Estee Lauder Cos. Inc (EL) — Q3 2015 Earnings Call Transcript

Good morning. On today's call are Fabrizio Freda, President and Chief Executive Officer; Tracey Travis, Executive Vice President and Chief Financial Officer; and Dennis McHenry, President of ELC Online. Dennis will discuss our current online business as well as future opportunities. Since many of our remarks today contain forward-looking statements, let me refer you to our press release and our reports filed with the SEC where you'll find factors that could cause actual results to differ materially from these forward-looking statements. Our discussion of our expectations for the fourth quarter and full fiscal year are before the impact of accelerated retail orders that took place in the fourth quarter of fiscal 2014 due to the July implementation of our Strategic Modernization Initiative, which would have occurred in our fiscal 2015 first quarter. You can find reconciliations between GAAP and non-GAAP figures in our press release and on the Investor Relations section of our website. And I'll turn the call over to Fabrizio.

Thank you, Dennis, and good morning, everyone. Our company delivered an excellent performance in the third quarter of fiscal 2015 with broad based gains across most brands, channels and regions. Our net sales rose a strong 8% in constant currency, exceeding the top end of our expectation by more than 1%. Sales levels and cost management drove our earnings per share, which climbed a robust 49% in constant currency, also surpassing our expectations. Importantly, we achieved these strong results despite some ongoing market challenges. One of the more difficult environments was Hong Kong where the expected recovery did not materialize due to continuing political protests and fewer travelers from Mainland China. Additional changes in travel patterns caused by currency swings negatively impacted travel retail trends in a number of countries: Brazil, Russia, Turkey and Hong Kong in particular. Economic growth in the European region was largely improved. Through our focused initiatives, we outperformed the markets in the region and delivered robust gains. Thanks to the multiple growth engines we have developed and our proven ability to execute through many challenges, we expect the pace of our constant currency sales growth to continue in the fourth quarter. Our strengths will continue to be driven by both new launches as well as acceleration of compelling products and services that are already resonating worldwide. As fiscal year '15 draws to a close, recognizing the progress we have made, we are increasing our constant currency sales growth forecast to 6% to 7% for the full year. On the bottom line, we are raising the floor of our constant currency EPS guidance range, which increases our midpoint target. Also, our EPS guidance includes dilution from acquisition-related costs. We are using our better-than-expected profit this quarter in part for incremental investment in the fourth quarter. These investments will drive Estée Lauder and Clinique's turnaround plan in the U.S. and support business-building capabilities. We also expect investment spending to continue to drive gains in some of our best-performing areas, including the U.K., Europe, and China in our luxury brands. Additionally, M-A-C is accelerating freestanding store openings. The improving trends we saw in the third quarter give us the confidence to spend more in the final few months on initiatives that we expect to carry our momentum into fiscal year '16. Global prestige beauty is one of the most vibrant areas in the consumer product space. It has provided consistent annual growth, currently, mid-single digits. Some areas are growing significantly better than others, so we are emphasizing those. For example, some of the fastest-growing product areas are contouring treatments and kits, facial oils and masks, eye and lip makeup, and high-end fragrances. Additionally, when consumers shop, they are increasingly attracted to e- and m-commerce sites and freestanding stores. Geographically, we see significant opportunity in most emerging markets. Recently, Europe has begun to improve. And in the U.S., the makeup category is thriving. We are strategically positioned to win in each of these large, higher-growth areas by brand, product category, geography, and channel, which led to our strong growth in the quarter, well ahead of the industry average. We believe we have just started tapping the potential in many of these areas, and we are finding ample room to drive our business. Our successful effort in developing a broader profile with multiple engines of growth and fashioning tomorrow's beauty trends were evident in our results. Even at the time when two of our biggest brands did not grow at acceptable levels in our largest market, the rest of our business more than compensated, fueling robust sales growth for the company. Our broad-based portfolio is a clear strategic advantage. Brands such as M-A-C, Jo Malone London, Smashbox, Bobbi Brown, or Tom Ford continue to be powerful engines of growth, generating double-digit sales gains. In fact, nearly half of our brands achieved at least 10% growth or more. In the U.S., the majority of our brands achieved a very strong performance. Many of our products are perennial bestsellers. We had growth across most channels with healthy retail sales in specialty multi, e-commerce, and freestanding stores. Nonetheless, Estée Lauder and Clinique sales growth in the U.S. department stores lagged behind prestige beauty growth in the market. As you know, we have been working to reignite stronger growth in these brands, and we have exciting new programs being deployed now and over the next 12 to 18 months. Clinique is taking a holistic approach. Its major launches earlier this fiscal year were successful higher-priced skincare products. And now the brand is also emphasizing its sizable makeup business in the U.S. and seeing encouraging results. For consumers, makeup provides instant gratification and fresh new looks. For Clinique, it offers more exciting opportunities for entry-priced products, which attract millennials and fit with the brand's heritage positioning. Clinique's spring makeup launches are in the important subcategories of foundation and lipstick. Launched in February, Beyond Perfecting foundation and concealer is helping to drive the entire makeup category for Clinique, which grew again in the U.S. in the quarter. Clinique is #1 in foundation in its home market. The brand's other exciting makeup launch, Clinique Pop