HELE - Helen of Troy: Good Long-Term Prospects But Near-Term Headwinds

Summary

• The current inflationary environment and lower demand are a concern in the near term.
• Retail inventory adjustments and lower demand in the majority of brands have slowed down progress towards the growth targets of the transformational strategy.
• The company should be able to deliver revenue growth in the medium to the longer term with the benefits realized from its transformational strategy.
• The company implemented Project Pegasus during the second quarter of fiscal 23 to support long-term profitability and margin expansion over the next couple of years.

Investment Thesis

Helen of Troy ( HELE ) is experiencing lower demand for the majority of its brands in the current inflationary environment as higher prices have affected the consumer's purchasing power. The company’s revenue generation is being adversely impacted by consumers delaying purchases of discretionary products and trade downs to opening price points in non-discretionary products. Furthermore, retail customers’ inventory adjustments to align with lower sell-through levels are also affecting the company's revenue growth. Margins are also being negatively impacted by inflationary costs. Looking forward, I believe that while uncertain macro headwinds are a near-term concern, as these headwinds subside in the medium term, the company should be able to deliver revenue growth in the medium to longer term. Once the retail inventory adjustments are over, inflation starts to moderate, and the cost savings from Project Pegasus initiatives start taking hold in the back half of FY24, the company should return to growth and see margin expansion. However, I believe we are still a couple of quarters away from fundamentals bottoming. Hence, I have a neutral rating on the stock and prefer to be on the sideline for a while.

Revenue Outlook

In the second quarter of the fiscal year 2023, Helen of Troy reported net sales of $5.2 million, up 9.7% Y/Y, with the acquisitions of Osprey and Curlsmith contributing 12%Y/Y to the growth. Moreover, revenue growth was supported by easier comparisons for water, air filtration, and humidification products in the Health & Wellness segment as a result of stop shipment actions in Q2 FY22 due to the EPA compliance packaging matter. In addition, higher international sales and favorable pricing also helped revenue growth. On a constant currency, organic sales declined by 1.5% Y/Y. The decline reflected lower consumer demand in the Beauty segment’s hair appliances category and home-related categories in the Home & Outdoor segment, and shifts in consumer spending patterns due to inflation. In addition, inventory adjustments by retailers in order to align with lower sell-through also negatively impacted organic sales growth. FX was a 0.9%Y/Y headwind in the quarter.

Helen of Troy is currently in phase two of its transformational strategy, which began in fiscal 2020 and will end in fiscal 2024. Phase II's goals include an annual increase in organic sales by 2.5%-3.5%, continued margin expansion by 20-30 basis points (bps) annually, strategic and effective capital deployment with ROIC of at least 20% by fiscal 24, and an annual EPS growth of more than 8%. Phase II focuses on continued investment in its Leadership Brands, with an aim to grow them through consumer-centric innovation, expanding them more aggressively outside of the United States, and adding new brands through selective acquisition that benefits the leadership brands and are up-and-comers in their categories. In line with its strategy, on April 22, 2022, the company completed the acquisition of Recipe Products Ltd., a manufacturer of innovative prestige hair care products for all types of curly and wavy hair that sells under the Curlsmith brand. The company is also divesting its low-performing mass-market personal care brands. These acquisitions and divestitures should help the company to improve its product portfolio for longer-term growth. Moreover, the company is also investing in an advance distribution center in Tennessee, which is planned to be operational in early fiscal 24. This distribution center is expected to improve the efficiency of the company and improve inventory management with the help of advanced technologies.

While the company’s initiatives under its transformational strategy are interesting, the current macroeconomic headwinds are adversely impacting its revenue growth and profitability, slowing down the progress toward phase two targets of the strategy. During times of high inflation, consumers are constantly shifting their buying patterns which are negatively impacting demand for various products in the company’s portfolio, especially for discretionary products. Consumers are also trading down to opening prices in non-discretionary products. This demand uncertainty led to inventory adjustments in retail channels affecting the company’s revenues.

Looking forward, the lower demand for HELE's products and continued inventory adjustments by retailers should impact sales growth in the near term. However, I believe the company should be able to return to revenue growth in the medium to long run. HELE’s transformational strategy should benefit it, through new product launches driven by consumer-centric innovations and M&A synergies, in the second half of fiscal 24. Moreover, the company’s mix of product portfolio across different price points, which the company refers to as good, better, and the best mix of product portfolio should also provide some support to revenue even in the case of customer trade downs. Also, I believe the retail inventory adjustments should be complete by the second half of fiscal 24. This should help the company resume its revenue growth in 2H2024 and beyond.

Margin Outlook

In the second quarter of fiscal 23, the company reported an adjusted operating margin of 13.9%, a decline of 320 bps Y/Y. The decline was attributed to increased outbound freight costs, increased marketing expenses, volume deleverage in the Beauty segment, unfavorable product mix within the Home & Outdoor segment due to the acquisition of Osprey, higher inventory obsolescence expense, inflationary costs including higher salary and wage costs, and higher distribution expenses.

In the second quarter, the company introduced Project Pegasus, a three-year restructuring initiative. The project is focused on improving profitability, operating margin expansion, and driving savings to reinvest into the business and creating a platform for future growth. The company expects to achieve annualized pre-tax operating profit improvements of $75 million to $85 million by the end of fiscal 2026 through Project Pegasus. The company estimates that 25% of the savings from this project will be recognized in fiscal 2024, another 50% in fiscal 2025, and the final 25% in fiscal 2026. Moreover, out of the total savings, management expects 60% to be achieved through lower cost of goods sold and 40% due to lower SG&A.

The initiatives under Pegasus to achieve these targets include:

• Optimizing the brand portfolio, accelerating the cost of good savings by identifying new opportunities to better leverage the scale and procurement, strengthening supplier, and platforming technologies more rapidly and at a lower cost.

• Enhancing the efficiency of the supply chain network,

• Optimizing the indirect spending, streamlining, and simplifying the organization.

Furthermore, the company has implemented plans to reduce inventory levels, increase inventory turnover, and improve cash flow and working capital. The Company anticipates that improvements related to these initiatives will begin in the second half of fiscal 2023 and will continue into fiscal 2024.

Looking forward, I believe, while inflationary costs and volume deleverage are near-term headwinds on margins, the company has good medium to longer-term margin growth prospects. The company should benefit once the inflation starts moderating and the cost-saving benefits of Project Pegasus are realized.

Valuation and Conclusion

Helen of Troy is currently trading at a P/E 11.29x FY23 consensus EPS estimate of $9.18 which is a discount versus its historic 5-year average forward P/E of 16.86x. Looking forward, I believe the near-term results should be adversely impacted by macro headwinds, lower demand and inventory destocking by retailers in response to lower sell-through. In the medium to longer term, the company should be able to post top and bottom-line growth helped by its transformational strategy and project Pegasus. However, I would prefer to be on the sidelines for now and wait till inventory destocking by retailers is complete and a normalized buying pattern kicks in. Hence, I have a neutral rating on the stock.

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