Estee Lauder Cos. Inc (EL) — Q2 2018 Earnings Call Transcript

Good morning, everyone. On today's call are Fabrizio Freda, President and Chief Executive Officer, and Tracey Travis, Executive Vice President and Chief Financial Officer. 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. To facilitate the discussion of our underlying business, the commentary on our financial results and expectations is before restructuring and other charges, provision of one-time impacts of the new U.S. tax law, and other adjustments disclosed in our press release. You'll find reconciliations between GAAP and non-GAAP figures in our press release and on the Investors section of our website. During the Q&A session, we ask that you please limit yourself to one question so we can respond to all of you within the time scheduled for the call. And I'll turn it over to Fabrizio now.

Thank you, Dennis, and good morning to everyone. We achieved outstanding financial results in our fiscal second quarter as our momentum grew. Our sales and earnings per share both saw double-digit growth, reflecting broad gains across regions and product categories. Sales increased by 14% in constant currency, leading to significant earnings growth driven by cost savings and improved efficiencies. Our adjusted diluted earnings per share rose by 23% in constant currency. We outpaced the global prestige beauty sales growth, enhancing our market share. Our success was anchored by a robust innovation strategy supporting our iconic high-quality products and heritage brands, which demonstrated strong loyalty and repurchase rates. Our performance capped a robust first half, and because of this and our confidence in future prospects, we are once again raising our full-year adjusted forecast. Multiple factors contributed to our success, including strong beauty sales during the holiday gift season across various categories and channels. Our prestige brands, known for high quality and authenticity, offered compelling products that resonated with consumers globally. We strategically focused our resources on priority areas within our growth engines to broaden our targeted consumer reach by investing in fast-growing nations and channels where consumer engagement is growing. Additionally, we enhanced our digital capabilities, improved in-store displays, and implemented new technologies to modernize the consumer experience. Strong execution by our talented global teams was essential to our success. Our winning strategy benefitted numerous areas of our business, with brands accounting for 95% of our sales posting gains this quarter; brands making up half of our sales experienced double-digit growth. Each of our three largest brands, Estee Lauder, Clinique, and MAC, achieved record sales, with all reflecting double-digit growth. Estee Lauder stood out with excellent performance, and Clinique and MAC showed solid global growth. Sales increased in about 80% of our markets and in nearly all channels. Our strategy focusing on high-performing categories and leveraging consumer preferences for innovative products and services is proving effective. Both skin care and makeup, our largest and most profitable categories, exhibited strong double-digit growth, providing robust engines for our business. The revitalization in skin care, which started about six months ago, accelerated, making it our best-performing category. Estee Lauder and La Mer brands led skin care growth with remarkable performances in every region. We have enhanced our skin care innovations, creating products that deliver immediate benefits and long-term effectiveness, appealing to key demographic segments, including millennials and ageless consumers. Despite a decline in global consumption, we've maintained our focus on skin care due to anticipated demand rebound and have taken steps to strengthen our offerings in critical subcategories, now seeing renewed interest in our brands. Our makeup strength came from brands like Tom Ford and MAC, with international growth in our makeup portfolio. The acquisition of Too Faced and BECCA, shortly before the previous year's second quarter, also contributed incrementally to our growth. Estee Lauder was among our top performing brands, posting double-digit growth for the third consecutive quarter, with widespread gains in every category, region, and most markets, particularly online, in China, and in travel retail. Estee Lauder's digital-first approach and social media strategy were instrumental in reaching younger consumers. The brand's emphasis on hero products yielded impressive results, with seven top franchises experiencing double-digit growth in the first six months of this fiscal year. Estee Lauder exemplifies a heritage brand benefiting from consumer loyalty through successful innovation around core products. Although we face strong competition from emerging brands, we believe that many lack the same loyalty and repurchase rates that our established brands possess. Trial often serves as an investment, with loyalty as the primary driver of profitability. Momentum persisted in our luxury portfolio, with high demand globally. As economies continue to improve, we anticipate our luxury brands will keep climbing. La Mer, Jo Malone, and Tom Ford each recorded double-digit growth across online platforms, travel retail, and European and Asian markets. Some midsized brands, including Origins, were top performers and contributed to skin care growth. From a channel perspective, our online travel retail and specialty-multi segments both continued strong growth, with double-digit sales climbs. Our online business surged in all regions, particularly in Asia-Pacific, where sales nearly doubled. Tmall has become a significant platform for our e-commerce in China, where sales flourished. This marked MAC's first holiday season on Tmall, providing a boost to online sales in Asia. La Mer also drew many new consumers on Tmall during Singles' Day, and we plan to introduce more brands on the platform this fiscal year. In North America, key shopping periods like Black Friday and Cyber Monday were vital for our online business, with substantial growth in sales on our brand and retailer sites. Mobile sales rose over 70%, with mobile live chat usage increasing fivefold compared to last year. Our online teams tailored local offers during this global shopping event. We continue to expand our online presence, now available in 38 countries, roughly one-quarter of our brick-and-mortar markets, promising future growth potential. Travel retail growth is largely driven by Asia and our five largest brands, all achieving strong double-digit rises in this channel. Our investments in emerging markets and the growing number of Chinese tourists contributed to this success. Demand generated in major local markets also influences travel corridors