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ESTEE LAUDER COMPANIES INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) RESULTS OF OPERATIONS We manufacture, market and sell beauty products including those in the skin care, makeup, fragrance and hair care categories which are distributed in over 150 countries and territories. The following table is a comparative summary of operating results for the three months ended September 30, 2014 and 2013, and reflects the basis of presentation described in Note 1 of Notes to Consolidated Financial Statements - Summary of Significant Accounting Policies for all periods presented. Products and services that do not meet our definition of skin care, makeup, fragrance or hair care have been included in the "other" category. Three Months Ended September 30 (In millions) 2014 2013 NET SALES By Region: The Americas $ 1,114.8 $ 1,202.4 Europe, the Middle East & Africa 942.2 891.2 Asia/Pacific 574.0 581.4 Net Sales $ 2,631.0 $ 2,675.0 By Product Category: Skin Care $ 1,091.4 $ 1,171.0 Makeup 1,021.3 1,001.0 Fragrance 377.4 367.4 Hair Care 128.1 124.8 Other 12.8 10.8 Net Sales $ 2,631.0 $ 2,675.0 OPERATING INCOME (LOSS) By Region: The Americas $ 57.4 $ 156.0 Europe, the Middle East & Africa 169.9 180.8 Asia/Pacific 120.7 113.9 348.0 450.7 Total charges associated with restructuring activities - (1.2 ) Operating Income $ 348.0 $ 449.5 By Product Category: Skin Care $ 176.4 $ 241.6 Makeup 125.9 166.3 Fragrance 39.0 36.9 Hair Care 8.8 8.4 Other (2.1 ) (2.5 ) 348.0 450.7 Total charges associated with restructuring activities - (1.2 ) Operating Income $ 348.0 $ 449.5 24 -------------------------------------------------------------------------------- Table of Contents THE ESTÉE LAUDER COMPANIES INC. The following table presents certain consolidated earnings data as a percentage of net sales: Three Months Ended September 30 2014 2013 Net sales 100.0 % 100.0 % Cost of sales 20.4 20.3 Gross profit 79.6 79.7 Operating expenses: Selling, general and administrative 66.4 62.8 Restructuring and other charges - 0.1 Total operating expenses 66.4 62.9 Operating income 13.2 16.8 Interest expense, net 0.5 0.5 Earnings before income taxes 12.7 16.3 Provision for income taxes 4.0 5.0 Net earnings 8.7 11.3 Net earnings attributable to noncontrolling interests - 0.1 Net earnings attributable to The Estée Lauder Companies Inc. 8.7 % 11.2 % In order to meet the demands of consumers, we continually introduce new products, support new and established products through advertising, merchandising and sampling, and phase out existing products that no longer meet the needs of our consumers or our objectives. The economics of developing, producing, launching, supporting and discontinuing products impact our sales and operating performance each period. The introduction of new products may have some cannibalizing effect on sales of existing products, which we take into account in our business planning. We operate on a global basis, with the majority of our net sales generated outside the United States. Accordingly, fluctuations in foreign currency exchange rates can affect our results of operations. Therefore, we present certain net sales information excluding the effect of foreign currency rate fluctuations to provide a framework for assessing the performance of our underlying business outside the United States. Constant currency information compares results between periods as if exchange rates had remained constant period-over-period. We calculate constant currency information by translating current year results using prior year weighted-average foreign currency exchange rates. Overview We believe that the best way to continue to increase stockholder value is to provide our customers and consumers with the products and services that they have come to expect from us in the most efficient and profitable manner while recognizing consumers' changing shopping habits. To be the global leader in prestige beauty, we are guided by our long-term strategy through fiscal 2017, which has numerous initiatives across geographic regions, channels of distribution, product categories, brands and functions that are designed to leverage our strengths, make us more productive and grow our sales. We have a strong, diverse and highly valuable brand portfolio with global reach and potential, and we are building upon and leveraging our history of outstanding creativity, innovation and entrepreneurship. We have expanded our distinctive "High-Touch" service model and continue to look for ways to further evolve it within our channels of distribution and geographic regions. We continue to deliver superior retailing experiences across our brands, particularly in freestanding retail stores and the travel retail channel where we have developed High-Touch services. We are increasing brand awareness and sales by investing to further expand our multi-pronged digital presence encompassing e-commerce and m-commerce, as well as digital and social media. We are leveraging our regional organization by aligning the talents and expertise of our people in an effort to assure that we are locally relevant with our products, services, channels, marketing and visual merchandising. 25 -------------------------------------------------------------------------------- Table of Contents THE ESTÉE LAUDER COMPANIES INC. As part of our strategy, we are positioning ourselves to capitalize on opportunities in the fastest-growing areas in prestige beauty. Skin care, our most profitable product category, remains a strategic priority for us, demonstrated by the recent launches of the Clinique Sonic System Purifying Cleansing Brush and Clinique Smart custom-repair serum, as well as La Mer's entrance into the skin care mask sub-category. Our focus on luxury consumers across all product categories has resulted in increased net sales of many of our higher-end prestige products through both new product launches and expanded distribution. We also continue to build our makeup product category, through the introduction of new product offerings, including new collections from our makeup artist brands and Pure Color Envy sculpting lipstick and sculpting eye shadow palette from Estée Lauder, and our fragrance category through new launches from our luxury fragrance brands. In addition, we are continuing to expand our hair care brands both in salons and in other retail channels. Our global footprint provides us many avenues of growth, enabling us to quickly utilize our strengths to capture opportunities around the world. We are strengthening our geographic presence by seeking share growth in