The Estée Lauder Companies Inc. (EL) Q2 2015 Earnings Report, Transcript and Summary

Good day, everyone, and welcome to the Estée Lauder Companies Fiscal 2015 Second Quarter Conference Call. Today's call is being recorded and webcast. For opening remarks and introductions, I will turn the call over to the Vice President of Investor Relations, Mr. Dennis D'Andrea. Please go ahead, sir.

Good morning. On today's call are Fabrizio Freda, President and Chief Executive Officer; and Tracey Travis, Executive Vice President and Chief Financial Officer; and Chris Good, President of the U.K. and Ireland. Chris is going to discuss both the strategy and our current business in the area. 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. Our discussion of our expectations for the full fiscal year are before the impact of accelerated retail orders that took place in the fourth quarter of fiscal 2014 July implementation of our Strategic Modernization Initiative, which would have occurred in our fiscal 2015 first quarter. You can find reconciliations between GAAP and non-GAAP figures in our press release and on the Investor Relations section of our website. And I'll turn the call over to Fabrizio.

Thank you, Dennis, and good morning, everyone. Our global business delivered strong financial results in the second quarter of fiscal 2015. Net sales rose more than 5% in local currency, better than we anticipated, and earnings per share also exceeded our forecast. Many of our brands, channels and countries contributed, and importantly, we expect this momentum will accelerate in the second half of our fiscal year due to the strength of our upcoming launch calendar. Prestige beauty continues to grow, sustained in part by heavy spending by key companies and occurred against the backdrop of increasing volatile macro events, including sharp currency fluctuations, political unrest and slower growth in some countries. We continue to invest in the future by acquiring 4 prestige brands that position us well for our sustained growth and profitability. I will start to discuss these acquisitions later on. Our results this quarter clearly demonstrated our strategy is working, since we were able to deliver solid performance when faced with market challenges and currency volatility. This is also a testament to our talent and the flexibility we have built into our business model to create resilience and agility. We are able to quickly adapt and change our focus when we see consumers and market dynamics shifting. Our consistent success is rooted in our multiple engines of growth, which has been -- which has enabled us to find opportunities across geographies, channels, consumer demographic, brands, innovation and acquisitions. We have strategically broadened our reach, so when the unexpected occurs, we are less exposed and have more positive levers to pull. Our strength in the second quarter was led by many of our prominent growth engines. Our luxury and makeup brands were standouts, which continued a recent pattern. We enjoyed excellent double-digit growth in the U.K. and most emerging…

Thank you, Fabrizio, and good morning, everyone. I am delighted to be here. I have been with Estée Lauder Companies for 15 years in a variety of leadership roles in Asia and Europe, and for the past 3 years as President of the U.K. and Ireland. The U.K. was the first market to be opened by the company outside North America in 1960, and indeed, it remains our second largest market after the U.S., representing more than 8% of total company sales and an even greater share of profits. Fabrizio spoke of the company's multiple areas of growth and the U.K. is one of our largest engines. Our company is #1 in prestige beauty in the U.K. and #2 in total beauty, which includes mass. The U.K. business is large, complex and has a very different distributional profile from Continental Europe. Many would view the U.K. business as mature. Average growth for total beauty has hovered between 3% and 5% for the last few years, with prestige beauty growing at approximately 5% on average. However, we view our U.K. business as an emerging market. What we mean by this is that we pursue high-growth opportunities across geographies, channels, categories and consumer segments. This approach has resulted in 3 years of growth trending well above the market. Our net sales in constant currency grew 11% last year and we are currently up 13% for the first half of fiscal '15. Strong results in an economy with GDP growth of only 2.6%. The U.K. is one of the world's most diverse nations and a top tourist destination. We go to great lengths to offer the most ethnically appropriate mix of business at every counter. We ensure our staff in merchandising is well-suited to the consumers of each location. Our approach is also…

