Description

Overview:

Adore Beauty Group ("ABY") is a pure-play online retailer serving the B2C beauty / personal care market, focusing on the fragrance, skincare, haircare, and makeup verticals. I believe it is a good mid-size short over the next 6 to 12 months for the following reasons:

1. Most short sellers have covered since the post-IPO sell-off so short interest is only 1.6% and ABY is outside the top 100 most shorted stocks as a percentage of float (for American readers, there are only about 300 companies on the ASX with market cap > $300m so this ranking is very, very low).
2. The market opportunity is far smaller than the $10B+ the management loves to showcases, increasing near-term risk of revenue deceleration as penetration increases.
3. The unit economics of each customer limit exponential growth in per customer value and force ABY to rely on unsustainable, volume-driven growth.
4. The business' high churn and poor margin structure will likely limit forward free cash flow generation to a very low single-digit percentage of revenue.

Thesis # 1: Small End-Market:

ABY targets the ANZ B2C beauty / personal care market, which has grown from $8.6B to $10.9B over FY15 - FY19 (+ 6% / Y). However, this broader market includes several verticals outside ABY's target market, like men's grooming, dietary supplements, electrical appliances, sex products, and oral care. A pivot to these areas is unlikely (see their website for yourself and judge whether they can pivot to men's grooming). ABY's prospectus breaks FY20 revenue down by fragrance (2%), skincare and cosmetics (57%), and makeup (14%). As such, the adjusted end-market for FY21 (based on figures in ABY's prospectus) is:

*** AUSTRALIAN MARKET ***

(+) Beauty and personal care market: A$11.6B
(-) Sex product: A$1.1B
(-) Dietary supplement: A$0.7B
(-) Electrical appliance: A$0.6B
(-) Men's grooming: A$0.8B
(-) Oral care: A$0.7B
= A$7.7B

*** NEW ZEALAND MARKET ***

(+) Beauty and personal care market: NZ$1.8B
(-) Sex product: NZ$0.3B
(-) Dietary supplement: NZ$0.03B
(-) Electrical appliance: NZ$0.2B
(-) Men's grooming: NZ$0.1B
(-) Oral care: NZ$0.1B
= N$1.1B
x NZD AUD of 0.96
= A$1.1B

The TAM excl. these verticals is therefore A$8.8B as of FY21. We must also account for online penetration. The most bullish rates of online penetration in this market (as per ABY's prospectus) range from 15-30%. In particular, the company-guided scenario for post-COVID impact on consumer spending is 13-25% for the Australian market and 9-11% for the New Zealand market. This is at the low-end of other countries like the US and UK in terms of online penetration in this market. For context, Amazon has struggled to meaningfully penetration the Australian market because the omnichannel presence of retailers like JBH and HVN is extremely strong.

Consequently, my estimate of ABY's realistic end-market (accounting for five-year growth of + 10% based on increasing penetration) is from $1-2B. This is extremely small, given that it is to be divided up amongst multiple competitors and ABY already has run-rate revenue approaching $240M. This implies that ABY has actually already penetrated anywhere from 11.8-21.9% (based on my proprietary estimates of market size) of the end market.

To summarise this first point:

1. ABY's end market is a fraction of the $10B+ that management loves to showcase in its prospectus and investor presentation, using adjustments based solely on ABY's own prospectus (exclusion of non-targeted verticals and adjustment for online penetration rates).
2. If ABY were to capture the entire industry, the gross profit generation (at constant margins of 30%) would only be 30% x $1-$2B = $0.3-$0.6B in FY24. ABY's current market capitalisation is already $448M, even after its steady sell-down post-IPO. The margin profile combined with this smaller end market makes ABY's valuation extremely difficult to support.
3. ABY already has high penetration (considering that we have not considered competitors), increasing the likelihood of near-term revenue deceleration going forward, especially as the Australian economy emerges from lockdown and consumer trends reverse COVID-19 inflated ecommerce figures.

Thesis # 2: Poor free cash flow generation as a structural company issue

ABY has extreely poor FCF generation for a company that has been able to grow revenue at high double digit percentages for several years (> 50% CAGR over FY17-FY21).



(G&I should be considered part of free cash flow because it relates to brand deals and proprietary online data which is essential to ABY's business)

FCF has consistently been a very low % of revenue (2.5% in FY17, 1.4% in FY18, 0.2% in FY19, 2.0% in FY20, 1.0% in FY21). I believe that this is a fundamental problem with the business, rather than a feature of early-stage growth, for several reasons:

1. There is high churn in ABY's user base, limiting ABY's ability to reduce marketing spend as a % of revenue and increase operating leverage.
2. The margin structure of the business fundamentally limits the value of each customer, resulting in high required customer numbers to support the current valuation. This is a function of ABY's status as a distributor - GM % is ~30%.

