Estee Lauder Companies Earnings 2018-12-31

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

(Mark One)-

x      Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the quarterly period ended December 31, 2018

 

OR

 

o         Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the transition period from               to              

 

Commission file number: 1-14064

 

The Estée Lauder Companies Inc.

(Exact name of registrant as specified in its charter)

 

 

212-572-4200

(Registrant’s telephone number, including area code)

 

Not Applicable

(Former name or former address, if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

 

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).  Yes x  No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer x	Accelerated filer o
Non-accelerated filer o	Smaller reporting company o
	Emerging growth company o

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

 

At January 29, 2019, 218,255,377 shares of the registrant’s Class A Common Stock, $.01 par value, and 142,907,134 shares of the registrant’s Class B Common Stock, $.01 par value, were outstanding.

 

 

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THE ESTÉE LAUDER COMPANIES INC.

 

INDEX

 

	Page
Part I. Financial Information
Item 1. Financial Statements (Unaudited)
Consolidated Statements of Earnings —
Three and Six Months Ended December 31, 2018 and 2017	2
Consolidated Statements of Comprehensive Income (Loss) —
Three and Six Months Ended December 31, 2018 and 2017	3
Consolidated Balance Sheets —
December 31, 2018 and June 30, 2018 (Audited)	4
Consolidated Statements of Cash Flows —
Six Months Ended December 31, 2018 and 2017	5
Notes to Consolidated Financial Statements	6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	35
Item 3. Quantitative and Qualitative Disclosures About Market Risk	58
Item 4. Controls and Procedures	58
Part II. Other Information
Item 1. Legal Proceedings	59
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	59
Item 6. Exhibits	59
Signatures	60

 

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PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements.

 

THE ESTÉE LAUDER COMPANIES INC.

 

CONSOLIDATED STATEMENTS OF EARNINGS

(Unaudited)

 

		Three Months Ended December 31						Six Months Ended December 31
(In millions, except per share data)		2018			2017			2018			2017
Net sales		$	4,005		$	3,744		$	7,529		$	7,018
Cost of sales		910			753			1,733			1,464
Gross profit		3,095			2,991			5,796			5,554
Operating expenses
Selling, general and administrative		2,257			2,214			4,265			4,174
Restructuring and other charges		29			67			70			101
Goodwill impairment		20			—			20			—
Impairment of other intangible assets		18			—			18			—
Total operating expenses		2,324			2,281			4,373			4,275
Operating income		771			710			1,423			1,279
Interest expense		35			32			69			63
Interest income and investment income, net		12			12			27			24
Other components of net periodic benefit cost		—			—			—			1
Earnings before income taxes		748			690			1,381			1,239
Provision for income taxes		171			565			302			684
Net earnings		577			125			1,079			555
Net earnings attributable to noncontrolling interests		(4		)	(2		)	(6		)	(5		)
Net earnings attributable to The Estée Lauder Companies Inc.		$	573		$	123		$	1,073		$	550
Net earnings attributable to The Estée Lauder Companies Inc. per common share
Basic		$	1.58		$	.33		$	2.94		$	1.49
Diluted		$	1.55		$	.33		$	2.88		$	1.46
Weighted-average common shares outstanding
Basic		363.3			368.7			365.1			368.5
Diluted		369.9			376.1			372.1			375.7

 

See notes to consolidated financial statements.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited)

 

		Three Months Ended December 31						Six Months Ended December 31
(In millions)		2018			2017			2018			2017
Net earnings		$	577		$	125		$	1,079		$	555
Other comprehensive income (loss):
Net unrealized investment gain (loss)		3			(6		)	5			(7		)
Net derivative instrument gain (loss)		9			4			9			(5		)
Amounts included in net periodic benefit cost		4			5			7			10
Translation adjustments		(38		)	28			(15		)	82
Provision for deferred income taxes on components of other comprehensive income		—			(3		)	(3		)	(2		)
Total other comprehensive income (loss)		(22		)	28			3			78
Comprehensive income		555			153			1,082			633
Comprehensive income attributable to noncontrolling interests:
Net earnings		(4		)	(2		)	(6		)	(5		)
Translation adjustments		1			—			1			(1		)
		(3		)	(2		)	(5		)	(6		)
Comprehensive income attributable to The Estée Lauder Companies Inc.		$	552		$	151		$	1,077		$	627

 

See notes to consolidated financial statements.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

CONSOLIDATED BALANCE SHEETS

 

