E.L.F. Beauty, Inc. annual report, FY2017

Business context and reporting period

E.L.F. Beauty, Inc. filed this Form 10-K for the fiscal year ended December 31, 2017. The company sells affordable cosmetics and skin care through national retailers, e-commerce, e.l.f. stores and international distributors; it reports as one operating segment. FY2017 sales were 87% retail and 13% direct-to-consumer. The United States generated 90% of sales.

Financial performance and liquidity

FY2017 net sales increased 18%. Gross margin improved three percentage points. SG&A rose 20% to $131.4 million, or 49% of sales, versus 48% in 2016. Cash fell to $10.1 million from $15.3 million. Working capital excluding cash was $62.2 million, compared with $29.3 million.

At year-end, total debt and capital lease obligations were $156.8 million, including $154.4 million under the term loan; unused revolving credit availability was $49.5 million. The term loan rate was approximately 4.0%, and the company was compliant with its financial covenants. Total contractual obligations were $217.3 million, including $156.8 million of bank debt and $31.8 million of operating leases.

In Q4 2017, net sales were $81.6 million, gross profit was $47.7 million and net income was $21.5 million. Q4 2016 comparables were $76.4 million, $45.3 million and $6.6 million, respectively.

Material changes versus the prior period

• Sales growth reflected increased shelf space, new retail accounts and expansion of direct channels. Walmart and Target accounted for 29% and 25% of FY2017 sales, respectively.
• Gross-margin expansion was attributed to margin-accretive innovation, improved customer terms, freight costs and foreign exchange, partly offset by customer mix and a higher inventory reserve.
• Interest expense declined 46% to $8.8 million, following debt repayment and refinancing. Other expense was $2.0 million, versus $3.0 million of other income in 2016, primarily reflecting RMB movements and the prior-year impact of legacy forward contracts.
• Operating cash flow improved, but was reduced by a $25.5 million decrease in accounts payable and accrued expenses and an $11.2 million increase in prepaid expenses and other assets.

Outlook, commentary, risks and unusual items

Management provided no specific sales or earnings guidance. It expected the FY2018 effective tax rate before discrete items to be approximately 30% and believed operating cash flow, cash on hand and revolving availability would cover operating, investing and financing needs for the next 12 months. Management expects near-term SG&A investment to support growth, including brand, infrastructure, stores and international expansion.

• FY2017 net income included an $11.6 million non-cash tax benefit from remeasuring deferred tax liabilities after U.S. tax reform and a $7.2 million benefit from stock-option exercises and restricted-stock vesting. The company reported a 49% effective tax benefit rate.
• Sales are seasonal, generally stronger in Q3 and Q4; advance working-capital needs and major-customer order timing can affect quarterly results and liquidity.
• Customer concentration is significant, and retailer purchases are generally made through discrete orders rather than firm long-term commitments.
• Substantially all products are sourced and manufactured by third parties in China. Supply disruption, quality issues, labor costs, trade measures, currency movements and regulatory changes could affect costs or availability.
• Debt bears variable interest; management estimated a 1 percentage-point rate increase would add approximately $1.5 million to annual interest expense. A hypothetical 10% adverse RMB movement was estimated to reduce net income by approximately $11.1 million.
• The company recorded a $0.2 million impairment charge on long-lived assets; no goodwill or indefinite-lived intangible impairment was recorded. Management reported no pending legal matter expected to have a material adverse effect.

Most important facts for investors to verify

• Underlying earnings excluding the tax benefits, and whether the reported 2017 net-income improvement is repeatable.
• Retailer sales, shelf-space trends and concentration, particularly at Walmart and Target.
• Gross-margin sustainability, inventory reserves and the effect of product mix, freight and foreign exchange.
• Cash conversion, seasonal working-capital requirements, available revolver capacity and debt covenant headroom.
• Progress on growth investments and the expected costs and effects of new accounting standards, including lease accounting.