Lex is a premium daily commentary service from the Financial Times. It helps readers make better investment decisions by highlighting key emerging risks and opportunities.
Wearing a lot of makeup is a bold statement. It is odd then that the world's largest maker of cosmetics by sales is about as conservative as they come. L'Oréal has €1.6-billion ($2.1-billion) in net cash on its balance sheet. Yet it can think of nothing better to do than give €500-million of it back to ordinary shareholders. A buyback program was unveiled in L'Oréal's annual results on Monday. Investors were pleased – shares in the French company picked up 4 per cent on Tuesday.
What about using some of that cash for mergers and acquisitions? Sure, they are a risky way to create value, but L'Oréal derives only 37 per cent of its sales from emerging markets, for example, compared with about 55 per cent for Unilever's personal care business. That suggests it could use some funds to buy growth in those markets.
Speculation is growing that L'Oréal is saving its cash to deploy in another manner. Nestlé still owns a 30-per-cent stake in the group, but the mutual lockup agreement ends next year. RBC Dominion Securities estimates that – assuming borrowing costs of 2.5 per cent, the sale of L'Oreal's 9-per-cent stake in Sanofi, and movements in its cash position – buying Nestlé's stake next year could boost the cosmetics group's earnings per share by a fifth and leave its net-debt-to-earnings in line with peers.
The other issue to keep an eye on is L'Oréal's advertising strategy. Acquisitions of lower-margin brands (Clarisonic) and currency moves dragged its gross margins down to 70.7 per cent in 2012, the lowest level in three years. L'Oréal smoothed that over by cutting advertising costs as a proportion of sales to the lowest level in four years. For a company so reliant on ads to convince customers that its products are more than just a pot of goo, that does not bode well.
On 20 times forward earnings, L'Oreal is 1/10 cheaper than Estée Lauder. It must be bolder to avoid looking like the girl next door.