positively. Chinese consumers are gaining market share across all corridors and skin care, with increasing numbers of Brazilian travelers bolstering our presence in Europe. We are expanding our less-distributed brands to more airports, enhancing our broader portfolio. Most growth this quarter stemmed from like-door increases. We are benefiting from initiatives designed to enhance conversion rates among travelers, pushing more purchases. We introduced new capabilities focusing on improved shopper insights, merchandising, and enhanced digital marketing strategies to cater to travelers. Anticipating ongoing strong channel growth both in the immediate and long term, we expect solid passenger growth, particularly among Chinese consumers driving global luxury spending. The specialty-multi channel is still witnessing significant traffic. Some brands are strategically positioning themselves in consumer-rich areas by entering select specialty-multi retailers, expanding their consumer reach. Brands like MAC and Estee Lauder succeed in attracting new consumers to this channel, as evidenced by their growing availability in the U.S. Recent second-quarter highlights include Jo Malone launching in Sephora in France and Italy, Clinique expanding its presence in Korea with [indiscernible] and Boots, MAC opening in MECCA in Australia, and Too Faced strengthening its foothold in Sephora internationally. Our freestanding stores are expanding internationally, though market performance varies. We aim to boost productivity, opening new stores in markets with limited distribution options. Some brands are testing new retail formats creatively, such as Estee Lauder refining its store concept and achieving strong sales momentum throughout Asia, debuting a new store in Milan, its first in Western Europe. Tom Ford opened its first beauty-exclusive store in London, merging luxury with technology, yielding positive initial results. Furthermore, MAC and Bumble and bumble launched a full-service makeup and hair studio in Dallas. Now, let's discuss regional performance. Asia-Pacific showed the highest percentage growth, particularly in China, where we experienced remarkable growth across categories and channels, with nearly every brand achieving double-digit gains, notably MAC and Tom Ford, whose businesses more than doubled. Estee Lauder, our biggest brand in China, also saw impressive growth. In Hong Kong, we recorded double-digit sales growth, our best second-quarter performance in five years. This was driven by a resurgence in local spending and an increase in inbound Chinese visitors. Successful holiday promotional programs and popular products contributed significantly to our sales. Most countries in Europe, the Middle East, and Africa recorded sales growth, particularly in Italy, where we grew five times faster than the prestige beauty sector. We also saw significant growth in Benelux, the Balkans, and the Nordic regions but faced challenges in the U.K. and Germany due to declining brick-and-mortar sales. The Middle East remained difficult, with retail sales setbacks. Our investments in emerging markets for distribution and digital marketing are proving effective, with notable growth in India, Turkey, Russia, and Brazil. We are ready to leverage these investments as these markets continue developing. Solid sales growth in North America was supported by the new brands, Too Faced and BECCA, alongside strong online sales through retail and brand sites, though we still face challenges from the slowdown in U.S. department store sales. While our business in these stores declined, we saw improvements compared to the first quarter, with our brands driving store traffic through influencer events and special promotions. Our holiday gift sets were met with positivity; Clinique attracted new customers with appealing products at competitive price points, while Estee Lauder's popular annual Blockbuster gift set sold out in the U.S. before season's end. Social media has proven to be the most effective tool for our brands in consumer engagement. We excel at collaborating with relevant influencers to create engaging content and generate traffic. For instance, Tom Ford launched a successful lipstick collection in Shanghai, featuring a celebrity-influencer event, driving significant growth across digital platforms and generating millions of engagements, even being showcased by Vogue China online. Such initiatives across our brands have kept us at the forefront of social media. In the past quarter, we ranked as the top prestige beauty company in earned media value in the U.S. according to various metrics. We continue to embrace new technologies aimed at enhancing the consumer experience, with Estee Lauder collaborating with Google to provide voice-activated nighttime skin care advice via Google Assistant, extending an intimate service into the home. We are also advancing groundbreaking technology for skin care and foundation products, and these innovations are accelerating; we are enthusiastic about the scientific advances in products that will support our growth and market share gains. Overall, global economies are in good health, which should sustain consumer demand. We anticipate strength in Asia and emerging markets, with the U.S. economy projected to accelerate due to forthcoming tax cuts. We expect to benefit from increased consumer spending online, although we predict continued challenges for brick-and-mortar retail in the U.S. In this global context, we remain cautious about potential political and social risks, including Brexit. As we pursue growth, we remain committed to enhancing cost savings and efficiencies. Our Leading Beauty Forward initiative is on track, showing initial positive results and enabling swift reallocation of resources and talent to our top-priority areas. With stronger leverage on our higher sales, we are focused on maintaining our earnings growth. In conclusion, I want to express gratitude to our global teams for their hard work, spirit of challenge, and remarkable performance, which have brought us numerous successes this quarter. We are incredibly proud of our talented workforce and their dedication to excellence in execution. The combination of our excellent results and the new U.S. tax legislation gives us a chance to invest in our people by accelerating benefits and rewards aimed at attracting, retaining, and motivating employees worldwide. We will solidify our plans in the coming months. As we head into the second half of our fiscal year, we feel well-prepared and optimistic about the state of global prestige beauty, confident in our continued leadership. To sustain our momentum, we intend to invest in accelerating categories, continue to drive our various growth engines, and improve our efficiency and productivity while seizing new global opportunities.

