Does recent IPO Olaplex (OLPX -5.14%) have what it takes to be a great business? Join Motley Fool analysts Sanmeet Deo and Emily Flippen as they discuss the tailwinds and challenges of investing in hair care. 

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This video was recorded on Dec. 14, 2021.

Emily Flippen: Welcome to Industry Focus. Today is Tuesday, December 14th. I'm your Consumer Goods host, Emily Flippen. Today I'm joined by Motley Fool analyst Sanmeet Deo, and we're going to be talking about Olaplex. It's a niche hair care business, but it's valued at over $16 billion. Maybe niche isn't the right word to describe it with but Sanmeet, thank you so much not just for joining, but for bringing this stock to our attention.

Sanmeet Deo: Yeah, thank you for having me on. Like you are saying I'm glad to bring a female hair care products to the mix here.

Emily Flippen: [laughs] Well, I always say this, I'm a terrible host of this consumer goods show because unlike the majority of people of my demographic, I don't spend a nearly enough time or money on things like clothing, makeup, or hair care. I blame the pandemic in the fact that I sit behind a screen all day. [laughs] I'm embarrassed to say I had actually never heard of this company until you started talking to me about it as a business that you really liked. When I say really liked, I don't mean just in the context of, well, maybe we can talk about this on Industry Focus, have an interesting conversation. I mean in the context of, I want to recommend this company. This is an interesting business that is growing pretty substantially. As I mentioned at the top of the show, I was astounded when I saw that its market cap was over $16 billion because for hair care business, that's pretty lofty. Pretty unusual we see pure-play hair care businesses valued at such a high rate. Naturally, I was extremely interested. I'm sitting here with my barely damaged hair, so I actually went out and I bought myself some of Olaplex's products.

Sanmeet Deo: Awesome.

Emily Flippen: They have an entire suite numbered order lead for you where you can try out. I put some of my hair. I will say I enjoyed it although I did notice how expensive the product was. But before I get into my own personal thoughts about the company, what is it about Olaplex that made you so excited?

Sanmeet Deo: When we talked last in Industry Focus, we talked about Sweetgreen and how I found that just from seeing it, retail stores consumer products, very often you see in the world and you get interested in when you're investor. You say, hey, is a public, let me look into it. This was not like that, it was actually a name I got from a fellow investor who pitched it to me to say, hey, take a look at this, is a consumer product company. I took a quick look in the financials Lumewave first-off. That in itself was the first thing that really blew my mind in terms of the insane amount of growth and margins that it has. Then as I started digging in, well further to figure out, well, what does this company actually do? I have tried before because you won't see it under my hair but I don't really have much hair. It doesn't really benefit me, but having wife that uses a lot of hair care products, I asked her and she hadn't tried it either but she has some good views on the industry, so I'd like to touch base with her on that. But admittedly, the financials is really what stuck out to me like first and foremost. Then as I started digging into it, the business and what they're doing seems very interesting and I can see why they have the growth that they have.

Emily Flippen: Well, sticking with me and not falling squarely into this demographic I will say, a lot of people in my demographic which is especially young women with a lot of hair spend more time on social media platforms in idea. This is really the bread and butter for Olaplex to have a lot of brand ambassadors. People out there who are actually getting paid by the company to promote the product. But it's not just paid promoters, it's also some pretty organic spread across social media that has brought this company to a lot of people's attention. It has a lot of, I'll say fans out there. If you actually look at their net promoter score, if memory serves their net promoter score is over 70, which is really strong especially again for these consumer-facing businesses that are more challenging when you're selling a consumer product to get that Net Promoter Score up. Some really big fans, I'll say out there in the market today. They have a really interesting approach by combining both professional settings with this retail setting. A lot of people will get exposure to Olaplex, not just through social media, scrolling through their news feeds, seeing people use it on their hair and talk about the results, but also by going into their salon. Olaplex actually has a couple of products that they call ProRx. They're only for professionals who will use these products on their customers hair and then recommend them to their customers. They have this dual-pronged approach, if you will, combining both these ambassadors within social media with ambassadors and salons as well.

