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ESTEE LAUDER COMPANIES INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) CRITICAL ACCOUNTING POLICIES AND ESTIMATES The discussion and analysis of our financial condition at June 30, 2014 and our results of operations for the three fiscal years ended June 30, 2014 are based upon our consolidated financial statements, which have been prepared in conformity with U.S. generally accepted accounting principles ("U.S. GAAP"). The preparation of these financial statements requires us to make estimates and assumptions that affect the amounts of assets, liabilities, revenues and expenses reported in those financial statements. These estimates and assumptions can be subjective and complex and, consequently, actual results could differ from those estimates. We consider accounting estimates to be critical if both (i) the nature of the estimate or assumption is material due to the levels of subjectivity and judgment involved, and (ii) the impact within a reasonable range of outcomes of the estimate and assumption is material to the Company's financial condition. 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. Management of the Company has discussed the selection of significant accounting policies and the effect of estimates with the Audit Committee of the Company's Board of Directors. Revenue Recognition Revenues from product sales are recognized upon transfer of ownership, including passage of title to the customer and transfer of the risk of loss related to those goods. In the Americas region, sales are generally recognized at the time the product is shipped to the customer and in the Europe, the Middle East & Africa and Asia/Pacific regions, sales are generally recognized based upon the customer's receipt. In certain circumstances, transfer of title takes place at the point of sale, for example, at our retail stores. Revenues are reported on a net sales basis, which is computed by deducting from gross sales the amount of actual product returns received, discounts, incentive arrangements with retailers and an amount established for anticipated product returns. Our practice is to accept product returns from retailers only if properly requested, authorized and approved. In accepting returns, we typically provide a credit to the retailer against accounts receivable from that retailer. As a percentage of gross sales, returns were 3.4% in fiscal 2014, 3.3% in fiscal 2013 and 3.5% in fiscal 2012. Our sales return accrual is a subjective critical estimate that has a direct impact on reported net sales. This accrual is calculated based on a history of actual returns, estimated future returns and information provided by retailers regarding their inventory levels. Consideration of these factors results in an accrual for anticipated sales returns that reflects increases or decreases related to seasonal fluctuations. Experience has shown a relationship between retailer inventory levels and sales returns in the subsequent period, as well as a consistent pattern of returns due to the seasonal nature of our business. In addition, as necessary, specific accruals may be established for significant future known or anticipated events. The types of known or anticipated events that we have considered, and will continue to consider, include, but are not limited to, the financial condition of our customers, store closings by retailers, changes in the retail environment and our decision to continue to support new and existing products. In the ordinary course of business, we have established an allowance for doubtful accounts and customer deductions based upon the evaluation of accounts receivable aging, specific exposures and historical trends. Our allowance for doubtful accounts and customer deductions is a subjective critical estimate that has a direct impact on reported net earnings. The allowance for doubtful accounts was $23.9 million and $22.7 million as of June 30, 2014 and 2013, respectively. The allowance for doubtful accounts was reduced by $8.3 million, $23.0 million and $13.8 million for customer deductions and write-offs in fiscal 2014, 2013 and 2012, respectively, and increased by $9.5 million, $14.6 million and $11.0 million for additional provisions in fiscal 2014, 2013 and 2012, respectively. Inventory We state our inventory at the lower of cost or fair-market value, with cost being based on standard cost which approximates actual cost on the first-in, first-out (FIFO) method. We believe this method most closely matches the flow of our products from manufacture through sale. The reported net value of our inventory includes saleable products, promotional products, raw materials and componentry and work in process that will be sold or used in future periods. Inventory cost includes raw materials, direct labor and overhead, as well as inbound freight. Manufacturing overhead is allocated to the cost of inventory based on the normal production capacity. Unallocated overhead during periods of abnormally low production levels are recognized as cost of sales in the period in which they are incurred. We also record an inventory obsolescence reserve, which represents the difference between the cost of the inventory and its estimated realizable value, based on various product sales projections. This reserve is calculated using an estimated obsolescence percentage applied to the inventory based on age, historical trends and requirements to support forecasted sales. In addition, and as necessary, we may establish specific reserves for future known or anticipated events. - 19 - -------------------------------------------------------------------------------- Table of Contents Pension and Other Post-retirement Benefit Costs We offer the following benefits to some or all of our employees: a domestic trust-based noncontributory qualified defined benefit pension plan ("U.S. Qualified Plan") and an unfunded, non-qualified domestic noncontributory pension plan to provide benefits in excess of statutory limitations (collectively with the U.S. Qualified Plan, the "Domestic Plans"); a domestic contributory defined contribution plan; international pension plans, which vary by country, consisting of both defined benefit and defined contribution pension plans; deferred compensation arrangements; and certain other post-retirement benefit plans. The amounts needed to fund future payouts under our defined benefit pension and post-retirement benefit plans are subject to numerous assumptions and variables. Certain significant variables require us to make assumptions that are within our control such as an anticipated discount rate, expected rate of return on plan assets and future compensation levels. We evaluate these assumptions with our actuarial advisors and select assumptions that we believe reflect the economics underlying our pension and post-retirement obligations. While we believe these assumptions are within accepted industry ranges, an increase or decrease in the assumptions or economic events outside our control could have a direct impact on reported net earnings. The discount rate for each plan used for determining future net periodic benefit cost is based on a review of highly rated long-term bonds. For fiscal 2014, we used discount rates for our Domestic Plans of between 4.30% and 4.90% and varying rates on our international plans of between 1.00% and 7.25%. The discount rate for our Domestic Plans is based on a bond portfolio that includes only long-term bonds with an Aa rating, or equivalent, from a major rating agency. We used an above-mean yield curve which represents an estimate of the effective settlement rate of the obligation, and the timing and amount of cash flows related to the bonds included in this portfolio are expected to match the estimated defined benefit payment streams of our Domestic Plans. For our international plans, the discount rate in a particular country was principally determined based on a yield curve constructed from high quality corporate bonds in each country, with the resulting portfolio having a duration matching that particular plan. For fiscal 2014, we used an expected return on plan assets of 7.50% for our U.S. Qualified Plan and varying rates of between 2.25% and 7.25% for our international plans. In determining the long-term rate of return for a plan, we consider the historical rates of return, the nature of the plan's investments and an expectation for the plan's investment strategies. See "Item 8. Financial Statements and Supplementary Data - Note 12 - Pension, Deferred Compensation and Post-retirement Benefit Plans" for details regarding the nature of our pension and post-retirement plan investments. The difference between actual and expected return on plan assets is reported as a component of accumulated other comprehensive income. Those gains/losses that are subject to amortization over future periods will be recognized as a component of the net periodic benefit cost in such future periods. For fiscal 2014, our pension plans had actual return on assets of approximately $129 million as compared with expected return on assets of approximately $68 million. The resulting net deferred gain of approximately $61 million, when combined with gains and losses from previous years, will be amortized over periods ranging from approximately 7 to 23 years. The actual return on plan assets from our global pension plans exceeded expectations, primarily reflecting strong performance from global equity and U.S. fixed income investments. A 25 basis-point change in the discount rate or the expected rate of return on plan assets would have had the following effect on fiscal 2014 pension expense: 25 Basis-Point 25 Basis-Point (In millions) Increase Decrease Discount rate $ (4.0 ) $ 4.2 Expected return on assets $ (2.7 ) $ 2.7 Our post-retirement plans are comprised of health care plans that could be impacted by health care cost trend rates, which may have a significant effect on the amounts reported. A one-percentage-point change in assumed health care cost trend rates for fiscal 2014 would have had the following effects: One-Percentage-Point One-Percentage-Point (In millions) Increase Decrease Effect on total service and interest costs $ 1.3 $ (1.1 ) Effect on post-retirement benefit obligations $ 13.9 $ (12.1 ) To determine the fiscal 2015 net periodic benefit cost, we are using discount rates of 4.30% and 3.60% for the U.S. Qualified Plan and the non-qualified domestic noncontributory pension plan, respectively, and varying rates for our international plans of between .50% and 6.75%. We are using an expected return on plan assets of 7.50% for the U.S. Qualified Plan and varying rates for our international pension plans of between 2.00% and 6.75%. The net change in these assumptions from those used in fiscal 2014 will result in an increase in pension expense of approximately $3 million in fiscal 2015. - 20 - -------------------------------------------------------------------------------- Table of Contents Goodwill, Other Intangible Assets and Long-Lived Assets Goodwill is calculated as the excess of the cost of purchased businesses over the fair value of their underlying net assets. Other indefinite-lived intangible assets principally consist of trademarks. Goodwill and other indefinite-lived intangible assets are not amortized. We assess goodwill and other indefinite-lived intangibles at least annually for impairment as of the beginning of the fiscal fourth quarter, or more frequently if certain