e.l.f. Beauty: Not So Pretty

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About: e.l.f. Beauty, Inc. (ELF), Includes: ULTA
by: The Value Investor
Summary

e.l.f. Beauty is posting not so pretty results.

Growth is coming to a standstill in the second half of the year, while margins are under pressure.

Despite a continued underperformance, shares are far from cheap at 30 times realistic earnings.

A small speculative position might be warranted at $10 as a potential take-out candidate, but I lack conviction to buy in size.

e.l.f. Beauty (ELF) has been a stock which I have watched with great scepticism after the company went public nearly two years ago. Strong growth and buzz regarding a new brand made that shares traded at a premium valuation of $25-30 at the time, as slower growth and lower margin trends made me very cautious at the time.

As shares have come down while the underlying business continued to grow, relative appeal has increased quite a bit. I looked at the shares as recent as January, when they traded around the $20 level, and I concluded that the valuation had become more appealing, yet not appealing enough to buy yet.

e.l.f. - Eyes, Lips & Face

The promise of the business is to provide beauty products at accessible prices, retailing at $6 or less, as cheap beauty products are in demand with millennials. These consumers focus on lower priced products and tend to become loyal customers over time.

Originally, the business was a pure play on e-commerce, supported by brand ambassadors on social media, although the company has grown into the retail channel as well. Besides lower price points, other distinguishing factors include innovation, rapid development and social media, although these trends have become more or less mainstream as well in recent years.

About The Growth Run-Up

In the year ahead of the initial public offering, e.l.f. saw decent growth as sales rose by 32% to $191 million in the year of 2015, accompanied by solid operating margins of 13%. Sales grew by 20% in 2016 to $230 million as margins narrowed to 10%.

Revenue growth was relatively solid but slowed down to 17% in 2017 with sales approaching the $270 million mark, with margins increasing to 12% again. The $33 million operating income number translates into realistic earnings of $20 million if we account for $8 million in annual interest costs and assume a 20% tax rate. With nearly 50 million shares outstanding, earnings per share would only come in at $0.40 per share. The company itself came up with a $0.64 per share adjusted earnings per share number as stock-based compensation (being a real expense) has been a major contributor to the discrepancy between both results.

Hence the reason for my caution as shares were trading at $20 per share at the start of the year, for a 50 times realistic earnings multiple, as the company operated with $146 million in net debt (for a 2.3 times leverage ratio).

The company furthermore warned that 2018 would be a softer year with sales and EBITDA expected to grow by just 6-8% this year, and adjusted earnings actually falling by four cents to $0.60 per share.

Troubles Continue

After re-confirming the full-year outlook alongside the release of the first-quarter results in May, shares have started to slide from June onward, having fallen from high-teens to $15 per share ahead of the second-quarter earnings report. That report triggered a fierce sell-off to levels around $11 at the moment of writing.

The company saw sales growth slow down to 6% in the second quarter, yet margins took a further beating. Reported adjusted EBITDA fell by $3 million to $10 million, as operating margins fell further in the seasonally softer quarter. Hence the company felt the need to cut the full-year sales outlook, now seeing an increase in sales at just low single-digits.

Adjusted EBITDA is now seen at $60 million, plus or minus $2 million, with adjusted earnings seen at $0.56-0.61 per share. The good news is that net debt has gradually come down (in absolute numbers) to $135 million, while relative leverage ratios remain unchanged.

To signal a vote of confidence: CEO Tarang Amin has announced the intention to buy up to $0.5 million worth of stock following the news. Of interest is that this was already mentioned in the press release, as the company knew that the report would not be welcomed by investors. Assuming that realistic earnings can be more or less flattish at $0.40 per share this year, multiples have compressed quite a bit, although a 30 times multiple is far from cheap at $12 per share.

Remaining Cautious

In January I was cautious despite the promise of a roll-out of the product line as Ulta Beauty (ULTA). I was cautious for the reason of the premium valuation, in combination with "problems" emerging so soon after the hype/IPO. In January, I concluded to become a buyer at $16 per share, equivalent to 3.5 times sales, while well-run peers traded around 4 times sales (but by no means were very cheap). Furthermore, most of the company's peers have far better margins, although their growth was slower. Fortunately, I have not acted upon my own advice, as I lost sight on e.l.f., and that has been my luck.

So what is a realistic level given today's circumstances? Given the growth reported in the first half of the year and the revised outlook, the company is more or less suggesting that sales growth in the second half of the year is flat. That is rather uninspiring given the fact that this is a relatively new company, the economy is doing fine, and the wider beauty category is decent as well. Hence, I refuse to pay a near 30 times multiple for a business with zero growth in decent circumstances, although I recognise that the valuation in terms of sales multiples is rapidly getting more appealing.

Hence, I might be willing to buy a small speculative position at $10, yet refrain from buying a decent stake based on the premium fundamental valuation.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ELF over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.