Sanmeet Deo: Yeah, absolutely. That's the interesting thing about this company where they are able to balance that. It's not something I knew but as I started looking at some comments from a competitor, balancing that is very difficult. Typically what happens is a product might be very popular with stylus. Stylus recommended it, they are very all onboard, and people trust their stylus. They look to their stylus to full product recommendations. But then what happens is once they go retail, they start selling in different stores, online, different channels. Sometimes that eats into the stylus business of recommending and they don't like that. They like to be exclusive and it maybe takes the exclusive or professionalism of the product away. Them being able to balance that is actually pretty impressive if you really dig in and figure out that that's not really commonly done and it's more rare than we as modern consumers might think. Again, like you said, they have a very strong engagement on social media platforms. Let's be honest, products like this are that's almost like a bread and butter in a very popular way to get their products out there known and in the community and used and demonstrated. Its very visual product. Once someone's use it shows before and after pictures, people are going to recognize, wow, this thing seems to work. They have over 2.1 million followers on Instagram. They have over 350 million hashtag Olaplex views on TikTok and 230,000 professional stylus in Olaplex lead communities on Facebook. Then also have a million-plus unique hair diagnostic quiz takers since October 2020 on their website. They are hitting all the main online communities and channels to really get their name out there.

Emily Flippen: I love this dynamic between professionals and consumers. You can understand why business like Olaplex would want to target both. Both are critical for growth. In fact, while these numbers are as of the S1, so they might have changed a bit since the company went public earlier this year. Around 55 percent of sales come through these professional channels in comparison to 27 percent of sales coming direct-to-consumer. That's or Amazon. Another 18 percent coming through specialty retail which is retail outlets like Sephora or Ulta. Now, that is to say they have this very diverse mix of where they're pulling revenue from. It's understandable that they want to retain relationships with professionals that account for over 50 percent of their sales while also still driving people to other avenues that are actually growing much faster than their professional channels. They're getting growth from both avenues here. But when you think about the relationship that Olaplex has between those professionals and these consumers, how do you navigate that? Because there are some professionals that will say, hey, why am I promoting a product that is freely available on a retail store shelves. It's the idea of professional or salon-quality, the moment it leaves their salon, it loses some of that credibility.

Sanmeet Deo: Yeah. They've definitely routed themselves also in science. Their patented chemical product that they use in their hair care products, decimino, it has a longer name, is scientifically proven to rebuild bonds in the hair. It's something where they have positioned themselves in deeply in science, but also in beauty. They are balancing not only just the stylist in the influence area, they're also balancing the science and the beauty. What gives me comfort for the investment in the company is that stylus have such conviction in the product that they are able to be OK with it being in retail and being sold because the professional products seems like it is exclusively sold in professional and customers can't get that product anywhere else. All the other products are more consumer oriented products that people are actually buying after the stylus just told them about some of their products. Then once they learn about the products from the stylist, then they'll go out and say, hey, I want some additional products, so I don't want to try a different product from them and go on Amazon or Sephora and check it out. There's a nice balance of consumers using and getting the products from both channels.

Emily Flippen: That's really where this business I think shines, is because when I look at what they did when they went to retail, I think they did their best to navigate the retail professional relationship by keeping that higher-price-point. Now it's time for my anecdotal story here. I went out wanting to try Olaplex. I went online. I was one of those million plus people who did their hair care quiz. They gave me a couple of recommendations about what I should buy. In particular, a handful of their products which they have numbered 0-7. Number 1 and 2 were only available professionally. But they recommended that I get number 0, number 3, 4, 5, and 7. So I did. I tried all of these different numbered products. While I will say, it did make my hair feel very nice, soft, and shiny, they were also very pricey. While you can get some of them in some packs, these trial packs, individually, each bottle sells for about $28 and they are small bottles. I think three and halfish ounces if memory serves, so pretty small amounts for a pretty high price points. I find myself really conflicted about what this price point does the consumer. Because on one hand having a premium image for a product that maybe it's bought less frequently is really good for Olaplex, because it let's professionals maintain the belief that Olaplex is that premium product. Whereas on the other hand, when you're pricing shampoo and conditioner at $28 a bottle, for very small bottle, that become something that rapidly limits the size of the market, so really only influent people who will be making this purchased, but also maybe decreases the frequency with which they'll be willing to make this purchase. I think I can make an argument on either side of the fence about the price point of this product. I see good things and I see bad things.

Sanmeet Deo: Absolutely, there's a higher-priced product and it is going to cost some money to buy it. They do sell bundles, and that brings the cost down a little bit. But what's interesting too in about even consumer products in general, consumer products or consumer restaurants or retail. If the product is really differentiated, it doesn't have as much competition, it's unique, people will be willing to pay out for the products if they really see value out of them. I think that's where they're positioning themselves and they've done a good job of positioning themselves. The CEO of Olaplex now JuE Wong, used to be the CEO of another hair care company, which you might know of and you may have tried Moroccanoil, which has become quite a popular brand over time. I think they do, it's a private company so don't exact numbers, but close to anywhere between 100-500 million. I know it's a big range of sales, but it's because it's a private company, so it's not easily accessible. But Olaplex has already surpassed that and that is a product that has been ubiquitous. My wife loves that product. It works great, it smells great. People love it. It's sold everywhere. People will buy up for something that delivers value to them. Olaplex, from what I've read from reviews and just doing some work on it, there's not many products that are doing what they're doing. In fact, I don't think there's any products. From everyone that I've asked and the reviews I've read, there isn't a product that's doing exactly what they're doing in repairing hair quickly and well. I think they're really differentiating themselves, which could sustain that price.

