Nevertheless, to maximise their chances of growing successfully in this highly competitive and fragmented market, cosmetic companies need to clear a number of hurdles that are key to success in the cosmetics industry. These include:
- Developing and maintaining a strong brand name, as is true of all consumer-goods industries;
- Aligning their branding strategy to their target markets, be it a premium strategy at the upper end of the range and selective distribution, or value strategy focusing on the larger but less profitable mass markets and bargaining power against big retail;
- Balancing their presence in developed markets, which assures profitability, with their presence in developing markets, which are fast growing and underpinned by favorable demographic trends but rather cost-sensitive.
- Detecting and adapting to socio-demographic trends in mature markets, such as the aging and wellness waves;
- Using in-licensing and incremental M&A to help optimise their brand portfolios; and
- Implementing these business factors on the basis of a sound financial risk profile.
Only a few market players are purely integrated cosmetic companies with substantial global reach. They include U.S.-based Avon Products Inc. (A/Negative/A-1), Elizabeth Arden Inc. (B+/Positive/--), The Estee Lauder Cos. Inc. (A/Stable/A-1), and Revlon Consumer Products Corp. (CCC+/Negative/--), France-based L'Oreal S.A. (--/--/A-1+), and Japan's Shiseido Co. Ltd. (A/Positive/A-1). These companies differ strongly in size and financial profile, reflecting not only the still fragmented nature of this market overall but also their different financial policy approaches (see table 1). In focusing on these integrated cosmetic companies with global reach, Standard & Poor's Ratings Services here excludes large industry players from neighboring industries, such as U.S. based Procter & Gamble Co. (AA-/Stable/A-1+) and France's LVMH Moet Hennessy Louis Vuitton S.A. (A-/Stable/A-2), or regional niche players like Bare Escentuals Beauty Inc. (B+/Stable/--), Philosophy Inc., or Concern Kalina (JSC) (ruA-/--/--).
Lux In Flux As Consumers Change Their Buying Habits
To successfully manage their growth strategies, participants in the cosmetics industry must stay attuned to what consumers are buying and where, so they can ensure their brands are best positioned within these channels. Historically, cosmetics companies have focused on either the mass or the prestige segments,
and leaders in the luxury market have traditionally shied mass channels. Yet this is now changing, owing to the more favorable growth trends in the mass market. Over the past several years, Elizabeth Arden has substantially expanded its fragrance business into the mass market. Estee Lauder, historically focused on the luxury end of the market, has revamped its channel mix to offset the decline in the department store retail channel due to lower store traffic and consolidation. Its department-store sales now account for about 34% of the company's total sales, compared with about 46% five years ago. In 2005, the company entered the mass market channel through the launch of its BeautyBank division, which now sells newly developed brands to mass merchandisers. Still, for luxury players, the challenge remains to maintain brand exclusivity and prestige while expanding sales in channels that are more value-oriented.
Some have managed to establish strong brand loyalty in high-growth specialty retail. Retailers such as Ulta and LVMH-owned Sephora have substantially expanded worldwide and have become an increasingly popular destination for cosmetic consumers. For example, Estee Lauder has sold selected lines of its
highly successful Clinique brand through these specialty retailers as part of a strategy to expand the brand. Direct-response television, such as infomercials and home-shopping T.V., have also become a highly effective marketing vehicle and educational mechanism to inform consumers of product and brand virtues and benefits. Coinciding with the increased interest in natural and organic-based cosmetics, spas and salons have become a more attractive venue to market new product lines serving this burgeoning segment.
In mature markets such as the U.S., the mass merchant channel--including Wal-Mart Stores Inc. (AA/Stable/A-1+), Target Corp. (A+/Stable/A-1), and Kohl's Corp. (A-/Stable/--)--has grown at the expense of traditional department store channel, driven by ongoing retailer consolidation and lower foot traffic.
Purchases of cosmetics, fragrances, and skin care are no exception to this pattern. Consumers remain value conscious while seeking more luxury-oriented offerings, and are finding discounters' retail formats more convenient and shopper friendly. What's more, as consumer confidence remains uncertain and fuel and energy costs stay high, consumers at times trade down to the value channels as their disposable income becomes pressured. Increasingly more of them are "cross-shopping" among the different distribution channels, which has intensified an already competitive operating environment for many
retailers and the cosmetic industry overall.
