Cosmetic fad or the real deal?
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Eyes. Lip. Face. That’s what beauty company, Elf (technically it’s e.l.f. Beauty), stands for. Started in 2004, by Joseph Shamah and Scott Vincent Borba, the company took a while to really hit escape velocity. The original business plan was to sell $1 makeup because the pair was talking to female friends who drove BWMs but also shopped for makeup at the 99 Cent store. There seemed to be a gap in the market for high quality makeup at a very low price.
But it wasn’t until the beginning of 2014, when TPG Growth took a majority stake in the company that things really started to take off. Sales doubled over the next five years, a reasonable 15% CAGR, but nothing like where they are today. Sales would double again over the next four years, accelerating to a 19% revenue CAGR over that period. But this year, sales growth could reach more than 70%. So what is happening and why is the company suddenly accelerating growth so rapidly?
Before we get into that question, let’s take a step back. Elf is a beauty company that sells cosmetics and skin care products. Cosmetics makes up the vast majority of revenue but skin care accounts for about 18% of sales, after including its recent $350 million acquisition of Naturium. The rest of revenue comes from products like lip-liners, mascaras, serums, etc.
The company’s most popular product is a $10 Power Grip Primer that has well over 5,000 reviews on Elf’s website. This product is a perfect example of the company’s “Holy Grail” strategy. Essentially, it’s creating better products at way cheaper prices. A normal “prestige” brand for a similar product would run you about $40. Elf’s products are prestige quality at mass market prices. On TikTok, you’ll find thousands of videos about this concept, called “dupes”. I feel like such an old person, trying to describe teenage girl TikTok crazes in financial language, but I’ll push forward. “Dupes” comes from the word “duplicates”, describing this exact phenomenon, where consumers are buying similar products at much cheaper prices. As some customers start feeling the effects of a tightening economy, “dupes” are becoming increasingly popular. The tried and true machine of capitalism at work – people generally find out about better products at lower prices.
There is also a little bit of double-whammy here. There is an economic phenomenon labeled the lipstick effect, where consumers are more likely to buy cheaper luxury goods in a weakening economy. So instead of an Hermes Birkin bag, maybe you’ll get some fancy makeup. Treat yo’self, right?
But consumers are trading down while treating themselves. So the super zoomed-out thesis for Elf is dupes + lipstick effect = cash.
After TPG bought the huge stake in Elf, they put Tarang Amin at the helm. A 25-year veteran in consumer products, he started his career as any good marketer would, at Procter & Gamble. There, he helped grow the shampoo brand, Pantene, 40x to $2 billion in sales. After that he took over the Litter, Food, and Charcoal business at Clorox, before taking his first lead role at Schiff Nutrition. While at Schiff, the market cap grew from $190 million to nearly $1.5 billion, when the company sold to Reckitt Benckiser at the end of 2012. So Amin was the perfect candidate for TPG to insert into Elf, which had a lot of promise but just hadn’t quite found its stride.
Amin has described Elf as having a core competency in marketing. In fact, he went as far to say that he thinks of Elf as an entertainment company who happens to sell makeup. Whether it be the millions of Instagram and TikTok followers or its high-profile partnerships with Jennifer Coolidge and Snookie, the company garners a disproportionate amount of attention. Having spent just about $100 million on advertising specifically last year, or 17% of sales, is impressive considering the company’s growth rate. Year-over-year, the company spent about $60 million more dollars on advertising than in the previous fiscal year, but added $187 million dollars in sales and $38 million in EBIT. Those are awesome numbers and they’re a testament to how viral and relatively inexpensive the company’s growth has been over the last couple years.