large, image-building cities within core markets such as the United States, the United Kingdom, France, Italy and Japan. In addition, we continue to expand our presence and accelerate share growth in emerging markets such as China, the Middle East, Eastern Europe, Brazil and South Africa and focus on consumers who purchase in the travel retail channel, in stores at their travel destinations or when they return to their home market. We are expanding our digital presence in international markets, which has resulted in growth in the net sales of our products sold online. We are applying what we have learned from our digital strategy in North America to other areas such as in China, where digital sales are reshaping the retail landscape. In North America, we are expanding our presence within other channels, such as specialty multi-brand retailers and freestanding retail stores. Internationally, we are growing in European perfumeries and pharmacies and in department stores, particularly in Asia and the United Kingdom. In addition, we are emphasizing our skin care and makeup initiatives to boost our travel retail sales and furthering efforts to grow our business in the freestanding retail store, online, specialty multi-brand retailer and prestige salon channels. The travel retail channel remains an important source of sales growth and profitability. Our business in this channel has benefited from the implementation of programs we designed to target consumers in distinct travel corridors, enhance consumers' "High-Touch" experiences and convert travelers into purchasers. While our business is performing well overall, we are seeing intensifying competitive pressures and economic challenges in certain countries around the world. We are cautious of a softer retail environment in certain channels in the United States, unfavorable foreign exchange due to the strength of the U.S. dollar in relation to certain currencies, the impact of lower volume of luxury gift giving in China, and slower growth in Hong Kong and from Chinese travelers. Additionally, the recent political instability in Hong Kong is negatively impacting our business and we are monitoring the effects of increased sanctions in Russia. We believe we can, to some extent, offset the impact of these challenges by accelerating areas of strength. However, if economic conditions or the degree of uncertainty or volatility worsen, or the adverse conditions previously discussed are further prolonged, then we expect there to be a negative effect on ongoing consumer confidence, demand and spending and, as a result, our business. We will continue to monitor these and other risks that may affect our business. Our investment in our global information systems is ongoing. Over time, we expect these initiatives to improve profitability by enhancing gross margin and supporting efficiencies in select operating expenses, freeing resources to strategically reinvest in activities to support our future growth. 26 -------------------------------------------------------------------------------- Table of Contents THE ESTÉE LAUDER COMPANIES INC. We rolled out the last major wave of our Strategic Modernization Initiative ("SMI") in July 2014 in certain of our remaining locations. As a result, some retailers accelerated their sales orders that would have occurred in our fiscal 2015 first quarter into our fiscal 2014 fourth quarter in advance of this implementation to provide adequate safety stock to mitigate any potential short-term business interruption associated with the SMI rollout. The impact on net sales and operating results by product category and geographic region is as follows: Three Months Ended September 30, 2014 Operating (In millions) Net Sales Results Product Category: Skin Care $ 91 $ 72 Makeup 65 41 Fragrance 21 14 Hair Care 1 - Other - - Total $ 178 $ 127 Region: The Americas $ 84 $ 53 Europe, the Middle East & Africa 68 53 Asia/Pacific 26 21 Total $ 178 $ 127 These actions created a difficult comparison between the fiscal 2015 first quarter and the fiscal 2014 first quarter of approximately $178 million in net sales and approximately $127 million in operating results and adversely impacted our operating margin comparisons. We believe the presentation of certain year-to-date comparative information in the following discussions that excludes the impact of the timing of these orders is useful in analyzing the net sales performance and operating results of our business. With our July 2014 rollout of SMI, locations representing approximately 93% of our consolidated net sales are SAP-enabled. We plan to continue the implementation of SAP at our remaining locations through fiscal 2017. First Quarter Fiscal 2015 as Compared with First Quarter Fiscal 2014 NET SALES Net sales decreased 2%, or $44.0 million, to $2,631.0 million. Lower net sales in skin care were partially offset by growth in our makeup, fragrance and hair care product categories. Geographically, lower net sales in the Americas and Asia/Pacific were partially offset by higher net sales in Europe, the Middle East & Africa. Excluding the impact of foreign currency translation, net sales decreased 1%. In advance of our July 2014 implementation of SMI at certain of our locations and to provide adequate safety stock to mitigate any potential short-term business interruption associated with the rollout, certain of our retailers accelerated their orders during the fiscal 2014 fourth quarter. Those additional orders, which totaled approximately $178 million, would have occurred in our fiscal 2015 first quarter and created a difficult comparison to the prior-year period. Adjusting for the impact of the accelerated orders, reported net sales would have increased 5%, with growth in all of our product categories and in each of our geographic regions except the Americas, which would have been relatively flat. Product Categories The overall change in net sales in each product category was negatively impacted as a result of the accelerated orders into the fiscal 2014 fourth quarter from certain of our retailers due to our implementation of SMI as follows: skin care, approximately $91 million; makeup, approximately $65 million; fragrance, approximately $21 million; and hair care, approximately $1 million. 