		December 31			June 30
(In millions, except share data)		2018			2018
		(Unaudited)
ASSETS
Current assets
Cash and cash equivalents		$	1,876		$	2,181
Short-term investments		525			534
Accounts receivable, net		2,000			1,487
Inventory and promotional merchandise, net		1,651			1,618
Prepaid expenses and other current assets		388			348
Total current assets		6,440			6,168
Property, plant and equipment, net		1,859			1,823
Other assets
Long-term investments		600			843
Goodwill		1,911			1,926
Other intangible assets, net		1,233			1,276
Other assets		633			531
Total other assets		4,377			4,576
Total assets		$	12,676		$	12,567
LIABILITIES AND EQUITY
Current liabilities
Current debt		$	18		$	183
Accounts payable		995			1,182
Other accrued liabilities		2,763			1,945
Total current liabilities		3,776			3,310
Noncurrent liabilities
Long-term debt		3,373			3,361
Other noncurrent liabilities		1,194			1,186
Total noncurrent liabilities		4,567			4,547
Contingencies
Equity
Common stock, $.01 par value; Class A shares authorized: 1,300,000,000 at December 31, 2018 and June 30, 2018; shares issued: 438,325,994 at December 31, 2018 and 435,413,976 at June 30, 2018; Class B shares authorized: 304,000,000 at December 31, 2018 and June 30, 2018; shares issued and outstanding: 142,907,134 at December 31, 2018 and 143,051,679 at June 30, 2018		6			6
Paid-in capital		4,162			3,972
Retained earnings		9,586			9,040
Accumulated other comprehensive loss		(430		)	(434		)
		13,324			12,584
Less: Treasury stock, at cost; 219,373,382 Class A shares at December 31, 2018 and 211,320,208 Class A shares at June 30, 2018		(9,018		)	(7,896		)
Total stockholders’ equity — The Estée Lauder Companies Inc.		4,306			4,688
Noncontrolling interests		27			22
Total equity		4,333			4,710
Total liabilities and equity		$	12,676		$	12,567

 

See notes to consolidated financial statements.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

		Six Months Ended December 31
(In millions)		2018			2017
Cash flows from operating activities
Net earnings		$	1,079		$	555
Adjustments to reconcile net earnings to net cash flows from operating activities:
Depreciation and amortization		269			256
Deferred income taxes		(46		)	106
Non-cash stock-based compensation		131			132
Net loss on disposal of property, plant and equipment		5			7
Non-cash restructuring and other charges		—			1
Pension and post-retirement benefit expense		35			35
Pension and post-retirement benefit contributions		(12		)	(14		)
Goodwill and other intangible assets impairments		38			—
Changes in fair value of contingent consideration		(9		)	3
Other non-cash items		(13		)	(9		)
Changes in operating assets and liabilities:
Increase in accounts receivable, net		(343		)	(281		)
Decrease (increase) in inventory and promotional merchandise, net		(21		)	66
Decrease (increase) in other assets, net		(53		)	1
Decrease in accounts payable		(174		)	(111		)
Increase in other accrued and noncurrent liabilities		387			692
Net cash flows provided by operating activities		1,273			1,439
Cash flows from investing activities
Capital expenditures		(292		)	(263		)
Proceeds from the disposition of investments		271			609
Purchases of investments		(14		)	(479		)
Net cash flows used for investing activities		(35		)	(133		)
Cash flows from financing activities
Proceeds (repayments) of current debt, net		(169		)	222
Repayments and redemptions of long-term debt		—			(1		)
Net proceeds from stock-based compensation transactions		59			83
Payments to acquire treasury stock		(1,126		)	(398		)
Dividends paid to stockholders		(297		)	(267		)
Payments to noncontrolling interest holders for dividends		(3		)	(1		)
Net cash flows used for financing activities		(1,536		)	(362		)
Effect of exchange rate changes on Cash and cash equivalents		(7		)	25
Net increase (decrease) in Cash and cash equivalents		(305		)	969
Cash and cash equivalents at beginning of period		2,181			1,136
Cash and cash equivalents at end of period		$	1,876		$	2,105

 

See notes to consolidated financial statements.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation

 

The accompanying consolidated financial statements include the accounts of The Estée Lauder Companies Inc. and its subsidiaries (collectively, the “Company”).  All significant intercompany balances and transactions have been eliminated.

 

The unaudited interim consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements.  In the opinion of management, all adjustments of a normal recurring nature considered necessary for a fair presentation have been included.  The results of operations of any interim period are not necessarily indicative of the results of operations to be expected for the full fiscal year.  The interim consolidated financial statements should be read in conjunction with the consolidated financial statements and accompanying footnotes included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2018.

 

Certain amounts in the consolidated financial statements of prior years have been reclassified to conform to current year presentation.

 

Management Estimates

 

The preparation of financial statements and related disclosures in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses reported in those financial statements.  Descriptions of the Company’s significant accounting policies are discussed in the notes to consolidated financial statements in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2018.  Management evaluates the related estimates and assumptions on an ongoing basis using historical experience and other factors, including the current economic environment, and makes adjustments when facts and circumstances dictate.  As future events and their effects cannot be determined with precision, actual results could differ significantly from those estimates and assumptions.  Significant changes, if any, in those estimates and assumptions resulting from continuing changes in the economic environment will be reflected in the consolidated financial statements in future periods.

