2023-05-07 01:54:40 ET
Summary
- e.l.f. Beauty's differentiated marketing and pricing policy is quite a game changer in the industry.
- The company had quite a good performance in the recent past, and stock almost quadrupled within 12 months.
- While ELF has a terrific business, its valuation doesn't excite me.
Overview
e.l.f. Beauty ( ELF ) is one of the fastest growing and most innovative companies in the US beauty industry. The company has challenged the traditional belief that quality cosmetics are only available at high prices by offering high-quality prestige-inspired beauty products for e ye, l ip, and f ace (hence the name e.l.f. Beauty) at affordable prices with the majority of its products retailing at below $6 which is significantly lower than other legacy cosmetic brands. For instance, e.l.f. cosmetic Poreless Putty Primer retails at $10 as compared to a prestige primer at $52, and the e.l.f. cosmetic 16HR Camo Concealer at $7 versus a prestige concealer at $30. ELF’s aggressive pricing policy encourages its customers to try and experiment and its product quality encourages them to do repeat purchases and increases brand loyalty.
Similar to its differentiated pricing strategy, ELF has a differentiated customer engagement model too. Unlike legacy beauty brands that often reach consumers through traditional media such as magazines, newspaper, and television, ELF builds brand equity and drive traffic to its national retail partners and its e-commerce website primarily through digital and social media such as Facebook ( META ), Instagram, and TikTok.
Another key aspect that I like about ELF is its leadership in the speedy introduction of new products. The company has innovation capabilities that can take a new product from concept to online launch in as few as 13 weeks and 20 weeks on average. Upon approval and validation on the online marketplace for a product, the company then directs it to the retail channel for sales. This greatly improves the store productivity of its retail channel partners.
While I like ELF’s strategy on pricing, marketing, and fast cycle innovation capabilities there are a few things that I want to highlight that concern me.
1. Concentration of sales to large retail channels.
2. Majority of ELF’s products are sourced from China.
Retailers such as Walmart ( WMT ), Target ( TGT ), and Ulta Beauty ( ULTA ) together constitute a total of 61% of the total revenue of ELF. Such significant dependence on a few retailers makes me concerned. Generally, the concentration of sales to few customers leads to the lesser bargaining power of the seller (here ELF). Any change in the policies or ability of ELF to meet the demand of retail customers relating to service level, inventory destocking, pricing, or promotional strategy, or the limitation in retail display space can have a material impact on the company’s revenue.
Moreover, ELF does not own or operate any manufacturing facility and uses multiple third-party suppliers and manufacturers based primarily in China. An increase in tariffs for cosmetic products as in 2019 can be detrimental to margins and political relations between the US and China doesn't make me appreciative of ELF’s over-dependence on Chinese imports.
Recent Earnings and performance highlights.
As represented in the chart below ELF’s revenue has grown exponentially post-pandemic growing from $268 million in FY19 (ending March 2019) to an anticipated $547 million of revenue in FY23 (ending March 2023). During the period, the company significantly outperformed its competitors and gained market share from 4.8% in March 2020 to 5.9% in March 2022 and is expected to be 7.4% in March FY23.
YCharts
The significant outperformance can be attributed to ELF's differentiated marketing and pricing policy, which is explained earlier in this article. Moreover, the company had increased its marketing and digital investment post-pandemic. In FY19, the company spent 7% of the net sales on marketing and digital investment which grew to 16% in FY22, and in FY23 it is expected to be 17-19%. While revenue doubled in these years, marketing and digital investments more than doubled as a percentage of revenue which means marketing and digital investment grew 4-5x during the period.
Company presentation
In addition to increased marketing spending, a major part of ELF’s outperformance is also attributed to inflation in recent years which accelerated the trade-down from higher-priced prestige products to more affordable ELF cosmetic products. Although trade down effect should continue to benefit ELF, it should not be as beneficial as it was in prior years due to cooling inflation which should lead to a slowing revenue growth rate in the future.
Valuation
ELF posted splendid numbers in recent years, beating the consensus estimates in every quarter for the last few years. Now the Street is expecting similar outperformance to continue in the future, which is well reflected in its stock price which almost quadrupled in the last 12 months and its stock is trading at a whopping 57.63x EV/EBITDA ((TTM)) multiple. ELF stock is trading at the highest point of EV/EBITDA multiple in its trading history.
YCharts
The stock looks even more overpriced when compared to the sector median EV/EBITDA multiple which stands at 14.15x. This means the company trades 307% higher than the sector median. Upon looking at the valuations, it is clear that one should pay dearly to buy ELF’s stock.
Conclusion
While ELF’s business is well positioned to outperform the cosmetic industry and gain share, I don't want to pay such a huge premium for that especially when benefits from trade down are expected to abate and overall stock market sentiments aren’t encouraging. The problem with ELF’s stock or stock of any other good business trading at sky-high valuation is that they tend to reverse quite quickly at even the slightest hint of earning growth slowdown or even an unrelated event such as a weakening overall market sentiment. This can weigh on the stock price and stocks like ELF, which recently rose significantly can take quite a beating. On the flip side shorting these stocks doesn’t makes sense either as it can surprise anytime on the upside. Hence, I would prefer to be on the sidelines for the time being.
For further details see:
e.l.f. Beauty: Beautiful Business, Ugly Valuation