events or circumstances exist. We test goodwill for impairment at the reporting unit level, which is one level below our operating segments. We identify our reporting units by assessing whether the components of our operating segments constitute businesses for which discrete financial information is available and management of each reporting unit regularly reviews the operating results of those components. We make certain judgments and assumptions in allocating assets and liabilities to determine carrying values for our reporting units. Impairment testing is performed in two steps: (i) we determine if an indication of impairment exists by comparing the fair value of a reporting unit with its carrying value, and (ii) if there is an impairment, we measure the amount of impairment loss by comparing the implied fair value of goodwill with the carrying amount of that goodwill. The impairment test for indefinite-lived intangible assets encompasses calculating a fair value of an indefinite-lived intangible asset and comparing the fair value to its carrying value. If the carrying value exceeds the fair value an impairment charge is recorded. Testing goodwill for impairment requires us to estimate fair values of reporting units using significant estimates and assumptions. The assumptions made will impact the outcome and ultimate results of the testing. We use industry accepted valuation models and set criteria that are reviewed and approved by various levels of management and, in certain instances, we engage third-party valuation specialists for advice. To determine fair value of the reporting units, we generally use an equal weighting of the income and market approaches. In certain circumstances, equal weighting will not be applied if one of these methods may be less applicable (e.g., only the income approach would be used for reporting units with existing negative margins). We believe both approaches are equally relevant and the most reliable indications of fair value because the fair value of product or service companies is more dependent on the ability to generate earnings than on the value of the assets used in the production process. Under the income approach, we determine fair value using a discounted cash flow method, projecting future cash flows of each reporting unit, as well as a terminal value, and discounting such cash flows at a rate of return that reflects the relative risk of the cash flows. Under the market approach, we utilize information from comparable publicly traded companies with similar operating and investment characteristics as the reporting units, which creates valuation multiples that are applied to the operating performance of the reporting unit being tested, to value the reporting unit. The key estimates and factors used in these two approaches include, but are not limited to, revenue growth rates and profit margins based on internal forecasts, terminal value, the weighted-average cost of capital used to discount future cash flows and comparable market multiples. The fiscal 2014 compound annual growth rate of sales for the first eight years of our projections, as considered appropriate for the individual reporting units, ranged between 3% and 17% with the higher growth rates in certain of the Company's smaller reporting units that are expected to continue the growth that they have exhibited over the past several years. The following fiscal 2013 estimates and factors exclude those related to our Darphin reporting unit, for which we recorded an impairment charge of the remainder of its goodwill. The fiscal 2013 compound annual growth rate of sales for the first five to eight years of our projections ranged between 5% and 22% with the higher growth rates in certain of the Company's smaller reporting units that are expected to continue the growth that they have exhibited over the past several years. For reporting units with positive earnings, growth in the corresponding earnings before interest and taxes ranged from 3% to 38% in fiscal 2014 as compared with 7% to 49% in fiscal 2013. The terminal growth rates were projected at 3% after eight years in fiscal 2014 and five to eight years in fiscal 2013, which reflects our estimate of long-term market and gross domestic product growth. The weighted-average cost of capital used to discount future cash flows ranged from 9% to 17% in fiscal 2014 as compared with 8% to 15% in fiscal 2013. The range of market multiples used in our fiscal 2014 impairment testing was from 1.2 to 3.5 times trailing-twelve-month sales and 9.0 to 12.0 times trailing-twelve-month earnings before interest, taxes, depreciation and amortization. The range of market multiples used in our fiscal 2013 impairment testing was from 1.5 to 3.5 times trailing-twelve-month sales and between 8.5 to 13.0 times trailing-twelve-month earnings before interest, taxes and depreciation and amortization. Future changes in these estimates and assumptions could materially affect the results of our reviews for impairment of goodwill. However, a decrease of 100 basis points in our terminal growth rate or an increase of 100 basis points in our weighted-average cost of capital would still result in a fair value calculation exceeding our book value for each of our reporting units. Changes in the valuation assumptions from those used in the prior year primarily reflect the impact of the current economic environment on the reporting units and their projected future results of operations. - 21 - -------------------------------------------------------------------------------- Table of Contents To determine fair value of other indefinite-lived intangible assets, we use an income approach, the relief-from-royalty method. This method assumes that, in lieu of ownership, a third party would be willing to pay a royalty in order to obtain the rights to use the comparable asset. Other indefinite-lived intangible assets' fair values require significant judgments in determining both the assets' estimated cash flows as well as the appropriate discount and royalty rates applied to those cash flows to determine fair value. Changes in such estimates or the application of alternative assumptions could produce significantly different results. The fiscal 2014 and fiscal 2013 terminal growth rate applied to future cash flows was 3% and the fiscal 2014 and fiscal 2013 discount rates ranged from 9% to 17% in fiscal 2014 and 10% to 18% in fiscal 2013. The fiscal 2014 and fiscal 2013 royalty rates ranged from 0.5% to 12%. These rates exclude those related to the Darphin trademark, for which we recorded an impairment charge for its remaining carrying value in fiscal 2013. As of our annual step-one goodwill and indefinite-lived asset impairment test on April 1, 2014, the fair values of our reporting units and the fair values of our indefinite-lived intangible assets substantially exceeded their respective carrying values. We review long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. When such events or changes in circumstances occur, a recoverability test is performed comparing projected undiscounted cash flows from the use and eventual disposition of an asset or asset group to its carrying value. If the projected undiscounted cash flows are less than the carrying value, an impairment would be recorded for the excess of the carrying value over the fair value, which is determined by discounting future cash flows. Income Taxes We account for income taxes using an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. As of June 30, 2014, we have current net deferred tax assets of $295.1 million and non-current net deferred tax assets of $85.5 million. The net deferred tax assets assume sufficient future earnings for their realization, as well as the continued application of currently anticipated tax rates. Included in net deferred tax assets is a valuation allowance of $115.2 million for deferred tax assets, where management believes it is more-likely-than-not that the deferred tax assets will not be realized in the relevant jurisdiction. Based on our assessments, no additional valuation allowance is required. If we determine that a deferred tax asset will not be realizable, an adjustment to the deferred tax asset will result in a reduction of net earnings at that time while the reduction of a valuation allowance will result in an increase of net earnings at that time. We provide tax reserves for U.S. federal, state, local and foreign exposures relating to periods subject to audit. The development of reserves for these exposures requires judgments about tax issues, potential outcomes and timing, and is a subjective critical estimate. We assess our tax positions and record tax benefits for all years subject to examination based upon management's evaluation of the facts, circumstances, and information available at the reporting dates. For those tax positions where it is more-likely-than-not that a tax benefit will be sustained, we have recorded the largest amount of tax benefit with a greater than 50% likelihood of being realized upon settlement with a tax authority that has full knowledge of all relevant information. For those tax positions where it is not more-likely-than-not that a tax benefit will be sustained, no tax benefit has been recognized in the consolidated financial statements. We classify applicable interest and penalties as a component of the provision for income taxes. Although the outcome relating to these exposures is uncertain, in management's opinion adequate provisions for income taxes have been made for estimable potential liabilities emanating from these exposures. If actual outcomes differ materially from these estimates, they could have a material impact on our consolidated results of operations. Quantitative Analysis During the three-year period ended June 30, 2014, there have not been material changes in the assumptions underlying these critical accounting policies, nor to the related significant estimates. The results of our business underlying these assumptions have not differed significantly from our expectations. While we believe that the estimates that we have made are proper and the related results of operations for the period are presented fairly in all material respects, other assumptions could reasonably be justified that would change the amount of reported net sales, cost of sales, operating expenses or our provision for income taxes as they relate to the provisions for anticipated sales returns, allowance for doubtful accounts, inventory obsolescence reserve and income taxes. For fiscal 2014, had these estimates been changed simultaneously by 2.5% in either direction, our reported gross profit would have increased or decreased by approximately $5.8 million, operating expenses would have changed by approximately $0.6 million and the provision for income taxes would have increased or decreased by approximately $0.7 million. The collective impact of these changes on operating income, net earnings attributable to The Estée Lauder Companies Inc., and net earnings attributable to The Estée Lauder Companies Inc. per diluted common share would be an increase or decrease of approximately $6.4 million, $5.7 million and $.01, respectively. - 22 - -------------------------------------------------------------------------------- Table of Contents 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 fiscal 2014, 2013 and 2012 and reflects the basis of presentation described in "Item 8. Financial Statements and Supplementary Data - Note 