27 -------------------------------------------------------------------------------- Table of Contents THE ESTÉE LAUDER COMPANIES INC. Skin Care Net sales of skin care products decreased 7%, or $79.6 million, to $1,091.4 million. Skin care net sales from certain of our heritage brands reflected a difficult comparison with the prior-year period, which featured significant launch activity related to the reformulation of certain iconic products, and were also particularly impacted by the accelerated orders. The decrease reflects lower sales of certain existing Advanced Night Repair products from Estée Lauder, as well as certain Even Better products and Dramatically Different Moisturizing Lotion+ from Clinique of approximately $173 million, combined. These decreases were partially offset by the recent launches of Advanced Night Repair Eye Synchronized Recovery Complex II from Estée Lauder, and Smart custom-repair serum and the Sonic System Purifying Cleansing Brush from Clinique of approximately $108 million of incremental sales, combined. The impact of foreign currency translation on skin care net sales was de minimis. Adjusting for the impact of the accelerated orders, reported net sales in skin care would have increased 1%. Makeup Makeup net sales increased 2%, or $20.3 million, to $1,021.3 million, primarily reflecting higher net sales from our makeup artist brands and the recent launches of Pure Color Envy sculpting lipstick from Estée Lauder of approximately $64 million, combined. Sales from our makeup artist brands benefited from new product offerings, as well as expanded distribution consistent with our retail store strategy. Partially offsetting these increases were lower sales of All About Shadow, which was a new launch in the prior-year period, and Superprimer from Clinique and Pure Color High Impact Lip Color from Estée Lauder of approximately $39 million, combined. The impact of foreign currency translation on makeup net sales was de minimis. Adjusting for the impact of the accelerated orders, reported net sales in makeup would have increased 9%. Fragrance Net sales of fragrance products increased 3%, or $10.0 million, to $377.4 million, primarily reflecting higher sales of Tom Ford and Jo Malone fragrances of approximately $25 million, combined. The recent launches of DKNY MYNY and Estée Lauder Modern Muse Chic also contributed approximately $23 million to the category, combined. These increases were partially offset by lower sales of certain Estée Lauder fragrances, including Estée Lauder Modern Muse, which was a new launch in the prior-year period, as well as certain existing Coach and Tommy Hilfiger fragrances and DKNY Be Delicious for Women of approximately $33 million, combined. The impact of foreign currency translation on fragrance net sales was de minimis. Adjusting for the impact of the accelerated orders, reported net sales in fragrance would have increased 8%. Hair Care Hair care net sales increased 3%, or $3.3 million, to $128.1 million, reflecting expanded global distribution of Aveda products in department stores, freestanding retail stores and in the travel retail channel, and Bumble and bumble products in specialty multi-brand retailers. The category also benefited from the recent launches of the new and reformulated Dry Remedy line of products from Aveda, as well as the expansion of the Hairdresser's Invisible Oil line of products from Bumble and bumble which contributed approximately $7 million to the increase, combined. Partially offsetting these increases were lower sales of the Invati line of products and Damage Remedy shampoo from Aveda of approximately $6 million, combined. Excluding the impact of foreign currency translation, hair care net sales increased 4%. The impact of the accelerated orders on reported hair care net sales was de minimis. Geographic Regions The overall change in net sales in each geographic region was negatively impacted by the accelerated orders into the fiscal 2014 fourth quarter from certain of our retailers due to our implementation of SMI as follows: Americas, approximately $84 million; Europe, the Middle East & Africa, approximately $68 million; and Asia/Pacific, approximately $26 million. Net sales in the Americas decreased 7%, or $87.6 million, to $1,114.8 million. Net sales in the United States and Canada decreased approximately $89 million, combined, primarily due to lower net sales from our heritage brands, driven by the impact of the accelerated orders and a difficult comparison with the prior-year period, which featured significant launch activity related to the reformulation of certain iconic products. We are cautious of a softer retail environment in some channels in the United States. Net sales in Latin America increased approximately $2 million, primarily due to higher net sales in Brazil and Mexico which were mostly offset by lower net sales in Venezuela. The decline in Venezuela was driven by the impact of foreign currency translation. Excluding the impact of foreign currency translation, net sales in the Americas decreased 6%. Adjusting for the impact of the accelerated orders, reported net sales in the Americas would have decreased less than 1%. 28 -------------------------------------------------------------------------------- Table of Contents THE ESTÉE LAUDER COMPANIES INC. In Europe, the Middle East & Africa, net sales increased 6%, or $51.0 million, to $942.2 million, reflecting higher sales in most countries in the region, led by the United Kingdom, Russia, the Middle East, the Balkans and certain Eastern European countries of approximately $62 million, combined. The higher sales in the United Kingdom were primarily driven by our makeup artist and luxury brands and also benefited from expanded distribution. Higher sales in Russia were primarily driven by certain of our heritage and makeup artist brands and a favorable comparison to the prior-year period, which reflected an uneven ordering pattern from a certain retailer. The higher sales in the Middle East, the Balkans and certain Eastern European countries were primarily driven by certain of our heritage and makeup artist brands as a result of new product introductions and expanded distribution. These increases were partially offset by lower net sales in our travel retail business and Germany of approximately $26 million, combined. The lower sales in our travel retail business were due to the impact of the accelerated orders. The decrease in sales in Germany was primarily driven by lower sales from certain of our heritage brands due in part to tighter inventory management by certain of our retailers. Excluding the impact of foreign currency translation, Europe, the Middle East & Africa net sales increased 5%. Adjusting for the impact of the accelerated orders, reported net sales in Europe, the Middle East & Africa would have increased 13%. Net sales in Asia/Pacific decreased 1%, or $7.4 million, to $574.0 million, primarily reflecting lower sales in Japan and