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Estee Lauder Companies 10-Q 2012
UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549-1004
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, 2011
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, former address and former fiscal year, 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 and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted 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 and post 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, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
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 25, 2012, 235,912,621 shares of the registrant’s Class A Common Stock, $.01 par value, and 151,778,082 shares of the registrant’s Class B Common Stock, $.01 par value, were outstanding.
THE ESTÉE LAUDER COMPANIES INC.
INDEX
THE ESTÉE LAUDER COMPANIES INC.
CONSOLIDATED STATEMENTS OF EARNINGS (Unaudited)
See notes to consolidated financial statements.
THE ESTÉE LAUDER COMPANIES INC.
See notes to consolidated financial statements.
THE ESTÉE LAUDER COMPANIES INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
See notes to consolidated financial statements.
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. For further information, refer to the consolidated financial statements and accompanying footnotes included in the Company’s Annual Report on Form 10-K for the year ended June 30, 2011.
All share (except par value per share), earnings per common share and cash dividends declared per common share information for the current period and all prior-year periods reflect the two-for-one stock split on the Company’s Class A and Class B Common Stock, which was effected in the form of a stock dividend for each share held by stockholders of record at the close of business on January 4, 2012. The number of shares of the Company’s Class A Common Stock issuable upon exercise of outstanding stock options and vesting of other stock-based awards were proportionately increased in accordance with the terms of the respective plans.
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. Certain significant accounting policies that contain subjective management estimates and assumptions include those related to revenue recognition, inventory, pension and other post-retirement benefit costs, goodwill, other intangible assets and long-lived assets, income taxes and derivatives. Descriptions of these policies are discussed in the notes to consolidated financial statements in the Company’s Annual Report on Form 10-K for the year ended June 30, 2011. Management evaluates its 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 or losses are reported as cumulative translation adjustments through other comprehensive income (loss) (“OCI”). Such adjustments, attributable to The Estée Lauder Companies Inc., amounted to $(18.1) million and $4.9 million of unrealized translation gains (losses), net of tax, during the three months ended December 31, 2011 and 2010, respectively, and $(131.4) million and $91.6 million of unrealized translation gains (losses), net of tax, during the six months ended December 31, 2011 and 2010, respectively. For the Company’s Venezuelan subsidiary operating in a highly inflationary economy, 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.
The accompanying consolidated statements of earnings include net exchange gains (losses) on foreign currency transactions of $6.7 million and $(3.6) million during the three months ended December 31, 2011 and 2010, respectively, and $(3.1) million and $(0.8) million during the six months ended December 31, 2011 and 2010, respectively.
THE ESTÉE LAUDER COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Accounts Receivable
Accounts receivable is stated net of the allowance for doubtful accounts and customer deductions totaling $35.5 million and $33.9 million as of December 31, 2011 and June 30, 2011, 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 are made primarily to department stores, perfumeries and specialty retailers. The Company grants credit to all qualified customers and does not believe it is exposed significantly to any undue concentration of credit risk.
The Company’s largest customer sells products primarily within the United States and accounted for $261.7 million, or 10%, and $246.3 million, or 10%, of the Company’s consolidated net sales for the three months ended December 31, 2011 and 2010, respectively, and $575.0 million, or 11%, and $528.3 million, or 12%, of the Company’s consolidated net sales for the six months ended December 31, 2011 and 2010, respectively. This customer accounted for $120.9 million, or 9%, and $92.3 million, or 10%, of the Company’s accounts receivable at December 31, 2011 and June 30, 2011, respectively.
Inventory and Promotional Merchandise
Property, Plant and Equipment
The cost of assets related to projects in progress of $228.2 million and $183.5 million as of December 31, 2011 and June 30, 2011, respectively, is included in their respective asset categories above. Depreciation and amortization of property, plant and equipment was $69.1 million and $63.8 million during the three months ended December 31, 2011 and 2010, respectively, and $136.4 million and $129.2 million during the six months ended December 31, 2011 and 2010, 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.
