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Tuesday, October 27, 1998

An Investment Opinion
by Dale Wettlaufer

Estee Lauder Outperforms Industry

Estee Lauder (NYSE: EL) picked up $2 to $65 after reporting very favorable first quarter results this morning. The diversified cosmetics, skin care, hair care, and fragrances company reported an 11% increase in net sales. In terms of local currencies, net sales increased 13% for the quarter. Net income growth outpaced net sales growth, with net income attributable to common stock increasing 17.5% and EPS up 17% for the quarter, putting the company's earnings growth performance in the top of the S&P 500 in a pretty flat quarter for the rest of the market.

Across product lines and geographies save for parts of Asia, Estee Lauder put together another good quarter, with makeup being the biggest growth driver with 16% sales growth before currency translation. Last year's new addition, jane, added to results, with that brand breaking into top-10 facial makeup sellers, according to Chain Drug Review and Information Resources Inc. Year-over-year, jane sales were up 36.6%, helped in very large part due to its acquisition by resource-rich Estee Lauder last year. This acquisition was perhaps the most important of the two major deals the company did last year, as it represents the company's entry into the drugstore cosmetics market and opens new opportunities for Estee Lauder. Jane products are currently sold in 12,000 stores, including Wal-Mart and Kmart.

Overall, Estee Lauder pointed to strong performances from the introductions of Clinique's Quickliner for Eyes, Prescriptives' Photochrome, and "ongoing strength of existing products like Clinique's Superlast Cream Lipstick, and Estee Lauder's Two-In-One Eyeshadow and Minute Makeup." Bobbi Brown was strong across geographies, with new doors (individual stores) added in Germany and France. Estee Lauder is taking the opportunity of weakness in the Asia/Pacific to increase brand awareness and penetration, with MAC and Bobbi Brown's strength in Japan evidencing those efforts.

Fragrances were another source of strength, with sales growing 10% before currency translation. Estee Lauder's introduction of Dazzling Gold and Dazzling Silver, the rollout of Kiton Napoli, the #3 position of Clinique Happy in U.S. department stores, and the success of the Hilfiger Athletics and tommy girl fragrances produced another strong quarter. Skin care sales growth was the weakest category but still grew 5%. That's compared with an overall 3% decrease in sales for fiscal 1998, so the performance is fine for a competitive category. Estee Lauder's Diminish and DayWear continued to show strength, and Clinique's All About Eyes and new Origins products contributed strongly to the category.

For the holiday season, the company is looking forward to strength from Aveda for Men and its Aveda Full Spectrum 97% natural hair color technology. Elsewhere, new fragrances are expected to do well, including Flirt and Bobbi. In cosmetics, the company is rolling out new foundations and mascara for MAC, new colors for Prescriptives, and new hair and body products from Bobbi Brown and Origins.

In terms of distribution, the company expects to have MAC, Bobbi Brown, and Origins in 50 new doors for the fiscal year and sees good prospects for its Tommy shops, which are store-within-store concepts currently in operation at Macy's in New York and Atlanta, and Foley's in Dallas. In addition, stores have reported excellent results from assisted-sell tests, with sales having increased 25-40%. Compared with the department store industry in general, Estee Lauder has outperformed in terms of sales growth, and it outperformed the mass-market cosmetics industry last year in every category except skin care.

The company expects to add doors for jane, which is increasingly a point of interest for investors, as it brings good breadth and topline brand performance to the company. Strategically, this is an important area for CEO Leonard Lauder, who said last year, "This is a channel of distribution we were once only peripherally aware of, and now we are very, very deeply involved," according to BrandMarketing Supplement to Supermarket News.

Financial performance was again very good, with the company hitting its goals. EBITDA, or earnings before interest, taxes, depreciation, and amortization was $151.3 million, at 15.2% of net sales. EBITDA was up 20% year-over-year. For investors, this can be a useful measure to compare companies where depreciation and amortization schedules can show wide divergences between companies, especially between companies that want to reduce taxes versus those that want to maximize reportable net income. EBITDA margin improved an impressive 120 basis points (100 basis points equal one percentage point) year-over-year. As expected, gross margin declined 30 basis points in the quarter while increased efficiencies brought through a 70 basis point improvement in operating expenses. Operating income reached 12.2% of net sales this quarter, up from 11.77% in Q1 fiscal 1998.

Return on Invested Capital (ROIC) on beginning invested capital for the quarter reached just over 19.1%, another solid performance for the company. Being a seasonally cyclical company, though, one quarter is not terribly comparable with the entire year. Year-over-year, ROIC performance was down nearly 550 basis points, though the quarter leading into the holiday season isn't the best barometer for a company such as Estee Lauder. The company feels comfortable with its ability to hit its historic goal of 8-9% sales growth in fiscal 1999.

On the many product fronts, net sales are strong and the company is using its excess capital in the right ways, having announced a discretionary 4 million share repurchase authorization earlier this year. In coming quarters, the company will continue to strengthen its longer-standing brands and reinvest in new initiatives. Estee Lauder is very much earning last year's excellent stock performance and should follow that up well in its second fiscal quarter with a good holiday season, being that the stock is fairly to slightly undervalued at the present.