Thank you, Chris, and good morning, everyone. First, let me briefly review our fiscal 2015 second quarter results, and then I will share with you our expectations for the third quarter and the full year. Reported net sales for the second quarter grew 1% compared to the prior year and rose 5% in constant currency, exceeding the top end of our expectations. December sales accelerated beyond what we expected, driven by the strength of our holiday programs, as well as the results in Hong Kong being better than what we had anticipated, despite the disruption from the political protest. Our gross profit margin of 81.2% was 50 basis points above the prior year, primarily reflecting favorable manufacturing variances and foreign exchange. Operating expenses rose 140 basis points to 60.4% of sales. The largest driver of the increase was higher general and administrative cost of 150 basis points, primarily reflecting strategic investment and capabilities, such as R&D and information technology as well as our acquisition activities. Retail store expenses rose 40 basis points, reflecting the addition of almost 150 freestanding retail stores over the past year. Partially offsetting these increases was 60 basis points of favorability and advertising, merchandising and sampling expenses, due primarily to the mix impact from the strong growth of our lower advertisement brands as well as the cadence of major launch activities for our heritage brands. As a result, operating margin decreased 90 basis points to 20.8%. Earnings per share came in at $1.13, approximately $0.08 above the top end of our guidance range, up 3% from the prior year, due primarily to the impact of the better-than-expected holiday results and improved tax rates and the decision we took to shift some of our marketing investments to the second half of the fiscal year to support planned…

[Operator Instructions] Our first question today comes from Olivia Tong with Bank of America Merrill Lynch.

First, just a shorter-term question. I think it's impressive that you're expecting improved growth in Q3 relative to Q2 on a like-for-like basis. And you walked through a couple of the key drivers just now, but which ones are trending better relative to your going-in expectations?

Our business is accelerating. First thing, our Clinique and Lauder brand are accelerating. And in the third and fourth quarters, we are going to have some important launches with very solid advertising spending and support in some key regions of the world. So that's the key factor, one of the key factor for acceleration. The second is the continued growth of our midsize brands, that has continued to accelerate, and this also is acceleration in distribution around the world entering other markets. And then, the amazing performance of M·A·C, so that's on the brand side. And then, as we -- as Tracey just explained, we have an expectation of a recovery in Hong Kong. We have returned to normalized growth in travel retail that, as we explained, has been growing 4% in the second quarter, but the net was minus 4% because of adjustment of retailer stocks that we are expecting to be finished. So the combination of these factors, combined with a relatively easier base period for what Tracey explained like, for example, the very severe weather conditions in the United States, make us believe that we are going to accelerate our growth trend.

Your next question comes from the line of Lauren Lieberman with Barclays.

I have so many questions. I guess, 2 things, one was just on the acquisition math. I understand the 40 basis points drag, but was just curious if you're including transaction costs in that. And then the second thing was I know it's very early and it's just been announced, but Fabrizio, your perspective on how Macy's acquiring Bluemercury could impact your business? Are there brands that you currently distribute in Bluemercury that have less distribution in the U.S.? That sort of thing would be great.

So Lauren, on the 40 basis points, yes, it includes transaction costs. It includes the performance of the acquisitions for the time that we've owned them, and it also includes our current preliminary estimate for purchase accounting, so it includes all of those things.

And on Bluemercury, yes, I think your observation is correct. We have some brands, which are in Bluemercury, which have a lower distribution in the U.S., and they're doing very well within Bluemercury. So the plan that Macy's announced yesterday of expanding Bluemercury and to continue building their business the way they announced yesterday will be very favorable to our brands and to the distribution strategy of some of our high-end brands in the United States.

Your next question comes from the line of Ali Dibadj with Bernstein.

Guys, couple of things. One is -- I just wanted a little bit more clarification. On the one hand we hear about bullishness and acceleration, which is great. And on the other hand, I'm trying to understand how that translates to EPS because you're taking down basically by $0.10, as you said, the back half of the year -- I don't know your guidance -- but that's on top of a $0.08, $0.09 beat on the quarter. So it's kind of a bigger takedown on EPS than one would have expected from currency. So I want to understand kind of the bridge there a little bit more. And in that context, secondly, if you can talk a little bit more about your expectations in the rebound in Hong Kong and in China more broadly? When we were there visiting recently, we found that there was certainly a social unrest aspect to it. There's also a lot of discussion around the Chinese consumer trading down and that might be more secular. So I love your point of view about that, if possible, too, please.

