e.l.f. Beauty (NYSE:ELF) is delivering solid results as market share grows and financials improve. However, the premium to peers looks elevated as the projected growth rates do not justify the company's current market value. We're bearish with a Sell rating and a target price of $177 in the base case

Business overview

e.l.f. Beauty is an American cosmetics brand founded in 2005. Its products include bath and skin care products, makeup, colour cosmetics, as well as cosmetic accessories and professional tools.

According to Nielsen analytics, e.l.f. is already the market leader in many categories.

The company's main sales channels are large chain stores such as Walmart, Target and Ulta Beauty. E-commerce accounts for approximately 16% of annual net sales. e.l.f. Beauty also operates overseas in 18 countries, but the majority of international sales come from the UK and Canadian markets.

e.l.f. Beauty uses third parties for production, so it isn’t sensitive to capital investment and its production isn’t limited by the natural capacity. Cosmetics suppliers are mainly located in China.

Business performance

Shares of e.l.f. Beauty are up >1300% over the past 5 years, making it one of the best performing ideas in the past. There's a reason for that - the financials have improved significantly, especially in the last 2 years.

e.l.f. Beauty was able to significantly strengthen its position in the beauty products market, increasing its market share to #1 in terms of units and #2 in terms of dollars spent on cosmetics.

Despite the low-cost nature of the business and its sensitivity to third party pricing, margins remain excellent and are improving over time. In the last financial year, e.l.f. achieved a gross margin of 71% and an adjusted EBITDA profitability (excluding SBC) of 22%.

Selling, general and administrative costs are the largest expense account for e.l.f. Beauty - its go-to-market strategy is all about digital advertising. The company invests heavily in its social media profiles, paying bloggers, celebrities and other influencers to promote its product, and we don't expect marketing budgets to decline further in absolute terms.

Financial results forecast assumptions & scenario analysis

In terms of expectations, e.l.f. Beauty remains a tricky one - the company is already the volume leader in most categories in the US and Canada, so it may be more difficult for the company to grow sales in the future. However, international market penetration remains low, leaving room for double-digit sales growth.

According to Statista, cosmetics is expected to grow at an annual rate of 3.33%, which is just normal pace for a developed industry.

When forecasting future sales, we take a top-down approach and consider a number of scenarios:

• We only assume that e.l.f.'s domestic market share will grow by around 10% p.a. for the next two years and by around 5% p.a. thereafter, as the company is already the market leader in its addressable niches according to Nielsen.
• We analyse 3 scenarios for the international market: in the base case, we assume that e.l.f. won't expand geographically very much, leaving organic market share growth in the existing 18 countries. In the aggressive case, we expect e.l.f. to increase the number of distribution channels and double its global market share in one year. In the conservative case, we expect global market share to grow at the same pace as the US in the 2020s (increasing market share by 50% in the next fiscal year, then a steep deceleration to about 10% per year, due to much lower penetration abroad).
• We therefore expect US sales to grow at a CAGR of 12% over the next 5 years and international sales to grow at a CAGR of 13% to 34%, depending on the scenario.

Management’s outlook is in line with our base case scenario: for FY2025 (CY2024), the company expects revenue growth of 20-22% (or net sales in the range of $1,228 mln to $1,249 mln).

Key expense assumptions are:

• We expect gross margin to improve slightly over time (approximately 30-50 bps per year) due to stable inflation differentials in China and the US, and also because e.l.f. product prices are lower, giving the company more room to increase prices.

• We expect SG&A as a percentage of sales to decline over time. The marketing budget is likely to grow over time (especially for the international divisions) and will probably be around 25% of net sales (current level), while the general & administrative budget will grow at a mid-single digit rate (inflation expectations + moderate headcount growth).

In our base case, we expect GAAP EBITDA to grow by 27% per annum over the next five years, with upside and downside risks for aggressive international expansion and moderate cases.

Relative valuation (market approach)

If we look at the market valuation of e.l.f. Beauty, it was trading at the same multiple as L'Oreal and The Estee Lauder in 2019-2021, but after an aggressive market expansion started, its multiple increased twice.

We believe that current prices already incorporate high projected earnings growth rates and therefore use the average of the closest peer multiples for forward valuation - 24.4x, adjusted for growth premium (projected EBITDA CAGR minus average of L'Oreal & Estee Lauder EBITDA CAGR). Therefore, we believe a fair multiple for e.l.f. Beauty is 28.5x.

Our implied target price is based on current net debt & shares outstanding, projected FY2026 GAAP EBITDA and a discount rate of 13% (which is the long-term average annual return of the S&P500 index). Under various scenarios, the intrinsic value ranges from $136 to $290 per share and is $177 in the base case (which assumes a GAAP EBITDA CAGR of 27%).

Even though we're optimistic about the business prospects, the projected growth is not enough to justify the current market valuation. There is one condition under which the company still has upside potential, but it's based on an incredibly positive scenario in the international market, where the go-to-market strategy needs to be adapted to local perceptions. Rating: SELL.

Conclusion

e.l.f. Beauty is well positioned with strong market leadership and significant growth potential in international markets. While the company has robust margins and a solid profitability profile, the current market valuation already reflects high projected growth rates. The stock is rated Sell in the base case, as the projected growth may not be sufficient to justify the current valuation. However, there is upside potential in a highly positive international expansion scenario, which requires an adjustment of the go-to-market strategy to local perceptions.

To manage your position, we recommend following e.l.f. Beauty and its peers financial reports and also market research articles.