L’Oréal reported second-quarter like-for-like sales growth of 6.8%, a deceleration from the 7.7% first-quarter increase, but the first half’s 7.3% print is the strongest first half in more than a decade. Growth was once again driven by luxe (35% of sales) and active cosmetics (10%), posting LFL sales growth of 12.2% and 14.4%, respectively. Consumer (44%) and professional (11%) advanced 2.8% and 2.7%, respectively. Looking at geographies, new markets (46% of sales) continues to shine, with 17% LFL growth, driven by Asia-Pacific’s 26%. However, Western Europe (28%) only grew 1%, while North America (26%) LFL revenue fell 1% due to a slowdown in makeup. We think this backdrop is unlikely to shift materially, which puts the onus on the firm to bring new products to market that align with consumer trends.
E-commerce, now 13.2% of company revenue, was a highlight, posting 49% growth, materially above the 25% market growth rate. We expect this channel will continue to be a material growth driver across categories and regions, as ongoing channel diversification will help the firm reach a wider range of consumers in the U.S. and abroad. This channel has allowed consumers to interact with brand content at any point of the day, engage with the community around a brand, and still receive the high-touch services (such as virtual try-on or online beauty advisors) they would at a traditional beauty counter.
For the first half, L’Oréal posted a record high operating margin of 19.5%, up from 19.2% a year ago. The improvement was driven by slightly lower expenditures in selling, general, and administrative and research and development, partially offset by higher advertising and promotion expenses. Luxe (37% of profits) drove the most material margin gains, with operating margins increasing to 23.8% from 23.4% in the year-ago period.
Our fair value estimate of L’Oréal remains under review as we transition coverage. We expect to reinitiate a fair value estimate in September.
Business Strategy and Outlook
As a dominant player in the global cosmetics industry, L’Oréal has developed an attractive portfolio of leading brands that have helped it secure an enduring competitive edge. We maintain these brands have allowed L’Oréal to develop long-standing relationships with retailers that rely on its offerings to drive store traffic; these assets, coupled with the firm’s attractive cost structure, underpin our wide moat rating. While we expect ample competition in the near term, particularly as newer distribution channels like e-commerce remove some of the initial barriers for newer entrants, we think L’Oréal’s hefty investments in product development and advertising will allow it to remain a step ahead of smaller rivals and gain further share.
We think L’Oréal’s widespread geographic range also positions it for further growth. For one, we believe the firm has been able to establish a foothold in developing markets (which we expect to be a key driver of sales as per capita beauty spending rises) by adapting to local consumer tastes and trends. As evidence, it often invests in research and development on a regional level to tailor products and technologies toward consumers in the area. L’Oréal has also made several strategic acquisitions to build a presence in underpenetrated markets. In 2015, it acquired Niely Cosmeticos, a leading hair care firm in Brazil, to expand its position in one of the world’s largest hair care markets. We estimate L’Oréal is now a top hair care player in the country, with an above 20% share.
It has also acquired certain fast-growing cosmetics brands to expand this fare on a global scale; NYX, an American makeup brand acquired in 2014, posted sales growth of 78% the following year and 124% in 2016, quadrupling its sales within two years of being acquired as its offerings were launched globally. We expect the firm will prudently pursue additional bolt-on deals to expand its presence in underpenetrated countries and channels; we believe doing so (even at slightly elevated multiples) affords it the ability to tap into opportunities (from a distribution and customer perspective) that would be costly to build out on its own.
We think L’Oréal’s position as the leading global beauty company, with a roughly 13% market share, has allowed it to develop the substantial brand intangible assets and cost advantages needed to earn a wide economic moat. Its returns on invested capital have averaged 21% (14% including goodwill) over the last decade, well above our 7% cost of capital estimate, which supports our belief that the firm has been able to secure a sustainable competitive edge.
L’Oréal’s portfolio of brands includes both mass market (consumer products segment) and premium (L’Oréal Luxe, Active Cosmetics) offerings across the hair care, skin care, fragrance, and makeup categories. It owns three of the top five global makeup brands, according to GlobalData--Maybelline (around 9% global value share), L’Oréal Paris (6%), and Lancôme (3%)--which has allowed L’Oréal to form entrenched relationships with retailers that depend on leading brands to drive store traffic and inventory turnover. We contend L’Oréal enhances its bargaining power in these relationships through exclusive product launches with certain retailers, as these releases often boost the visibility of both parties. It has also been able to maintain pricing within its mass market beauty offerings, which we view as evidence of the firm’s durable brand assets across a range of price points. For example, its nail color brand, Essie, sells for roughly $9 at Target, Walmart, Walgreen’s, and Ulta; in our opinion, this minimal spread across a variety of retailers indicates the firm’s commitment to disciplined pricing.
