In theory, there is a lot to like about the beauty, fragrance, and skin care sector. Estee Lauder's (NYSE:EL) focus on premium products plays to the return of high-end spending, while Elizabeth Arden's (NASDAQ:RDEN) fragrances have been working well this year. Meanwhile, a weak employment market should ensure that Avon Products (NYSE:AVP) can find representatives, and Revlon's (NYSE:REV) mass market consumer must surely be better positioned in 2014.
Moreover, an aging demographic coupled with declining marriage rates in developed markets should ensure strong demand from developed markets in the future. Meanwhile, a growing middle class in the emerging world is likely to spur prospects for years to come. On the other hand, the sector has much of this already priced into its valuation. Is there still value in the sector?
Bifurcated consumers, Elizabeth Arden and Revlon
While demographics and social trends are favoring the sector, it is not immune from economic realities. The big story in retail over the last few years has been how markets have become increasingly bifurcated. In other words, luxury goods are doing fine, and the low end has been outperforming in relative terms due to consumers trading down. However, mass market consumer products are finding life very tough.
These themes have also played out in the beauty companies. For example, Elizabeth Arden recently reported that its prestige channel sales grew 5% in its last quarter, while its mass retail sales were down mid-single digits in-line with the category. All told, its reported sales fell in the quarter.
It was a similar story with mass-market focused beauty companies like Revlon, who reported a sales decrease of 2.2% in its third quarter. Indeed, Revlon has sought to diversify its end market exposure with its $655 million acquisition of The Colomer Group, a company that sells professional beauty products to salons.
Get the Avon lady smiling again
Avon Products(NYSE:AVP) differs from the others in that it has a direct selling distribution model. Theoretically this makes it an attractive company in a weak employment market, because it shouldn't have difficulty in recruiting distributors. However, it hasn't quite worked out like that recently. Its core US market "continues to decline" according to its management on its recent conference call.
It gets worse. Avon has a served model transformation, or SMT, initiative with which it intends to make internal improvements to its business. Unfortunately, the pilot program in Canada led to a "steep drop in the active representative count". This is not a good sign for a company that intends to turn around its sales organization.
Estee Lauder's(NYSE:EL) focus on the premium end of the market probably makes it the most attractive company in the sector, but is it a buy?
Estee Lauder's puts and takes
As you would expect, Estee Lauder's operating performance has many things in common with its peers.
First, the industry has had to innovate in order to stand still. Revlon's innovation has, by its own admission, had "mixed results" with its Nearly Naked face creams underperforming expectations. Similarly, Elizabeth Arden's fragrance sales suffered a slight decline in its last quarter, because these products came up against a high volume of fragrance launches last year. The lesson is that beauty companies need to keep innovating.
Unfortunately for the company, many of Estee Lauder's innovative new products for the holiday season are coming from its fragrance category. Fragrance is one of its smallest categories, and it has the lowest operating margin (10% compared to the company average of 16.8%). One concern is that Estee Lauder is investing in lower margin businesses to generate growth.
Second, the overriding lesson of retail this year has been that if you don't offer promotions you will lose market share. Indeed, Estee Lauder highlighted that the environment was "very promotional" from July to September, but its "focus was on innovation." Quoting from its recent conference call, Estee Lauder's management said:
Now we believe that our promotion, our competitiveness, during the holiday season will be dramatically improved. Our programs are much stronger, in this sense, however, we do not plan to increase promotions for the long term.
This looks like a response to tough conditions over Christmas, but will Estee Lauder be forced to promote after Christmas as well?
Finally, like Avon, Estee Lauder is undergoing a major initiative in order to improve its operational performance. Estee Lauder's strategic management initiative, or SMI, is essentially a SAP roll-out intended to improve inventory turns from two times to three times in the future. In plain English, this means it will hold less inventory in order to sell the same amount of goods.
To be fair, the SMI is still being rolled out and it's causing disruptions to Estee Lauder's sales patterns, as retailers tend to buy in ahead of implementation. However, the plan to get the magic three multiple seems a long way away considering current trends.
Estee Lauder attractive but at what price?
In conclusion, theory is a wonderful thing, but reality is another. The facts are that the beauty sector is a tough market to be in right now. Avon has internal issues to deal with, Revlon is trying to diversify away from its core mass consumer market, and Elizabeth Arden is forced to innovate in order to generate growth.
Estee Lauder appears the most attractive, but it too faces concerns. Furthermore, with a P/E ratio of nearly 26 times forward earnings to June 2014, the stock is hardly a good value.
Lee Samaha has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.