Emily Flippen: I have some thoughts about the hair care industry, about what you said is that particularly using Moroccanoil as an example. But I'm going to hold off on my thoughts until we get to the risk sections, because you did talk a little bit about the sales here. You mentioned at the offset of the show that what made Olaplex standout to you is the financial performance. When you look at the financial performance of this company, what stands out?

Sanmeet Deo: What stands out the most are the margins. The margins are astronomically high. The gross margins are above 80 percent. If you just take the past last 12 months as of September, gross margins, 81 percent, EBITDA margins 64 percent. EBITDA margins are even more difficult to get such high margins on and they are profitable already. A lot of the different consumer tech names that we see are profitable, this is profitable and it's growing at a very high clip. But the profit margins are really what six out.

Emily Flippen: Well, I don't want to be a Debbie Downer here, but I will anyway, because it's the show. What am I going to do? I will say, as I mentioned, this is a 16 and a half billion dollar company. While this is a profitable business that is growing very rapidly, I really hate the use of adjusted figures in this case. Because as with most consumer goods businesses, the figures adjusted, especially when you're looking at things like adjusted EBITDA metrics, takeaway a lot of really important aspects about consumers businesses, and one of those is obviously taxes. But in this case another aspect is interest expense. That only means that around $185 million of that over $500 million in sales are hitting the bottom line. That becomes a lot harder to swallow when you think about that 16 and a half billion dollar valuation. But let's talk about this interest expense a bit. I'm going to caveat my feelings here. I've been wrong on this stuff in the past, but I'm a little bit nervous. When I look at their debt load, they have just under $750 million in long-term debt, that borrow over $55 million in interest expense over the last year. That was nearly 20 percent of their operating profit, more than 30 percent of their operating cash flow and then you add taxes on top of it. It just means that their actual net income margins, the actual GAAP level of profitability is much lower. Now, this debt was obtained because Olaplex was acquired by a PE firm, Advent International earlier in 2020. They saddled Olaplex with a lot of debt, paid themselves a pretty penny in the process. Advent still owns 77 percent of the shares outstanding. That ownership structure does make me a bit nervous. The caveat I'll provide is, I remember as a relatively new Fool, one of the first companies I looked at was Yeti. I've talked about Yeti a ton on the show in the past. But I remember having this conversation with the other analysts where I talked about virtually the same situation, a company whose co-founders had left, although in this case obviously co-founders not involved. But co-founders had left tons of debt broadened by an outside PE firm. They were controlled entity. I didn't like it. Yeti has done amazing things. This could still be great. But that debt does make me nervous.

Sanmeet Deo: Yeah, I know absolutely. Typically when a PE firm takes over a company and they saddle with debt, it's a company that has steady cash flows and revenues and so they're relying on that steadiness of revenue and cash flows to pay off the debt, and so debt doesn't tend to be concerned. For all intents as much as I might sound so excited about this company, I'm definitely aware there are many risks of this company. For all intents of purposes, even though it has 11 products, it's a single product type company where this is what they're doing in terms of the hair care products and so they are very reliant on that. They're very reliant on some of the customers they have. They have customer concentration which you might be talking about later. They are reliant on these things and that does present some risks, which given the heavy load of debt and interest expenses, if they can't cover that that becomes a problem. The one thing that does give me some comfort that it's in a category and product area that tends to have a lot of resilience and even some of the stuff I've read from some competitors, even post-pandemic. What's happened is it slowed once the pandemic hit in this category, but post-pandemic it's jumped back right to the growth that it was in prior to the pandemic and the care category which includes share appears, treatments, oils, masks, stuff that Olaplex is in seems more resilient to crisis. There is some stability there or be it, take that with a grain of salt.

Emily Flippen: I want to talk about their risks. I guess I will give you my bare case, because I love playing devil's advocates. But give me the bull case, if Olaplex is successful over the next 3-5 years, what happened? What is the business look like?

