L'Oréal: Premiumization In The Beauty Industry

L'Oréal (OTCPK:LRLCF) is the world's leading beauty player with over 110 years of rich history. Consumer Products, L’Oréal Luxe, and Active Cosmetics are their key business lines, and all these segments have been contributing to the company’s growth through consistent premiumization. I believe L’Oréal should be one of the core holdings in global portfolios due to its high-quality growth and fairly valued stock price. I recommend a “Buy” rating for L’Oréal.

L’Oréal Growth in the Beauty Industry

Over the past two decades, L’Oréal has consistently delivered organic revenue growth across different economic cycles. Their cosmetic revenue growth only declined by 1.5% in 2009 and 4.1% in 2020, primarily due to the pandemic. I believe the resilient growth in the cosmetics business can be attributed to the following reasons:

Pricing Growth: Although L’Oréal does not disclose its pricing growth, I believe the cosmetic industry has been increasing product prices year over year, especially in skincare, makeup, and perfume categories. According to the Global Cosmetic Industry report, the beauty industry saw an average unit price increase of 10% in January 2022, and mass brick-and-mortar beauty prices were up by 7.5% in 2021.

Less Correlation between Cosmetics Consumption and the Macro Environment: According to L’Oréal's management team, the entire cosmetic industry grew by 1% in 2009. This is key evidence that cosmetics consumption has less correlation with the macroeconomic environment than other consumer product categories. Women continue to purchase skincare and makeup products, and these have become staples to some extent.

As evident from the chart below, L’Oréal's skincare, makeup, and perfume segments have shown remarkable growth over the past two decades, serving as significant drivers of L’Oréal’s overall growth.

Premiumization Drives the Ship

One of L’Oréal’s key strategies is the premiumization of their product lines. L’Oréal's management has expressed their commitment to investing in product quality and selling at higher price points, with premiumization deeply ingrained in the corporate culture. Through premiumization, L’Oréal can command higher average selling prices and achieve better gross margins. For instance, L’Oréal Luxe business's operating margin expanded from 15.1% in FY09 to 22.9% in FY22, while Active Cosmetics' margin increased from 20.2% to 25.4% during the same period.

I believe another advantage of premiumization is that it shifts L’Oréal's client base more towards the middle class and high-net-worth individuals. These clients tend to have consumption patterns that are more resilient and stable than those in the lower-income segments during economic downturns. Consequently, this shift in the customer mix can make L’Oréal’s business less cyclical over time.

Diversified Business

In comparison to smaller beauty companies, L’Oréal boasts a broader geographic presence and a wider range of product categories. I believe that this extensive diversification allows L’Oréal to mitigate various business risks, including those related to regional geopolitical factors and fashion trends, among others.

Financials and Outlook

L’Oréal announced their half-year result on July 27^th 2023, which included a remarkable 13.3% organic revenue growth, a 30bps margin expansion, and an impressive 11.2% growth in earnings per share. This signifies exceptionally robust financial performance across all segments.

Their gross cash flow increased by 14.5% year over year, and they initiated a share repurchase program amounting to EUR 500 million. As of the end of June 2023, their net debt leverage stood at only 0.5x, indicating a robust balance sheet.

Regarding long-term growth, their management has indicated that the Beauty market should experience growth rates of 4-5%, yet it has exceeded 10% over the past six months. They anticipate a modest slowdown in market growth in the near term, but overall, they express a bullish outlook on long-term growth prospects.

Key Risks

China has established its own Hainan free trade port in the south, featuring duty-free shops for local consumers. However, L’Oréal has observed a noticeable decline in revenue growth in Hainan between Q1 and Q2 of this year. This decline can be attributed to a Winners of China's "Daigou" crackdown on Daigou trade initiated by the local government in May, which, according to L’Oréal’s management, has had a significant impact on industry-wide sell-outs. China accounts for approximately 23% of the group's sales, with Hainan contributing around 3% of the total revenue. Consequently, the industry-wide sell-off could have some near-term implications for their growth in the Hainan region.

Valuation

In the discounted cash flow model, I assume a 10% organic revenue growth rate for FY23 and FY24, reflecting the current high inflationary market environment, with pricing contributing to the Beauty industry's growth. From FY25 onward, I project a moderated organic growth rate of 9%, based on my estimates. Additionally, L’Oréal has a track record of acquiring small regional brands from time to time, and I anticipate that these acquisitions will contribute 1.6% to the top-line growth.

Taking into account their historical margin expansion trends and their premiumization strategy, I model a margin expansion of 40-60 basis points per year. This leads to a forecasted operating margin of 24.3% by FY32 in the model, with the free cash flow reaching 22%.

In the model, I utilize a 4% terminal growth rate, a 10% discount rate, and a 24% tax rate. After discounting all the free cash flow from the firm and deducting net debts, the calculated fair value of their stock price stands at EUR 410 per share. This suggests that their stock price is currently close to fair valuation.

Conclusion

In conclusion, L’Oréal's diversified portfolio of brands and global regional exposure in the Beauty industry positions their business as highly resilient across different economic cycles. Their successful premiumization strategy has allowed them to expand margins and capture a growing customer base among middle-class and affluent families. Based on the model's calculations, the stock price is currently assessed as nearly fairly valued, leading me to assign a 'Buy' rating.

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