Estée Lauder (EL 0.89%) stock has enjoyed an incredible run in the past year as its top and bottom lines put up growth numbers that paint the picture of a company firing on all cylinders (and grabbing market share in the process).

In this episode of Industry Focus: Consumer Goods, Vincent Shen and senior Motley Fool contributor Asit Sharma lay the foundation in understanding Estée Lauder global business. Find out what's driving its incredible growth, why prestige branding is so important, and what lies ahead for this skincare giant.

A full transcript follows the video.

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This video was recorded on April 10, 2018.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Tuesday, April 10th, and I'm your host, Vincent Shen. I'm really looking forward to the discussion that we have lined up for you. The goal recently for this show was to line up another company that we could debut coverage for here on Industry Focus. And so far, this year, we've really mostly focused on small or mid-cap names like Pool Corporation, Thor Industries, and then some of the recent IPOs in the consumer and retail sector.

But our focus today will actually be a larger enterprise, and that company is Estée Lauder. Besides being a huge name in the cosmetics industry with a market cap of over $50 billion, the stock has enjoyed an incredible run in the past year. The shares are up almost 80%, and that makes Estée Lauder one of the best performers in the consumer retail space. Joining me today via Skype is senior Motley Fool contributor, Asit Sharma. Welcome back, man!

Asit Sharma: Thanks a lot! I'm so excited to be here! I am psyched about this topic.

Shen: Yeah, sure! This popped up on my radar after doing a screen looking at what companies, at least in terms of their stock performance, have been really leading the pack in the past year. Obviously, when you have companies that are gaining over 50%, if not triple digits, usually small entities, but in this case, you have this $50 billion company that's seen an 80% gain in the past year. And honestly, the timing of this discussion has been pretty appropriate. My wife has actually been encouraging me recently to adopt a more comprehensive skin care regimen, and then boom, just like that, Estée Lauder pops up on our radar. I thought that was kind of funny. 

Estée Lauder Company, ticker EL, they manufacture and sell a large variety of skincare products, makeup, fragrances, and hair care products. In the trailing 12-month period, the company generated about $13 billion dollars in total sales across its very large brand portfolio. That includes brands that it personally owns and operates and then also some designer labels that it licenses with. Asit, if you're looking to give someone new to Estée Lauder a 10,000-foot view of the company, what do people need to know about the business?

Sharma: One of the most important things to know about this business, Vince, is that it was founded by Estée and Joseph Lauder in 1946. This is so important to the company, because the personality of Estée Lauder has permeated the rest of the history the company, and we'll talk about that as we go on. It sells in basically five categories. Skincare is the second biggest category, that made up about 30% of revenue in the last year. Makeup, which was about 43% of revenue. Fragrance at 14%, hair care at 5%, and other at 1%. 

This company conceives of and it markets itself as a prestige beauty house. That means that most of its products are going to trend toward that higher-end of the spectrum, toward the luxury brands designation. But it does offer a good number of entry-level or mass-market products. I'm going to read listeners some of the brands that Estée Lauder manufacturers. These include its eponymous brand, Estée Lauder, Aveda, Bobbi Brown, La Mer, Rodin, Origins, Clinique, Aramis, and many other names that you would recognize. But the company also licenses fragrances and some cosmetics for, again, extremely well-known names such as Tommy Hilfiger, Donna Karan, DKNYMichael Kors, and Tom Ford. So we see that the company has its fingers across this spectrum of brands in skincare, makeup, and fragrance, primarily.

The marketing philosophy follows Estée Lauder's original idea of personalized high-touch interactions with customers. Estée Lauder used to travel tirelessly to sell her product, and she herself would apply makeup to customers coming into department stores. She really was a shoe leather marketer from the very beginning. And the company has maintained this aspect of marketing even through technology today, it has interactive ways to show applications of its products, usage demonstrations, etc. So this is something very important about the company. When you buy their product, you have a pretty good chance of having encountered it through a human being, either in a department store, perhaps in an airport, in a duty-free shop. They're really high on this one-to-one marking strategy.

Shen: If you'll just let me jump in really quick there, I think it's hard to overstate how important that touch, that one-touch, and that prestige element, is for the company. Across retail right now, given how much the competitive environment is changing, and barring a major economic downturn, which we'll talk about in terms of risks later on, these luxury companies are generally outperforming. You see this in high-end shopping malls and how aspirational brands have often managed to stand out. I think with skincare and cosmetics, it's really no different. These prestige brands are outgrowing the mass market ones, and they've been doing so pretty consistently for a few years now. 