 

Currency Translation and Transactions

 

All assets and liabilities of foreign subsidiaries and affiliates are translated at period-end rates of exchange, while revenue and expenses are translated at weighted-average rates of exchange for the period.  Unrealized translation gains (losses), net of tax, reported as cumulative translation adjustments through other comprehensive income (loss) (“OCI”) attributable to The Estée Lauder Companies Inc. were $(34) million and $30 million, net of tax, during the three months ended December 31, 2018 and 2017, respectively, and $(13) million and $84 million, net of tax, during the six months ended December 31, 2018 and 2017, respectively.  For the Company’s subsidiaries operating in highly inflationary economies, the U.S. dollar is the functional currency.  Remeasurement adjustments in financial statements in a highly inflationary economy and other transactional gains and losses are reflected in earnings.  These subsidiaries are not material to the Company’s consolidated financial statements or liquidity.

 

The Company enters into foreign currency forward contracts and may enter into option contracts to hedge foreign currency transactions for periods consistent with its identified exposures.  Accordingly, the Company categorizes these instruments as entered into for purposes other than trading.

 

The accompanying consolidated statements of earnings include net exchange losses on foreign currency transactions of $7 million and $17 million during the three months ended December 31, 2018 and 2017, respectively, and $21 million and $35 million during the six months ended December 31, 2018 and 2017, respectively.

 

Concentration of Credit Risk

 

The Company is a worldwide manufacturer, marketer and distributor of skin care, makeup, fragrance and hair care products.  The Company’s sales subject to credit risk are made primarily to department stores, perfumeries, specialty multi-brand retailers and retailers in its travel retail business.  The Company grants credit to qualified customers and does not believe it is exposed significantly to any undue concentration of credit risk.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

Inventory and Promotional Merchandise

 

Inventory and promotional merchandise, net consists of:

 

		December 31			June 30
(In millions)		2018			2018
Raw materials		$	438		$	432
Work in process		191			222
Finished goods		840			798
Promotional merchandise		182			166
		$	1,651		$	1,618

 

Property, Plant and Equipment

 

		December 31			June 30
(In millions)		2018			2018
Assets (Useful Life)
Land		$	29		$	30
Buildings and improvements (10 to 40 years)		269			237
Machinery and equipment (3 to 10 years)		748			719
Computer hardware and software (4 to 10 years)		1,245			1,193
Furniture and fixtures (5 to 10 years)		121			104
Leasehold improvements		2,217			2,152
		4,629			4,435
Less accumulated depreciation and amortization		(2,770		)	(2,612		)
		$	1,859		$	1,823

 

The cost of assets related to projects in progress of $346 million and $300 million as of December 31, 2018 and June 30, 2018, respectively, is included in their respective asset categories above.  Depreciation and amortization of property, plant and equipment was $121 million and $114 million during the three months ended December 31, 2018 and 2017, respectively, and $237 million and $226 million during the six months ended December 31, 2018 and 2017, respectively.  Depreciation and amortization related to the Company’s manufacturing process is included in Cost of sales, and all other depreciation and amortization is included in Selling, general and administrative expenses in the accompanying consolidated statements of earnings.

 

Income Taxes

 

On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (the “TCJA”).  The TCJA includes broad and complex changes to the U.S. tax code that impacted the Company’s accounting and reporting for income taxes.  The impacts under the TCJA in the prior fiscal year primarily consisted of the following:

 

·                  A reduction in the U.S. federal corporate income tax rate from 35% to 21%, effective January 1, 2018, which resulted in a fiscal 2018 U.S. blended statutory income tax rate for the Company of 28.1%.

·                  A one-time mandatory deemed repatriation tax on unremitted foreign earnings (the “Transition Tax”), which the Company elected to pay over an eight-year period.

·                  A remeasurement of U.S. net deferred tax assets.

·                  The recognition of foreign withholding taxes in connection with the reversal of the Company’s indefinite reinvestment assertion related to certain foreign earnings.

 

Staff Accounting Bulletin No. 118 (“SAB 118”) established a one-year measurement period (effective December 22, 2017), whereby provisional amounts recorded for effects of the changes from the TCJA could be subject to adjustment.  The one-year measurement period expired on December 22, 2018 and, therefore, the accounting to record the effects of the changes from the TCJA was required to be completed during the three months ended December 31, 2018.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

For the year ended June 30, 2018, the Company recorded the following provisional charges related to the TCJA:

 

·                  $351 million associated with the Transition Tax.

·                  $53 million in connection with the remeasurement of U.S. net deferred tax assets resulting from the statutory tax rate reduction.

·                  $46 million related to foreign withholding taxes associated with the reversal of its indefinite reinvestment assertion related to certain foreign earnings.

