In 2019, L’Oréal reported like-for-like sales growth of 8%, outpacing our 7% estimate and global beauty market growth of 5.0%-5.5%. Asia-Pacific (now L’Oréal’s largest region at 32% of sales) grew an impressive 26%, which contrasts sharply with Western Europe’s (28% of sales) 2% gain and North America’s (25% of sales) 1% drop. L’Oréal gained market share in three of its four segments: luxe, professional, and active cosmetics, with the latter growing at 16%, more than double the market rate of 7%. However, L’Oréal’s global consumer segment grew 3%, lagging the market’s 4% rate. To improve the segment’s performance in 2020, the firm put new organizations in place in the problematic markets of the U.S. and Brazil, developed a more robust lineup of innovations, and implemented a program designed to better serve emerging markets and improve execution.
In fiscal 2019, L’Oréal’s adjusted operating margins increased 30 basis points to 18.6%, missing our 19.1% forecast, which resulted in EPS of EUR 7.74 that fell short of our EUR 7.93 estimate. However, the underperformance was due to higher-than-expected marketing investment (30.8% of sales compared with our 30.0% estimate). We view this as a good use of capital, given the firm’s marketing prowess, as these investments strengthen its brand equities, which underpins our wide moat rating.
While near-term volatility in L’Oréal’s results due to the coronavirus and the firm’s material exposure to China is likely, the impact of shuttered stores on sales should be somewhat mitigated, as half of China’s sales are online. Once the outbreak is contained, we expect L’Oréal’s growth trajectory in the country to resume, as was its experience with SARS and MERS outbreaks in 2003 and 2012-13, respectively. We do not expect to make a material revision to our EUR 193 per share fair value estimate (outside of adjustments related to the time value of money). As such, we encourage investors to remain on the sidelines at current levels.
Business Strategy and Outlook
We believe L’Oréal has secured a wide moat, fortified by a mix of market-leading brands, entrenched relationships with retailers, and a cost advantage, underpinned by scale. L’Oréal is the world’s third-largest advertiser, which we think affords it a degree of negotiating power. We expect these benefits to endure for the next 20 years, prompting its wide moat designation.
L’Oréal is the world leader in beauty, and as such, is well positioned to benefit from the mid-single-digit growth of the industry. Across the globe, per capita consumption of beauty products is on the rise, driven by a steady gain in the purchasing power of the middle class, particularly in emerging markets where L’Oréal sourced 43% of 2018 revenue. Consumers in Eastern Europe and Latin America spend one third of the level that developed market consumers spend on beauty, while consumers in Asia and the Middle East spend only 20%. We believe that L’Oréal’s strong brands, coupled with its marketing and research and development (R&D) prowess, will help ensure the firm remains a key beneficiary of this secular growth.
One characteristic of L’Oréal that sets it apart from its peers is its wide-reaching, well-balanced portfolio across mass, prestige, salon, and medical/dermatological channels. The firm is adept at pivoting resources to best opportunities. It is currently facing headwinds in mass beauty (as consumers trade up to prestige), department stores (as consumers shift to other channels), and makeup in North America (which has slowed from a 2017 cyclical peak). Even so, for the first half 2019, L’Oréal posted organic constant currency revenue growth of 7.3%. This diversification has also served it well in a more recessionary climate. Heading into the great recession of 2008 and 2009, L’Oréal was reporting high-single-digit revenue growth. In 2008 and 2009, revenue decelerated to 2.8% and negative 0.4%, respectively, before rebounding to 11.6% in 2010. While these growth rates are modestly boosted by acquisitions, we think the continued growth of revenue during a challenging economic landscape demonstrates the benefits of L’Oréal’s diversified exposure.
We believe that L’Oréal’s portfolio of strong brands, entrenched relationships with its retail partners, and cost advantages afford it a wide economic moat. These advantages are further evidenced by returns on invested capital (ROIC) including goodwill that has averaged 22% over the past 10 years, well in excess of our 7% estimate of the firm’s weighted average cost of capital (WACC).
We think L’Oréal’s dominance in global beauty speaks to the strength of its brands and also enables the company’s strategic partner status with retailers. L’Oréal is the #1 player in the global beauty market, with $29.4 billion in annual beauty revenue, compared with $21.5 billion for #2 Unilever and $12.8 billion for #3 Estee Lauder. L’Oréal’s market leadership expands across the globe, with the firm holding the #1 spot in North America, Asia-Pacific, Western Europe, and Eastern Europe. L’Oréal is the #2 player in Africa/Middle East, and the #3 company in Latin America. We estimate that about 50% of the global beauty market is considered mass, which consists of moderately priced items sold primarily in supermarkets, drugstores, discount stores, specialty beauty outlets, and online. We estimate 25% is considered prestige beauty, premium priced items sold in department stores, travel retail, freestanding stores, and online. L’Oréal holds the top spot in mass market beauty and is the #2 player in prestige, behind Estee Lauder. The remaining 25% of the market is split between the professional channel, catering to hair and nail salons, and dermo-cosmetics, serving medi-spas and dermatologists.
