INCOME TAXES
We account for income taxes in accordance with Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," as amended. This statement establishes financial accounting and reporting standards for the effects of income taxes that result from an enterprise's activities during the current and preceding years. It requires an asset and liability approach for financial accounting and reporting of income taxes.

As of June 30, 2007, we have current net deferred tax assets of $124.0 million and non-current net deferred tax liabilities of $16.6 million. The net deferred tax assets assume sufficient future earnings for their realization, as well as the continued application of currently anticipated tax rates. Included in net deferred tax assets is a valuation allowance of approximately $5.5 million for deferred tax assets, where management believes it is more likely than not that the deferred tax assets will not be realized in the relevant jurisdiction. Based on our assessments, no additional valuation allowance is required. If we determine that a deferred tax asset will not be realizable, an adjustment to the deferred tax asset will result in a reduction of earnings at that time.

We provide tax reserves for Federal, state, local and international exposures relating to periods subject to audit. The development of reserves for these exposures requires judgments about tax issues, potential outcomes and timing, and is a subjective critical estimate. Although the outcome relating to these exposures is uncertain, in management's opinion adequate provisions for income taxes have been made for estimable potential liabilities emanating from these exposures. In certain circumstances, the ultimate outcome of exposures and risks involves significant uncertainties which render them inestimable. If actual outcomes differ materially from these estimates, including those that cannot be quantified, they could have a material impact on our results of operations, as we experienced in the fourth quarter of fiscal 2006 (see "Results of Operations, Fiscal 2006 as Compared with Fiscal 2005-Provision for Income Taxes").

DERIVATIVES
We account for derivative financial instruments in accordance with SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. This statement also requires the recognition of all derivative instruments as either assets or liabilities on the balance sheet and that they be measured at fair value.

We currently use derivative financial instruments to hedge certain anticipated transactions and interest rates, as well as receivables and payables denominated in foreign currencies. We do not utilize derivatives for trading or speculative purposes. Hedge effectiveness is documented, assessed and monitored by employees who are qualified to make such assessments and monitor the instruments. Variables that are external to us such as social, political and economic risks may have an impact on our hedging program and the results thereof. For a discussion on the quantitative impact of market risks related to our derivative financial instruments, refer to "Liquidity and Capital Resources-Market Risk."

STOCK-BASED COMPENSATION
We are required to record the fair value of stock-based compensation awards as an expense in accordance with SFAS No. 123(R), "Share-Based Payment," as amended. In order to determine the fair value of stock options on the date of grant, we apply the Black-Scholes option-pricing model. Inherent in this model are assumptions related to expected stock-price volatility, option life, risk-free interest rate and dividend yield. While the risk-free interest rate and dividend yield are less subjective assumptions that are based on factual data derived from public sources, the expected stock-price volatility and option life assumptions require a greater level of judgment which makes them critical accounting estimates.

We use an expected stock-price volatility assumption that is a combination of both current and historical implied volatilities of the underlying stock which are obtained from public data sources. This approach is used as a predictor of future realized and implied volatilities and is directly related to stock option valuation. For stock option grants issued during the fiscal year ended June 30, 2007, we used a weighted-average expected stock-price volatility of 24% based upon the implied volatility at the time of issuance.

With regard to the weighted-average option life assumption, we consider the exercise behavior of past grants and model the pattern of aggregate exercises. Patterns are determined based on specific criteria of the aggregate pool of optionees including the reaction to vesting, realizable value, long-run exercise propensity, pent-up demand, stock run-up effect and short-time-tomaturity effect. For stock option grants issued during the fiscal year ended June 30, 2007, we used a weightedaverage expected option life assumption of approximately 8 years.

While we believe the above critical estimates are based on outcomes that are reasonably likely to occur, if we were to increase or decrease the expected option life by one year and simultaneously increase or decrease the expected volatility by 100 basis points, recognized compensation expense would have changed approximately $2.0 million in either direction for the fiscal year ended June 30, 2007.

QUANTITATIVE ANALYSIS
During the three-year period ended June 30, 2007, there have not been material changes in the assumptions underlying these critical accounting policies, nor to the related significant estimates. With the exception of our tax settlement with the Internal Revenue Service in the fourth quarter of fiscal 2006, which finalized the ultimate liability for exposures which were previously inestimable (see "Results of Operations, Fiscal 2006 as Compared with Fiscal 2005-Provision for Income Taxes"), the results of our business underlying these assumptions have not differed significantly from our expectations.