Thank you, Fabrizio, and good morning everyone. Before we review the financial results and expectations for the balance of the year, I'd like to take a few moments to discuss the implications for our Company of the recently enacted Tax Cuts and Jobs Act. We believe the legislation allows us to build on our strength. We are a significant employer in the U.S. and a net exporter, with our headquarters here in New York City, and manufacturing, research and development, and distribution facilities in Minnesota, New York, and Pennsylvania. The Tax Act will provide us with greater flexibility to deploy our cash more efficiently around the world and certainly here in the U.S. This further reinforces our already strong capital structure, high return on invested capital, and effective deployment of our resources. The reduction in the U.S. statutory rate supports the continuation of the downward trend we have already seen in our global effective tax rate over the past few years. It will also allow us to realize better returns on our recent strategic acquisitions and minority investments. In the second quarter, we recorded three one-time items related to the new tax legislation which we consider nonrecurring. The first is a charge of $325 million, equal to $0.86 per share, related to a tax on historical foreign earnings that have not been repatriated to the U.S. The effective tax rate is 15.5% for liquid unrepatriated earnings generally held as cash and cash equivalents and 8% on earnings that have been reinvested in foreign operations. The cash impact of this tax is payable over eight years. The second is a charge of $51 million, equal to $0.14 per share, related to the re-measurement of U.S. net deferred tax assets at the lower statutory rate. The third charge of $18 million, equal to $0.05 per share, reflects the establishment of a net deferred tax liability for withholding taxes related to the expected repatriation of certain foreign earnings. It is important to note that these charges, the combined impact of which is $394 million or $1.05 per share, are provisional and may require adjustment within the allowable one-year measurement period. The tax bill is complex, and the final impacts may differ from these estimates due to changes in the regulatory interpretation of the Tax Act. Now regarding our global effective tax rate for fiscal 2018, it is estimated to decrease to approximately 24%. This takes into account the reduction in the U.S. statutory rate, as well as our geographic mix of earnings and the year-to-date impact of the change in accounting for share-based compensation we discussed with you last quarter. Additional provisions of the Tax Act become effective for us in fiscal 2019. We are continuing to review these impacts, which include additional provisions affecting taxes on our foreign earnings and the loss of certain deductions. Including these impacts, at this time we estimate that the fiscal 2019 effective tax rate could be between 23% and 24%. Overall, we have a smaller effective tax rate benefit than some other companies. The increased flexibility in liquidity, however, provides greater strategic support for our long-term sustainable growth. We expect further clarification on the tax legislation as the remainder of the fiscal year progresses, and we will update you on the expected tax rate for fiscal 2019 in August when we also provide you with our guidance for the next fiscal year. As it relates to cash and cash investments, at the end of December we had $3.4 billion of cash and liquid investments outside of the U.S. The ability to repatriate our global liquidity when needed could provide additional financial agility to an already strong balance sheet. We will seek to maximize those repatriations in the most efficient manner, if not all of the cash is available to immediately repatriate to the U.S. As our cash needs in the U.S. generally exceed our cash generation, greater access to our global cash reduces our reliance on debt to fund seasonal working capital, dividends, and other priorities. Our strong balance sheet has provided us with the financial flexibility to fund our growth opportunities, and our capital allocation strategy has generated strong returns on invested capital over the past several years. Our priorities for capital deployment to drive shareholder value remain unchanged and include investing in our business to support our profitable growth strategy, strategic acquisitions that we believe can earn a strong return on invested capital for our shareholders and enhance our global position in prestige beauty, and returning excess free cash flow to shareholders via a combination of share repurchases and dividends. Now, I'll move on to our financial results for the second quarter. I'll remind you that my commentary excludes the impact of restructuring and other charges and adjustments primarily related to our Leading Beauty Forward initiative and the U.S. tax legislation which I just discussed. Net sales for the second quarter were $3.74 billion, up 14% in constant currency compared to the prior year period. This outstanding performance was broad-based across our business. Every region and most countries contributed to growth, with exceptional performance in Asia Pacific and travel retail. Every product category grew, led by a strong resurgence in skin care, double-digit growth in makeup and fragrance, and solid results in hair care. Incremental sales from Too Faced and BECCA contributed approximately 2 percentage points of