Research Notes: Consumer Upstarts (Part I)
Young, nimble brands were supposed to be the future. They haven't been
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For a good chunk of the 2010s, I followed Procter & Gamble (PG) quite closely. P&G was a few years (and a couple of CEOs) into a massive turnaround effort, an effort that clearly wasn’t working. Organic sales and earnings growth was minimal. PG stock went nowhere from the spring of 2013 to the middle of 2018:
source: YCharts. Chart from 4/1/13 to 7/1/18
During this stretch I occasionally sold out-of-the-money call spreads on the stock — because, to be honest, I thought P&G was done. The very business model that had driven the dominance of companies like P&G, Unilever (UL), Coca-Cola (KO), General Mills (GIS), and Conagra Brands (CAG) appeared to be under significant threat.
Consumers seemed to want newer, more focused, more niche brands. Meanwhile, the advantages of scale enjoyed by the largest players was being undercut by the fact that smaller rivals could now lease much of that same scale. Their IT departments could use Amazon.com (AMZN) unit Amazon Web Services; Facebook (FB) and others offered targeted marketing opportunities that literally hadn’t existed a decade earlier.
I wasn’t alone in seeing things that way. J.M. Smucker (SJM) moved aggressively into categories like pet food and coffee due to the better growth prospects of those businesses — but also because existing end markets were not only lower-growth but fragmenting. In 2011, the Wall Street Journal highlighted the “hourglass effect” hollowing out the middle-class section of the market where P&G had thrived.
To be fair, I wasn’t that wrong. PG stock did roughly double from 2018 levels before a recent pullback, and KO still sits near all-time highs. (As I wrote in April, I’m still a bit skeptical toward both.) But CAG, GIS, and UL have struggled to varying degrees. Many once-great apparel and/or retail players are down sharply from their highs. At the very least, the long-successful strategy of simply buying large-cap consumer names and holding them forever no longer works.
What’s interesting, however, is that the companies that were taking share from incumbents haven’t set the world on fire, either. It’s not just in food and CPG, either. Blue Apron (APRN), Purple (PRPL) and Casper Sleep (taken private at less than half its IPO price) saw early buzz based on their direct-to-consumer models, only to provide sharply negative returns.
There have been a few winners, admittedly. Lululemon (LULU) is one of the best companies in the apparel space. Chewy (CHWY) is a $9 billion company (though returns from its IPO price have lagged the market, even with a big jump in trading Thursday). Dollar Shave Club sold to Unilever for $1 billion. It’s possible I’m forgetting others as well.
Still, overall, youngish businesses trying to sell goods to consumers have, at least on the public markets, been a pretty significant disappointment. And perhaps that makes sense. After all, the end markets those businesses are targeting, whether mattresses or laundry detergent, aren’t really growing any faster from a multi-year perspective. Yet more entrants mean more pricing competition, more marketing spend and, for the industry as a whole, lower profits.
With so many of the newer challengers — particularly the most recent IPOs — so far underwater, the question is if any of these companies are cheap enough to own. This week and next, we’ll take a look at some of the fallen angels in the consumer space to try and answer that question.
The Honest Company (HNST)
We highlighted HNST in this space two weeks ago. As I wrote then, I still think there’s a buyout in this company’s future. There’s value to the brand. HNST trades at 0.7x revenue; P&G is over 4x on the same basis, and UL more than 2x. With Honest’s SG&A running at 25%-plus of revenue, it’s not difficult for a large acquirer to model an accretive deal that provides exposure to some of the more attractive categories and demographics in the space.
Of course, Honest has to want to sell. With the stock down almost 80% from its IPO 13 months ago, that decision probably doesn’t happen any time soon.
The same problem is going to hold for other 2021 consumer IPOs. On paper, acquisitions by larger players will make sense. But it’s incredibly difficult for a company to sell at such a sharp discount to its IPO price without exhausting every opportunity to find an alternative. (Casper was actually a bit of an outlier here, taking the opportunity to exit less than two years after its IPO.)
It does look like Honest most likely can’t get to profitability on its own. But for HNST, and likely a number of similar stocks, management has to come to that understanding as well.
The OTLY stock chart is one you don’t see every day. The fundamentals, in their own way, are even more amazing.
Oatly went public little over a year ago, raising over $1 billion in the process. Yet the company absolutely needs to raise a significant amount of capital in the next 12 months.
Oatly finished Q1 with $411 million in cash. Guidance suggests Q2-Q4 capex of $347-$447 million. Management ostensibly could pull back, but commentary surrounding Q1 results and the company’s strong belief in up-and-to-the-right demand suggests it won’t, at least not immediately. Operating losses — Q1 Adjusted EBITDA was negative $71 million — should wipe out the remainder of the cash balance.
That means Oatly will need to utilize its revolver, with about $475 million in capacity. But one of the covenants of that revolver requires positive EBITDA by Q2 2023 — unlikely, to say the least, given EBITDA margins in Q1 were negative 43%.
If, however, Oatly can raise $400 million by the end of the year, that covenant gets pushed out four quarters. Oatly needs that cushion — and it probably needs that cash. On the Q1 call last month, even management said “we have sufficient liquidity to fund our business through 2022.” In other words, dilution is coming.
All that said, if you look past, you know, the actual fundamentals of the stock, the business does look somewhat intriguing here. It’s easy to dismiss oat milk as a fad, or at least a highly commoditized product, but Oatly’s top-line growth has been impressive. Revenue rose 53% in 2021 after more than doubling the year before; Oatly is guiding for 37-43% growth this year. Both China and the Americas (Europe was more than half of sales last year) have significant room for further penetration going forward.