The obvious question that comes to my mind is – yeah, this is all great, but how sustainable is this growth? There are 800 cosmetic brands that Nielsen tracks and, interestingly, over the past five years, only one brand has grown its market share each and every quarter. You guessed it – Elf. I’m not saying that five years is that long, but it’s a testament to the marketing engine that Amin has put into place. With that said, I personally worry about pricing power and brand loyalty. If the whole ethos of the brand is affordability, what happens when a company comes in with even lower prices? I mean we’re seeing it in fast fashion right now where Shein is eating everyone’s lunch. Further, Elf has software-like gross margins at 71%, so there certainly seems to be room to squeeze them from a competitor’s perspective. That means the $10 Power Primer only costs Elf $3 to make. The company manufactures all of its products through third-parties in China so it’s not unreasonable to expect that a native Chinese brand could recreate Elf’s products at even cheaper prices. On the other hand, there is likely some brand loyalty, especially with distribution partners. Target, in particular, is growing more excited about Elf products. Over the past five years, Target has accounted for anywhere between 20-25% of the company’s sales, but Amin estimates they will be over 40% this year. Walmart and Ulta will likely make up another 40%, split evenly amongst themselves, by the end of this year. Somewhat surprisingly, e-commerce only accounts for about 15% of the business and the majority of that is Amazon. So the company’s own website is actually a very small piece of the overall business, though it is growing much faster.
Essentially, more than 80% of the business goes through the big three national makeup retailers, Target, Walmart, and Ulta, and the rest is split between Amazon and Elf’s own website. I’m painting with broad brush strokes here but that is the general breakdown – probably another 5% comes from stores like Walgreens and CVS too.
Interestingly, at the end of 2018, Elf decided to close down its 22 stores and focus on partnering with national retailers. They found that retailing wasn’t their speciality, but marketing was. So they would rather let Target deal with end caps and displays and Elf would focus on TikTok, Instagram, and YouTube influencers. Once again, I’m not sure how defensible this is but Elf has done quite a bit over the years to gain mindshare and, in return, market share. In some respects, the fact that Target is so heavily invested in Elf puts me at ease, but on the other hand, now that Target accounts for such a large chunk of the business, it may have more negotiating leverage. Further, what about when Target wants to do private-label partnerships at even lower prices? Does Elf really have enough brand loyalty to continue growing through challenges like that? To me, Elf sort of goes in the Celsius-like box of consumer goods. These businesses can have incredible, and I mean incredible, growth but consumer tastes can change quickly. I’ve seen more fads boom and bust than I can count. But to speak out of the other side of my mouth, some brands have true staying power and it can be difficult to discern beforehand. I also think the product really matters. Something like Celsius, where people get really accustomed to the taste, I think lends itself to higher brand loyalty. Whereas a makeup company may have lower switching costs if there really is a better product at lower prices. Or even a comparable product at lower prices. But with social media reviews, word can spread very quickly about great products, especially among teenage girls, where Elf has strong mindshare. The key to Elf’s growth also leaves it susceptible to competitors trying to run the same playbook. Now, I’m not saying it’s easy to replicate this success, but when your moat is “marketing”, it’s like running on a treadmill, you can’t stop or else you’ll fall off. Elf does have distribution strength now and they’re providing a lot of value to their retailer partners. Elf brings in more store traffic, which increases the odds that consumers buy other goods during their visit. So it’s certainly in the retailer’s best interests to be a good partner to Elf but that also doesn’t necessarily seem defensible. But maybe that’s the argument against the private label risk – Target doesn’t want to make Elf mad because of the free incremental foot traffic. Yet, $400 million is not even half a percent of Target’s overall sales. So Elf has a long way to go before they start having serious negotiating leverage.
While Elf is flying off the Target shelves, I’m curious how sustainable this is. At the same time, there is a bit of counter-positioning here. High margin brands don’t want to lower prices because they would risk losing brand power and they would have less margin to reinvest into marketing. On the other hand, Elf may not have much pricing power because of this. If the prices start rivaling the competition, maybe consumers won’t have as much loyalty. But for now, that’s not the case and Elf is in the zeitgeist. A combination of low prices, solid quality, fantastic marketing, and strong distribution means there is no slowing in sight but with lots of competition and fast-changing consumer tastes, I question the long-term sustainability of growth. To speak out of the other side of my mouth, the company’s penetration in the beauty category is quite low and I could see them offering other things like hair care and expanding its SKU count. Am I hedging myself here? Quite frankly, yes. I’ve seen these consumer stories play out for far longer than I would imagine. Celsius is one example. But a lot of things have to go right because the barriers to entry are somewhat low. On the other hand, Monster Beverage is the best performing stock of all time :)