So on the first question in terms of our EPS guidance. We spoke about the fact that we did make a decision within the last quarter to shift some of our marketing funds into the third quarter, primarily, and some into the fourth quarter to support our second half launches, particularly for our heritage brands, given the some of the strength in those programs, so that's the piece of it. And then the other piece is from an EPS standpoint, within the range covering the dilution effect of the acquisitions. So those are the 2 pieces that are impacting that.

And I just want to underline that there is a conscious decision to support our new innovation on Lauder and Clinique in a significant way because one of our priorities is to accelerate the growth trend of our Clinique and Lauder brands. And if we are able to do that, obviously, this will further improve our really strong brands as an overall company. Now to answer your second question is the -- so what is our expectation? Hong Kong, we expect to go back to growth, but we agree, and our expectation is not that we'll go back to the kind of growth that was there a couple of years ago. It is the fact that there is less traffic there than before in the stores of Chinese tourists. And it's the fact that these Chinese tourists are -- not trading down probably is not the right word, but the profile of the Chinese tourist, which is in this moment in Hong Kong, is less high end than they used to be. So because of this, we are prudently assuming that Hong Kong will go back to growth, but we are not assuming back to the kind of growth that was a few years ago. In terms of the Chinese having overall attitude to trade down, I don't think so. I think Chinese are just -- the high-end Chinese, which continue to spend well, are just changing their destinations. And it's true that Hong Kong so less of this kind of profile, but it's also true that places like Japan are seeing more than at places like London or Paris are seeing more solid travel of high-end Chinese in Europe is actually on an increasing trend. So Chinese consumer remains good travelers. They remain heavy spenders when they travel, remain very passionate, interested in beauty. And they remain interested in a very high-end prestige beauty products, but the destinations are switching and that's why what we were saying before, our agility and our ability to manage these traveling corridors in the best way and to evolve our traveling management, depending on how they travel, is a big strength. And I think you will see the results of this in the next months.

Your next question is from the line of Connie Maneaty with BMO Capital Markets.

So a couple of things. On the acquisitions, is the dilution limited to purchase accounting and will it last a quarter or 2? Or will it also stretch into next year? Then I have a question on China.

Okay. So the purchase accounting is -- or the dilution is related to 3 things: One, are the deal acquisition costs, so those are onetime costs. They will not continue forward, obviously. The second is the -- just the operating performance of the combined acquisitions, which is small. And then the third piece is purchase accounting and right now we have an estimate for purchase accounting for a couple of the acquisitions we have not closed the purchase accounting yet, and you will certainly see all of that reflected in our 10-Q when we issue it later today. And that will continue forward, the purchase accounting impact. So -- but obviously, we have great expectations for the 4 brands. Chris talked about how excited he is to have them in his market and what he thinks the U.K. can do from an acceleration standpoint with the brands. So we would expect that dilution to mitigate over, certainly, into the next few years.

Okay. And then on China, I think you said sales rose 4%, but what did same-store sales do?

You mean the same-door? Sorry, what is the question?

Yes, same-store sales growth in China. What did that do?

Plus 4%. So the numbers in China this second quarter were plus 15% retail growth, plus 4% same-door retail growth and plus 4% net sales.

A trend change from the first quarter.

Yes, big acceleration for the previous quarter. And as I said in my prepared remarks, with the acceleration across all brands with a great performance of the biggest brand in prestige beauty in China, Estée Lauder, and in acceleration all our midsize brands as well at the same time.

Your next question is from the line of Wendy Nicholson with Citi Investment.

On Asia, can you tell us what local currency sales in Asia would have been, excluding...

We lost your first part of the sentence. Could you repeat?

Sure. Sorry about that. Just following up on Asia. Number one, can you tell us what local currency sales growth in Asia would've been if you excluded the pressure from Hong Kong? And just to put that in the context of kind of your long-term revenue growth target of 6% to 8%, Asia has been trending -- I know it's very bumpy quarter-to-quarter, but it's been trending actually slower than your other regions. And I'm wondering your confidence, just long-term with the challenges in Korea, and you call out Taiwan and Singapore, all being weak. Does Asia go back to growing at the higher end of the other regions? Or are we in sort of permanent slowdown mode in Asia? And then my other question is, just going back to sort of your enthusiasm about Clinique and Estée Lauder specifically. It's awesome that those brands are reaccelerating, but doesn't that put some margin pressure on you because that's where you advertise more heavily? So if can you talk about your confidence about your margin goals, given the fact that those brands are accelerating, that would be helpful, too.