2 - Summary of Significant Accounting Policies and Note 19 - Segment Data and Related Information" for all periods presented. Products and services that do not meet our definition of skin care, makeup, fragrance and hair care have been included in the "other" category. Year Ended June 30 2014 2013 2012 (In millions) NET SALES By Region: The Americas $ 4,572.3 $ 4,302.9 $ 4,101.1 Europe, the Middle East & Africa 4,163.7 3,758.7 3,603.2 Asia/Pacific 2,232.7 2,121.6 2,011.4 10,968.7 10,183.2 9,715.7 Returns associated with restructuring activities 0.1 (1.5 ) (2.1 ) Net Sales $ 10,968.8 $ 10,181.7 $ 9,713.6 By Product Category: Skin Care $ 4,769.8 $ 4,465.3 $ 4,225.2 Makeup 4,210.2 3,876.9 3,696.8 Fragrance 1,425.0 1,310.8 1,271.0 Hair Care 515.6 488.9 462.4 Other 48.1 41.3 60.3 10,968.7 10,183.2 9,715.7 Returns associated with restructuring activities 0.1 (1.5 ) (2.1 ) Net Sales $ 10,968.8 $ 10,181.7 $ 9,713.6 OPERATING INCOME (LOSS) By Region: The Americas $ 537.3 $ 423.2 $ 288.4 Europe, the Middle East & Africa 938.3 813.4 746.3 Asia/Pacific 349.1 307.2 340.2 1,824.7 1,543.8 1,374.9 Total charges associated with restructuring activities 2.9 (17.8 ) (63.2 ) Operating Income $ 1,827.6 $ 1,526.0 $ 1,311.7 By Product Category: Skin Care $ 975.8 $ 830.1 $ 746.7 Makeup 715.9 580.4 538.0 Fragrance 104.1 120.3 100.1 Hair Care 33.7 26.7 12.2 Other (4.8 ) (13.7 ) (22.1 ) 1,824.7 1,543.8 1,374.9 Total charges associated with restructuring activities 2.9 (17.8 ) (63.2 ) Operating Income $ 1,827.6 $ 1,526.0 $ 1,311.7 - 23 - -------------------------------------------------------------------------------- Table of Contents The following table presents certain consolidated earnings data as a percentage of net sales: Year Ended June 30 2014 2013 2012 Net sales 100.0 % 100.0 % 100.0 % Cost of sales 19.7 19.9 20.5 Gross profit 80.3 80.1 79.5 Operating expenses: Selling, general and administrative 63.6 64.8 65.1 Restructuring and other charges - 0.1 0.7 Goodwill impairment - 0.1 - Impairment of other intangible assets - 0.1 0.2 Total operating expenses 63.6 65.1 66.0 Operating income 16.7 15.0 13.5 Interest expense, net 0.5 0.5 0.6 Interest expense on debt extinguishment - 0.2 - Other income - 0.2 0.1 Earnings before income taxes 16.2 14.5 13.0 Provision for income taxes 5.2 4.5 4.1 Net earnings 11.0 10.0 8.9 Net earnings attributable to noncontrolling interests - - - Net earnings attributable to The Estée Lauder Companies Inc. 11.0 % 10.0 % 8.9 % 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 continued to implement a long-term strategy that is guiding us through fiscal 2017. The strategy 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 plan to continue building upon and leveraging our history of outstanding creativity, innovation and entrepreneurship. We have succeeded in expanding our distinctive "High-Touch" service model and will continue to look for ways to further evolve it within our channels of distribution and geographic regions. As an example, we continue to enhance our capabilities to deliver superior retailing experiences across our brands, particularly in freestanding retail stores. We also continue to increase brand awareness and sales by expanding our multi-pronged digital presence encompassing e-commerce and m-commerce, as well as digital and social media. We are leveraging our regional organization in an effort to assure that we are locally relevant with our products, services, channels, marketing and visual merchandising. - 24 - -------------------------------------------------------------------------------- Table of Contents As part of our strategy, we are continuing to position ourselves to capitalize on opportunities in the fastest-growing areas in prestige beauty. Skin care, our most profitable product category, continues to be a strategic priority for our innovation and investment spending, particularly in the Asia/Pacific region and with product launches such as Advanced Night Repair Synchronized Recovery Complex II from Estée Lauder and Dramatically Different Moisturizing Lotion + from Clinique. We are also focusing our attention on luxury consumers across all product categories and have seen continued strength in the net sales of many of our higher-end prestige products. 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 Sculpting lipstick from Estée Lauder and our fragrance category through new launches and innovation, such as Estée Lauder Modern Muse and new fragrances from Michael Kors and Tory Burch. In addition, we are continuing to expand our hair care brands both in salons and in other retail channels. 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 prioritize efforts 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 also continue to expand our digital presence in international markets, which has resulted in growth in the net sales of our products sold online. In North America, despite solid retail sales growth during the holiday season, we saw a softening in the retail environment during the second half of fiscal 2014 in our traditional department store channel, due in part to adverse winter weather conditions. At the same time, we continued to expand our presence in other channels, such as specialty multi-brand retailers, freestanding retail stores and online. Internationally, we continue to take actions to grow 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 continuing efforts to grow our business in the freestanding retail store, online, specialty multi-brand retailer and prestige salon channels. The travel retail channel continues to be 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 overall business is performing well, we are seeing continued softness in certain Southern European countries and Korea due to challenging economic environments, as well as intensifying competitive pressures globally. Elsewhere, we are cautious of an uncertain retail environment in the United States in the short term, unfavorable foreign exchange rates in certain emerging countries, and the lower growth rates we have been experiencing in China. We also continue to see an adverse impact of Chinese government actions on the travel and spending of Chinese consumers, which are affecting sales in the travel retail channel, at their travel destinations and within their home market. We believe we have and will continue to offset to some extent the impact of these challenges as a result of our strategy to mitigate weaknesses we find in certain areas by utilizing the strengths of our diverse brand portfolio and geographic presence in other areas. 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. Looking ahead to fiscal 2015, we plan to continue building on our strengths and our heritage of innovation to bring unique and high-performance products with long-term appeal and enduring quality to our consumers. We expect our strategy will enable us to continue to succeed in high growth channels, benefit from regional opportunities, focus on emerging market consumers and enhance our local relevance. We plan on continuing to incorporate our personalized "High-Touch" philosophy through customization with key retailers, expansion in freestanding retail stores and extending it to fast-growing digital platforms. We remain dedicated to investing in select areas to improve our capabilities or develop new ones. Our main focuses are digital capabilities, research and development, product innovation, consumer insight, information technology improvements and operational excellence. - 25 - -------------------------------------------------------------------------------- Table of Contents We rolled out the last major wave of SMI in July 2014 in certain of our remaining locations. As a result, some retailers accelerated their sales orders that we believe would normally occur 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: Year Ended June 30, 2014 (In millions) Net Sales Operating 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 favorable comparison between fiscal 2014 and fiscal 2013 of approximately $178 million in net sales and approximately $127 million in operating results and impacted our operating margin comparisons. While these additional orders benefited our fiscal 2014 net sales and operating results comparisons, we expect there to be a corresponding adverse effect on our first quarter and full year fiscal 2015 net sales and operating results. 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. Impact of Recent Economic Events in Venezuela Our Venezuelan subsidiary has been operating in a highly inflationary economy since January 2010. Ongoing macroeconomic uncertainties in Venezuela have resulted in stringent controls on foreign currency exchange. In February 2013, there was a devaluation of the Venezuelan currency, the bolivar fuerte ("VEF"), from an official rate of 4.3 to 6.3. We recorded a devaluation charge in our fiscal 2013 third quarter, which did not have a significant impact on our consolidated net sales or operating income. In October 2013, the Venezuelan government introduced an auction-based foreign currency exchange mechanism ("SICAD I"). Participation in the weekly auctions is limited to certain industries determined by the Venezuelan government. Since we were unable to transact in the only SICAD I auction we were authorized to participate, we continued to use the official published rate of 6.3 to remeasure our VEF-denominated monetary assets and liabilities. During the third quarter of fiscal 2014, the Venezuelan government enacted additional changes to the country's foreign exchange controls that expanded the use of SICAD I and created a third exchange control mechanism ("SICAD II"), which allows all companies in all sectors to apply for the purchase of foreign currency and foreign currency denominated securities for any legal use or purpose. As a result, we considered our company-specific facts and circumstances in determining the appropriate remeasurement rate, principally assessing our legal eligibility to access the available foreign exchange mechanisms, the transactions that would be eligible, our past and expected future ability to transact through those mechanisms, and our intent to utilize a particular mechanism for particular purposes. Although the SICAD II mechanism and its level and frequency of exchange continue to be regulated by the Venezuelan government, it offers the possibility of foreign exchange in a theoretically open market without restricted uses and in our opinion is the only mechanism legally available at this time for our highest priority transactions, which are the import of goods. We have submitted applications to access U.S. dollars through the SICAD II mechanism and certain applications have been approved and we have received funds through June 30, 2014. While there is no guarantee our future applications will be accepted, based on the enacted changes and related considerations of how our business is eligible under the requirements established by the Venezuelan authorities, we believe the SICAD II rate was, and continues to be, the most appropriate rate that reflects the economics of our Venezuelan subsidiary's business since March 24, 2014, when the SICAD II mechanism became operational. As a result, we changed the exchange rate used to remeasure our VEF-denominated monetary assets and liabilities from 6.3 to the SICAD II rate, which was 49.98 as of June 30, 2014. Accordingly, a remeasurement charge of $38.3 million, on a before and after tax basis, was reflected in