An outsider in the family castle

Add to that list “the family company.” As any management expert will tell you, there can be no place less welcoming to a nonindigenous executive than a closely held family business. Often clan members fight among themselves, and frequently those clashes entangle the professional managers the family brought in to solve the problems they could not.

Fabrizio Freda witnessed those hazards firsthand when working at Gucci in the late 1980s. Then in his twenties, the Naples-born executive was directing strategic planning for the iconic leather-goods retailer and saw the family conflict up close. “I was certainly naive when I went to Gucci,” he now admits. “The family members had very different points of view of where they were trying to lead the company. There were several members of the family in the management or as owners, all driving in different directions.”

Which brings up two remarkable facts about the now 56-year-old executive: The first is that he knowingly, willingly, eagerly chose to do it again — taking the CEO job at Estée Lauder Cos. in July 2009. The second is that since that time, he has apparently figured out how to manage in a corporate environment few outside execs are able to tolerate, let alone master. Fabrizio Freda, it seems, has tamed one of the most family-centric, family-controlling, family-inhabited businesses around.

Under his leadership Estée Lauder — which owns Clinique, MAC, La Mer, and Bobbi Brown, among other leading brands — has been transformed from a cost-heavy underachiever into arguably the top performer in global cosmetics. For the fiscal years from 2009 to 2013 (ending June 30), the company increased sales by 39%, or 8.5% a year, to $10.2 billion — handily beating the cosmetics business at rival L’Oréal (four-year sales growth of roughly 30%), as well as the No. 3 and No. 4 players in the prestige cosmetics industry: Shiseido of Japan (down 1% over the period), and LVMH of France, owner of the Dior and Guerlain labels (up 33%).

Estée’s market share in the lucrative global prestige segment has jumped to 15.1%, reaching a virtual tie with L’Oréal (15.3%). But Freda’s biggest accomplishment, surely, has been to boost the company’s operating margins alongside that rapid sales growth — a rare feat that has done wonders for the bottom line. Since fiscal 2008, Estée’s profits have more than doubled to just over $1 billion, while operating margins have risen to 15%, from around 10%. That’s getting close to L’Oréal’s industry-leading margin of 16.7%, and Freda argues convincingly that he’ll boost margins by more than a full percentage point within two years.

Estée’s stock price, meanwhile, has reflected that success — and, it would seem, is anticipating more: The company’s shares have jumped 336%, or 33% annually, since Freda became CEO, lifting Estée’s market cap by an astounding $21 billion, from $6.5 billion to $27.6 billion, and creaming not only the S&P 500 (up 16% annually over the time frame) but most of its competitors as well. Of the major cosmetics names, only Revlon, a mass retail player one-seventh the size of Estée, has fared better.

Forty percent of Estée Lauder’s shares are owned by the family of Estée Lauder — which is to say that Freda has helped make the Lauder clan, one of the world’s leading benefactors of breast cancer and Alzheimer’s disease research, roughly $8.5 billion richer in a handful of years. Hiring Freda, indeed, may have been the smartest move the Lauder family has made in a decade. Truth be told, though, even they (and more than a few not-quite-family Estée veterans) had their doubts that Freda would be a good fit when he was hired as president and chief operating officer in March 2008. Freda, who had come straight from Procter & Gamble, was summarily dismissed by many as “the Pringles man,” after the potato chips label he’d run at the food giant, several sources tell Fortune. Rival executives mocked him for driving a gold-hued Jaguar, which they said revealed his garish taste — a quality incompatible with the refined Estée aesthetic. (“That’s unfair,” quips Freda in his melodic Italian accent. “The color was champagne.”)

The Lauders, including the family patriarch, Leonard, and other directors who hired Freda were so wary that he (or any outsider) could thrive there, they named him COO only with the proviso that if things didn’t work out, the board could fire him without penalty. “Leonard was concerned he’d P&G-ize the company so that it would lose its DNA in entrepreneurship and marketing,” says Barry Sternlicht, CEO of Starwood Capital, an Estée director since 2004.

Today, no surprise, the family members who feared that Freda would fail now fear that he’ll leave. Freda, after all, would be an obvious candidate to succeed A.G. Lafley, 66, who’s slated to retire soon at P&G. “I don’t know if P&G has come after him,” says Estée director Irv Hockaday, a former CEO of Hallmark Cards, “but if P&G hasn’t got him on the radar screen, they should.”