China of approximately $27 million, combined. The lower sales in Japan were attributable to the accelerated orders. The lower net sales in China were primarily due to certain of our heritage brands and reflected a difficult comparison with the prior-year period, which featured significant launch activity. These decreases were partially offset by higher net sales in Korea, Australia, Taiwan and New Zealand of approximately $20 million, combined. These increases were primarily due to higher net sales from certain of our makeup artist and luxury brands, partially due to expanded distribution and promotional activities. In Hong Kong, we are cautious of the slower growth rate and our business is being negatively impacted by the recent political instability. Excluding the impact of foreign currency translation, Asia/Pacific net sales decreased 2%. Adjusting for the impact of the accelerated orders, reported Asia/Pacific net sales would have increased 3%. We strategically stagger our new product launches by geographic market, which may account for differences in regional sales growth. COST OF SALES Cost of sales as a percentage of total net sales increased to 20.4% as compared with 20.3% in the prior-year period. This change reflected an increase in obsolescence charges of approximately 30 basis points, partially offset by a favorable effect of exchanges rates of approximately 20 basis points. Additionally, a favorable impact from pricing was offset by an unfavorable change in the mix of our business. Since certain promotional activities are a component of sales or cost of sales and the timing and level of promotions vary with our promotional calendar, we have experienced, and expect to continue to experience, fluctuations in the cost of sales percentage. In addition, future cost of sales mix may be impacted by the inclusion of potential new brands or channels of distribution which have margin and product cost structures different from those of our current mix of business. OPERATING EXPENSES Operating expenses as a percentage of net sales increased to 66.4% as compared with 62.9% in the prior-year period. As a percentage of net sales, this increase primarily reflected higher selling and shipping costs of approximately 130 basis points, an increase in general and administrative expenses of approximately 90 basis points and higher store operation costs driven by freestanding retail store expansion of approximately 70 basis points. Also contributing to the increase were unfavorable changes in foreign exchange transactions of approximately 40 basis points and higher costs related to stock-based compensation of approximately 30 basis points. Spending on advertising, merchandising and sampling remained flat as a percentage of net sales as a result of our reallocation of our investment spending among brands and media formats. Adjusting for the impact of the accelerated orders into the fiscal 2014 fourth quarter, operating expenses as a percentage of net sales would have decreased approximately 20 basis points, primarily reflecting lower spending on advertising, merchandising and sampling, mostly offset by higher costs related to freestanding retail store expansion, unfavorable changes in foreign exchange transactions and an increase in general and administrative expenses. Changes in advertising, merchandising and sampling spending result from the type, timing and level of activities related to product launches and rollouts, as well as the markets and brands being emphasized. 29 -------------------------------------------------------------------------------- Table of Contents THE ESTÉE LAUDER COMPANIES INC. OPERATING RESULTS Operating income decreased 23%, or $101.5 million, to $348.0 million. Operating margin decreased to 13.2% of net sales as compared with 16.8% in the prior-year period, which reflected our higher operating expense margin and, to a lesser extent, our lower gross margin. The overall operating results were impacted by approximately $127 million related to the accelerated orders into the fiscal 2014 fourth quarter from certain of our retailers, which created a difficult comparison to the prior-year period. Adjusting for the impact of the accelerated orders, operating income would have increased 6% and operating margin would have increased 10 basis points. Product Categories The overall change in operating results in each product category was negatively impacted by the accelerated orders into the fiscal 2014 fourth quarter from certain of our retailers due to our implementation of SMI as follows: skin care, approximately $72 million; makeup, approximately $41 million; fragrance, approximately $14 million; and the impact on hair care was de minimis. Skin care operating income decreased 27%, or $65.2 million, to $176.4 million, primarily reflecting lower results from our heritage brands, due to a difficult comparison with the prior-year period, which featured significant launch activity related to the reformulation of certain iconic products, and were particularly impacted by the accelerated orders. Partially offsetting this decrease was lower investment spending as a result of the lower level of launch activity in the current-year period. Makeup operating income decreased 24%, or $40.4 million, to $125.9 million, primarily reflecting lower results from our heritage brands due to lower net sales that were impacted by the accelerated orders, as well as increased investment spending behind recent product launches, partially offset by improved results from M†A†C. Fragrance operating income increased 6%, or $2.1 million, to $39.0 million, reflecting higher results from our luxury fragrance brands as a result of new product launches and expanded distribution. Hair care operating results increased 5%, or $0.4 million, to $8.8 million, primarily reflecting higher net sales driven by expanded global distribution and new product launches, as well as lower investment spending as compared with the higher level of spending in the prior-year period to support the Invati line of products. Adjusting for the impact of the accelerated orders, skin care, makeup, fragrance and hair care operating results would have increased 3%, 1%, 43% and 6%, respectively. Geographic Regions The overall change in operating results in each geographic region was negatively impacted by the accelerated orders into the fiscal 2014 fourth quarter from certain of our retailers due to our implementation of SMI as follows: Americas, approximately $53 million; Europe, the Middle East & Africa, approximately $53 million; and Asia/Pacific, approximately $21 million. Operating income