Looking For The Beauty In e.l.f. Beauty (ELF), I Found The Beast
I leave no stone unturned when it comes to finding mispriced stocks in a variety of sectors. And I was doing my due diligence on the beauty sector and e.l.f Beauty, Inc. (ELF) a few weeks ago. This is a new company in the beauty sector that went public in late 2016, and perhaps, many investors have never heard of it thus far.
e.l.f. Beauty is engaged in the beauty industry selling its products through its website, its e.l.f. stores and at Target (TGT), Walmart (WMT), CVS Health (CVS) and other retailers. It offers products for eyes, lips and face such as eyeshadow, eyeliner, mascara and eyelashes, eyebrows, concealer and primer, brushes and tools, sets and palettes, lipstick, lip gloss, lipliner, lip care and brushes. Also, it sells a number of products as over-the-counter (OTC) drug products, which are subject to the FDA OTC drug regulatory requirements because they are intended to be used as sunscreen or to treat acne.
e.l.f. Beauty, Jefferies And The Focus On Online Marketing
What really puzzled me was a recent bullish call from Jefferies. Specifically, in early June 2017, Jefferies initiated coverage on e.l.f. Beauty with a Buy rating and $30 price target and reiterated the buy rating a few weeks ago noting that:
"ELF among few mid cap ways to play MSD+ beauty category growth; offers superior 22% EBITDA margin profile for its size, with compelling & clear 20%+ sales growth drivers. Brand equity building virally," wrote analyst Stephanie Wissink.
Back in early June 2017, the stock was at approximately $25.50, so the analyst estimated that it had a 19% upside potential. And she has not changed her bullish view since then.
On that front, bulls say that the company's key advantage is that it focuses on online marketing and has strong working relationships with about 500 bloggers, as quoted below:
" Few brands have had as singular a focus on social media as e.l.f., a cosmetics line that does zero in the way of traditional advertising yet has strong working relationships with about 500 bloggers. As the CMO for e.l.f. (the acronym stands for Eyes Lips Face), Ted Rubin is known for his active use of Twitter (where he has 20,000 followers) and his responsiveness. Rubin, a former protege of Seth Godin, says he responds to every tweet he gets. The social media outreach, along with distribution at Target, a recession-friendly price of $1 per item and a positive review in O: The Oprah Magazine two years ago have helped e.l.f. build a strong brand on the cheap. "
Is this enough to justify the company's high valuation and weak balance sheet?
The Free Cash Flow Problem And The Leverage
Digging into the company's balance sheet, I found that:
1) China: e.l.f. Beauty currently sources and manufactures substantially all of its products from third-party suppliers and manufacturers in China. As of June 30, 2017, it had a team of 64 employees in China to manage its supply chain.
2) Revenue and EBITDA: Based on the company's guidance, revenue and adjusted EBITDA in 2017 are expected to be $270 million and $62 million, respectively.
3) Margins: Gross profit margin and operating margin in the first nine 2017 were approximately 62% and 10%, respectively. The gross profit margin is decent but the operating profit margin is low.
4) Operating cash flow: The company had negative operating cash flow of approximately $6.2 million for the first nine months of 2017 because of "a $34.1 million decrease in accounts payable and accrued expenses primarily due to payments for inventory ordered at the end of fiscal year 2016". However, it generated positive operating cash flow of $11.6 million in Q3 2017.
5) Free cash flow: It generated FCF of approximately $9.4 million in Q3 2017, but it didn't manage to generate FCF in the first nine months of 2017. Therefore, generating FCF in 2017 doesn't seem to be a slam dunk while e.l.f. Beauty doesn't make any estimate on the operating CF or FCF in 2017 leaving us in the dark, based on the latest guidance.
6) Liquidity: As of September 30, 2017, it held $5.7 million of cash & cash equivalents and had borrowing capacity of approximately $32 million under the Revolving Credit Facility.
Specifically, on December 23, 2016, the company entered into a new five-year, $200 million senior secured credit facility with a syndicate consisting of several large financial institutions. The facility consists of a $35 million revolving line of credit and a $165 million term loan.
All amounts under the Revolving Credit Facility are available for draw until the maturity date on December 23, 2021. The Term Loan Facility maturity date is also December 23, 2021.
The interest rate on both the Revolving Credit Facility and the Term Loan was 4.5% per annum as of June 30, 2017. Amortization installment payments on the Term Loan Facility are required to be made in quarterly installments of:
A) $2,062,500 for fiscal quarters ending March 31, 2017 through December 31, 2018.
B) $2,475,000 for fiscal quarters ending March 31, 2019 through December 31, 2019.
C) $3,093,750 for fiscal quarters ending March 31, 2020 through December 31, 2020.
D) $4,125,000 for fiscal quarters ending March 31, 2021 through September 30, 2021.
E) The remaining Term Loan Facility balance is due upon the maturity date.
7) Net debt and leverage: As of September 2017, net debt was approximately $162 million with current debt and long-term debt being $18.1 million and 149.7 million respectively. Based also on the latest guidance, the company's leverage as of September 2017 was approximately 2.6 times.
Key Metrics For e.l.f. Beauty And The Peers
Let's check now the "big picture". And from a fundamental standpoint, the "big picture" is the relative valuation analysis based on the most significant metrics.
