Throughout this year, The Honest Company, Inc. (NASDAQ:HNST) has prioritised premiumisation and cost reduction, aiming to bolster margins by streamlining product offerings towards higher profitability. Their strategic move includes appointing a new CFO to revive this relatively young company facing stagnant growth and negative earnings. The latest Q3 2023 earnings showcase promising results from this ‘less is more’ strategy, with improved year-over-year revenue and gross profit margins. Notably, the company has raised its FY 2023 guidance for the third consecutive quarter. Despite these positive indicators and a 20% rise in stock price, the company has yet to achieve positive earnings. With cash reserves trailing its debt intake, I feel it is too early to jump on the turnaround narrative. Therefore, I recommend a wait-and-see hold rating.
Company Overview
Established in 2012, Honest initially gained attention for its emphasis on safe, eco-friendly, and affordable childcare products, notably associated with actress Jessica Alba. However, despite an impressive $1 billion valuation in 2015, the company faced challenges and lost momentum. Its rapid product line expansion led to an oversight in quality control, resulting in costly setbacks. Yet, in the current year, the company has set a clear objective: to overhaul its financial and consumer standing. Prioritising brand elevation, margin improvement, and operational rigour, Honest aims to steer its business toward greater stability and health.
The company operates within three primary product categories: diapers and wipes, which saw a 5% YoY decline in Q3 2023; skin and personal care, experiencing a 4% YoY drop attributed to the removal of lower-margin products. Lastly, it’s household and wellness segment surged by 68% YoY, primarily propelled by the burgeoning baby clothing business’s growth and expansion.
The company utilises various sales channels, notably its digital platform, which boasted a 19% year-over-year growth, primarily fuelled by robust performance on Amazon (AMZN). Conversely, its retail channel experienced a 9% YoY decrease. Presently, the sales distribution stands at 47% digital and 53% retail.
The company recently appointed Dave Loretta as its new CFO and revised its FY 2023 forecast, adjusting the adjusted EBITDA from an initial range of negative $22 million to negative $26 million to a narrower range of negative $15 million to negative $18 million. Additionally, revenue expectations have been raised to approximately $329.79 million. Despite these adjustments, the ongoing negative figures raise concerns about the company’s profitability in the foreseeable future, especially given its current growth rate. In FY 2022, the company reported revenue of $313.7 million; this is only a 5% increase YoY.
Financial Overview
The financial status of The Honest Company presents a blend of positives and challenges. While it’s boosting its top line, the growth appears relatively stable, and it continues to report negative earnings. Yet, there’s a silver lining in its positive and consistently rising levered free cash flow. Nonetheless, a cause for concern emerges as its debt outweighs its cash reserves.
Q3 2023 saw record revenue at $86 million, marking a 2% year-over-year increase driven by heightened shipments and expanded retail presence. Achieving a noteworthy milestone, the company’s gross margin has grown from 30% to 32% YoY, attributed to cost-saving measures and a strategic emphasis on higher-margin products. This resurgence reflects the successful repositioning of the brand as a premium offering.
The concerning trend of the net income in the red, specifically at a negative $53 million in the trailing twelve months, highlights a decline compared to the figure reported in FY2022. It’s important to consider that ongoing transformation efforts may be impacting the net income negatively.
The company’s recent performance is marked by two consecutive quarters of positive operating cash flow, indicating a notable turnaround. The TTM levered free cash flow stands at a positive $16.2 million, a significant contrast to the previously increasing negative cash flow observed in prior financial years. This positive shift suggests promising prospects for the company’s financial health.
Reviewing the Q3 2023 balance sheet, the company closed with $23 million in cash and cash equivalents, marking a $5 million increase from the previous quarter. Impressively, year to date, the company reduced its inventory by 31%, amounting to $36 million, exceeding its $20 million target. However, it’s important to note the depletion of the company’s cash reserves compared to FY2021. This trend warrants caution, especially considering the company’s ongoing lack of profitability.
Valuation
The Honest Company is yet to achieve positive earnings, and while its revenue growth remains positive, it has notably slowed compared to its three-year CAGR of 10.01%. Particularly for a younger company, a steeper top-line growth would instill confidence in consumer interest, which seems lacking here. Analysing the financial metrics, the price-to-book ratio sits at 1.14, indicating that investors are valuing the company slightly above its book value. However, the company’s performance has trailed the S&P 500 index, reflecting a 56.27% loss in value over the past year.
Despite ongoing efforts to pivot towards premium, higher-margin products and improve gross profit margins, there are red flags. YoY, the EBIT margin has declined by 12.06%, and while the company is making efforts to do more with less, there are no clear growth drivers. Given these indicators, the current state doesn’t present an attractive investment opportunity.
Risks
The Honest Company, despite being a young entity, continues to grapple with the challenge of not yet achieving positive earnings. While management has revised the FY 2023 forecast, significant top-line growth remains elusive, and the path to profitability lacks clear drivers. Stagnant growth at this early stage is a notable cause for concern. Regarding the company’s capital structure, despite management’s statements, an examination reveals that debt slightly outweighs its cash reserves. This presents a potential risk factor that needs attention, especially in a company striving to establish itself in the market.
Final thoughts
The Honest Company’s financials portray a mixed picture with positive operating cash flow and improved guidelines for FY2023. However, the stagnant top line and debt slightly outweighing its cash reserves are concerning. The lack of clear growth drivers and stagnant top-line growth, combined with a declining EBIT margin year over year, suggests a cautious approach. The 20% jump in stock price after its most recent earnings may indicate an increase in confidence by the market towards the stock. I believe it is best to wait and see for stronger results. Therefore, I recommend a hold rating.
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