The Estée Lauder Companies Inc. (EL) Q2 2011 Earnings Report, Transcript and Summary

Good day, everyone, and welcome to the Estée Lauder Companies Fiscal 2011 Second Quarter Conference Call. [Operator Instructions] For opening remarks and introductions, I would like to turn the call over to the Vice President of Investor Relations, Mr. Dennis D'Andrea. Please go ahead, sir.

Good morning, everyone. On today's call are Fabrizio Freda, President and Chief Executive Officer; and Rick Kunes, Executive Vice President and Chief Financial Officer. Also on our call today is Veronique Gabai-Pinsky, Global Brand President of Aramis and Designer Fragrances, BeautyBank and IdeaBank. Veronique will discuss strategic progress in our ADF division. Since many of our remarks today contain forward-looking statements, let me refer you to our press release and our reports filed with the SEC, where you'll find factors that could cause actual results to differ materially from these forward-looking statements. We will also discuss certain of our results in non-GAAP financial terms. You can find a reconciliation between GAAP and non-GAAP figures in our press release and in the Investors section of our website. And I'll turn the call over to Fabrizio.

Good morning. I am pleased you have joined us for our fiscal 2011 second quarter conference call. Once again, our company had an exceptional quarter. Sales grew 11% to $2.5 billion, diluted earnings per share were $1.77, up 38% versus a year ago. Both these results are before restructuring charges. This record second quarter performance was widespread across categories, regions and brands. Virtually all product categories posted higher sales in every region. And our largest brands: Estée Lauder, Clinique, M-A-C, Aramis and Designer Fragrances showed global double-digit growth in local currency and led the robust sales increase. Our results reflect success on many levels, including notable launches effective of the styling and marketing strategies, improvements to our high-touch service model and compelling holiday offering. Based on our better-than-expected performance during the first half of this year, thanks to strong sales, a weak dollar and improved cost control, we are comfortable raising our guidance for fiscal 2011 again. We now estimate a range of $3.40 to $3.60 per share, an increase of $0.50. I want to remind you that we are now 1 1/2 years into our four-year strategy. We have made substantial progress in every quarter, bringing us closer to our financial operating goals. We remain confident in our continuing ability to execute our plans and as a result, we are raising our fiscal 2013 operating margin target range by another 50 basis point to 13% to 14%. We will continue to evaluate our margin targets as appropriate. After fiscal 2013, we will implement the next stage of our strategic journey. Our main mission and motivation is to reinforce our focus and our leadership in global prestige beauty. We measure our progress by growing faster than average prestige beauty sales, which is a key strategic objective. In the recent quarter,…

Thank you, Fabrizio, and good morning, everyone. First, I will give you a little background on myself and the Aramis and Designer Fragrance group and then I will outline our strategy that is turning the division around. I've spent the past 20 years in the Beauty business, including more than a decade in senior positions at L'Oreal; Guerlain, a division of LVMH; and Symrise, a fragrance house. I have been with Aramis and Designer Fragrances for seven years, the last four as President, and recently added BeautyBank and IdeaBank to my responsibilities. The Aramis and Designer Fragrance division or ADS makes up more than 40% of the companies' Fragrance business and is comprised of nine brands. Though the Donna Karan and Tommy Hilfiger fragrances drive much of the volume globally, our other brands including Michael Kors, Coach, Sean Jean, Missoni and Aramis are important to our success in their regions of strengths where we intend to build them to their full potential. I am happy to share with you the journey we have taken to evolve our Fragrance model to one that we believe is more competitive, profitable and sustainable. You can see some of the rewards of this work in the greatly improved Fragrance results we reported today and over the past year. As you know, the Fragrance industry has been challenged and we have not been immune. Global prestige fragrances have grown less than 1% over the past three years and the U.S. prestige Fragrance industry declined mid-single digits. Historically, ADS delivered below-average profitability compared to both the company and the industry. Beginning two and a half years ago, we formed our Fragrance task force and carefully evaluated the reasons for the underperformance. The most important reasons were: higher-than-average cost of goods; a fragmented portfolio with no clear…

