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Recession Resistant? Wall Street Sees Rough Road Ahead

Most large beauty firms have solid financing and don?t need to look to the credit markets for capital. However, emerging players will have a rougher road.

This holiday, beauty firms will do what many Wall Street analysts have done since the start of the financial crisis: hunker down and hope for the best.

Most large beauty firms, with the exception of those with a heavy debt load, have solid financing and don’t need to look to the credit markets for capital. However, emerging players — many of which have won favor with consumers and alternative retail channels with their niche positioning — will have a rockier road ahead, said financial experts.

“Smaller businesses — or brands that are $10 million to $30 million in size — are starting to see their momentum slow,” said Cathy Leonhardt, a managing director at the investment banking firm Peter J. Solomon Co. “When you are facing an economic headwind, it’s tough. They are either looking for capital or an exit.”

It seems many of these niche brands are opting for the exit route. “The common question is, ‘What can I get for my company, and should I sell now before things get worse?” said Jani Friedman, a managing director at Demeter Group, a boutique investment bank, referring to smaller firms. The potential sellers like the numbers they’re hearing, according to Friedman, and there is no shortage of interested investors.

Christopher Spahr, principal at William Blair & Co.’s Consumer Investment Banking Group, said, “The sellers’ expectations in the premium, natural products space have not come down. This is one sector where you will see healthy activity. You continue to see strategics do deals with emerging brands that have relevance, and sponsors are still eager to do deals.”

He acknowledged the scarcity of credit, which has become more expensive than last year, has prompted some private equity firms to over-equitize deals, or invest more of their fund’s money, because the promise for growth is great.

“In beauty, there are generally only a handful of transactions a year, and these deals are less dependent on debt [financing],” said Spahr.

On the retail front, analysts expect large beauty firms will also fare better than their midsized or niche peers.

“We’ve been talking about the ‘empty middle’ for some time,” said Deutsche Bank analyst William Schmitz, adding that the high-end and low-end brands will likely perform decently at the expense of the middle tier. In the mass market, some of these lower performers hang onto mass retail space simply by paying slotting fees, he added.

On the prestige side, Schmitz said he’ll be watching to see how well Estée Lauder’s gift-with-purchase resonates with holiday shoppers. “Lauder makes the gift-with-purchase decision in January for the following Christmas, so it can be a total crapshoot.” He added that once the company makes that decision it can’t reverse it — should fashion trends shift, for example — because the suppliers have to be lined up well in advance. Schmitz said that Fabrizio Freda, who joined the Estée Lauder Cos. Inc. in March as chief operating officer, aims to find ways to shorten the supply chain.

In the mass market, financial experts are expecting retailers and their large beauty suppliers to launch aggressive promotional campaigns, which might put the squeeze on midsized players that can’t keep pace.

Wal-Mart is looking to its beauty suppliers, like Elizabeth Arden, to entice consumers to spend by highlighting more affordable items, said SunTrust Robinson Humphrey analyst William Chappell. “Wal-Mart understands people aren’t going to be buying flat-screen TVs this year,” he said, noting that about five years ago, Arden had success encouraging Wal-Mart Stores Inc. to move its fragrances out from behind glass, which the retailer did in most stores.

But, plagued by high theft, store managers began putting fragrances behind lock and key once again. This holiday, it seems the two companies have reached a compromise with Wal-Mart merchandising about two-thirds of its scents in an open-sell environment, said Chappell.

In a recent report on Arden, Wachovia Capital Markets LLC analyst Jason Gere said select mass retailers, like Wal-Mart, are focused on spending to promote the fragrance category in a bid to siphon shoppers from department stores.

He wrote, “Though Arden already generates half its sales from the mass channel…there appears to be a bigger opportunity to improve awareness and the placement of product in the channel, especially with the U.S. department store channel still having challenges. The beginning of this expansion plan should start this holiday season.”

SunTrust’s Chappell also noted that Bare Escentuals and Ulta are working together to cater to cash-strapped shoppers. To that end, Bare Escentuals will introduce a $15 starter kit. Bare Escentuals’ traditional starter kit sells for about $60. Its less expensive counterpart is expected to contain fewer items and smaller sizes, said Chappell.

The move caters to consumers’ increasingly practical mind-set, which thankfully for beauty markets this holiday seems to deem a lipstick a more reasonable expense than a cashmere wrap or designer handbag.