years. As such, we believe Estee deserves a wide moat rating.

We see Estee as poised to benefit from premiumization trends, as beauty consumers in developed and emerging markets alike upgrade for perceived better-quality ingredients, efficacy, and service. Outside North America, we view Estee as particularly well-positioned in Asia (where skin care makes up 50% of premium beauty spending), thanks to highly regarded skin care brands (La Mer and Estee Lauder) and a newly opened innovation center and factory in the region that should enable it to deliver locally relevant products in a timely fashion. Further, we think its strategy to extend its brand reach is strong, given only half of Estee’s 20-plus brands are currently available in China, India, and Brazil. In addition, we expect Estee to dial up investments in digital channels and travel retail to complement its strong ties with brick-and-mortar retailers, in order to keep Estee’s brands top of mind for consumers and ensure its products are easily accessible as beauty users shop across channels. 

Despite our sanguine view on Estee, we see risks on the horizon. The premium pure-play is more exposed to macro cyclicality versus peer L’Oréal (50% in mass), as consumers tend to trade down or delay their higher ticket discretionary spending amid recession concerns. In addition, Estee may need some time to refresh its lackluster cosmetics portfolio (except for M.A.C. and Tom Ford), leaving the firm vulnerable to market share loss to rivals L’Oréal, Shiseido, and LVMH. Furthermore, a slower-than-expected recovery in travel retail from pandemic disruptions has created uncertainties in product planning and inventory management, but we anticipate growth in the channel will resume in time.

Business Strategy & Outlook

We believe Estee Lauder has carved out a wide economic moat, thanks to the strong brand equity and entrenched retail relations associated with its premium beauty products, in addition to cost advantages stemming from procurement, manufacturing, and marketing scale efficiencies. Its competitive edge is evident in returns on invested capital (including goodwill) that exceeded our 7.2% weighted average cost of capital estimate over the past 10 years, and we project excess investment returns to continue over the next 20 years. 

Estee Lauder’s intangible asset-driven moat is premised on the brand prowess the firm has cultivated around an impressive stable of top-selling prestige brands spanning skin care, color cosmetics, fragrance, and hair care categories over the past 75 years. Starting from its namesake Estee Lauder brand in 1958, the company has expanded its portfolio over the years to include 22 global brands such as La Mer, Clinique, Origins, M.A.C., Bobbi Brown, Jo Malone London, and Aveda. Exclusively targeting the premium segment (roughly 40% of the overall beauty market globally, according to Euromonitor), Estee has established a strong reputation for quality ingredients, product efficacy, and high-touch customer service, which enables the firm to maintain consumer loyalty and remain a fixture on the bestselling product lists across North America, Europe, and Asia. As such, Estee has held the number one market share position in premium color cosmetics globally over the past 10 years, with its share of 24% in 2022 ahead of L’Oreal at 17% and LVMH at 14%. We attribute its category-leading performance to the appeal of makeup artist brands M.A.C. and Bobbi Brown as well as Estee’s ability to parlay the core Estee Lauder and Clinique brands in the makeup category. Over the same period, the firm has maintained its number two position in premium skin care, with its 14% share in 2022 behind that of L’Oréal at 18%, but significantly ahead of third-place Shiseido at 7%. As premium fragrance and hair care are lower priorities historically, Estee’s market shares in the two categories are smaller, ranking sixth at 8% share in 2022 and fourth at 4%, respectively. L’Oréal topped both categories with market shares of 16% and 22%. 

We see structural factors in the $360 billion global beauty market as conducive to Estee’s brand equity. Driven by an ingrained human desire to look and feel better with the help of beauty products and rising purchasing power in emerging markets, consumers have been upgrading from mass to premium brands, spending $38 billion more in high-end offerings in 2022 compared with 2012, and driving the share of premium products of overall beauty purchases to 40% (up from 33% 10 years ago). Although beauty demand dipped during the pandemic, premium sales have rebounded strongly, sending 2022 combined revenue across skin, fragrance, makeup, and hair care 8% above the 2019 level. Riding on the secular tailwinds, premium beauty sales growth is forecast by Euromonitor to accelerate to 7% annually over the next five years (from 5% the past 10 years). 

We view Estee’s premium-only brand positioning as dovetailing well with the premiumization trend, enabling the firm to expand sales at 9% annually over the past five years (including the pandemic-driven correction in 2020). This is attributable to constant product innovation, such as skin-nourishing compounds developed in labs using fermented nutrient-rich algae and antioxidant extract. A steady stream of new products built on innovative and consumer-oriented components has enabled Estee to uphold its premium perception, generate buzz among its loyalty customers, and create opportunities to engage and introduce new users to the community. Just as important, the influx of eager shoppers upgrading to premium beauty has allowed Estee to bolster its brand profile with efficient marketing campaigns in its North American home market (26% of global premium skin care and makeup sales in 2022) as well as in the important Asia Pacific region (50%). Holding marketing and advertising expenses at a constant 23% of sales over the past five years, Estee managed to expand its share in the global premium skin care market by 300 basis points to 14% in 2022 and is one of only two companies to have gained share in the segment. Although Estee trails L’Oréal, as the latter grew share by 400 basis points to 18% over the same period, we’d note L’Oréal has a larger marketing budget (31% of sales) and more brands participating in the segment. That said, we don’t think the gap between Estee’s ad and marketing spending as a percentage of sales and that of L’Oréal is as wide as the reported numbers indicate. In fact, Estee also spends heavily on dedicated in-store beauty consultants (mid- to high-single-digits percentage of sales) to promote its brands and products, which we deem as serving a similar purpose to advertising and marketing, but such expenses are included in selling costs.