our consolidated statement of earnings for the year ended June 30, 2014. - 26 - -------------------------------------------------------------------------------- Table of Contents Furthermore, in January 2014, in an effort to control inflation, pricing and product shortages, the Venezuelan government enacted a law which imposed a cap on profit margins. We have evaluated the impact of this law and while it has challenged our local business, it did not have a significant impact on our consolidated financial statements for the fiscal year ended June 30, 2014. Further controls on foreign currency exchange or other actions by the Venezuelan government could have an impact on our local business, however, we do not consider our Venezuelan operations significant to our overall business. On a consolidated basis, we derived less than 1% of our net sales and approximately 1% of our operating income (before the remeasurement charge) from our business in Venezuela for the year ended June 30, 2014. Returns and Charges Associated with Restructuring Activities During the second quarter of fiscal 2013, we closed our multi-faceted cost savings program implemented in February 2009 (the "Program") and have executed substantially all remaining initiatives as of June 30, 2014. Total cumulative restructuring charges and other costs to implement those initiatives from inception of the Program to date are $317.5 million. Restructuring Charges (Adjustments) The following table presents aggregate restructuring charges (adjustments) related to the Program to date: Employee- Related Asset Contract Other Exit (In millions) Costs Write-offs Terminations Costs Total Fiscal 2009 $ 60.9 $ 4.2 $ 3.4 $ 1.8 $ 70.3 Fiscal 2010 29.3 11.0 2.3 6.2 48.8 Fiscal 2011 34.6 2.4 3.0 1.1 41.1 Fiscal 2012 37.1 1.7 12.6 2.2 53.6 Fiscal 2013 7.7 2.1 1.5 3.3 14.6 Fiscal 2014 (4.1 ) - 1.2 - (2.9 ) Charges (adjustments) recorded through June 30, 2014 $ 165.5 $ 21.4 $ 24.0 $ 14.6 $ 225.5 The following table presents accrued restructuring charges (adjustments) and the related activities under the Program to date: Employee- Related Asset Contract Other Exit (In millions) Costs Write-offs Terminations Costs Total Balance at June 30, 2012 $ 47.9 $ - $ 0.8 $ 0.5 $ 49.2 Charges 7.7 2.1 1.5 3.3 14.6 Cash payments (26.0 ) - (2.1 ) (3.1 ) (31.2 ) Non-cash write-offs - (2.1 ) - - (2.1 ) Translation adjustments 0.2 - - - 0.2 Other adjustments (2.3 ) - - - (2.3 ) Balance at June 30, 2013 27.5 - 0.2 0.7 28.4 Charges (adjustments) (4.1 ) - 1.2 - (2.9 ) Cash payments (16.6 ) - (0.8 ) (0.5 ) (17.9 ) Translation adjustments 0.3 - 0.1 (0.1 ) 0.3 Balance at June 30, 2014 $ 7.1 $ - $ 0.7 $ 0.1 $ 7.9 Accrued restructuring charges at June 30, 2014 are expected to result in cash expenditures funded from cash provided by operations of approximately $7 million and $1 million in fiscal 2015 and 2016, respectively. - 27 - -------------------------------------------------------------------------------- Table of Contents Total Returns and Other Charges (Adjustments) Associated with Restructuring Activities The following table presents total returns and charges (adjustments) associated with restructuring and other activities related to the Program: Year Ended June 30 (In millions) 2014 2013 2012 Sales returns (included in Net Sales) $ (0.1 ) $ 1.5 $ 2.1 Cost of sales 0.1 1.2 1.5 Restructuring charges (adjustments) (2.9 ) 14.6 53.6 Other charges - 0.5 6.0 Total charges (adjustments) associated with restructuring activities $ (2.9 ) $ 17.8 $ 63.2 Other charges in connection with the implementation of the Program were primarily related to consulting and other professional services. Fiscal 2014 as Compared with Fiscal 2013 NET SALES Net sales increased 8%, or $787.1 million, to $10,968.8 million, primarily reflecting growth in all of our product categories and geographic regions. The impact of foreign currency translation on the change in net sales was de minimis. 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. We believe those additional orders, which totaled approximately $178 million, would normally occur in our fiscal 2015 first quarter and created a favorable comparison to fiscal 2013. While these additional orders benefited our fiscal 2014 net sales comparison, we expect there to be a corresponding adverse effect on our first quarter and full year fiscal 2015 net sales. Adjusting for the impact of the accelerated orders, reported net sales would have increased 6%, with growth in all of our product categories and geographic regions. Product Categories The change in net sales in each product category benefited from the accelerated orders during the current year, as discussed above, as follows: skin care, approximately $91 million; makeup, approximately $65 million; fragrance, approximately $21 million; and hair care, approximately $1 million. Skin Care Net sales of skin care products increased 7%, or $304.5 million, to $4,769.8 million. The recent launches of Advanced Night Repair Synchronized Recovery Complex II and Micro Essence Skin Activating Treatment Lotion from Estée Lauder, and Dramatically Different Moisturizing Lotion + and reformulated Repairwear Laser Focus from Clinique contributed approximately $615 million of incremental sales, combined. Also contributing to the increase were higher sales of La Mer products and the Nutritious line of products from Estée Lauder of approximately $144 million, combined. Partially offsetting these increases were lower sales of certain existing Advanced Night Repair Synchronized Recovery products from Estée Lauder and Dramatically Different Moisturizing Lotion and Repairwear Laser Focus from Clinique of approximately $493 million, combined. Excluding the impact of foreign currency translation, skin care net sales increased 8%. Adjusting for the impact of the accelerated orders, reported net sales in skin care would have increased 5%. Makeup Makeup net sales increased 9%, or $333.3 million, to $4,210.2 million, primarily reflecting higher net sales from our makeup artist brands, the recent launch of All About Shadow from Clinique and higher sales of Smashbox products of approximately $339 million, combined. Sales from our makeup artist brands benefited from new product offerings, as well as expanded distribution in line with our retail store strategy. Partially offsetting these increases were lower sales of Chubby Stick Moisturizing Lip Colour Balm and High Impact Lip Color from Clinique, as well as the prior-year launches of Pore Refining Solutions Makeup from Clinique and Pure Color Vivid Shine Lipstick from Estée Lauder of approximately $34 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 7%. Fragrance Net sales of fragrance products increased 9%, or $114.2 million, to $1,425.0 million, primarily reflecting the recent launches of Estée Lauder Modern Muse, the Michael Kors Collection, Jo Malone Peony & Blush Suede and Tory Burch, as well as higher sales of Tom Ford Black Orchid of approximately $149 million, combined. These increases were partially offset by lower sales of Estée Lauder pleasures, Donna Karan Cashmere Mist, DKNY Be Delicious So Intense and Coach Poppy of approximately $31 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 7%. - 28 - -------------------------------------------------------------------------------- Table of Contents Hair Care Hair care net sales increased 5%, or $26.7 million, to $515.6 million, reflecting the continued success and growth of the Invati line of products and the new and reformulated Dry Remedy line of products from Aveda, which contributed approximately $25 million, combined to the increase. The category benefited from sales generated from expanded global distribution of Aveda products to salons and in the travel retail channel and Bumble and bumble products to specialty multi-brand retailers. Partially offsetting these increases were lower sales of Ojon products. The decrease in Ojon net sales was primarily due to the exit of that business from the direct response television channel in our fiscal 2014 second quarter. Excluding the impact of foreign currency translation, hair care net sales increased 6%. The impact of the accelerated orders on the change in reported net sales in hair care was de minimis. Geographic Regions The overall change in net sales in each geographic region benefited from the accelerated orders during the current year, as discussed above, 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 increased 6%, or $269.4 million, to $4,572.3 million, primarily reflecting higher net sales in the United States of approximately $231 million, including the $84 million in accelerated orders. This growth primarily reflected new collections from our makeup artist brands, higher sales of prestige products from our luxury brands, the continued expansion of Smashbox at specialty multi-brand retailers and department stores, contributions from new product innovations from certain of our heritage brands, new launches from certain of our designer fragrances and expansion into new retail channels by certain of our hair care brands. We are cautious of an uncertain retail environment in the United States in the short term. Net sales in Latin America increased approximately $24 million, led by Venezuela and Brazil. The net sales increase in Venezuela was primarily due to price increases as a result of rising inflation. Net sales in Canada increased approximately $15 million. Excluding the impact of foreign currency translation, the Americas net sales increased 7%. Adjusting for the impact of the accelerated orders, reported net sales in the Americas would have increased 4%. In Europe, the Middle East & Africa, net sales increased 11%, or $405.0 million, to $4,163.7 million, primarily reflecting higher sales from our travel retail business, the United Kingdom, Germany and France of approximately $335 million, combined. The net sales increase in our travel retail business primarily reflected the success of new launch initiatives, an increase in global airline passenger traffic and expanded distribution, as well as the impact of the accelerated orders. This was despite a slowdown at retail, in part, due to an adverse impact of Chinese government actions on the travel and spending of Chinese consumers. Higher sales in the United Kingdom and France were primarily driven by certain of our makeup artist and luxury brands. The net sales increase in Germany was primarily driven by our makeup artist and certain of our heritage brands. These increases were partially offset by lower net sales in South Africa and India of approximately $7 million, combined, driven by the weakening of their respective currencies. We are seeing continued softness in certain Southern European countries due to challenging economic environments. Excluding the impact of foreign currency translation, Europe, the Middle East & Africa net sales increased 9%. Adjusting for the impact of the accelerated orders, reported net sales in Europe, the Middle East & Africa would have increased 9%. Net sales in Asia/Pacific increased 5%, or $111.1 million, to $2,232.7 million, primarily reflecting higher sales in China and Hong Kong of approximately $119 million, combined. Higher sales in China were primarily driven by expanded distribution. Despite the higher sales in China, we are cautious of the lower growth rates we have been experiencing during the current year. The net sales increase in Hong Kong was primarily due to higher net sales from certain of our heritage and luxury brands. These increases were partially offset by lower net sales in Japan and Australia of approximately $17 million, combined. The declines in Japan and Australia were driven by the weakening of their respective currencies, which more than offset an improvement in their local retail environments and the impact of the accelerated orders in Japan. Excluding the impact of foreign currency translation, Asia/Pacific net sales increased 9%. Adjusting for the impact of the accelerated orders, reported net sales in Asia/Pacific would have increased 4%. 