 

During the three and six months ended December 31, 2018, the Company recorded a credit of $2 million and $12 million, respectively, to adjust its fiscal 2018 provisional charge associated with the Transition Tax.  These credits reflect certain technical interpretations related to the Transition Tax computation.  The final cumulative charge related to this matter is $339 million.  The charges related to the Transition Tax are primarily included in Other noncurrent liabilities in the accompanying consolidated balance sheet as of December 31, 2018.

 

During the three months ended December 31, 2018, the Company recorded an increase of $8 million to its provisional charge recorded in fiscal 2018 associated with the remeasurement of its net deferred tax assets resulting from the reduction in the U.S. corporate income tax rate.  This adjustment was due to the revision of certain temporary differences.  The final cumulative charge related to this matter is $61 million.

 

In addition, the Company recorded a charge of $9 million for the three months ended September 30, 2018 related to foreign withholding taxes recorded in fiscal 2018 in connection with the reversal of its indefinite reinvestment assertion related to certain foreign earnings.  This charge reflected the Company’s interpretation of recently issued guidance from the U.S. government, and the accounting for this item pursuant to SAB 118 was considered complete as of September 30, 2018.  The final cumulative charge related to this matter is $55 million.

 

Although the accounting related to the income tax effects of the TCJA is complete pursuant to SAB 118, certain technical aspects of the TCJA remain subject to varying degrees of uncertainty as additional technical guidance and clarification from the U.S. government is expected to be issued over an extended period.  Receipt of additional guidance and clarification from the U.S. government may result in material changes to the provision for income taxes.  To the extent applicable, the Company would recognize such adjustments in the provision for income taxes in the period that additional guidance and clarification is received.

 

Provisions under the TCJA that became effective for the Company in the current fiscal year include a further reduction in the U.S. statutory rate to 21%, a new minimum tax on global intangible low-taxed income (“GILTI”), a base erosion anti-abuse tax, a foreign derived intangible income deduction and changes to IRC Section 162(m) related to the deductibility of executive compensation.

 

For more information about the TCJA and the related impact on the Company, see Note 8 — Income Taxes in the notes to consolidated financial statements in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2018.

 

The effective rate for income taxes was 22.9% and 81.9% for the three months ended December 31, 2018 and 2017, respectively, and 21.9% and 55.2% for the six months ended December 31, 2018 and 2017, respectively.  The decrease in the effective tax rate in both periods was primarily attributable to the provisional charges related to the TCJA that were recorded in the three months ended December 31, 2017.  Also contributing to the lower effective tax rate was a higher benefit related to share-based compensation awards, the impact of the lower U.S. statutory tax rate and a lower effective tax rate on our foreign operations due to a favorable geographic mix of earnings, partially offset by the impact of GILTI.

 

As of December 31, 2018 and June 30, 2018, the gross amount of unrecognized tax benefits, exclusive of interest and penalties, totaled $68 million and $60 million, respectively.  The total amount of unrecognized tax benefits at December 31, 2018 that, if recognized, would affect the effective tax rate was $47 million.  The total gross interest and penalties accrued related to unrecognized tax benefits during the three and six months ended December 31, 2018 in the accompanying consolidated statements of earnings was $1 million and $3 million, respectively.  The total gross accrued interest and penalties in the accompanying consolidated balance sheets at December 31, 2018 and June 30, 2018 was $12 million and $9 million, respectively.  On the basis of the information available as of December 31, 2018, the Company does not expect significant changes to the total amount of unrecognized tax benefits within the next twelve months.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

Other Accrued Liabilities

 

Other accrued liabilities consist of the following:

 

		December 31			June 30
(In millions)		2018			2018
Advertising, merchandising and sampling		$	417		$	348
Employee compensation		416			579
Deferred revenue		425			33
Sales return accrual		197			—
Payroll and other taxes		293			190
Accrued income taxes		245			90
Other		770			705
		$	2,763		$	1,945

 

Debt

 

In October 2018, the Company replaced its undrawn $1.5 billion senior unsecured revolving credit facility that was set to expire in October 2021 with a new $1.5 billion senior unsecured revolving credit facility (the “New Facility”).  The New Facility expires on October 26, 2023 unless extended for up to two additional years in accordance with the terms set forth in the agreement.  Up to the equivalent of $500 million of the New Facility is available for multi-currency loans.  Interest rates on borrowings under the New Facility will be based on prevailing market interest rates in accordance with the agreement.  The costs incurred to establish the New Facility were not material.  The New Facility has an annual fee of approximately $1 million, payable quarterly, based on the Company’s current credit ratings.  The New Facility contains a cross-default provision whereby a failure to pay other material financial obligations in excess of $175 million (after grace periods and absent a waiver from the lenders) would result in an event of default and the acceleration of the maturity of any outstanding debt under this facility.

