The Beauty Flywheel is Broken

I wanted to take a mini-break from writing about luxury and shift into discussing the beauty industry. While luxury and beauty are linked, the fundamental drivers are different. You can read my analysis of the Luxury Flywheel here: Part 1, Part 2 and Part 3.

With e.l.f. Beauty's recent acquisition of Hailey Bieber's Rhode, I thought it was worth digging into Croda, a company that has been instrumental in enabling the emergence of "Instagram" or "Indie" brands. Before doing that, it is worth going over the beauty industry at a high level to gain some context on what is going on.

The Beauty Flywheel

Global beauty should grow 4% to 5% long-term driven by secular trends like health and wellness, premiumization and an emerging middle class. Historically, the largest players like L'Oréal and Estée Lauder benefited from significant competitive advantages allowing them to grow faster than industry whilst expanding margins. Today, "big beauty" is facing structural headwinds and is a structurally worse business. The rough outlines of this article were influenced by Stratechery, especially some of the recent commentary on Nike.

Traditional Beauty Model

The traditional beauty model was to spend billions on TV ads, billboards, and magazines (typically 20% to 30% of sales on A&P) to increase brand awareness then dominate scarce shelf-space at retailers like Wal-Mart, Target, Ulta Beauty, Sephora and Macy's.

This traditional model favored scale players who could spend the most dollars on advertising and exert the most leverage on retailers. Add-in the fact that formulating and manufacturing cosmetics requires expertise and the barriers to entry were enormous making big beauty a highly attractive industry. The graphic below from Stratechery illustrates the model. Stratechery in this case was referring to razors but the same concept applies to beauty.

Today, this model is facing several structural headwinds and while I expect big beauty brands like L'Oréal and Estée Lauder to amply navigate these headwinds, their best days are behind them.

E-Commerce and Direct-to-Consumer (DTC)

E-commerce in theory levelled the playing field between established beauty brands and DTC start-ups. Shelf-space was no longer a cornered resource of the strongest brands but rather, shelf space became an infinite resource in the world of e-commerce leaving distribution wide open to "Indie" or "Instagram" brands. The last 10 years saw a rapid increase in DTC brands in multiple consumer verticals including Dollar Shave Club and Harry's for razors, Warby Parker for glasses, Away for suitcases, and Casper for mattresses.

However, theory and reality proved to be different. In a world of infinite shelf space, the reality for most DTC brands was the cost of "online rent" was equivalent or higher than the cost of physical rent. Brands needed to pay Google and Facebook to generate demand. Not only was this expensive but Google and Facebook didn't increase brand awareness or brand affinity leaving most DTC brands fighting it out in a hyper competitive market. Google and Facebook ended up being the real winners and the most successful brands that did build brand awareness and affinity moved away from DTC and began wholesaling to brick and mortar or even to Amazon, to maximize reach. Harry's began selling to Costco, Casper began selling to Mattress Firm, and many of the brands above are available on Amazon.

Beauty's Economics and Customer Acquisition

While the promise of DTC never materialized in many verticals, there are a few things that specifically make beauty very well suited to DTC.

Recurring high-margin products that are easy to ship are more likely to have DTC success. The massive success of Dollar Shave Club let to a flood of new DTC brands but many of these brands missed a basic point: razors are high-margin, recurring, and simple to ship with minimal returns. Cosmetics have similar dynamic. Once a customer gets into a beauty routine, they generate repeat sales, potentially for multiple products, with minimal returns so while the first sale requires a high marketing investment (low-ROIC), repeat sales are very high margins (high-ROIC). A DTC brand like Tatcha can gain momentum powered by both new and repeat customers giving it a higher chance of reaching escape velocity relative to a DTC company selling suitcases, bedsheets, or baby products. This is especially powerful as beauty ASP's are relatively high at $25, $50 or even $250 with juicy margins. While all of this technically favors the big beauty brands, to the extent an Indie brand gains momentum, the recurring high margin nature of the products gives these Indie brands a fighting chance.

Cosmetics require coaching and education. Advertising can be classified as "demand-gen" or "brand building". Demand-gen means ranking at the top of search results on Google, Amazon, or Instagram for someone actively looking for toner while brand building is showing Clinique ads to females aged 35 to 45 so that next time they're at Macy's, they choose Clinique. While both are important, cosmetics are a little different because in addition to demand-gen and brand-building, you need coaching and education. Cosmetics don't sell themselves like laundry detergent or shampoo.

Coaching and education was always part of the industry's history. Historically, cosmetics were a "behind the counter" product at fancy department stores where a salesperson educated the customer, kind of like a pharmacist.