While we believe that the estimates that we have made are proper and the related results of operations for the period are presented fairly in all material respects, other assumptions could reasonably be justified that would change the amount of reported net sales, cost of sales, operating expenses or our provision for income taxes as they relate to the provisions for anticipated sales returns, allowance for doubtful accounts, inventory obsolescence reserve and income taxes. For fiscal 2007, had these estimates been changed simultaneously by 2.5% in either direction, our reported gross profit would have increased or decreased by approximately $4.7 million, operating expenses would have changed by approximately $0.6 million and the provision for income taxes would have increased or decreased by approximately $1.4 million. The collective impact of these changes on operating income, net earnings and net earnings per diluted common share would be an increase or decrease of approximately $5.3 million, $6.7 million and $.03, respectively.

RESULTS OF OPERATIONS

OVERVIEW
We manufacture, market and sell skin care, makeup, fragrance and hair care products which are distributed in over 135 countries and territories. We believe that the best way to increase stockholder value is to provide our customers and consumers with the products and services that they have come to expect from us in the most efficient and profitable manner. With this goal in mind, we have developed a long-term strategy based on the following five imperatives:

1. Optimize brand portfolio
2. Strengthen product categories
3. Strengthen and expand geographic presence
4. Diversify and strengthen distribution channels
5. Achieve operational and cost excellence

In fiscal 2007, we continued to find ways to strengthen our core brands and product categories, maximize highgrowth brands, incubate and develop next generation brands and divest non-strategic brands. Net sales from Estée Lauder and Clinique grew on a global basis, fueled by strong demand overseas. Our faster growing M·A·C, Bobbi Brown, La Mer, Jo Malone and Aveda brands continued to grow in virtually all regions and we acquired the remaining equity interest in Bumble and bumble. Sean John Unforgivable continued to be a success at retail in North America and we rolled out the brand in certain international markets during fiscal 2007. We launched products under the Tom Ford brand name in North America and Europe and entered into a license agreement with Ford Motor Company to create a fragrance using the name Mustang. In July 2007, we acquired the Ojon Corporation, a privately held hair care and skin care company based in Canada. In August 2007, we sold Rodan + Fields back to its founders.

The majority of our net sales continue to be generated outside the United States. Around the globe, we generated growth in sales and profits in our travel retail business and increased our presence in China and Russia. We also acquired a distributor in Turkey and established an affiliate in Brazil.

In alternative distribution channels, we continued to grow our online business in North America, where products from most of our brands are available at Company-owned websites. However, in order to streamline this business, we terminated our majority-owned Gloss.com joint venture. In addition, we recently expanded the online business into the United Kingdom, Australia and France. Certain of our products are now available at specialty retailers such as Sephora, ULTA, and Shoppers Drug Mart. We made strategic investments to establish the platform upon which we intend to build our pharmacy channel business in Europe. Origins has recently expanded into the French pharmacy channel. We also began to expand the number of Company-owned Jo Malone retail stores in Europe, including the brand's first French store in Cannes.

We continued to make progress on our Strategic Modernization Initiative ("SMI"). In May 2007, our Aveda operating unit began using SAP software, a critical part of SMI. We anticipate SMI implementation will continue at additional locations in fiscal 2008, with the majority of our locations to be implemented through fiscal 2010.

Despite the rise in energy and raw material costs, we were able to improve our overall cost of goods margin by negotiating new contracts with suppliers and achieving significant savings by sourcing from Asia. We also reduced the number of our global manufacturing and distribution facilities by increasing the use of third-parties to control shipping and warehousing costs. In addition, we improved speed to market of new SKUs and expanded our hub warehouse concept, which allows us to take components on a just-in-time basis.

During fiscal 2007, we also faced challenges, many of which we expect to be ongoing in fiscal 2008. For instance, we continue to see challenges for certain of our core brands due in part to the consolidation and changes taking place among retailers and the decline in effectiveness of gift-with-purchase promotions. In addition, the fragrance business model continues to be a challenge, with even the most successful launches having difficulty becoming profitable. Efforts to expand geographically are complicated by increasing regulatory issues and cultural barriers.

As we continue to implement our strategic imperatives, we expect to make selective investments, embark on new business endeavors, and pursue initiatives that we believe will have long-term benefits. The timing, impact and magnitude of any particular actions, such as an acquisition to strengthen our product categories and/or diversify our distribution channels, are subject to numerous factors and cannot be predicted.

The following table is a comparative summary of operating results from continuing operations for fiscal 2007, 2006 and 2005 and reflects the basis of presentation described in Note 2 and Note 17 to the Notes to Consolidated Financial Statements for all periods presented. Products and services that do not meet our definition of skin care, makeup, fragrance and hair care have been included in the "other" category.

The following table presents certain consolidated earnings data as a percentage of net sales:

In order to meet the demands of consumers, we continually introduce new products, support new and established products through advertising, sampling and merchandising and phase out existing products that no longer meet the needs of our consumers. The economics of developing, producing, launching and supporting products influence our sales and operating performance each period. The introduction of new products may have some cannibalizing effect on sales of existing products, which we take into account in our business planning.

top of page	< back | next >