Summary
- I wrote an article about the Honest company back in November, which probably came a bit out of the left field for many readers.
- I don't usually write about higher-risk type growth stocks such as this one - but I'm happy to take reader requests and do research.
- In this case, I went neutral on the company. Here is my update for the year 2023, and what you can expect from HNST.
Dear readers/followers,
I wish that certain companies and businesses came with somewhat higher appeal than they actually do. The Honest Company ( HNST ) is one of them. It's not that I dislike companies that focus on clean, effective, ESG, and sustainable consumer products - I just find them to be mostly unproven (by that I mean financially) in the long-term sense, which means that I have to apply fairly severe discounts to account for the elevated amount of bottom-line risk due to the company's morals and what they "cost".
Granted, the environment for such companies has significantly changed in the past few years - for the better. However, I am far from convinced that we as of yet are in a position where it can be argued that such strategies are suitable for everyone, or even that they offer long-term profitability in various market situations.
Different investors handle sustainability, ESG, and "rights" differently. Me, I don't confuse these ambitions for profitable investments, unless they can prove this is the result. When I invest in the stock market, I do so for one reason - profit.
I do give money to charity, and this is how I support ESG, sustainability, and various rights and causes - but I never confuse one with the other, as some are seeming to want to do in this market/day and age.
So, when I revisit Honest Company, it's the bottom line and potential profitability that we're going to be concerned with - nothing else.
The Honest Company - Honestly attractive for 2023?
So, first off, the company has actually outperformed the broader market ever-so-slightly since my first article, being up around 4.4%. This is in line with the broader NASDAQ which has outperformed for January and for the period overall. It's not close to my own investment RoR and portfolio returns - but whenever a company beats the market, it is worth noting.
One of the first misconceptions I want to keep hammering home against though is the fact that HNST is a freshly-started growth stock. It is not. Honest company has been around for some time, and to call a company that's been around since 2009-2012 "new", would be to call a 10-year-old "newborn" - doesn't work. HNST has mostly been around and active during times of ZIRP, which is another notch against the company.
Why?
Because if a company cannot be profitable during ZIRP and COVID-19 lockdowns, which let's be clear, HNST has not been , how is it hoping to turn a profit when rates go up and funding/interest costs go up?
HNST has delivered a negative net for every year they have been in business and fiscal they've closed. The latest net loss was a total of negative $45M, or negative $0.5/share. During the past few years, the company has also issued substantial amounts of equity, essentially doubling its SO in less than 2-3 years.
This in itself does not mean that the company is bad, or isn't going anywhere - but these are trends I want to point to.
Honest Company has, by all appearances, good products. I base this off consumer reviews and having a female friend who uses their lineup, as well as several young mothers who use it for their newborns. The products are appealing and seem to be on the forefront when we look at things like toxicology and safety, as well as zero animal testing, owing to rigorous testing that's perhaps more at home at a giant like L'Oreal ( OTCPK:LRLCY ) than a small, up-and-coming company like HNST.
So, the company is essentially David fighting Goliath in and industry where you technically need hundreds of millions to even be able to "do" what most of the big players are doing efficiently or with profit. The beauty industry is absolutely brutal, with crushing margins, marketing spends, R&D costs, and shelf space costs/concerns. Whenever I see someone trying to market or push for new innovative products in the space, and the people aren't from one of the big companies, I cringe. It's not as bad as say, the beverage industry with Coke ( KO ) and the giants there, but it's pretty damn close. Even having good products is in no way a guarantee of success.
However, having good products is inarguably a common requirement for even having a consumer staples business - and HNST has that. Now they just need to prove that they have what it takes to turn this into a consistently profitable business - because that is where the company currently fails.
The latest quarterly report from HNST was in no way a change in this trend. While HSNT was able to report a decent growth in top-line sales of 2%, this doesn't really change the underlying case for or against the company. Consumption growth and top-line growth, all of which the company does have is a good thing and obviously a requirement, but it still doesn't mean "invest".
The company manages 30% gross margins at this time. To give you an idea of where this is in context to the broader peer group, global peers with actual scale like L'oreal have gross margins of 73.2%, and that's after COVID-19 on an LTM basis. That is more than twice the margins that HNST has, and while it might seem unfair to compare the two, this is what HNST actually competes with. L'oreal, even with its scale and those margins, spends significantly on SG&A and R&D, and ends up with a just-south-of-20% OM. Even Beiersdorf, another giant in the industry, manages at the very least 15-16% OM with a 50-65% gross margin level.
HNST 30% in gross means that they're likely unable to compete in most relevant areas, and the biggest question should be how the company means to become a profitable business.
Like most companies in this situation, HNST works a lot with "adjusted" numbers. The company isn't just skincare products of course, it's also diapers, wipes, and household products - but these areas are just as difficult to compete in, and for 3Q22, numbers for skincare are actually down.
You can, by the way, set the company next to any hygiene and/or household product company as well - the trends still stand. There are also a number of worrying tendencies coming out of 3Q22.