THE ESTÉE LAUDER COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Income Taxes
The effective income tax rate was 32.6% and 31.0% for the three months ended December 31, 2011 and 2010, respectively. The increase in the effective income tax rate was principally due to favorable income tax reserve adjustments booked in the prior-year period, including a tax and interest benefit of $11 million, net of tax, attributable to concluding the examination by the U.S. Internal Revenue Service (“IRS”) of fiscal 2006 through 2008. The prior-year rate was also favorably impacted due to the reinstatement of the U.S. federal research and experimentation tax credit, retroactive to January 1, 2010, the majority of such benefit recorded discretely in the prior-year period.
The effective income tax rate was 32.6% and 31.7% for the six months ended December 31, 2011 and 2010, respectively. The increase in the effective income tax rate was principally due to favorable income tax reserve adjustments booked in the prior-year period, including a tax and interest benefit of $11 million, net of tax, attributable to concluding the examination by the IRS of fiscal 2006 through 2008.
As of December 31, 2011 and June 30, 2011, the gross amount of unrecognized tax benefits, exclusive of interest and penalties, totaled $96.7 million and $104.8 million, respectively. The total amount of unrecognized tax benefits at December 31, 2011 that, if recognized, would affect the effective tax rate was $61.5 million. The total gross interest and penalties accrued related to unrecognized tax benefits during the three and six months ended December 31, 2011 in the accompanying consolidated statements of earnings was $6.1 million and $9.2 million, respectively. The total gross accrued interest and penalties in the accompanying consolidated balance sheets at December 31, 2011 and June 30, 2011 was $45.0 million and $37.7 million, respectively. On the basis of the information available as of December 31, 2011, it is reasonably possible that the total amount of unrecognized tax benefits could decrease in a range of $25 million to $30 million within 12 months as a result of projected resolutions of global tax examinations and controversies and a potential lapse of the applicable statutes of limitations.
During the six months ended December 31, 2011, the Company formally concluded the IRS examination of fiscal years 2009 and 2010. The conclusion of this examination did not materially impact the Company’s consolidated financial statements.
Recently Adopted Accounting Standards
In December 2010, the Financial Accounting Standards Board (“FASB”) amended its authoritative guidance related to Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more-likely-than-not that a goodwill impairment exists. In determining whether it is more-likely-than-not that a goodwill impairment exists, consideration should be made as to whether there are any adverse qualitative factors indicating that an impairment may exist. This guidance became effective for the Company’s fiscal 2012 first quarter. The adoption of this standard did not have an impact on the Company’s consolidated financial statements.
In December 2010, the FASB amended its authoritative guidance related to business combinations entered into by an entity that are material on an individual or aggregate basis. These amendments clarify existing guidance that if an entity presents comparative financial statements that include a material business combination, the entity should disclose revenue and earnings of the combined entity as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period. The amendments also expand the supplemental pro forma disclosures to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. This guidance became effective prospectively for business combinations for which the acquisition date was on or after the first day of the Company’s fiscal 2012. This disclosure-only guidance did not have an impact on the Company’s results of operations, financial position or cash flows.
In January 2010, the FASB issued authoritative guidance that requires entities to make new disclosures about recurring or nonrecurring fair-value measurements of assets and liabilities. The Company adopted the new guidance in its fiscal 2010 third quarter, except for certain detailed recurring Level 3 disclosures, which became effective for the Company’s fiscal 2012 first quarter. The Company currently does not have any recurring Level 3 assets or liabilities.
THE ESTÉE LAUDER COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Recently Issued Accounting Standards
In December 2011, the FASB issued authoritative guidance that creates new disclosure requirements about the nature of an entity’s rights of offset and related arrangements associated with its financial instruments and derivative instruments. This revised guidance helps reconcile differences in the offsetting requirements under U.S. GAAP and International Financial Reporting Standards (“IFRS”). These requirements mandate that entities disclose both gross and net information about instruments and transactions eligible for offset in the statement of financial position as well as instruments and transactions subject to an agreement similar to a master netting arrangement. This disclosure-only guidance becomes effective for the Company’s fiscal 2013 third quarter, with retrospective application required. The Company currently does not hold any financial or derivative instruments that are subject to an enforceable master netting arrangement. However, the Company currently utilizes the right of offset when netting certain negative cash balances in its statement of financial position. This guidance is not expected to have an impact on the Company’s results of operations, financial position or cash flows, but may require certain additional disclosures if such balances are material or if the Company enters into additional arrangements that fall under the provisions of this guidance.