 

Recently Adopted Accounting Standards

 

Hedge Accounting

 

In August 2017, the FASB issued authoritative guidance to simplify hedge accounting.  The guidance includes provisions that:

·                  enable entities to better portray their risk management activities within the financial statements;

·                  expand an entity’s ability to hedge nonfinancial and financial risk components;

·                  reduce complexity in fair value hedges of interest rate risk;

·                  eliminate the requirement to separately measure and disclose hedge ineffectiveness;

·                  require the entire change in fair value of a hedging instrument to be presented in the same income statement line as the hedged item;

·                  ease certain documentation and assessment requirements;

·                  modify the accounting for components excluded from the assessment of hedge effectiveness; and

·                  require revised tabular footnote disclosure.

 

The guidance also provides transition relief to make it easier for entities to apply certain amendments to existing hedges (including fair value hedges) where the hedge documentation is required to be modified.

 

Effective for the Company — Fiscal 2020 first quarter, with early adoption permitted in any interim period.  The guidance must be applied:

·                  using the modified retrospective approach for cash flow and net investment hedge relationships that exist on the date of adoption; and

·                  prospectively for the presentation and disclosure requirements.

 

Impact on consolidated financial statements — The Company has early adopted this guidance effective as of its fiscal 2019 first quarter, and no cumulative adjustment to retained earnings was required.  Upon adoption, all derivative gains and losses will be recognized in the same income statement line as the hedged items which, for all foreign currency cash flow hedges, is in Net sales.  There is no change to the interest expense classification of gains and losses from interest rate swap fair value hedges.  The amended presentation and disclosure requirements are being applied prospectively.  See Note 5 — Derivative Financial Instruments for further information.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

Pension-related Costs

 

In March 2017, the FASB issued authoritative guidance that amends how companies present net periodic benefit cost in the income statement and balance sheet relating to defined benefit pension and/or other postretirement benefit plans.  Within the income statement, the new guidance requires companies to report the service cost component within operating expenses and report the other components of net periodic benefit cost below operating income.  In addition, within the balance sheet, the guidance changes the components of the pension cost eligible for capitalization to the service cost component only (e.g., as a cost of internally manufactured inventory or a self-constructed asset).

 

Effective for the Company — Fiscal 2019 first quarter.  The guidance must be applied:

·                  retrospectively as it pertains to the income statement classification of the components of net periodic benefit cost; and

·                  prospectively as it pertains to future capitalization of service costs.

 

Impact on consolidated financial statements — The Company adopted this guidance when it became effective, and although certain components of pension expense are being reclassified out of operating income, this did not have a material impact on reported operating income.  The Company elected the practical expedient which permits the use of amounts previously disclosed in its pension and post-retirement plan footnote as the basis for estimating the amounts necessary to retrospectively restate the prior-year period consolidated statements of earnings.

 

Revenue from Contracts with Customers

 

In May 2014, the FASB issued authoritative guidance, Accounting Standards Codification Topic 606 — Revenue from Contracts with Customers (“ASC 606”), that defines how companies should report revenues from contracts with customers.  The standard requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.  It provides companies with a single comprehensive five-step principles-based model to use in accounting for revenue and supersedes prior revenue recognition requirements, including most industry-specific and transaction-specific revenue guidance.

 

In March 2016, the FASB issued authoritative guidance that amended the principal versus agent guidance in its new revenue recognition standard.  These amendments do not change the key aspects of the principal versus agent guidance, including the definition that an entity is a principal if it controls the good or service prior to it being transferred to a customer, but the amendments clarify the implementation guidance related to the considerations that must be made during the contract evaluation process.

 

In April 2016, the FASB issued authoritative guidance that amended the new standard to clarify the guidance on identifying performance obligations and accounting for licenses of intellectual property.

 

In May 2016, the FASB issued authoritative guidance that clarified certain terms, guidance and disclosure requirements during the transition period related to completed contracts and contract modifications.  In addition, the FASB provided clarification on the concept of collectability, the calculation of the fair value of noncash consideration and the presentation of sales and other similar taxes.

 

In May 2016, the FASB issued authoritative guidance to reflect the Securities and Exchange Commission Staff’s rescission of its prior comments that covered, among other things, accounting for shipping and handling costs and accounting for consideration given by a vendor to a customer.

 

In December 2016, the FASB issued authoritative guidance that amends various aspects of the new standard to clarify certain terms, guidance and disclosure requirements.  In particular, the guidance addresses disclosure requirements for remaining performance obligations, impairment testing for contract costs and accrual of advertising costs, as well as clarifies several examples.

 

Effective for the Company — Fiscal 2019 first quarter.  An entity is permitted to apply the foregoing guidance retrospectively to all prior periods presented, with certain practical expedients, or apply the requirements in the year of adoption, through a cumulative adjustment.