Lip Colour and Primer, features an accessible price point and a case that displays the color inside. Clinique has bet its newest product will further accelerate its lipstick sales, which are projected to be up double digits in the U.S. this fiscal year. In both skincare and makeup, Clinique is launching products that play to its strengths and reinforces leadership in key subcategories. One important area for the brand is moisturizers where it holds the leading position in prestige beauty in North America. To further strengthen its authority, Clinique is launching this fall its first cream in its best-selling Dramatically Different Moisturizing line by adding a formula geared to consumers with dry skin. The new cream should generate incremental sales in its powerful core franchise. We believe the brand is beginning to attract more millennials through these new makeup and skincare products, and at the same time, it is engaging consumers with fresh advertising, communication, in-store merchandising, and new services. The Estée Lauder brand is modernizing its image and reaching out to a wider demographic while continuing to serve its core consumer with significant new products. It has been successful this year with several makeup products and expect this trend to continue with Kendall Jenner, the brand's millennial spokesmodel. In the fall, Kendall will appear in digital, print, and TV advertising for an exciting new fragrance called MODERN MUSE LE ROUGE, which expands the inspirational concept behind the Modern Muse franchise. She will also promote upcoming makeup products, which we'll be discussing during our next call. Makeup and fragrance are good recruiting categories for younger consumers. The most exciting development at Estée Lauder is its next major launch. A new franchise of transformative product that creates visible definition for a beautiful, more contoured-looking face, which is an important new beauty trend. Named New Dimension, the collection includes a concentrated serum, a liquid tape precision treatment, and contour kits for face and eyes. The actress Eva Mendes will be the face of this new skincare product in digital, TV, and print advertising. New Dimension is targeted to global consumers of multiple ages and ethnicities. The line launches in North America in July followed by international markets in September and additional products will roll out later in the year. We expect New Dimension to create a new subcategory for Estée Lauder brand for core consumers. Let me now discuss our total international business. We continue to successfully execute our emerging market growth strategy, which is progressing well. In total, local currency sales from all emerging markets aside from China climbed 29% with exceptional results in Brazil, Turkey, and South Africa. In some markets, such as Russia, devaluated currencies reduced outbound travel, creating more local demand and sending sales up sharply. M-A-C is our largest brand in many emerging markets, including Brazil, Turkey, and The Philippines. Strong gains in these countries contributed to its stellar global growth. M-A-C is now available in more than 100 countries and territories, having entered 4 new markets only this quarter. China continues to be an area of strength for us. Our constant currency net sales climbed 14%, and most of our brands were up double digits. Although skincare remains the dominant category, makeup has seen rapid acceleration, allowing us to leverage our position as the worldwide leader in prestige makeup. Our total retail sales in China rose high single digits for the quarter, and we estimate we gained share overall. Sales increases were broad-based across our brands with several up double digits, including Clinique. Sales also rose in nearly all channels, including department stores, freestanding stores, and Sephora. Today, Chinese consumers can buy our products in brick-and-mortar stores in 94 cities, 3 more than last quarter. The most rapid growth, however, was online where our business more than doubled. Our travel retail business improved despite several challenges. Retail sales climbed 7%, slightly higher than passenger traffic growth, which remained robust. The strongest retail gains were in Asia/Pacific, led by Japan, which benefited from tourists attracted by the weak yen as well as Thailand and Australia. We believe we gained share in travel retail in calendar 2014 driven by accelerated growth in certain limited distribution brands and improving business in Europe, the Middle East & Africa. We continue to add distribution points and invest in the channel to help fuel our future growth. Online channel continued to show exceptional progress this quarter and is a key element of our long-term growth strategy. Our brands will benefit from the best-in-class capability we have established in this rapidly growing area from both retailer expansion and our continued brand size development. Dennis will discuss these exciting opportunities for e- and m-commerce. As we continue to demonstrate, we have significant growth drivers through our business and are particularly excited about the long-term potential of the 4 brands we recently acquired. We are integrating them into our operations and developing strategic plans for their future that started tapping into our capabilities in infrastructure to leverage their creativity and growth potential. During the quarter, we continue to improve our productivity, manage our expenses and delayed some planned investment spending until the fourth quarter to fuel new initiatives. Tracey will provide more detail. We are pleased with our results to date in fiscal 2015. We are confident we will achieve our full year targets even in the face of continued headwinds and remain optimistic about our long-term strategic direction. We are currently in the process of updating our compass, our 10-year view of the prestige beauty landscape that will provide insights to fuel our multiple engines of growth and propel our business forward. Our goal is to continue to generate superior top line growth, above the industry average and leverage that growth into increased profitability in order to enhance stockholder value. Now I will turn the call over to Dennis McHenry who has led the company's highly successful and profitable Online division for the last 12 years. Under his leadership, e-commerce has grown from its infancy to a thriving business that will constitute approximately 8% of our company sales this year and an even greater portion, approximately 12%, in our most developed markets.

