Adore Beauty’s valuation raises eyebrows ahead of IPO



Quadrant has agreed not to sell more shares until the company releases its FY 2021 results.

Adore’s founders Kate Morris and James Height will earn $45.9 million each by selling 40 per cent of their holdings. Their individual stakes will fall from 19.3 per cent to 10.8 per cent each.

The founders’ remaining shareholdings will also be escrowed to prevent further sales, but for unspecified time periods.

Quadrant bought its 60 per cent stake in September 2019, leading some professional investors to ask why it has only waited just over a year to sell its ownership interest. The likely answer being that Quadrant believes now is a good time, given soaring e-commerce valuations.

On the plus side, Adore will still be led by its founders over the long term, with most great growth businesses on the sharemarket led by founders.

E-commerce star

On face value, Adore looks a retail star as a beneficiary of the accelerated adoption of e-commerce by consumers who want goods delivered to their homes.

Active customers are forecast to grow 79 per cent in calendar year 2020, from 404,033 to 724,459, in a result the retailer also attributes to increased marketing spends, new sales channels and partnerships.

Growth initiatives ahead include the launch of a mobile app, an increased loyalty program and new products.

In calendar 2020, revenue is forecast to climb 76.3 per cent to $158.2 million, with net profit after tax tipped to nearly triple from $1.4 million to $3.5 million.

It has even been claimed, perhaps mischievously, that Adore’s decision to launch a sex toy category in late 2019 was more about sexing-up the pre-IPO valuation on behalf of private equity number crunchers, than a commitment to sexual pleasure. Adore marketed the product pivot heavily at the time, but it does not rate a mention in the glossy prospectus.

Much of its profit growth is expected to come from gross profit margins expanding from 30.7 per cent in 2019 to a forecast 32.1 per cent in 2020. The company says this can be achieved through better terms with suppliers and less discounting.

Online retailers such as Redbubble and Kogan have enjoyed improved profit margins in 2020 as consumers have been left competing for certain goods while demand rocketed.

The investor’s conundrum is whether the increased demand is sustained if the pandemic and associated restrictions recede over the long term.

According to Adore’s prospectus, industry experts estimate the total beauty and personal care market in Australia generated sales of $10.9 billion in 2019, with online sales of 7.3 per cent or about $797 million.

Online sales are widely expected to grow as a percentage of total sales over time, but at what rate is subject to a range of estimates and uncertainties.

Adore’s forecasts suggest online sales in Australia could grow at a compound annual rate of 24 per cent over the next four years to equal a market size of $3.2 billion.

Valuation worries

On completion of the offer at $6.75 per share, Adore will have a market value of $635.3 million or an enterprise value of $614.8 million when deducting $20.6 million of cash on hand. The company has minimal borrowings, other than a working-capital-type facility with Commonwealth Bank for up to $10 million.

The group is valued on an eyebrow-raising 181 times forecast net profit of $3.5 million in calendar 2020 or 454 times its trailing net profit in 2019.

By comparison, Kogan, at $21.88, trades on 40 times UBS’ estimates for 54¢ in earnings per share in FY 2021.

Adore’s enterprise value is priced on 96 times forecast EBITDA. Kogan’s enterprise value to FY 2021’s forecast EBITDA is 22.3 times. Kogan recently reported EBITDA climbed 466 per cent year-on-year in August 2020, whereas Adore expects EBITDA to double to $6 million in 2020.

At $4.43, BWX, which manufactures and sells beauty and skincare products under the Sukin brand, is valued on 18.1 times broker Canaccord Genuity’s estimate for $34.5 million in EBITDA in FY 2021.

Evidently Adore is priced more aggressively than online-only peers and those in the beauty and skincare sector.

Retailers that sell in physical stores with small online sales are traditionally valued on profit multiples in the low double-digits as retail is a competitive, low-margin business, where it is hard to develop a moat and consistently grow profits.

Incessant competition can lead to discounting that hurts margins. It is rare for a retailer to never discount goods. One exception is hardware giant Apple, as it has a competitive advantage via technology and the quality of its hardware.

But a seller of make-up and beauty products is unlikely to ever possess this kind of advantage.

Real beauty

As an online-only retailer, Adore can arguably command higher earnings multiples than a bricks-and-mortar retailer as it can boast better profit margins by saving on costs such as rent and in-store sales staff.

The prospectus markets Adore’s enterprise value as 3.9 times forecast sales of $158.2 million in 2020.

Retailers are not normally valued on sales multiples as profit margins are slender versus technology businesses and they don’t boast scalability where sales can grow faster than costs over the long term.

Adore’s gross profit margin is forecast at 32.1 per cent, which is about average for a retailer and reflects the fact it sells goods at cheaper prices. Leading software companies may boast gross margins above 80 per cent.

Estée Lauder, which sells expensive or luxury make-up and beauty products, commands a gross profit margin of 75.2 per cent. In part, this is due to its brand power providing a moat. Estée Lauder trades on 54 times adjusted earnings per share of $US4.12 in 2020, which is cheaper than Adore.

As with the most retailers, Estée Lauder’s earnings have been lumpy on a historical basis.

Adore also has to manage warehouses, inventory, logistics, supply chains, and working capital, unlike a software or tech business valued on a sales multiple that posts minimal profit.

Investors generally bet that software businesses priced on sales multiples will be able to grow future profits consistently as eventually sales will rise much faster than costs that can be fixed.

A software business may also generate recurring revenue from the same clients over a number of years on high profit margins. Yet if a retailer like Adore sells 10,000 lipsticks in 2019, it has to sell another 10,001 in 2020 just to grow annual sales assuming the same selling price.

By contrast, a software business may only need to add one new client in an entire year to grow sales, assuming it doesn’t lose any.

Buying into the idea that Adore deserves a frothy tech valuation may not make much sense then, but it is undoubtedly enjoying powerful e-commerce tailwinds.

Bulls will argue the tailwinds will carry online retailers higher as sales climb, whereas bears would suggest the entire e-commerce space will prove an epic shorting opportunity if the shift to online shopping proves a temporary phenomenon as COVID-19 fades into memory.

For investors, beauty will be in the eye of the beholder when it comes to Adore’s valuation. It hits the ASX boards on October 27.

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