The concern is so acute that in September 2012, the board granted Freda a gigantic pay package designed to keep him at Estée for several more years. In effect, if the stock continues to perform well, Freda will receive as many as 359,000 new shares, vesting between 2015 and 2017. Should Estée’s share price rise from its current level of about $71 to $125 by 2017 (a target consistent with the company’s earnings-per-share growth rate over the past five years), Freda’s stock grant could be worth as much as $45 million. And that’s in addition to other big incentives he gets every year. By Fortune‘s reckoning, Freda could hold well over $100 million in Estée Lauder stock in five years.

“This package is big, large, enormous — you can pick the adjective,” says Dick Parsons, a senior adviser to Providence Equity Partners and a former chairman of Citigroup and CEO of Time Warner, who has been an Estée director since 1999 and serves on the compensation committee. “Our thinking is that this is such a huge number that it would discourage another company from buying him out. He’s king of the hill, and he likes this hill.”

It’s an extraordinary turn of events for a fellow who, just six years ago, was running a $1.3 billion snack business. “He’s honestly one of the best CEOs I’ve ever seen in my life, and I’ve seen a lot of CEOs,” says director Sternlicht. “Nine out of 10 people would have failed in this job.”

The classic challenge with a family enterprise — particularly one a few generations out from the founder — isn’t that the clan can’t field a good manager to lead; it’s that it rarely finds just one. At Estée Lauder, indeed, there are two generations of Lauders simultaneously proffering advice and filling pivotal roles in management.

Leonard Lauder, 80, the eldest son of Estée Lauder, served ably as CEO for 17 years — leading the company through an expansive period of growth in the 1980s and 1990s — and comes to the headquarters in the white granite GM Building in Midtown Manhattan every day. Leonard, who retains the title chairman emeritus, peppers Freda and numerous other managers with counsel and complaints, and weighs in on every big decision at the flagship Estée Lauder brand. His brother, Ronald, 69, also a large shareholder, is a former Estée Lauder executive who later served as a top Defense Department official in the Reagan administration. Ronald is a powerful, outspoken voice in all the big decisions on the company’s future.

Ronald’s daughter Jane, 40, has done a shrewd job running Origins, a brand specializing in skin care products featuring plant extracts and other natural ingredients — and is often mentioned as a future candidate for CEO. Her sister, Aerin, 43, served as the creative director for the Lauder label and recently launched an independent business, Aerin LLC, that offers her Aerin Beauty array of fragrances and makeup alongside the Estée Lauder brand in department and specialty stores. Leonard, Jane, and Aerin all serve on the board. That board, moreover, is led by Leonard’s son William, who occupied the CEO post for five years before Freda’s arrival and now holds the unusual position of executive chairman.

In an intricate, if not convoluted, power-sharing arrangement, William supervises two management areas on his own: legal and communications. The CFO and the chief of human resources report to both William and Freda. And though both men must agree on hiring a CFO or head of HR, either William or Freda can fire those executives on his own, without the other’s approval.

Underlying all this power are company shares. While the Lauders own 40% of Estée Lauder stock, they own 86% of the company’s voting shares — a special class of stock reserved for the family. “You have three very smart people from the family active in the company day to day — Leonard, William, and Jane,” says Sternlicht. “Everyone has an opinion on where resources should be spent, as you’d expect. It’s hard to have family in the company, and here you have lots of family in the company, and they are not shy people.”

Freda, a trim, 5-foot-10 athlete with wavy gray hair, navigated this byzantine management structure mostly by ear. “Typically CEOs talk before they listen,” says board member Hockaday. “Fabrizio is an intense guy but a good listener.” Freda regularly sits down with Leonard Lauder in a suite at Manhattan’s Pierre Hotel to discuss the company’s future and field any of the patriarch’s queries and complaints, says Leonard. “He’ll quietly disagree, even if he’s looking in the eyes of a majority owner who can throw him out,” adds Hockaday. “But then he explains his rationale, going through every point to the point of exhaustion, until you come away converted.”