in the Americas decreased 63%, or $98.6 million, to $57.4 million, primarily reflecting the decrease in net sales in our heritage brands in the United States and Canada driven by the impact of the accelerated orders and a difficult comparison with the prior-year period, which featured significant launch activity related to the reformulation of certain iconic products. To a lesser extent, operating results also declined in Latin America, due to lower results in Venezuela. This decrease was partially offset by lower investment spending by our heritage brands. Adjusting for the impact of the accelerated orders, operating income in the Americas would have decreased 29%. In Europe, the Middle East & Africa, operating income decreased 6%, or $10.9 million, to $169.9 million. Lower results in our travel retail business, primarily due to the accelerated orders, and Germany totaled approximately $36 million, combined, partially offset by higher operating results in the United Kingdom, Russia, France and South Africa of approximately $25 million, combined. The improved results in France and South Africa primarily reflected a decrease in investment spending. Adjusting for the impact of the accelerated orders, operating income in Europe, the Middle East & Africa would have increased 23%. In Asia/Pacific, operating income increased 6%, or $6.8 million, to $120.7 million. Higher results in Korea, Australia, China and Taiwan totaled approximately $19 million, combined. The improved results in China were primarily due to lower investment spending as compared with the higher level of spending in the prior-year period to support launches by certain of our heritage brands. These higher results were partially offset by lower operating results in Japan, due to the accelerated orders, and Hong Kong of approximately $13 million, combined. Adjusting for the impact of the accelerated orders, operating income in Asia/Pacific would have increased 25%. INTEREST EXPENSE, NET Net interest expense decreased to $13.2 million as compared with $13.5 million in the prior-year period, primarily due to higher interest income. 30 -------------------------------------------------------------------------------- Table of Contents THE ESTÉE LAUDER COMPANIES INC. PROVISION FOR INCOME TAXES The provision for income taxes represents U.S. federal, foreign, state and local income taxes. The effective rate differs from the federal statutory rate primarily due to the effect of state and local income taxes, the taxation of foreign income and income tax reserve adjustments, which represent changes in our net liability for unrecognized tax benefits including tax settlements and lapses of the applicable statutes of limitations. Our effective tax rate will change from quarter to quarter based on recurring and non-recurring factors including, but not limited to, the geographical mix of earnings, enacted tax legislation, state and local income taxes, tax reserve adjustments, the ultimate disposition of deferred tax assets relating to stock-based compensation and the interaction of various global tax strategies. In addition, changes in judgment from the evaluation of new information resulting in the recognition, derecognition or remeasurement of a tax position taken in a prior annual period are recognized separately in the quarter of change. The effective rate for income taxes was 31.5% and 30.8% for the three months ended September 30, 2014 and 2013, respectively. The increase in the effective tax rate was principally due to a slight increase in income tax reserve adjustments. NET EARNINGS ATTRIBUTABLE TO THE ESTÉE LAUDER COMPANIES INC. Net earnings attributable to The Estée Lauder Companies Inc. as compared with the prior-year period decreased 24%, or $72.6 million, to $228.1 million and diluted net earnings per common share decreased 23% from $.76 to $.59. NON-GAAP FINANCIAL MEASURES We use certain non-GAAP financial measures, among other financial measures, to evaluate our operating performance, which represent the manner in which we conduct and view our business. Management believes that excluding these items that are not comparable from period to period helps investors and others compare operating performance between two periods. While we consider the non-GAAP measures useful in analyzing our results, they are not intended to replace, or act as a substitute for, any presentation included in the consolidated financial statements prepared in conformity with U.S. GAAP. The following tables present Net Sales, Operating Income and Diluted net earnings per common share adjusted to exclude the impact of accelerated orders associated with the July 2014 SMI rollout. The tables provide reconciliations between these non-GAAP financial measures and the most directly comparable U.S. GAAP measures. % Change Three Months Ended in September 30 % Constant ($ in millions) 2014 2013 Variance Change Currency Net Sales, as reported $ 2,631.0 $ 2,675.0 $ (44.0 ) (2 )% (1 )% Accelerated orders associated with SMI rollout 178.3 - 178.3 Net Sales, as adjusted $ 2,809.3 $ 2,675.0 $ 134.3 5 % 5 % Three Months Ended September 30 % ($ in millions) 2014 2013 Variance Change Operating Income, as reported $ 348.0 $ 449.5 $ (101.5 ) (23 )% Accelerated orders associated with SMI rollout 127.2 - 127.2 Operating Income, as adjusted $ 475.2 $ 449.5 $ 25.7 6 % Three Months Ended September 30 % 2014 2013 Variance Change Diluted net earnings per common share, as reported $ .59 $ .76 $ (.17 ) (23 )% Accelerated orders associated with SMI rollout .21 - .21 Diluted net earnings per common share, as adjusted $ .80 $ .76 $ .04 5 % 31 -------------------------------------------------------------------------------- Table of Contents THE ESTÉE LAUDER COMPANIES INC. FINANCIAL CONDITION LIQUIDITY AND CAPITAL RESOURCES Overview Our principal sources of funds historically have been cash flows from operations, borrowings pursuant to our commercial paper program, borrowings from the issuance of long-term debt and committed and uncommitted credit lines provided by banks and other lenders in the United States and abroad. At September 30, 2014, we had cash and cash equivalents of $1,395.4 million compared with $1,629.1 million at June 30, 2014. Our cash and cash equivalents are maintained at a number of financial institutions. To mitigate the risk of uninsured balances, we select financial institutions based on their credit ratings and financial strength and perform ongoing evaluations of these institutions to limit our concentration risk exposure. Our business is seasonal in nature and, accordingly, our working capital needs vary. From