Beauty stocks a good look for small-cap portfolios

As megatrends go, the move towards “affordable luxury” products and services has had relatively less attention. Look closer: one retail segment after another is selling to the masses products and services once designed for affluent customers.

Travel is an example. International airfares and five-star resort holidays used to be the preserve of the rich. Now, a luxury resort holiday in Bali costs less than $2,000 for five nights (off-peak), and some return airfares from Australia are under $500.

A meal at a trendy Melbourne restaurant might set a couple back at least $300 (with drinks). Now, they might order the food online and have it home-delivered for half the price.

In autos, who would want to pay hundreds of thousands of dollars for a prestige car when more manufacturers are introducing on-demand car services? Why buy one Porsche when you might be able to pay a monthly fee and access a range of different Porsches, as needed?

Brands worldwide have good reason to target the affordable luxury segment. The bottom end for many products and services is becoming increasingly commoditised and offering lower margins. The top end has all the wealth but is a small market by customer volume.

It’s the aspirant, booming middle class that offers most growth. Another 3.1 billion middle-class consumers, two thirds of whom will be Asian, are expected by 2030, on OECD forecasts. That means more consumers craving upmarket, cheaper products in coming years.

The cosmetics industry is benefiting from this trend. Cosmetics and toiletries retailing in Australia grew at 2.6% annually over five years to FY17, estimates business forecaster IBISWorld. That growth is better than it looks given weakening retail sales growth and intense price competition from supermarkets, discount pharmacies and online cosmetics retailers.

IBISWorld predicts the industry’s annual growth to slow to 1.5% amid persistent consumer weakness and rising competition in cosmetics and toiletry sales. But the sharemarket has a different view, with share prices for cosmetics providers rising.

Consider BWX (BWX:ASX), one of the market’s best Initial Public Offerings (IPOs) in recent years. BWX makes, markets and distributes branded skin and haircare products, focusing on beauty markets. Key brands, owned or distributed, include Sukin, Derma, USpa, Edward Beale and Renew Skincare.

After raising $39 million in an IPO on the ASX in November 2015, BWX has soared from a $1.50 issue price to $6.91. The stock, up 46% over one year, is trading near 52-week highs.

BWX is expanding overseas. This month it announced the planned acquisition of Andalou Naturals, a natural skin, body and haircare brand for at least US$80 million, and a $100 million capital raising.

That followed the September 2017 acquisition of Nourished Life, a leading online Australian retail platform in organic skincare and wellness products, for $20 million. BWX said the deal was more than 5% earnings-per-share accretive (based on a nine-month contribution from Nourished Life). It looks like another good acquisition.

I wrote favourably about BWX for The Switzer Super Report at $4.87 in April 2017 and wish I had done so sooner. A 41% gain in six months since that report reinforces the company’s momentum.

Arguably, BWX’s biggest challenge is keeping up the growth. The company’s footprint is expanding in the United Kingdom through a distribution deal with Boots, a leading pharmacy retailer, and now through the US with the latest acquisition. BWX’s product range is clearly resonating with consumers here and overseas.

As much as I rate BWX and its long-term prospects, the share price looks to have factored in the potential for now. A forecast Price Earnings (PE) multiple of almost 28 times forecast FY18 earnings, based on consensus estimates, is high for a small cap with limited history as a listed company.

An average price target of $5.99, based on a consensus of six broking firms, suggests BWX is fully overvalued after the latest price rally. Best to wait for some steam to come out of the share price for this well-run cosmetics small cap.

Chart 1: BWX (BWX:ASX)

Source: nabtrade

Elsewhere, micro-cap cosmetics retailer McPherson’s (MCP:ASX) stands out with a 46% total return (including dividends) over one year. Like BWX, McPherson’s is defying predictions of slower growth in cosmetics sales as consumers rein in budgets.

McPherson’s is not a pure cosmetics play. The company’s home-appliance division contributed 25% of FY17 revenue and has had write-downs in the value of its brands and goodwill. McPherson’s health, beauty and wellness business is the clear focus and growth engine.

