Summary
- HNST has pulled back into what should be reasonably strong support.
- The company has its issues, but expectations are very low at this point.
- I like the risk/reward here on the bullish side.
Consumer staples companies have held up better than more aggressive areas of the market during this downturn, as they generally do. After all, these tend to be companies with lower growth, predictable revenue and earnings, and largely inelastic demand from consumers. What you don’t normally get in this group is meaningful growth, but in the case of the beleaguered Honest Company ( HNST ), I think the pieces just may be in place for a turnaround in the share price.
Let’s start with a daily chart.
Ever since Honest went public about a year and a half ago, it’s been sold by investors. The stock went from $18 in June of 2012 to $2.54 this June, and in basically a straight line. However, since that low, the stock has been in rally mode, and I’m not sure it’s done yet.
I’ve drawn in what could be trendline support, which intersects almost exactly with where the stock closed on Friday. In addition, the upward-sloping 50-day simple moving average is almost exactly where the stock closed on Friday. I always like trading stocks that have multiple means of support that converge on the same area because the odds of that support holding rise sharply.
In the case of Honest, we can see the 50% retracement of the June rally is also within pennies of the current share price. So while this is no guarantee the $3.50 area will hold, there’s plenty of reason to be optimistic that it will.
Further, the accumulation/distribution line is moving higher during this consolidation, meaning investors are buying the dips rather than selling the rips.
The PPO, which is my favorite momentum indicator, is also testing the centerline as the histogram gradually turns higher. This is exactly the kind of behavior you want after a big rally, and with the PPO testing the centerline while simultaneously seeing the stock at what should be solid support, the odds are firmly in the favor of the bulls.
Let’s briefly look at the weekly chart as well to get a longer-term perspective.
I’ve kept this one simple because I wanted to point out that the RSIs (5 and 14 weeks in this chart) are showing vastly improved momentum. In addition, the weekly PPO produced a buy signal back in June and hasn’t looked back. The weekly PPO histogram has come down slightly during the consolidation, but the PPO itself is still in massively oversold territory. Point being, I think the weekly chart is confirming what the daily chart is telling us.
Let’s take a look at the fundamentals and see if we can find some supporting evidence of the bull case.
Growth opportunities abound, but at what cost?
HNST is a very small company in the world of retail, with about $320 million in annual revenue, and a market cap of almost exactly the same amount. That means we can reasonably expect some growth over and above the established stalwarts of the group such as P&G ( PG ) or J&J’s ( JNJ ) consumer business. So how does HNST stack up?
Almost two-thirds of the company’s revenue is baby products, with about a third coming from skin and personal care products, and about 5% from household and wellness. That last category is what HNST calls “emerging” revenue, but that category has also been a bit of a dud in terms of consumer acceptance and revenue growth.
At any rate, HNST has grown its digital and retail presences through key physical retail partnerships with big names like Target ( TGT ) and Ulta ( ULTA ), and digitally with Amazon ( AMZN ) and its own website. I think this 50/50 mix of digital and physical is a strong trait of the brand and something the management team has executed well, particularly with its physical retail partnerships.
Virtually all of its revenue is from the US, so it’s possible HNST can expand internationally someday. I don’t see it as ready for that given it faces some challenges with growth at home, but the company notes that Jessica Alba, the company’s founder and public face of the company, is quite popular internationally. Will that help? Maybe, but for now I’m assuming HNST is a US story until proven otherwise.
The company has also been growing its core products revenue by leaps and bounds in a lot of cases, which I think is cause for optimism longer-term.
We can see diapers, wipes, and skin care products are all growing at rates well in excess of peers, and that market share is growing as a result. I see the baby products category in particular as ripe for products that Honest makes, in that if someone is going to spend a little extra for a more natural product, it is likely to be for their children. That’s the entire idea behind Honest, and I think it’s a good one. I’m not the only one, apparently, as the company’s core products continue to grow quite nicely.
Let’s now take a look at what all of this boils down to, and that’s revenue growth expectations. Revenue is everything for the investment case for Honest, as it continues to operate unprofitably, so we cannot use traditional earnings metrics.
Revisions were rough for about a year as we saw sharp cuts to the top line pretty much right out of the gate. However, we’ve seen six months or so of flat estimates, and while I’d obviously prefer they move higher, it appears the cutting of revenue estimates has ceased. That’s a big step towards an ultimate bottom in the stock.
With much more reasonable revenue targets, and very modest growth expectations now priced in, I see Honest as having a great shot at some upside surprises in the years to come if it can continue to execute with core products.
A huge caveat to the bull case
Revenue is important for Honest, but one thing the company has thus far done a poor job of is managing its margins. I get it; there are inflationary pressures everywhere. However, the strongest companies in each industry are combatting these pressures with pricing and sourcing actions. On the evidence below, it appears Honest doesn’t have an answer.
This chart depicts gross margins and SG&A costs on a trailing-twelve-months basis for the past couple of years, and it’s not pretty.
Gross margins have declined sharply, particularly in the most recent quarter. While SG&A costs have dipped of late, it just hasn’t been enough. One simple way I like to measure a retailer’s efficiency is to subtract SG&A costs from gross margins, but on this measure, Honest has never produced a positive value. I also understand Honest is not a pure retailer but it’s close enough to make this comparison.
The point is that I’m not sure Wall Street is worried about the company’s revenue growth; I believe it is (rightly) more worried about its ability to effectively monetize that revenue growth.
The upside is that the company’s poor performance on margins means that expectations are very low, so if Honest can find a way, the upside potential could be huge.
Let’s value this thing
As mentioned, the company has no profits so we’ll use price-to-sales instead.
The company IPO’d to a valuation of about 5X forward sales, but as the share price and revenue expectations have come down, we’re at 1X forward sales today. That’s cheap on both a relative basis and absolute basis, and reflects the company’s weak margins, in my view. To be clear, it would take a massive turnaround in margins to get back to 5X sales, but I do think we can reasonably expect something materially higher than 1X.
One final consideration is that Honest has core products that work and have clearly resonated with consumers. It has a very low P/S ratio, but it also has a clean balance sheet with a negative net debt position. This combination of factors, in my view, also makes Honest an attractive acquisition target for other companies that make things like diapers and wipes. A buyer would be able to make Honest Company’s unsustainable SG&A structure redundant by tucking it in to its existing SG&A structure, instantly improving the margin profile of the products Honest sells. While this is not reason enough to buy Honest Company stock, I do think it’s a real possibility that Honest gets acquired.
For me, the chart looks supportive of higher prices, it appears analysts reached peak pessimism in terms of revenue cuts, and the valuation is very cheap. It’s possible Honest goes lower, of course, but I think the risk is firmly skewed to the upside on this one.
For further details see:
Honest Company: An Asymmetric Upside Opportunity