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EL > SEC Filings for EL > Form 10-K on 20-Aug-2014All Recent SEC Filings

Show all filings for ESTEE LAUDER COMPANIES INC

Form 10-K for ESTEE LAUDER COMPANIES INC


20-Aug-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

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.

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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.

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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.

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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.

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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

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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
. . .
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