L’Oréal has a dominating presence across all beauty categories. The beauty market is primarily composed of skincare, makeup, haircare, and fragrance. According to GlobalData, L’Oréal is the leader in skincare with 10% share (ahead of Beiersdorf’s 5%), and the leader in makeup with 21% share, ahead of Estee Lauder’s 11%. In haircare, L’Oréal and Procter & Gamble are tied for the top spot with 16% share. In fragrance, #2 L’Oréal’s 9% market share lags Coty’s 14% slice. L’Oréal has several brands that have reached top 10 global status. Its namesake brand is #1 in haircare, #2 in makeup, and #3 in skincare. Lancôme is #5 in makeup, #7 in skincare, and #9 in fragrance. Maybelline is the #1 makeup brand, Garnier is #3 in haircare, and Giorgio Armani is #6 in fragrance.
We think the demonstrated pricing power of L’Oréal’s brands provides further evidence of strong brand equities. L’Oréal has disclosed that about 85% of its organic revenue growth stems from a combination of price and mix. Over the past five years, this implies over 4% in annual price/mix increases, well above the rate of inflation. We note that over the long term, L’Oréal’s gross margins have improved, which is another indicator of ability to price above the rate of inflation, as the mix of its business has been relatively stable over time. Private label has a very low level of penetration in the beauty categories, which we think indicates that consumers are not as price sensitive, and brands play a more important role than price for purchasing decisions. According to GlobalData, private-label penetration is only 3.4% in skincare, 2.7% in haircare, 2.5% in makeup, and 0.9% in fragrance. These rates are much smaller than the mid-single-digit to low-double-digit range for most other consumer packaged goods (CPG) categories.
The Morningstar Cosmetic Brand Strength Framework (adapted from the Morningstar CPG Manufacturers Brand Strength Framework) was constructed to assess the brand strength of the various companies in the cosmetics space. It evaluates each cosmetic firm’s pricing power, market share, the importance of safety/consumers risk aversion, protection from private label, and level of conspicuous consumption. It is our belief that the strongest brands have pricing power and high market share. We think they operate in categories where consumers are more risk averse to trying unfamiliar products, and categories that have a low level of private label penetration. Finally, we believe strong brands tend to have a high level of conspicuous consumption, as consumers are less price sensitive for items that display wealth or social status. The framework rates L’Oréal as having a high degree of brand strength overall, with high scores for pricing power, market share, and the importance of safety/consumers risk aversion, and moderate scores for protection from private label and level of conspicuous consumption. L’Oréal does not carry a low rating for any metric.
We think L’Oréal’s substantial investments in its brands have contributed to strong brand equities as well as entrenched relationships with retailers, as a consistent stream of innovative products and subsequent advertisements serve to drive traffic into stores and online. Over the past five years, L’Oréal spent an average of 29.4% of revenue on advertising and promotion (ahead of the 19.0% global beauty average), and 3.3% on research and development, also ahead of the 2.5% average. But we do not surmise that the level of spending alone drives these intangible assets. We believe that L’Oréal is a good steward of these resources and realizes a very high return on these investments. In fact, L’Oréal has reported that six of its brands (Maybelline, NYX, Urban Decay, L’Oréal Paris, Lancôme, and Kiehl’s) have received recognition for excellence in digital marketing, social media, e-commerce, and mobile. L’Oréal has also disclosed that 43% of media spend is for digital marketing and an impressive 75% is allocated to precision advertising, which reaches consumers identified as having a high propensity to purchase the touted product. This is materially higher than the 10% to 20% average spend we estimate most CPG companies direct toward precision marketing.
With its leading brands and vast resources to support its mix (through innovation and marketing), we think L’Oréal also benefits from entrenched relationships with retailers, which we believe helps to secure the firm’s intangible assets. Furthermore, the beauty market is attractive to retailers as it reports a higher growth rate (mid-single-digit) than most other consumer products (low-single-digit). We surmise its standing dissuades retailers from discounting its fare (crucial as it works to sustain its premium brand image). We think L’Oréal’s clout with these retailers can be demonstrated by the consistent prices on the firm’s products across channels. For example, the Urban Decay Naked2 palette sells for $54, whether at Ulta, Sephora, or Nordstrom. Even in mass, price disparities are limited. Essie “Ballet Slippers” nail polish sells for $8.77 at Walmart, $8.79 at Target, and $9.00 at Walgreens and Ulta.