From the start, Freda drove the brand presidents hard, demanding detailed data to back up every spending decision, but he did little firing. “When he arrived, I expected that he’d do to some extent what most new CEOs do — clean house,” says Rose Marie Bravo, an Estée director who is a former CEO of Burberry. “But he made almost no changes to the creative people. Instead, he tried to improve them. I’ve never seen that before in business.” Freda also encouraged his team to offer ideas that challenged his own. “The historical face of the imperial CEO who knows it all belongs to another time,” says Freda. “This is the period of the humble, listening CEO, who creates a future based on the strengths of the past.”

In another departure from the standard MBA playbook, he also believes that big companies waste their time pushing managers to work on their weaknesses, when their bosses should encourage them to strengthen their strengths. “Don’t make people improve 10% or 20% in areas they’re not good at,” says Freda. “But that’s what big companies do every day. It’s like being a soccer coach and telling the goalkeeper to learn to play attack.” He would prefer to turn a good brand builder into an even better brand builder rather than push him or her to become a financial whiz. Then he can pair the marketing expert with a crack CFO so that the team is well-rounded.

This wasn’t a tack he learned at P&G. The lesson came much earlier — when Freda was 19 years old. A family friend who knew Federico Fellini arranged for young Fabrizio to spend a week in 1976 on the set of Fellini’s Casanova outside Rome. Freda marveled as the maestro sought perfezione, shooting take after take of a scene in which Casanova, played by Donald Sutherland, romances an actress portraying a doll. “Sutherland was dancing with this inanimate doll,” Freda recalls, “and suddenly the doll comes to life, as if even a doll couldn’t resist falling in love with Casanova. What made this scene so fantastic was the way it surprised the audience by ending in a place you’d never expect.”

But it was another kind of magic that impressed Freda more: Fellini’s seemingly effortless ability to orchestrate diverse talents of his cast and crew — harmonizing the work of sound engineers, camera operators, and actors. Freda, quite consciously, has plied that same cinematic art at the 67-year-old Estée Lauder. Says Freda: “In movies or cosmetics, it’s bringing different, even opposite, skills together that creates something magical.”

Raised in a duplex apartment on a hill overlooking the isle of Capri, framed by the Mediterranean Sea, Freda saw much of the world at a young age. His father built bridges, power plants, and housing throughout Italy and the Middle East, and the teenage Fabrizio would often travel with him. “He was above all a ‘mind,’ a brilliant engineer, a great chess and bridge player,” says Freda of his father. Fabrizio, for his part, was more of a “body.” At 11 he won the Ping-Pong championship of Italy for his age group, and today he is a formidable sailor and tennis player. “He’s a retriever who’s infuriating because he hits everything back,” says his wife of 23 years, Mary-Ann, who is a native of Belgium.

After graduating from the University of Naples in 1981, Freda spent four years marketing Dash detergent and other household brands for P&G in Italy. There he spearheaded the creation of two new blends for its Splendid coffee brand, a strong “robusta” version for southern Italy and a softer, Arabica entry for the north. The two new flavors were a huge hit. But even then, Freda was eyeing the luxury-goods business. When a job heading strategy for Gucci opened up in 1986, he grabbed it — though the gig wouldn’t last long. Less than two years later Gucci ceased to be a family enterprise when the feuding relatives sold to an investor group. “The lesson I learned was to be absolutely sure the strategy throughout the company is aligned before starting to operate,” Freda says. Luckily P&G wanted him back, and there he climbed steadily up the ranks, eventually heading the $1.3 billion global snack business, which was dominated by Pringles.

By 2007 it was clear to the Estée board that a company with tremendous capabilities was delivering mediocre performance. The Lauders had assembled the best portfolio in prestige cosmetics, yet Estée Lauder was losing ground to drugstore brands like P&G’s Olay and CoverGirl. Disappointed by the stock’s poor showing, Ronald Lauder in particular was calling for an outside CEO. “This company has so much potential, and we’re not using it!” Ronald would tell fellow directors. The problem was basic: The culture encouraged sales growth at all costs, but the extra revenues were bringing subpar profits. Costs of manufacturing and procurement were far too high. At the same time, the brand managers kept pouring money into unprofitable categories, notably fragrances, to prop up sales — even as they were starving, relatively speaking, big winners such as skin care. It wasn’t even clear who was in charge of the P&Ls: the brand presidents or the country heads? So even if the Clinique chief wanted to support healthy products, the manager for Japan, say, might steer money to unhealthy ones.