Thank you, Veronique, and good morning, everyone. As you know, my discussions on the quarter and the outlook exclude restructuring and special charges. We had another outstanding quarter, driven by broad-based growth across our regions and categories. Sales rose 11% to $2.49 billion. Net earnings for the quarter rose 39% to $355.8 million, compared with $256 million in the prior year quarter. And diluted EPS was $1.77 compared to $1.28 last year. Sales growth was about four points higher than the top end of our guidance. About two points of the upside was due to a weaker U.S. dollar than we had forecast, and another two points came from stronger overall holiday business. Our cost of goods margin and operating expenses came in about where we expected, allowing us to leverage the incremental sales with the majority of the benefit dropping to the bottom line. Most of our major categories saw robust gains. Compared to last year, we saw the fastest growth in the strategically important Skin Care category. Sales rose 14% in local currency with improvements in every region led by Europe, the Middle East and Africa. Strong innovation at Estée Lauder and Clinique and solid growth at La Mer were the largest contributors to the category. In Makeup, local currency sales rose 9%, driven by our M-A-C and Bobbi Brown brands and the addition of Smashbox. This was partially offset by the discontinuation of Prescriptives in department stores. The category grew in all regions, with particular strength in Asia/Pacific. Our Fragrance business grew 13%, excluding currency. The category grew double digits in the Americas and Europe, helped by recent launches and good holiday sell-through. In Hair Care, sales rose 2% as gains at Aveda were mostly offset by soft results at Ojon. On a geographic basis, Europe, the…

[Operator Instructions] Our first question today comes from Alice Longley with Buckingham Research.

You never said anything about the weather in the March quarter, which has been pretty grim here in the U.S. Have you factored that into your guidance? And could you give us a little sense of what the sales growth will be in the Americas in the third quarter as is in your guidance now?

So, I think that we did indicate in the third quarter and for the second half of the year, that we did not anticipate really quite the robust results that we've seen in the Americas region that we have to date. So we do anticipate a little bit of a slowdown because we think that the continuing high level of unemployment is going to have some impact on our business here in the U.S. Regarding weather, specifically, it's built into our numbers, yes. But you know, the weather is several days out of a three-month period. So let's see what the impact is but it may not be quite as significant as you might think.

Travel Retail, can you give us an update on what percentage of sales in Travel Retail is now, is it up to 10% of your sales? And are the margins on that business still around 3x your corporate average?

It's 9% -- a little bit over 9% of our business and its margins are -- it contributes more than 20% of our profits. So it's an important piece of business for us, certainly.

Your next question comes from the line of Caroline Levy with CLSA. Caroline Levy - Credit Agricole Securities (USA) Inc.: I wonder if you could talk about new product introductions in China and whether there's any progress on that and whether that, in any way, hindered your sales growth. I know it was strong. So any sense you could give us about that China business.

Yes, this is Fabrizio. In China, we are making progress on the registration front because with a lot of work and a lot of diligent amount of research, we are able to respond to the new requirement for reregistration of existing products. So we are working at progressing there. In term of the ability to register new ingredients in China for the moment, the industry has not been really reopened to the right process. We are actively working on this and we hope that in the short time, this will be reopened. However, we are not waiting for that. Because first of all, there many of our product launches which do not assume new ingredients so they can be operated. And second, we have some amazing products and SKUs on many brands that still have relatively low level of awareness and trial, so we are focusing on bringing our best product to the maximum potential in this environment where we need to delay or postpone some of the global launches. Caroline Levy - Credit Agricole Securities (USA) Inc.: And then if I might on Makeup. If you could talk about anything you're doing on the Estée Lauder or Clinique brands on Makeup that could accelerate growth for those two.

On both of these brands, there are two aspects on Makeup that we are doing. First of all, our Makeup innovation pipeline is going to be stronger and stronger in the next 12, 18 months. We have some very exciting innovations, both on the side of Estée Lauder and on the side of Clinique. At the same time, both brand are improving their High-Touch service environment, with special focus also on the Makeup experience. For example, in my remarks, I'd underlined the importance of to what we call the foundations room of the Estée Lauder brand. There will be a testing in department store in the U.S. where consumers can get the perfect match of their foundation based on perfect lighting that we had elaborated with a big light producer around the world. So both innovation and services.