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 decreased to 19.7% as compared with 19.9% in the prior year. Cost of sales as a percentage of total net sales reflected strategic changes in pricing and the mix of our business of approximately 30 basis points and favorable manufacturing variances of approximately 10 basis points. Partially offsetting these changes were an increase in obsolescence charges and the unfavorable effect of exchange rates of approximately 10 basis points, each. 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. - 29 - -------------------------------------------------------------------------------- Table of Contents OPERATING EXPENSES Operating expenses as a percentage of net sales decreased to 63.6% as compared with 65.1% in the prior year. As a percentage of net sales, this decrease primarily reflected lower spending on advertising, merchandising and sampling of approximately 110 basis points, lower selling costs of approximately 50 basis points and a favorable comparison to the prior year, which reflected restructuring, goodwill and other impairment charges of approximately 40 basis points, combined. These improvements were partially offset by a charge in the current year to remeasure net monetary assets in Venezuela of approximately 30 basis points and unfavorable changes in foreign exchange transactions of approximately 10 basis points. Adjusting for the impact of the accelerated orders in the current year, operating expenses as a percentage of net sales would have decreased 50 basis points, primarily reflecting lower spending on advertising, merchandising and sampling, and lower selling costs. 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. OPERATING RESULTS Operating income increased 20%, or $301.6 million, to $1,827.6 million and operating margin increased to 16.7% of net sales as compared with 15.0% in the prior year, which primarily reflected our lower operating expense margin and, to a lesser extent, our higher gross margin. The overall operating results were also impacted by approximately $127 million related to the accelerated orders in the current year, as discussed above, which created a favorable comparison to the prior year, partially offset by the current year remeasurement of net monetary assets in Venezuela of $38.3 million. While these additional orders benefited our fiscal 2014 operating results comparison, we expect there to be a corresponding adverse effect on our first quarter and full year fiscal 2015 operating results. The following discussions of Operating Results by Product Categories and Geographic Regions exclude the impact of total charges (adjustments) associated with restructuring activities of $(2.9) million, or less than 1% of net sales, for fiscal 2014 and $17.8 million, or less than 1% of net sales, for fiscal 2013. We believe the following analysis of operating results better reflects the manner in which we conduct and view our business. Adjusting for the impact of the accelerated orders in the current year and charges (adjustments) associated with restructuring activities, operating income would have increased 10% and operating margin would have increased 50 basis points. Product Categories The overall change in operating results in each product category benefited from the accelerated orders during the current year, as discussed above, 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 increased 18%, or $145.7 million, to $975.8 million, primarily reflecting higher results driven by recent product launches from Estée Lauder and Clinique and higher sales of luxury skin care products. Makeup operating income increased 23%, or $135.5 million, to $715.9 million, primarily reflecting improved results from our makeup artist brands and certain of our heritage brands, attributable to growth in net sales. We reallocated our investment spending among brands and media formats which positively impacted operating income in the skin care and makeup product categories. Fragrance operating income decreased 13%, or $16.2 million, to $104.1 million, primarily reflecting higher investment spending behind recent major launches, partially offset by higher results from our luxury brands. The current year remeasurement of net monetary assets in Venezuela impacted the skin care, makeup and fragrance product categories by $12 million, $16 million and $10 million, respectively. Hair care operating results increased 26%, or $7.0 million, to $33.7 million, primarily reflecting higher results from Aveda and strategic reductions in spending behind Ojon products. Adjusting for the accelerated orders, operating income in the skin care, makeup, fragrance and hair care product categories would have increased (decreased) 9%, 16%, (25%) and 26%, respectively. Geographic Regions The overall change in operating results in each geographic region benefited as a result of the accelerated orders during the current year, as discussed above, 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 increased 27%, or $114.1 million, to $537.3 million, primarily reflecting the increase in net sales, as previously discussed, as well as a more measured approach to spending. These improvements were partially offset by the current year remeasurement of net monetary assets in Venezuela. Adjusting for the impact of the accelerated orders, operating income in the Americas would have increased 14%. - 30 - -------------------------------------------------------------------------------- Table of Contents In Europe, the Middle East & Africa, operating income increased 15%, or $124.9 million, to $938.3 million. Higher results from our travel retail business and in the United Kingdom totaled approximately $126 million, combined, primarily reflecting higher sales. The higher results in our travel retail business also reflected the impact of the accelerated orders. These improvements were partially offset by lower operating results in France and the Middle East of approximately $10 million, combined. The lower results in France were due to higher spending on advertising, merchandising and sampling. Adjusting for the impact of the accelerated orders, operating income in Europe, the Middle East & Africa would have increased 9%. In Asia/Pacific, operating income increased 14%, or $41.9 million, to $349.1 million. Higher results in Korea, Japan and Hong Kong totaled approximately $45 million, combined. The higher results in Korea were due to lower spending on advertising, merchandising and sampling and the higher results in Japan primarily reflected the impact of the accelerated orders. The higher results in the region were partially offset by lower operating results of approximately $11 million in China and Thailand, combined. The lower results from China were primarily driven by an increase in investment spending as a result of new product introductions and increased distribution. Adjusting for the impact of the accelerated orders, operating income in Asia/Pacific would have increased 7%. INTEREST EXPENSE, NET Net interest expense decreased to $50.8 million as compared with $54.8 million in the prior year, primarily due to the refinancing of debt at lower rates in fiscal 2013 and higher interest income. INTEREST EXPENSE ON DEBT EXTINGUISHMENT During the first quarter of fiscal 2013, we redeemed the $230.1 million principal amount of our 7.75% Senior Notes due 2013 at a price of 108% of the principal amount. We recorded a pre-tax expense on the extinguishment of debt of $19.1 million representing the call premium of $18.6 million and the pro-rata write-off of $0.5 million of issuance costs and debt discount. OTHER INCOME We recognized $23.1 million as other income during fiscal 2013, primarily reflecting the amended agreement related to the August 2007 sale of Rodan + Fields (a brand then owned by us). 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 year to year 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 period of change. The effective rate for income taxes was 32.0% and 30.6% for fiscal 2014 and 2013, respectively. The increase in the rate of 140 basis points was principally attributable to a higher effective tax rate related to the Company's foreign operations, which included the impact of the Venezuela remeasurement charge for which no tax benefit has been provided, as well as slightly higher favorable income tax reserve adjustments recorded in the prior year. NET EARNINGS ATTRIBUTABLE TO THE ESTÉE LAUDER COMPANIES INC. Net earnings attributable to The Estée Lauder Companies Inc. as compared with the prior year increased 18%, or $184.3 million, to $1,204.1 million and diluted net earnings per common share increased 19% from $2.58 to $3.06. - 31 - -------------------------------------------------------------------------------- Table of Contents NON-GAAP FINANCIAL MEASURES We use certain non-GAAP financial measures, among other financial measures, to evaluate our operating performance, which represent the manner in which we conduct and view our business. Management believes that excluding these items that are not comparable from period to period helps investors and others compare operating performance between two periods. While we consider the non-GAAP measures useful in analyzing our results, they are not intended to replace, or act as a substitute for, any presentation included in the consolidated financial statements prepared in conformity with U.S. GAAP. The following tables present Net Sales, Operating Income and Diluted net earnings per common share adjusted to exclude the impact of accelerated orders associated with the July 2014 SMI rollout, the Venezuela fiscal 2014 remeasurement charge, returns and charges (adjustments) associated with restructuring activities and the fiscal 2013 interest expense on debt extinguishment. The tables provide reconciliations between these non-GAAP financial measures and the most directly comparable U.S. GAAP measures. % Change Year Ended June 30 % in Constant ($ in millions) 2014 2013 Variance Change Currency Net Sales, as reported $ 10,968.8 $ 10,181.7 $ 787.1 8 % 8 % Accelerated orders associated with SMI rollout (178.3 ) - (178.3 ) Returns (adjustments) associated with restructuring activities (0.1 ) 1.5 (1.6 ) Net Sales, as adjusted $ 10,790.4 $ 10,183.2 $ 607.2 6 % 7 % Year Ended June 30 % ($ in millions) 2014 2013 Variance Change Operating Income, as reported $ 1,827.6 $ 1,526.0 $ 301.6 20 % Accelerated orders associated with SMI rollout (127.2 ) - (127.2 ) Venezuela fiscal 2014 remeasurement charge 38.3 - 38.3 Total charges (adjustments) associated with restructuring activities (2.9 ) 17.8 (20.7 ) Operating Income, as adjusted $ 1,735.8 $ 1,543.8 $ 192.0 12 % Year Ended June 30 % 2014 2013 Variance Change Diluted net earnings per common share, as reported $ 3.06 $ 2.58 $ .48 19 % Accelerated orders associated with SMI rollout (.21 ) - (.21 ) Venezuela fiscal 2014 remeasurement charge .10 - .10 Total charges (adjustments) associated