time to time, we may enter into investing and financing transactions that require additional funding. To the extent that these needs exceed cash from operations, we could, subject to market conditions, issue commercial paper, issue long-term debt securities or borrow under our revolving credit facilities. Based on past performance and current expectations, we believe that cash on hand, cash generated from operations, available credit lines and access to credit markets will be adequate to support currently planned business operations, information systems enhancements, capital expenditures, potential stock repurchases, commitments and other contractual obligations on both a near-term and long-term basis. Our cash and cash equivalents balance at September 30, 2014 includes cash in offshore jurisdictions associated with our permanent reinvestment strategy. We do not believe that the indefinite reinvestment of these funds offshore impairs our ability to meet our domestic debt or working capital obligations. If these indefinitely reinvested earnings were repatriated into the United States as dividends, we would be subject to additional taxes. The effects of inflation have not been significant to our overall operating results in recent years. Generally, we have been able to introduce new products at higher prices, increase prices and implement other operating efficiencies to sufficiently offset cost increases, which have been moderate. Credit Ratings Changes in our credit ratings will likely result in changes in our borrowing costs. Our credit ratings also impact the cost of our revolving credit facility as discussed below. Downgrades in our credit ratings may reduce our ability to issue commercial paper and/or long-term debt and would likely increase the relative costs of borrowing. A credit rating is not a recommendation to buy, sell, or hold securities, is subject to revision or withdrawal at any time by the assigning rating organization, and should be evaluated independently of any other rating. As of October 28, 2014, our commercial paper is rated A-1 by Standard & Poor's and P-1 by Moody's and our long-term debt is rated A+ with a stable outlook by Standard & Poor's and A2 with a stable outlook by Moody's. Debt At September 30, 2014, our outstanding borrowings were as follows: Long-term Current ($ in millions) Debt Debt Total Debt 3.70% Senior Notes, due August 15, 2042 ("2042 Senior Notes") (1), (6) $ 249.0 $ - $ 249.0 6.00% Senior Notes, due May 15, 2037 ("2037 Senior Notes") (2), (6) 296.6 - 296.6 5.75% Senior Notes, due October 15, 2033 ("2033 Senior Notes") (3) 197.8 - 197.8 2.35% Senior Notes, due August 15, 2022 ("2022 Senior Notes") (4), (6) 249.8 - 249.8 5.55% Senior Notes, due May 15, 2017 ("2017 Senior Notes") (5), (6) 319.3 - 319.3 Other borrowings 6.5 14.0 20.5 $ 1,319.0 $ 14.0 $ 1,333.0 -------------------------------------------------------------------------------- (1) Consists of $250.0 million principal and unamortized debt discount of $1.0 million. (2) Consists of $300.0 million principal and unamortized debt discount of $3.4 million. (3) Consists of $200.0 million principal and unamortized debt discount of $2.2 million. (4) Consists of $250.0 million principal and unamortized debt discount of $0.2 million. (5) Consists of $300.0 million principal, unamortized debt discount of $0.1 million and a $19.4 million adjustment to reflect the termination value of interest rate swaps. (6) The Senior Notes contain certain customary incurrence-based covenants, including limitations on indebtedness secured by liens. 32 -------------------------------------------------------------------------------- Table of Contents THE ESTÉE LAUDER COMPANIES INC. We have a $1.0 billion commercial paper program under which we may issue commercial paper in the United States. As of September 30, 2014, we had no commercial paper outstanding. We have a $1.0 billion senior unsecured revolving credit facility that expires on July 15, 2019, unless extended for up to two additional years in accordance with the terms set forth in the agreement (the "Facility"). At September 30, 2014, no borrowings were outstanding under the Facility. The Facility may be used for general corporate purposes. Up to the equivalent of $350 million of the Facility is available for multi-currency loans. The interest rate on borrowings under the Facility is based on LIBOR or on the higher of prime, which is the rate of interest publicly announced by the administrative agent, or ½% plus the Federal funds rate. We incurred costs of approximately $1.0 million to establish the Facility, which costs will be amortized over the term of the Facility. The Facility has an annual fee of $0.6 million, payable quarterly, based on our current credit ratings. The Facility also contains a cross-default provision whereby a failure to pay other material financial obligations in excess of $150.0 million (after grace periods and absent a waiver from the lenders) would result in an event of default and the acceleration of the maturity of any outstanding debt under the Facility. We have a fixed rate promissory note agreement with a financial institution pursuant to which we may borrow up to $150.0 million in the form of loan participation notes through one of our subsidiaries in Europe. The interest rate on borrowings under this agreement is at an all-in fixed rate determined by the lender and agreed to by us at the date of each borrowing. At September 30, 2014, no borrowings were outstanding under this agreement. Debt issuance costs incurred related to this agreement were de minimis. Total debt as a percent of total capitalization (excluding noncontrolling interests) was 26% at September 30, 2014 and June 30, 2014. Cash Flows Net cash provided by operating activities was $127.7 million during the three months ended September 30, 2014 as compared with $29.9 million in the prior-year period. The improvement in cash flows provided by operating activities primarily reflected a favorable change in accounts receivable reflecting the timing of shipments and improved collections, due in part to the accelerated orders in fiscal 2014 in connection with our July 2014 SMI implementation. The improvement was partially offset by an unfavorable change in other liabilities due to higher payments related to employee compensation, and a decrease in net earnings. Net cash used for investing activities was $80.3 million during the three months ended September 30, 2014 as compared with $94.9 million in the prior-year period. The decrease primarily reflected the receipt of the remaining $8.4 million principal amount of the