The company’s plan to bring more manufacturing in-house will cost cash — but it should boost margins as well. If Oatly can get to 2025/2026, there’s a world in which turns into a reasonably stable, profitable, if niche player in the industry.
There’s also the takeout possibility. Gluten-free leader Boulder Brands was bought by Pinnacle Foods back in 2015 for almost 2x revenue — and there seemed clear risk at the time that gluten-free was a fad in a way that oatmilk probably isn’t.
The problem is that — almost incredibly given post-IPO performance — OTLY still trades at ~2.5x revenue, assuming modest net debt year-end and revenue toward the low end of the company’s outlook. And that 2.5x multiple is based on the current share count; assume ~20% dilution is coming (say, Oatly raising $550M against the current market cap of ~$2.2B) and the multiple gets up to ~3x.
We’ve hit this broader theme over and over again: so many of these stocks that are down 80%-plus simply don’t seem to have compelling fundamentals. OTLY is no exception. Indeed, had the company gone public this year, one can imagine a relatively niche IPO, in which Oatly raised something like $300 million at a $1.5 billion valuation and analysts called it “an undercovered growth story”.
Perhaps management needs to start running that kind of company, instead of serving the “growth at any cost” mentality that dominated the market until last year.
Beyond Meat (BYND)
Oatly has some amazing fundamentals, but Beyond Meat’s are laughable. Not in the sense that they’re laughably bad (well, that too) but in the sense that a fundamental-driven investor should literally laugh out loud at some of the numbers.
Let’s start here. BYND stock is down 83% over the past year — and its short interest still is 40% of the float. If we used those figures to create a version of the SaaS Rule of 40(which is not a terrible idea in this market), perhaps the S—Co Rule of 40, BYND would come in at a sterling 123.
But it’s the first quarter numbers that really tickle the funny bone. Beyond Meat — which makes hamburgers out of peas — posted a gross margin of 0.2%. Its gross margin is more properly measured in basis points. Its EBITDA loss was 72% of revenue (a percentage not more properly measured in basis points). Yes, the company is growing its sales — but at a 1.2% clip year-over-year.
Any good investor knows to look beyond the headline fundamentals for a single quarter. But it’s not like a closer look suggests those headline figures were notably skewed. Launch costs for Beyond Meat Jerky hit gross margins by 940 bps — but that still suggests gross margins below 10%. That aside, gross margin still fell by more than 20 percentage points year-over-year, with the company citing “increased trade discounts” and “list price reductions” in Europe.
In other words, Beyond Meat is cutting prices. Meanwhile, like everyone else, it’s facing higher costs. The problem is that even fixing those costs doesn’t help much: Beyond Meat’s gross margins fell 700 bps-plus last year. Again, this is not a single-quarter problem. Even in 2020, with a net pandemic tailwind, the company only generated $12 million in Adjusted EBITDA (with $27 million in stock-based comp). The loss on the same basis last year was $112 million.
Beyond Meat’s $1 billion in convertible debt (thankfully at a 0% coupon) matures in 2027 — and is yielding more than 20%. Beyond Meat’s equity still has a valuation of roughly $1.5 billion. Insert your own joke here, and keep an eye out for any opportunity to join the horde of traders shorting this stock.
FIGS, Inc. (FIGS)
FIGS is one of the few big decliners that does, on its face, look rather intriguing. And that might be in part because the stock probably doesn’t quite belong on this list.
FIGS manufactures and sells scrubs and other apparel for healthcare workers. It’s not a B2B model, as the overwhelming majority of revenue appears to come from direct sales. But it’s a different B2C model than an average retailer, and kind of not really a true ‘consumer’ stock.
Coincidentally or not, that model has worked out well so far. Revenue increased 59.5% in FY21 (ending January); guidance suggests 22-26% growth this year. There is a concern in terms of profitability, with Adjusted EBITDA actually guided down year-over-year, as margins are plunging to 16-18% against 25% the year before. But some compression in this environment isn’t surprising, given supply chain problems. Many similar young D2C players would kill for 16-18% EBITDA margins.
Valuation now seems rather reasonable: FIGS trades at 13x the midpoint of EBITDA guidance, and ~20x even adding back stock-based comp (as we’ve all suddenly decided to do in this market). Capex is exceptionally light (~$10M total the last three years), so that 20x EBITDA multiple suggests P/FCF in the ~30x range, maybe a touch lower.
This does look like a potential long-term winner, even with short-term concerns. Notably, the Q1 report was a huge disappointment, with the full-year revenue and margin outlook both cut. FIGS blamed supply chain issues, but young companies that miss once often miss again. Short interest still is 17%, so some traders clearly see a risk of FIGS taking the path of other DTC plays and becoming a repeat disappointer.
All told, we’re not jumping in just yet. But FIGS at least deserves to be a watchlist stock. If the business stabilizes, the stock is going to rise. The problem, obviously, is that remains a big ‘if’.
As of this writing, Vince Martin has no positions in any securities mentioned.
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There are some short-term pressures in there, with Oatly calling out a 970 bps hit from short-term underutilization of capacity. But, again, negative 43%. That’s not turning positive in five quarters.
The SaaS Rule of 40 says that revenue growth percentage + free cash flow margin should exceed 40.
Bulls argued that the closure of restaurants which served Beyond Meat products offset much of the “stay at home” boost.
FIGS has a B2B offering, in which it provides “team” orders. As far as I can tell, the company hasn’t broken out penetration of those B2B sales, which suggests they’re relatively small. Those orders aren’t necessarily ‘classic’ B2B revenue, either; team orders can be driven by a group of employees, rather than an employer actually purchasing items from FIGS.