Your next question comes from the line of Chris Ferrara with Bank of America Merrill Lynch.

I guess, the 2013 operating margin target that you just rated to, it seems like it would suggest, since it looks like you're probably going to do 13 in fiscal '11. I guess it suggests either -- I guess an acceleration in the reinvestment rate or maybe diminishing returns on those investments. And based on the results that we're seeing so far, that just doesn't seem likely, so can you just kind of shed a little bit of light on why the margin expansion would slow, given what you're seeing in strength on the top line? I mean, even with a slight deceleration in top line, it just seems unrealistic.

Yes, let me tell you basically, this is -- we are trying to balance in this moment growth and we are trying to get the right flexibility for investment in our biggest opportunity. In this moment we have two big phenomena there. First of all, we want to add the flexibility of reinvesting on what's working in our profitable brands and to grow their overall market share. And second point, we are gaining substantial market share in emerging markets behind investment and we are learning how to do that. Now my point of view is, much better to grow market share in emerging markets in a moment they are emerging, meaning when there is strong growth and there is not yet a finally formed competitive environment then they've been late in market share growth and then having to fight for market share when the markets are completely established. So we plan to continue accelerate our penetration in the emerging markets and we assume to have the flexibility of investment for that, which is not necessarily as you said, investment which had lower return, it's just the investment which are a bit more uploaded upfront in term of market share dynamic and build up. The second point of this concept of balance is that frankly, in the last two quarters particularly this last quarter, we are really hitting on all cylinders. And we cannot assume that we will continue hitting to every second cylinder in every moment in the next two years. Let me just make you the point, what are those cylinders? First of all, internal cylinders. Our innovation globally is working fantastically. U.S. department store holidays was better than expected. Our more investment in advertising and less investment in promotion that we committed to is working and frankly, was…

Your next question comes from the line of Linda Bolton Weiser with Caris. Linda Weiser - Caris & Company: Can you just remind us what percent roughly of your business is Japan? And also can you comment on the slowing of growth in Korea, that's an important market and I think you said it was up only 4%? And also finally, can you comment on -- you alluded to growth objectives and initiatives in Brazil, and L'Oreal is also eyeing that market as a big opportunity for growth, can you just comment on how you think you're going to be successful there? And maybe how you're approaching it differently or maybe similarly to L'Oreal?

I'll start from the second question and I will look with the sort of specific one for the first one. On Brazil, Brazil is going to be an important market for us. As you know, Brazil is a market which is pretty well-developed. It's one of the biggest beauty market of the globally developing mass and not in prestige. So our challenge is very different from the one on L'Oreal. L'Oreal is also a mass focus. A mass division. We don't. We are 100% focused on prestige and luxury and this assumed that in Brazil, we'll need to help building the distribution channel that allow the distribution of prestige. And particularly, being able to create a prestige market value equation despite the barriers to entry to the market there. So it's going to be a step-by-step approach, gradual focus on prestige and will include development of free-standing stores as one of the channels that will help Brazil creating a luxury market.

And then regarding Japan, it's between 4% and 5% of our global sales is in Japan. And the Korea growth rate of 4%. Korea as a market is really sensitive to movement in their exchange rate versus the U.S. dollar. And we see a shifting of business between the domestic market and the Travel Retail market. And if you've been to Korea, you'll understand that they're -- in Seoul in particular, they're very integrated there. The stores are right next to each other essentially and shoppers move based on exchange rate movements. They shop between the Travel Retail channel and/or the local market channel. And we really look at Korea as a business on a combined basis, if you will, like how is our sales going through both of those channels and our business is pretty healthy.

Your next question comes from the line of Wendy Nicholson with Citi Investments Research.