this growth, which means our organic growth accelerated this quarter to 12%. Our gross margin declined 40 basis points compared to the second quarter last year. The unfavorable impact of our fiscal 2017 acquisitions was 55 basis points, which was partially offset by supply-chain efficiencies of 15 basis points. Operating expenses as a percentage of sales improved 70 basis points. Higher investments in advertising and promotion expense were more than offset by lower selling expenses, which reflected both our channel mix shift and our ongoing success in reallocating resources through Leading Beauty Forward, as well as productivity improvements and indirect procurement. As we indicated last quarter, the change in the timing of stock compensation expenses adversely impacted operating expenses in the second quarter and is expected to have an additional impact in the third quarter. Operating income rose 19%, and operating margin increased by 40 basis points to 20.9%. Our effective tax rate this quarter, before restructuring charges and the one-time charges from the tax legislation, was 24.4%, a 450 basis point improvement from the prior year quarter. The rate improved primarily due to a favorable geographic mix of earnings as well as the impact of the lower U.S. statutory rate. Diluted EPS of $1.52 increased 25% compared to the prior year and grew 23% in constant currency. Earnings per share for the quarter included $0.03 of favorable currency translation. The strong EPS performance reflected the continued outstanding results from our Asia-Pacific and travel retail businesses, our innovation success in skin care, and the momentum in expense management and cost savings programs. We are obviously pleased with our first half results, with our net sales increasing 14% in constant currency and diluted EPS rising at more than double the net sales rate at 30% in constant currency in our first six months of the fiscal year. Our free cash flow nearly doubled as well, as we generated $1.45 billion in net cash flow from operating activities in the first half and invested $263 million in capital expenditures. We used $398 million to repurchase 3.5 million shares of our stock and paid $267 million in dividends. So now let's turn to our outlook for the third quarter and the full year. Given the strength of our first half performance, we are again raising our full-year guidance. We expect continued strong execution to drive performance in our second half as well, even as our growth comparisons become more difficult. Too Faced and BECCA are now in the base year of comparison and will therefore be part of our organic growth going forward. We are also comparing to the strong acceleration in growth in China, Hong Kong, and travel retail that began in the second half of last year, and we are slightly more cautious on the brick-and-mortar retail environment in North America and the U.K. And it is always worth noting that as a global enterprise, there will continue to be a number of macro and geopolitical risks, which are outlined in our press release and which Fabrizio referred to as well. That said, we are raising our sales growth expectation for the fiscal 2018 full year to 10% to 11% in constant currency. This includes approximately 2 points of growth from the incremental sales from Too Faced and BECCA. Currency translation is expected to benefit reported sales growth by 2.5 percentage points, reflecting weighted-average rates of $1.19 for the euro, $1.33 for the pound, and 112 for the yen for the fiscal year. Our Leading Beauty Forward initiative and our cost savings programs have excellent momentum and continue to evolve. For example, we continue to reallocate resources to strengthen our capabilities in global digital marketing, which amplifies our ability to connect more directly with consumers. We've also made progress streamlining some of our global functions. We expect to continue to maintain this flexibility to invest a portion of the sales leverage in savings into our brands and markets where we have experienced strong momentum, as well as areas of strategic importance, while also expanding our operating margin. We are raising our EPS expectations to a range of $4.27 to $4.32 before restructuring and other charges, and the one-time charges associated with tax legislation. This includes approximately $0.15 of benefit from currency translation. In constant currency, we expect EPS to rise by 19% to 20%. At this time, our effective tax rate is expected to be approximately 24% for fiscal 2018. This reflects the blended U.S. statutory rate of 28% from the new U.S. tax legislation, which was effective as you know January 1. For the fiscal 2018 third quarter, our sales are expected to rise by approximately 9% to 10% in constant currency. Currency translation is estimated to add approximately 3 percentage points. EPS is forecasted to be between $1.02 and $1.04 before restructuring charges. This includes an approximate $0.06 benefit from currency. Our expectations for double-digit growth in both sales and earnings per share for our fiscal year reflect the strength of the execution by our talented global teams and the investments we have made, focused particularly behind successful innovations. We will continue to support our abilities to invest in our growth priorities as we also continue to deliver cost savings and expense leverage with our Leading Beauty Forward initiative. All of these elements position us well in the context of accelerating economies around the world.