The pricing environment is favorable in beauty as well, as brand differentiation is largely based on perceived efficacy in key areas such as brightening and anti-aging, which underpins consumer loyalty and repeat purchase frequency. Risk aversion to new skin care and makeup products for fear of skin irritations further adds to the sticky relationship between users and their trusted beauty brands. As a result, private-label penetration is only in the low-single-digits for mass beauty and virtually non-existent in the premium segment, versus the mid-teens or low 20s common in the U.S. consumer goods sphere. While Estee has not disclosed retail-level pricing trends thus impeding our ability to gauge its pricing power, management has indicated that price elasticity is low for its core products (including Estee Lauder, La Mer, Clinique, and M.A.C.) and that demand tends to hold up following price increases. Quantitatively, we’d point to consistently high gross margins averaging 77% over the past five years as an indication of consumers’ willingness to pay a premium for the perceived quality attributes and social currencies associated with Estee’s prestige products. Moreover, we view the firm’s ability to hold gross margins relatively stable in the past three years despite persistent input and distribution cost inflation as a testament to Estee’s pricing power, as the firm was able to preserve its margins by passing on cost increases in price hikes. Using calendar year 2019 as the base of comparison, gross margins in calendar 2022 narrowed by 300 basis points to 74% (versus 77%), which indicates a contraction that is not immaterial at first glance. However, once we adjust for the unseasonably weak June 2022 quarter (with gross margins plunging to 71%) driven by lockdowns in China (a third of Estee sales) and high costs associated with the new factory construction in Japan throughout 2022, we estimate gross margins narrowed a much more moderate 110 basis point to 76% relative to 2019, comparable to the 60-basis-point gross margin contraction witnessed by L’Oréal during the same period. Anticipating continued solid growth in skin care, which should drive better fixed cost leverage in manufacturing and distribution, we expect this profitability metric to rebound to the high 70s level by 2027. 

From our vantage point, Estee’s agile and thoughtful channel strategies are instrumental to a close relationship with retail partners, helping to fortify Estee’s competitive position both in brick-and-mortar channels and on digital platforms. Thanks to its popular premium brands across key beauty categories, Estee has established itself as a key partner for premium retailers in the beauty aisle, leveraging in-store promotions, retailer-exclusive product release and gift with purchase, and advertising campaigns to drive store traffic and consumer purchases. Even with an accelerating channel mix shift to digital, we believe brick-and-mortar relationships remain important in providing in-person discovery and trial of beauty products for Estee to activate and maintain its relationships with consumers. In recent years, Estee had cut freestanding retail doors (by 10%-15%) and various department store counters to improve its brick-and-mortar productivity. At the same time, it has also selectively invested more in fostering closer relations with iconic luxury department stores (such as Harrods in London, Isetan in Tokyo, and SKP in Beijing) to uphold its prestige brand positioning and target doors and counters where shopper traffic and demand for high-touch, in-person beauty services remain strong. In addition, Estee has been astute in targeting travel retail as a valuable selling and marketing channel to tap emerging market consumers. The firm has invested, ahead of most beauty peers, in building relationships with leading duty-free operators including Dufry and DFS (owned by LVMH) in Europe as well as China Duty Free and Hotel Shilla in Asia, setting up eye-catching displays and counters in highly trafficked airports in London, Paris, Hong Kong, Singapore, and Seoul to make a favorable first impression on emerging market travelers oftentimes new to Estee’s premium offerings. The travel retail investments usually take place in tandem with the build-out of a distribution network and retail presence on the ground in key emerging markets such as China, enabling Estee to keep these consumers engaged with the brand. Estee’s strategic targeting in brick-and-mortar is complemented by stepped-up investments in digital and omnichannel capabilities over the past several years. These investments have bolstered the firm’s digital proficiency, enabling Estee to stay relevant in collaboration with retailers to deliver an integrated, personalized, and consistent shopping experience as consumers shop across channels and digital platforms. The 30% sales exposure to digital channels in 2022 (up from 13% in 2018 and higher than the 21% average in the beauty industry) speaks to Estee’s commitment to and strong execution of its digital transformation priorities. 

In addition to brand intangibles, we see a competitive cost structure as the second pillar to our wide economic moat rating. Given Estee’s position as a leading player in prestige beauty, we think the firm benefits from significant scale ($18 billion of sales exclusively in high-end offerings, comparable to premium sales at L’Oréal, on our estimate) in procurement (of ingredients and advertising), manufacturing, and distribution. In advertising and marketing, Estee’s $4 billion annual budget (23% of sales, comparable to the 25% average in our global beauty coverage) puts the firm among the top 30 advertisers globally in consumer-related products, affording the firm strong bargaining power relative to smaller peers in securing desirable time slots for broadcast media, coveted outdoor advertising locations, and endorsements from celebrities and internet influencers. In sourcing, as high-end beauty products increasingly differentiate based on natural ingredients, including supply constrained plant-based extracts that are favored by Asian consumers, the vast resources of Estee place the firm favorably (ahead of smaller competitors) in gaining access to such ingredients. Moreover, the scale and distribution bandwidth of Estee allows the firm to accelerate the commercialization process from budding lab concepts to on-trend end-market products, scaling innovation at a faster pace and a lower cost compared with smaller, startup rivals.

Quantitative evidence also supports our view that Estee benefits from cost advantages. We analyze direct operating costs in manufacturing and distribution (by removing discretionary spending such as advertising, research, and development, as well as non-cash costs including depreciation and amortization) and calculate direct operating margins to gauge Estee’s cost competitiveness relative to its global beauty peers under our coverage. Based on our estimate, at 47%, Estee enjoys the second-highest direct operating margin of all beauty names that we cover, behind only wide-moat L’Oréal (direct operating margin at 59%).

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.

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