In September 2011, the FASB amended its authoritative guidance related to testing goodwill for impairment. Under the revised guidance, entities testing goodwill for impairment have the option of performing a qualitative assessment before performing Step 1 of the goodwill impairment test. If entities determine, on the basis of qualitative factors, that the fair value of the reporting unit is more-likely-than-not less than the carrying amount, the two-step impairment test would be required. This guidance becomes effective in the beginning of the Company’s fiscal 2013, with early adoption permitted. The Company is currently evaluating the timing of adopting this guidance which will not have an impact on the Company’s consolidated financial statements.
In September 2011, the FASB amended its authoritative guidance related to multiemployer benefit plans. This revised guidance is intended to provide enhanced qualitative and quantitative disclosures about an employer’s significant financial obligations to a multiemployer pension plan and, therefore, help financial statement users better understand the financial health of all significant plans in which the employer participates. To the extent the information required under the revised standard is not available in the public domain, as may be the case for some foreign plans, employers should include more qualitative information about the plan. This disclosure-only guidance becomes effective for the Company’s fiscal 2013, with early adoption permitted and full retrospective application required. The Company is currently evaluating the timing of adopting and the impact of this guidance on the Company’s consolidated financial statements.
In June 2011, the FASB amended its authoritative guidance related to the presentation of comprehensive income, requiring entities to present items of net income and other comprehensive income either in one continuous statement or in two separate consecutive statements. This guidance also required entities to present reclassification adjustments for each component of accumulated other comprehensive income in both net income and other comprehensive income on the face of the financial statements. In December 2011, the FASB issued an update to this guidance deferring the requirement to present reclassification adjustments on the face of the financial statements. However, the Company is still required to present reclassification adjustments on either the face of the financial statement where comprehensive income is reported or disclose the reclassification adjustments in the notes to the financial statements. This guidance, including the deferral, becomes effective for the Company’s fiscal 2013 first quarter, with early adoption permitted and full retrospective application required. The Company is currently evaluating the impact of adopting this guidance but believes that it will result only in changes in the presentation of its consolidated financial statements and will not have a material impact on the Company’s results of operations, financial position or cash flows.
In May 2011, the FASB amended its authoritative guidance related to fair value measurements to provide a consistent definition and measurement of fair value, as well as similar disclosure requirements between U.S. GAAP and IFRS. This guidance clarifies the application of existing fair value measurement and expands the existing disclosure requirements. This guidance becomes effective for the Company’s fiscal 2012 third quarter. This guidance is not expected to have a material impact on the Company’s results of operations, financial position or cash flows, but may require certain additional disclosures.
THE ESTÉE LAUDER COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2 — GOODWILL AND OTHER INTANGIBLE ASSETS
The Company assigns goodwill of a reporting unit to the product category in which that reporting unit predominantly operates at the time of its acquisition. The following table presents goodwill by product category and the related change in the carrying amount:
Other intangible assets consist of the following:
The aggregate amortization expense related to amortizable intangible assets for the three months ended December 31, 2011 and 2010 was $3.4 million and $3.9 million, respectively, and for the six months ended December 31, 2011 and 2010 was $6.9 million and $7.5 million, respectively. The estimated aggregate amortization expense for the remainder of fiscal 2012 and for each of fiscal 2013 to 2016 is $6.7 million, $13.6 million, $13.5 million, $13.4 million and $13.3 million, respectively.
Impairment Testing During the Six Months Ended December 31, 2011
During the second quarter of fiscal 2012, the Ojon reporting unit identified a potential decline in its projected results of operations, primarily resulting from a softness in the direct response television channel, which caused the Company to review and revise Ojon’s long-term forecast. The Company concluded that these changes in the business of the Ojon reporting unit triggered the need for an interim impairment test of its trademarks as of December 31, 2011. These changes in circumstances were also an indicator that the carrying amount of the customer list may not be recoverable. The Company performed an interim impairment test for the trademarks and a recoverability test for the customer list as of December 31, 2011. For the trademarks, the Company concluded that the carrying value exceeded its estimated fair value, which was based on the use of a royalty rate to determine discounted projected future cash flows (“relief-from-royalty method”). As a result, the Company recognized an impairment charge of $6.7 million. This charge was reflected in the hair care product category in the Americas region. The Company concluded that the carrying value of the customer list is recoverable.