with restructuring activities (.00 ) .03 (.03 ) Interest expense on debt extinguishment - .03 (.03 ) Diluted net earnings per common share, as adjusted $ 2.95 $ 2.64 $ .31 12 % - 32 - -------------------------------------------------------------------------------- Table of Contents Fiscal 2013 as Compared with Fiscal 2012 NET SALES Net sales increased 5%, or $468.1 million, to $10,181.7 million, reflecting growth in all of our major product categories within each geographic region. Excluding the impact of foreign currency translation, net sales increased 6%. The following discussions of Net Sales by Product Categories and Geographic Regions exclude the impact of returns associated with restructuring activities of $1.5 million and $2.1 million recorded during fiscal 2013 and fiscal 2012, respectively. We believe the following analysis of net sales better reflects the manner in which we conduct and view our business. Product Categories Skin Care Net sales of skin care products increased 6%, or $240.1 million, to $4,465.3 million. The fiscal 2013 launches of Perfectionist CP+R, Advanced Time Zone, Advanced Night Repair Eye Serum Infusion and the Optimizer line of products from Estée Lauder contributed approximately $273 million, combined, to the increase. Also contributing approximately $99 million, combined, to the increase were the fiscal 2013 launches of The Moisturizing Soft Cream from La Mer and Even Better Eyes Dark Circle Corrector from Clinique. Partially offsetting these increases were lower sales of Perfectionist CP+ Serum and Time Zone, as well as Idealist Even Skintone Illuminator, which was a new launch in fiscal 2012, from Estée Lauder of approximately $162 million, combined. Excluding the impact of foreign currency translation, skin care net sales increased 7%. Makeup Makeup net sales increased 5%, or $180.1 million, to $3,876.9 million, primarily reflecting an increase in net sales from our makeup artist brands of approximately $156 million, combined. The fiscal 2013 launches of High Impact Extreme Volume Mascara and Chubby Stick Intense from Clinique and Pure Color Vivid Shine Lipstick from Estée Lauder contributed approximately $47 million of incremental sales, combined to the increase. Partially offsetting these increases were lower sales of Repairwear Laser Focus Makeup from Clinique and Pure Color Eyeshadow and Doublewear Stay-In-Place Makeup from Estée Lauder, all of which were new launches in fiscal 2012, of approximately $45 million, combined. Excluding the impact of foreign currency translation, makeup net sales increased 6%. Fragrance Net sales of fragrance products increased 3%, or $39.8 million, to $1,310.8 million. Incremental sales from the fiscal 2013 launches of Zegna Uomo, DKNY Be Delicious So Intense, Tommy Hilfiger Freedom Men and Coach Love contributed approximately $30 million, combined, to the increase. Higher sales of Jo Malone and Tom Ford fragrances contributed approximately $60 million, combined, to the increase. These increases were partially offset by lower sales of Estée Lauder Sensuous Nude and DKNY Golden Delicious, both of which were new launches in fiscal 2012, as well as pureDKNY, of approximately $52 million, combined. Excluding the impact of foreign currency translation, fragrance net sales increased 4%. Hair Care Hair care net sales increased 6%, or $26.5 million, to $488.9 million, primarily reflecting the continued success of the Invati line of products and the fiscal 2013 launches of Pure Abundance Style Prep and Be Curly Curl Controller from Aveda. The category also benefited from sales generated from expanded global distribution, in particular, to salons for Aveda and multi-brand specialty retailers for Bumble and bumble. Partially offsetting these increases were lower sales of Bumble and bumble brand products to salons and lower net sales of Ojon brand products due, in part, to a reduction in our business in the DRTV channel. The impact of foreign currency translation on hair care net sales was de minimis. Geographic Regions Net sales in the Americas increased 5%, or $201.8 million, to $4,302.9 million. The increase during fiscal 2013 was primarily attributable to growth in the United States of approximately $172 million, due in large part to product offerings from our heritage and makeup artist brands. Net sales in Canada increased approximately $13 million, primarily reflecting increased sales from certain of our heritage brands as a result of expanded distribution. These increases also reflected the efforts of our expanded pull/push activities, which included innovative advertising that continued to draw new consumers to our brands and our ongoing efforts to work with retailers in the United States and Canada on strengthening the "High-Touch" concepts used to help market our products. Net sales in Latin America increased approximately $19 million, led by Venezuela and Mexico. The impact of foreign currency translation on net sales in the Americas was de minimis. - 33 - -------------------------------------------------------------------------------- Table of Contents In Europe, the Middle East & Africa, net sales increased 4%, or $155.5 million, to $3,758.7 million, primarily reflecting higher sales from our travel retail business and in the United Kingdom and the Middle East of approximately $185 million, combined. The net sales increase in our travel retail business primarily reflected a strong retail environment for our products, new product launches and, to a lesser extent, an increase in global airline passenger traffic. Higher sales in the United Kingdom were primarily driven by our makeup artist brands and new product launches from certain of our heritage brands. In addition, the United Kingdom benefited from increased sales of certain of our luxury fragrance and skin care products. Higher sales in the Middle East were primarily driven by our makeup artist brands and sales of luxury fragrances. These increases in the region were partially offset by lower net sales in Spain, Russia, Switzerland and the Balkans of approximately $45 million, combined. With the exception of Russia, these lower net sales reflected the challenging economic environments in certain countries in Europe. The lower net sales in Russia primarily reflected destocking associated with challenges with a certain customer. The overall change in Europe, the Middle East & Africa net sales was inclusive of unfavorable exchange rates due to the strengthening of the U.S. dollar against most currencies in this region of approximately $75 million. Excluding the impact of foreign currency translation, net sales in Europe, the Middle East & Africa increased 6%. Net sales in Asia/Pacific increased 5%, or $110.2 million, to $2,121.6 million, primarily reflecting growth in our sales of skin care products, in line with our strategy. We increased sales by approximately $160 million in China and Hong Kong. Net sales in China benefited from expanded distribution. Higher sales in Hong Kong were primarily driven by launches from our heritage brands and higher-end prestige skin care products. These increases were partially offset by lower net sales in Korea and Japan of approximately $66 million, combined. The lower net sales in Korea primarily reflected a challenging economic environment and continued competitive pressures facing prestige beauty in Korea. The decline in Japan was driven by the weakening of the Japanese yen. Excluding the impact of foreign currency translation, net sales in Asia/Pacific increased 6%. 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 decreased to 19.9% as compared with 20.5% in fiscal 2012. This improvement reflected changes in the mix of our business and pricing of approximately 40 basis points, favorable manufacturing variances of approximately 20 basis points and the favorable effect of exchange rates of approximately 10 basis points. These improvements were partially offset by a provision for foreign transactional taxes of approximately 10 basis points. OPERATING EXPENSES Operating expenses as a percentage of net sales decreased to 65.1% as compared with 66.0% in fiscal 2012. This improvement reflected a decrease in general and administrative costs as a percentage of net sales of approximately 50 basis points, a decrease in charges associated with restructuring activities of approximately 40 basis points and lower selling and shipping costs as a percentage of net sales of 10 basis points. Also included in this improvement was a favorable change in foreign exchange transactions of approximately 10 basis points and lower charges associated with other intangible asset impairments of approximately 10 basis points. Partially offsetting these improvements were higher costs related to stock-based compensation of approximately 20 basis points and increased spending on advertising, merchandising and sampling in line with our strategy of approximately 10 basis points. 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 being emphasized. OPERATING RESULTS Operating income increased 16%, or $214.3 million, to $1,526.0 million. Operating margin increased to 15.0% of net sales as compared with 13.5% in fiscal 2012, reflecting our higher gross margin and the decrease in our operating expense margin, as previously discussed. The following discussions of Operating Results by Product Categories and Geographic Regions exclude the impact of total returns and charges associated with restructuring activities of $17.8 million, or 0.2% of net sales, in fiscal 2013 and $63.2 million, or 0.7% of net sales, in fiscal 2012. We believe the following analysis of operating results better reflects the manner in which we conduct and view our business. Product Categories Skin care operating income increased 11%, or $83.4 million, to $830.1 million, primarily reflecting improved results from higher-margin product launches from Estée Lauder and La Mer, partially offset by goodwill and other intangible asset impairment charges of $17.7 million. Makeup operating income increased 8%, or $42.4 million, to $580.4 million, primarily reflecting improved results from our M†A†C brand, partially offset by certain of our heritage brands and an increase in investment spending in line with our strategy. Fragrance operating income increased 20%, or $20.2 million, to $120.3 million, primarily reflecting increased profitability from certain Jo Malone, Estée Lauder and Clinique products, partially offset by lower results from certain of our designer fragrances. Hair care operating results increased over 100%, or $14.5 million, to $26.7 million, due to a favorable comparison to fiscal 2012 which was impacted by other intangible asset impairment charges of $21.7 million, partially offset by lower sales of Bumble and bumble brand products and higher investment spending by Aveda to support the Invati line of products. - 34 - -------------------------------------------------------------------------------- Table of Contents Geographic Regions Operating income in the Americas increased 47%, or $134.8 million, to $423.2 million, primarily reflecting improved results from our makeup artist and luxury brands and certain of our hair care and heritage brands, driven by improved category mix, partially offset by the timing and level of strategic investment spending in fiscal 2013. In Europe, the Middle East & Africa, operating income increased 9%, or $67.1 million, to $813.4 million. Higher results from our travel retail business, the Middle East