 

Impact on consolidated financial statements — On July 1, 2018, the Company adopted ASC 606, see Note 7 — Revenue Recognition for further discussion.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

Goodwill

 

In January 2017, the FASB issued authoritative guidance that simplifies the subsequent measurement of goodwill by eliminating the second step from the quantitative goodwill impairment test.  The single quantitative step test requires companies to compare the fair value of a reporting unit with its carrying amount and record an impairment charge for the amount that the carrying amount exceeds the fair value, up to the total amount of goodwill allocated to that reporting unit.  The Company will continue to have the option of first performing a qualitative assessment to determine whether it is necessary to perform the quantitative goodwill impairment test.

 

Effective for the Company — Fiscal 2021 first quarter, with early adoption permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017.

 

Impact on consolidated financial statements — The Company has early adopted this guidance effective as of its fiscal 2019 second quarter and applied the new guidance in its quantitative goodwill impairment test related to the Smashbox reporting unit.  See Note 3 — Goodwill and Other Intangible Assets for further information.

 

Recently Issued Accounting Standards

 

Measurement of Credit Losses on Financial Instruments

 

In June 2016, the FASB issued authoritative guidance that requires companies to utilize an impairment model for most financial assets measured at amortized cost and certain other financial instruments, which include trade and other receivables, loans and held-to-maturity debt securities, to record an allowance for credit risk based on expected losses rather than incurred losses.  In addition, this guidance changes the recognition method for credit losses on available-for-sale debt securities, which can occur as a result of market and credit risk, and requires additional disclosures.  In general, modified retrospective adoption will be required for all outstanding instruments that fall under this guidance.

 

Effective for the Company — Fiscal 2021 first quarter.

 

Impact on consolidated financial statements — The Company is currently evaluating the impact of applying this guidance on its financial instruments, such as accounts receivable and short- and long-term investments.

 

Leases

 

In February 2016, the FASB issued authoritative guidance that requires lessees to account for most leases on their balance sheets with the liability being equal to the present value of the lease payments.  The right-of-use asset will be based on the lease liability adjusted for certain costs such as initial direct costs, prepaid lease payments and lease incentives received.  Lease expense will be recognized similar to current accounting guidance with operating leases resulting in a straight-line expense, and finance leases resulting in a front-loaded expense similar to the current accounting for capital leases.

 

In July 2018, the FASB amended this guidance to clarify certain narrow aspects of the new lease accounting standard that may have been incorrectly or inconsistently applied, and does not add new guidance.  Also in July 2018, the FASB issued authoritative guidance that allows companies to elect to adopt the new standard using a modified retrospective transition approach with a cumulative-effect adjustment to retained earnings in the period of adoption.  Companies that elect the new adoption method will not be required to restate the prior comparative periods in the financial statements.

 

Effective for the Company — Fiscal 2020 first quarter, with early adoption permitted using either of the modified retrospective transition approaches described in the standard, with certain practical expedients.

 

Impact on consolidated financial statements — The Company currently has an implementation team in place that is performing a comprehensive evaluation of the impact of the adoption of this guidance, which includes assessing the Company’s lease portfolio, implementing a new system to meet reporting requirements, and assessing the impact to business processes and internal controls over financial reporting and the related disclosure requirements.  While the Company’s evaluation is ongoing, it believes the adoption of this standard will have a significant impact on its consolidated balance sheets.  As disclosed in Note 14 — Commitments and Contingencies in the notes to consolidated financial statements in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2018, the Company had $3,320 million in future minimum lease commitments as of June 30, 2018.  Upon adoption, the Company’s lease liability will generally be based on the present value of such payments and the related right-of-use asset will generally be based on the lease liability, adjusted for initial direct costs, prepaid lease payments and lease incentives received.  The Company plans to adopt the new standard when it becomes effective in the fiscal 2020 first quarter using the modified retrospective transition approach for leases that exist in the period of adoption and will not restate the prior comparative periods.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

Goodwill and Other — Internal-Use Software

 

In August 2018, the FASB issued authoritative guidance that permits companies to capitalize the costs incurred for setting up business systems that operate on cloud technology.  The new guidance aligns the requirement for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software.  The guidance does not affect the accounting for the service element of a hosting arrangement that is a service contract.  Capitalized costs associated with a hosting arrangement that is a service contract must be amortized over the term of the hosting arrangement to the same line item in the income statement as the expense for fees for the hosting arrangement.

 

Effective for the Company — Fiscal 2021 first quarter, with early adoption permitted in any interim period.  This guidance can be adopted either:

·                  retrospectively; or

·                  prospectively to all implementation costs incurred after the date of adoption.

 

Impact on consolidated financial statements — The Company is currently evaluating the impact of applying this guidance to its business systems that operate on cloud technology.

 

No other recently issued accounting pronouncements are expected to have a material impact on the Company’s consolidated financial statements.

