OLPX - Olaplex: A PR Nightmare

2023-11-01 18:00:00 ET

Summary

• Olaplex, a hair care company, is facing a lawsuit claiming its products cause hair damage and dry hair.
• The company's financials have been in turmoil, with revenues decreasing sharply and margins shrinking with a year-over-year revenue decline of 48% in Q2.
• I take a look at Olaplex's valuation through a bullish and a bearish DCF model.

Olaplex Holdings, Inc. ( OLPX ) sells hair care products in the United States as well as internationally. The company has found itself in a challenging position as a lawsuit against Olaplex claims the products damage consumers' hair. The growing concerns have translated into freefalling revenues and shrinking margins, making Olaplex's financials crumble after years of high growth. The stock price has fallen into a small fraction of the IPO price as a result. In this text, I analyse the valuation through two DCF model scenarios.

The Company & Stock

Olaplex provides hair care products. The company's products use an ingredient called Bis-aminopropyl Diglycol Dimaleate, which Olaplex claims to help in protecting and strengthening bonds in hair, preventing hair from damage. The company relies on active social media marketing and specialty retail partners to sell its products.

The company's brand and financials have been in turmoil in recent quarters. Olaplex has found itself in a media scandal - nearly 30 women have issued a lawsuit against the company. In the lawsuit, the women claim that Olaplex's products cause damaged hair, as well as inflammation and hair loss. In addition, Olaplex uses an ingredient called lilial, that has been banned in the EU with concerns about the ingredient's effects on fertility. Olaplex's revenues have decreased very sharply as a result as the brand has been massively damaged. Olaplex claims that the products are safe to use, but the company's PR team hasn't been able to revert Olaplex's reputation to any extent.

As a tiny promising factor, the company's executive chairman John Bilbrey has been buying some shares in the autumn:

The insider buys haven't helped Olaplex's stock performance. From the company's IPO in late 2021, Olaplex's stock has lost around 94% of its price:

Financials

Before the concerns about the products' safety emerged, Olaplex achieved hypergrowth. From 2019 to 2022, the company achieved a revenue CAGR of 68.1%. On a quarterly basis, Olaplex's problems started in Q3/2022 as the company's revenues decreased by 16% quarter-over-quarter. In the most recent quarter, Olaplex's revenues decreased by 48% year-over-year:

Although Olaplex's revenues have started to deteriorate, the company still operates at healthy margins. The company's EBIT margin has come down from figures between 50% and 60% into a figure of 22.6% in Q2/2023, though - as revenues have decreased, the margin has come down significantly:

Upcoming Q3 Earnings

Olaplex is reporting its Q3 earnings on the 7th of November. Analysts are expecting revenues of $116 million, representing a year-over-year decrease of 34% and a quarter-over-quarter growth of 6%. I believe that expecting q/q growth is quite optimistic, as the company's struggles seem to continue - in my opinion, the revenue estimate is likely to be too high. Analysts also expect an EPS of $0.02, compared to previous year's Q3 EPS of $0.09 - Olaplex's profitability is expected to fall very significantly, which I also see as likely.

Valuation

Olaplex's forward P/E history is intriguing - the company's P/E ratio has gone from a high of 77.9 near Olaplex's IPO into a current ratio of 9.1:

To get a clearer view of Olaplex's valuation in terms of scenarios, I constructed two discounted cash flow models instead of my usual one model - in one scenario, I model in a recovery from the recent turmoil into a new path of growth. In the other DCF model scenario, I model deteriorating financials in case the lawsuit against Olaplex seems to turn out badly for the company.

In the first, bullish scenario, I model the company's operations to mostly recover from the brand damage. I estimate Olaplex's revenues to decrease by -34.5% in 2023, representing the upper range of Olaplex's current revenue guidance. After 2023, I model in a recovery as Olaplex's name would clear from the current scandal - for 2024, I estimate a growth of 17%. After the year, I model the growth to slow down in steps into a perpetual growth rate of 2.5%. From 2023 to 2032, the estimates represent a CAGR of 7.9%. As the company's revenues recover, I estimate the EBIT margin to do the same with a figure of 33.2% in 2032, representing a margin expansion of 7.8 percentage points from the 2023 estimate. This scenario crafts the following DCF model scenario with a fair value estimate of $3.24, around 125% above the current price at the time of writing:

On the other hand, the current scandal has a good chance of sticking in the short- to medium-term, or even long-term. In the bearish scenario, I estimate the current challenges to continue into the following years, although with smaller revenue decreases. For 2024, I estimate the revenues to decrease by 8%, followed by shrinking revenues up until 2028. After 2028, I estimate the company's revenues to stabilize into a perpetual growth rate of 2%. The estimated revenues represent a CAGR of -1.5% from 2023 to 2032. As the revenues decrease, I estimate slightly thinning margins - I estimate the EBIT margin to stabilize at a figure of 19.0%, 5.7 percentage points the 2023 estimate in the bearish scenario. These estimates craft a DCF model scenario with a fair value estimate of $0.70, around 52% below the current price:

As Olaplex has a large amount of amortizations that worsen reported the company's operating income, Olaplex has a very good cash flow conversion that I considered in the DCF models. The used weighted average cost of capital is derived from a capital asset pricing model:

In Q2, Olaplex had $14.7 million in interest expenses. With the company's current amount of long-term debt, Olaplex's annualized interest rate comes up to a figure of 8.94%. The company uses quite a significant amount of debt compared to its current market capitalization - I estimate a long-term debt-to-equity ratio of 30%.

On the cost of equity side, I use the United States 10-year bond yield of 4.87% as the risk-free rate. The equity risk premium of 5.91% is Professor Aswath Damodaran's latest estimate for the United States, made in July. Tikr estimates Olaplex's beta at a figure of 1.21 , using monthly data from a period of five years. Finally, I add a small liquidity premium of 0.5% into the cost of equity, crafting the figure at 12.52% and the WACC at 10.78%.

Takeaway

When simplifying the investment case into two scenarios that follow my DCF model scenarios, the market currently prices in a 29% probability of the bullish scenario and a 71% probability of the bearish one. I believe that these implied odds for the bullish scenario are still approximated too high; a recovery from the brand damage seems like a miracle. Although the stock could have a very significant upside if the brand image improves, I believe that investors still get a poor risk-to-reward ratio. For the time being, I have a sell rating for the stock.

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