We believe another facet of L’Oréal’s competitive edge stems from a scale-based cost advantage, given its position as the dominant player in global beauty. We think its scale provides it with greater purchasing power over suppliers than its smaller peers, which allows the firm to procure inputs at attractive unit costs. Advertising is a significant expense for L’Oréal, and as the world’s third-largest advertiser (behind Samsung and Procter & Gamble), the firm should be able to procure the related products and services at a lower rate than most of its peers. We think the firm’s global network also results in scale-related efficiencies in manufacturing and transportation. Furthermore, we believe the firm’s vast resources enable it to respond to evolving consumer trends more effectively and to help the firm recover more quickly and cost effectively if it were to miss a trend. In order to gauge a firm’s cost advantage, we look at direct operating margin, which adjusts for costs not directly related to production and distribution--discretionary costs such as advertising and research and development. L’Oréal has the highest direct operating margin of all the beauty companies under our coverage, at 56.0%, compared with the 40.8% average for all global beauty companies under Morningstar coverage.
Finally, we think additional evidence of L’Oréal’s competitive edge is reflected in the high ROICs that it reports, averaging 22% including goodwill and 48% excluding goodwill over the past 10 years, substantially higher than our 7% estimate of the firm’s cost of capital. Furthermore, this high level of return has been remarkably consistent, ranging from 18.6% to 23.8%.
Fair Value and Profit Drivers
We are nudging up our fair value estimate for L’Oréal to EUR 193 from EUR 192 primarily due to cash generated since our last update. We maintain our long-term expectations for mid-single-digit revenue growth and operating margins gradually increasing to 20% over the next 10 years. Our updated valuation implies fiscal 2020 price/adjusted earnings of 24 times and an enterprise value/adjusted EBITDA of 15 times.
Given the strong secular growth driving higher beauty consumption, we expect 6.6% average revenue growth over the next five years, moderating to 4.5% over the last five years of our 10-year explicit outlook (with long-term constant-currency growth estimates of 6% for luxe and active cosmetics, 2.5% for consumer, and 2.0% for professional). This outlook generally aligns with (or is a modest deceleration) from its recent performance. As such, over the last five years, constant-currency organic growth has averaged 9.0% for luxe, 8.0% for active cosmetics, 2.6% for consumer, and 2.0% for professional. While it is probable that the firm will engage in various acquisitions and divestitures, we do not include unannounced deals in our model (given the uncertainty surrounding timing and magnitude).
We expect ongoing productivity enhancements and mix improvements to increase gross margins 10 basis points annually, taking gross margins from last year’s 72.8% to 73.8% over the next 10 years. We believe selling, general, and administrative expense (SG&A) as a percent of sales will remain in line with historical levels, at around 20.5% including depreciation and amortization. We expect the firm to continue to invest heavily in its brands, which we view as essential to maintaining strong brand equities, a cornerstone of the firm’s wide moat. Our forecast calls for advertising and promotion at 30.0% of sales and R&D maintaining a 3.4% level. The net result is 20.0% operating margins by the end of our explicit forecast.
Risk and Uncertainty
L’Oréal is a global company that conducts business in over 150 countries. While the production of products in the consumer division is spread across the globe, all active cosmetics and professional products are produced in continental Europe, while luxury products are produced in continental Europe, the U.S., and Japan. Therefore, open trade policy is essential for the firm to provide products in a timely and cost-effective manner. Given the uncertainties with Brexit, as well as ever-evolving U.S. trade policy, it is difficult to ensure that L’Oréal will be able to continually supply product in an efficient manner.
The firm’s global reach also subjects the company to volatility as it pertains to currency fluctuations and uncertain economic and political environments. For instance, the protests in Honk Kong have impacted retail sales not only in Hong Kong, but travel retail throughout the region has been impacted.
Furthermore, the growing prevalence of e-commerce and digital marketing has reduced barriers to entry in the beauty market, for makeup in particular. As a result, there has been an onslaught of new market entrants, some of which have had a better pulse of evolving consumer trends and have made significant traction in the marketplace. While L’Oréal’s large brands have continued to report robust growth, even with the growing popularity of these independent brands, the onslaught of new entrants is unlikely to abate, particularly as the channels through which consumers purchase are likely to continue to bifurcate.
We are upgrading L’Oréal’s stewardship rating from Standard to Exemplary, due to the firm’s demonstrated judicious use of shareholder capital and diligent governance.