and the United Kingdom totaled approximately $77 million, combined. Partially offsetting these improvements were lower results in Germany and Spain of approximately $5 million, combined, as well as goodwill and other intangible asset impairment charges of $17.7 million. In Asia/Pacific, operating income decreased 10%, or $33.0 million, to $307.2 million. Higher results from China and Thailand totaled approximately $22 million, combined. These higher results were more than offset by lower operating results of approximately $51 million in Korea, Hong Kong and Japan, combined. The lower results in Hong Kong were due in part to investment spending to support new product launches. INTEREST EXPENSE, NET Net interest expense was $54.8 million as compared with $61.1 million in fiscal 2012. Interest expense decreased primarily due to the refinancing of debt at lower rates. INTEREST EXPENSE ON DEBT EXTINGUISHMENT During the first quarter of fiscal 2013, we redeemed the $230.1 million principal amount of our 7.75% Senior Notes due 2013 at a price of 108% of the principal amount. We recorded a pre-tax expense on the extinguishment of debt of $19.1 million representing the call premium of $18.6 million and the pro-rata write-off of $0.5 million of issuance costs and debt discount. OTHER INCOME In December 2012, we amended the agreement related to the August 2007 sale of Rodan + Fields (a brand then owned by us) to receive a fixed amount in lieu of future contingent consideration and other rights. Accordingly, we recognized $22.4 million, net of discount of $0.4 million, which has been classified as other income in our consolidated statements of earnings. Prior to this amendment, we earned and received $0.7 million of contingent consideration. In November 2011, we settled a commercial dispute with third parties that was outside our normal operations. In connection therewith, we received a $10.5 million cash payment, which has been classified as other income in our consolidated statement of earnings. 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 year to year 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. The effective income tax rate for fiscal 2013 was 30.6% as compared with 31.8% in fiscal 2012. The decrease in the effective income tax rate of 120 basis points was principally due to a decrease in the effective tax rate of our foreign operations as compared with fiscal 2012, as well as the retroactive reinstatement of the U.S. federal research and development tax credit signed into law on January 2, 2013. NET EARNINGS ATTRIBUTABLE TO THE ESTÉE LAUDER COMPANIES INC. Net earnings attributable to The Estée Lauder Companies Inc. as compared with fiscal 2012 increased 19%, or $162.9 million, to $1,019.8 million and diluted net earnings per common share increased 20% from $2.16 to $2.58. The results in fiscal 2013 include the impact of total returns and charges associated with restructuring activities of $11.7 million, after tax, or $.03 per diluted common share. The results in fiscal 2012 include the impact of total returns and charges associated with restructuring activities of $44.1 million, after tax, or $.11 per diluted common share. - 35 - -------------------------------------------------------------------------------- Table of Contents 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 June 30, 2014, we had cash and cash equivalents of $1,629.1 million compared with $1,495.7 million at June 30, 2013. 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, potential acquisitions and investments, commitments and other contractual obligations on both a near-term and long-term basis. Our cash and cash equivalents balance at June 30, 2014 includes approximately $1,140 million of cash in offshore jurisdictions associated with our permanent reinvestment strategy We do not believe that the indefinite reinvestment of these funds offshore impairs our ability to meet our domestic debt or working capital obligations. If these indefinitely reinvested earnings were repatriated into the United States as dividends, we would be subject to additional taxes. The effects of inflation have not been significant to our overall operating results in recent years. Generally, we have been able to introduce new products at higher prices, increase prices and implement other operating efficiencies to sufficiently offset cost increases, which have been moderate. Credit Ratings Changes in our credit ratings will likely result in changes in our borrowing costs. Our credit ratings also impact the cost of our revolving credit facility as discussed below. Downgrades in our credit ratings may reduce our ability to issue commercial paper and/or long-term debt and would likely increase the relative costs of borrowing. A credit rating is not a recommendation to buy, sell, or hold securities, is subject to revision or withdrawal at any time by the assigning rating organization, and should be evaluated independently of any other rating. As of August 14, 2014, our commercial paper is rated A-1 by Standard & Poor's and P-1 by Moody's and our long-term debt is rated A+ with a stable outlook by Standard & Poor's and A2 with a stable outlook by Moody's. Debt At June 30, 2014, our outstanding borrowings were as follows: Long-term Current ($ 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) 321.1 - 321.1 Other borrowings 10.4 18.4 28.8 $ 1,324.7 $ 18.4 $ 1,343.1 -------------------------------------------------------------------------------- (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 $0.2 million and a $21.3 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. We have a $1.0 billion commercial paper program under which we may issue commercial paper in the United States. As of June 30, 2014, we had no commercial paper outstanding. - 36 - -------------------------------------------------------------------------------- Table of Contents In July 2014, we replaced our undrawn $1.0 billion unsecured revolving credit facility that was set to expire on July 14, 2015 (the "Prior Facility"), with a new $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 "New Facility"). At June 30, 2014, no borrowings were outstanding under the Prior Facility. The New Facility may be used for general corporate purposes. Up to the equivalent of $350 million of the New Facility is available for multi-currency loans. The interest rate on borrowings under the New 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 New Facility, which costs will be amortized over the term of the facility. The New Facility has an annual fee of $0.6 million, payable quarterly, based on our current credit ratings. The New 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 this 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 June 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) decreased to 26% at June 30, 2014 from 29% at June 30, 2013. Cash Flows Net cash provided by operating activities was $1,535.2 million, $1,226.3 million and $1,126.7 million in fiscal 2014, 2013 and 2012, respectively. The increase in cash flows provided by operating activities as compared with fiscal 2013 was primarily driven by an increase in net earnings, an increase in accrued income taxes as a result of the level and timing of tax payments and an increase in accounts payable, primarily due to the timing of payments. These changes were partially offset by an increase in accounts receivable, which primarily reflected accelerated orders in connection with our July 2014 SMI implementation. Cash flows provided by operating activities increased in fiscal 2013 as compared with fiscal 2012 primarily driven by an increase in net earnings, a decrease in pension and post-retirement benefit contributions and a favorable change in accounts receivable due to the timing of shipments and collections. These improvements were partially offset by an increase in the levels of inventory, primarily to maintain acceptable service levels in line with forecasted sales activity, as well as for the remaining safety stock from the fiscal 2013 SMI implementation. Also offsetting these improvements were a change in accounts payable, primarily due to the timing of payments, and a decrease in accrued income taxes, resulting from the timing and level of tax payments. Net cash used for investing activities was $511.6 million, $465.5 million and $428.3 million in fiscal 2014, 2013 and 2012, respectively. The increase in cash flows used for investing activities as compared with fiscal 2013 primarily reflected higher capital expenditure activity in the current year related to leasehold improvements and counters. The increase in cash flows used for investing activities during fiscal 2013 as compared with fiscal 2012 primarily reflected higher capital expenditure activity in fiscal 2013 related to counters and leasehold improvements. Net cash used for financing activities was $856.9 million, $611.5 million and $585.1 million in fiscal 2014, 2013 and 2012, respectively. The increase in cash used for financing activities as compared with fiscal 2013 primarily reflected an increase in treasury stock purchases which were partially offset by lower dividend payments that resulted from the transition to quarterly dividends in the third quarter of fiscal 2013 and the final annual dividend payment made that year. In addition, the prior year reflected the proceeds from the issuance of the 2022 Senior Notes and 2042 Senior Notes, which was partially offset by the redemption of the 2013 Senior Notes and repayment of commercial paper. The increase in cash used for financing activities in fiscal 2013 as compared with fiscal 2012 primarily reflected the repayment of outstanding commercial paper during fiscal 2013, higher dividends paid as a result of the increase in the annual dividend rate and transition to a quarterly dividend payout schedule, and higher redemptions of long-term debt during fiscal 2013, partially offset by the proceeds from the issuance of the 2022 Senior Notes and 2042 Senior Notes in August 2012 and lower treasury stock repurchases. - 37 - -------------------------------------------------------------------------------- Table of Contents Dividends The following is a summary of cash dividends declared per share on our Class A and Class B Common Stock during the year ended June 30, 2014: Date Declared Record Date Payable Date Amount per Share August 14, 2013 August 30, 2013 September 16, 2013 $.18 October 30, 2013 November 29, 2013 December 16, 2013 $.20 February 4, 2014 February 28, 2014 March 17, 2014 $.20 May 1, 2014 May 30, 2014 June 16, 2014 $.20 On August 14, 2014, a dividend was declared in the amount of $.20 per share on our Class A and Class B Common Stock. The dividend is payable in cash on September 15, 2014 to stockholders of record at the close of business on August 29, 2014. Pension and Post-retirement Plan Funding Several factors influence the annual funding requirements for our pension plans. For the U.S. Qualified Plan, our funding policy consists of annual contributions at a rate that provides for future plan benefits and maintains appropriate funded percentages. Such contribution is not less than the minimum required by the Employee Retirement Income Security Act of 1974, as amended, ("ERISA") and subsequent pension legislation, and is not more than the maximum amount deductible for income tax purposes. For each international plan, our funding policies are determined by local laws and regulations. In addition, amounts necessary to fund future