Thank you, Fabrizio, and good morning, everyone. We have been a leader in online prestige beauty and consistently delivered outstanding growth year after year. Our compounded annual growth rate over the past 5 years was 25% with an accretive margin to the company. Our global technology platform, combined with the regional and local market execution, has allowed us to serve consumers at the local level with global business scale. The online beauty channel continues to grow, and we are well positioned to capitalize on this opportunity. Consumer preferences are shifting, and more and more people are comfortable shopping online and via mobile for beauty products. We are committed to bringing our High-Touch services online to meet those changing consumer needs. We were the first global prestige beauty company to go online with the Clinique brand in the U.S. in 1996. Today, we have more than 130 direct-to-consumer e- and m-commerce sites in 30 countries. Together with our marketing sites, we attract over 325 million online visitors globally each year. Our direct-to-consumer sites generate approximately 60% of our global online sales, with retailer sites generating the remaining 40%. Both are contributing growth of over 25% a year. This year, we are seeing strong growth from retailer sites such as Nordstrom and Macy's in the United States, John Lewis Partners in the U.K., and Douglas in Europe. We greatly value our partnership with all of our retailers around the world. Together, we share best practices and explore ways to win in the growing online business and the new world of omni-channel. In aggregate, our online sales are expected to grow nearly 30% this year, an acceleration over our previous 5 years, with double-digit growth across all regions. North America accounts for approximately 65% of our sales. The U.S. is our most established market and often leads in experimentation of conversion-driving enhancements before they are rolled out to international sites. From the very beginning, we've been focused on bringing our signature High-Touch service from in-store to online. It is important to us that our consumers can engage with our beauty advisers and makeup artists along their digital shopping journey. Many of our brand sites feature live video chat with beauty advisers, integrated content in commerce, enhanced product browsing, photo uploads, skincare diagnostics, shoppable videos, auto replenishment, and more. These enhancements not only support our mission to deliver our best High-Touch service to our consumers; they also successfully drive engagement and conversion to sales. Internationally, the U.K. is our second largest market, contributing approximately 15% of our global online sales, with particularly strong momentum from M-A-C, Bobbi Brown, Jo Malone, and Clinique brand sites as well as several of our important retail partners. Asia/Pacific, Europe and the Middle East & Africa, and Latin America, which contribute the balance of our online sales, are collectively growing over 50% year over year. While many markets in these regions are relatively new entries for us and are currently small, they are experiencing high growth, and we are excited about their long-term potential. Emerging markets continue to be a key building block for our international growth. China is our third largest online market. We are on track to more than double our online sales in China this year. In addition to our 6 brand sites, we have 4 shop-in-shop sites on Tmall. Estée Lauder is the #1 perceived beauty brand on Tmall, and we are thrilled that La Mer became our fourth brand on the platform a few weeks ago. All 4 of our brands on Tmall are greatly exceeding our expectations, and we plan to launch additional brands there in the near future. Virtually all of our brands are growing double digits online globally. We work closely with them to support product launches and ensure online is used as an engine to drive buzz, product information, and sales. Beauty is one of the most active categories online with countless searches for products and how-to videos. Beyond our brand sites, we strive to remain active, relevant, and innovative in social media in order to drive engagement. A terrific example is our I Love Makeup channel on YouTube, which features our company's products, makeup tutorials, and video storytelling. It is the most subscribed beauty channel on YouTube of any brand with 30 million views. We are experiencing strong mobile growth with some markets generating more than half of their online sales from mobile phones and tablets. Across all regions, sales growth from mobile devices has greatly exceeded sales growth from PCs. To capitalize on the shift in consumer behavior to mobile, we have expedited the launch of m-commerce sites around the world and have developed strong capabilities to win in the mobile space. Omni-channel is a strategic initiative for the company to enhance consumer shopping experience by allowing them to seamlessly move across channels. We are in the early stages of developing our omni-channel concepts. This quarter, we plan to launch omni-channel pilots with M-A-C and Origins' freestanding stores in the U.S. with more to follow in the U.K. and internationally next fiscal year. We remain excited about the future of our online business. We have developed a strong business model for e- and m-commerce with winning capabilities and teams. For example, we're able to take our learnings from M-A-C and apply them to maximize our launch in new markets such as M-A-C in Brazil. We will continue to launch new markets, expand our brand distribution in existing online markets, and win with our retail partners. As we continue to fuel growth in online and drive omni-channel initiatives, we believe we will seize significant opportunities ahead of us. In closing, I would like to thank my colleagues in the company and our retail partners worldwide for their continued partnership. I will now pass the call over to Tracey.