Estée Lauder has employed this prestige first strategy for almost a decade. Last month, at a retail industry conference, the CEO, Fabrizio Freda, he actually went into detail, I think it's really interesting here, about why the high-end business is outperforming. The way he describes it specifically for skin care is that No. 1, the differentiator, as obvious as it may seem, is product quality, because that tends to lead to customer loyalty -- and the idea that customers will only go back and buy a second time the products that they enjoy using and that they find to be effective in terms of their skincare and their cosmetics. And then No. 2, another differentiator is innovation, because in this industry, meeting people's needs is already kind of a given. So there's not as much that's fresh in meeting people's needs, but if you're able to surprise your customers with unique products, that's much more likely to win them over. Then, No. 3, the prestige world offers a more compelling overall experience. You mentioned some of these aspects, Asit.

Between the product quality, the product innovation that I just mentioned, but then, the education element for customers who go into some of the brick-and-mortar stores, for example, that Estée Lauder manages through its various brands, and then also department stores, for example, having that experience, interacting with the brands at a makeup counter and in stores, is very powerful. And the interesting thing is, he gave that all in the context of more developed markets like the United States and Europe. But then, he ties that to emerging markets, too, because these three principles are still in play. But then, prestige also has the additional benefit in developing markets of being aspirational, and that's very relevant, obviously, when you have a growing middle class with consumers in very fast-growing regions like Asia.

Something else that I think is really important for this business in terms of how they sell through their products is their sales channels, so distribution model, because they have a variety of different storefronts, their online business. What's the story there, Asit?

Sharma: The company has a really interesting division of channels. The first is primarily department stores. These are specialty retailers as well. This is a straight quote from the company, "Upscale perfumeries and pharmacies and prestige salons and spas." So again, look at that gamut of high-end luxury, premium, all the things that you mentioned, Vince, which in my mind always translate into margin, profit margin.

Shen: Yeah, exactly. 

Sharma: They're also in freestanding stores. They own about 1,400 freestanding stores, and about 500 additional stores are operated by third parties. They operate those under four labels: MAC, this is a Canadian company which the company acquired in the 1990s; Jo Malone London; Bobbi Brown, which many listeners will be familiar with; and Aveda, also a very common name. This distribution channel, as you said, Vince, it's heavy into brick and mortar. 

But the company is also really into online sales. It's got a burgeoning e-commerce channel. It has about 1,400 different e-commerce and mobile sites. One thing that I'm really interested in is, we talked about Hudson a few weeks ago, Vince, and that it leases retail space in airports. This is something that has been a boon to the company in terms of what it calls travel retail. So those folks in China who are driving up sales in that market are also great travelers, and they spend money in the places they visit. There are a few companies of Estée Lauder's size that are quite as good at pulling dollars -- or pulling yuan, rather -- out of customers as they work their way through airports and then travel in the countries that their final destination is. This is just an overview of how widespread and how many distribution channels this company has. 

Shen: I think the story that management really paints regarding its recent growth and strength, it's all about taking a very holistic approach to how they leverage their very broad product and brand portfolio, and then how they push into these different channels and geographic markets, online, their online channels, and then also traditional outlets like department stores, specialty retailers.

Something else I wanted to cover, too, that I think has shaped a little bit of their recent strategy. About two years ago, the company implemented a restructuring effort that they called Leading Beauty Forward. With that, they're taking efforts to change their marketing and adapt them to a more digital focus, given how important it is, obviously, that comes up all the time on the show. Ultimately, they want to better connect with their customers. A big part of that, for example, is social media and how social media influencers can be a key part of how they connect with younger consumers, since that demographic tends to find the social media medium to be the most compelling. 

Then, beyond that, the company has also worked toward a nimbler supply chain, for example. Something that was very pronounced in terms of the effect with this restructuring is the time to market for products. Historically, it took the company about 18 months to bring an idea to market. Now, it's just 12 months for bigger ideas, while small changes can happen as quickly as just five or six months. Then, the restructuring has also helped, for example, lower their inventory levels, align some of the functions at the company so they can support all those different sales channels that we've mentioned. Overall, in terms of quantitative value, management estimates an annual benefit of about $200 to $300 million from Leading Beauty Forward, so pretty powerful.

Last thing here, before we get to the next part of our discussion, that I think is very important in terms of the context of how this business works and how it's grown over the years, is in terms of M&A activity for the company. The company is a pretty regular buyer. They are often looking for brands that they can roll into the portfolio, fill in certain niches that they maybe feel are under-covered and offer a good return on investment. I think, in the past few years, they've acquired something like six or seven smaller brands. What are some of the details there, Asit?

