L’Oréal: Uncovering The Beauty Of Long-Term Investment Potential (OTCMKTS:LRLCF)

Introduction

L’Oréal (OTCPK:LRLCF, OTCPK:LRLCY)is one of the greatest European corporate success stories, having generated a return of 48,000% since 1987. L’Oréal was founded in 1909 by Eugène Schueller, a French chemist who created the first synthetic hair dye. In its early years, the company focused on the production and sale of hair dyes and quickly managed to expand throughout Europe. During World War II, Schueller kept the business running. In the years following the war, L’Oréal expanded its product portfolio and began to develop new beauty products, including creams and lotions.

In the 1960s and 70s, L’Oréal expanded beyond Europe and established a presence in the United States and Asia. Since then, L’Oréal has continued to expand and acquire new brands and companies worldwide. Today, it is the largest company in the cosmetics sector and in my opinion, despite having had such impressive returns over the last few decades and the valuation at first glance may seem very high, I believe it can continue to offer good long-term performance.

The Cosmetic Sector: The Importance of Emotions

L’Oréal is by a significant margin, the largest company in the world’s cosmetic sector. The management emphasizes that they are solely focused on being the best within this sector, which gives them a focus advantage over most competitors in the industry who, except for Estée Lauder, are also engaged in other businesses such as health, consumer goods, or luxury. This extreme specialization in the cosmetic sector has granted them several competitive advantages that we will explore throughout this article.

From my point of view, the cosmetic sector is one of the most interesting for investment within defensive consumer goods because it presents characteristics not found in other types of products. The need to look and feel good is inherent to being human; in fact, the earliest evidence of cosmetic use by humanity dates back to prehistory when women used a red pigment mixed with water for ‘makeup’ and in rituals and hunts, men also painted their bodies with religious shapes and motifs. This innate human need is reflected in the way we consume and use cosmetic products.

Of course, caring for our image is not only about how others perceive us, but also about our self-esteem. Using beauty products that improve our appearance can have a positive impact on our self-esteem, which in turn makes us feel more confident and comfortable in our own skin. In this sense, it is not difficult to see how the beauty product market benefits from the same dynamics as social media. Both are based on the need for approval and recognition from others, and both can have a positive impact on our self-perception. It is natural for humans to seek ways to feel better about ourselves, and beauty and cosmetic products provide an effective tool for achieving this. At the end of the day, there is nothing wrong with wanting to look and feel better.

The emotions that cosmetic products generate are difficult for other basic consumer goods to match. This gives a great power to cosmetic brands like L’Oréal, as customers will be more willing to accept price increases. For example, from my point of view, someone who suffers from acne and finds a cream that alleviates it will be more willing to accept a 10% price increase on that cream than a similar increase on a food brand because the emotions stirred by both products are not as potent in both cases.

Revenue Breakdown

In the cosmetic industry, L’Oréal stands out as the only player present in every subsegment, not only participating but also leading in each. L’Oréal reports its sales across the following four segments:

Professional Products

This segment focuses on the distribution of beauty products through professional beauty salons, spas, beauty schools, and other professional channels. The products include hair dyes, hair treatments, styling and finishing products, among others. Prominent brands under this segment include Kérastase, Redken, L’Oréal Professional, and Matrix. Continuous training is also provided to hair professionals to ensure optimal use and application of their products. This segment is the most sensitive to market cycles as these are non-essential services that are often cut back during times of crisis. However, I believe it is a good recurring source of income since these types of establishments tend to place periodic orders for products, giving L’Oréal a certain stability in its sales.

Mass Consumer Products

This segment is the largest in terms of revenue and sales volume, targeting the mass market. It includes a wide range of makeup, skin care, and hair care products primarily sold in supermarkets, pharmacies, and retail stores, as well as online. Brands like L’Oréal Paris, NYX, Garnier, and Maybelline New York are staples of this segment. It is a highly competitive part of the market, but L’Oréal has several brands positioned as leaders and enjoys the highest margins in the sector. It is expected that this part of the market will grow at the same rate as the cosmetics sector, that is, slightly above the economy but without stellar growth, as it is a mature sector with less possibility for price increases. This segment is undoubtedly the most anti-cyclical and, with operating margins of 20% as we will see later, is extremely profitable.

