Because you're worth it

L'Oreal is the largest beauty company in the world, selling a variety of different brands.

Also owns a minority stake in Sanofi-Aventis - this is ignored here, all earnings are operational earnings.

 

Sales and Profitability

By sales, the company is the largest in the world, closely followed by the beauty divisions of P&G and Unilever.  The other players, such as Ester Lauder, Avon have less than half their revenue.

Notes on the categories:

• For P&G we are looking at 'Beauty' category: this excludes 'Grooming' (men's personal care)
• For Unilever, it is 'Personal Care': this includes all skin care, hair care,m deodorants and oral care.
  

Looking at profitability:

All operating margins above exclude taxes.  P&G and Unilever numbers are special: their margins exclude additional company-wide 'corporate' costs (so really, their margins should be reduced a little):

• P&G 'corporate' costs are mentioned in the breakdown, but I could not understand the description.
• Unilever's profit numbers also exclude corporate (2011: about 8% of operating profit).  However the profit numbers already include interest costs.

We can see that size matters.  The top 3 (Loreal, P&G, Unilever) consistently have a distinctly higher profit margin.  L'occitaine is still in its early growth phase, hence its high profit margin.

The beauty market is still quite fragmented.   Total size is estimated at 153bn Euros - all the players above together have less than 50% market share.  There must be a 'long tail' of smaller, localized or niche players.

It is a fiercely competitive market; L'Oreal is one of several large players and there are no barriers to entry for smaller players.

Marketing Costs

Since marketing is their largest cost, lets compare:

L'Oreal consistently spends one of the highest percentage of sales on marketing.

In dollar terms, it was the only company to increase marketing spend every year over the period shown.  Tom Russo often talks about a company's capacity to suffer: the ability to spend money for the long term, while ignoring short term drops in EPS.  Publicly listed companies often face pressure to cut costs.  L'Oreal is controlled by the Bettencourt family and Nestle, who each have a 30% stake, it seems to meet this criteria.  (Wonder why Tom Russo has no direct investment in L'Oreal?)

 

Industry Growth

Woldwide growth has been 3-5% in good times and 1% in bad times:

Looking at different regions:

• Developed countries show low single digit growth in good times, offset by the same low single-digit declines in bad times.
• Developing countries (AsiaPac, Eastern Europe and Latin America) show continual high growth (between 5-20%).  Don't know about bad times - was not able to get figures back from the Asian Financial Crisis.

Cyclical

L'Oreal's sales show mid to high digit growth in good years; -ve single digit growth in bad years:





How much of their costs are fixed vs variable?  From the 2009 contraction:







Their main costs are variable, especially A&P.  Low fixed costs (depreciation and R&D), high variable costs (A&P and others - that covers SGA and COGS - cannot break them down due to depreciation).

 

Balance sheet:

Compared to their 2011 earnings of 5bn Euros, the balance sheet looks fine.

Negligible liabilities. Debt, contingent liabilities and operating leases added up are far less than 1bn.

Pension fund is underfunded by 753m.   Conservatively invested: 50% bonds, 35% equities.  Acturial gains/losses are recognized as they occur, it seems that other losses (e.g.: poorer than expected returns) are not.  Their assumptions look reasonable:

History of Debt and acquisitions

The beauty industry is fast changing, and L'Oreal makes constant acquisitions.  How are their acquisitions funded, and what is the effect on their balance sheet?

Long-term debt and spending on acquisitions is below, with operational earnings for comparison:

• LT debt has always been less than 1 years operational earnings, except in briefly in 09.
• Acquisitions are always funded by debt, no new shares issued.
• Sometimes they change their LT debt to ST debt, usually before paying it off.
• They are conservative: Historically, L'Oreal does not carry large amounts of debt, and likes to pay it off within a few years after accumulating it.

Business Model

Low capex, low working capital, high marketing.

In the long term: develop brands so that customers come to retailers for them.  Occasionally acquire some of the new brands that pop up and give them support to expand.

In the short term: its a constant battle to push new ideas, new products, new advertising.  And to keep up with compeditors.

Independent Retailers

A recent trend is the rise of large, independent beauty retailers stocking multiple brands.  LVMH's Sephora is the largest:

Sephora is popular because they offer a large variety of products in a clean, bright environment, allowing customers to try them.  They are a possible threat to beauty brands, as they will try to push their house products first, LVMH brands second, then others third.