Now let's digit into these two points...

*** Subpoint 1. High churn in ABY's customer base and low customer value ***

ABY has struggled to meaningfully increase revenue per user and user value, despite a revenue CAGR of > 50% over the last four years. The company's own data (company prospectus) highlights low customer retention of 44.8% in FY17, 55.6% in FY18, 53% in FY19, 61% in FY20, and 61% in FY21 (FY21 report). Note that the increase in FY20-21 retention (which still implies ~40% churn) is most likely transient and due to a lack of alternatives throughout on and off lockdowns.

ABY's showcases misleading long-term cohort data (Figure 19 in prospectus) regarding revenue per user. The chart I have referred to effectively illustrates the increase in revenue per user by year of that customer cohort (how many years they have been an active customer). This increases from $150 to $450 over Year 1 to Year 9. The issue, however, is that users do not stick around long enough (or at least consistently) enough to generate this value. If, for example, 45% of customers leave each period, only 5% of the original cohort would still be active customers just 5 years after their first interaction with ABY. After 9 years, the $450/customer figure would represent < 0.5% of the original cohort.

We can actually build a simple model to support a 40% churn rate in FY19-FY21 cohorts. The following assumptions are made:

1. There is a steady customer base of 146K from FY19 onward that does not churn and has revenue per customer progression of $287, $300, and $325 because of estimated cohort ages of 5, 6, and 7 years.
2. The revenue per customer progression is $150, $200, and $225 for cohorts ages of 1, 2, and 3 years. This is based on Figure 19 in the prospectus I referred to earlier.
3. The assumed churn rate (in line with mid-term averages) is 40% for cohorts initiated in FY19-FY21.

This model is a bit difficult to put to paper in this format, but output is below.

The estimated revenue from this model for FY19-FY21 is $73.8m, $124.9m, and $177.8m. This is a % of actual of 101%, 103% and 99%. The very high accuracy of this model of past churn supports the hypothesis that ~40% of new users are churned each period and also confirms my suspicion that the business is really supported by a smaller loyal cohort (steady base), and that incremental customers are much lower value (given 800K users it is reasonable to expect the high-spending beauty customers have been captured in the 7m person market).

Moreover, the fact that ABY's own revenue per customer figures all trend toward the low-end of the $150-$450 range despite massive increases in y/y customer numbers supports my hypothesis that most of ABY's users are churned before they become high value:

* FY19 ARPC: $204
* FY20 ARPC: $206
* FY21 ARPC: $219

Volume-driven (i.e. through more customers) growth will become increasingly difficult as ABY scales, given that their target market of younger females in Australia and New Zealand is quite limited; data from the World Population Review states that the number of females in Australia and New Zealand between the ages of 12 and 50 (inclusive) is only 7.8m and ABY already has > 800K customes. This may lead to near-term revenue deceleration, given that penetration in the end market (based on my top-down market analysis) is almost 20% and 10% based on customer numbers (this paragraph). ABY's business update in Q3 confirms subscriber deceleration in terms of growth rates - I take this as a sign to press the short, not cover (still > 100x FCF).

ABY also showcases a chart highlight revenue composition by year vs. cohort.

It looks like exponential lift. Look closer, and you'll see that most of this is volume-driven (as I've harped on about) through more customers, as calculated below:

FY19: $31m revenue from new customers vs. 212K new customers vs. $146 ARPC
FY20: $53m revenue from new customers vs. 371K new customers vs. $143 ARPC
FY21: $68m revenue from new customers vs. 458K new customers vs. $148 ARPC

Keep in mind that the vast majority of these new customers will be churned in a few periods.

*** Subpoint 2. Poor margin structure ***

The primary reason for ABY's struggle to generate free cash flow is its poor margin structure. GM is ~30% because ABY's business model is distribution of third-party products; whilst the products themselves are not "commodities", ABY is only a distributor, limiting its pricing power compared to retailers (such as Lovisa) that manufacture in-house and can have gros margins > 75% given sufficient revenue uplift. This is a fundamental problem with ABY's business model, as evidenced by their admitted struggle to pivot into private label brands. The reason is simple: everyone I've asked about the company uses the site to buy products like Mecca - they have not interest in ABY's private label products.