 

NOTE 2 — INVESTMENTS

 

Beginning in the first quarter of fiscal 2019, the Company accounts for its cost method investments at cost, less impairment, plus/minus subsequent observable price changes, and will be required to perform an assessment each quarter to determine whether or not a triggering event has occurred that results in changes in fair value.  These investments were not material to the Company’s consolidated financial statements as of December 31, 2018.

 

Gains and losses recorded in accumulated OCI (“AOCI”) related to the Company’s available-for-sale investments as of December 31, 2018 were as follows:

 

(In millions)		Cost			Gross Unrealized Gains			Gross Unrealized Losses			Fair Value
U.S. government and agency securities		$	403		$	—		$	(3	)	$	400
Foreign government and agency securities		99			—			(1		)	98
Corporate notes and bonds		447			—			(5		)	442
Time deposits		—			—			—			—
Other securities		15			—			—			15
Total		$	964		$	—		$	(9	)	$	955

 

Gains and losses recorded in AOCI related to the Company’s available-for-sale investments as of June 30, 2018 were as follows:

 

(In millions)		Cost			Gross Unrealized Gains			Gross Unrealized Losses			Fair Value
U.S. government and agency securities		$	427		$	—		$	(5	)	$	422
Foreign government and agency securities		114			—			(2		)	112
Corporate notes and bonds		479			—			(7		)	472
Time deposits		200			—			—			200
Other securities		16			—			—			16
Total		$	1,236		$	—		$	(14	)	$	1,222

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

The following table presents the Company’s available-for-sale securities by contractual maturity as of December 31, 2018:

 

(In millions)		Cost			Fair Value
Due within one year		$	528		$	525
Due after one through five years		436			430
		$	964		$	955

 

The following table presents the fair market value of the Company’s investments with gross unrealized losses that are not deemed to be other-than temporarily impaired as of December 31, 2018:

 

		In a Loss Position for Less Than 12 Months						In a Loss Position for More Than 12 Months
(In millions)		Fair Value			Gross Unrealized Losses			Fair Value			Gross Unrealized Losses
Available-for-sale securities		$	37		$	—		$	890		$	(9	)

 

Gross gains and losses on sales of investments included in the consolidated statements of earnings were not material for all periods presented.

 

The Company utilizes the first-in, first-out method to determine the cost of the security sold.  Sales proceeds from investments classified as available-for-sale were $11 million and $166 million for the three months ended December 31, 2018 and 2017, respectively, and were $23 million and $296 million for the six months ended December 31, 2018 and 2017, respectively.

 

NOTE 3 — GOODWILL AND OTHER INTANGIBLE ASSETS

 

Impairment Testing During the Six Months Ended December 31, 2018

 

During December 2018, the Smashbox reporting unit made revisions to its internal forecasts reflecting a slowdown of its makeup business driven by increased competitive activity and lower than expected growth in key retail channels for the brand.  The Company concluded that these changes in circumstances in the Smashbox reporting unit triggered the need for an interim impairment review of its trademark and goodwill.  Accordingly, the Company performed an interim impairment test as of December 31, 2018.  The Company concluded that the carrying value of the Smashbox trademark exceeded its estimated fair value, which was determined utilizing a royalty rate to determine discounted projected future cash flows.  As a result, the Company recognized an impairment charge of $18 million for the trademark.  After adjusting the carrying value of the trademark, the Company completed an interim quantitative impairment test for goodwill and recorded a goodwill impairment charge related to the Smashbox reporting unit of $20 million.  The Company early adopted the FASB’s authoritative guidance that eliminated the second step from the quantitative goodwill impairment test.  In accordance with this guidance, the Company compared the fair value of the Smashbox reporting unit with its carrying amount to calculate the impairment charge.  The fair value of the reporting unit was based upon an equal weighting of the income and market approaches, utilizing estimated cash flows and a terminal value, discounted at a rate of return that reflects the relative risk of the cash flows, as well as valuation multiples derived from comparable publicly traded companies that are applied to operating performance of the reporting unit.  These impairment charges were reflected in the makeup product category and in the Americas region.  As of December 31, 2018, the remaining carrying values of the goodwill and trademark related to the Smashbox reporting unit were $120 million and $59 million, respectively.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

The following table presents goodwill by product category and the related change in the carrying amount:

 

(In millions)		Skin Care			Makeup			Fragrance			Hair Care			Total
Balance as of June 30, 2018
Goodwill		$	185		$	1,186		$	256		$	391		$	2,018
Accumulated impairments		(36		)	—			(22		)	(34		)	(92		)
		149			1,186			234			357			1,926
Goodwill acquired during the period		—			7			—			—			7
Impairment charge		—			(20		)	—			—			(20		)
Translation adjustments, goodwill		—			—			(1		)	(2		)	(3		)
Translation adjustments, accumulated impairments		—			—			—			1			1
		—			(13		)	(1		)	(1		)	(15		)
Balance as of December 31, 2018
Goodwill		185			1,193			255			389			2,022
Accumulated impairments		(36		)	(20		)	(22		)	(33		)	(111		)
		$	149		$	1,173		$	233		$	356		$	1,911

