SSDOF - L'Oreal: Good Prospects Quality Business But Pricey

2023-06-11 03:59:27 ET

Summary

• Solid Q1 2023 performance with double-digit sales growth despite China's sluggishness.
• Near-term prospects are cautiously optimistic, with buoyant global beauty market and potential market share gains supporting L'Oreal's financial performance.
• Numerous factors to support medium-term performance.
• Inventory risks could negatively affect near-term prospects while competitive risks could dampen medium-term prospects.

Good prospects for the world’s leading cosmetics giant L’Oreal ( OTCPK:LRLCF ) but valuation is pricey.

Q1 2023: solid performance with sales up by double digits despite sluggishness from China

Continuing on last year’s momentum when sales rose 10.9% YoY on a like-for-like basis to EUR 38.26 billion for the year ended December 2022, L’Oreal delivered a solid quarter for Q1 2023 (quarter ended March 2023), with sales up 13% YoY on a like-for-like basis and 14.6% YoY on a reported basis to EUR 10.38 billion. The performance is noteworthy considering continued softness from China. L’Oreal’s performance outpaced rival Estee Lauder ( EL ) whose Q3 FY 2023 (quarter ended March 2023) sales dropped 12% YoY to USD 3.75 billion partly due to slower than anticipated recovery of Asia travel retail.

All segments delivered strong performance.

• Consumer Products, L’Oreal’s biggest segment by revenues which covers brands like L’Oreal Paris, Garnier, and Maybelline New York to name a few, reported sales of EUR 3.8 billion for the quarter, up 14.7% YoY on a like-for-like basis.

• Luxe, L’Oreal’s second-biggest segment by revenues which covers brands like Lancome, Yves Saint Laurent, Armani, Biotherm, Urban Decay, Valentina, Prada, Diesel, Takami, reported sales of EUR 3.7 billion, up 6.5% YoY on a like-for-like basis.

• Dermatological Beauty, which covers brands like La Roche-Posay, Vichy, CeraVe, was the fastest-growing segment for Q1 2023, with sales rising 30.6% YoY on a like-for-like basis to EUR 1.6 billion.

• Professional Products, which covers brands like L’Oreal Professionnel Paris, Pureology, Pulp Riot, and Matrix, reported sales of EUR 1.1 billion for the quarter, up 7.6% YoY on a like-for-like basis.

Strong performance from all geographies except North Asia which was dragged by China weakness but nevertheless grew in the low single digits, partly supported by L’Oreal proactively leveraging their local eCommerce channels to drive sales.

• Europe saw sales rose 16% YoY on a like-for-like basis to EUR 3.3 billion.

• North America sales rose 16.6% YoY on a like-for-like basis to EUR 2.7 billion.

• North Asia sales rose 1.9% YoY on a like-for-like basis to EUR 2.83 billion.

• SAPMENA-SSA sales rose 26.7% YoY on a like-for-like basis to EUR 840.8 million.

• Latin America sales rose 22.3% YoY on a like-for-like basis to EUR 684.4 million.

Near term, there are reasons to be cautiously optimistic about L’Oreal’s prospects. Inflation is moderating , a positive for consumer spending power and therefore the outlook for beauty product sales which have so far held up well despite macro headwinds, possibly due in part to the lipstick effect.

Meanwhile China, which has been a drag on beauty sales due to the country’s covid lockdown policy which was relaxed in December last year, could see growing momentum in beauty sales as travel and social activity resumes. L’Oreal navigated China's market challenges very well last year and appears well prepared to capitalize on a pickup in China’s beauty sales this year. L’Oreal could possibly gain market share in the country at the expense of rival Estee Lauder who, with its longer supply chain in China (Estee Lauder doesn't have a production facility in China and imports products from facilities around the world) is at a disadvantage compared to L’Oreal who has manufacturing and distribution facilities in the country.

L’Oreal management is confident of the company’s outlook for 2023 expecting to achieve continued sales growth this year, in contrast to rival Estee Lauder who expects FY 2023 full year sales to decline between 10%-12% ..

Looking further ahead…

Bright prospects for the global beauty market, particularly exciting prospects in markets like India

Global beauty sales are expected to continue growing, with growth projected in the low single digits . Certain markets offer particularly promising opportunities notably India where the addressable market is expected to double over the next three years on the back of a rapidly expanding middle class. L’Oreal with its global presence, large brand and product portfolio which caters to a wide spectrum of age brackets and beauty needs (such as skin and hair types etc), and scale advantages is positioned to capture some of that growth.