Jean-Paul Agon was named CEO in 2006, adding the chairman role in 2011. He joined L’Oréal in 1978 and held numerous positions of increasing responsibility across division and continents. The business has performed well under his leadership, reporting consistent ROICs in the low-20s including goodwill and in the upper-40s excluding goodwill. The stock has also performed well during his tenure. Over the past 10 years, the shares have averaged 11.9% annual total return, compared with 11.4% for the household and personal products industry and 9.3% for the Morningstar France total return index.
The board consists of 15 directors: chairman Agon, three members of the Bettencourt family (descendants of the founder), who own 33.1% of the firm, two directors from Nestle, which owns 23.2% of shares, seven independent directors, and two employee representatives, as employees own 1.5%. In 2014, Nestle sold a portion of its stake back to L’Oréal, reducing its ownership from 29% to the current 23%, to acquire L’Oréal’s interest in the 50/50 joint venture Galderma, a provider of dermatological solutions. Prior to March 2018, Nestle and the Bettencourt family had a bilateral agreement that prevented either entity from raising its stakes in L’Oréal, but the parties have not renewed the agreement, giving both parties increased flexibility. Even so, Nestle has stated it has no intention of increasing its stake in L’Oréal, and we do not anticipate a reduction either, due to the pronounced tax implications of such a move.
We applaud the board’s diversity in terms of nationality (given L’Oréal’s global customer base) and gender (46% female), as the firm’s customers are largely women. We think the board’s diverse experience in profession (finance, sales, marketing, science, to name a few) and industry (consumer products, digital marketing, and investments) stands to serve shareholders well. While we generally prefer the roles of chairman and CEO to be separated, as we think this enhances independence, this is somewhat mitigated by nearly half of the directors being independent. Furthermore, the board periodically reviews the optimal board structure, specifically if the roles of CEO and chairman should be separated. Between 2006 and 2011 the roles were separated to ensure a smooth transition between Sir Lindsay Owen-Jones (the previous CEO) and Agon. In 2014 and 2018, the board conducted a review and determined that the firm is better served by Agon maintaining both roles, and we appreciate that the current structure helps ensure decisions can be made quickly in the highly competitive international environment. Directors serve four-year terms, which we think is not optimal, as we believe one-year terms empower shareholders to make changes, if they see fit.
L’Oréal has demonstrated prudence (if not conservatism) in compensating board members and executives. The average board member is paid about EUR 90,000 ($100,000) annually, half the amount of the median S&P 500 board member. Executive compensation also seems judicious, with Agon’s fixed compensation holding at EUR 2.2 million, unchanged since 2014. Executive compensation is designed to be 25% fixed, 25% short-term incentive, and 50% long-term incentive, which we think sufficiently incents executives. Variable compensation is tied to goals related to like-for-like sales growth, market share growth, operating profit, earnings per share, cash flow, and sustainability. While we think these metrics are aligned with shareholder interests, we think the addition of a ROIC target would be beneficial.
The valuations of L’Oréal’s acquisitions and divestitures appears to be fair. In 2017, the firm sold The Body Shop for $1.1 billion, 12 times EBITDA per our estimate, which seems reasonable given the business’ low-single-digit growth and mid-single-digit profitability. We think the divestiture was astute, as it freed up capital for L’Oréal to invest in businesses with more favorable growth and profitability. Also in 2017, L’Oréal purchased various skincare brands (including CeraVe) from Valeant Pharmaceuticals for $1.3 billion, or 7.7 times revenue. Although this multiple is quite high, we believe the firm is extracting significant value as it expands the high-growth CeraVe brand, which was one of the drivers of the active cosmetic’s impressive 11.9% organic constant currency growth for 2018. In 2016, L’Oréal purchased IT Cosmetics (a U.S.-based line of makeup and skincare) for $1.2 billion, or 6.6 times sales, which we view as fair, given the business’s 56% revenue growth in the year preceding the transaction.
L’Oréal, founded in 1909 by Eugene Schueller when he developed the first harmless hair colorant, is the world’s largest beauty company. It participates primarily in skincare (32% of 2018 revenue), makeup (27%), haircare (27%), and fragrance (9%). L’Oréal is a global firm, with 30% of its revenue sourced from Western Europe, 27% from North America, and 43% from emerging markets (27% Asia-Pacific, 7% Latin America, 7% Eastern Europe, and 3% Africa/Middle East). The firm sells its products in many channels, including mass retail, drugstores/pharmacies, department stores/perfumeries, hair salons, medi-spas, branded freestanding stores, travel retail, and e-commerce. The firm’s top selling brands are Lancôme, Yves Saint Laurent, Maybelline, Kiehl’s, L’Oréal Paris, Garnier, and Armani.