Rodan + Fields note receivable, and lower capital expenditure activity related to computer software and counters. Net cash used for financing activities was $272.6 million during the three months ended September 30, 2014 as compared with $114.9 million in the prior-year period. The increase in cash used for financing activities primarily reflected an increase in treasury stock purchases and higher dividend payments. Dividends For a summary of quarterly cash dividends declared per share on our Class A and Class B Common Stock during the three months ended September 30, 2014, see Notes to Consolidated Financial Statements, Note 9 - Equity. Pension and Post-retirement Plan Funding There have been no significant changes to our pension and post-retirement funding as discussed in our Annual Report on Form 10-K for the fiscal year ended June 30, 2014. Commitments, Contractual Obligations and Contingencies There have been no significant changes to our commitments and contractual obligations as discussed in our Annual Report on Form 10-K for the year ended June 30, 2014. For a discussion of contingencies, see Notes to Consolidated Financial Statements, Note 6 - Contingencies. Derivative Financial Instruments and Hedging Activities There have been no significant changes to our derivative financial instruments and hedging activities as discussed in our Annual Report on Form 10-K for the fiscal year ended June 30, 2014. 33 -------------------------------------------------------------------------------- Table of Contents THE ESTÉE LAUDER COMPANIES INC. Foreign Exchange Risk Management We enter into foreign currency forward contracts to hedge anticipated transactions, as well as receivables and payables denominated in foreign currencies, for periods consistent with our identified exposures. The purpose of the hedging activities is to minimize the effect of foreign exchange rate movements on costs and on the cash flows that we receive from foreign subsidiaries. The majority of foreign currency forward contracts are denominated in currencies of major industrial countries. We may also enter into foreign currency option contracts to hedge anticipated transactions where there is a high probability that anticipated exposures will materialize. The foreign currency forward contracts entered into to hedge anticipated transactions have been designated as foreign currency cash-flow hedges and have varying maturities through the end of September 2016. Hedge effectiveness of foreign currency forward contracts is based on a hypothetical derivative methodology and excludes the portion of fair value attributable to the spot-forward difference which is recorded in current-period earnings. Hedge effectiveness of foreign currency option contracts is based on a dollar offset methodology. The ineffective portion of both foreign currency forward and option contracts is recorded in current-period earnings. For hedge contracts that are no longer deemed highly effective, hedge accounting is discontinued and gains and losses accumulated in other comprehensive income (loss) are reclassified to earnings when the underlying forecasted transaction occurs. If it is probable that the forecasted transaction will no longer occur, then any gains or losses in accumulated other comprehensive income (loss) are reclassified to current-period earnings. As of September 30, 2014, these foreign currency cash-flow hedges were highly effective in all material respects. At September 30, 2014, we had foreign currency forward contracts in the amount of $1,786.6 million. The foreign currencies included in foreign currency forward contracts (notional value stated in U.S. dollars) are principally the Euro ($322.2 million), British pound ($306.6 million), Swiss franc ($200.5 million), Canadian dollar ($170.3 million), Hong Kong dollar ($142.4 million), Japanese yen ($118.7 million) and Australian dollar ($99.6 million). Credit Risk As a matter of policy, we enter into derivative contracts only with counterparties that have a long-term credit rating of at least A- or higher by at least two nationally recognized rating agencies. The counterparties to these contracts are major financial institutions. Exposure to credit risk in the event of nonperformance by any of the counterparties is limited to the gross fair value of contracts in asset positions, which totaled $25.8 million at September 30, 2014. To manage this risk, we have established strict counterparty credit guidelines that are continually monitored. Accordingly, management believes risk of loss under these hedging contracts is remote. Certain of our derivative financial instruments, with two counterparties, contain credit-risk-related contingent features. At September 30, 2014, we were in a net asset position for certain derivative contracts that contain such features. The fair value of those contracts as of September 30, 2014 was $10.1 million. As of September 30, 2014, we were in compliance with such credit-risk-related contingent features. Market Risk Using the value-at-risk model, as discussed in our Annual Report on Form 10-K for the fiscal year ended June 30, 2014, the high, low and average measured value-at-risk for the twelve months ended September 30, 2014 related to our foreign exchange contracts are as follows: (In millions) High Low Average Foreign exchange contracts $ 27.4 $ 7.4 $ 16.5 The change in the value-at-risk measures from June 30, 2014 related to our foreign exchange contracts reflected an increase in foreign exchange volatilities and a different portfolio mix. We believe that any resulting loss incurred would be offset by the effects of market rate movements on the respective underlying transactions for which the derivative financial instrument was intended. OFF-BALANCE SHEET ARRANGEMENTS We do not maintain any off-balance sheet arrangements, transactions, obligations or other relationships with unconsolidated entities, other than operating leases, that would be expected to have a material current or future effect upon our financial condition or results of operations. 