Elf Beauty Stock Analysis: Is It a Buy After 48% Drop?

Elf Beauty Stock Performance

Elf Beauty's stock has experienced a significant decline of 48% over the past three months, prompting many investors to question whether this presents a buying opportunity. This comprehensive analysis will evaluate the company's recent financial performance, long-term results, key risks, and current valuation to determine if Elf Beauty stock is a worthwhile investment for long-term investors.

Recent Financial Results

Q2 2023 Highlights

• Revenue increased from $216 million to $324 million (50% growth)
• Selling, General and Administrative (SG&A) expenses doubled from $92 million to $180 million
• Operating income decreased from $61 million to $51 million

The most notable aspect of Elf Beauty's recent quarterly results is the substantial increase in SG&A expenses, which primarily includes advertising costs. While revenue grew by 50%, SG&A expenses doubled, indicating that the company is spending significantly more to maintain its growth rate. This has resulted in a decrease in operating income despite the revenue increase.

Management's Focus on Growth

Elf Beauty's management team has emphasized their track record of 22 consecutive quarters of sales growth and market share gains. This focus on growth suggests that the company is willing to increase spending to achieve desired growth levels, even if it comes at the expense of profitability in the short term.

This strategy may be concerning for investors who prefer companies that prioritize profitable growth and focus on low-hanging fruit opportunities. The aggressive spending approach could indicate that organic growth is slowing, requiring more investment to maintain high growth rates.

Future Outlook

Despite the increased spending, Elf Beauty has raised its outlook for fiscal year 2025:

• Revenue forecast increased from $1.24 billion to $1.3 billion
• Adjusted net income forecast raised from $190 million to $199 million

This improved outlook suggests that management believes the increased investments will pay off in the long run.

Share Repurchase Program

In response to the stock price decline, Elf Beauty has announced a $500 million share repurchase program, up significantly from the previous $25 million program. This move indicates that management believes the company's shares are undervalued at current levels.

Long-Term Financial Performance

Revenue Growth

Elf Beauty has demonstrated impressive revenue growth over the past few years:

• Trailing 12-month revenue: $1.13 billion
• 2019 revenue: Approximately $250 million

This growth is particularly noteworthy for a cosmetics company, as the industry is not typically associated with such rapid expansion.

Cash Flow from Operations

Despite the strong revenue growth, Elf Beauty's cash flow from operations has not shown consistent improvement:

• 2020: Approximately 20% of revenue
• Recent quarters: Declining trend

This inconsistency in cash flow generation is a potential red flag, as it suggests that the company's growth may not be translating into improved operational efficiency.

Analyst Expectations

Wall Street analysts project Elf Beauty's earnings per share to grow by 177% annually over the next five years. While this is still a high growth rate, it represents a significant slowdown compared to the company's performance over the previous five years.

Return on Invested Capital (ROIC)

Elf Beauty's ROIC had been improving for several years, but this trend has recently reversed:

• Current ROIC: 15.81%
• Recent trend: Downward

This reversal in ROIC is concerning, as it may indicate that the company is struggling to maintain its efficiency as it grows. The downward trend could be a major factor in the recent stock price decline, as investors may perceive that Elf Beauty has reached its peak performance and future growth will come at the expense of profitability.

Valuation

Elf Beauty's current valuation metrics:

• Forward Price-to-Earnings (P/E) ratio: 25
• Previous peak P/E ratio: Over 60

The current forward P/E of 25 is significantly more reasonable than the company's previous valuation. However, it may still be considered somewhat high for a cosmetics company, depending on one's growth expectations.

Investment Recommendation

Based on the analysis of Elf Beauty's financial performance, growth strategy, and current valuation, the stock is currently rated as a HOLD.

Reasons for the hold rating:

1. Increased spending on advertising and its impact on profitability need to be monitored over the next few quarters.
2. The downward trend in return on invested capital is concerning and requires further observation.
3. The current valuation, while more reasonable than before, is still not compellingly low for a cosmetics company.

However, there are potential catalysts that could lead to an upgrade in the future:

1. If the forward P/E ratio falls to the high teens (around 17-18), the stock would become more attractive from a valuation perspective.
2. Improvement in the ROIC trend and demonstration of more efficient growth could positively impact the investment thesis.
3. Stabilization or reduction in SG&A expenses as a percentage of revenue would indicate better cost management.

Conclusion

Elf Beauty has demonstrated impressive revenue growth in recent years, but the company's aggressive spending to maintain this growth is causing concern. The recent stock price decline has made the valuation more reasonable, but not yet compelling enough to warrant a strong buy recommendation.

Investors should closely monitor Elf Beauty's upcoming quarterly results, focusing on:

1. The trend in SG&A expenses relative to revenue growth
2. Changes in return on invested capital
3. Cash flow from operations as a percentage of revenue

If these metrics show improvement and the valuation becomes more attractive, Elf Beauty could become a more appealing investment opportunity. For now, a cautious approach is warranted, and the stock remains a hold for long-term investors.

Key Takeaways

• Elf Beauty's stock has dropped 48% in the past three months
• Revenue growth remains strong, but profitability is under pressure due to increased spending
• Management is focused on maintaining high growth rates, potentially at the expense of efficiency
• Return on invested capital has shown a concerning downward trend
• Current valuation is more reasonable but not yet compellingly low
• The stock is rated as a hold, with potential for upgrade if key metrics improve and valuation becomes more attractive

Investors considering Elf Beauty should carefully weigh the company's growth potential against the risks associated with its aggressive spending strategy and recent profitability challenges. As always, it's essential to conduct thorough research and consider your own financial goals and risk tolerance before making any investment decisions.

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