Thank you, Dennis, and good morning, everyone. First, I will review our fiscal 2015 third quarter results and then share our expectations for the fourth quarter and the full year. My commentary excludes the impact of the Venezuela remeasurement charges that we recorded in both this quarter and the year-ago quarter. Net sales for the third quarter grew 1% over the prior year and rose more than 8% in constant currency, above the top end of our expectations. Sales did accelerate sequentially from last quarter, as we expected, driven primarily by improved results in the U.S., Latin America, China, and most of Europe and the Middle East. Our recent acquisitions contributed 50 basis points to sales growth this quarter. Our businesses in Hong Kong and travel retail continued to be softer than expected, as Fabrizio noted earlier. Our gross profit margin of 80.5% was 10 basis points above the prior year period, primarily reflecting currency favorability of 20 basis points. Operating expenses improved 60 basis points to 64.9% of sales. The largest drivers of the decrease were 70 basis points of favorable selling and shipping expenses and 40 basis points of advertising, merchandising, and sampling expense leverage, as we continue to experience faster growth from brands with less traditional advertising, and those brands have become a greater proportion of our total sales mix. Partially offsetting these improvements were increases in certain G&A expenses such as retail store operations and information technology as well as acquisition-related fees. During the quarter, given a mixed retail environment in certain markets, including in part due to the severe winter weather conditions in the U.S., we were also more prudent during the quarter in some areas of our planned second-half spending, which contributed to the lower operating expense margin. This will also contribute to an acceleration in spending in Q4. As a result, operating margin rose 70 basis points to 15.6% in the quarter. Earnings per share came in at $0.72, approximately $0.22 above the top end of our guidance range, due primarily to better-than-expected sales and to the timing of certain investment spending in general and administrative costs. EPS would have been $0.10 higher on a constant currency basis for the quarter. All elements of working capital continued to improve during the quarter compared to the prior year. This was largely driven by continued progress in inventory days to sell, which decreased by 28 days to 164. The primary drivers of the improvement in inventory were a combination of favorable currency translation, supply chain process improvements, and a favorable comparison to the preliminary SMI-related inventory build in the prior year. For the 9 months of this fiscal year, we generated approximately $1.4 billion of cash flow from operating activities, an increase of 18% or $216 million versus the prior year period, most of which is driven by working capital improvements. We invested $280 million in capital projects, largely in customer-facing areas such as counters and new retail stores to support our brands' growth plan. During the third quarter, we completed the acquisitions of GLAMGLOW and Frédéric Malle, bringing the total paid-for-acquisition cost this fiscal year to $237 million, which we funded with a combination of cash on hand and commercial paper, leaving our free cash flow to be distributed back to stockholders. Regarding the return of capital to stockholders, for the 9 months ended March 31, we deployed $626 million of cash to repurchase approximately 8 million shares of stock, reducing our diluted shares outstanding by approximately 7 million shares from the prior year period. We also distributed $260 million in dividends to stockholders, which was a 15% increase over the prior year period. We continue to expect to distribute approximately 100% of our free cash flow in share repurchases and dividends by the end of this fiscal year as another vehicle to enhance stockholder value. Let me now turn to our outlook for the fourth quarter and for the full fiscal year. My commentary for the full year continues to exclude the impact of the acceleration of retailer orders that shifted sales from the first quarter of fiscal 2015 into the fourth quarter of fiscal 2014 related to our July rollout of SMI. The impact of that shift was $178 million in sales and $127 million in operating income, equal to approximately $0.21 per share, and it affects comparisons of both the fourth quarter and the full fiscal year. With 2 months to go to the end of our fiscal year and the momentum we've built in the third quarter, we are raising our sales estimate and now expect sales growth for the full year of approximately 6% to 7% in constant currency. This includes 30 basis points from our recent acquisitions. The U.S. dollar has continued to strengthen since we provided guidance last quarter, and currency translation is now expected to negatively impact our full year sales growth by approximately 5 percentage points equal to $550 million in sales. Our estimate for the remainder of the year assumes 1.08 for the euro, 1.50 for the pound, and 1.20 for the yen. Our sales growth guidance, including the negative currency impact, is approximately 1% to 2%. We are narrowing our full year EPS range to $2.92 to $2.97. This compares to our fiscal 2014 EPS of $2.95 before charges and the accelerated orders. The 5% negative currency impact on sales equates to approximately $0.27 of earnings per share, $0.04 more than our last update. In constant currency, we are raising the low end of our range and maintaining the high end of our previous change. On this basis, EPS is expected to rise between 8% to 10% for the year. Our EPS guidance continues to include approximately $0.06 of dilution from acquisitions. Our sales in the fourth quarter are expected to grow 7% to 8% in constant currency or flat-to-down 1% on a reported basis. The strong constant currency sales growth in the fourth quarter is expected to come from new product launches from Clinique and Estée Lauder in both skincare and makeup, as Fabrizio mentioned earlier; incremental growth from our previously announced acquisitions; continued acceleration of growth in North America; continued strong momentum from M-A-C and our other makeup brands; and an easier comparison in Japan against the past VAT increase of sales period in the prior year. We are very pleased with the overall course of our business thus far as we have managed through a tremendous amount of global market volatility by continuing to execute well against our strategy and by leveraging the strengths in our portfolio, creating accelerated momentum in the second half of the year versus the first half. We expect mid- to high-single-digit constant currency sales growth in the fourth quarter, and we are committed to reinvesting behind our strategic priorities. We plan to meaningfully increase investment in our fourth quarter behind both our current and upcoming product launches as well as to support accelerated door-opening activity, particularly for M-A-C. We also expect to continue our investments in building capability in areas such as information technology, R&D, digital marketing, and human resources. Lastly, the fourth quarter will reflect $0.03 of acquisition-related activities. We anticipate fourth quarter EPS will come in between $0.27 and $0.32. The approximately 8% negative currency impact on sales growth in the quarter equates to approximately $0.10 per share. In closing, we are pleased with our team's ability to navigate major macro headwinds and deliver strong operating results, and we believe we are well positioned to deliver great results for this year as well as position ourselves for another strong year of growth in the next fiscal year. And with that, we conclude our prepared remarks, and we'll be happy to take your questions now.

