Estee Lauder 2007 Annual Report Download - page 38

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THE EST{E LAUDER COMPANIES INC. 37
QUANTITATIVE ANALYSIS
During the three-year period ended June 30, 2007, there
have not been material changes in the assumptions under-
lying 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 fi scal 2006, which fi nalized 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
signifi cantly 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 justifi ed 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 fi scal 2007, had these
estimates been changed simultaneously by 2.5% in either
direction, our reported gross profi t 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 com-
mon share would be an increase or decrease of approxi-
mately $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
effi cient and profi table manner. With this goal in mind,
we have developed a long-term strategy based on the
following fi ve 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
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 fi nancial 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 pre-
dictor of future realized and implied volatilities and is
directly related to stock option valuation. For stock option
grants issued during the fi scal 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 specifi c 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-to-
maturity effect. For stock option grants issued during the
fi scal year ended June 30, 2007, we used a weighted-
average 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 approxi-
mately $2.0 million in either direction for the fi scal year
ended June 30, 2007.