Sephora's sales are unknown: LVMH's Selective Retailing group made 6.4bn Euros sales in 2011, but this includes DFS plus a few other businesses...so maybe say 4bn.  Compared to 19bn Euros sales of L'Oreal alone, or a total estimated market of 153bn Euros, Sephora is still a small player.  The beauty product retailing space is still fragmented, but if Sephora keep doubling the number stores every 6 years, they could gain some control over the market in the future, similar to how supermarkets can replace some products with their own brands (e.g.: Kraft cheese) and therefore control pricing.

Another US player is Ulta, supposedly more mass market, but trying to move upmarket.  They had roughly 1.4bn Euros sales in 2011, and 449 stores.

Retailers are not a threat yet, but may be later.

Conclusion:

Like:

• One of the strongest players in a growing industry.  Wide variety of brands from mass market to luxury.
• Recurring income (unlike watches, cars for example).  Low capex.
• Good play on emerging markets, can deploy capital to wherever the growth is.
• As people grow from poor to middle class, they use more beauty products.  And after they get richer, they use more expensive beauty products.

Don't like:

• Fiercely competitive industry, no barriers to entry.  Constant re-invention, pushing of new products (or of marketing passing itself off as re-invention).  Consumer tastes can be fickle.  The phrase "You're only as good as your last ad" comes to mind.
• Possible threat of large retailers gaining control of products placement and pricing: Sephora/Ulta.  LVMH is a formidable competitor. Not a threat yet, but something to watch for.

I'll put L'Oreal on my watchlist to buy

The Beauty Industry

Want to look at beauty products because they are based on branding.  Unlike other supermarket products, such as tissues, cleaning detergent, or breakfast cereal - I've never seen a woman buy a generically branded beauty product.

A quick look at the market, to get a feel for the products sold and the industry.

Breakdown by Category

An estimated breakdown of the total beauty product market, from L'oreal's 2011 Annual Report:
Some of these products, like toiletries, deodorants, nail polish, hair coloring, perform simple, straightforward functions.  For others, like perfume and skincare, its not really clear what they do, and they rely 100% on branding.  Skincare products are the most expensive, as well as the most nebulous in their claims, especially with the latest trend of combining them with 'anti-aging'.

What are you paying for?

Marketing

Even for lower-end products performing a simple, clear function, marketing is still important.  For example, this advertisement pushed sales up by over 50% in three months, and by another 100% in the follow-up online campaign:


The largest expense for beauty companies is marketing:

Company	2011 Revenue spent on Marketing
Loreal	31%
Beiersdorf (Nivea)	30%
Revlon	20%

So the idea here is to bombard people advertisements everywhere: on TV, magazines, cinemas, bus stops, internet... wherever.  With the breakdown in traditional media (do people still watch free-to-air TV, or read paper magazines anymore?), it will be interesting to see how the beauty industry adapts.

A Story

The Body Shop is probably the best example of a brand selling a story.  Even people like me, who know nothing about cosmetics, had some vague idea that they use natural products, love animals and help African tribes.

Brief history, from Branded Beauty by Mark Tungate:

• Anita Roddicks opened first shop in 1976.  Wanted to sell natural beauty products inspired by her travels.  Invited customers to bring back bottles for refills as she barely had enough bottles.  Handwrote the labels.  "Tales of the products and how they were made were displayed alongside photographs of the countries she had visited and the tribes peoples she had met. She was selling the story as much as the product" [*].
• After opening a second branch, set up a franchise model.    Franchises agreed to stick closely to the branding and retail template.  Billed the products as 'cruelty free'.
• Floated on LSE in 84.   Rapidly spread franchises over UK.  First US shop in 88.  Rivals started making 'cruelty free' products.  In the early 90's, 'switched "her stores' focus to 'saving the planet'...just as public awareness of environmental issues began to accelerate.'  [*]
• Established a marketing dept and appointed an advertising agency in 95.  Company still associated with activism, e.g.: save the whales,  WTO protests.
• In 1998 Roddicks started to relinquish control, and in 2002 stepped into a non-executive role.  Continued her activism.In 05, set up the Roddick foundation. 
• Sold Body Shop to L'oreal in 2006.
• Anita Roddicks died in 2007.