However, I don't include in this relative valuation analysis the big players such as L'Oreal (LRLCY), Shiseido (SSDOY), Estee Lauder (EL), Coty (COTY) and Ulta Beauty (ULTA). Given that e.l.f. Beauty is a medium-size business, I will include only medium-size and small emerging plays starting with the EV-to-Adj.EBITDA ratio:
And I will continue with the EV-to-Annual Revenue ratio:
Let's also check the leverage at the table below:
Lastly, let's check another key metric, the gross profit margin in the first nine months of 2017:
When it comes to the beauty sector, I'm bullish on it. First, check this excerpt from the global information company The NPD Group:
"Consumers are redefining the meaning of beauty in their lives by seeking feel good experiences and striving for healthier lifestyles. As a result, the beauty industry in the U.S. grew 6% in 2016 and has gained $1 billion for three consecutive years reaching $17 billion in sales, with millennials tending to be at the forefront of lifestyle changes".
"The global beauty industry is expected to rise from $80 billion today to $90 billion by 2020, while the premium beauty is expected to generate an additional $20 billion of global revenue by 2021, as it continues to be the driving force behind the global beauty industry. This growth will be driven by the U.S. and Chinese markets, which are expected to account for 54% of the market by 2021".
Amid this global growth, I want to emphasize these key details that mustn't go unnoticed:
1) The Makeup boom and the lipstick: Makeup was the big headline for the industry in 2016 and is the ultimate trend right now, with the lipstick being the leading lady in the makeup industry. Lipstick is the star of the show with a strong YoY growth rate of 13.6%. As also linked above:
" Four out of every five dollars gained in prestige beauty stemmed from makeup. The makeup category once again experienced the greatest sales growth (12%) and contributed 82% of the industry’s total gains. "
"For several years now, makeup has been skyrocketing within the cosmetics industry. On an international scale, make-up has seen a record growth of 8.4% across all geographical areas. According to research conducted by L’Oréal, the makeup industry is progressing six times faster than the cosmetics industry as a whole in Western Europe. This refers to every sector of the industry including luxury, mass-produced and professional".
One of the key reasons behind this explosion is the selfie generation:
"An explosion due especially to the birth of generation Z. Selfie- and social network-savvy, this age group hold their image and appearance in high regard. They're changing the norm, constantly keeping up with the latest trends and creating a buzz around new products and looks".
2) Skincare and fragrance: As linked above, skincare followed in YoY sales growth (2%) and fragrance (1%). The market drivers in Skincare are those products that help the face to be makeup ready, including masks (24%), lip treatments (20%), facial cleansers (7%) and facial exfoliators (5%).
3) Cosmeceuticals: These are skin-care products (i.e. creams, lotions and ointments) that are the combination of cosmetics and pharmaceuticals. Cosmeceuticals are cosmetic products with bioactive ingredients purported to have medical or drug-like benefits.
According to Persistence Market research, the cosmeceuticals market is expected to witness a surge across the globe and experience the fastest growth in personal care industry with players like Beiersdorf, L'Oréal, Procter & Gamble (PG), Johnson & Johnson (JNJ), Shiseido (SSDOY) and Unilever (UL) being the key vendors in the global cosmeceuticals market.
Increasing demand from middle age and growing urban population are expected to drive the global cosmeceuticals market which will reach $61 billion by 2020 accounting for approximately 16% of the entire cosmetics industry.
e.l.f. Beauty doesn't focus on the brick-and-mortar stores but invests big in online marketing to grow its business. And given that the companies of the beauty sector need to look beyond the traditional retail channels, I find online marketing to be more important than ever. Actually, there are a bunch of reasons why online marketing is not just important but rather a must when it comes to connecting with consumers these days.
However, there is a problem with e.l.f. Beauty's existing online marketing plan. Unlike other firms from the same sector such as Synergy CHC Corporation, e.l.f. Beauty doesn't have its own tech center for the execution of its online marketing plan but relies heavily on social media influencers to market its products. As such, my concern about e.l.f. Beauty's existing marketing strategy is that marketing arrangements with social media influencers are rarely exclusive.
More importantly, e.l.f. Beauty is a very expensive stock. It's far more expensive than its peers based on the key metrics EV/Adj. EBITDA and EV/Revenue.
Additionally, e.l.f. Beauty is not going to file for bankruptcy anytime soon following Perfumania Holdings (PERF), a highly leveraged firm from the beauty industry that filed for bankruptcy a few weeks ago. But its leverage coupled with its limited cash concern me a lot because I project that it will not generate enough free cash flow in 2018 to easily service its debt next year.
Moreover, the company's gross profit margin in the first nine months of 2017 doesn't really impress me. As shown above, ELF's gross profit margin doesn't stand out of the crowd, although things have improved on a YoY basis given that the gross profit margin in 2015 and 2016 was approximately 53% and 58%, respectively.
On top of this, after checking all the corporate developments, I don't see a strong catalyst that could push the stock in 2018 significantly higher than the current price level.
After all, I don't really need more criteria to avoid e.l.f. Beauty. To me, there are other picks from the sector with much better risk/reward ratio than ELF's.
However, I will not short ELF at the current price of $22.10/share for the following reasons:
1) The company traditionally experiences higher sales in the second half of the year compared with the first half of the year (seasonality). I forecast that this potential increase in sales coupled with a potential change in trend in accounts payable could help the company generate FCF in Q4 2017, which could make investors stay optimistic on the company for 2018.
2) Positive outlook for the industry in 2018, as presented in the paragraph above.
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Disclosure: I'm long SNYR.
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