obligations under these plans could vary depending on estimated assumptions as detailed in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates." The effect of our pension plan funding on future operating results will depend on economic conditions, employee demographics, mortality rates, the number of participants electing to take lump-sum distributions, investment performance and funding decisions. For the U.S. Qualified Plan, we maintain an investment strategy of matching the duration of a substantial portion of the plan assets with the duration of the underlying plan liabilities. This strategy assists us in maintaining our overall funded ratio. For fiscal 2014 and 2013, we met or exceeded all contribution requirements under ERISA regulations for the U.S. Qualified Plan. As we continue to monitor the performance of our plan assets, we may decide to make discretionary cash contributions to the U.S. Qualified Plan or our post-retirement plan in the United States during fiscal 2015, but do not have plans to do so at this time. For fiscal 2014 and 2013, we made benefit payments under our non-qualified domestic noncontributory pension plan of $7.2 million and $6.1 million, respectively. We expect to make benefit payments under this plan during fiscal 2015 of approximately $14.4 million. For fiscal 2014 and 2013, we made cash contributions to our international defined benefit pension plans of $27.9 million and $25.9 million, respectively. We expect to make contributions under these plans during fiscal 2015 of approximately $24.0 million. Commitments and Contingencies Certain of our business acquisition agreements include "earn-out" provisions. These provisions generally require that we pay to the seller or sellers of the business additional amounts based on the performance of the acquired business. Since the size of each payment depends upon performance of the acquired business, we do not expect that such payments will have a material adverse impact on our future results of operations or financial condition. For additional contingencies refer to "Item 3. Legal Proceedings." - 38 - -------------------------------------------------------------------------------- Table of Contents Contractual Obligations The following table summarizes scheduled maturities of our contractual obligations for which cash flows are fixed and determinable as of June 30, 2014: Payments Due in Fiscal (In millions) Total 2015 2016 2017 2018 2019 Thereafter Debt service (1) $ 2,330.6 $ 79.7 $ 68.0 $ 364.8 $ 44.7 $ 44.6 $ 1,728.8 Operating lease commitments (2) 2,010.6 291.7 274.0 240.5 215.9 190.6 797.9 Unconditional purchase obligations (3) 2,280.1 1,091.6 437.3 430.5 243.7 37.8 39.2 Gross unrecognized tax benefits and interest - current (4) 1.1 1.1 - - - - - Total contractual obligations $ 6,622.4 $ 1,464.1 $ 779.3 $ 1,035.8 $504.3 $ 273.0 $ 2,565.9 -------------------------------------------------------------------------------- (1) Includes long-term and current debt and the related projected interest costs, and to a lesser extent, capital lease commitments. Interest costs on long-term and current debt are projected to be $61.3 million in each of the years from fiscal 2015 through fiscal 2017, $44.6 million in fiscal 2018 and fiscal 2019 and $728.7 million thereafter. Projected interest costs on variable rate instruments were calculated using market rates at June 30, 2014. Refer to "Item 8. Financial Statements and Supplementary Data - Note 9 - Debt." (2) Minimum operating lease commitments only include base rent. Certain leases provide for contingent rents that are not measurable at inception and primarily include rents based on a percentage of sales in excess of stipulated levels, as well as common area maintenance. These amounts are excluded from minimum operating lease commitments and are included in the determination of total rent expense when it is probable that the expense has been incurred and the amount is reasonably measurable. (3) Unconditional purchase obligations primarily include inventory commitments, estimated future earn-out payments, estimated royalty payments pursuant to license agreements, advertising commitments, capital improvement commitments, planned funding of pension and other post-retirement benefit obligations, commitments pursuant to executive compensation arrangements, obligations related to our cost savings initiatives and acquisitions. Future earn-out payments and future royalty and advertising commitments were estimated based on planned future sales for the term that was in effect at June 30, 2014, without consideration for potential renewal periods. (4) Refer to "Item 8. Financial Statements and Supplementary Data - Note 7 - Income Taxes" for information regarding unrecognized tax benefits. As of June 30, 2014, the noncurrent portion of our unrecognized tax benefits, including related accrued interest and penalties was $69.5 million. At this time, the settlement period for the noncurrent portion of the unrecognized tax benefits, including related accrued interest and penalties, cannot be determined and therefore was not included. Derivative Financial Instruments and Hedging Activities We address certain financial exposures through a controlled program of risk management that includes the use of derivative financial instruments. We enter into foreign currency forward contracts and may enter into option contracts to reduce the effects of fluctuating foreign currency exchange rates and interest rate derivatives to manage the effects of interest rate movements on our aggregate liability portfolio. We also enter into foreign currency forward contracts and may use option contracts, not designated as hedging instruments, to mitigate the change in fair value of specific assets and liabilities on the balance sheet. We do not utilize derivative financial instruments for trading or speculative purposes. Costs associated with entering into these derivative financial instruments have not been material to our consolidated financial results. For each derivative contract entered into where we look to obtain hedge accounting treatment, we formally document all relationships between hedging instruments and hedged items, as well as our risk-management objective and strategy for undertaking the hedge transaction, the nature of the risk being hedged, how the hedging instruments' effectiveness in offsetting the hedged risk will be assessed prospectively and retrospectively, and a description of the method of measuring ineffectiveness. This process includes linking all derivatives to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions. We also formally assess, both at the hedge's inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. If it is determined that a derivative is not highly effective, or that it has ceased to be a highly effective hedge, we will be required to discontinue hedge accounting with respect to that derivative prospectively. - 39 - -------------------------------------------------------------------------------- Table of Contents 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 June 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 June 30, 2014, these foreign currency cash-flow hedges were highly effective in all material respects. At June 30, 2014, we had foreign currency forward contracts in the amount of $1,597.3 million. The foreign currencies included in foreign currency forward contracts (notional value stated in U.S. dollars) are principally the British pound ($267.2 million), Euro ($239.8 million), Swiss franc ($170.4 million), Canadian dollar ($138.6 million), Australian dollar ($111.3 million), Japanese yen ($108.0 million) and Hong Kong dollar ($103.0 million). Credit Risk As a matter of policy, we only enter into derivative contracts 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 $4.2 million at June 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 June 30, 2014, we were in a net liability position for certain derivative contracts that contain such features. Such credit-risk-related contingent features would be triggered if (a) upon a merger involving the Company, the ratings of the surviving entity were materially weaker than prior to the merger or (b) the Company's credit ratings fall below investment grade (rated below BBB-/Baa3) and the Company fails to enter into an International Swaps & Derivatives Association Credit Support Annex within 30 days of being requested by the counterparty. The fair value of collateral required to settle the instruments immediately if a triggering event were to occur is estimated at approximately the fair value of the contracts. The fair value of those contracts as of June 30, 2014 was $4.5 million. As of June 30, 2014, we were in compliance with such credit-risk-related contingent features. Market Risk We use a value-at-risk model to assess the market risk of our derivative financial instruments. Value-at-risk represents the potential losses for an instrument or portfolio from adverse changes in market factors for a specified time period and confidence level. We estimate value-at-risk across all of our derivative financial instruments using a model with historical volatilities and correlations calculated over the past 250-day period. The high, low and average measured value-at-risk during fiscal 2014 related to our foreign exchange contracts is as follows: Year Ended June 30, 2014 (In millions) High Low Average Foreign exchange contracts $ 27.4 $ 7.4 $ 18.9 The model estimates were made assuming normal market conditions and a 95 percent confidence level. We used a statistical simulation model that valued our derivative financial instruments against one thousand randomly generated market price paths. Our calculated value-at-risk exposure represents an estimate of reasonably possible net losses that would be recognized on our portfolio of derivative financial instruments assuming hypothetical movements in future market rates and is not necessarily indicative of actual results, which may or may not occur. It does not represent the maximum possible loss or any expected loss that may occur, since actual future gains and losses will differ from those estimated, based upon actual fluctuations in market rates, operating exposures, and the timing thereof, and changes in our portfolio of derivative financial instruments during the year. We believe, however, that any such 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. - 40 - -------------------------------------------------------------------------------- Table of Contents 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. RECENTLY ISSUED ACCOUNTING STANDARDS Refer to "Item 8. Financial Statements and Supplementary Data - Note 2 - Summary of Significant Accounting Policies" for discussion regarding the impact of accounting standards that were recently issued but not yet effective, on our consolidated financial statements. 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; (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; - 41 - -------------------------------------------------------------------------------- Table of Contents (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 this 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. Item 7A. Quantitative and Qualitative Disclosures About Market Risk. The information required by this item is set forth in Item 7 of this Annual Report on Form 10-K under the caption "Liquidity and Capital Resources - Market Risk" and is incorporated herein by reference. |