We think L’Oréal’s pricing power is reinforced by the low level of private-label penetration in the category (which remains under 3% globally for makeup) as well as an aspect of conspicuous consumption, as cosmetics are often given as gifts. This dynamic is particularly evident in the firm’s luxury segment, as consumers are more likely to pay far more for the perceived higher quality of products from established high-end brands; the perception of these brands often takes decades to change, allowing for longer product lifecycles and sustained pricing premiums. Additionally, in the skin care category (32% of sales), we think consumers’ risk aversion to untested products allows for substantial brand recognition and further price gaps over private label offerings (averaging above 60% across the skin care category, by our estimates). L’Oréal devotes substantial resources to support these brand assets, including investments in advertising and promotion (averaging around EUR 6.8 billion annually, or 30% of sales, over the last 10 years) and research and development (averaging over EUR 750 million annually, or 3% of sales), which have allowed it to maintain visibility among consumers, sustain its retail relationships, and routinely launch innovative new products.
We believe L’Oréal also enjoys one of the most attractive cost structures in the household and personal care category. We think its scale provides it with greater purchasing power over suppliers than its smaller peers, allowing it to procure specialized inputs like custom packaging and thousands of raw materials at attractive unit costs. L’Oréal has developed a nimble supply chain that often allows it to source inputs locally (by our estimates, from around 100 countries) and produce goods close to the end markets. These advantages are reflected in its direct operating margin (which adjusts for costs not directly related to production and distribution), which we estimate to be around 56%--the highest among the household and personal care companies under our coverage.
Fair Value and Profit Drivers
We're raising our fair value estimate to EUR 192 per share from EUR 182 after incorporating fourth-quarter results and the time value of money since our last update. Our valuation implies a 2019 price/adjusted earnings ratio of 25 and an enterprise value/adjusted EBITDA ratio of 16. We remain optimistic about the firm’s near-term growth prospects and forecast five-year compound revenue growth of 5.1%. We think these top-line gains will be fueled by sustained investments behind the brand intangible assets that underpin its competitive edge. We model research and development expenses averaging above 3% of sales annually and advertising and promotion expenses averaging nearly 30% annually over our 10-year explicit forecast, both of which are comparable to the firm’s historical rates. L’Oréal’s initiatives to streamline its operations (which include improvements in its manufacturing, procurement, and supply chain) to create cost efficiencies should allow for strengthening profitability over the long term. We model gross margin averaging 73% and operating margin averaging around 20% over the next 10 years, versus 72.8% and 18.3%, respectively, in 2018. This suggests operating income growth averaging 6% annually over the next decade.
We expect L’Oréal Luxe (about 35% of sales) to be a key driver of growth over our forecast period, given premiumization trends that have led to outsize growth in the luxury cosmetics market. Management has estimated beauty consumers to be twice as likely to trade up than down, which makes sense given the perceived higher quality of luxury cosmetics. As such, we forecast sales in this segment averaging above 7% annual growth through 2023. We also think the consumer product division (45% of sales) will average above 3% growth over our forecast, as L’Oréal scales newer brands, like NYX, and launches new products within its core L’Oréal Paris and Maybelline franchises (which we estimate to be the top two global makeup brands, by value). An expanding middle class in developing markets should lead to higher disposable incomes and per capita cosmetics spending, as well. Consequently, we expect sales in L’Oréal’s new markets geographic segment (43% of 2018 sales) to average high-single-digit growth over the next five years (outpacing our roughly 4% estimate for the overall industry).
Risk and Uncertainty
From our perspective, the principal risks facing L’Oréal concern its capacity to make effective brand investments in the event of weakened per capita cosmetics spending, evolving consumer tastes, or heightened competition. While the global cosmetics market has remained healthy in recent years, averaging roughly 4% annual growth over the last decade, a softer macroeconomic outlook could curb discretionary spending and weigh on L’Oréal’s top line. Moreover, the firm generates around 70% of its revenue outside Western Europe, and currency volatility, particularly in developing markets, could damp sales and profitability.
