Bare Escentuals: Expectations Ratcheted Down Too Much

Revenue growth at Bare Escentuals (BARE) has slowed sharply this year, crawling to a 3% rate in Q3. Nonetheless, we expect the top and bottom lines to grow in 2009. We do have some concerns regarding the long-term growth of the minerals-based cosmetics category, and we are unsure whether the company can maintain EBIT margin around 30%. However, the adverse implications of these long-term issues should not be overweighted in light of continued growth and a valuation of less than 5x 2009E earnings. Bare shares may be too cheap to ignore.

BUSINESS OVERVIEW

Bare Escentuals is a prestige beauty brand and a leader in mineral-based cosmetics. It makes branded cosmetics, skin care and body care and professional skin care. Distribution consists of infomercials, home shopping TV, specialty beauty retailers, Bare boutiques, spas and salons, and online.

SELECTED OPERATING DATA

FYE December 31	2005	2006	2007	YTD 9/30/08
% of revenue by distribution channel and segment:
Retail – infomercial	37%	33%	25%	19%
Retail – boutiques	14%	14%	17%	20%
Total retail	51%	47%	41%	39%
Wholesale – premium	19%	28%	32%	32%
Wholesale – shopping TV	15%	13%	12%	12%
Wholesale – spas and salons	9%	8%	11%	12%
Wholesale – international	6%	4%	3%	4%
Total wholesale	49%	53%	59%	61%
Revenue growth by distribution channel and segment:
Retail – infomercial	77%	33%	-2%	-18%
Retail – boutiques	51%	58%	53%	39%
Total retail growth	69%	40%	14%	4%
Wholesale – premium	253%	121%	49%	11%
Wholesale – shopping TV	39%	31%	22%	22%
Wholesale – spas and salons	27%	38%	71%	26%
Wholesale – international	71%	11%	7%	29%
Total wholesale growth	84%	65%	43%	17%
Total revenue growth	83%	52%	30%	12%
Gross margin by distribution channel:
Retail	77%	80%	80%	80%
Wholesale	65%	64%	65%	67%
Total gross margin	71%	72%	71%	72%
EBIT margin by distribution channel and corporate overhead:
Retail	31%	36%	35%	33%
Wholesale	57%	60%	59%	61%
Corporate	-14%	-13%	-16%	-18%
Total EBIT margin	30%	35%	33%	32%
% of revenue by geography:
U.S.	94%	96%	92%	88%
International	6%	4%	8%	12%
Revenue concentration by major customer:1
Customer A	15%	13%	12%	12%
Customer B	<10%	13%	13%	12%
Customer C	<10%	14%	16%	15%

1 Top three customers are QVC, Sephora, Ulta.

INVESTMENT HIGHLIGHTS

• 74% of target consumers are aware of mineral makeup, but only 23% of those have tried it. 45% of consumers say they are likely to try mineral makeup in the next year, according to Bare.

• bareMinerals core foundation products offer healthy, lightweight alternative to conventional liquid- or cream-based cosmetics while providing light to maximum coverage for all skin types.

• 12% share of $3.6 billion U.S. facial makeup market. Bare continues to gain share.

• Large opportunity in “extension” markets, with only 2% share of $4.9 billion U.S. color market and 1% share of $7.8 billion U.S. skin care market.

• To grow distribution to 786 U.S. doors by yearend 2008, up from 559 in 2007 (potential of 2,300).

• International only 8% of revenue, but Bare is pursuing growth in Europe, Japan, and Canada.

• Bare Escentuals was the top-selling cosmetics brand at specialty retailers Sephora and Ulta in 2005, 2006 and 2007. The company has strong brand awareness and consumer loyalty.

• No-celebrity marketing lowers cost. Bare spends 7-8% of sales on ads and promotion, while L’Oreal and Estee Lauder spend ~30% and ~25% each.

• Guidance for 10% revenue and EPS growth in 2008, with guidance lowered from 20-25% to 15-20% in July and to 10% in late October.

INVESTMENT RISKS & CONCERNS

• Are mineral-based cosmetics a fad? Bare’s explosive growth in an emerging category suggests that the company has benefited from the “in” factor.

• Aggressive long-term growth targets. Even if Bare performs well, it may not meet its long-term targets of 20-25% sales and 25% EPS growth.

• Management turnover in several high-level positions may heighten growth and execution risks.

COMPARABLE PUBLIC COMPANY ANALYSIS

($mn)	MV	EV	EV/Rev	P/TB	08 P/E	09 P/E
AVP	9,605	11,048	1.0x	13.8x	11x	11x
EL	5,884	6,987	.9x	3.4x	13x	12x
RDEN	390	816	.7x	3.4x	9x	8x
REV	424	1,691	1.2x	n/m	10x	8x
BARE	407	629	1.1x	n/m	4x	4x

MAJOR HOLDERS

CEO Leslie Blodget 6% │ Other insiders 7% │ Berkshire Partners 20% │ Capital World 10% │ Wellington 8% │ Artisan 5% │ Thornburg 5%

Disclaimer: Copyright 2008 by BeyondProxy LLC. BeyondProxy and its affiliates may have positions in and may make purchases or sales of the securities discussed in this report. It is the policy of all Related Persons to allow a full trading day to elapse after the publication of this report before purchases or sales of any securities discussed herein are made. No Related Person held a position in securities discussed in this report as of the date of publication. Use of this report and its content is governed by the Terms of Use described in detail here.

Comments

[ProConsulta...:]

BARE was a great growth story at 30% PA, but was too unifocussed, and inward looking, as the entire growth was based mainly on foundations. They never made real gains and inroads into eye, lip, nail and other color cosmetics categories. They never leveraged a fantastic skin care line they had in MD Formulations. Most of all they never parlayed and translated their US growth Internationally. Lastly, an overreliance on Infomercials for a high premium brand has limitations.

The Maven.

2008 Dec 17 09:01 AM

[Market Folly:]

we track hedge fund portfolios on our blog and numerous funds were selling out of BARE last quarter, including Tremblant Capital: www.marketfolly.com/20...

and blue ridge capital: www.marketfolly.com/20...

among others

2008 Dec 17 10:40 AM

[Dr. Kris:]

I love their products but there are too many good imitators. The stock is down 90% from its mid-2007 peak. It needs to break the resistance gap at $6 on convincing volume before I'd be a buyer. Sorry, but unless they can come up with a great new product or marketing scheme, I don't think they'll be able to stand out from the rest.

2008 Dec 19 03:00 AM