THE ESTÉE LAUDER COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3 — RETURNS AND CHARGES ASSOCIATED WITH RESTRUCTURING ACTIVITIES
In an effort to drive down costs and achieve synergies within the organization, in February 2009, the Company announced the implementation of a multi-faceted cost savings program (the “Program”) to position itself to achieve long-term profitable growth. The Company anticipates the Program will result in related restructuring and other charges, inclusive of cumulative charges recorded to date and through the remainder of the Program, totaling between $350 million and $450 million before taxes. While the Company will continue to seek cost savings opportunities, the Company’s current plans are to identify and approve specific initiatives under the Program through fiscal 2012 and execute those initiatives through fiscal 2013. The total amount of charges (pre-tax) associated with the Program, recorded, plus other initiatives approved through December 31, 2011, is approximately $307 million to $312 million, of which approximately $202 million to $204 million relates to restructuring charges, approximately $50 million of other costs to implement the initiatives, approximately $39 million to $42 million in sales returns and approximately $16 million in inventory write-offs. The restructuring charges are comprised of approximately $154 million to $156 million of employee-related costs, approximately $27 million of other exit costs and contract terminations (substantially all of which have resulted in or will result in cash expenditures), and approximately $21 million in non-cash asset write-offs. The total amount of cumulative charges (pre-tax) associated with the Program recorded from inception through December 31, 2011 was $249.6 million.
The Program focuses on a redesign of the Company’s organizational structure in order to integrate it in a more cohesive way and operate more globally across brands and functions. The principal aspect of the Program was the reduction of the workforce by approximately 2,000 employees. Specific actions taken since the inception of the Program included:
· Resize and Reorganize the Organization — The Company continued the realignment and optimization of its organization to better leverage scale, improve productivity, reduce complexity and achieve cost savings in each region and across various functions. This included reduction of the workforce which occurred through the consolidation of certain functions, which the Company achieved through a combination of normal attrition and job eliminations, and the closure and consolidation of certain distribution and office facilities.
· Turnaround or Exit Unprofitable Operations — To improve the profitability in certain of the Company’s brands and regions, the Company has selectively exited certain channels of distribution, categories and markets, and has made changes to turnaround others. This included the exit from the global wholesale distribution of the Company’s Prescriptives brand and the reformulation of Ojon brand products. In connection with these activities, the Company incurred charges related to product returns, inventory write-offs, reduction of workforce and termination of contracts.
· Outsourcing — In order to balance the growing need for information technology support with the Company’s efforts to provide the most efficient and cost effective solutions, the Company continued the outsourcing of certain information technology processes. The Company incurred costs to transition services to outsource providers and employee-related termination costs.
Restructuring Charges
The following table presents restructuring charges related to the Program as follows:
THE ESTÉE LAUDER COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following table presents aggregate restructuring charges related to the Program:
The following table presents accrued restructuring charges and the related activities under the Program:
Accrued restructuring charges at December 31, 2011 are expected to result in cash expenditures funded from cash provided by operations of approximately $14 million, $8 million and $3 million in fiscal 2012, 2013 and 2014, respectively.
THE ESTÉE LAUDER COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Total Returns and Other Charges Associated with Restructuring Activities
The following table presents total charges associated with restructuring activities related to the Program:
During the three and six months ended December 31, 2011, the Company recorded adjustments to reflect revised estimates of sales returns associated with prior initiatives. During the three months ended December 31, 2010, the Company recorded $1.5 million of sales returns (less a related cost of sales of $0.5 million) and a write-off of inventory of $4.3 million associated with turnaround operations, primarily related to the reformulation of Ojon brand products. During the six months ended December 31, 2010, the Company recorded $1.5 million reflecting sales returns (less a related cost of sales of $0.5 million) and a write-off of inventory of $5.1 million associated with turnaround operations, primarily related to the reformulation of Ojon brand products. Other charges in connection with the implementation of the Program primarily relate to consulting and other professional services.