My question goes back to the discussion of the long-term margin target and -- two questions, specifically. Number one, SAP, can you update us in terms of what you're expecting in terms of cost savings and whether that is reflected in the outlook for 13% to 14% operating margin? And then second, can you give us a little bit more color on China specifically, sort of just as a model for those emerging markets, Fabrizio, where you said you want to be first as opposed to last. How much money are you making on the bottom line in China right now? And do you think that margin goes down before it goes up? Because I would imagine that at the growth rate you're putting up there, at some point there's favorable operating leverage and that margin ought to go up. So I'm surprised emerging markets are going to cost so much more relative to what they're costing today.

Wendy, let me start on the second part of the question. You are absolutely right that on China, specifically, that business model we are working on is a business model where the growing margin, meaning the margin after the strong pieces of investment is going to be accretive to the average of the company and not dilute it. It's been designed on purpose to make sure that the future growth of what we believe will be the biggest market of the globe in 2020, 2025, will always be for this company an accretive to margin. However, that is not an easy task but that's the goal. To arrive to this goal at what we call the growing margin, meaning after -- and we will decide when we are ready to get there, we are ready to invest in the years in various areas. We are investing obviously in advertising our main brands to create the right awareness. We are investing into accelerating our distribution particularly in secondary cities around China. We are investing creating new capabilities. Even we have recently launched internally an evolution of our strategy where we want to build really our second home, that's the way we define it, in China. Which has implication in term of our organization capability, the amount of local talent we'd hire, we distribute in the company globally, how seriously we take the relationship with the future of China and how much we invest in research, you probably are already aware that we are creating a research center. We have created. We are increasing a research center in Shanghai. We are looking also to many other areas to further enhance our ability to work digitally in China, etc. So it's a combination of big investment in capability, advertising, introducing new brands and increasing distribution that in the short time, will make China still profitable but obviously will require investments. While in the going, the results of all these will be accounted, hopefully will be accretive to the total margin of the company. And I'll let Rick answer the first of your questions.

So Wendy, for SAP, we talked about the majority of our locations being up and running by the fiscal '12 to '13 timeframe. So when we talk about benefits for SAP, quite honestly, right now we're in investment mode. And most of those benefits become enabled as we get the majority of our locations, if not all of our locations up and running on SAP. The benefits that we see coming from SAP are really one of the legs that gets us beyond our fiscal '13 operating margin target. So that is really something beyond that's really going to support our continued growth and improvement in profitability. The things that it does for us, obviously, better supply chain management will improve our gross margin. Better inventory management, it also is a big supporter of our indirect procurement organization, which we're building out now but it really will enhance the information that they have to work with. And also, it helps, quite honestly, support the organizational changes that we have in place because it will give them better information faster and help them make better business decisions. So most of the benefit is to come from SAP and most of it, quite honestly, falls outside of our current strategic planning timeframe which takes us through fiscal 2013.

Your next question comes from the line of Bill Schmitz with Deutsche Bank.

A couple of quick questions. Can you just -- the fixed cost percentage of sales I know it used to be around 60%, 65%. Is that number still the same? And do you envision that coming down over the next two or three years?

The number is roughly around that area, Bill. And one of the things that we're doing, quite honestly, very well right now is leveraging incremental sales growth and really keeping a close eye on that fixed expenditure, if you will. So we've got things in place like productivity, headcount and other measures that are really allowing us to leverage this great sales growth that we have and give us a lot of resources to invest more in some of the key business drivers, advertising, merchandising and sampling, and also improve our profitability. So it is roughly in that 60% area and there's fixed and there’s semi-fixed and there's lots of things that can get in there but that's a good benchmark.

Will that come down over time?

It will come down certainly as our sales grow faster, absolutely, because we're leveraging that fixed cost.

Lastly, just in terms of the Gift-With-Purchase and the purse with purchase, I mean, is it fair to say that a lot more sales this quarter were out at full price? And I guess, the longer-term question is, do you think the issue is finally off this, like, heroin of discounted sales, because I really don't need it. I think, you guys kind of proved that in the holiday season. But are your competitors falling in line on that the new sort of sea change in the industry?