I was hoping you could provide a bit more clarification on the full year guidance. I understand the additional foreign exchange challenges, but considering the significant outperformance this quarter and the progress in offsetting M&A dilution, the full year outlook suggests you plan to reinvest everything back into the business in Q4. I know this was part of a timing decision, but could you elaborate on where the investment will be targeted and what type of return we should anticipate? It is somewhat surprising not to see more of a positive impact from this given the strong underlying top line. Additionally, regarding guidance, I realize the second part might need to wait until August for a comprehensive update. However, the foreign exchange situation seems to have significantly impacted your planned margin growth based on this full year outlook. I'm curious about what risk this poses to your longer-term goal of achieving 17.5% EBIT margins by fiscal '17 as you look ahead.

All right, Steve, great questions. Historically, in the fourth quarter, when we've had a successful year and generated additional savings from our cost-saving initiatives and business momentum, we seize the opportunity to invest in our strong growth drivers to finish the year on a high note and set ourselves up for the upcoming fiscal year. That's our plan for this year as well. The investment in the fourth quarter consists of planned spending we aimed for in the second quarter, which we decided to reinvest in the fourth quarter for the brands showing positive momentum, provided the third quarter performed well. Additionally, as I mentioned earlier, we adopted a cautious approach in the third quarter due to weather challenges in North America, anticipating an acceleration in sales. We wanted to ensure that momentum was realized before investing heavily in marketing programs for our new product launches in that quarter. The results from the third quarter support that decision. The fourth quarter will include ongoing support for the turnaround plans for Estée Lauder and Clinique, along with new product launches in both the third and fourth quarters, which will receive our investment support. We are also increasing support for the growth observed at M-A-C, Tom Ford, and Jo Malone in line with their exceptional performance this year. We faced some delays in M-A-C store openings planned for the third quarter, so there will be several openings in the fourth quarter creating additional investment demands. Moreover, we will continue investing in our corporate capabilities, ramping up spending in areas like R&D, information technology, HR, and digital. As for our outlook for the next couple of years, we will provide an update in August regarding the impact of foreign exchange on our long-term forecast. Fabrizio, feel free to add anything further.

Yes, we will provide an update, and you sought to understand the current situation. Currently, we have a margin of 0.4 points, which we expect will be supported by the acquisitions. I want to clarify that this will take around 18 months, so it won't have a long-term effect; ultimately, these acquisitions will enhance our margins, and the costs associated with them will be absorbed within that timeframe. The impact from currency fluctuations is around 0.5 points at the moment. We are exploring internal strategies to achieve greater savings or take other actions to navigate the current currency challenges. However, it's important to note that currency conditions may change again in the long run, so it's uncertain. We will share our perspective on the appropriate balance for the future in August.

I would like to discuss the online opportunity in China. It is currently the third largest market, but it remains relatively small. However, in other categories, it is quite substantial. I am curious about your perspective on how significant this could become in the next five to ten years compared to the physical retail business. Additionally, I would like to hear about your plans to activate the New Dimensions. Did I understand that correctly?

Yes.

So to answer the first question, I would like Dennis to say a few words. But today, we have 8% of our global business online. I hope you were impressed as much as we are by the progress that's been made online and by the potential in the long term. In the countries which are more developed like the U.S., we have about 12% of our business; we believe that in China, China could be 20% of our business in the long term being online the way the country is progressing, the way the other categories are progressing in this area. We're at the beginning of the journey in China where we are very well advanced in the U.S. I don't know, Dennis, if you want to add anything.

Yes. I think, first of all, we're pleased with the growth in China. We're going to more than double our business this year. We expect in the next few years that our business will be about 20-plus percent, as Fabrizio mentioned. It is a business that's quite new for us online in the market. And in the current quarter, it basically performed as well as the U.K. in terms of the size of the business. So it's become, essentially in this past quarter, equal to our #2 business and growing at triple digits. So we're very pleased.