NOTE 4 — DERIVATIVE FINANCIAL INSTRUMENTS
The Company addresses certain financial exposures through a controlled program of risk management that includes the use of derivative financial instruments. The Company enters into foreign currency forward contracts and may enter into option contracts to reduce the effects of fluctuating foreign currency exchange rates and interest rate derivatives to manage the effects of interest rate movements on the Company’s aggregate liability portfolio. The Company also enters into foreign currency forward contracts and may use option contracts, not designated as hedging instruments, to mitigate the change in fair value of specific assets and liabilities on the balance sheet. The Company does not utilize derivative financial instruments for trading or speculative purposes. Costs associated with entering into these derivative financial instruments have not been material to the Company’s consolidated financial results.
For each derivative contract entered into where the Company looks to obtain hedge accounting treatment, the Company formally documents all relationships between hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking the hedge transaction, the nature of the risk being hedged, how the hedging instruments’ effectiveness in offsetting the hedged risk will be assessed prospectively and retrospectively, and a description of the method of measuring ineffectiveness. This process includes linking all derivatives to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions. The Company also formally assesses, both at the hedge’s inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. If it is determined that a derivative is not highly effective, or that it has ceased to be a highly effective hedge, the Company will be required to discontinue hedge accounting with respect to that derivative prospectively.
THE ESTÉE LAUDER COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The fair values of the Company’s derivative financial instruments included in the consolidated balance sheets are presented as follows:
(1) See Note 5 — Fair Value Measurements for further information about how the fair value of derivative assets and liabilities are determined.
The amounts of the gains and losses related to the Company’s derivative financial instruments designated as hedging instruments are presented as follows:
(2) The amount of gain recognized in earnings related to the amount excluded from effectiveness testing was $0.3 million for the three months ended December 31, 2011 and 2010. There was no gain (loss) recognized in earnings related to the ineffective portion of the hedging relationships for the three months ended December 31, 2011. There was a net $0.5 million loss recognized in earnings related to the ineffective portion of the hedging relationships for the three months ended December 31, 2010.
THE ESTÉE LAUDER COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(3) The amount of gain (loss) recognized in earnings related to the amount excluded from effectiveness testing was $(2.1) million and $0.1 million for the six months ended December 31, 2011 and 2010, respectively. There was no gain (loss) recognized in earnings related to the ineffective portion of the hedging relationships for the six months ended December 31, 2011. There was a net $0.5 million loss recognized in earnings related to the ineffective portion of the hedging relationships for the six months ended December 31, 2010.
(4) Changes in the fair values of the interest rate swap agreements are exactly offset by changes in the fair value of the underlying long-term debt.
The amounts of the gains and losses related to the Company’s derivative financial instruments not designated as hedging instruments are presented as follows:
THE ESTÉE LAUDER COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Foreign Currency Cash-Flow Hedges
The Company enters into foreign currency forward contracts to hedge anticipated transactions, as well as receivables and payables denominated in foreign currencies, for periods consistent with the Company’s identified exposures. The purpose of the hedging activities is to minimize the effect of foreign exchange rate movements on costs and on the cash flows that the Company receives from foreign subsidiaries. The majority of foreign currency forward contracts are denominated in currencies of major industrial countries. The foreign currency forward contracts entered into to hedge anticipated transactions have been designated as foreign currency cash-flow hedges and have varying maturities through the end of September 2013. Hedge effectiveness of foreign currency forward contracts is based on a hypothetical derivative methodology and excludes the portion of fair value attributable to the spot-forward difference which is recorded in current-period earnings.
The ineffective portion of foreign currency forward contracts is recorded in current-period earnings. For hedge contracts that are no longer deemed highly effective, hedge accounting is discontinued and gains and losses accumulated in OCI are reclassified to earnings when the underlying forecasted transaction occurs. If it is probable that the forecasted transaction will no longer occur, then any gains or losses in accumulated OCI are reclassified to current-period earnings. As of December 31, 2011, the Company’s foreign currency cash-flow hedges were highly effective in all material respects. The estimated net gain as of December 31, 2011 that is expected to be reclassified from accumulated OCI into earnings, net of tax, within the next twelve months is $8.5 million. The accumulated gain (loss) on derivative instruments in accumulated OCI was $16.8 million and $(13.2) million as of December 31, 2011 and June 30, 2011, respectively.