- Digital revenue is down 14%, though this seems mostly due to a timing and promotion issue, not as much an actual, fundamental decline in digital sales. However, the company did make the decision to cut digital marketing due to costs , and that is a potentially massive issue.
- OpEx are up significantly, including litigation fees and product donation.
- Adjusted EBITDA numbers are still negative $5M and below.
- Net loss is worse , going from negative $5M in 3Q21 to negative $12M here.
Retail revenue is up - that one is positive - especially at Target ( TGT ), with the company growing legacy channels as well as launching most of the company's product lines at Walmart (WMT). Another positive.
However, this also begs the question (knowing Walmart prices as well as company margins) of how the company, once again, is expected to turn a profit while trying to keep its prices low.
The whole environmental impact-ESG sort of pushes really work for companies that have the size and scale to do so, with it being a drop in the bucket. For a company with negative GAAP, negative adjusted EBITDA numbers, and negative operating margins, it's a death knell. The company is trying to compete in mass-market retail, cutting digital spending (where margins are higher due to DTC) while at the same time trying to push the most qualitative and friendly products out to market.
As a debt holder (if there were significant ones), I'd start to get worried here, not more positive. The company is essentially one of the businesses that lose more money the more sales it has - at least currently.
One thing that's positive is that the company really doesn't have any debt - at least not to any degree worth mentioning. There are leases on the balance sheet and some other current liabilities, but no significant debt - so there is that.
Let's move on to valuation.
Honest Company valuation
My question for a company like this always comes down to when we can expect profit, and what the company might be/could be worth without profit. Honest company doesn't produce anything revolutionary. While the company may have certain patents, nothing about the beauty products with the exception of the ESG-friendliness and the fact of impressive celebrity endorsement and management is unique.
Beauty products of this sort are a commodity - and the company doesn't exactly price its products to imply that they are non-commoditized.
The only possibility I see is that scale eventually allows the company to sell more products to retailers, increase efficiencies, and work its manufacturing and logistics side to leverage that scale and cost side. Unfortunately, this is to be done in an environment fraught with pressures from inflation, increased costs, and what the company also admits - increased CAC (Customer Acquisition Costs). The company has already confirmed this, with its reduced overall marketing spending.
What you see in Honest company is a very good description of why I, when it comes to beauty and care products, only invest in companies that own every step of their chain, such as L'Oreal, Essity ( OTCPK:ESSYY ), or others.
The street targets for Honest company currently come in at $4.25/share. That's 5 analysts following, and those analysts gave the company a $14/share price target around a year back, during the year-end of 2022. Had you followed that one, you would have been very deeply in the red. That target then was slowly cut, cut again, and cut down to where we see it now, with a low PT of $3/share.
Still, out of those 5 analysts, 3 do have a "BUY" or equivalent rating here, so kudos to them for sticking to their guns - however, I'm not going to follow that 28.8% upside they see here, because I can't really fathom or "get to" the targets or fundamentals where such a PT of over $4/share would be viable for a non-profitable business in this segment.
At best , I believe this company represents a sort of decent buyout candidate for its brand, if the company's manufacturing, sourcing, and ethical processes can be preserved in such a transaction, given that this is a big part of the appeal of this brand.
Otherwise, I believe shareholders and investors are in for a long slough.
To those that say HNST isn't comparable to peers - of course, it is. You can invest $10,000 into L'Oreal, or $10,000 into HNST. That's 10k of your hard-earned dollars into either A or B, generating revenue, income, and profit for you. And as it looks now, company B has no real mark at when it expects to break even.
if you invest knowing all the challenges here, you're basically lending them your capital for free at this time.
What I want, as I've said before, is clarity or proof that the company, with its business model, can actually generate GAAP profit. I believe that with reduced digital marketing spending, increased costs, and now entering into large retailers, the path to GAAP profitability is more clouded than before.
Because of that, I would assign the company a SOTP valuation of around $1.1/share, which is the estimated, 0.8x value of its assets less liabilities/debt - though if we do get that far down, there might be other issues to the company.
Thesis
Here is my introductory thesis for Honest Company:
- My thesis going into HNST is "HOLD", and not buy. If you hold the company, you obviously hope for a long-term turnaround, and selling at a loss is not something I do unless I've lost confidence in the business.
- The company has great products and processes, but lacks the profitability that would make the company even remotely interesting to me at this time.
- My PT comes to an impaired sum-of-the-parts valuation for the cash/equivalents and net PP&E on its books, and I value it at $1.1/share. This means that it's more than double as expensive as I believe it should be here.
Remember, I'm all about:
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Buying undervalued - even if that undervaluation is slight, and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.
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If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.
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If the company doesn't go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.
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I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.
Here are my criteria and how the company fulfills them ( italicized ).
- This company is overall qualitative.
- This company is fundamentally safe/conservative & well-run.
- This company pays a well-covered dividend.
- This company is currently cheap.
- This company has a realistic upside based on earnings growth or multiple expansion/reversion.
The company fulfills none of my investment criteria at this point.
For further details see:
The Honest Company: Potential Profitability A Concern, Reiterating Hold