2023-06-13 06:45:59 ET
Summary
- e.l.f. Beauty, Inc. offers cosmetic and skin care products.
- Revenue has grown at a CAGR of 13%, driven by an aggressive strategy to gain market share by disrupting the established incumbents.
- Margins have improved over time but remain below its peers as the company invests in growth. This is the correct decision.
- The company's current strategy should drive continued growth in the coming years.
- e.l.f.'s valuation is rich, we suggest caution.
Investment thesis
Our current investment thesis is:
- e.l.f . Beauty, Inc. (e.l.f.) is an industry disruptor providing value to consumers through a superior price-to-quality ratio.
- Revenue growth is fantastic and we think this should continue, with margins improving over time.
- Cosmetics and Skincare should remain resilient during weaker economic conditions, representing further value for investors.
- Taking market share for competitors Y/Y best illustrates the company's value.
Company description
e.l.f . Beauty, Inc. offers cosmetic and skin care products under various brand names like e.l.f . Cosmetics, e.l.f . Skin, Well People, and Keys Soulcare worldwide. The company provides products such as eye, lip, face, paw, and skin care through direct-to-consumer channels and national and international retailers.
Share price
ELF stock price has made impressive gains in the last year, with investors turning positive on the company's long-term prospects.
Financial analysis
e.l.f. financials ( TIKR Terminal)
Presented above is ELF's financial performance for the last decade.
Revenue
ELF's revenue has grown at a CAGR of 15% in the last decade, with much of this coming in the last few years. As the following illustrates, the company has consistently achieved strong quarterly growth, driven by the successful implementation of its strategy to shake up the cosmetic and skin care markets. We will break down the various components of this strategy below, and why we think this will propel the business forward in the coming years.
e.l.f . invests heavily in research and development to create new and innovative products, with the desire to create a market-leading offering across a host of different segments. The company has introduced several products that have become popular among consumers, such as the Poreless Putty Primer . We say "offering" because e.l.f. is not trying to create the absolute best product possible, this would be very costly to them and the consumer. They are trying to create a high-quality product at an affordable price, balancing between the premium market and the affordable segment. Most businesses that balance between the two fail, and rightly so, because to provide both to consumers is to give more by taking from the company's pockets. e.l.f . is closer to the affordable side of the spectrum but markets its product as comparable to the premium offering, relying on marketing, rather than input costs, to justify its premium comparability. The following illustrates the pricing difference between e.l.f . and the market.
This is a good time to transition into e.l.f .'s engagement with customers. The company has a strong focus on customer engagement and has created several initiatives to build customer loyalty. These initiatives include a rewards program and loyalty benefits. The competitive edge here is that e.l.f . offers a wide variety of products, allowing for a greater cross-selling opportunity through these rewards programs, compared to many of its peers who specialize.
Further, e.l.f . has been increasing its investment in digital marketing to reach a wider audience. This is the social media generation, with businesses created and destroyed by what is "trending". TikTok and Instagram are dictating consumer trends. The company has launched several digital campaigns, such as the #eyeslipsface campaign, which went viral on TikTok. Our view is that e.l.f . is "punching above its weight" here, able to continually garner interest that is dollar-for-dollar superior to its peers. L'Oreal ( LRLCF ) has 10m Instagram followers while having revenues of $41bn. e.l.f ., on the other hand, has 6m followers and revenue of $0.5bn. This is a monumental difference and reflects how closer e.l.f . is to the next generation in comparison.
Social media impressions (e.l.f.)
As part of this social media push, the company is partnering with several companies and celebrities, such as Chipotle and Jennifer Coolidge , to create limited-edition products. These collaborations help to increase brand awareness and generate hype. Management intends to increase marketing spend further in the coming years, in order to maintain its strong moment.
This moves us onto the more operational/financial side of its revenue strategy execution.
e.l.f . is leveraging its successful marketing to expand its product range to cater to a wider range of skin tones and textures. Further, it is launching new products across skincare and cosmetics. This should increase its total addressable market and help bring more consumers into the ecosystem.
e.l.f . is also expanding its presence in international markets, once again leveraging its successful marketing to enter markets that are in a sense, already waiting for their entry. The difference in marketing today vs. 10 or 20 years ago is that TikTok/Instagram etc. are global, so even though e.l.f . does not have a presence, it is still selling to customers. e.l.f . has done well to expand into other anglosphere countries, which culturally are similar to the US.
