Playing The Lipstick Indicator

This story features DOWNER EDI LIMITED, and other companies. For more info SHARE ANALYSIS: DOW

The company is included in ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

In the first quarter of 2008, make-up giants L’Oreal and Estee Lauder knew we were facing a global recession. They knew because sales of lipstick over the period were on the increase. The last time they had witnessed such a jump from normal sales figures was in the months following 9/11. The world entered recession soon after.

Indeed, it is a phenomenon that Leonard Lauder had spotted many years earlier. So reliable was its predictive capacity that Lauder called it the Lipstick Indicator. It’s been right ever since.

There are some crazy market indicators out there, some with logical justification and some without. It is noted, for example, that women’s skirts tend to be shorter ahead of bull markets and longer ahead of bear markets, in terms of the prevailing fashion. There is not much justification for this necessarily. But why would women suddenly start buying more lipstick ahead of a recession? Isn’t that counterintuitive?

The first point to note is you never know you’re in a recession until well after you are. Last night the first estimation of the US third quarter GDP growth figure was released, and it was negative for the first time since 2001. That figure will be revised several times, right up to the end of the fourth quarter, and then we start on the fourth quarter estimations. If the fourth quarter is also negative, and remains that way through revisions all the way into March, then yes – it is a technical recession.

But it started at least nine months earlier.

And that’s only the “technical” definition – two consecutive quarters of negative GDP growth is officially called a recession. But realistically if positive growth becomes less positive from one quarter to the next, then growth has already begun to “recede”. So as far as your average citizen is concerned recessions begin long before the boffins can actually say they had begun. Average citizens know this because they may have already seen falling house prices, or rising unemployment, or crippling inflation, or simply become uneasy about things. If so, they start to be a little more frugal with their spending. As soon as this happens, by default a “recession” of at least some degree must follow.

There are many consumer goods and industries that are traditionally “immune” to a recession. The two most obvious are Healthcare and Consumer Staples. In the former case, if you need prescription drugs you will forsake all else in tough times and buy those drugs. You also must eat, so while you may lay off the caviar or switch to home brands your consumption of milk, bread and other staples is unlikely to diminish.

These are examples of industry sectors that will not suffer a collapse of sales during times of economic hardship. Telco is another example, because we’ll still make phone calls. Funeral Services is up there, because people don’t wait for bull markets in which to die. And perhaps the most reliable of all, particularly in Australia, is beer.

Well, at least for the blokes. For the chicks, there’s a lot more to consider. Blokes might, for example, use a recession as a great excuse not to have to go anywhere near a clothes shop for at least another twelve months. Chicks, on the other hand, have a dilemma. Women might see monthly purchases of new clothes as a “staple”, but deep down they know their partners are right when they label clothes buying as “discretionary” spending. And discretionary spending is the first thing to go when economic times get tougher.

What can a poor girl do? If new clothes are unattainable, this means massive withdrawal symptoms. New clothes are one thing that brings joy. But if it’s all about beauty, one can cut back without conceding altogether. If you can’t have a whole new outfit what about just a new look? What about a different lipstick?

In tough economic times, women will spend on new lipstick in lieu of a new outfit. Because we only find out we were in a recession long after it actually began, if lipstick sales begin to increase unusually we therefore know what’s coming next. Global make-up retailers noted lipstick sales shooting up in the first quarter. L’Oreal reported, recall the Citi pharma analysts, that by June the company’s lipstick sales were up 54%. The subsequent quarter in the US was one of negative growth. Need I say more?

Australian Pharmaceutical ((API)) released its full-year results yesterday. API is Australia’s largest retailer of pharmaceuticals and other things you might find at the chemist, such as make-up. L’Oreal is one of API’s biggest creditor accounts. API recently became the owner of the Priceline chain of franchised pharmacies.

The Australian drug industry has undergone all sorts of upheaval, rationalisation and consolidation over the past couple of years. It was not about rushing to be in the best position to sell lipstick, but about a once private business dealing with all the lingering teething problem of going public, and doing so within a highly regulated environment (think PBS – pharmaceutical benefit scheme). Most of the argy-bargy was settled, coincidently, just before Healthcare suddenly hit the spotlight as one of the best sectors to be in while the stock market in general collapsed.

It’s been a turnaround story as well for API, and on yesterday’s results analysts had to concede that things were looking a lot better. Revenues surprised most. But there were two problems.

One is that part of API’s grand plan is to continue the rollout of more Priceline stores. The other is that part of that plan is the sale of existing API corporate stores to new Priceline franchisees. In the latter case, about half of API’s FY08 profit came from store sales. Understandably, analysts are concerned that such sales distort the bottom line and are at risk of diminishing as times get tougher. In the case of the former, Priceline franchises are not just chemists, they’re mini-department stores of all things pharmaceutical and cosmetic. Retail is not a good place to be in a recession. Even management painted a somewhat gloomy picture.

But that is to deny the defensive qualities of lipstick!

The upshot is that most analysts could not find argument with management, and marked down earnings expectations. Though the one Sell rating going into the result – UBS – found enough cause to upgrade to Neutral, bringing the number of Hold ratings to five from six. A Hold rating can easily be explained by the average price target, which is 83c to yesterday’s closing price of 54c.

The one Buy rating is Citi, and it is Citi who this morning drew attention to our Indicator.

It was also Citi who was the only broker in the FNArena database to bother commenting on the Downer EDI ((DOW)) annual general meeting, held yesterday.

Now Downer specialises in engineering and construction in the resources and telco sectors, and as such is about as far away from lipstick as you could get. But strangely enough there is a lot of lipstick factor going on with Downer EDI.

Peers in Downer’s sector include Leighton ((LEI)), WorleyParsons ((WOR)), Boart Longyear ((BLY)), United Group ((UGL)) and Transfield ((TSE)). Year to date, the share prices of each are down 52%, 72%, 80%, 54% and 74% respectively.

Downer is down 9%.

One reason Downer has “outperformed” so spectacularly is because while the above group were lapping it up in the boom of the previous couple of years, Downer was struggling. Poor management and poor execution meant Downer had already underperformed. But now it has a new management and improving execution and has started from an already low valuation base.

The other reason is that of all the companies in the sector, Downer has the highest level of recurring revenues. In boom times, this means “dull”. In bust times, this means “safety”.

Such outperformance from other listed stocks in other sectors has led analysts in recent times to pull Buy ratings back to Neutral, or even Sell. But Downer is still boasting a 4/3/1 B/H/S ratio in the FNArena database. Citi, for one, suggests Downer’s earnings could continue to grow in FY09 even as the abovementioned peers see their earnings drop. The AGMs of the peer group to date have been very dour affairs indeed, with Leighton making a big profit downgrade, Worley warning of tough times ahead and Boart all but going into “care and maintenance”. But Downer’s AGM was decidedly upbeat, notes Citi, with management highlighting ongoing expansion opportunities while maintaining previous earnings guidance.

Maybe Downer wears lipstick after all.

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