A Beauty In The Bargain Bin

What's the critical difference between a Micro-D Deep Thermal Refinisher and a Resilience Lift Extra-Firming Revitalizing Mask? Don't ask me. But you don't have to be a discerning consumer of Estée Lauder's (EL ) multitudinous potions to spot an opportunity in the cosmetics maker's shares, which since January have worked their way down some 26%.

The latest blow fell late in September, after the New York company warned investors of weaker earnings in the first quarter of fiscal 2006. The stock sank below 34, a depth not seen in two years. Just the same, a glance at Estée Lauder finds it's hardly about to go the way of its eponymous founder, who died last year. A closer look finds a company of substance that has tumbled into the bargain bin.

YES, LAUDER IS SHOWING some wrinkles and warts, not least the ongoing consolidation of its primary outlets, department stores. Lauder's two biggest customers, May Department Stores and Federated Department Stores (FD ), completed their merger in August. That's one reason behind the slowdown in sales. Nor did it cheer investors to learn that Ronald Lauder, one of the founder's sons and a director, sold some stock just days before the company's profit warning. A spokeswoman notes that Lauder's sale amounted to a small part of his stake and that "he continues to be a committed shareholder." Insider sales -- at Lauder or any other company -- are never bullish. More meaningful to me, however, is what Chief Executive William Lauder (Estée Lauder's grandson) did in September when he exercised options on 50,000 shares, which were due to expire in November. He did not then turn around and sell the shares, as often happens with exercises of employee options, but is holding them.

In any case, the company's financial statements hardly offer a rationale for dumping Lauder. The company has amassed a strong balance sheet. At last report, cash came to $553 million and total debt to $715 million. Its debt-to-capital ratio, a bit below 30%, is less than at rival Avon Products (AVP ) (50%), never mind Revlon (REV ) (a financial fright with a negative net worth). Even after capital spending of $230 million and paying $90 million in dividends, Lauder still had produced more than $159 million of free cash flow during fiscal 2005, ended last June.

What's more, Lauder isn't shrinking -- it's just growing more unevenly than it had expected. This fiscal year the company still sees sales rising perhaps 6%, not counting foreign-exchange effects, but with a speedier second half making up for a slowing in the summer quarter. Notably, Lauder is now deducting from its reported earnings the cost of granting stock options as employee pay, an expense it figures will come to 14 cents or so per share this year. Even after that charge, Lauder expects that its widening profit margins will produce earnings per share this year of at least $1.95. If reached, that would be a gain of nearly 17%.

To feed growth, Lauder is counting on more gains abroad, not just in Europe but also in such Asian markets as Hong Kong, Taiwan, and China. Back home, it has been developing lower-priced brands, such as American Beauty, Good Skin, Grassroots, and Flirt!, which it's pushing through Kohl's, a growing chain. All told, including its core Estée Lauder and Clinique lines, Lauder now has a total of 26 brands, including many it is selling via the Web or in their own stores. One such brand is Origins, a line of natural-ingredient lotions and cosmetics with 131 freestanding outlets. Finally, the company is hoping to attract younger women to the flagship Estée Lauder line with the face of actress Gwyneth Paltrow, soon to appear in holiday ads for the fragrance Pleasures.

Any of these initiatives may falter, but such risks today strike me as well reflected in Lauder's price. Near 35, the stock goes for a multiple of enterprise value to operating earnings of under 11. The stock also yields 1.1%. Think of the payout as a gift with your purchase.

By Robert BarkerBy Robert Barker

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