This leads us to what e.l.f . has achieved as a result of this strategy. One metric to judge this is growth in product consumption relative to the market, as it allows a comparison of relative outperformance. If we just look at growth in isolation, it is difficult to judge what the alpha is. Color and Skincare are both key segments for the business and as the graph illustrates, e.l.f . is substantially outperforming.
Y/Y growth v. the market (e.l.f.)
Further, we should compare e.l.f . to the top performers in the industry given the level of superiority against the market as a whole. As the following graph illustrates, the company is rapidly gaining market share relative to the others.
market share growth (e.l.f.)
Economic considerations
Current economic conditions are an opportunity for e.l.f .. Inflation and elevated rates are impacting consumers' spending patterns, as a greater portion of income is committed to living costs. We are seeing reduced discretionary spending in many industries as a response. Cosmetics and skincare are fairly inelastic, as these products are highly valued by consumers and are part of their daily routine. This said, there is opportunities to encourage consumer to trade down as incomes are squeezed. e.l.f . is positioned perfectly as a price-attractive option.
Margin
e.l.f .'s margins are quite attractive, having trended up in the last decade. The company has seen a 22ppt improvement in GPM and a 2ppt improvement in EBITDA-M.
The gains are driven by both pricing and cost. e.l.f . has done well to achieve scale economies as production has rapidly accelerated due to growth. Further, Management has been active with pricing and looks to have balanced this perfectly by not impacting hype around the brand.
The only concern would be that currently, the GPM gains do not translate to EBITDA, because of the increased S&A spending to acquire new customers. So far, this is a valid investment in our view, as scale is key. We believe this should not be a concern as e.l.f . is generating recurring customers and loyalty, and so once S&A begins trending down as a % of revenue, we suspect revenue will not be impacted.
Balance sheet
e.l.f . is conservatively financed, as the rapid growth in recent years contributing to a net cash position. Given the growth trajectory, the company is in a position to raise debt if required, as a means of conducting M&A or improving flexibility.
Management is not currently distributing to shareholders, which is not unusual given the current strategy and point in the business lifecycle. Our expectation is for this to continue and for cash to be reinvested into growth.
Outlook
Presented above is Management's outlook for FY24. The key is how high Management would go relative to our bullish view on the business, as this report has already illustrated that strong growth should be achieved. With Management guiding 20%+, there is a degree of execution risk.
Valuation
ELF stock is currently trading at 66x LTM EBITDA and 94x P/E. This is clearly an astronomical level that cannot be sustained. Markets are pricing in an impressive future.
e.l.f . is a high-growth business that will see a material change to its financial operations in the coming years (margin expansion and introduction of distributions). In order to assess a business such as this, our belief is that we should first consider what it should be worth at maturity (which valuations are easier to assess) and work back from there.
L'Oreal and Estee Lauder ( EL ) are the most comparable businesses, which are currently trading at 27x and 26x LTM EBITDA, respectively. The two businesses do deserve a premium to what will be a "mature" e.l.f ., as they own a range of brands that diversifies them. This said, we believe e.l.f . can reach their margin levels, as spending transitions away from heavy marketing. Therefore, we would imply a "future" valuation to e.l.f . of 25x.
Our view is that EBITDA can grow at a 15-20% rate in the coming years, which would mean it takes roughly 5 years to reach our "fair value". At this point, the company would still have the runway to outperform the market, but there is a substantial risk that comes with this.
Our general approach to this is that if the 5Y multiple gives us a sufficient discount, and remaining upside through continued growth, the stock is a buy. In this case, we believe the latter is likely, but the former is not. Investors currently are better off remaining patient.
Risks
With a >30x NTM EBITDA multiple, e.l.f . is trading at a steep premium. This is a reflection of investors pricing in a continuation of its current trajectory of both growth and margin improvement. This leaves the business susceptible to a share price correction if performance does weaken, even if this is only short term.
Final thoughts
e.l.f . is a fantastic business that has successfully delivered on its strategic goals. The next steps for the business are to continue growth and consolidate its position as the leading market disruptor. We have seen many businesses live and die by their hype, and do not think e.l.f . will be one of those.
The key value for investors is that the company is providing a disruptive product. Consumers buy into the quality and like the pricing, which is causing its competitors to take note. Its margins show that this is not coming at the expense of shareholders.
e.l.f .'s valuation is difficult to assess but markets are currently pricing in strong execution which does not leave upside.
For further details see:
e.l.f. Beauty: Results Of Incredible Growth Story To Be Seen