2023-10-06 07:18:09 ET
Summary
- ELF has a competitive advantage due to its lower prices, asset-light business model, and ability to quickly bring new products to market.
- The company's strong financial performance and market share demonstrate its strength in the beauty industry.
- The valuation of ELF is relatively high, but if the company can sustain its growth, the current price could be a bargain in the future.
Thesis
At the end of FY23 and at the beginning of FY24, e.l.f. beauty (ELF), which stands for eyes, lips, face, increased its net sales significantly.
This rapid increase also led to a rapid increase in ELF's share price. However, this is not one of the unprofitable, fast-growing tech stocks. This is a beauty company that is already profitable with strong EBIT and FCF margins. And the combination of fast growth and good profitability is very rare.
This could be one of the investments that ends up on the list of S&P 500 stocks with the best returns of the decade if they continue to produce stellar results. However, if they were to fall back to the growth levels of FY22 or the first half of FY23, the share price would likely suffer. So let me show you what I think about this company and how I think I would approach it.
ELF'S Business
ELF is a beauty company whose main customers are women with an affinity for beauty. The categories ELF serves are eyes, lips, face, skin care and tools. And their business model is to make affordable, high-quality cosmetics. ELF is also known for its dupes of high-end products , which have a large number of fans . In addition, their marketing campaigns are designed to go viral, usually through TikTok.
Does ELF Have A Competitive Advantage?
ELF's average price point is $6 , compared to $9 for regular-priced competitors and $20 for premium brands like Estee Lauder (EL). Because ELF produces in China, they are more asset-light, which leads to lower prices, and they can also produce relatively quickly and get new ideas or dupes to market quickly.
If we compare ELF to Coty (COTY), which has been a turnaround story over the last few years, and to the two big players, Estee Lauder and L'Oreal (LRLCF), we can clearly see that it can compete with them even though it is a fast-growing company. Estee Lauder's numbers are a little worse, as usual, as they have some difficulties in China, but ELF has almost the same gross and net profit margins as its much more expensive competitors. If you can sell products for an average of $6 and have the same margins as a company that is described as luxury beauty, that speaks to the strength of ELF. An EBIT margin of 15.96% and an FCF margin of 11.90% are incredibly strong for a company growing this fast. And when we look at net income per employee, we can clearly see that ELF's asset-light business model is working. $295k per employee vs. $44k, $20k and $72k shows a strong competitive advantage in terms of cost structure.
In addition, ELF really understands how to market themselves on TikTok and other social media sites. Here they are currently miles ahead of the competition. Due to their social media hype, their latest limited edition, Lip Duo Collaboration, sold out in 18 minutes. But I am not sure that this is an advantage that will grow over time, because I think that the other companies will most likely use ELF as a kind of playbook, and therefore their moat in this area may shrink over time. It is definitely an advantage that will be tested and attacked. In addition, the beauty market has relatively low barriers to entry, and new companies will emerge and attack the established ones.
But the last few quarters of hyper-growth and the fact that ELF has 18% market share at Target and is their number one brand in their niche shows that this is a very strong company. Their budget friendly dupes are perfect for times like these when many people are struggling with money and if they can get good quality items for a good price, they like it.
Is The Valuation Of e.l.f. Beauty Reasonable?
- Diluted EPS TTM: $1.78
- Discount rate: 10%
- Terminal multiple Year 10: 25x
In my opinion, the best way to see if a stock price is justified is to do a reverse DCF to see what is priced in. In this case, ELF needs to grow EPS by 21% annually over the next 10 years to justify the current share price. ELF's 3-year diluted EPS CAGR is 79.15% . Revenue growth is expected to slow in the coming years, but with an FCF margin of ~12%, they will have plenty of FCF to return to shareholders via buybacks, which would boost EPS. I do not think they will do massive buybacks for the next 3-5 years, but after that, when they are a more mature company, it could be an option. But even without buybacks, 21% annual EPS growth is a lofty goal, but achievable for a fast-growing profitable company like ELF.
Compared to its more mature peers, ELF is certainly expensive at 8x P/S and 49x EV/EBIT, but considering the last two quarters of 78% and 76% revenue growth, the valuation normalizes a bit. It would only take a few more quarters like this to grow into the valuation. The big question is whether the last few quarters were an anomaly due to increased social media hype, or if this growth is sustainable. If they can keep up the pace, the current valuation would look like a bargain in 3 years, but if they struggle to keep growing at this rate, the downside is relatively large for someone starting a new position at this price. The acquisition of Naturium, with a sales growth rate of ~80%, certainly secures growth for a few quarters.
ELF'S Balance Sheet
ELF has $143 million in cash and $79 million in debt and $107 million in TTM operating income. Therefore, both cash and operating income are greater than debt. This makes their balance sheet extremely strong as they could probably pay off all of their debt in less than 1 year if they wanted to and still maintain good liquidity.
Capital Allocation Skills
Before the rapid rise in 2023, ELF was a mediocre company in terms of return on capital. In the low teens for years. Currently, the ROIC looks fantastic at 21%, especially when we consider the low debt, which leads to low cost of capital. But the question is the same as with revenue growth. Can they sustain it, or is it just for a short period of time? I have seen many companies that had fantastic numbers for 1 to 3 years and then disappeared when the hype died down.
Risks
The biggest risk is valuation and what happens if growth slows. An 8x P/S multiple is not overly expensive when we look at some of the other companies today, but it could easily fall to a 4x multiple or lower if growth disappoints. Also, you have to worry that they are very dependent on China, although they are trying to build a Plan B with their Thailand operations, just in case something unforeseen happens. But we have to note that they have handled the China situation much better than other larger companies over the past few years. And I also think that the China risk is often overstated for political reasons. Because China also benefits greatly from these companies.
Conclusion
ELF is a very exciting company with a strong balance sheet and a competitive advantage that they need to prove they can defend. Their Beauty Squad loyalty program has more than 3.9 million members, which is quite a feat for such a young company. The risk is lower now than it was 1 month ago when the stock was trading at $130+, but since then the stock has been in a free fall and could fall even further. ELF could be one of those stocks that will never be cheap, but will still deliver phenomenal returns. On the other hand, people who get in now may be out of luck, as the stock has already priced in a lot of growth.
I could see ELF as a small position, say in the 1% range, to minimize the risk. If growth slows and the stock continues to fall, it would not have much impact on the overall portfolio return. But if ELF continues to grow and does so at 5x or 10x over the next few years, the small position would become a meaningful one with some additional investment.
For further details see:
e.l.f. Beauty: This Is A Rare And Rewarding Combination Of 2 Important Factors