Sanmeet Deo: I see multiple products in a hair care. They're looking to grow 2-3 each year, so continue to expand that portfolio, expand into skincare, which is they already have patents for products in skincare. They've already said that their customers, if they came out with skincare products, would be interested in. Another interesting thing I saw focusing on some other categories of growth. That could be like under served consumer groups. Could be males who do use a high-frequency of hair care products, exploring pet care segment, that's something that's also there. Taking different areas like that and expanding into those to expand their product line and then also growing outside of the United States, which will be a challenge because the balance between stylists and growth there and going retail is lot more trickier and challenging internationally versus the United States. Recommendations from stylists in countries like Germany, Japan are more important and it's a huge barrier to entry, so they're going to have some trickier water to navigate abroad, but growing there and expanding there will definitely will be a bull case for them.

Emily Flippen: Yeah, I think the skincare industry in particular is really interesting. One the numbers that they pointed out was that it's a $140 billion a year global industry, so nearly double the size of the hair care industry which is strange to think about. To be exact they have even a little bit of success in skincare. It could be good for them. Although I will say going back, when I think about the risks to this business, I already mentioned valuation as one that it keep my eye on, but even more so than that, I really find myself hitting this wall and I can't get over it for some reason maybe listeners can, maybe you can Sanmeet is just with how fickle hair care and consumer products can be sometimes. When I think about Moroccanoil, or Argan oil, they were these things that revolutionize the haircare industry. Everybody was really excited about them, and then they fell off. They went to the next best thing. I think right now in terms of hype, maybe Olaplex is reaching a peak that if they're unable to develop any new product to reach that same level of hype, they end up falling off to whatever the newest thing is in hair care. For that reason I find myself just, I guess, trading cautiously in these waters. All the numbers are pointing in the right direction. Management's executing, I like to big vision that they have. But man, I just can't get over that one aspect which is hair care. Am I just never going to invest in the hair care company? I might not.

Sanmeet Deo: It's interesting you mentioned that and one of the points I wanted to make too is, given that there is, quite a bit of risk as we've outlined for this business. One thing for listeners and members to focus on and identify as well is, would you want this as a broader part of your portfolio, and given the risks that are there in this company, how do you size that. You don't make, this isn't one of those companies or stocks that you make an out sized position in your portfolio. This is one of those where given the things that we like, balance with the risks involved, valuation, expanding, concentration of customers and ownership and all the things you've outlined, maybe we make this a smaller portion of our portfolio. Maybe it's like a two and a half, three percent, four percent position for our portfolio that gives us exposure into this industry that we can feel comfortable with and so, I wouldn't just if you're too concerned with the rest I wouldn't just throw it aside and say yes, I don't want to invest in the area at all, or if it's too risky then you want to invest in like maybe a bigger beauty care product company or retailer, especially retailer, where are you still get exposure to this but you are not concentrating your bet. Like Sephora, I don't think Sephora is public but like an Ulta or something. Definitely portfolio sizing and positioning is definitely key to for a name like this.

Emily Flippen: Yeah, super-interesting, you say that I'm actually an Ulta shareholder and if memory serves in their most recent call, they called out Olaplex is one of their best selling products. Definitely getting some exposure if you're a shareholder in Ulta and probably a handful of other businesses in that aspect, retailers of beauty products. You're probably getting some ancillary exposure to Olaplex. The last thing I'll mention here before we pull out is that there is some concentration within customers, Sephora beauty systems group, which is the parent company of Sally Beauty and owns a network of other professional consultants, as well as Amazon, reach greater than 10 percent of total sales in the most recent year. Something to keep an eye on. I'm not worried about any of those channels to be frank with you, but if you are going to be an investor, be sure that you are aware, there's some concentration in terms of the retailers with which they distribute products.

Sanmeet Deo: Yeah absolutely.

Emily Flippen: Sanmeet, I have to say, I love you coming on and talking about this company, bringing it to our attention. This is probably one that in a year from now, I'll kick myself for being so bearish upon in terms of just the market itself but in terms of execution, it's certainly doing a wonderful job and I can't wait to watch what the future it hasn't store.

Sanmeet Deo: Well, to be fair, I could be kicking myself for it as being a trend that just fizzled out. We'll see where it'll end up in the years to come.

Emily Flippen: We'll flip the coin. [laughs] Well, again, thank you so much for joining, I appreciate it.

Sanmeet Deo: Absolutely. Thank you for having me on.

Emily Flippen: Listeners, that does it for this episode of Industry Focus, if you have any questions just want to reach out and say, hey, shoot us an email at [email protected], or tweet us @MFIndustryFocus. As always, people on the program may own companies discussed on the show and the Motley Fool may have formal recommendations for/or against any stocks mentioned. So don't buy or sell anything based solely on what you hear. Thanks Tim Sparks for his work behind the screen today, Sanmeet Deo, I'm Emily Flippen. Thanks for listening and Fool on!