And on New Dimension, we are very excited about this new launch of the Estée Lauder brand. We believe that the contouring category is a new trend, so there are many consumers around the world who are enthusiastic about entering this category and experimenting with what the experience can be. The product is excellent, does a fantastic job, so we have a great formula, and we have great plans. I hope, as I explained in my prepared remarks, that we plan to start from the United States in July and then roll out internationally as of September. This also clarifies the way we think of giving our best shot to accelerate the U.S. market.

It sounds like, on new products, that there's a decent size surge relative to recent years. So how do you think about the contribution from new products going forward, not only in Q4 but fiscal '16 as well? And then following on that, as you focus more efforts behind millennials, does that in any way impact how you think about the contribution of price mix to the top line?

I'll address this one. Our percentage of sales driven by innovation is increasing each year. We've made significant advancements recently, exceeding market trends. As the makeup industry accelerates, it naturally becomes more focused on innovation since it involves more product launches than other categories. We are well-equipped to stay ahead of the industry average in innovation, creativity, and new product launches. As I mentioned earlier, our approach involves thorough market analysis to identify what is substantial and rapidly growing. Additionally, we are focusing on anticipating and developing breakthrough areas. Our strategy combines targeted innovation on emerging trends with the creation of new concepts, contributing to a consistent growth in innovation year after year.

You guys have been pretty upfront in terms of some of the pricing differentials related to China and travel retail over the past couple of years and how that impacted your European business in particular. Can you talk a little bit about what you've seen in some of the other luxury categories in terms of some of the price changes out there? And is that something that you see entering the prestige beauty category going forward?

I realized I didn't address the previous question regarding pricing and the mix with millennials. To start, entry price point products tend to perform better with millennials, especially in the high-end luxury segment. However, this does not mean that these entry price point products are any less profitable for us. In fact, the mix of entry price products in our prestige category is favorable for us, and we don't perceive any pressure from this trend. On the contrary, it's a positive development. Regarding pricing in our category, we have established a global pricing process and strategy. Our internal team consistently monitors prices, price changes, currency fluctuations, and also what our competition is doing worldwide. This has been our approach for several years now, and we see no need to alter our strategy or processes. We will continue to manage the amortization process, adapt to currency changes, and respond to market competition. Most importantly, we are focused on addressing consumer needs, and we will persist in this direction as we have over the past year.

Fabrizio, I wanted to revisit advertising for this quarter. At the start of the quarter, you had intended to boost ad support for the business, anticipating that this would lead to increased sales from that support and improved product launches. While you did experience an 8% organic sales lift, which is positive, the 40 basis points of ad leverage you achieved seems significantly different from expectations. Can you provide clarity on how much advertising was actually deferred to Q4? Was the brand mix so different, meaning did the brands that typically need more advertising grow at a faster rate? Was that mix so unexpected that you were able to achieve growth with just 40 basis points of advertising leverage? I’m looking for more insight into this.

Sure. Let me say first of all, yes, we are postponing some advertising to the fourth quarter, as Tracey explained. Let me refer to the total year because your comment anyway is correct. We have, in percentage, advertising leverage on the total year. Even if by quarter, this is assessed by swings where we invest more on the initiatives we choose to support more. But for the total year, this is absolutely a correct statement. Our absolute level of advertising is basically flat. But in percentage of sales, we are leveraging it. Why is this happening? First of all, within the advertising, there is a swing toward digital that has an impact, and in many countries today, it is still a positive impact. Second, there is a fact that our traditional brands, which are typically more advertised, Estée Lauder and Clinique, as you know, are not the ones which are driving the growth the fastest. On the contrary, the fastest-growing brands such as M-A-C or Jo Malone or La Mer or Bobbi Brown are not advertised the traditional way. They're advertised more in digital, but most importantly, a lot of what we consider their marketing is taking place in their freestanding stores and is in areas where the cost is somewhere else; it's not on the advertising line. In some of these brands, we are not necessarily leveraging the support to the brand; we're just changing the line where you will find it, as Tracey explained. I don't know if, Tracey, you want to add anything on that.

Yes. With our expansion into direct-to-consumer, we are experiencing changes in our expense categories, such as an increase in store operating expenses and occupancy costs. Additionally, as Fabrizio mentioned, there is a shift in our advertising and promotion expenses since the brands in this area are growing at a slower pace compared to those expanding through direct-to-consumer. Regarding your question about our expectations for the third quarter and what has moved to the fourth quarter, we have approximately $30 million in advertising and promotional expenditures that have shifted from the third to the fourth quarter. This will enable us to promote both the launches we had in the third quarter and those planned for the fourth quarter.