Sharma: Just a reminder, the company went public in 1995. That was also the year that it made its first acquisition. Up until that time, for over 50 years, Estée Lauder had developed brands in-house. There was an individual cosmetician who was like a cult figure in New York City in the mid-90s. Her products were sold in Neiman Marcus. That was none other than Bobbi Brown, who I just mentioned a few minutes ago. That was the company's first acquisition, in '95. That brand is now sold in 60 countries. So the model is acquire these brands and then, obviously, expand them.

I went back and looked at the history. Since then, the company has had a pretty regular cadence of acquiring a major brand every two years. But in recent years, that has really ticked up. Just to review a few, Estée Lauder bought Hollywood skin care brand Glamglow in January of 2015; fragrance house Kilian in February of 2016; BECCA, which is a makeup brand, November 2016; and Too Faced in December of 2016. Now, the company has a June 30th year-end, so those last two acquisitions actually came in the most previous fiscal year. That speaks to what Vince was saying, that the company ramped up its acquisitions in the past few years.

But I think that this emphasis Estée Lauder has on technology, innovation, as you mentioned, Vince, research and development spends about $120 million a year in research and development -- I think that lends itself to buying these brands, wrapping them in, and then doing brand extensions, making new products, testing them out, offering new SKUs in these varieties of markets. And oftentimes, they will take a brand from the U.S. and transplant it, the lift and shift model, into Asia with a few modifications. And that's been very successful for them.

Shen: Absolutely. Alright, next up, we're going to look at their most recent financial performance, some of the things that are driving this very robust performance and wrap with our usual look at things like their future opportunities, some of the risks to the business, and valuation. 

Let's dedicate a couple of minutes now to their most recent results for this part of the show. Estée Lauder has reported, I think, the first half of its current fiscal year so far. The highlights seem to be an accelerating top line and earnings growth in double digits. Then, their guidance, I believe, has already been revised upward more than once so far in this fiscal year, so pretty impressive. What are we looking at exactly here? 

Sharma: The financial model for Estée Lauder is really intriguing to me. Vince, you mentioned trailing 12-month sales of about $13 billion. In the last fiscal year, the company sold closer to $12 billion, if you look at their reporting year. Extremely high gross margins for Estée Lauder. They tend to run at around 80% quarter after quarter. That's not necessarily an indication of how profitable its manufacturing process is. That is an indication of these high price points it can sell its product at. To accompany that high gross margin is a high general and administrative cost and a high selling cost. That takes up about 60% of each sales dollar.

If we look at the close to $12 billion that the company sold in the last fiscal year, it made a gross profit of $9.4 billion. Now, out of that $9.4 billion, Estée Lauder spent nearly $3 billion in advertising, merchandising, sampling, promotion and product development. So you can see what it's doing. It's selling product at a very high price point, that aspirational price point, and it's taking some of that gross profit and just pouring it into getting the product in front of people. What this generates at the end of the day is a pretty reliable 10% net profit margin year after year. So it's a stable business with a very stable structure in how it makes each sales dollar and each profit dollar. And for the past few years, it's been growing sales at a good clip, 4% to 5%. 

Now, what's happened in the last year is pretty amazing. Cumulative revenue growth in the first six months of this fiscal year are up 16% to $7 billion. So that is a leap, really, from what the company has historically been able to generate. It's had to revise its full-year forecast twice already this year. The company now expects full-year growth for this year of 10% to 11%, and that's because it will have a weaker third and fourth quarter this year.

I wanted to flip it back to you, Vince. Let's talk about this growth and what's driving it.

Shen: Yeah, sure. I'll add also, for investors who want to look out a little bit further, management has mentioned that in the next three years, they expect revenue to grow 6% to 8% annually, while earnings continue to go up double digits. They also think that their profitability can continue to improve with their operating margin, for example, expanding about half a percentage point each year. So management does offer a little bit further outlook, in terms of some of that guidance.

But the big things that we wanted to focus on are the sources of that strength. Company management has pointed to several specific elements. The ones that they seem to call out the most clearly are China. That is what the CEO believes is the largest opportunity long-term. Then, there is travel retail, which we've touched on briefly, the online channel, and then the Estée Lauder namesake brand itself.

Let's look at China first. Growth in that region has easily been in the double digits, and what they've seen is that young consumers there are very, very passionate about prestige beauty, which obviously fits beautifully with this company's focus and business model. The thing is, Chinese consumers are transitioning from what was previously a focus on skincare to also some of the other categories that the company offers, like makeup and fragrances. The CEO describes it as going from tapping just one engine in the Estée Lauder business to a multi-engine model for this market. In the last quarter, that's their fiscal 2018 second quarter, they said that the Chinese makeup business doubled. The online business in that region also doubled, and now it's over 25% of sales as of that second quarter. 