The U.S. was down about 3% excluding acquisitions, and it seems that conditions in brick-and-mortar stores are slightly improving, but they are still not positive overall. If you could provide the number for how the U.S. performed excluding acquisitions, that would be helpful. Additionally, how quickly is the market in China expanding and how much are you exceeding that growth?

So the U.S. was slightly down ex-acquisitions, and we talked about some of the successes that we had in the U.S. with our holiday programs, which we felt very good about and some of the challenges as it relates to brick-and-mortar in the U.S. Online was up strongly in the U.S. and globally as well. So, mixed results in the U.S. And again, our teams are working quite well with our retailers to try to accelerate growth in the second half of the year and beyond. China?

On China, the China market was growing double-digit, the total market, and we are growing much, much stronger than the market, much stronger than the market. So we are gaining market share in China, and in quarter two was our strongest share market gain in a given quarter in China.

Congrats on the results. I was just following up, I understand the tough comparison that Tracey had mentioned, but embedded in your guidance for the fourth quarter it seems like you are decelerating EPS to about 6% at the top of the guidance. So, I was hoping to get some clarity perhaps on you reinvesting some of the gains that you had in the year into more advertisement or innovation, how should we think about the balance of profitability I should say, because definitely I understand the tough comparisons, so if you can elaborate I would appreciate. Thank you.

As we say, we are delivering, we plan to deliver our margin growth goals for the fiscal year in total. But in the second semester, we are planning to invest in our strengths. And so you mentioned advertising, in absolute terms advertising will increase significantly, particularly in the digital areas in the influencer global strategies and with focus in the markets where there is momentum. So we are investing on strengths. And advertising would also increase a little bit, slightly in terms of percentage of sales. But we are also investing in technologies which are driving our business drivers. We are investing in reinforcing our analytics, which are driving our ability to make choices on the business that I believe this quarter proves they are becoming sharper and sharper every time. We are investing more in the key markets where we see momentum and in subcategories where we see momentum, and obviously on our key brands and hero products and the hero product franchise strategy that we are pushing, which is working so well. And we will continue to invest online where we see strong growth both in the area of our brand dotcom and in the retailer dotcom with all our partners. So, we will continue to invest in our strengths and we plan to solidify and make sustainable the strong accelerated growth trends.

Fabrizio, this is very helpful. You mentioned digital. So the question that we all asked back in the last call was about Amazon. So you mentioned that it wouldn't be included, if anything, this fiscal year. How do you feel, like because you are increasing investments in digital, are you feeling that is going to be a decision that will remain independent, basically you will remain independent in your digital investments in terms of channel?

Yes, we are not changing our strategy. We continue to invest in our brand dotcom, in our retailer dotcom, and in the platforms where we control our assets and our destiny.

This is Russ Miller on for Nik. We wanted to ask on Leading Beauty Forward. Are you seeing any specific new opportunities that perhaps you did not see initially?

Great question. Yes, we actually have seen new opportunities. So there has been relative to Leading Beauty Forward we launched almost two years ago now, and I think I have mentioned and Fabrizio has mentioned on previous calls, we've gotten quite a bit of engagement throughout the organization for the program and it's allowed us to move forward in a lot of areas as it relates to changing some of our organization structures to be a bit more efficient and more leveraged as well as bringing new capabilities into the organization along with reducing costs. So we have added some programs to Leading Beauty Forward.

Good morning and congratulations. I had a couple of questions. First, just trying to understand, on the BECCA and Too Faced in the quarter, they contributed a couple of points of growth. I think the plan initially was for 3 points. I know it's not significant, but was there anything that changed versus what you expected with the competition? And then, Fabrizio, for you, if you talk about reinvesting in expanding some of these newer brands like a Too Faced internationally, can you just help outline for us what the intermediate roadmap can look like there?

I think I can answer the two questions in one. Basically, we are still in line with our plans on Too Faced and BECCA, and we are very happy with how these brands are performing within our portfolio, and particularly they are filling one of our strategic priorities, which is to increase our market share in the specialty channel globally, and this is really, really working. In terms of how the plan changes, the plan changes continuously, our big strength is the agility to adjust the plan when we see market variation. So in that sense, Too Faced has been growing less than what we originally thought in the U.S., and we have been accelerating, on the contrary, the growth internationally more than what we thought, and that's why in the short term it is likely different impact on profitability because the international expansion is slightly more expensive than the North America expansion. But those are variations of agility within the overall plan, which we are very happy with.