So let me start with Asia, Wendy. And thank you for those questions. In terms of APAC, excluding Hong Kong, APAC for the second quarter would have grown low single digits.

Okay, so on Asia. It's the fact that in this moment, as we explained, Asia is not at the top growth of our -- it's for the reason you summarized, meaning Hong Kong is slow, China has slowed down on average, although we have an excellent quarter too. Korea is flattening and Japan is being in this recession environment. So it's a fact. Interestingly, one of our best-performing countries in Asia, and it's normally it is Australia and New Zealand. So yes, it's a fact that today Asia is in a moment of softness. Now, my point of view, our compass and our strategic work for the future will -- it counts on the fact that this will change. This -- Asia will be and know that will be volatile, will be up and down. This is a down moment. But Asia is a long-term opportunity and a very strong region in terms of projecting long-term growth. And the reason for that is obviously the huge increase of the middle-class, the growth of the prestige channel overall in these markets. The fact that we have deployed to Asia only a small percentage of our portfolio for the moment, the distribution opportunity which are in Asia. So when you look at the opportunity for growth and assumed a stabilization of political or economical turmoil, Asia is definitely continue to be a long-term opportunity. And as I said in my prepared remarks, China, particularly, continued to be a very important long-term opportunity for the company, and Chinese consumers, wherever they travel, particularly. Last, I don't want to meet the travel retail -- Asians are formidable travelers and they're very heavy spenders and travelers. So we really are going to drive the travel retail in China and Asia the best we can and…

Your next question is from the line of Caroline Levy with CLSA.

I actually did want to just pursue that margin conversation a little bit, because as you see these opportunities behind launches, how do we think about what your goals are coming off of what will be a very low-margin year because of SMI? I mean -- because of, yes, the transitions. Do you see maybe fiscal '16 being an unusually strong margin year? How much are you going to let flow to the earnings level versus invest behind these ideas?

I'll let Tracey add what she wants to, but I want just to frame the point. I mean, we are trying to manage this company for the long-term, sustainable, profitable growth. And you see out there the amount of volatility and continuous changing environment and continuous competitive environment that we are facing. I believe that what we've built, meaning our agility and flexibility to respond to these external and internal challenges that we face in this long-term evolution, is a strength. And so in order to manage these strengths the best, we have given you our long-term objectives. And within that, we will be managing for optimization, depending on internal and external situations. So the mix of, as we said, mix of our brands, growth, leverage, ability, productivity improvement, combined with cost savings that come from SMI, that comes from many other opportunities that we are constantly working on. And the growth acceleration in the region and as -- and sorry, I should mention that China, the acceleration, already high profit channels that we're managing like travel retail, online, et cetera, this combination, we believe, will definitely deliver the long-term goals. How we will do it by quarter or by 6 months is the flexibility we are trying to preserve, to be able to leverage our key strengths, which is the agility to win in a very volatile world. Tracey?

I think you said it well. The only thing I would add is we spoke a quarter or 2 ago about the program that we have established for the next few years on cost savings, and we have quite a structure around that. The team is delivering results in multiple areas, in direct procurement, returns, there's focus on obsolescence. And as I mentioned in my prepared remarks, some of the benefits that you're seeing from inventory and working capital is a result of on the efforts of the teams working together on really improving supply demand match and starting to bring, with increased service level, starting to bring inventory levels down. So more of that will be coming over the next few years and we certainly see a bigger year from an impact standpoint in fiscal '16. That is supporting, as Fabrizio mentioned, some of the investments that we're making in these other areas for long-term growth. So we are very pleased with the model we have, the combination of cost savings and investments for long-term growth.

Your next question is from the line of Michael Steib with Crédit Suisse.

Fabrizio, wanted to follow up on your comments regarding the performance in travel retail channel, if I may. It's been such a strong growth driver over the years. I think this quarter, you mentioned it was growing at about mid-single digits, a bit of a slowdown, but you expect it to return to more normal growth patterns going forward. I wonder what that confidence is based on. Is this based on innovation? Or are you expecting to gain share going forward?

