To The Moon

$The Honest Company, Inc.(HNST)$ is one of the companies that had terrible share price performance. Since its IPO back in May 2021, the share price is down almost 75%.

Jeremy from Financial Education covered it in a couple of his videos and I decided to take a dive deep at it myself. There's one topic that I'd like to mention before I start with the analysis and valuation.

As humans, we should be able to respectfully disagree and that is okay. There are plenty of negative and hateful comments and that doesn't add value to anyone. When valuing companies, everybody makes assumptions about the future regardless of the approach that is used. Nobody knows what the future brings and we're all going to be wrong with our assumptions. The goal is to be less wrong than the market.

As always, the video is available for those who prefer to watch: https://youtu.be/60gp9HK3E94

What is Honest company?

Honest is a company that formulates, designs, and sells clean products with a focus on sustainability and thoughtful design.

They're reporting three different segments and each one has a different purpose:

1. Diaper and wipes - Although the products are self-explanatory, this is the segment that is used as a customer acquisition tool. It might sound strange, but here's my rationale. When most people go out to buy shoes or clothes, most of us have some sort of a relationship built with certain brands (as well as opinions about brands that are not as good). For a new start-up shoe company to grab our attention, is a difficult task. However, new parents do not have built a relationship with diaper-related brands, so Honest has an almost equal chance to grab the attention of all other brands in this segment. This segment accounts for 63% of all revenue (historical growth was 16% in 2020 and 7% in 2021).
2. Skin and personal care - This is the second segment and the success of the company depends on it. It depends on the new products that are introduced, the acceptance by the customers, and the shelf space that they get in the stores. This segment accounted for 32% of all revenue (historical growth was 36% in 2020 and 28% in 2021).
3. Household & Wellness - The last segment is not their core business, it is related mainly to the sale of sanitizing wipes, hand sanitizers, and disinfecting spray. As expected, the sales increased significantly during 2020 and declined in 2021. Currently, this segment represents only 5% of the total revenue and is expected to further decline.

The margins

Their gross margin is around 35%, which is acceptable for a company in this industry.

Roughly 50% of the sales come through their digital channel, which is not surprising due to the nature of these products. Buying diapers is a relatively simple activity and it doesn't require any examination prior to purchase.

in $m

However, the 35% margin is not sufficient to cover their SG&A, Marketing, and R&D expenditures, yet. Its operating margin is -12%, which is not surprising for a young and growing company.

Financial position

The company has a relatively simple balance sheet and one that's small in size. There are two main points to be noted:

1. The cash position as of December 31st is roughly $100m, which is sufficient to sustain losses for the next 3-4 years.
2. The company has no debt apart from capital leases of around $40m.

What's next?

The analysts are forecasting 0% revenue growth in 2022, mainly due to the expected decreased sales of sanitizing products, which is offset by an increase in revenue in their two main segments. That doesn't mean the company is no longer growing. As for 2023, the expected growth is around 10%.

Valuation - key assumptions

As the valuation is based on certain assumptions, here are mine:

Revenue growth - 0% next year, followed by 8% up until year 5, then decrease to the risk-free rate of 2.41%.

Operating margin - negative 8% for next year, improving slowly over time, up to 18% in 8 years from now (close to industry average)

Discount rate - 11% (Based on WACC)

The outcome is as follows:

in $m

Of course, there are a couple of adjustments to be made.

(in $m, except per share numbers)

What if my assumptions are wrong?

Based on my assumption, the company's revenue will grow by 70% in 10 years. However, I could be wrong. So here are a couple of different scenarios related to the revenue and operating margin 10 years from now.

Jeremy's assumptions are somewhere between the last two rows, however, he is very optimistic also about the margin (expects a net margin of almost 17%, that's close to a 22% operating margin). In that case, the fair value is close to $12/share today.

Does that mean that he's wrong? Of course not, his assumptions about the future of Honest are different than mine and that's okay. We can disagree respectfully.

I hope you enjoyed the post, feel free to add your take on the company and provide feedback.