LRLCY - L'Oréal: Great Fundamentals But A Little Pricey

2023-07-13 10:55:50 ET

Summary

• L'Oréal is the leading provider and manufacturer of beauty products.
• The company has enjoyed years of growth thanks to its strong pricing power and brand equity.
• According to my valuation, the stock is currently fairly valued.

Thesis

L'Oréal ( LRLCF ) is a high-quality business delivering high-quality beauty products. The company operates in an industry with high growth and where brand quality matters to the consumer. I assign the company a wide economic moat due to its pricing power, intangible assets and cost advantage. Despite all the pros I assign a hold because of the current valuation. I will explain the main points of my thesis below.

Company Overview & Outlook

L'Oréal was founded in 1909 and is the leading manufacturer and seller of beauty products. The firm derives revenue from five main segments: Skincare, Makeup, Haircare, Fragrance, and Hair coloring. L'Oréal owns more than 35 brands across many different channels and operates in 150 countries. Its products are sold in department stores, hair salons, e-commerce, and more. 29.9% of revenue comes from the EU, 26.6% from NA, 29.6% from North Asia, 6.2% from Latin America, and 7.7% from SSA. Most of L'Oréal's revenue comes from skincare (40%); the same thing is true with Estee Lauder, and for a good reason because skincare products tend to be very profitable and bought on a recurring basis.

L'Oréal's exposure to emerging markets will help them in the future as the middle class grows and expands, especially in countries like India and China. In fact, Consumers in China spend more on body products than their counterparts in North America and Europe. L'Oréal's market is substantial and growing. The beauty industry has been growing consistently for years now and is expected to keep growing at an annual rate of 5% from 2023 to 2027. I expect L'Oréal to share in this growth given its strong market position.

Competitive Advantages

I believe L'Oréal has many competitive advantages such as pricing power, cost advantage, brand equity, relationship with retailers, and more but I will only be focusing on the first three. L'Oréal has been a leader in the beauty market for years and I like to think that is possible because of its strong brand equity. The firm's portfolio of brands is well diversified among many different segments and geographies. The company has an 89% awareness rate in the U.S. which means 89 out of 100 Americans know the brand L'Oréal, 31% penetration rate, and 26% loyalty rate. L'Oréal spent an average of 31.74% of total revenue on advertising in the past three years making them the third largest ad buyer in the world. As a result, L'Oréal is the #1 player in the beauty market with a 19% market share in Europe, 14% in North America, 13% in North Asia, 10% in Latin America, and 11% in Sapmena.

L'Oréal's pricing power comes from its intangible assets and market. The company has previously said that 85% of its organic revenue growth comes from price and mix. This suggests that from 2018 to 2022, the firm had over 4% in annual price and mix increases which is way above the inflation rate of 2%. Despite the price increases the company has been implementing, revenue has hit an all-time high year after year since 2018. This shows that consumers aren't switching to another provider despite the price hikes, which speaks to how strong the company's brands are. Plus, the beauty market is dominated by big players such as L'Oréal, P&G, Estee Lauder, and Unilever, and there is very little room for small companies. This further proves that consumers care about the brand, not the price.

Below is an image that shows the percentage of people that pay attention to brands when buying cosmetics and body care by country.

As for cost advantage, it is very simple really. L'Oréal's products are in high demand and suppliers would want to do business with them and L'Oréal can leverage that by negotiating attractive deals related to procurement, manufacturing, and shipping. This helps the company minimize its costs which is why they have been able to maintain a gross margin of 72% in the past three years way above the sector median. In simple terms, L'Oréal has access to the same products and services as its peers but at a much lower cost. As a result of these competitive advantages, the firm has been able to maintain an ROIC of 15% without goodwill in the past five years, way above my WACC estimate of 8%.

Given the company's strong pricing power and cost advantage. Over the past five years, the firm has been able to expand its operating margin at a much faster rate than its peers. Gross Profit margin didn't experience much growth, but it's still above the sector median of 31%. However, the company's margins did get hurt in 2022 due to high inflation, but it seems like L'Oréal is holding up pretty well when compared to its peers, and that further proves the resilience of the company's intangible assets.

Recent Performance

The company reported very strong earnings growth in the first quarter of 2023 with 13.0% like-for-like, and 14.6% reported growth. All of the geographic zones experienced double digits growth except for North Asia due to a reduction of stock-in-trade in mainland China at the very beginning of the year. The company also experienced growth in volume which means the consumer is not ready to give up on the company's products despite sticky inflation.

Valuation

NOTE THAT THE VALUATIONS ARE RELATED TO THE STOCK LISTED ON THE FRENCH STOCK EXCHANGE. THE CURRENT PRICE IS €403.

The company is currently trading at a P/E ratio of 37.88x and EV/EBITDA of 27x. These ratios are high when compared to peers, but this is to be expected because L'Oréal is a company that investors are willing to pay a premium price for.

In my base case, I project an annual revenue growth rate of 6% from 2023 to 2027, with the Gross margin expanding by 200 basis points as a result of the company's cost advantage and strong pricing power. This implies an EPS of €11.57 and a P/E ratio of 35.84x for 2023. Using a discount rate of 8.07%, I discounted the future cash flow and terminal value into the present. I arrived at an equity value of $222 billion. As a result, I get a value of €412 per share which represents a 3% upside from the current price of €403. Thus, I assign a hold because the stock seems fairly valued to me.

Risks

1) The rise in E-commerce has lowered the barriers to entry in the beauty market making it easy for any new competitor to start selling online without much upstart cost. Plus, there are other big competitors such as P&G, Estee Lauder, and Unilever.

2) L'Oréal suffered a 6% revenue decline in 2020 amid COVID-19 but the company landed on its feet after growing by 15% in 2021 and 18% in 2022. Similar events can cause the company's revenue to decline.

The Bottom Line

The main takeaway is that L'Oréal is a market leader that I believe is protected by multiple competitive advantages. The firm operates in an industry that is still growing consistently and is not very exposed to macro conditions. The firm's exposure to the emerging market will help them as the middle class grows and expands. L'Oréal's commitment to allocate a lot of capital towards advertisement has allowed the company to enjoy years of growth, pricing power, and cost advantage. I assign a hold mainly because of the valuation. I will keep an eye on the company in case it enters my buy zone.

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