The Estée Lauder Companies Inc. — Fiscal 2019 Second-Quarter 10-Q
Reporting period: Three and six months ended December 31, 2018; unaudited. The company manufactures and sells prestige beauty products across skin care, makeup, fragrance and hair care in more than 150 countries and territories.
Financial performance
| Metric | Three months ended Dec. 31 | Six months ended Dec. 31 |
|---|---|---|
| Net sales | $4.005 billion, up 7% reported and 9% in constant currency | $7.529 billion, up 7% reported and 9% in constant currency |
| Gross margin | 77.3%, down from 79.9% | 77.0%, down from 79.1% |
| Operating income | $771 million, up 9%; margin 19.3% versus 19.0% | $1.423 billion, up 11%; margin 18.9% versus 18.2% |
| Net earnings attributable to Estée Lauder | $573 million; diluted EPS $1.55 | $1.073 billion; diluted EPS $2.88 |
| Operating cash flow | $1.273 billion for six months, versus $1.439 billion |
Quarterly reported net earnings rose from $123 million and six-month earnings from $550 million in the prior-year periods. Those comparisons are heavily affected by large Tax Cuts and Jobs Act charges in the prior year. Adjusted diluted EPS, excluding specified items, was $1.74 for the quarter, up 14%, and $3.15 for six months, up 15%.
Cash and cash equivalents were $1.876 billion at December 31, 2018; short-term investments were $525 million. Current assets were $6.440 billion and current liabilities $3.776 billion. Total debt was $3.391 billion ($18 million current, $3.373 billion long-term), versus $3.544 billion at June 30, 2018. The company reported debt at 44% of total capitalization, compared with 43% at fiscal year-end.
Performance drivers and changes
- Skin care led category growth: quarterly sales increased 16% to $1.732 billion, supported by Estée Lauder and La Mer. Makeup sales rose 3% to $1.560 billion; fragrance fell 5% to $537 million; hair care rose 7% to $154 million.
- By region, quarterly sales increased 13% in Europe, the Middle East and Africa and 17% in Asia/Pacific, while the Americas declined 7%. China and Hong Kong, online sales and travel retail were important growth contributors. U.S. and U.K. retail softness weighed on results.
- Reported gross margin fell 2.6 percentage points in the quarter. Management attributed most of the decline to adoption of ASC 606 and hedge-accounting changes; product mix was favorable, partly offset by obsolescence, foreign exchange and manufacturing costs. Operating-expense ratio improved, helping lift reported operating margin.
- ASC 606 was adopted July 1, 2018 using the modified retrospective method; prior-year results were not restated. It reduced current-period reported sales by $67 million for the quarter and $134 million for six months, and operating income by $54 million and $85 million, respectively. The company recorded a $229 million after-tax reduction to opening retained earnings. These accounting changes limit direct period comparisons.
Outlook, management commentary and risks
- Management said sales momentum continued, supported by prestige skin care, China and Hong Kong, travel retail, product launches, digital marketing and expanded consumer reach. It did not provide a specific near-term sales or earnings forecast in this filing.
- The Leading Beauty Forward program is expected to generate annual pretax net benefits of $350 million to $450 million after full implementation. Estimated total pretax charges are $900 million to $950 million; cumulative charges recorded through December 31 were $632 million. The program is expected to reduce positions by approximately 1,800 to 2,000 overall and is planned to be completed through fiscal 2021.
- The company recorded $38 million of Smashbox impairments: $20 million for goodwill and $18 million for its trademark, citing increased competition and weaker-than-expected growth in key retail channels. Further impairment is possible if forecasts, distribution expansion or cost-reduction plans do not materialize.
- Key risks cited include competition; shifting shopping preferences and declining traffic in some U.S. and U.K. brick-and-mortar channels; macroeconomic, political and trade uncertainty, including Brexit and tariffs; foreign exchange and tourism; retailer consolidation, destocking and credit exposure; and execution of product launches, restructuring and technology initiatives.
- Operating cash flow declined year over year, primarily due to higher international inventory, accounts-receivable growth and lower accounts payable, partly offset by higher pretax earnings. Financing cash outflow included $1.126 billion of treasury-stock purchases and $297 million of dividends. Management said available cash, operating cash flow, investments, credit lines and market access should support planned needs.
- The company reported no material expected adverse effect from current legal proceedings; reasonably possible losses beyond recorded accruals were described as not material. It is reviewing certain advertising claims after testing did not meet company standards; management said this is not a product-safety or manufacturing-quality issue, did not expect a material impact and recorded no accrual.
Important facts for investors to verify
- Separate underlying growth from reported results: ASC 606 and hedge-accounting adoption affected sales, costs and margins, while prior-year tax charges materially distort GAAP earnings comparisons.
- Track whether Smashbox stabilizes and whether its remaining $120 million of goodwill and $59 million of trademark value remain supportable.
- Monitor Leading Beauty Forward’s remaining costs, timing and realization of projected annual savings.
- Assess working-capital trends and cash generation against substantial share repurchases, dividends and capital expenditures.
- Review exposure to U.S. and U.K. retail weakness, foreign exchange, travel retail demand and geopolitical or trade developments.