McPherson’s hair and beauty products include the Manicare, Lady Jayne, Dr LeWinn’s, A’Kin, Multix and Swisspers brands. In its latest result, McPherson’s benefited from a strong profit-growth margin that more than offset a 10% decline in revenue.

McPherson’s is getting its act together. Underlying profit rose 15% to $19.6 million in FY17, net debt fell by 27 % and margins expanded by almost 1% to 8.6%. The supply chain is being strengthened and McPherson’s export focus increased.

The company wants to position its products for a burgeoning Chinese market that has rising demand for Australian and New Zealand health, beauty and wellness brands.

The market is not fully factoring in McPherson’s transformation gains and growth prospects in Australia and overseas, at the current price. Share-valuation service Skaffold believes McPherson’s is 26% undervalued at the current price. Skaffold values the company at $1.85 in 2018, rising to $2.10 in 2020.

As a micro-cap stock, McPherson’s suits experienced investors comfortable with higher risk.

Chart 2: McPherson’s (MCP:ASX)

Source: nabtrade

Australian Pharmaceutical Industries (API:ASX) is another potential beneficiary of rising demand for health, beauty and wellness products. API’s retail brands include Priceline Pharmacy and Soul Pattinson Chemist. API also has a pharmacy distribution operation and a medicines and consumer toiletries manufacturing business in New Zealand.

As Australia’s third-largest national pharmaceutical wholesale distributor, API operates in an industry characterised by high regulation and price setting by governments on subsidised pharmaceuticals (via Medicare). Investors seeking purer cosmetics exposure should stick to BWX and McPherson’s; API is a more complex business.

The potential upside is growth in the Priceline Pharmacy franchise model, developed by API to give chemists a stronger retail offering based on health and beauty products. The Priceline Pharmacy network had 462 stores at the end of FY17 and met its target of 20 new stores that year. Its “Sister Club” loyalty program has a whopping 7.1 million members.

Total Priceline Pharmacy network sales rose 5.2% to $2.1 billion — a reasonable result given the tough retail climate, which the company expects to persist in FY18. Over-the-counter medicines were especially strong with 12% annual growth.

Priceline’s growth in a weak consumer market is encouraging. Sister Club, relaunched this year, is a huge online database to target customers through enhanced digital marketing strategies. A much stronger e-commerce offering should please franchisees and attract new ones.

Moreover, as Priceline’s network grows, so too does its buying power and economies of scale. Priceline’s brand awareness should continue to rise and the chain looks well positioned in the health and beauty sector against competitors, such as Chemist Warehouse, which has a broader pharmacy offering.

API says it will be net debt free by the end of this year, giving it scope for acquisitions that drive growth. The company in August withdrew from the process to buy Laser Clinics Australia, reiterating that it would assess other acquisition opportunities as they emerged.

AP has many challenges in its retail and wholesale operations. But a share price that has fallen from a 52-week high of $2.38 to $1.64 looks too conservative on API’s prospects. Technical analysts will want API to hold support around $1.50 on a chart, a key price point.

Chart 3: Australian Pharmaceutical Industries (API:ASX)

Source: nabtrade

Morningstar values API at $2 and has an accumulate recommendation. Morningstar wrote: “We expect this momentum (growth in Priceline) to continue given the Priceline franchise value proposition, in light of challenges faced by independent pharmacies in Australia, including ongoing regulatory reform.”

An average share-price target of $1.96, using a consensus of five broking firms (too small to rely on) suggests API is undervalued at the current price. A PE of about 13 times FY18 earnings is not overly demanding for one of the big-three pharmacy distributors and a company with a growth engine in Priceline. An expected yield of about 5% is another plus.

Longer term, demand for affordable luxury cosmetics will keep rising, driving more customers into Priceline’s franchised and company-owned stores. Buying pricier cosmetics from a discount chain is not exactly a glamorous retail experience. But that’s what affordable luxury is all about; bigger-name brands through cheaper channels.