Okay. And then if I could just ask one for Tracey on the gross margin, now that you are lapping acquisitions, could you just help us think about the back half outlook, what are you seeing in terms of input costs versus some of the supply-chain efficiency opportunities you've been delivering on?

So, it's a great question. We don't expect to see the year-over-year reductions and negative impact on our gross profit margin now that we are lapping the acquisitions in the second half of the year. We do expect some increases in input costs as well. There will be a bit of a delayed impact from that, but we certainly are mindful of fuel prices going up and the impact that that could have on us, as well as a few other input costs. But in general we are expecting slight favorability in our gross margin for the balance of the year.

Maybe turning back to China, I was just hoping you could just compare the same-store sales trends that you saw in the second quarter to those that you saw in Q1, because I think they were up over 30% in the first quarter, I'm just trying to figure out how they compare. And more broadly, I'm just wondering if you would characterize demand in China as sort of comparable on a sequential basis or whether you are seeing actually signs of further underlying improvement, obviously adjusting for the seasonality, because I think we are all just trying to understand how sustainable the strength that you're seeing in China is when we normalize it out over the next 12 to 18 months. And maybe perhaps as you comment on that, you could just expand on how much benefit you think maybe the categories been receiving this year from the lower import taxes, and then Tracey, maybe just tactically whether you see any benefit in the third quarter of this year for maybe a later Chinese New Year?

I mean, to answer your China expectation is a difficult question to answer in the long-term, but we believe that double-digit growth is sustainable. That's basically the bottom line. Prestige beauty has been growing double-digit in China in the past five quarters, and to your question, it is accelerating. We see the market in quarter two was stronger and our performance was stronger than previously, so the reason for the acceleration. What is driving this acceleration? Yes, there's been an impact on the duty reduction on the pricing in the country that we all have executed, and this probably is passing through what's happening in the market and building the consumption. And that is not only that; it is also the digital economy and the impact of social media are strong and are getting better, and we are getting very good in executing this. Our team in China is executing in a fantastic way, and a lot of the great results have to be attributed to their talent in executing our programs. The other aspect is pretty simple, we are not increasing the number of cities and we are not increasing distribution in quarter two in a very big way. The majority of the growth has been same-store. And the other interesting aspect is that China is leapfrogging the model of many other big markets like the United States. In which sense? In the sense that the department store, the brick-and-mortar is still very focused in high-traffic areas. For example, we are only in 170 cities. Today we serve consumers from 650 cities because the remaining cities we serve via online. That's why, in China, online is already 27% of our sales in quarter two, which is making the growth in China pretty productive and the ability to make it sustainable in my opinion better. So in a nutshell, we believe that double-digit market growth should be relatively sustainable, obviously subject to some shorter up and downs, and we believe we have a very solid position, and this solid position should continue.

And regarding Chinese New Year, it is a few weeks later this year than it was last year. So we do expect to see slight, both from anniversarying a stronger acceleration last year, as well as on a later Chinese New Year this year, a bit of mitigated growth in the third quarter from China because of that.

Can you talk about how many countries some of these brands that are on fire in, like Too Faced, Tom Ford, how many countries are already in and how much more opportunity there is? And then in terms of e-commerce, how does the mix of your sales differ versus brick-and-mortar? Is it more skin care heavy versus makeup? Is it new customers or existing, or is it a consumer who is trying something new or existing who is replenishing? And as more consumers move online, how do you expect that mix to potentially shift?

I'll start from the second question. So, our online business is strong across, but the strongest categories are skin care and makeup, and the business has a slightly higher percentage of replenishment and repurchase than the brick-and-mortar, which means that the growth online of hero products or franchises that have good loyalty is very important, and is very strong. Said in our way, a strong position online allows better loyalty and better repurchase, so it allows the brand to be stronger and more profitable over time. In terms of the global distribution of brands?

So, Olivia, we still have quite a bit of upside. Too Faced, in particular, is still largely a U.S.-based brand. We have started the plans to rollout internationally, and given the potential that we believe the brand has, actually are accelerating those plans over the second half of the year and into fiscal 2019. Our most broadly distributed brands are Estee Lauder and Clinique, and as we said, Estee Lauder has experienced double-digit growth in the second half. So, distribution certainly is a factor in growth, but also strong consumer engagement and strong innovation can drive even a more broadly distributed brand to grow, as we are seeing with Estee Lauder and Clinique growing this quarter, as did MAC. So we have, with our 30 brands, quite a bit of flexibility. We talk about multiple engines of growth, and we've certainly built that over time from a Company standpoint, both brands, regions, and obviously channels, and we are executing against that, I think as you can see from our quarter results and our year-to-date results.