Another emerging shopping channel is Internet-based sales, as companies enhance their e-commerce platforms in an effort to entice online consumers. Travel retail is also growing, as airline passenger traffic rises and additional retail space in airports expands. This channel is higher margin, but also subject to some common risk factors linked to the travel industry, including terrorism, a weaker economic environment, or other external factors that may contribute to a decline in tourism.
Overall Business Dynamics: A Playground For Convergence
As well as facing the challenge common to most branded consumer goods sectors of balancing the complementary dynamics of cost-efficiency gains, marketing cost, and brand management, cosmetics companies are also more susceptible to transition and convergence. On the one hand, cosmetics tend to be dispensable products rather than commodities, making the industry highly dependent on effective advertising and socio-demographic trends; on the other, low entry barriers make the industry an ideal common playground for industry convergence and positioning across the entire range between the premium and the mass market.
Typically for branded consumer goods industries, the perfumes and cosmetics industry is subject to the dynamics of branding and marketing: A strong brand offers pricing flexibility in generally competitive markets, while the need to maintain or enhance branding power is assured through appropriate marketing
expenditure, which underpins sales growth but puts pressure on margins.
To capture growth resulting from globalization or socio-demographic shifts in developed markets, perfume and cosmetics companies try to create headroom for profitability through innovation and international diversification. On the cost side, the available range of cost-efficiency enhancements should provide
further margin potential, as in other sub-segments of the branded consumer goods industry. The distinctive element of the perfumes and cosmetics sector, however, lies in the combination of two factors: Low entry barriers for production and strong reliance on brand differentiation for sales success position the industry among the luxury, fashion, body-care, and health segments. Perfumes and cosmetics are typically sold in the department store and mass channels, and fall into the category of affordable luxury goods. They may be an easy way for luxury players, who usually own and control premium brands, to diversify their brand and acquire new clientele through a relatively affordable product. In late 2005, Elizabeth Arden entered into a co-marketing agreement with Allergan, a specialty pharmaceutical company, to globally launch its reformulated, licensed Prevage skin-care brand at a higher price point with patented antioxidants as an anti-aging prestige skin-care product targeting consumers looking to reduce wrinkles. On the other hand,
body-care companies may chose perfumes and cosmetics as a way to position themselves on the premium side in the context of brand polarization. One example for this strategy is Germany-based Beiersdorf's La Prairie brand, which pursues its positioning in the premium segment through a strategy
focusing on wellness and anti-age features. Through an appropriate product policy, integrated perfume and cosmetics producers like L'OrTal differentiate their product range across different customer segments and manage to adapt their local offer toward both the luxury and the mass market.
As a result of these sector characteristics, brand equity, marketing and innovation, geographic diversity, scale, and operating efficiency are the main features for the industry's business dynamics.Brand recognition is the name of the game
Brand equity is a key feature for the cosmetics industry as markets continue to grow both in developed and developing markets. All leading players in the sector benefit from strong global brand recognition with consumers. Key growth drivers are expected to be new product development and innovation, which allows
these companies to leverage their strong brand recognition and take advantage of greater margin opportunities. Emerging markets are expected to support future volume growth as increasing numbers of consumers adopt industrialized countries' consumption patterns. In their attempt to diversify their product
and client bases, perfume and cosmetics producers face the challenge to attract the maximum number of customers under the affordable luxury approach without jeopardizing the exclusivity of the brand itself.
Still, although brand recognition is probably the most important factor in the sector's industry dynamics, there is no uniform approach with regard to brand management. Some companies pursue a multibrand strategy to try optimize the value of their key brands, as Estee Lauder has with Clinique. Some utilize an
umbrella brand approach, as Shiseido unfolds its product range under one global label. Others, like L'Oreal, pursue a multi-brand strategy aiming to adapt to differences in local tastes through the development or acquisition of different brands in different world regions. L'OrTal's license agreement with
Giorgio Armani represents licensing as another way of enhancing a company's portfolio of brands, which may reduce the capital intensity of brand management, but which may also reduce its ability to control the brand's development.
Product and geographic diversity are increasingly important for growth
Strong product and geographic diversification remain key growth drivers for perfume and cosmetics companies. Diverse product offerings and brands allow companies to offset competitive initiatives with a certain product segment or brand. Significant operations in multiple markets help companies minimize the
impact of weak operations and/or competitive factors in a particular market.