Otherwise, they are also working to balance a physical and digital footprint in that region. For example, the company will use data from their online purchases to determine which cities to enter. But the namesake Estée Lauder brand already has a physical presence in 170 of the higher-traffic cities in China, but there's still 600 more that they can reach online and use that data to determine where else to expand to. The big thing in terms of consumer habits that I thought would be interesting to point out, which was really surprising, was Chinese consumers will often use up to seven or eight skincare products per day. So as the company builds customer loyalty, they further penetrate into the available product categories in that market, the growth accelerates even more quickly because of that kind of usage. So really big opportunity there for the company. 

Another one of the pillars is their online sales. What is the company seeing there? What stood out to you, Asit?

Sharma: The company has this unusual, savvy ability to go into a region and figure out the best way to market itself online. You mentioned social media influencers, Vince. That's very big for Estée Lauder. Their mobile base sales in the most recent quarter rose 70%. One of the things that distinguishes Estée Lauder from some of the other huge conglomerates that I look at is, they really understand where and when to sell. For example, there's a huge holiday in China called Singles Day, which happens every November 11th. And the better companies in China, those that are really great at marketing, fully take advantage of this holiday, and that's something that Estée Lauder has really jumped on. They also understand that it's important to be on places like Tmall, which is an online shopping venue in China, and they're really selling ferociously through that channel.

One of the things that you see that's the confluence of both of these trends is this travel retail. Often, consumers will learn about some of these aspirational brands within the company's portfolio within an area through an online channel, and then when they travel, they can buy those products. They aren't always available in specific regions in China. And Vince, as you mentioned, they're in 170 cities physically, they sell to another 480 cities in China online. So if you're a Chinese consumer, you may not have any retail presence that you can physically go to, but you learn about these brands, and when you travel to other Chinese cities or you travel abroad, that's the point at which you make that purchase.

There's one more thing that I found very insightful about the way the company has been able to sustain its growth, and that is, it pays attention to its flagship brands. The brands of Estée Lauder, Clinique, and MAC, together as a group, grew by double digits in this second fiscal quarter. And that is really impressive, because the Estée Lauder brand, of course, has been around for decades. I wanted to read one thing that the CEO, Fabrizio Freda, said in his most recent earnings call, which speaks to this: "Estée Lauder is a prime example of a heritage brand benefiting from continued consumer loyalty as it successfully innovates around its core products and engages consumers in modern ways. Although we continue to face strong competition or trial from upstart and indie brands, we believe many of them won't have the staying power and repurchase rate of our established brands and core product. Trial is often an investment."

So in the end there, he's speaking about this idea of getting product into the hands of consumers, often free. So they try it and then continue to buy it. But the amount of investment the company makes in its leading brands is impressive, and the fact that they're able to keep growing these flagship brands, which are older than I am, in the double digits, is simply amazing.

Shen: Yeah. We have a few more minutes here. I want to make sure we leave enough time to talk about these last couple of topics. One thing to keep in mind is, that growth in Asia, for example, very strong, other developing markets, very strong. But the U.S. home market is somewhere where they're seeing mixed results still, and that's something to keep in mind, in terms of how they're going to approach that. Traditionally, Estée Lauder has been very reliant on department stores. And obviously, there's a lot of changes, there's struggles going on in terms of department stores' brick-and-mortar operations. Given some of those challenges, the company is going to have to rethink how it can access consumers and meet their needs basically where consumers now choose to shop and how that's changing. For example, that might mean increasing offerings with certain specialty retailers like Ulta and Sephora

Also, they're working with department stores to improve that in-store experience and support their efforts to grow their online and digital businesses, too, because that's often an area of strength for these companies that have otherwise experienced a lot of weakness. Something else, again, the company mentioned, I think they said they're 20% into their efforts of taking advantage of some of the data and analytics they're getting from their consumers, in that they've managed to gather it from a lot of their online sites, in terms of, in partnership with some of these other retailers that they sell through. But the remaining 80% is in terms of how they can use that data to optimize the way they sell, how they gauge the demand and what consumers are looking for. But they are testing that and using that.

An interesting tidbit is how they're noticing how, for example, differences between the Boston and California markets might actually end up being bigger than the differences between the California and Japan markets. So being able to fine tune their offerings for each region is going to be really important for the company going forward.