So we are gaining share in travel retail. In fact, the data on travel retail of retail, which are available to now at the first 9 months of the calendar '14. And in these 9 months, we continue to grow ahead of the market. So we continue to grow market share in travel retail. We plan to continue to grow market share in travel retail. The key drivers of that are the expansion of our brand portfolio, the continuous expansion of airport and opportunities and the growth in the existing high-traffic airports, which is driven mainly by increased conversion, meaning today, between 10% and 15% of the travelers buy anything. And so just 1 or 2 points increase in this conversion is a great growth opportunity. So the combination of these will provide growth. The amount of traffic in airports, which is the other factor we monitor, as you know, is growing. So this slowdown versus the traffic in this last period is not attributable, in my opinion, to any long-term trend. It's to a very specific situation and it's mix of travelers. Basically, it's not only we had been growing slightly below traffic, but entire industry has been growing. So we are still ahead of the industry. The industry is below traffic. The reason for that, the moment the traffic, which is -- the mix is changing and the increase of travelers are Americans and Europeans, and the decrease of travelers are Brazilian, Russian and Chinese, you understand that unfortunately, the level of growth in the selling, meaning in the conversion changes, so it's a temporary mix of travelers impact that makes that growth of the travel retail sales be slightly below the growth of traffic. As soon as the balance, the mix of travelers would again evolve, this will change again and I believe the conversion factor will push again, sales growth well ahead of traffic. Now we have a competitive strength in this area because we are the market leader of a both skin care and makeup combined. And we are, on the contrary, not the market leader in the fragrance part of the business. So when we have populations, which are very interested in makeup and skin care being the traveling -- sorry, the growing part of the traffic, we have an advantage. And that's why in our compass clearly show that we should be favored by the travel mix in the long term.

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

I have a couple of housekeeping questions and then a broader sort of question. The first is on FX impact. Is that transaction and translation? Or just translation? And then maybe, like sort of how you view your pricing versus if there's any pre-buy ahead of maybe some pricing and some mix to offset some of the currency hit? And then on the acquisition side, so the math is $40 million of sales, but it seems like based on your guidance for the EPS dilutions, it's a $33 million loss. So I'm just trying to figure out how that happened? And then the longer-term strategic question is: First, Greater China, if you included Hong Kong, Macau, travel retail and the mainland, what that would be as a percentage of sales? And then the implications. It sounds like wholesale prices in China might be going down because I guess there's some stuff going on with e-commerce where they waived the duty on products there. So do you think that shifts consumptions back to mainland and maybe away from some of the other faster-growing channels like travel retail? That would be really appreciated. I'm sorry for the long-winded question.

No, that's fine, Bill. So let me start. In terms of the foreign exchange impact that we spoke about, both for the quarter and the year, we were speaking about translation impact. However, embedded, obviously, in our reported results is the impact of transaction foreign exchange. So I did mention that on cost to goods, we actually had a benefit in for -- transaction foreign exchange. And that is related to some of the favorable hedges that we have in place, which over time, will mitigate. But it is primarily the reported numbers that I gave you were translation numbers. As it relates to the acquisitions, again, there are 3 parts to that dilution effect for this year. A portion of it is onetime and that is the deal-related cost for 4 acquisitions. A portion of it is purchase accounting, and again, that is preliminary purchase accounting and we will certainly true that up in the next -- within the next quarter or so. And then a portion is the operating performance, a smaller portion is the operating performance of the acquisition, which should be accretive, certainly, at least the operating portion of the acquisitions accretive in the next year or so. The purchase accounting, because of the structure of the deal, is dilutive and will be dilutive, but not nearly as dilutive as this year.

Okay. And on Hong Kong, China and this -- I would exclude the traveling, but Hong Kong, China is about 10% of our business. And the travelers is -- we don't look at it in this way because we look at travel retail via corridors. And wherever there are Chinese shoppers, there are also Korean, Japanese, and so it's very difficult to define any place Greater China. So -- but Hong Kong, China is about 10% and then obviously, that is a very interesting path of travel retail, which is attributable to traveling Chinese consumers. And we believe this, as I said, this remains a very big opportunity of growth for the long term and we have an extremely solid portfolio. We are the market leader in this segment. We have an amazing portfolio of brands, but we have not yet deployed to these group of people all our strengths. For example, we are not yet deployed also in new acquisitions. So the only changes or regulations in China, frankly, there are frequent evolution and changes. But I don't believe that in -- again, there will be an impact on travel retail and other winning channels like online. I personally believe that the online channels within China will continue to grow, just because the consumer habits and the consumer preference or the way they're shopping will continue to go in that direction and we are ready to gain market share all this time in that area. And travel retail, again, is the result of the passion of Chinese for traveling and for buying during their travel. And so even if the price differential had to go down, I still believe there will be a very interesting growth factor on traveling Chinese.