First of all, following up on the advertising question, as you head into 2016, I understand you don't want to provide guidance, but as you focus more on your flagship brands, Clinique and Estée Lauder, do you anticipate an increase in the overall advertising ratio? Secondly, regarding the DDML cream, when you launched DDML+, it did not lead to incremental revenue growth but rather cannibalized the core business. What leads you to believe that the cream will contribute additional revenue to that franchise?

Okay, thanks, Wendy. I'll take the first part, and Fabrizio will take the second part. Again, we're not going to give guidance, obviously, for fiscal '16. But certainly, as we indicated, we do plan to support Estée Lauder and Clinique as they continue to respond to both the new product launches and differential advertising and mixture of traditional advertising in TV, in print, as well as increasing levels of digital advertising that we would expect to spend more in fiscal '16 on both of those brands. However, given the mix of shifts that we're seeing with the faster growth of other brands, that does not necessarily mean that when you look at our advertising and promotion line, you will see deleverage. Quite the opposite. I think you'll continue to see us leverage marketing, advertising, and promotion with the growth that we are seeing in the makeup artist brands and some of our direct-to-consumer channels.

Yes. And Wendy, on the cream, first of all, Clinique has an outstanding DDML lotion business, which is loved by consumers and is preferred in many parts of the world. But for example, the cream form is very preferred in Europe. We have seen that some years ago, we developed a cream called Supreme for Europe in a cream form. This had been one of the key drivers in that region for the Lauder brand. Now Clinique will have a cream-preferred form that will have, first of all, a completely different regional relevance. In the U.S., the cream is very preferred with people with drier skin. In fact, today, in our profile of Clinique, we have an opportunity to have a much higher market share for DDML in the area of people with dry skin. So there is a white space, an extra business, non-cannibalizing, which is a big next opportunity with this initiative, in our opinion, in every country of the world.

Just a question for Dennis. Can you give us a sense of how the profitability of the Online business compares with the remainder of your business? And then Fabrizio, you obviously posted strong organic sales growth this quarter. You're expecting another strong quarter in Q4. As you look out to fiscal 2016, can you discuss if you expect some of the key drivers behind that back half strength will continue? On the other hand, in Hong Kong, can you discuss your expectations there and what you're expecting going forward?

I will begin addressing this while Dennis prepares his response regarding the profitability of the Online business and Online in general. The current trends contributing to our strong growth are expected to continue. I mentioned in my opening comments that we have multiple engines of growth. More than one-third of our business is experiencing double-digit growth, which implies that the rest can grow in line with the market, allowing us to maintain the kind of progress you're witnessing today sustainably in the long term. Our strategy focuses on areas that are not just large but also growing faster than average, and we prioritize agility and speed in reallocating resources as needed. Our operational approach emphasizes agility and quick resource reallocation to respond to market dynamics. This is key to our success. The multiple engines of growth, our diversified offerings, and our ability to reallocate resources based on trends are our competitive advantages. I believe these factors will continue to positively influence our business trends in fiscal year 2016 and beyond. Regarding Hong Kong, we do not see the recovery we had hoped for. Chinese tourist numbers in Hong Kong remain weak, and ongoing protests are causing a decline in high-end retail activity. We do not expect a quick recovery in Hong Kong. We are focusing on capturing more local business, which is clearly more sustainable for the long term. We are shifting resources towards more entry-level price points instead of just the high end that our market has typically targeted. This reallocation will take time, but I remain confident that Hong Kong will continue to be a vibrant and outstanding market in the long term. It will just take some time to adjust our resources to align with the current situation. Dennis?

Yes. As to the margin contribution of the online business, we don't break that out publicly. It's different, frankly, by market and by region. I will tell you that it is in the group of the highest contributors of margin to the company. So we're up in the realm of the groups that contribute the most margin to the operating margin of the company.

I wanted to understand what kind of growth rate is anticipated for the fourth quarter for brands Clinique and Estée. And just sort of broadly longer term, what's a reasonable growth rate for those brands over the next, call it, year or 2 relative to what you've been seeing for those brands and sort of how do you holistically think about growth longer term for those brands?

At this moment, we expect these two brands to experience a slight decline this fiscal year. We are working to achieve a light positive growth next year and then accelerate further over time. This is why I keep mentioning that it will take about 12 to 18 months to see a turnaround and subsequent acceleration. For now, you should anticipate a slight decline transitioning to slight positive growth. However, we anticipate a very positive impact on the overall company acceleration, especially if the rest of the business continues to be as strong and vibrant as it is today.

I have a question for Dennis regarding the decisions to collaborate with retailers. Previously, I've heard discussions about how you choose to launch a specific brand at a certain brick-and-mortar retailer, like Macy's on 34th Street compared to the nearby Sephora. What is the thought process behind your online business with these retailers, particularly in terms of expanding your presence with Ulta.com?

Yes. The first thing we do is we look in each country, in each market at fit for each particular brand. We would prefer to support authorized retailers in our brick-and-mortar relationships, as they are important to each one of our brands. We do look at other opportunities in each market. For instance, the Tmall opportunity in China is a unique business model. It allows us to run our own freestanding stores, if you will, shop-in-shop online. And we do look around the globe at other fits for our brands. But our preference is to start and to build our business with our authorized retailers and help them grow their online business and our brand business with them.