Sephora innovated by eliminating the awkward counters and empowered customers to touch, feel, try and experiment with the product to educate themselves via its "open sell" approach.

This then evolved into combining the best of both worlds where customers could test out the product on the shelf while beauty specialists roamed the aisles to explain a product's benefits, and even do actual makeovers. All of this favored big beauty brands who dominated shelf space at these retailers.

Influencers > Beauty Specialists. We are now entering the coaching 2.0 phase. As it turns out, short-form (Tik Tok) and long-form (YouTube) videos happen to be extremely potent formats when it comes to coaching and educating. This content can be watched in the comfort of your own home, allows for easy before and after comparisons, and videos are done in a format that is highly entertaining. In fact, I'd argue that online education and guidance is far superior to an in-store experience or even a physical makeover as rather than have some rando at Ulta coach you, your coach is Rihanna or Selena Gomez. Try watching this 10 minute video of Rihanna in what looks to be her actual house doing a makeup routine with a dozen different Fenty products. It is compelling.

This is where influencers and celebrities, especially those that already have 50m (Hailey Bieber), 100m (Rihanna) or 400m (Selena Gomez) followers have a critical competitive advantage over big beauty. Sure, Estée's Clinique spends more on A&P and might have greater brand awareness but Hailey Bieber has a much higher chance of convincing her 50m followers to watch a 2 minute tutorial on her new glazing milk whereas Clinique will struggle with this, and seeing as she already has 50m followers, she doesn't have to spend that much on demand-gen to be a relevant brand. In fact, she scaled Rhode, a 10 SKU company, into $200m in sales in just 3 years.

For context, this Clinique tutorial ranked pretty high when I searched Clinique on YouTube. It has 20k views, 5 comments, and 851 likes. Clinique is a multi-billion dollar brand owned by Estée Lauder.

If I do the same search for Hailey Bieber's Rhode, I get a similar number of videos and within each video, there are significantly more subscribers, views, likes, and comments. This one has 309k views, 9,500 likes, and 383 comments. Who do you think is better at education and guidance? Estée or Rhode? With Rhode, I feel like I'm Hailey Bieber's bestie while with Clinique, I feel like I'm watching an ad.

Outsourced R&D and Manufacturing

The issue historically was that it was hard for Kylie Jenner, Rihanna, Selena Gomez, and Hailey Bieber to gain access to R&D and manufacturing expertise, but today, it's relatively easy.

Historically, big CPG brands had a competitive advantage sourcing, developing and manufacturing specialty and active ingredients. Over-time, these CPG companies began thinking of themselves as marketing organizations, so began outsourcing manufacturing to become more capital light to ODMs like Korea Kolmar and Cosmax. Eventually, they even began outsourcing their R&D to ingredients specialists like Croda. Margins improved and their shelf space dominance meant growth kept tracking above industry, but they let a critical competitive advantage atrophy.

Today, Hailey Bieber or Selena Gomez can show up at Croda or Cosmax and they can formulate an entire line-up of cosmetics from scratch. In fact, Cosmax can even design the packaging and help with brand strategy. Below is how Cosmax describes it's brand portfolio.

Below is Cosmax calling itself an Original Brand & Design manager (OBM) where it can do manufacturing, ingredients, and packaging as a one stop shop. These capabilities have led to 25k+ cosmetics companies in Korea (up from 5k 10 years ago), many of which Cosmax counts as clients along with L'Oréal (Cosmax cites L'Oréal Paris, YSL, Lancome, and Maybelline as clients). In fairness to L'Oréal, they look to have maintained significant in-house R&D and manufacturing capabilities.

The trend of outsourcing also corresponded with an accelerating trend towards "active" ingredients, due in part to the rise of Korean beauty.

Korean Beauty: Actives and Velocity

Leading with Active Ingredients. A bottle of lotion might be 70% water, 15% commodity chemicals, 10% specialty ingredients and 5% "actives". Specialty ingredients add texture and feel while active ingredients provide functional benefits like anti-aging, smaller pores, sun protection, and smooth and firmer skin.

Indie brands, especially Korean brands, could not compete with Estée Lauder's Clinique or La Mer so decided to hone-in on functional benefits from actives. Korean Beauty companies led this trend as the Asian market was historically very skincare focused which is much more actives-intensive than color cosmetics, with a specific obsession on skin tone, skin smoothness, and anti-aging.

The legacy brands owned by big CPG companies were slow to adapt to this change, partly as they'd outsourced their R&D, whereas newer brands anchored their differentiation to actives. Case in point, Hailey Bieber's Rhode heavily emphasizes actives as a point of differentiation (see below).