Yes, but to give you a general perspective on digital distribution, some of our brands today are in one-tenth of the distribution of Lauder and Clinique; some others, in one-fifth. So, if the benchmark will be Lauder and Clinique, there will be infinite opportunity for the distribution. But the reality is that we have a different distribution target by brand, and some brands, particularly our luxury brands portfolio, will be eased and will continue to be less distributed and more focused and more selective than our broader distributed brands. So, it's a complex portfolio, and it's very selected distribution by brand that is what we are aiming; but the key point is there is further opportunity of distribution in our portfolio.

Nice quarter, guys. I guess one question that will kind of dovetail into the second: maybe if you could talk just about the working capital improvements that you saw in the quarter, the free cash flow, how we are thinking about that going forward? And then when we think about the proceeds of free cash flow while we are lapping Too Faced and BECCA, where do you see, and I wouldn't call them holes in the portfolio, but where you can continue to strengthen the portfolio including maybe opportunities if there are any tail-brands in the portfolio to divest, just how you are thinking about where the portfolio could be maybe a couple of years from now?

So, on the working capital, thank you for recognizing that we did have improvements in working capital, both in terms of our inventory days to sell and certainly payables also. So, we continue to have many strategies across the organization to improve working capital, and we expect that to continue over the next few years, ongoing improvements in working capital. As it relates to our capital allocation decisions, and I talked about some of that in our prepared remarks, but our M&A strategies, we certainly feel very good about the portfolio we have. We have identified some whitespace areas that, if the right assets become available, we, given our strong balance sheet and strong cash flow, would certainly entertain those acquisitions if they have the right return on invested capital.

And our M&A strategy is pretty articulated, and we have also minority investments that may become available in the next year, so which are already part of our articulated portfolio strategy. And so, our priority is fielding our strategic opportunities and doing it only with brands that are strong enough for doing it, and obviously which are available at the right level of return on invested capital; and this will continue. So how do we see our portfolio in the long term? Stronger, better, and better covering all our key strategic opportunities to help us deliver the real ultimate goal of sustainability, which is a multiple engine growth, well-diversified portfolio which is covering the key long-term opportunity that we analyze and envisage with our complex strategic process.

Congratulations from me on an amazing quarter. On China, I was wondering how many consumers you think you are actually reaching, in the sense of how many are buying your product today versus five or six years ago, and how much of your growth do you think will come just from middle class Chinese increasing and entering into your price points? The second point on that is, for many brands we've seen local competitors get stronger and eat away market share, but it actually seems like the reverse is happening even with Korean skin care being maybe less fashionable than it once was; if you could just comment on that? And I'm sorry but a final one, what are you doing in bricks-and-mortar to renovate the stores, where are you having success with that?

So, a lot of questions. How many consumers in China? Frankly, our business in the last year has been growing exponentially, and so we touch probably five times or ten times the number of consumers that we've been touching two years ago, depending on where you start the benchmark. So, the growth is exponential. And what I want to – rather than a number that frankly would not be the right way to answer, but conceptually what's happening is two things. There are more and more consumers which are entering quality products among the Chinese consumers, they are going for quality. And going for quality they choose more and more many of our brands and particularly our hero franchises. And then there is a great repeat purchase which is increasing. So, it's not only more consumers, which was the heart of your question, but it's the same consumer using more of their total usage with high-quality products in our portfolio. As you know, Chinese have a very intense regimen of products in skin care, and so they use depending obviously by person up to seven or eight products of skin care per day. So the more you can penetrate that regimen, the more the growth is there and exponential. So, we are acting on two levels: yes, growing the number of consumers and also growing the penetration of the portfolio usage of each consumer. The second thing is the growth of consumers in Tier 2, 3, and 4 cities; this is exponential. And the reason why it's accelerating, as explained before, is because even if the physical distribution is not reaching these consumers, the online distribution is, and so there are more and more consumers, millions and millions of consumers getting more and more access to our products via the online distribution, and this is very, very important. And that's why we focus so much on quality of products, on safety of products, on the amazing hero franchises, because at the end it's not just conquering a consumer for one time; it's conquering loyalty and a repeat purchase of satisfied consumers, and that's what makes the business sustainable in China like in any other emerging market. Then you asked what we do on brick-and-mortar, what we do, we renovate. Tracey, do you want to cover that?

Yes, we are continuing to renovate our freestanding stores. In fact, as we said in the prepared remarks, one of the big focus areas for the Company is improving the productivity of our freestanding stores. So, in some of the MAC stores, for instance, we have converted them to open style. We are testing out services in freestanding stores and investing in capital as it relates to that. So there is continued remodeling in addition to opening new doors, primarily in EMEA and APAC, and really the focus on renovations in the U.S. in terms of some of the tests.