I think, something else bigger picture in terms of risk for this company, of course, when you are a prestige brand, you're operating at luxury levels, and the risk of an economic downturn is always there. What do you think about that?

Sharma: Certainly. One of the things that we've seen is, during recessions, discretionary companies get hit, and this is one of those. Very interesting phenomenon going on. Retail traffic in the United States, Vince, as you mentioned, something that the company discloses in its annual report is its largest customer, which is Macy's. Macy's accounted for 8% of fiscal 2017 sales. So you can trace that decline in physical foot traffic and the way Macy's and its peer companies have been hit with the fact that U.S. sales only grew at a 5% rate in this most recent quarter. We were talking about Europe and the Middle East growing double digits, and of course Asia-Pacific growing over 33%. 

So the company has to find ways to offset that slowing foot traffic. Data and analytics could obviously be a key to doing that. If this experience of investing in data and analytics is going to be anything like the company's investments in technology and personalization have been for them, I think they can probably offset more foot traffic losses. It's good that at least this North American traffic hasn't caused revenue losses yet. They're still creeping along at a positive rate. So I think that the company will be able to, if the economy stays where it is at this slow growth rate, offset declines. 

Now, if we go into a slower phase of economic growth, obviously, then the company could get hit. Which leads us into this next, last topic, Vince, valuation. The stock has gotten a little pricey over the past 12 months.

Shen: Yeah. With a lot of the strength that we've spoken to with this business -- again, the shares being up about 80% in the past year, it's definitely approaching a point where that growth that it's seeing on the top line, the double-digit growth that it's seen in its earnings, it's very enviable, obviously, for this company, and it seems like a lot of investors are jumping in and trying to get a piece of that growth. I believe, in terms of its forward price-to-earnings, for example, it's at very high levels compared to its historical averages. So there's definitely a premium going on there. What do you think?

Sharma: This company is trading at about 35x forward earnings. That's 10 turns higher than its average over the last 10 years, which is about 25x forward earnings. Just to compare it to some of the companies that Estée Lauder lists as competitors: LVMH, that's Louis Vuitton Moët Hennessy, the famous luxury brand, trades at a forward P/E ratio of 25x. Coty trades also at a forward P/E ratio of 25x. Then, two companies which are broader consumer conglomerates, which nonetheless, each has divisions which provide a lot of competition to Estée Lauder, Procter & Gamble trades at a forward P/E ratio of 19x and Unilever trades at a forward P/E ratio of 20x. 

So you see all four of these great companies are cheaper right now relative to Estée Lauder. And that's the one thing which cools my enthusiasm a bit. I looked at the balance sheet, a very solid, clean balance sheet. Obviously, the company has the revenue side of the equation figured out. But if you look at the actual trailing 12-month P/E ratio of this company, it's past 50x. And on the chart, it looks like a Michael Jordan vertical leap, a standing vertical leap. Just, you pull it back a year and you just see it take off, where, as Vince mentioned, the stock moved this 80% over the last 12 months.

My personal opinion, if you're interested in investing in Estée Lauder, maybe wait for a pullback. I rarely say that with a great company. I always feel that over time, it truly doesn't matter. But here, this may be a case of, it's gotten a little bit ahead of itself. And I'm curious, Vince, what are your thoughts? Do you think it might have gotten just a little bit ahead of where its normalized price should be?

Shen: I think, in doing research for this, I wasn't previously very familiar with the company. I've been really won over, I think, by the story. In reading multiple calls and looking at their presentations with management, I think the way they're approaching this, the industry, their growth, their vision for how things will continue is really strong and compelling. And I generally do favor these companies that focus on these higher price points, this prestige level, as being stronger and a little more robust, in terms of the consumer demand and how they resonate with customers. 

So, I'm with you in that. But keeping in mind, long-term, this story is really important. I'd say, because the stock is trading at a premium right now, it's at a more expensive level, if you're interested in getting in, take a small position and then over time get into your position that way. That's always something we recommend with any stock that you invest in, not to dump everything you're planning to put into the stock at one time. You can ride out any major jumps over a period of six months or a year, for example, that way.

Sharma: Agreed. My last point, if you're interested in investing, read the conference call transcripts. There's so much going on and so many strategies that Estée Lauder is employing. I really couldn't do it justice in this brief podcast. But if you like the company, it's quite interesting, take a read through those, I think you'll be rewarded.

Shen: Alright. Thank you very much, Asit! That's all the time we have for today. We will definitely follow up on this company, probably later this year, see how they're going in terms of their bullish rally, and then how some of those various growth initiatives are panning out. 

People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Thanks again for listening and Fool on!