L’Oréal Luxe

L’Oréal Luxe operates in the luxury segment of the market, offering high-end skincare, fragrances, and makeup products. These products are primarily sold in specialized stores, department stores, and luxury boutiques, as well as in dedicated spaces in airports. Brands such as Lancôme, Giorgio Armani Beauty, Yves Saint Laurent Beauté, and Kiehl’s are part of this segment. In my opinion, these types of products have greater potential because they possess superior brand power, making them highly desired items with significant pricing power.

What seems very important to highlight are the agreements L’Oréal has signed in this segment with various luxury brands. In these agreements, L’Oreal is responsible for the development, production, and distribution of the beauty and cosmetic products of the brands, while the other party retains ownership and receives a percentage of the profits generated from the sale of these products.

These agreements are a win-win for both parties since L’Oréal, leveraging its economies of scale and sector know-how, can achieve much better execution than the brand could on its own without having to do practically anything. On the other hand, L’Oréal can leverage the visibility of the brands it works with to increase its business volume, leading to more economies of scale and entering a virtuous cycle in which both parties benefit.

Many brands collaborate with L’Oréal in this way; in fact, most luxury brands that are not part of a larger group like LVMH work with L’Oréal. To give some examples, Ralph Lauren has been working with L’Oréal for more than 38 years, and Cacharel for over 50. In 2018, Armani renewed its contract until 2050, and brands like Diesel switched their provider to L’Oréal in 2006. Some of the more recent partnerships include Prada in 2019, Valentino in 2021, and Miu Miu in 2024.

However, the most important partnership is undoubtedly with YSL, secured in 2008 during a period of weakness for the Kering group. This partnership generates the most revenue and could pose a risk if it were to break at any point. Although both parties claim to be satisfied, Kering has recently mentioned wanting more control over its supply chain and, being a sufficiently large group, might want to exit the agreement and operate independently. While I believe both parties gain more together, it is a risk that must be closely monitored as it could impact an estimated 3-4% of revenues.

Active Cosmetics

This segment focuses on dermatological products and is aimed at consumers with specific skin care needs, such as sensitive skin issues, aging, or dermatological conditions. These products are usually recommended by health professionals and are mainly available in pharmacies, parapharmacies, and specialty stores. Brands like La Roche-Posay, Cerave, Vichy, and Skinceuticals are leaders in this field. This segment is the fastest growing and, as we will see later, it achieves the highest operating margin. L’Oréal positioned itself in this sector very early and is now capitalizing on all this growth thanks to its acquisitions. For example, in 2017 they acquired Cerave for approximately €1bn, which was 10 times its sales, but today it is already generating more in revenue than it cost.

Financials

L’Oréal has managed to grow its sales by a compound annual growth rate of 7.2%, outperforming the cosmetic market, which is estimated to have grown by around 5-5.5% during the same period. This may not seem like an extraordinary growth rate, but as we will see later on, these increases are more than enough to create significant value for its shareholders. Considering the maturity of this market, from my perspective, it demonstrates L’Oréal’s dominant position in the sector.

If we break down these sales by segment, we can see that consumer products have traditionally been the segment with the highest margin. However, the luxury segment has been closing the gap and is expected to become the company’s largest source of revenue in a short time. I view this as a positive development because, as we will see, it has higher margins and greater pricing power. On the other hand, I would like to highlight the rapid growth of the active cosmetics segment in recent years, which is becoming an increasingly larger part of the pie. This is also very positive because this segment has the highest operating margin.

Regarding profitability, L’Oréal is extremely profitable. The gross margin has exceeded 70% in recent years and has continued to expand gradually. Maintaining such high gross margins for such extended periods is often a sign that the company possesses a formidable defensive moat that is difficult to overcome. With such a low cost of sales, its largest expenditure by far is marketing and advertising, accounting for 32% of sales. In such a competitive market, a high investment in advertising is not a sign of weakness, but rather a necessity to keep brands trending. Given L’Oréal’s scale, they can spend much more on marketing than their competitors, thereby overshadowing them and virtually monopolizing advertising spaces like TV, influencers, or social media.