 

Other intangible assets consist of the following:

 

		December 31, 2018									June 30, 2018
(In millions)		Gross Carrying Value			Accumulated Amortization			Total Net Book Value			Gross Carrying Value			Accumulated Amortization			Total Net Book Value
Amortizable intangible assets:
Customer lists and other		$	696		$	356		$	340		$	697		$	332		$	365
License agreements		43			43			—			43			43			—
		$	739		$	399		340			$	740		$	375		365
Non-amortizable intangible assets:
Trademarks and other								893									911
Total intangible assets								$	1,233								$	1,276

 

The aggregate amortization expense related to amortizable intangible assets was $12 million for the three months ended December 31, 2018 and 2017 and was $25 million for the six months ended December 31, 2018 and 2017.  The estimated aggregate amortization expense for the remainder of fiscal 2019 and for each of the next four fiscal years is as follows:

 

		Fiscal
(In millions)		2019			2020			2021			2022			2023
Estimated aggregate amortization expense		$	26		$	44		$	43		$	42		$	42

 

NOTE 4 — CHARGES ASSOCIATED WITH RESTRUCTURING AND OTHER ACTIVITIES

 

In May 2016, the Company announced a multi-year initiative (“Leading Beauty Forward,” “LBF” or the “Program”) to build on its strengths and better leverage its cost structure to free resources for investment to continue its growth momentum.  LBF is designed to enhance the Company’s go-to-market capabilities, reinforce its leadership in global prestige beauty and continue creating sustainable value.  The Company plans to approve specific initiatives under LBF through fiscal 2019 related to the optimization of select corporate functions, supply chain activities, and corporate and regional market support structures, as well as the exit of underperforming businesses, and expects to complete those initiatives through fiscal 2021.  Inclusive of approvals from inception through December 31, 2018, the Company estimates that LBF may result in related restructuring and other charges totaling between $900 million and $950 million, before taxes.  In connection with LBF, at this time, the Company estimates a net reduction over the duration of LBF in the range of 1,800 to 2,000 positions globally.  This reduction takes into account the elimination of certain positions, inclusive of positions that are unfilled, as well as retraining and redeployment of certain employees and investment in new positions in key areas.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

Program-to-Date Approvals

 

Of the $900 million to $950 million restructuring and other charges expected to be incurred, total cumulative charges approved by the Company through December 31, 2018, some of which were recorded from Program inception through December 31, 2018, were:

 

		Sales
		Returns						Operating Expenses
(In millions)		(included in Net Sales)			Cost of Sales			Restructuring Charges			Other Charges			Total
Approval Period
Fiscal 2016		$	4		$	28		$	87		$	71		$	190
Fiscal 2017		11			10			132			118			271
Fiscal 2018		—			24			166			68			258
Six months ended December 31, 2018		—			9			19			29			57
Adjustments through December 31, 2018		(1		)	(1		)	(46		)	(1		)	(49		)
Cumulative through December 31, 2018		$	14		$	70		$	358		$	285		$	727

 

Included in the above table, cumulative restructuring initiatives approved by the Company through December 31, 2018 by major cost type were:

 

(In millions)		Employee- Related Costs			Asset- Related Costs			Contract Terminations			Other Exit Costs			Total
Approval Period
Fiscal 2016		$	75		$	3		$	5		$	4		$	87
Fiscal 2017		126			1			—			5			132
Fiscal 2018		161			—			1			4			166
Six months ended December 31, 2018		17			1			—			1			19
Adjustments through December 31, 2018		(45		)	—			(1		)	—			(46		)
Cumulative through December 31, 2018		$	334		$	5		$	5		$	14		$	358

 

During the six months ended December 31, 2018, the Company continued to approve initiatives to enhance its go-to-market support structures and optimize select corporate functions.  These actions will result in a net reduction of the workforce, which includes position eliminations, the re-leveling of certain positions and an investment in new capabilities.  The Company also approved consulting and other professional services primarily related to the implementation and integration of new processes and technologies, temporary labor backfill and recruitment related to the new capabilities.  The Company continued to approve implementation costs, temporary labor backfill and consulting fees for an initiative related to supply chain planning activities.  In addition, the Company approved other charges to support the LBF Project Management Office, consisting of internal and external resources that are intended to further drive project integration, organizational design capabilities and change management throughout the organization.

 

As initiatives under LBF progress through implementation, the Company has identified certain costs that were approved but will not be incurred.  These costs, reflected as adjustments to the cumulative approved restructuring and other charges presented above, were primarily related to estimated employee-related costs for certain employees who either resigned or transferred to other existing positions within the Company.

 

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