A diverse range of products allows companies to expand their sales by attracting new groups of consumers. Wellness- and anti-age-related features, such as L'OrTal's Active Cosmetics segment, seek to attract the wealthy retiring baby-boomer generation. Similar strategies seek to attract younger or male consumers as new clients for cosmetics products.
All leading industry players are well diversified outside their home markets and have a well established presence in developing markets. In light of the limited growth potential in industrialized home markets and the high potential for a growing class of new potential clients, companies have increasingly focused their attention on developing markets such as Eastern Europe, Russia, and China, where the emergence of new middle classes promises new growth potential. China and South Korea are the core focus of Shiseido's international operations, where the company has successfully launched its Aupres brand, which is exclusive to China. However, while industry players have achieved double-digit top-line growth in these markets, profitability still lags what can be achieved in U.S. and European home markets. The emerging
middle classes tend to be more price sensitive than their peers in developed markets, so that a sales strategy has to strike a balance between exclusivity and affordability. We expect this trend to persist in the medium term.
International diversification requires adaptation to local particularities. In Eastern European and Latin American markets, regions with a strong tradition of wearing scents, the fragrance sector is achieving double-digit growth, and market segmentation also includes children and babies. By comparison, the Asian
market is considered the smallest regional market for fragrances, growing only at mid-single-digit pace.
Nevertheless, this region is the most important market for skin care, traditionally dominated by Japan but increasingly supported by strongly growing demand in China. In India, a key emerging market in which pale skin is often considered desirable, the skin-lightening product category has grown substantially in recent years.
Quest for innovation raises marketing and R&D costs Advertising, promotion, and R&D represent even larger expenditure items for the perfume and cosmetics segment than for the consumer-goods industry as a whole. Similarly to the luxury and fashion industries, successful market positioning requires high
marketing expenditure through distinguishing campaigns, which under a premium approach can reach up to 30% of sales in the industry (see chart 2). Owing to the strong correlation between marketing effort and sales development, marketing campaigns are the agents of innovation and have to be permanently
adapted to new trends. Celebrity advertising has become a powerful marketing tool, notably for fragrances over the past years, but more recent trends focus more on the self-esteem of the consumer looking for exclusive ingredients.
The quest for innovation has also increased the industry's R&D budgets (see chart 3). New developments in wellness- and health-related products, in particular, could increase leading industry players' R&D-tosales ratios. What's more, the proliferation of organic alternatives to traditional chemical cosmetics responds to wellness and environment-friendly consumer trends and further fuels the sector's need to invest in the development of new products. It is no coincidence that L'OrTal has employed the "blockbuster" term used in the pharmaceutical industry to describe successful drugs, to characterize
successful innovations. This underpins the rising importance of R&D in the cosmetics industry's cost structure.
Big is beautiful, but brand licensing is more cost effective
Greater scale is an advantage for integrated producers of perfumes and cosmetic products, as it enables multinational players to leverage fixed costs. This has encouraged all the main players to launch restructuring programs to improve their cost structures and create additional resources to invest in new product development and product promotion. Still, scale plays a less decisive role in bargaining power than distribution strength. Leading global players, such as L'Oreal, EstTe Lauder, or Shiseido may benefit
from important economies of scale thanks to their integrated research and distribution platforms. However, the combination of low entry barriers and high reliance on distinctive brands does not require an industry player's presence along the entire value chain. For this reason, the segment is particularly characterized by brand licensing, which offers market players the chance to extend their activity or their geographic scope without necessarily incurring the related need of capital expenditure.
Players balance margin pressure against increased cost efficie
Perfumes and cosmetics are less exposed to competitive pricing pressure than other branded consumer goods, as they are less price sensitive than segments that face permanent threat of private label competition or retailer bargaining power. Yet, due to the marketing-intensive nature of the industry, the typical business strategy for a perfume and cosmetics player is to balance margin pressure through increased cost efficiency. This helps finance brand innovation and advertising expenses, which are necessary to maintain market share. Given the competitive environment and rising commodity cost pressures, global players have taken substantial steps to contain costs. Over the past two years, Avon Products has allocated pretax charges of $500 million as part of an ongoing multi-year restructuring initiative that is focused on reducing headcount, rationalizing facilities, and reducing costs to operate more
efficiently over the long term. At the same time, the company continues to invest in enhancing efficiencies in its global supply chain, through simplifying its product lines and more efficient strategic sourcing of raw
materials. Avon will also close existing distribution centers and build a new centralized distribution center in Ohio that will ultimately handle up to one-half of Avon's U.S. orders. These efforts have enabled Avon to programs, all of which is critical to its efforts to maintain and expand market share. Utilizing this strategy has become increasingly common to all these major competitors in the sector.