William Lauder recognized the problems, and showed vision. It was William who pushed investment in China and pioneered selling over the Internet. But on the crucial issue of reducing costs and getting the brands to operate in concert rather than as fiefdoms, William couldn’t get the troops to follow him. “I encountered a lot of resistance,” says William. “People would say, ‘It’s worked for 15 years. Why change it?’ ” Adds Sternlicht: “Family members have relationships and history and loyalties, so it’s hard for a family member to get done what needs to be done.”

William is more comfortable looking at acquisitions, courting retailers, and overseeing big strategic initiatives than engaging in day-to-day management. Hence his disagreements with Freda have been minimal, by most accounts. The two men also agree, importantly, on what has made Estée what it is: an ethos that encourages folks who excel in advertising, design, and image-making to hatch innovative products and build original, if quirky, brands. The Lauder family had long believed in that imperative. And Freda aimed to preserve that freewheeling vibe while at the same time turning Estée Lauder into what it could and should be, a powerful money spinner. “The key was taking a gorgeous box of Crayolas — those brands that were disorganized but had all the right colors but not in the right order — and make them work together,” says Sternlicht.

Freda’s main objective was to shift from an obsession for growing sales to a drive for profits. To get there he needed to make the brands’ managers — those creative types — fixate on selling more product and hew to a new set of metrics based on profitability. He won over the troops, big egos included, by demonstrating how their brands could keep growing, and eventually grow far faster, if the managers substantially lowered their costs. “That was the breakthrough,” recalls Freda. “People were afraid they wouldn’t grow. I showed that they could keep growing and make a lot more money if they cut expenses and plowed the money back into what was profitable, not just growing.” The financial crisis also worked in Freda’s favor. It made the need for cost cutting far more vivid, and Freda insisted that this was a dour, downbeat period that required serious cost cutting.

Freda put the brand presidents fully in charge of the P&Ls and charged the country heads with conducting consumer research. He and William insisted that the brand leaders learn the basics on how growing sales faster than costs unleashes an explosion in profits. While bonuses in the past were tied mainly to sales growth, the two bosses skewed the payouts two-thirds to profit measures, including return on equity. “When I was running Starwood Hotels, I wanted the hotel people to be aware of profit measures, and they said they couldn’t do it,” says Sternlicht. “I backed down. Fabrizio didn’t back down.”

Once again, Freda didn’t demand that marketing types become financial wonks. Instead, he created a sense of excitement about how Clinique or Origins could sell more if its costs were lower. “Your eyes glaze over when you hear about return on equity,” says Jane Lauder. “But you have a real appreciation if you can spend those savings on things that really drive sales.” Before Freda’s arrival, each national operation in Europe had separate procurement staffs who called many of the same suppliers of flasks and cartons. Freda centralized purchasing by region and lowered costs by concentrating bigger purchases on far fewer suppliers. The number of bottle sizes in fragrances declined by half. Origins stopped printing on the inside of its cartons to generate savings. The number of distribution facilities around the globe shrank by a third. By centralizing purchasing and other back-office functions, Freda eliminated 2,000 jobs, 6% of the workforce. He and William installed a new rule to keep costs from coming back: The brands were limited to raising wage costs, their biggest expense, at just three-quarters the rate of sales growth; if revenues expanded 10%, the wage bill could rise just 7.5%.

The plan worked. Since fiscal 2009, the cost of producing all of Estée’s products has risen just 8%, compared with a revenue increase of almost 40% — a margin that has left loads of money for both increased profits and a major boost to advertising and promotion. The overall ad and marketing budget, in fact, has swelled some 50% under Freda, to $2.8 billion a year.

Another linchpin of the Freda strategy is to play only the winners. In the past Estée had long overspent on fragrances, the least lucrative of its major product lines. By the late 2000s the perfume market was overrun by fierce competition among designer and celebrity brands. Yet in 2008, Estée’s managers were desperately propping up sales by spending fully half of their total U.S. ad budget on fragrances, which contributed just around 18% of sales.

