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Looking For A Bounce in Estee Lauder (EL)

By: Martin Tillier
Posted: 2/7/2014 10:18:00 AM
Referenced Stocks: EL

A colleague during my time in the foreign exchange market had a plan for the inevitable day when shouting and waving his arms around became a less attractive way of making a living. He devoted a portion of each paycheck to a fund which he used to open and run a small chain of hair salons.

To many of us this was hilarious as he was the antithesis of what most imagine a hairdresser to be; a big gruff man with rough edges and a short temper. His reasons for doing so, however, always struck me as sound. It was a recession proof business, he reasoned. Whatever the economic climate, people would still get their hair cut. If anything, in tough times the affordable luxury of beautification becomes more popular as a refuge from the harsh realities of life.

One would think that cosmetics would fall in the same category, but major international brands still get hit hard in tough times. Shares of Estee Lauder (EL), for example, lost over 63% between September of 2008 and March of 2009. The resilience of vanity is indicated by the stock's performance since then.

EL 1

I don’t know about you, but I regard 665% as a reasonable 5 year return.

Beyond showing the benefits of 20/20 hindsight, this observation does have a point. EL and other cosmetics companies are often heavily punished by the market for economic weakness in general, but that often just sets up an opportunity. So it was on Wednesday, when Estee Lauder released Q2 earnings. This was yet another one of those seemingly illogical reactions that baffle the casual observer and have been fairly common this earnings season.

EL reported earnings of $1.09 per share which beat management’s previous guidelines and consensus estimates, off of in-line revenues. The stock got trashed, trading close to 10% lower that day before recovering to close at $65.36, still a 5.5% drop from the previous day’s close. This all came on top of a tough couple of months for EL which had dropped from a high of $75.77 at the end of November. To understand the drop we must first understand the reason it got to that level in the first place.

As always, beating street estimates for revenue and earnings in previous quarters played a part, but the biggest driver of the move up was probably the prospect of growth in the Chinese market. As evidence of slowing growth in China surfaced the assumptions based into that $75+ valuation were questioned. By Wednesday’s release then, EL had been under pressure for some time. When management gave a somewhat downbeat outlook after reporting great numbers the market chose to focus on the negative. This is something I have pointed out before and is not unusual when a negative sentiment dominates, but it can be confusing if you just look at the headline numbers.

Often, this is a warning that there is more to come, but in EL’s case I believe it just sets up a great opportunity. Management have a history of cautious guidance and, while it is possible that market sentiment may stay negative for a while, Wednesday’s big drop took the stock into an area of significant, obvious technical support.

EL quickly bounced off of the $64 level shown by the yellow line and now that that has held four times a break back through the resistance around $68.50 looks more likely than any move significantly lower.

As with all technical levels this means nothing if the company fails to meet expectations, but I believe that from this fundamental perspective the negative reaction of the market looks overblown. Firstly, while growth in China is seen as important in the future, China is still a small part of Estee Lauder’s business. Let’s be clear, 10% growth in that market is disappointing compared to growth in the low 20s in the same Quarter last year, but it isn’t disaster.

It would, however, still be dangerous if expectations had led to ridiculously high valuations, but EL trades at a discount to other large cap consumer staples by many metrics. Even if expectations are revised somewhat lower, the stock still represents decent value in my eyes.

Using the logic of my erstwhile colleague it is distinctly possible that even if the Chinese economy begins to really slow, cosmetics could still be an area of decent growth as the emerging middle class there become even more status conscious. Hmmm, maybe I should take a look at Chinese hair salons...