Fabrizio, I was hoping you can address 2 things on the whole strategy with millennials given that they're always looking for new news, and it's probably making you accelerate some of your innovation or at least the pace of innovation. How do you manage this complexity, number one, but also the integrity of both Clinique and Estée Lauder brands in particular as you step up the new news? Any help with that would be most appreciated.

Yes. I'll begin, Nik, and then Fabrizio will continue. One of the key aspects, starting with Estée Lauder, is that many of our brands are successfully engaging with millennials. As part of the turnaround strategy for Estée Lauder and Clinique, we are not only focusing on our core customers but also on attracting this digitally-savvy millennial demographic, which consumes information differently. Consequently, we are enhancing the digital focus of these two brands. From a communication perspective, we've made specific spokesmodel choices for Estée Lauder to better connect with this audience and introduced new products for Clinique that appeal to both millennials and our core consumers, with a focus on more entry-level price points for millennials. For instance, we began the year with two premium skincare products, the Sonic device and Smart Serum, aimed at our core franchise and broader consumer base while developing strategies to attract millennials. We routinely manage product complexity with numerous brands and SKUs, conducting annual line edits to reduce and rationalize SKUs as part of our cost-saving initiatives. With the support of SMI, we now have greater visibility into this information than ever before. Fabrizio? Yes. I want to emphasize that the complexity will improve with the plans that Tracey just described, even as we introduce more innovation, set specific targets, and enhance local relevance, which is another factor in our complexity. We are prepared to manage this complexity effectively. Regarding millennials, it's encouraging to see how much they appreciate our products. When we communicate with them in a way that resonates, their enthusiasm for our offerings is evident. The impact of our millennial spokesmodels on social media has been remarkable, helping us connect better with this demographic. For instance, our vibrant online business, which is primarily fueled by millennials, is one of our fastest-growing areas. Internally, we are also focused on becoming an appealing workplace for millennials. Senior management regularly engages with them, and we have programs in place to listen to their insights on what they seek as consumers and professionals. This feedback helps us modernize our company's approach both externally and internally. We recognize the importance of modernization and see the millennial generation as key players in driving that change.

So a couple of things. One is, I just wanted to see if you have an inventory level target across SAP because it's quite great there, giving all that cash back to shareholders. I wanted to see kind of how far it can go. And the number two is if you could tell us a little bit more about the relative slowness on skincare plus 4%, and how that ties to or is exclusively driven by the heritage brands especially in the U.S. And what you think you can do about it especially in the context of expanding into new channels with those brands. So Ulta, more in Sephora, more SKUs, more brands, perhaps more third-party commerce sites, et cetera. Is that one of the solutions to resolve perhaps a skincare problem?

Okay. So Ali, I'll take the inventory question. We are aggressively working with our organization to manage inventory turnover and to improve inventory turnover, and you're seeing the beginning results of that now. So we spoke about it last year that post-SMI, we'd have the opportunity to really leverage the tool and start to drive some of the supply chain opportunities from an organizational standpoint, everything from improved forecasting to improved flow of inventory and movement of inventory throughout our supply chain and to our consumers and our customers. So that's happening. We have talked in the past about a target of 140. We have not given a time frame as it relates to that. We are aggressively working towards achieving that goal and being able to communicate a more specific time frame for you as it relates to that goal. So you can expect an inventory update from us on the August call along with our 3-year outlook.

Yes. In my view, skincare is currently one of the largest and fastest-growing categories globally, alongside makeup. You mentioned skincare in the U.S., which certainly needs to pick up pace, but worldwide, skincare is thriving. In Asia, it's still the dominant category and continues to grow. The U.S. skincare market has benefited significantly from breakthrough innovations that enhance consumer interest, which is a primary focus for us. Additionally, these innovations can help increase traffic and interest in department stores, creating more activity and engagement around skincare. Online, skincare is also experiencing substantial growth, highlighting its potential when properly targeted. You also pointed out the specialty channel, which has mainly focused on makeup and driven its growth. We believe the strategies and activation methods used in the specialty channel can be applied to skincare, potentially boosting prestige skincare in the U.S.

Just a real quick question for you, Dennis. As you talk about your online business is almost $1 billion here in the next 12 months or so, can you talk about the data capture and some of the information that you're using, whether it's directly for the online business or just strategically across the organization, the information that you're capturing online?

Yes. It's a great question. Actually, online, as you're alluding to, we can capture so much consumer insights, and we are starting to really use those in all areas of the business, not only in our marketing for the total business in every channel but also in product development, in R&D. We're really getting so much feedback from our consumers, and we're using all of those data insights, which frankly differ by market and by brand around the world, but we're able to collect those globally because we have one global technology platform. We're sharing them throughout the company to make better decisions and better strategies and better products.