Yes, Bill, this is Fabrizio. Yes, we are purposely diminishing the level of promotion and switching the money or the investment from short-term promotion to initiatives support and equity building, and this is working. So not only we are increasing the total ANP level, which includes promotion, this one is going up as a line, it's going up thanks to converting to more ANP support in all the savings that we have in cost of goods in many other areas. But then, within the ANP line, we are furthering the improving the mix, switching more money in pool activities like print advertising, television advertising, digital advertising and less money into promotions and other minor activity in stores that were less efficient in building the long term. This is one of the biggest move that we are making and I think a lot of the results are coming from that. The -- if competition is follow [ph] (1:07:00) probably is a mixed picture There are a couple of luxury competitors which are taking, in my opinion, for what I can see, a similar approach. But I would say that the majority of the competition is not following this kind of direction. Rick, you wants to add a point?

Yes, I was just going to mention, Bill, that regarding our gifts as a percentage of sales, we're about 30 basis points lower than year-over-year. So Fabrizio's point, we're pulling money out of that pure promotional area and investing it in things that we think are much more beneficial over the long term.

Your next question comes from the line of Andrew Sawyer with Goldman Sachs.

Fabrizio, I think when you talked about your long-term margin target historically, you'd alluded to the desire to get the U.S. department store business stabilized before you ratchet that up further. Do you feel more comfortable about the multi-year prospects for the Department Store business? And maybe you can touch a little bit on how some of these new initiatives you have are working in terms of modernizing the format.

Yes. We feel more comfortable with the direction but I don't think the work is finished. It's just the beginning of a long journey. What we are doing together with our retail partners is basically creating a model where our biggest brands concentrate their advertising effort on big new winning initiatives, the example is Clinique Even Better Dark Spot. This advertising brings, because of this great brand is the new initiative in print, television, digital advertising, all in concept, focus is on one big idea. The result of this is that this brings many new users, a new consumer into the department store door to get to the Clinique counter, in my example, and then at the counter, with the service that we are creating, sell more than one product because can bring the consumer into a regimen of use, that it doesn't sell only the single product advertised. Plus, thanks to CRM and other activity create more loyalty and obviously continue to sell the overall equity of the brand and the full experience of the brand. This is, I believe, the right model for prestige, which is very competitive as of the alternative model of mass, and consumer seems to like this model. And importantly, this model brings to the retailers in your question to department store in the U.S., more traffic. And we have the number. Our Clinique Even Better Clinical have been bringing you traffic of people that before were not entering those department stores, to department stores, thanks to this new model. So we are contributing with this new model and second, we are contributing including the overall services of the beauty floor of department stores with our brands, which as you know are a big percentage of this growth. I think the number I quoted in my prepared remarks, which today in Skin Care, we are 21 out of the 25 top SKUs in U.S. department store. It's clear and consumers are voting. They prefer our products and our service. And in this way, I think we can get a big contribution. Said this, obviously department store will need to continue to do their part in creating the right level of traffic and the right level of new modern shopping experience, which is needed to conquer the young people of the future. But we are optimistic.

Just a quick one for Rick, could you give us some color on the amount of buybacks you're still looking for this year?

Sure. Our strategy for cash has always been the same, invest in our business and I think we're doing a nice job at that. Make acquisitions, we acquired Smashbox this year and then return excess cash to shareholders. Our total shareholder return for the last 18 months is about 150%. We increased our dividend about 38% after our annual meeting. And we continue to see both dividends and share repurchases as options to return excess cash to shareholders. I think over the last 18 months, we purchased around 7 million shares back. We're a little bit slower in the second quarter, admittedly, but we intend to continue that for the balance of the year and we have, I think, 15 million approximately shares still outstanding in our share repurchase authorized by the Board of Directors. And so we'll continue the activity in the balance of the year.

Your next question comes from the line of Ali Dibadj with Sanford C. Bernstein and Co.