Despite rising cost items related to marketing and innovation, the industry has managed to maintain its historic operating margins, fueled by growing demand for affordable luxury products over the past few years. Operating margins that can be achieved in the market depend on the company's choice between a luxury or a mass-market driven approach. Accordingly, operating margins in the sector cover a broad spectrum and lie between the high single-digit (Elizabeth Arden) up to the 20% range. (L'OrTal).Sound Financial Profiles Facilitate Growth
Cosmetic and fragrance companies with substantial cash generation capacity, good liquidity, and access to the capital markets have greater flexibility to fund operating initiatives and acquisitions. Global leaders such as Estee Lauder and L'Oreal possess a global platform to integrate and distribute new brands. At the same time, given the highly competitive operating environment in cosmetics and fragrances, we expect a substantial portion of operating cash flow to continue to be applied to advertising and promotion. High investment-grade companies, including L'Oreal, Avon, and Estee Lauder maintain strong liquidity through significant annual free cash flow generation and large cash balances, which facilitates each company's ability to support increased debt levels to fund potential acquisitions. L'Oreal has expanded its free operating cash flow above $2 billion over the past few years, which provides flexibility for the company to manage its share repurchase activity, acquisitions, and operating initiatives.
Marginal liquidity, by contrast, can negatively impact a company's ability to compete and improve its operations. In the past, Revlon underinvested in advertising, promotion, and in-store merchandising presentation, which led to declining sales and earnings, as well as lost market share. Following an
unsuccessful launch of its Vital Radiance product line, Revlon improved its financial flexibility with its December 2006 refinancing, and has increased spending to more aggressively promote its Revlon and Almay brands. However, the company's highly leveraged capital structure and negative free cash flow
generation places some limitations on additional debt capacity and at some point could again impact its ability to invest in advertising and store product presentation. This case illustrates that an inability to promote its brands at desired levels could contribute to lost market share and could cause operating margins to decline.
Acquisitions set to accelerate
Standard & Poor's expects consolidation of the cosmetics industry will accelerate over the medium term, as global players look to add niche brands that serve the market's growth segments. We expect cosmetic companies to pursue acquisitions that provide opportunities to further optimize and diversify brand portfolios with new brands that could be built off of existing distribution platforms and grow in key international markets. Although Shiseido is not considered an acquisitive company, it has complemented its portfolio through the acquisition of some established brands in the past such as Sea Breeze, NARS, and Zotos. For the larger players with substantial scale already, a platform is in place to expand upstart, niche brands in major categories, including cosmetics, fragrance, and skin care. Furthermore, even the most well complemented portfolio could increase its profitability by leveraging its distribution base to expand in complementary markets.
Ratings developments will depend, to a large extent, on how industry participants execute their financial policies. Specifically, in evaluating uses of capital, they will depend on how potential strategic acquisitions
are weighed against funding shareholder-value initiatives, such as share repurchases and dividends.
Given the high valuation multiples of recent acquisitions and the increased presence of private equity players, we will consider to what extent industry leaders maintain discipline in pursuing acquisitions and how this is managed against rewarding shareholder value. We will continue to assess the impact of
prospective acquisitions, in terms of expected improvement in sales mix and profitability, scale and brand potential, but also in terms of potential integration issues. The stability of the industry's cash flow generation allows us to take a slightly longer-term approach compared with that applied to other branded consumer-goods sectors. However, although cash generation capacity is generally high, it is threatened by high marketing expenditure, which is critical to brand investment and achieving global growth. To this end,
the effectiveness of restructuring programs and cost-cutting initiatives to offset high advertising and promotion, and the prioritization of cash flow utilization will be critical to each company's financial risk profile.
The improving economic environment, particularly in Europe, has contributed to maintaining global cosmetics companies' business risk profiles. Those companies that successfully seize the opportunities arising from currently favorable trading conditions, socio-demographic trends, and new consumers in
developing markets through appropriate innovation; that maximize their cost efficiency to effectively support their branding and advertising policies; and that have the necessary underlying financial flexibility, will enjoy the strongest position for future growth.