A positive aspect of marketing being the main expense is that it can be easily reduced in times of crisis or when additional cash is needed. If the cost of sales were too high, it would be much more difficult and take longer to reduce than marketing costs. Thus, the company has an added layer of security for potential adverse situations. As shown in the graph, during the COVID-19 pandemic in 2020, L’Oreal cut back on advertising expenses and quickly restored them to normal levels once the situation improved. Therefore, I believe that being able to afford such high marketing expenses while maintaining high and growing net margins, what L’Oréal achieves by investing so much in advertising is to protect its terminal value.

Investment in R&D is crucial in the cosmetics industry, especially in the active cosmetics segment, to stay at the technological forefront. To capitalize on the prominent growth in dermatology, it is essential to meet the specific demands of each customer through the development of new products. L’Oréal, thanks to its considerable size, invests over €1 billion annually in R&D, which, although significant, represents only 3% of its total sales. This investment is nearly three times that of Estée Lauder (EL), positioning L’Oréal favorably to maintain its leadership and increase its competitive advantage through its scale.

Furthermore, L’Oréal’s ability to sustain slow, but steady growth in its operational margins is remarkable. Both gross and operational margins have seen gradual expansion over the last decade, with minimal fluctuations. This consistency offers investors the ability to more accurately predict future cash flows, reducing the likelihood of significant declines in these margins and maintaining a consistently positive trend.

In addition to being extremely consistent over time, L’Oréal’s profitability ratios are also much better than those of its closest competitors. To give you an idea, the operating margin of LVMH (OTCPK:LVMHF) Parfums & Cosmetics has never exceeded 15%, and those of Estée Lauder have always been lower, except in 2022 after which they plummeted. This clearly demonstrates that L’Oréal is the most solid company in the sector, as it has been able to maintain significantly higher margins than the industry average for extended periods with hardly any fluctuations.

Valuation and conclusions

To evaluate L’Oréal, I believe it’s essential to consider the sustainability of its business and our ability as investors to accurately predict its future cash flows. At first glance, L’Oréal’s stock might always seem overvalued, typically trading above a P/E ratio of 25x over the last decade, yet its compounded annual return has consistently exceeded 10% in recent years. Thus, companies that always seem expensive but continue to outperform the market are, in reality, often undervalued.

L’Oréal is a higher-quality company compared to the market average, which is necessarily reflected in its valuations. They are leaders in a business growing faster than GDP while gaining market share. Cosmetics is a notably resilient industry. Consider that in 2008 or 2020, L’Oréal’s sales only fell by 6% and recovered quickly in the following years. Additionally, the management has demonstrated excellent resource management, maintaining consistently increasing margins over time, positioning their brands as industry leaders with very effective executions throughout the years without leveraging the company.

Therefore, for such a stable and high-quality company, I believe we need to open our minds and acknowledge that these types of businesses can grow much more than the GDP for many decades, as L’Oréal has done for over 100 years, generating exceptional value for its shareholders. It is unreasonable to expect such a company to trade at a P/E of 15x except in catastrophic events. Paying a valuation of 25x can offer long-term double-digit returns because the market recognizes that their cash flows are extremely secure and will always be willing to pay more as long as this security continues over time, which, given the characteristics of their business, I believe will last for many more decades.

This does not mean that any price should be paid for this action. Currently, I believe L’Oréal is trading slightly above its fair price at around 33x. I think that despite the quality of this company, we must be cautious, and I would feel more comfortable increasing my position closer to 25x. Something that can also help us monitor when L’Oréal is at a good price is to pay attention to the purchases of the executives, as they tend to accurately hit the lows in valuation. Although I have mentioned that I think the stock is slightly overvalued, I do not believe that one should sell one of the best companies in the world just because of a temporary overvaluation, so I have decided to assign L’Oréal’s stock the rating of “Hold”.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.