The Honest Company (NASDAQ: HNST) manufactures and sells a variety of products, including diapers and wipes, skin and personal care items, and household and wellness products.
In 2023, diapers and wipes accounted for 63% of revenues, skin and personal care products for 26%, and household and wellness products for 11%, as detailed in the Q1 investor presentation.
The company emphasizes clean ingredients and sustainability, competing with many large industry players under the single brand, Honest.
Since its IPO in 2021, The Honest Company’s stock has performed poorly. The company’s growth has slowed considerably, and it continues to report negative GAAP earnings, making improvements in profitability crucial.
Modest Growth Story
The Honest Company has experienced modest revenue growth throughout its history. In 2020, prior to its IPO, revenues increased by an impressive 27.6%. However, since then, growth has slowed, with a CAGR of 4.5% up to Q1 2024.
The company targets similar modest growth, expecting low to mid-single-digit growth in 2024 and annual growth of 4% to 6% beyond 2024.
In Q1 2024, The Honest Company reported a year-over-year revenue growth of 3.4%, continuing its modest growth trajectory. The company has significant potential for expansion in retail spaces and better shelf presence, currently selling under 51 thousand doors compared to a leading competitor’s 93 thousand doors.
The Honest brand’s performance remains a key driver of future revenues.
Profitability Improvements
Over the past twelve months, The Honest Company reported a negative operating income of -$21.8 million, with an operating margin of -6.3%, highlighting the need for profitability improvements.
Despite revenue growth, SG&A expenses have decreased from 2021, resulting in a significant improvement in operating income from -$49.8 million in 2022.
Q1 results showed continued profitability improvement, with SG&A reduced by $3.4 million year-over-year. More significantly, the gross margin increased by 12.8 percentage points to 37.0%, nearing an all-time high. This follows several quarters of improved gross margin leverage.
For 2024, The Honest Company forecasts an adjusted EBITDA in the positive low- to mid-single-digit millions. While the guidance still indicates a negative operating income, it represents an improvement.
In 2023, the company achieved an adjusted EBITDA of -$11.2 million, and continued profitability improvements are expected to push the company towards GAAP profitability in the coming years.
Balance Sheet Strength
Despite the need for profitability improvements, The Honest Company maintains a relatively healthy balance sheet with $33.6 million in cash and no interest-bearing debt.
Negative earnings include $9.1 million in depreciation and amortization, but capital expenditures are low at $1.4 million, making cash flows better than earnings suggest. Significant stock-based compensation also improves cash flows, though it causes dilution.
Favorable working capital trends have resulted in positive free cash flow over the past year. However, working capital can fluctuate, especially as the company targets growth, and constant dilution affects current investors’ stakes.
Valuation Analysis
To estimate a fair value for the stock, a discounted cash flow model was constructed. The Honest Company is expected to continue its modest growth, with a 4% revenue growth estimate for 2024, accelerating to 5% into 2025 and 2026, and then gradually declining to a perpetual growth rate of 2.5%, representing a CAGR of 4.2% from 2023 to 2033.
Operating leverage, cost control, and increased gross margins are expected to leverage the EBIT margin from -10.7% in 2023 to 8.0%.
The company’s strong cash flow conversion is supported by low capital expenditures, higher depreciation and amortization, significant stock-based compensation, and losses from previous years that can lower taxes.
Based on these estimates, the DCF model values The Honest Company’s stock at $2.46, approximately 15% below the current stock price. While the company is making progress towards healthier earnings, the modest growth story does not present a particularly attractive investment case at this time.
Where to From Here?
The Honest Company continues to report modest growth and improved margins, but earnings remain negative. Despite this, the company’s cash flows are neutral, and the balance sheet is stable, even with negative earnings.
While the earnings trajectory is expected to improve, pushing the company towards profitability in the coming years, the current stock price does not seem attractive given the associated risks.
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