Market share gains to support financial performance

L’Oreal’s market share increased to over 14% in 2022, from 13.2% two years ago.

A number of strategic factors could support continued market share gains. The company is acquisitive and could increase market share inorganically; recent acquisitions include luxe brand Aesop for USD 2.5 billion and Skin Better Science . The company’s strategy has long been to acquire small emerging brands and scale them using their extensive distribution network. For Aesop for instance, L’Oreal has identified significant growth opportunities in China. Decent leverage gives balance sheet flexibility for further acquisitions; L’Oreal’s debt to equity is 20.8, considerably better than rivals like Estee Lauder, Shiseido ( OTCPK:SSDOY ), and Unilever ( UL ).

Innovation and R&D efforts could support organic market share gains and L’Oreal’s size advantage could translate into advantages on the innovation front.. L’Oreal’s R&D expenses have continued to grow for years, reaching EUR 1.1 billion in 2022, representing an R&D intensity of ~3%. L’Oreal’s R&D spend is higher in absolute and relative terms compared to rival Estee Lauder who spent USD 307 million on R&D translating into an R&D intensity of 1.7%.

Additionally, the scale up of newly acquired emerging brands could contribute to continued growth. Smaller brands like Takami , and Youth to the People , both acquired by L'Oreal in 2021, are at the early stages of their globalization journey and could contribute to market share gains and revenue growth.

Margins steady, decent balance sheet, consistent growth in FCF

L'Oreal’s FY 2022 operating margin expanded 40 basis points to 19.5%. Net profit margin improved to nearly 15%. Margins have largely remained the same over the past decade. Rival Estee Lauder's FY 2022 operating margin rose to 20%, up from 18.5% the previous year. Net margins however were down to 13.5% from 17.7% the previous year.

L'Oreal's current ratio is decent at 1.02, and quick ratio at 0.61.

FCF growth has been lumpy, but on a clear upward trajectory over the past decade. FY 2022 FCF dipped in large part due to inventory policy whereby management decided to increase their safety stocks, mainly in the U.S ., to counter supply chain bottlenecks.

Risks

Competitive risks

Barriers to entry in the beauty industry have been historically low and changing consumer preferences and beauty trends open avenues for new players to enter, presenting considerable competitive risks in a fragmented market.

Over in India and China, both very promising markets, competition is intense not only from international players like Unilever and Estee Lauder, but from a number of mushrooming local players as well. Notable local players in China include established players like Pechoin, and new players like Skynfuture (one of China’s fastest-growing beauty players with a YoY growth of more than 900% in eCommerce sales),

Notable competitors in India include established players like Forest Essentials and Kama Ayurveda, unicorn beauty startups Mamaearth and MyGlamm , and smaller players like SUGAR Cosmetics, WOW Skin Science and Plum to name just a few.

These local brands may have the advantage of a better understanding of local culture and tastes, presenting formidable competition to international players.

Inventory

L’Oreal’s inventory levels increased considerably in 2022 (up nearly EUR 1 billion to EUR 4 billion at the end of 2022 from EUR 3.1 billion the previous year). If the demand environment sours due to a prolonged or more severe-than-anticipated recession, L’Oreal may be stuck with excess inventory and may be forced to book inventory write downs.

Conclusion

L'Oreal continues to deliver solid results on the back of market share gains and a resilient beauty market. L'Oreal could be poised to continue this momentum as inflation moderates and China's economy re-opens near term. Looking further ahead, L'Oreal's continued investments into innovation, acquisitions, and scale up of newly acquired smaller brands could support performance but competitive risks could dampen their prospects.

Analysts are mostly neutral on the stock.

L’Oreal’s stock is up 27% over the past year and currently trades at a P/E of 38, higher than the sector median of 22.4, and their current market capitalization of USD 230 billion (around EUR 213 billion) is 38 times higher than L'Oreal's FCF which has hovered around EUR 5.5 billion over the past three years, quite pricey considering competitive risks in what is a mature, relatively slow-growing, fragmented, and fast-changing industry. L'Oreal's prospects while good, are likely baked into the stock. Investors may opt to wait for a better entry point and the stock could be viewed as a hold.

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