The Long and Short
Estee Lauder downgraded by S&P
Meredith Contente | December 1, 2023
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
While investment grade corporate bond spreads have largely moved tighter lately, Estee Lauder’s front end debt has tightened more than its peers in the ‘A’ US consumer discretionary curve, despite a downgrade from S&P. The downgrade comes on the heels of the company’s fiscal first quarter earnings. While EL hit its quarterly guidance, management revised its full year outlook downward given persistent weakness in the company’s retail travel business. Outlooks at both rating agencies are currently negative as leverage is expected to remain above the threshold for the current A1/A ratings.
Given the continued ratings risk, EL’s front end debt, particularly in the three-to-five-year part of the curve could underperform. Any improvement to leverage now seems pushed to fiscal 2025 at the earliest, as management prioritizes capital spending and the dividend over debt reduction. While the severe decline in the travel retail channel is only anticipated to be temporary, any protraction is negative for both leverage and the ratings. (Exhibit 1).
Exhibit 1. EL Curve vs. Single-A US Consumer Discretionary Curve (Week over Week)
Fiscal 1Q Results
EL saw organic net sales fall 11% in the quarter, driven by continued weakness in its Asia travel retail business coupled with a slower-than-expected recovery of prestige beauty in China. While these headwinds were partially offset by organic growth in the US and nearly all markets in EMEA, the continued weakness in China led the company to reduce full year guidance. Management expects the headwinds in China to persist throughout fiscal 2024. EL’s operating income dropped 85% year-over-year, leading to a 14-percentage point decline in the operating margin (to 2.8%). Operating income declined across all geographical areas, once again led by the deterioration in the travel retail business, which represents 20% of the company’s top line.
Fiscal first quarter EBITDA totaled roughly $315 million, down 63% from the year-ago period. On a LTM basis, EBITDA was approximately $2.03 billion, relative to nearly $8.0 billion of total debt, translating to leverage of 4.0x. Leverage remains well above the 1.5x-2.0x range needed to stabilize the current ratings profile. Management is likely to prioritize cash for capital expenditures and to support the dividend (versus debt reduction), which is expected to consume roughly $2.0 billion combined on an annual basis. Free cash flow for fiscal 2024 (consensus estimates are calling for $665 million of free cash flow in fiscal 2024), will only cover a portion of the company’s capital expenditures and dividend this year, which means EL will need to rely on its cash balance or issue debt to fund the shortfall. That said, any reduction to leverage will need to come from EBITDA growth which has now been pushed to fiscal 2025.
Updated 2024 Guidance
EL lowered it full year outlook to reflect the slower pace of recovery it is currently witnessing primarily in mainland China. EL now expects a return to net sales growth in the second half of fiscal 2024 versus previous expectations for sequential net sales improvement quarterly. No range for growth was provided by management. Furthermore, EL only expects progressive operating margin improvement in the second half of the fiscal year, versus its original expectation for sequential operating margin improvement quarterly. Operating margin improvement will largely be dictated by the cadence of improvement witnessed in the Asia retail travel channel and mainland China. Given the recent respiratory illness that has spiked in China since the company’s earnings release, recovery could take even longer than expected.
Additionally, management highlighted a profit recovery plan for fiscal 2025 and 2026. The plan is to take effect in early calendar 2024 in order to start reaping the benefits in fiscal 2025. Under the plan, management will target specific areas of the business to improve the gross margin while lowering operating expenses. Management expects to drive roughly $800 million to $1.0 billion of incremental operating profit through fiscal 2025 and 2026. EL will focus on four separate pillars of growth including: optimizing mix across luxury skin care and fragrance brands; maximize value through better price realization; leveraging recent strategic investments; and creating meaningful cost efficiencies across the supply and value chains.
S&P Remains Negative
S&P downgraded EL’s rating one notch and left the rating on negative outlook reflecting the significant deterioration of the company’s profitability and credit metrics. Leverage of 4.0x is considerably higher than the 1.5x-2.0x range needed to stabilize the ratings. The agency highlighted the 51% year-over-year decline in its retail travel business, which has been negatively impacted by the economic slowdown and geopolitical issues in China. S&P remains concerned over how the business recovers given the unemployment rate in China, which stands above 5.0%. Furthermore, local laws have constrained selling conditions of non-local brands as the government tries to preserve the health of Chinese brands.
S&P noted that while EL has historically maintained a conservative financial policy, with leverage largely below 1.5x, management has not announced any changes to its capital allocation policies that will support leverage reduction. The agency believes that management will continue to prioritize the dividend over debt reduction. While share repurchases have been suspended since the Tom Ford acquisition, capital expenditures and the dividend will more than consume free cash flow, leaving no real ability to repay debt. Furthermore, the company is anticipated to buy out the remaining stake in Deciem by the end of fiscal 2024, which is estimated to cost EL $900 million.
Moody’s is Negative Too
Moody’s revised EL’s outlook to negative in September 2023 based on the higher debt levels associated with the Tom Ford acquisition, coupled with the weak operating performance. While Moody’s believes a recovery is likely for EL, the agency does not expect it to materialize until the latter part of 2024. That said, credit metrics will remain weak for the rating for some time. Moody’s also notes the lack of visibility regarding the timing of a meaning rebound of the travel retail business in Asia. That said, the agency believes operating profit compression that persists beyond the first half of fiscal 2024 would pressure the rating. Absent any improvement to guidance or should management further see a delay in their recovery prospects, Moody’s is likely to downgrade. Moody’s expects leverage to be in the high 2.0x area by the end of fiscal 2024, which seems like an unattainable target at this point.