And then I would just add, Fabrizio called out the results that we saw in the last quarter as China is accelerating in terms of performance. So I think in terms of what is going on now with e-commerce and the ports, we are not seeing an impact yet from any of that activity.

We have time for one more question. Your last question is from the line of Jason English with Goldman Sachs.

A couple of questions, one on margins and one on top line. So I was a getting excited about your gross margin this quarter. I think it's the highest quarterly gross margin we have on history, at least for the last decade or so we have modeled. But Tracey, you took a little bit of it out -- the excitement out when you said there's hedge gains in there. So can you walk us through that gross margin, what's driving and how much of that benefit is transitory? And then secondly on top line, I love the enthusiasm behind your heritage brands, on Estée and Clinique. It's hard to buy into some of that enthusiasm based on what we've been seeing in the U.S. or seeing and hearing about in terms of market share trends, the sluggish performance of which I think you once again called out in the press release this morning. So can you zoom in a little bit more on the U.S. and talk about the initiative you have to revitalize these 2 core brands in the U.S?

So we're glad we squeezed you in as well. In terms of the gross profit margin, about 20 basis points of the 50 basis points that I spoke about was related to transaction -- foreign exchange transaction gains. And then the balance was related to manufacturing variances and a little bit of mix. So as you know, mix, category mix and geographic mix, has a big impact on our gross profit margins as does, obviously, the impact from pricing as well. So we certainly expect that we will continue to see benefits, but they will vary quarter-by-quarter, depending on our region mix and depending on our channel mix. But that's really -- that was the impact in the quarter specifically related to the transaction gain.

Okay. And on the acceleration on the brands, given what you say you're seeing in the U.S., and only on Lauder and Clinique brands. First of all, our enthusiasm is for the beginning of an acceleration process. So I want to, again, be very clear, it's only the beginning of an improvement. And second part of our enthusiasm is for our belief in the programs, which are in front of us in the next 12, 18 months on these 2 brands. So we are enthusiastic about seeing early improvements and we are enthusiastic about the programs of the next 12, 18 months, and we understand, if you are not yet fully buying into it, and we need to prove it to you. The second thing we are enthusiastic is in the learning we are taking when we put these 2 brands in the condition to win, where we can show the strengths, which is in the heritage brands. Clinique and Lauder are among the best brands of the industry since a long time. And in fact, one of the things that was in the U.K. presentation, we show you what these brands can do when they are in the right distribution support initiative mode. So I'll ask also Chris to explain in a few moments what are the learning in the U.S. that we will actually transfer to other region, including the -- sorry, the learning in the U.K. that we will transfer to our regions, including the U.S., which is the other part of our belief in the future acceleration. Chris?

Thank you, Fabrizio. Yes. Well, first and foremost, it's really about growing the consumer base. And in that sense, we've been working very hard on sourcing for mass, and we've seen great results in that area. And also specifically targeting many of the new consumer groups, like the multi-ethnic consumer and the growing emerging consumer in that area. Also broadening the breadth of product usage of our existing customers, so getting them to buy across the brands and across the portfolio. Playing the portfolio very strongly indeed because we have in the U.K. the 4 portfolio of brands, almost the 4 portfolio. Reaching consumers in the way that they want to shop, so really building upon and developing the omnichannel experience. And finally, and very importantly, executing with excellence the terrific innovation that the brands deliver for us.

And in -- with these conditions implemented with the current innovation plan, Lauder and Clinique are growing mid-single digit in the U.K. as we speak, so even before the acceleration programs.

That concludes today's question-and-answer session. If you were unable to join for the entire call, a playback will be available at 1:00 p.m. Eastern time today through February 19. To hear a recording of the call, please dial (855) 859-2056, passcode 67722547. 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.