Two questions. The first one is around Travel Retail, given that it continues to be so important to your business. I mean 45-ish percent of growth, 8% to 9% of sales, so it really contributed, call it 3.5, four points to top line growth and maybe seven to eight points to the bottom line. And you mentioned it as one of the risks going forward, generally it's done very well so far. To help us dimensionalize the risk, could you talk a little bit about how that just aggregates, how that business just aggregates, in fact the growth just aggregates by region, I guess, location of transaction by region? And then also, new doors versus kind of same-store sales?

Let me explain to you what's happening in Travel Retail. First of all, Travel Retail is growing, as I've explained, there are three big dynamics: The first dynamic is, there is more people traveling. And in this dynamic I want to underline the majority of the new travelers have an origin in Asia and they are actually Chinese. And the numbers say that in this year, Chinese traveling have been reached 40 million and they assume to be 90 million in the next three, four years. So this obviously, the Chinese traveling is the biggest source of Travel Retail, which brings me back to what I was explaining before based on Wendy question, that the importance of us winning in China and investing upfront and creating amazing desirability in China, has a double implication is obviously the margin in China but also the results in Travel Retail. Because in this moment, Travel Retail growth is heavily influenced by the brands which have a strong image with Chinese consumers in China. So we, in our strategy are linking those two elements so far very successful. The second point is that we are improving our marketing and advertising activities within Travel Retail to improve conversion of the traffic into shoppers. Only 10% of the people entering in airport shops. If this can become 12% or 13%, this percent is already a big increase on demand. In this way, we are also increasing advertising in airports or services at Travel Retail in airports, et cetera, and many other marketing tools. The third is that we are gaining market share in the fastest-growing categories within Travel Retail. Travel Retail historically has been composed by 50% of Fragrances and the remaining 50%, Skin Care, Makeup and a very little bit of Hair Care. In reality, we are taking a very strong direction in winning big in Skin Care and Makeup in Asia where Travel Retail is actually more directed by Skin Care and Makeup than the average globally, while finding the right balance between Makeup and Skin Care, and the important category of Fragrances in regions like Latin America or Europe or North America. And in this way, combined, we are having a solid performance in Fragrance, but we are having a skyrocket performance in Skin Care and Makeup mainly in Asia. Finally, you asked about how this is by region, I would say Asia is the fastest growing, but Europe is still the biggest and Latin America is also growing very, very fast. That's the current status.

And then Ali, one last point, we mentioned in prepared remarks -- in my comments I said that there was some buy in, if you will, and stocking up in Asia, in particular for Chinese New Year. And so, our sell-in was a little bit stronger than our sell-through in the second quarter, that will balance itself out for the rest of the year. So that 45% number while a great number, does not really reflect sell-through. Our sell-through number was a little bit less than that.

We have time for one more question which comes from the line of Mark Astrachan with Stifel, Nicolaus. Mark Astrachan - Stifel, Nicolaus & Co., Inc.: Just looking at Hair Care. Curious if the increased focus on that business by some of your principal competitors potentially impedes your ability to grow sales and increase profitability. And then just related to that, could you talk about what you think your size is whether beneficial, or does it make more difficult to compete in that market versus some of those competitors?

Yes. Our strategy is to compete in the high-end market in salons and specialized retailers for Hair Care. And in that niche, we have a relatively high market share actually in the U.S, and we are very small internationally. So to answer your question, we operate in a niche and our strategy, I don't think we'll conflict with what our competition is doing because they're mainly operating in mass or in larger scale than we are. Our idea is to continue gaining strong market share in the high-end area of Hair Care and I believe we can do that. And in terms of size, our size in the U.S, in that segment allow us to compete effectively. Internationally, we are very small and in fact our international expansion strategy is going to be very focused. Meaning, few markets where we will enter in this high-end segment and operate to create critical mass there is opposite to a strategy of being little or small in many small markets.

That concludes today's question-and-answer session. If you were unable to join for the entire call, a playback will be available at 12 noon, Eastern time today through February 17. To hear a recording of the call, please Dial (800) 642-1687 using the pass code 37271213. That concludes today's Estée Lauder conference call. I would like to thank you all for your participation, and wish you all a good day.