e.l.f. Beauty - Idiosyncratic Risks Are Too High
Summary
- Recent share price performance has not compensated investors for high business risk.
- Free Cash Flow faces significant headwinds from profitability, working capital and topline growth point of view.
- Insiders have increased their selling activities over recent months.
- Relative pricing of e.l.f. Beauty appears too optimistic at this point.
Source: ELF Investor Presentation
e.l.f. Beauty (NYSE:ELF) has been on a tear over the past year, thus outperforming most large cap names in the beauty space.
Data by YChartsHowever, there is one problem with this return over the past year - it does not compensate for the extremely high risk. Simply looking at market risk exposure, as measured by the beta, ELF is significantly riskier than the high quality names in the space, such as Estée Lauder (EL) and L'Oréal (OTCPK:LRLCY).
Source: prepared by the author, using data from Yahoo!Finance
Thus to compensate for the market risk over the past year, ELF should have returned approximately 52% based on the S&P 500 return over the same period and risk-free rate at around 1.5%.
Data by YChartsTherefore, although at first glance ELF might appear as the best performer in the group, on a risk-adjusted basis it was one of the worst performers while high quality names, such as Estée Lauder and L'Oréal is where alpha has been generated.
The problems with ELF, however, do not stop there. Digging into the business and the idiosyncratic risks associated with it, there are three key problem areas that in my opinion make ELF a far inferior investment when compared to other names in the space.
The problem with profitability and free cash flow
ELF has a significant problem when it comes to some of the most important business fundamentals, such as operating profit and free cash flow. While the stock moves mostly on expectations about future topline growth, ELF's operating profit and FCF have both gone nowhere since the IPO in 2016.
Data by YChartsMore worrisome, ELF will have a hard time improving these metrics without the help of more acquisitions and leverage.
Starting with profitability, ELF already trades at too high of a forward EV / EBITDA multiple relative to its peers when we control for gross profitability.
Source: prepared by the author, using data from Seeking Alpha
Gross profitability usually exhibits a strong relationship with multiple valuations in the consumer staples space since it is very stable over time and is also indicative of the pricing power of the company's products.
In the case of ELF, the company relies on high turnover of its low priced products, which makes a sustainable increase in gross margins highly unlikely.
Moving down the Income Statement, the prospects of the company's operating income are even worse as it needs to dial up its advertising & promotion expenses relative to sales. In my last analysis on ELF, I provided the following comparison to some other names in the industry which spend a significantly higher share of their sales on advertising & promotion.
Source: author's calculations based on data from quarterly and annual reports
On a question regarding the level of operating expenses during the last conference call, the CEO of the company gave the following vague response which indicates that marketing expenses are unlikely to decrease.
So we've long had a series of investments, both in terms of marketing, as well as the team in our infrastructure, with a vision of we'll be able to leverage those investments over time. So our approach is going to be continued to stay strong. On a marketing standpoint, we believe those marketing investments we're making definitely are bearing fruit in terms of the market share gains that you see in our continued business momentum.
Tarang Amin - Chairman & Chief Executive Officer
Source: ELF Q3 2021 Earnings Call Transcript
The next problem is the company's very high share-based compensation program which is necessary to support its already low free cash flow. After a minor decrease in FY 2020, ELF's share-based compensation increased significantly over the past year.
Source: prepared by the author, using data from annual and quarterly reports
While such compensation schemes are quite popular, especially with high growth companies, in the case of ELF this practice is taken to extremes.
On a trailed twelve months basis, the total amount of share-based compensation represented 227% of the company's cash flow provided by operating activities.
It is true that last 12-month period saw some one-off items which resulted in significantly depressed cash flow, however this ratio was as high as 35% even during the fiscal year of 2020 and 30% during FY 2019 when cash flow from operating activities peaked at $55.6m.
Finally, significantly higher inventory and receivables resulted in $37m cash outflow during the nine months ending in December of last year.
Source: ELF Q3 2021 10-Q SEC Filing
While this was largely attributed to the addition of the two new brands, it does bring a higher risk inventory write-offs should these products do not sell as expected.
