Wow, Wall Street apparently thinks e.l.f. Beauty (ELF) is the next big thing in cosmetics.
Shares of the decade-old cosmetics brand, which mostly sells lipstick and bronzer priced at $6 to cash-starved millennials, exploded about 41% in their first day of trading on Thursday. The market's enthusiastic response isn't difficult to rationalize. For starters, the market is almost always attracted to easy-to-understand consumer IPOs. e.l.f. Beauty certainly fits the bill, hawking cosmetics at Walmart (WMT) , Target (TGT) , CVS (CVS) , online retail stores and yes, even with Amazon (AMZN) .
Secondarily, the company doesn't sell natural cosmetics that aren't for everyone (you see more of these places popping up in malls, but the stuff doesn't agree with everyone's skin) and doesn't compete head on with Clorox's (CLX) all-natural Burt's Bees juggernaut. So that's good. Its product line is fairly limited, but at the same time it has pushed the envelope with products priced over $6 and found success.
The exec team is stocked full of veterans of the consumer products business, including the CEO, who told me on the NYSE floor Thursday that ELF has about 300 new products at various stages of development. And, the cosmetics market is healthy overall. The U.S. makeup market is anticipated to grow by a compound annual growth rate of 3.8% from 2013 to 2018, reaching $8.4 billion, according to research firm MarketResearch.
Top it off with Macy's (M) recently plunking down a decent chunk of change to acquire cosmetics brand BlueMercury and Clorox and Procter & Gamble (PG) perpetually on the prowl for new platforms for growth and one could see why the market bought into the ELF story in the early going. But in good conscious, one can't buy a new issue that exploded 41% in the first day of trading. Moreover, digging into the company, there are several things that the market has chosen to overlook but are important considerations.
First, the company is overly reliant on Walmart and Target, which combined make up about 51% of annual sales. It's great that ELF has these relationships, but it will be hard to drive deeper penetration in the cosmetics aisle given each retailer's focus on private-label brands and the devotion of more space to a popular Burt's Bees.
Further, the profitability of the company so far hasn't been gangbusters, underscoring the competitive forces that tend to weigh on profit margins in the cosmetics space. As an aside, I wasn't too keen on the CEO sidestepping my question on what international markets ELF plans to attack next (international sales only represent 7% of the business). The market is going to push ELF hard to grow now that it has embraced the stock. It would be nice to learn more about the company's expansion strategy.
All in all, ELF has a bit of proving to do to everyone. One cosmetics brand that doesn't need proving is Sephora (yes, ditto Ulta (ULTA) , but not keen on the company's latest earnings warning). By most measures, Sephora remains a juggernaut in the cosmetics space due to its attentive customer service, decent prices and ever-increasing number of products.
Because Sephora isn't publicly traded, the way to play the company's strength and healthy outlook for cosmetics demand in the U.S. is through J.C. Penney (JCP) . J.C. Penney now has about 578 Sephora shops open out of a total of 1,013 stores. Sephora continues to be one of the top-performing businesses inside of J.C Penney, likely producing same-store sales growth consistently around a high-single digit percentage. Going forward, J.C Penney likely will take the successful Sephora shop concept to hundreds of more stores. And why not? They are driving customer traffic to the stores (makeup has to be replenished) and lifting the overall sales for the stores.
J.C. Penney is likely to own the holiday season given its value-oriented marketing messages and improved assortments. Toss in the Sephora factor and one gets a little sexier investment choice than an e.l.f. Beauty at the moment.