Estee Lauder is punished for its light guidance. Here’s why we are not joining the sellers

Estee Lauder tumbled Wednesday as investors focused on the company’s weak fiscal fourth-quarter outlook instead of its strong third-quarter numbers. We’re looking deeper and believe that business fundamentals and profit are set to improve into the next fiscal year. Revenue in the three months ended March 31 advanced 5% year over year to $3.94 billion, edging out the Wall Street consensus of $3.91 billion, according to estimates compiled by LSEG. Sales were up 6% on an organic basis, also better than the 5% organic growth expected by analysts. Adjusted earnings per share more than doubled on annual basis to 97 cents per share, well ahead of 49-cent estimate, LSEG data showed. Estee Lauder Why we own it: We see profitability improving as management executes on its turnaround plan and works to improve gross margin performance. Operating margin also stands to benefit as management looks to right-size and streamline the business and structurally reduce operating expenses. Competitors: L’Oreal, Chanel, LVMH and Bath & Body Works Most recent buy: April 18, 2024 Initiated: Sept. 27, 2022 Bottom line The market reaction does not accurately reflect the positive underlying trends we’re seeing at Estee Lauder. The current-quarter outlook is clearly overshadowing largely positive results for the January-to-March period. However, the real focus should be on the directionality of the business and improving profitability going forward. We are, in fact, seeing an inflection play out in the back half of Estee Lauder’s fiscal year, as CEO Fabrizio Freda said in February would be the case. Inventory continues to normalize in Asian travel retail — think duty-free stores located in airports — and, as result, the company has finally returned to net sales growth in that highly problematic part of the business. We were encouraged to hear Freda on Wednesday call for sequential acceleration in organic growth in the current quarter — its fiscal 2024 fourth quarter — and indicate the company’s second-half operating margin is set to expand compared with the first half of the year and the year-ago period. These are signs the worst should be behind Estee Lauder. EL YTD mountain Estee Lauder’s year-to-date stock performance. While full-year adjusted earnings are still expected to decline on an annual basis, Estee Lauder encouragingly bumped up its outlook. That adds support to the strong second half idea — even if its fourth-quarter sales and earnings forecast came in light. Moreover, management remains on track with its so-called Profit Recovery Plan, and we expect to see further margin improvement lead to continued earnings growth in fiscal 2025 and beyond. Against this backdrop, we’re reiterating our 1 rating and $162 price target. However, we’re not stepping in to buy more just yet. Last month, when we added to our position and upgraded the stock back to a 1, we emphasized that Estee Lauder still isn’t out of the woods, calling it a “high-risk, volatile situation.” For that reason, we still intend to keep the position small for the time being and will remain patient as we look for the stock to find support and settle. Guidance Estee Lauder expects sales to increase 5% to 9% year over year in its fiscal fourth quarter, below the 12.7% expected by analysts, according to FactSet. Organic sales — which remove the impact of acquisitions and foreign currency — are expected to increase 6% to 10% in the quarter versus the year-ago period, also below the 12.7% growth expected by the Street. Management expects adjusted earnings in the range of 19 cents to 29 cents on a constant currency basis, a pretty large miss versus the 75 cents per share the Street was looking for, according to FactSet. The fourth-quarter projections forced management to also lower its full-year fiscal 2024 sales outlook. Management is now looking for reported sales to be down 2% to 3% on annual basis and organic sales to be down 1% to 2% year over year. Previously, both sales figures were projected to land in a range of down 1% to up 1% versus its fiscal 2023. Wall Street had projected both to fall less than 1%. Despite the haircut to the sales outlook, management increased their full year 2024 diluted earnings outlook to a range of $2.14 to $2.24 per share, up from $2.08 to $2.23. However, that is still lower than the Wall Street estimate of $2.25 per share. The implication of the upward revision to full-year earnings is likely that the back half of the year — the third and fourth quarters — is shaping up to at least be in-line and possibly better than expected. However, despite the Asian travel retail rebound materializing sooner than expected, some company spending that was anticipated to occur in the third quarter was pushed out into the fourth quarter, pressuring the earnings guidance for the current quarter. That’s also part of the reason we got such a large beat this time around. Given our view that management is likely guiding conservatively so it can overdeliver — a smart move as it works to regain credibility with investors following a string of disappointing results — we think it’s highly likely the back half will ultimately come in better than expected. Ultimately, we think Wednesday’s 13% decline is way overdone relative to the new information we received. If we combine Estee Lauder’s third-quarter earnings of 97 cents per share with the midpoint of its fourth-quarter guidance, we end up with second-half earnings of $1.21 per share. Prior to the report, Wall Street’s estimate was for second-half earnings of $1.24 per share. Yes, Estee Lauder’s refreshed outlook is a little light at the midpoint, but it doesn’t strike us as worthy of the dramatic stock plunge that took place. Profit Recovery Plan Management offered encouraging commentary beyond the current quarter into fiscal years 2025 and 2026. Estee Lauder’s so-called Profit Recovery Plan appears to be on track. It is expected to result in profit margin expansion, with an emphasis on gross margin expansion delivered through a combination of improving product mix, increased supply chain efficiencies and higher price realization. Estee Lauder executives continue to expect this plan to drive an increase of $1.1 billion to $1.4 billion in operating income by the end of fiscal 2026, with “slightly more than half” to be realized in fiscal 2025. Quarterly commentary Operating income outpaced expectations, though that was not necessarily a shock given the sales and earnings beats. Operating profit margin also was significantly better than expected, coming in at just over 14% versus 8.5%, reflecting strong expense management. In the year-ago period, it stood at 8.4%. Estee Lauder’s skincare business — its highest-margin category — realized 9% organic growth, benefiting from growth in all geographic regions. Notably, its Asia travel retail operations helped drive the double-digit sales growth seen in the EMEA geographic segment. Management called out a “significant sequential improvement” in retail sales trends. Inventory normalization efforts also continue to progress. The recovery in Asia travel retail also drove results in Estee Lauder’s makeup segment, which was up 4% organically versus the year-ago period. Fragrance was up 1% year over year organically, as a decline in Estee Lauder-branded products was more than offset by mid-single digit growth in the company’s luxury brands, which saw growth in all geographic regions. In hair care, where organic sales declined 4% versus the prior year, the weakness reflects softness of the Aveda brand as a result of weak salon channel sales in North America. Geographically, Estee Lauder’s segment called The Americas benefited from double-digit growth in Latin America, which itself was driven by strength in the makeup business in Mexico and Brazil. Revenue in North America, meanwhile, was flat versus the year-ago period as growth in its fragrance segment was offset by weakness in makeup and hair-care sales. Sales in the Asia/Pacific segment were up thanks to growth in skin care and fragrance in Hong Kong, mainland China and Japan. Hong Kong benefited from a rebound in consumer travel. Mainland China results reflect the lapping of Covid-19 related headwinds in the year-ago period, though sales of prestige beauty products remain challenged. Japan benefited from strong fragrance sales. (Jim Cramer’s Charitable Trust is long EL. See here for a full list of the stocks.) 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