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Bare Escentuals (BARE) is a maker of mineral based cosmetics. The company's brands include bareMinerals, bareVitamins, RareMinerals, i.d., Bare Escentuals, and md formulations. Bare Escentuals utilizes several sales channels, including premium wholesale (32.1% of 2007 sales) to over 700 retail locations, over 50 company owned boutique stores (17%), infomercials (25%), home shopping television via QVC (12%), spas and salons (11%), and international distributors (3.5%). The company has a presence internationally in Europe and Japan, and as of the most recent quarter an impressive 12% of revenues were from non-U.S. locales.

So how does BARE stack up as a potential Magic Formula investment? First, the good news. Growth since going public has been fantastic: 38% CAGR in sales, and 46% in operating earnings. Mineral based cosmetics is quickly taking share from traditionally heavier liquid and cream based products. Bare Escentuals also utilizes a very low cost marketing strategy focusing on infomercials, QVC demonstrations, and word-of-mouth. The product placement is at the high end of the market as well, allowing higher gross margins. Customer loyalty is very high, and the product is high quality, being a top seller at specialty retailers Ulta and Sephora. These factors have led to very good profitability, with an impressive MFI return on capital averaging well over 100% over the last 3 years. Free cash flow trends are also very good, with free cash flow margin averaging above 10%. The business model is sound and profitable, and growth trends have been favorable.

Unfortuantely, the bad news far outweighs the good news, and this stock gets nowhere near the MagicDiligence Top Buys list. First of all is competition. Don't think for a second that the cosmetics heavyweights like Avon (AVP), L'oreal, and Neutrogena (JNJ) have been blind to the trend towards mineral cosmetics. All of these players have rolled out their own mineral lines, and even downmarket drug store brands have entries in this category. This competition will slow down revenue growth, and it's happening already; BARE has seen precipitous drops in revenue growth each of the last 3 years, and the trend has intensified this year. Without a doubt this is a no-moat business. Cosmetics users can easily switch to a competing product, and Bare Escentuals faces several competitors with bigger economies of scale (allowing cheaper products), larger marketing resources, and better brand recognition. Competition and lack of a moat is a giant "strike one" against the company.

But there are more reasons to shy away. The company carries a massive debt load for it's size: 31 million in cash vs. 231 million in debt. While operating earnings cover interest at a fairly comfortable 9x today, the debt is variable rate, meaning a reversal of today's low interest rate environment can shrink that multiple quickly. Also, Bare Escentuals is equity negative, almost always a bad sign, especially for a small company with no moat and heavy competition. On the bright side, BARE has been aggressively paying down the debt: it was over 377 million just 3 years ago. However, financial health is a big concern here.

When investing in small caps it is essential to have good financial health and some sort of built-in competitive advantage that prevents sales from falling off of a cliff. Unforunately, Bare Escentuals has neither. While there are lots of growth avenues for the company, predicting it's future results is a crapshoot at best. There are much better stocks on the Magic Formula list to choose from.

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Posted by Steve on 2008-09-18 13:37:21

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