At December 31, 2011, the Company had foreign currency forward contracts in the amount of $1,486.3 million. The foreign currencies included in foreign currency forward contracts (notional value stated in U.S. dollars) are principally the British pound ($333.4 million), Swiss franc ($259.4 million), Euro ($219.7 million), Canadian dollar ($109.2 million), Australian dollar ($98.8 million), South Korean won ($74.7 million) and Japanese yen ($60.0 million).
Credit Risk
As a matter of policy, the Company only enters into derivative contracts with counterparties that have a long-term credit rating of at least A- or higher by at least two nationally recognized rating agencies. The counterparties to these contracts are major financial institutions. Exposure to credit risk in the event of nonperformance by any of the counterparties is limited to the gross fair value of contracts in asset positions, which totaled $16.9 million at December 31, 2011. To manage this risk, the Company has established strict counterparty credit guidelines that are continually monitored. Accordingly, management believes risk of loss under these hedging contracts is remote.
Certain of the Company’s derivative financial instruments contain credit-risk-related contingent features. At December 31, 2011, the Company was in a net asset position for certain derivative contracts that contain such features with two counterparties. The fair value of those contracts as of December 31, 2011 was approximately $0.8 million. As of December 31, 2011, the Company was in compliance with such credit-risk-related contingent features.
THE ESTÉE LAUDER COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5 — FAIR VALUE MEASUREMENTS
The Company records its financial assets and liabilities at fair value, which is defined as the price that would be received to sell an asset or paid to transfer a liability, in the principal or most advantageous market for the asset or liability, in an orderly transaction between market participants at the measurement date. The accounting for fair value measurements must be applied to nonfinancial assets and nonfinancial liabilities, which principally consist of assets and liabilities acquired through business combinations, goodwill, indefinite-lived intangible assets and long-lived assets for the purposes of calculating potential impairment, and liabilities associated with restructuring activities. The Company is required to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The three levels of inputs that may be used to measure fair value are as follows:
Level 1: Inputs based on quoted market prices for identical assets or liabilities in active markets at the measurement date.
Level 2: Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets and liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
Level 3: Inputs reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. The inputs are unobservable in the market and significant to the instrument’s valuation.
The following table presents the Company’s hierarchy for its financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2011:
The following table presents the Company’s hierarchy for its financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2011:
THE ESTÉE LAUDER COMPANIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following table presents the Company’s hierarchy as of December 31, 2011 and impairment charges for the three and six months ended December 31, 2011 for certain of its nonfinancial assets measured at fair value on a nonrecurring basis, due to a change in circumstances that triggered an interim impairment test:
(1) See Note 2 for discussion of the valuation techniques used to measure fair value, the description of the inputs and information used to develop those inputs.
Fair Value of Financial Instruments
The following methods and assumptions were used to estimate the fair value of the Company’s other classes of financial instruments for which it is practicable to estimate that value:
Cash and cash equivalents — The carrying amount approximates fair value, primarily because of the short maturity of cash equivalent instruments.
Available-for-sale securities — Available-for-sale securities are generally comprised of mutual funds and are valued using quoted market prices on an active exchange. Available-for-sale securities are included in Other assets in the accompanying consolidated balance sheets.
Foreign currency forward contracts — The fair values of the Company’s foreign currency forward contracts were determined using an industry-standard valuation model, which is based on an income approach. The significant observable inputs to the model, such as swap yield curves and currency spot and forward rates, were obtained from an independent pricing service. To determine the fair value of contracts under the model, the difference between the contract price and the current forward rate was discounted using LIBOR for contracts with maturities up to 12 months, and swap yield curves for contracts with maturities greater than 12 months.
Current and long-term debt — The fair value of the Company’s debt was estimated based on the current rates offered to the Company for debt with the same remaining maturities. To a lesser extent, debt also includes capital lease obligations for which the carrying amount approximates the fair value.
The estimated fair values of the Company’s financial instruments are as follows:
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