Our ending inventory balance was higher on a year-over-year basis as planned, and is expected to remain at higher levels through March. This is largely due to the addition of Key Soulcare and W3LL PEOPLE, plan space expansion and new distribution for health and higher product costs as a result of mix and changing FX rates.
Source: ELF Q3 2021 Earnings Call Transcript
In comparison, Estee Lauder was faced with quite the opposite dynamic in its inventory levels.
Source: Estee Lauder Q2 2021 10-Q SEC Filing
Contrary to ELF, Estee Lauder significantly improved its working capital requirements over the past six months.
During the first half of our fiscal year, we generated $1.98 billion in net cash flows from operating activities, which was substantially above the prior year, due primarily to improvements in working capital management.
Source: Estee Lauder Q2 2021 Earnings Transcript
The problem with topline growth
Topline growth for ELF has also been somehow elusive, even though the chart below would suggest otherwise it does exclude the company's closed down physical stores and does not show the full picture.
Source: ELF Q3 2021 Earnings Presentation
Even after accounting for ELF topline benefit from its recent acquisition of W3ll People and the boost provided by the pandemic for players with stronger e-commerce presence, the overall sales growth has been far from impressive.
Source: prepared by the author, using data from annual and quarterly reports
At the same time the FY 2021 guidance was recently upgraded to 7%-9% from 5%-7% previously which still implies a significantly lower growth during the fourth quarter of this fiscal year when compared to the last three quarters as sales grew by more than 8% during the first nine months of the FY 2021.
Now let's turn to our outlook for fiscal 2021. We are raising guidance for fiscal year fiscal 2021. We now expect net sales growth of approximately 7% to 9% versus fiscal 2020 up from 5% to 7% previously. We expect adjusted EBITDA between $59 million and $60 million, as compared to $57 million to $60 million previously. Adjusted net income between $33 million and $34 million as compared to $31 million to $33 million previously, and adjusted EPS of $0.63 to $0.64 per diluted share, as compared to $0.59 to $0.63 per diluted share previously.
Source: Estee Lauder Q2 2021 Earnings Transcript
Finally, the mere fact that the company is now moving away from its previously praised singe-brand strategy and is relying on acquisitions does not bode well with the narrative of a high-growth company. The company's main competitive advantage of low priced products is also at risk from growing private label beauty brands.
The problem with insider transactions
Increasing insider selling activity is always a red flag for a company, especially as its share price is flirting with all-time highs, temporary tailwinds are dissipating and fundamentals struggle.
* excluding transactions from Tpg Growth II Advisors, Inc.
Source: prepared by the author, using data from Yahoo!Finance and openinsider.com
After the strong share price performance over the last year, insiders are now selling even more of their ELF holdings than they used to as selling activity accelerated during the last few months of 2020 and the first months of 2021.
While insider selling activity does not mean much in itself, it is worrisome to see increased insider selling after taking into account everything said above.
Conclusion
e.l.f. beauty recent share price performance is a good example why investors should always risk-adjust their returns before judging performance. The company now faces a number of headwinds which would likely weigh on profitability, working capital and free cash flow going forward. At the same time topline growth does not seem attractive enough to compensate for the deteriorating fundamentals and business risk. At the same time relative valuation remains elevated and insiders continue sell their e.l.f. holdings.
This article was written by
Vladimir Dimitrov, CFA is a former strategy consultant within the field of brand and intangible assets valuation. During his career in the City of London he has been working with some of the largest global brands within the technology, telecom and banking sectors.
He graduated from the London School of Economics and is interested in finding reasonably priced businesses with sustainable long-term competitive advantages.
Vladimir is the leader of the investing group The Roundabout Investor where he teaches the process of evaluating roundabout investments; defined by potential high capital return, growth in free cash flow, safe dividends and conservative capital allocation. He offers weekly investment ideas, a model portfolio, a watchlist, macro outlooks, and sector deep dives. Learn more.Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.
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