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More on Estee Lauder

By Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (Sept. 29, 1999) -- About two weeks ago, I wrote a piece on Estee Lauder (NYSE: EL) and its accounts receivables credit loss accounting, which was a response to a piece (subscription needed) by's Herb Greenberg. Since Herb responded to my piece and invited me to return comment, I thought I would. The article I wrote is right here, so no need to totally rehash the issue. In a nutshell, Greenberg's source says Estee Lauder went light on its provision for doubtful accounts in fiscal 1999 to make its earnings estimate.

Much of the argument posed by Greenberg's source, and Herb himself, is predicated upon the assumption that there is a "right" level of reserves for doubtful accounts (as a percentage of gross receivables). My contention is that a totally formulaic approach to the issue doesn't render evidence accurate enough to serve as a strong basis for accusing the company of fudging the numbers. As you can see in my previous article, the history of the company's financials isn't even lengthy enough to establish a reasonable baseline assumption as to the correct level of allowances for doubtful accounts. We have four fiscal years -- 1996 through 1999. The average allowance for doubtful accounts, as a percentage of gross receivables, is 7.1% over four years. The average deviation from that mean has been 6.6% (not percentage points) over four years. If the dataset were larger, you might be able to conclude that in any year, the allowance is somewhat likely to differ from the average by 6.66% -- giving you an expected range of allowances of 6.7% to 7.6% of gross receivables.

As we see, 1998 and 1999 were both outside the expected range. 1998 was higher and 1999 was lower. But at this point, the dataset means little. It's only four years of operating data to go on. None of this is statistically significant -- not that the movement of accounts receivables reserves is like the oscillation of an electron, anyway. This is a living, breathing business where management has to estimate loss activity before it occurs. I believe, though, that the point is quite valid that you can't make the case that Estee Lauder is deceiving investors to the tune of $0.02 per share because the ending allowance for doubtful accounts was lower than last year. Business is just more complicated than that. In selling something short, I want a stronger case than that (which is why I made the comment on why the short seller is basing the argument on this, because I think it's a weak case) and in writing about companies, I want a stronger case than that if I were going to intimate that a company is doing something shady (because of legal exposure and because there are a lot more fish to fry than this negligible issue).

Credit loss reserves fluctuate for a number of reasons. The composition of customers can change, the composition of product sold on credit can change, and macroeconomic conditions certainly fluctuate. Also, the credit loss provision is an estimate (which gives the short seller leeway to make the argument). Here's what we see at Estee Lauder that may explain some of the fluctuation:


International earnings before taxes and minority interest as a percentage of total EBIT&MI: 1999, 63%; 1998, 62.3%; 1997, 72.6%; 1996, 62.6%; 1995, 61.8%

Clearly, 1997 saw a spike up in the trend of international earnings, but I don't think the credit loss provision in 1998 follows directly from that. I think the credit loss provision in 1998 may reflect a pretty hefty drop-off in Asia/Pacific sales experienced in 1998, where sales in that region dropped more than 15% year-over-year. Remember that Estee Lauder's fiscal year ends in June, so the "Asian contagion" fell into fiscal 1998. That's the year the allowance for doubtful accounts spiked as a percentage of gross receivables. The final cleanup on those accounts fell into fiscal 1999 with the near-doubling in charge-offs that year.

What might also be assumed here is that the charge-offs for 1999 may have been overly conservative and that the provision for doubtful accounts in 1999 may reflect an internal estimate of some of those charged-off accounts being recovered in fiscal 2000. There are a number of levers in the accounting here. There's the balance sheet allowance, the income statement provision, and the charge-off/recovery dynamic, which always affects the other two. For a better illustration of these dynamics, look at the big commercial banks from 1991 to 1996. Income statement provisions decimated balance sheets and killed earnings in the early part of the period. But later, from 1994 to 1996, many banks didn't have to take any provisions for credit losses, which gave rise to an explosive increase in earnings. That's because the banks were making big recoveries on previously charged-off assets.

This is an interesting point, and I'd like to continue with it on Friday, as I'm running out of space today. By the way, these Estee Lauder pieces aren't "attacks" on Herb Greenberg. As I said the other day and as I've said numerous times before, Herb's stuff is great. I just don't agree with the assessment on Estee Lauder (or American Power Conversion), but I've agreed with him much more often than not. He just hears from me when I disagree with him.

I'll bring this full-circle on Friday by way of looking at how credit loss provisions lead charge-offs. The two things don't move 100% in-phase with each other. This decade's experience with banks is the perfect example of that.

I think we'll get back to Costco on Friday as well.

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