Description

e.l.f. Beauty, Inc. (ELF) is a discount beauty brand that primarily sells in the US.

Risk/Reward: Risk of -10.0% against to short to $18.81 vs. Reward to short of +38.5% to $10.52

1) A lot needs to change at ELF to make sense as an LBO/take-private, or even at its current valuation

• ELF has little pricing power, the majority of products are $1-8 price points (free shipping at $25+ orders online), so it is a volume player; it is the Aeropostale of US Cosmetics

• Relies on brick and mortar retailers (87% of 2018 FY sales); including Walmart (30%), Target (21%), CVS, and ULTA, not the easiest consumers to push pricing to

• E-commerce is under-developed at ELF currently at 13% of 2018 FY sales

• Management closed their 22 corporate retail stores in February 2019

• Announced a new CFO in March 2019 and changed their fiscal year in December 2018 to a March year end, as retailers reset their cosmetics shelves annually in February or March

• ELF has substantial SG&A fat, US FTE doubled from 104 to 193 (2016 vs. 2015)

• Even if management went back to a 2015 SG&A structure, SG&A would be closer to $65-80mm given current sales

• Management has no intention of cutting staff, they view ELF as a platform for growth

• CEO has been a strong seller of ELF stock historically and is consistently profiled on Forbes, Bloomberg, CNBC, and thestreet.com

• Under a scenario, which I model as: zero revenue growth, GMs deteriorate at 50bps per year (reasonable/generous) and SG&A deleverage of 5% per year.  With a 10% premium ($18.81/sh) buyout, IRRs are 14.58%. At a 44% premium ($24.62/sh), IRRs are negative

• Everything is predicated on the SG&A leverage and exit multiple, which I assume to be 15x EBIT, this could be viewed as the best case scenario for an operator

• LTM EBIT margins are around 17.5% for EL and RBC estimates EL EBIT margins of 23% by 2025

• ELF would need 250bps of SG&A leverage per year to be in the same ballpark

• A rational strategic acquirer would pay a multiple of gross profit (TEV/GP) below their trading multiple of gross profit

• These valuations imply significant downside for the equity of ELF (-20% to -50%)

• In November 2019, Coty announced the acquisition of the Kylie Jenner Brand.  $177mm in LTM sales (40%+ yoy) with a sales split of 50% e-com/50% brick & mortar (with a November 2018 ULTA store entry)

• Assuming 70% GMs, 25%+ EBITDA margin (cited in Coty presentation)

• Would not expect an acquirer to pay 9.5x gross profit or 6.7x revenue for negative to flat revenue growth at ELF

2) ELF trends are negative for both Dollar and Units

• Through Jan 11, 2020, the industry is still suffering on a unit and dollar basis, and the street is overly-enthusiastic regarding 3+ months of ELF Nielsen data with increased pricing on products at retail (pricing raised to help offset 25% China tariff on cosmetics)

3) Secular/Innovation Cycle issues in US Cosmetics

• ULTA's management calls the problems in the industry "an innovation problem"

• Female teen spend according to a Piper Jaffray survey (Fall 2019) fell by 21% to $106/yr, 15% below the multi-survey average of $124/year (Spring 2017 was peak)

• CEO of Ulta Beauty Aug 29, 2019, Q2’19 conference call:

"We believe that the main issue driving this softer cycle in cosmetics is that the newness and innovation that have been the focus of most brands this year has just not driven the kind of incremental growth we've enjoyed for some period of time. Over the past several years, we've seen strong growth in cosmetics, driven by new rituals and application techniques, like contouring and brow styling, and innovative new product formats like liquid lip, palettes and minis. This innovation resulted in new makeup routines requiring new products which drove strong incremental growth. The most recent the cycle of innovation has just not driven those behaviors, resulting in a soft cycle for the cosmetics category in the U.S. as innovation and newness brought to the market has not driven the expected growth."

• Even luxury brands are not immune to these trends

• Links:

https://www.scmp.com/lifestyle/fashion-beauty/article/3030592/why-french-luxury-cosmetics-need-compelling-brand-story

4) China tariffs on the products (25%+)

• Substantially all of ELF’s third-party suppliers and manufacturers are located in China

• There is uncertainty what the impact of higher priced goods could mean for US cosmetic gross margins and pricing power

• The Office of the U.S. Trade Representative (USTR) increased tariffs from 10% to 25% on imported cosmetic products from China beginning Friday, May 10, 2019

• Links:

https://www.personalcarecouncil.org/statement/statement-by-francine-lamoriello-evp-global-strategies-personal-care-products-council-on-the-impact-of-increased-tariffs-on-chinese-imports/ https://www.cosmeticsbusiness.com/news/article_page/US_beauty_industry_hit_by_trade_war_with_China/154762

5) Potential FDA regulation on Cosmetics

• Potential unknown/harmful chemicals in cosmetics, FDA ingredient changes may occur 

• Volumes could shrink or re-formulation cause gross margins to fall

• Links:

https://www.cnbc.com/2018/08/01/fda-begins-first-inquiry-of-lightly-regulated-cosmetics-industry.html

https://www.theguardian.com/us-news/2019/may/22/chemicals-in-cosmetics-us-restricted-eu

http://nyscc.org/suppliers-day/attend/program-schedule/icmad-fda-cosmetics-regulations-workshop/

Catalyst

Negative Earnings Q4'19

CFO/CEO Management Changes

Private Equity shareholder overhang