I just want to confirm a few things to make sure I understood them correctly. The first one is on the top line implied guidance for Q4. It's about 5%. Are you okay with that, or are you saying that you are going to invest more to boost that number? I understand a tough compare, but I just want to make clear what you said. Secondly, BECCA and Too Faced, it was expected to be 3% of the growth; it was 2%. You kind of addressed this a little bit in one of the previous questions. But what is the underlying growth of BECCA and Too Faced today? Is it still in that kind of 70% to 80% range? And one more, maybe those two I'll let you answer and then I have one more.

So, in terms of Q4, you're correct that the implied growth is in the mid- to high single digits for Q4, and we are anniversarying a very strong Q4 from last year, Ali. We will continue to invest in Q4 in higher advertising and promotion, more in Q3 than in Q4, but we have a tremendous amount of momentum as we have indicated in certain markets and behind certain innovations, and we'll continue to invest for the balance of the year against that.

And on this, I just want to clarify just the process that we go through. We analyze this; we analyze our risks, our opportunity in this 5%. There is a lot of our point of view on the base, as Tracey explained, the base period and the risks which are in front of us, including some risks specifically in the U.S., Bon-Ton announcement, and many other things which are in this number. But anyway, our teams are always charged to beat our estimates. That's just the way we work. So, to answer your question: are you trying to beat this number? Yes, every time; that's exactly the way our organization works. We are trying to mitigate the risks and better perform on our implementation. In terms of BECCA and Too Faced, no, they are not growing 70%, if that's the question, and they are growing more in line with what the expectation will be over the long term. In the calendar year 2017, it was our first calendar; they grew double digits, and that was what we wanted. And then by month, by quarter, up and downs depending on the competitive environment. I think that's why we are doing faster than what we thought also on these two brands—the creation of multiple engines of growth, meaning the internationalization of the brands and the acceleration particularly of the online platforms of the brands where we have plenty of opportunities to improve and accelerate. So, we are going to invest and focus on creating more engines of growth also on those two brands in the next steps, as was originally planned but faster than originally planned.

Okay, thank you. And then my last question was just around SG&A. Clearly, it's good; it's down again 70 basis points. I feel less down than it has been, and I totally remember and get the share-based compensation comment, but if you could help us kind of figure out the components of that underlying the SG&A reduction, and in particular if it relates at all going forward to a comment you made just at the end, Tracey, of employee benefits and reward plan you were thinking about and will give more detail, you said that in your prepared remarks?

Yes, so clearly we are exploring some options, as Fabrizio said, as it relates to employee benefits, and that is embedded within our guidance. But in terms of the full year SG&A, what I indicated was we are seeing a tremendous amount of growth from travel retail as well as online, so just mix obviously impacts our selling expense. And beyond that, we have done a fair amount of work in terms of selling effectiveness, both to provide our selling teams with the tools to enhance their productivity as well as making sure we've got the right investment for the volume growth that we are experiencing across different channels that have selling in them. So that is the largest leverage, if you will, of expense. The other is employee productivity, so we have also leveraged our G&A expense as it relates to employee productivity.

I had a question on prestige beauty in the U.S. and the growth you are seeing currently and your outlook for the category as well as the consumer this year, and then if you guys could frame that for us given the slowdown we are seeing in mass beauty, that would be helpful. I guess I'm trying to understand if it's realistic to assume the prestige beauty category growth could accelerate this year and curious to hear how you think about the opportunities for increased purchases and possibly up-trading given the health of the consumer.

So, I'm not sure exactly what the question is, the U.S. growth, what we expect about prestige beauty in the U.S. So, the overall prestige beauty market in the U.S. is solid, and we expect this to continue to be solid and possibly to accelerate because of the new consumption trend that the consumer is setting. So, the overall consumption is positive and accelerating. Where is more the consumption happening? And the consumption is happening more and more online. And so we see very good performance of the retail dotcom of most of our customers, including department stores which are having excellent performance there. We see a strong growth of our brand dotcom. We see some great performance in some specialty retailers. But where we still see the traffic not picking up for beauty in the level we would like is the physical distribution of certain retailers, particularly in the area of department stores. And we see some potential changes, like the recently announced change of the Bon-Ton department store chain, that will impact store closures and reallocation of resources. So, the market is solid, but the physical retail environment is subject to continuous evolution and challenges. And so, since we have an over-proportional exposure to the physical department store distribution in the U.S., that's where our prudence on the estimate for that part of the market comes from, not from the consumption. The consumption is relatively solid.

Thank you everybody for participating in our call. And again, we are pleased with our results and incredibly pleased with the performance that our teams generated in the first half of the year, and we look forward to the second half of the year.

Yes, thank you, thank you to everybody and thank you to our teams.