ABY's own data highlights a predominately variable cost structure, retaining just 13.8-19.2% of revenue after all variable costs (COGS, marketing, wages) are considered. The % of revenue of each line item is broken down below:

FY18: COGS (69.8%), Marketing (8.5%), Wages (9.3%), Other Opex Excl. NRI (9.7%) = Overall 97.3%
FY19: COGS (70%), Marketing (9.4%), Wages (10.2%), Other Opex Excl. NRI (8.1%) = Overall 97.7%
FY20: COGS (68.2%), Marketing (11.6%), Wages (9.4%), Other Opex Excl. NRI (8.9%) = Overall 98.1%
FY21: COGS (66.9%), Marketing (12.9%), Wages (10.2%), Other Opex Excl. NRI (6.1%) = Overall 96.1%

More telling is management's admission that marketnig is predominately variable, supporting my hypothesis that high churn fundamentally limits scaling potential based on lower marketing spend as a % of revenue. In addition, I find it hard to believe that many of these "fixed costs" are truly fixed, because employee costs (which they claim are fixed) are arguably a more stable % of revenue than VC, even as revenue grows > + 50% y/y. In my experience, cost discipline can't be learned once revenue is taken care of. The only costs that appear to be scaling are "other costs". Thus, downside margins after all variable costs are deducted is likely to approach 10% of revenue. This does not consider working capital, reinvestment, etc. This cost structure does not support long-term customer value. In line with my assessment, per customer economics are quite stable year to year, with low to no uplift in per customer value.

*** Subpoint 3. Calculation of LTV and required user numbers to support valuation ***

We can use the company's unit economic values (approx average order freq (AOF) of 2.1 and average order value (AOV) of $100), our prior margin calculations, and historical churn ranges to assess the lifetime value (LTV) of each customer to ABY.

AOF: 2.1
x AOV $: 100
= ARPC $: $210

% Margin @ Low operating leverage: 10%
% Margin @ High operating leverage: 20%

% Churn (High): 55%
% Churn (Low): 39%

LTV (High): $107.69
LTV (Low): $38.18

This means that the market capitalisation ($448m) would required 4m users at high LTV (high margin, low churn) and 12m users at low LTV (mid margin, higher churn), compared to ABY's current ~800K users. To put this into context, this is 53-150% of the number of females in ABY's target market (as calculated previously at 7.8m). These calculations also ignore other costs (fixed costs, working capital, PP&E) and the time value of money, too, making ABY's valuation extremely difficult to support (> 248x FCF), even at its steady-state business model.

# Catalyst #

1. Likely fall in retention rates from COVID-19 peak in 1H22 or 2H22, driven by reversion of customer behaviour.
2. Slowdown in growth rates across customer numbers and revenue.
3. Shift in focus to the bottom-line as revenue growth decelerates.

# Potential Risk #

1. Potential expansion of ABY beyond AUS/NZ could be negative, even if just announced and not executed on.
2. Successful line of produts produced in-line could increase margins (more unlikely than # 1 in my opinion, given the customer base and my checks).

# Summary #

1. ABY has an addressable end market of $1-2B in FY21-24 vs. the stated market of $10B+ that management showcases in investor presentations. Penetration is increasing, greatly increasing the risk of revenue deceleration.
2. High churn in ABY's user base limits long-term value creation. Management showcases misleading data regarding revenue per user that does not accurately consider churn rates. Also consider that ABY offers first-time customers discounts, so they are consistently losing on a large % of their customer base's sales.
3. Churn rates of up to 40% are supported based on derived revenue figures and are reasonable to expect going forward, given that ABY is a reopening loser as spending habits (somewhat) normalise. You can see a spike in monthly added users throughout lockdowns in their prospectus quite clearly.
4. The margin structure of the business is primarily variable and free cash flow generation is very poor. Resulting LTV per customer does not support valuation under realistic customer counts.
5. I haven't even considered competitors that could act as additional frictions to ABY's revenue growth, given their very high penetration rates already.

# Important Note on Trade #

Readers will notice the sell-off from $6.9 to $4.6. This means it's time to press the short even harder, especially as the market has failed to give them credit for user growth in the double digits y/y (lower risk of upside reaction on top-line figures only). This has been a trend in recent ASX ecommerce names (have a look at the charts vs. release data of Marley Spoon (MMM) and Booktopia (BKG).

Catalyst

# Catalyst #

1. Likely fall in retention rates from COVID-19 peak in 1H22 or 2H22, driven by reversion of customer behaviour.
2. Slowdown in growth rates across customer numbers and revenue.
3. Shift in focus to the bottom-line as revenue growth decelerates.