L’Oréal’s primary challenge to defending its leading share will be its ability to develop products that resonate with consumers across the globe. A failure to adapt its portfolio to current beauty trends or local tastes could erode L’Oréal’s customer base, given the competitive cosmetics landscape (which includes other global branded operators as well as local peers). Further, an increased proportion of distribution through specialty multibrand stores and the e-commerce channel could allow smaller, niche entrants to gain traction in both the high-end and mass market segments. L’Oréal’s consumer product business could also be plagued by increased private-label penetration in mass market retail channels, which could weaken its pricing power, particularly if consumers’ spending power is constrained. We think L’Oréal will be able to defend its share against these headwinds, given the substantive resources it devotes to research and development (averaging above 3% of sales over the last decade) and advertising and promotion (30%), but note that its ability to grow above the overall cosmetics market will hinge on these investments.
Although L’Oréal has a controlled structure, with the founding Bettencourt family owning 33% of shares and Nestle owning another 23%, we think its stewardship of shareholder capital has been Standard, as demonstrated by returns on invested capital averaging 20% over the last decade. Chairman and CEO Jean-Paul Agon has been with the firm for over 40 years, including more than a decade in his current role, and we view his extensive experience as a valuable asset for the firm and its shareholders. Agon’s fixed compensation stands at EUR 2.2 million (unchanged since 2014).
The board of directors has 15 members, with three directors appointed by the Bettencourt Meyers family and two by Nestle. Nestle and the Bettencourt family have a bilateral agreement that prevents either party from raising its stakes until six months after the death of Liliane Bettencourt (which occurred in September 2017); consequently, both firms have had greater strategic flexibility since March 2018. However, we do not think Nestle is likely to dispose of this stake in the near term, particularly in light of the pronounced tax implications of such a move. We’d prefer if the directors were elected annually, rather than in staggered terms. While we note this structure limits the influence of minority shareholders on the firm’s long-term strategy, we view its actions to have been shareholder friendly thus far, as seen by its solid returns on invested capital and the amounts of excess cash returned to shareholders annually (with dividends and share repurchases totaling over EUR 2.5 billion in 2018).
We think L’Oréal’s recent acquisitions and divestitures have been in line with its strategy to expand into markets outside Western Europe and diversify its distribution. In 2015, the firm’s acquisition of Niely Cosmeticos, the largest independent hair care company in Brazil, cemented its position in the Latin American hair care market (with a more than 20% share in Brazil). In 2017, the firm’s new markets segment contributed above 40% of sales versus just over one fourth of sales in 2006 (implying high-single-digit annual sales growth in these regions), which suggests the firm has been able to build out its presence in faster-growing markets through strategic deals. But the firm isn’t merely focused on growth abroad. In 2016, it acquired IT Cosmetics, a U.S. prestige beauty brand for $1.2 billion, or roughly 6.6 times trailing annual sales, which we view as a fair price given that the brand posted 56% sales growth in the 12 months before it was acquired. We also view the divestiture of The Body Shop (sold to Natura in 2017 for an enterprise value of around EUR 1 billion, or 1.1 times sales) positively, as this disposal should allow the firm to allocate its resources to higher-return opportunities. As evidence, The Body Shop sales had fallen nearly 5% in 2016, and its operating margin averaged below 7% over the last five years, paling in comparison to the above 20% operating margins in the firm’s other segments.
The firm has been able to balance these investments with shareholder returns. L’Oréal’s dividend has increased annually for more than a decade (with an average payout ratio of 50% over this frame), and we expect the firm will continue to return cash to shareholders over the long term through dividends and share repurchases. Our 10-year forecast calls for average dividend growth of 7%, implying a payout ratio around 56%, and share repurchases averaging a low-single-digit percentage of shares outstanding.
L’Oréal is a leading cosmetics firm, with around a 13% global market share and operations in 140 countries. The firm’s consumer product segment, which sells brands like L’Oréal Paris, Maybelline New York, and Garnier in mass-market channels, contributes nearly half of its revenue. Its second-largest segment, L’Oréal Luxe (35% of sales), sells luxury beauty brands, including Lancôme, Kiehl’s, and Urban Decay, through more selective distribution channels. Roughly two thirds of the company’s sales are generated outside Western Europe.