34 -------------------------------------------------------------------------------- Table of Contents THE ESTÉE LAUDER COMPANIES INC. CRITICAL ACCOUNTING POLICIES As disclosed in our Annual Report on Form 10-K for the fiscal year ended June 30, 2014, the discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in conformity with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses reported in those financial statements. These judgments can be subjective and complex, and consequently actual results could differ from those estimates and assumptions. Our most critical accounting policies relate to revenue recognition, inventory, pension and other post-retirement benefit costs, goodwill, other intangible assets and long-lived assets, and income taxes. Since June 30, 2014, there have been no significant changes to the assumptions and estimates related to our critical accounting policies. RECENTLY ISSUED ACCOUNTING STANDARDS For a discussion regarding the impact of accounting standards that were recently issued but not yet effective, on the Company's consolidated financial statements, see Notes to Consolidated Financial Statements, Note 1 - Summary of Significant Accounting Policies. FORWARD-LOOKING INFORMATION We and our representatives from time to time make written or oral forward-looking statements, including statements contained in this and other filings with the Securities and Exchange Commission, in our press releases and in our reports to stockholders. The words and phrases "will likely result," "expect," "believe," "planned," "may," "should," "could," "anticipate," "estimate," "project," "intend," "forecast" or similar expressions are intended to identify "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include, without limitation, our expectations regarding sales, earnings or other future financial performance and liquidity, product introductions, entry into new geographic regions, information systems initiatives, new methods of sale, our long-term strategy, restructuring and other charges and resulting cost savings, and future operations or operating results. Although we believe that our expectations are based on reasonable assumptions within the bounds of our knowledge of our business and operations, actual results may differ materially from our expectations. Factors that could cause actual results to differ from expectations include, without limitation: (1) increased competitive activity from companies in the skin care, makeup, fragrance and hair care businesses, some of which have greater resources than we do; (2) our ability to develop, produce and market new products on which future operating results may depend and to successfully address challenges in our business; (3) consolidations, restructurings, bankruptcies and reorganizations in the retail industry causing a decrease in the number of stores that sell our products, an increase in the ownership concentration within the retail industry, ownership of retailers by our competitors or ownership of competitors by our customers that are retailers and our inability to collect receivables; (4) destocking and tighter working capital management by retailers; (5) the success, or changes in timing or scope, of new product launches and the success, or changes in the timing or the scope, of advertising, sampling and merchandising programs; (6) shifts in the preferences of consumers as to where and how they shop for the types of products and services we sell; (7) social, political and economic risks to our foreign or domestic manufacturing, distribution and retail operations, including changes in foreign investment and trade policies and regulations of the host countries and of the United States; 35 -------------------------------------------------------------------------------- Table of Contents THE ESTÉE LAUDER COMPANIES INC. (8) changes in the laws, regulations and policies (including the interpretations and enforcement thereof) that affect, or will affect, our business, including those relating to our products or distribution networks, changes in accounting standards, tax laws and regulations, environmental or climate change laws, regulations or accords, trade rules and customs regulations, and the outcome and expense of legal or regulatory proceedings, and any action we may take as a result; (9) foreign currency fluctuations affecting our results of operations and the value of our foreign assets, the relative prices at which we and our foreign competitors sell products in the same markets and our operating and manufacturing costs outside of the United States; (10) changes in global or local conditions, including those due to the volatility in the global credit and equity markets, natural or man-made disasters, real or perceived epidemics, or energy costs, that could affect consumer purchasing, the willingness or ability of consumers to travel and/or purchase our products while traveling, the financial strength of our customers, suppliers or other contract counterparties, our operations, the cost and availability of capital which we may need for new equipment, facilities or acquisitions, the returns that we are able to generate on our pension assets and the resulting impact on funding obligations, the cost and availability of raw materials and the assumptions underlying our critical accounting estimates; (11) shipment delays, commodity pricing, depletion of inventory and increased production costs resulting from disruptions of operations at any of the facilities that manufacture nearly all of our supply of a particular type of product (i.e. focus factories) or at our distribution or inventory centers, including disruptions that may be caused by the implementation of SAP as part of our Strategic Modernization Initiative, other information technology initiatives, or by restructurings; (12) real estate rates and availability, which may affect our ability to increase or maintain the number of retail locations at which we sell our products and the costs associated with our other facilities; (13) changes in product mix to products which are less profitable; (14) our ability to acquire, develop or implement new information and distribution technologies and initiatives on a timely basis and within our cost estimates and our ability to maintain continuous operations of such systems and the security of data and other information that may be stored in such systems or other systems or media; (15) our ability to capitalize on opportunities for improved efficiency, such as publicly-announced strategies and restructuring and cost-savings initiatives, and to integrate acquired businesses and realize value therefrom; (16) consequences attributable to local or international conflicts around the world, as well as from any terrorist action, retaliation and the threat of further action or retaliation; (17) the timing and impact of acquisitions, investments and divestitures; and (18) additional factors as described in our filings with the Securities and Exchange Commission, including the Annual Report on Form 10-K for the fiscal year ended June 30, 2014. We assume no responsibility to update forward-looking statements made herein or otherwise. |