 The Body Shop was the first brand to bring 'organic' and 'cruelty free' products into the mainstream.  Since then others have followed.  Later on, it'll be interesting to see how it has fared since being bought over.

Luxury

Some beauty products are luxury items.  The way to build these brands seems similar to other luxury products, such as watches or handbags:

• Control of retail experience: boutiques, beauty salons, spas, kiosks in department stores. Where you manage your own staff and create your own environment.
• Selective placement, or strict control of channels.  In other words: making sure the products is always variable in an appropriately upscale place (e.g.: given only to top range rooms in a hotel or 1st class passengers in an airplane).  And that they never go on sale.
• Crossover of other brands/icons e.g.: Dior, Chanel moving into skincare.

Being Different

Quick example of a new company, also from Branded Beauty.  Aesop skincare as started by a salon owner in Melbourne in 1987; by 2011 had 36 stores worldwide.  Their products are very distinctively and simply packaged.  Their stores are unique to their neighborhood: one in Tokyo has recycled materials from a demolished house nearby, one in London's Mayfair has a Gregorian air with antique green walls.  These stores are marketing tools, often featured in design and architecture magazines.  Their website features artistic stuff like photography and travel guides.  Products are also supplied to selected restaurants/hotels.  "Our customers tend to be urban, worldly, well-traveled, curious and quite demanding".  Founder says that mainstream cosmetics are "passionless products constructed by marketing departments and focus groups, and designed to exploit the vulnerabilities of people to appeal to those who would like to be lighter, slimmer, thinner, whatever...".  Maybe he's right.

Perhaps this company is where The Body Shop was 20 years ago.

Scientific Research

R&D seems to be a part of marketing.  From Branded Beauty again: how a cream is launched:

• Companies watch the market carefully and launch new lines based on their competitors and the latest trends, or because their old lines are getting tired.
• Find a new active ingredient - a story to tell.  Written down, with the aim of creating the advertising copy at the end of the process.
• Discuss with the laboratory.  Refine the story until the research supports it.  An example is Vichy's LiftAvtiv Derm Source, targeting the epidermis to imply that it the source of all skin problems and can be target with a plant extract.
• Laboratory makes samples, and tests that the active ingredients do not react with the common ingredients (water, preservative, fragrance) or with the bottle.  Packaging is decided with marketing team.
• Sample creams are created tested by several people for texture.
• Blind consumer tests carried out with volunteers.  Asked to use the cream for 15 to 30 days to see how it affects their skin.  Small sample groups - as few as 30 - allow companies to claim things like '80% of women tested noted an effect on their skin'.
• Packaging and advertising with agency.  'Dramatize science'.   Translate some scientific terms into something women can understand (epidermis --> 'derm source'), and have a close up picture like a biology textbook.  Maybe add a celebrity.

From conception to launch usually takes 18 months.

Interesting note that the UK Advertising Standards Authority is one of the strictest in the world, and may not even allow normal sounding claims ('younger looking skin') and digital enhancement, even when the advertisements are peppered with disclaimers.  Overseas brands often have to adjust advertising copy for the UK market.

Conclusion

Marketing and packaging is the most important part of a beauty product.  Even for simple, lower end items such as nail polish, lipstick, maybe even shampoo and conditioner.  Skincare products are the highest priced - as their claims are the most nebulous, they can afford to price their products higher and use any possible angle to sell them: creams with new scientific breakthroughs or ancient herbal remedies, gold dust...whatever story you can think of, it can be spun.

As ethical, cruelty-free and organic ingredients have become mainstream, the industry will move on to other things.  Neutriceuticals, neurocosmetics, nanotechnology, whatever.

There are no barriers to entry in this business.  Brands and beauty products pop up like mushrooms.  At the high end of the market, anyone can come up with a new twist, like Aesop above, or Absolution (customizable creams), Caudalie (vinotherapy - wine).  At the mass-market end, there may be some barriers in terms of scale, due the the distribution and marketing required, but even here, new products emerge frequently.

I would guess that women know they are buying hope-in-a-jar, but are happy to do so anyway.  Maybe it is soothing or stress relieving for them.  As long as people keep buying the fantasy, there may be money to be made.