Good ELF Bad ELF

e.l.f. Beauty (ELF) priced above their proposed range last night at $17. Capital markets have been whispering that the deal is "hot" for a while.

In short - the story is very good, the financials are not quite as stunning as they seem in the roadshow. 

Part of the excitement about ELF may be due to the stellar performance of Ulta Salon (ULTA) which as you can see from the chart has been huge. The Chairman and CEO of ELF also credits himself with the success of Pantene which has gone from almost nothing to a massive global brand.

The company is all about women and millennials. Unlike other companies their employee base actually matches their target demographic. From a positioning standpoint they are striving to be a cut above drugstore brands but well below high end "designer" brands.

Because their customer is younger and more experimental the company leverages social media, rapidly paced product innovation, value pricing and a multi-channel distribution model. A fairly unique combination.

The graphic here illustrates the rapid growth and market share gains that ELF is enjoying. Our first thought looking at this was "wow, some of these brands are old and tired."

ELF uses a strategy of creating slightly improved versions of very popular "prestige" products at much lower prices. The recipe has worked like a charm. Many of these are actually good products but some are really pure marketing and roughly equivalent to common store brands. But it works.

Today most of their revenue comes from retail (Target, Walmart, CVS, Old Navy) but e-commerce is growing rapidly. Cosmetics are great because they deliver very high sales per square foot and it's easy to carry inventory.

A close female friend of mine once said "every woman is looking for the blush and lipstick combination that is going to change their lives." (Don't shoot me, it's a real quote.) It speaks to the demand for new products with different colors and textures to use for different looks.

In terms of "moat" the company believes that their supply chain and expertise gives them product development and delivery advantages which are not easily copied, at least not to the quality levels they can deliver.

Growth is going to come from increased brand awareness and new products. They are launching a new product every week. Market share is very small now so there should be ample "headroom" for ELF to grow into.

Retail channels have room to grow too - they are just getting into major drug chains and specialty retailers like Ulta Salons.

Profits are good too, at least at first blush. (sorry!) In 2015 the company generated $46M of EBITDA on $191M in revenue. The going-forward model is a little squishy but with good margins already investors may look past it. If you really dig in the EBITDA number is not as good as it looks:

There is a lot of baggage in the EBITDA reconciliation - For example 2015 net income was $4.4M but reported EBITDA was $46M! $12M in interest expense and $8M related to foreign currency contracts (?!?). The LTM figures look even worse - $2.8M in net versus $50M in EBITDA.

Overall goal is to be a "billion dollar brand" which is certainly achievable. Who doesn't want to look good and save money?

Stock and Valuation

Post offering there will be 45-46M shares outstanding. At the $15 mid-point that's a capitalization of $675M.

As noted above the profitability is less than meets the eye but should improve over time. Another thing to factor in (on which the roadshow is silent) is that post-IPO the company will still be carrying debt. It's not terrible - they will have paid off some and eliminated the convertible preferred but it's just over $160M. Very manageable but something to factor into valuation. 

We're estimating that ELF will do on the order of $250M this year in revenue. As a direct comparable ULTA is trading at 3.7x sales. If we put that ratio on ELF we would get an EV of $925M. If we back out the debt of $160M we get $765M for the market cap which is equal to $17/share. If we ignore the debt the share price would be $20. 

To be fair the right way to do this is build an IV but I fear it would yield an even lower result, at least if we look at operating income (versus EBITDA).