Freda ended licenses with poorly performing fragrance brands Sean John and Daisy Fuentes. He also closed makeup line Prescriptives in stores. It was a key moment in his relationship with the Lauders. For Leonard, Prescriptives was a favorite, if deeply troubled, child. Still, he supported Freda’s decision, knowing that it would send a strong signal of support for his CEO’s profit-centered campaign. Freda has engineered a vast reallocation of resources by shifting ad spending away from fragrances into three highly lucrative areas. The first has been skin care, which is growing faster than makeup and boasts the highest margins because the creams and serums cost the least to manufacture and package. The second has been expansion in China, where Estée’s sales, by Fortune’s estimate, have tripled to around $600 million in the past three years. (The theme there, once again, is skin care, which accounts for over 80% of the Chinese market.) And the third is travel retail — what consumers buy when they’re outside their home countries. The driver here has been the huge rise in air travel by Brazilians and Chinese. For every real or yuan they spend on an Estée Lauder product at home, the Brazilians and Chinese spend two times as much abroad.

The three-column strategy has helped revive the two largest signature brands, Estée Lauder and Clinique — both of which had been vastly overusing one of Mrs. Estée Lauder’s original inventions, “gift with purchase,” to generate puny gains in sales. The brands would spend lavishly on newspaper, radio, and direct-mail advertising to entice women to buy skin cream by offering a bag of smaller-size makeups and creams along with it, hoping the customers would come back later and pay for the bigger sizes. It wasn’t happening, and the free merchandise was destroying profitability. “Women got used to coming to the stores to buy Estée Lauder brand products only when they heard ‘Come get your free gift,’ ” says Ali Dibadj, an analyst with Sanford C. Bernstein. “It was becoming like your grandmother’s brand,” says Linda Weiser, an analyst at investment bank B. Riley.

When Jane Hudis became Estée’s brand global president in 2009, she spent weeks with Leonard in the company’s archives studying the signature brand’s old ads and packaging, looking for ways to restore the excitement. Hudis made the choice to drastically curtail gift with purchase. The lower promotion costs freed up money for Hudis to invest in product launches. Last year Estée introduced a new formulation of one of its bestsellers, Advanced Night Repair, a serum that purports to restore the skin’s suppleness while you’re sleeping, which has given a big boost to sales. The comeback at the Estée Lauder brand is astounding. By Fortune estimates, its sales have jumped from $1.8 billion in 2008 to nearly $3 billion this year.

Once tired, Clinique is also on the rise. But the hottest major brand in the family is MAC. It takes only $10 or $20 more to move up from a drugstore to a MAC eyeliner, and MAC’s edgy, outrageous image is proving a big draw. It’s hard to associate its vibe with the relatively dignified Lauders. MAC was founded by two makeup artists in Toronto in the early 1980s, and started by selling heavily pigmented products for drag queens. Notably, the brand’s first spokesperson was drag queen recording artist RuPaul, and its motto was — and still is — “All ages, all races, all sexes.” When Leonard first saw the folk with the multiple piercings and tattoos working for MAC, he got the shock of his life. “I’m a nice Jewish boy from New York, and here I am looking at purple hair, orange hair, pierced lips,” he marvels. “I’d never seen people like that in my life. But I loved the brand because it was so weird and wonderful.”

Estée Lauder finished its purchase of MAC in 1998 for $120 million, when sales were $60 million. Today it is one of the largest makeup brands in the world, with almost $2 billion in revenues — and it’s growing in double digits. Freda absolutely loves MAC, which is the archetype for what he’s striving for: huge and growing sales per store and counter, so the revenues dwarf the far lower fixed costs. MAC is estimated to generate $1.45 million in sales at its stores and counters, three times the average in the prestige industry. The brand spends lavishly on training makeup artists, and Freda raves about their high-touch artistry. “MAC is as much about education in doing makeup as products,” he says. “It’s all about the emotion around the brand, the intangibles.”

Sitting in his small 40th-floor Midtown office on a late September afternoon, Freda talks with near rapture about a “look” that his company’s MAC artists now do effortlessly on untold thousands of women and men: It’s called the smoky eye — though it sounds like “smoky ride” when he says it. The makeup artists apply layers of mascara in great feathered sweeps. “If you do it by yourself and don’t do it right, it’s like someone punched you in the eye!” marvels the CEO. When he describes it, it almost sounds like a scene from a Fellini film.

This story is from the November 18, 2013 issue of Fortune.