The bottom right ingredient from Rhode is squalene, which helps improve skin hydration, softens and smooths skin, and reduces the appearance of fine lines and wrinkles. The issue is that squalene is extracted from sharks' liver, probably not a great ESG message. Croda leveraged it's chemical expertise to manufacture squalene using non-animal derived ingredients at very high purities. In fact, Croda's squalene is found in both your face lotion as well as Pfizer's COVID vaccine. Croda customers get access to these types of innovation, something most beauty brands can no longer do in-house.

High Velocity Innovation. Another very important point on Korean Beauty was their high-velocity approach to R&D. In fact, the real trend was never as simple as "Korean" beauty but rather "ingredients-led, high velocity innovation", which is an accurate way to describe a US-company like e.l.f. Beauty.

As I described, big beauty companies were historically marketing, not R&D, organizations and as they got bigger, R&D got slower and more bureaucratic. For example, I heard that Estée Lauder would hold strategic sessions amongst senior leaders once a year to discuss key themes and trends over the next 2 years to inform the R&D pipeline and marketing initiatives for their entire 30-brand portfolio. Sounds great on paper but how the hell do a handful of executives know what is going on with teenagers in Japan or millennials in Germany.

The Korean brands were the opposite. They rapidly identified trends ground up. e.l.f. does this as well where the CEO will literally do AMAs with customers to figure out what products to develop. Rather than take 2 years to develop a product like Estée Lauder product, a Korean brand could develop and launch a new product within 2 months. Social media meant trends cycles were happening faster. Legacy beauty brands were stuck with the legacy model where new merchandise was introduced seasonally while Korean brands were operating with the Zara model. This Zara model was enabled by the ecosystem of ingredients suppliers and ODMs that emerged as a result of big beauty brands outsourcing these functions.

While Amore Pacific may have had 1,000 masstige SKUs, they would easily refresh 200 to 300 of those every year with new packaging, technologies and ingredients whereas the big beauty brands were often refreshing a few dozen SKUs, with basic changes like color palettes. Many of the innovations that you now see brands implementing like cushion foundation, fragrance rollers, lip glow, serum formulas, snail cream, etc. were all launched several years earlier in Korea.

The new Zara model of cosmetics was enormously successful, first in Asia, and more recently in the US and Western Europe. Sales of Korean cosmetics into the US are growing rapidly (50%+) and e.l.f. which has adopted a similar model to Korean Beauty is dominating, while legacy masstige brands of traditional beauty are now stagnant.

The table below from Korea Kolmar, a Korean ODM, shows the massive success Korean Beauty has had and it is just getting started.

L'Oréal has been one of the strongest big beauty players and has barely held onto market share while lesser beauty groups have lost significant share to Korean beauty or those like e.l.f. Beauty that have followed a similar playbook.

While big beauty brands have responded by increasing their pace of innovation, their R&D and innovation muscles have atrophied over the last 2 decades so most have resorted to acquiring their way into innovation.

Luxury Brands Expanding into Beauty

While the Zara model began encroaching at the bottom of the period, big beauty is facing significant pressure at the top. L'Oréal classifies 36% of its brands as "luxe" while Estee is viewed as 100% "premium" but the juiciest $100+ ASP products with 70% to 80% margins likely represent 10% to 15% of the industry and within this highly attractive sub-segment, big beauty is getting squeezed.

The threat of Indie brands simply don't apply within this highly attractive luxury subsegment. The reason is that in "true luxury", heritage, status, and brand power all matter and the big luxury brands simply have better brands than big beauty. Dior does €8bn in clothing/bag sales and an additional €3bn in beauty sales so their total A&P spend is in the order of €1bn and while the majority of that €1bn is directed at selling more handbags, there is clearly a halo effect that benefits beauty sales. While Estée Lauder did $16bn in sales across multiple brands, they spent $3.6bn total (23% of revenue) on A&P on 30 different brands. Dior clearly has greater overall brand visibility and recognition to any Estée Lauder brand.

While e-commerce doesn't really matter when it comes to selling handbags, it is a very potent tool when it comes to selling luxury cosmetics. Chanel and Dior were historically far more selective in distribution partners to say La Mer or Lancome, which you can find in mass-market retailers, and while this was the right strategic decision for the health of the overall Dior brand, it wasn't particularly helpful in selling more Dior cosmetics. With the advent of e-commerce, Chanel and Dior can continue to be highly selective with distribution partners but benefit from relatively wide reach allowing customer living in a smaller city or in the burbs where there are no high end stores, to still conveniently access the brand.

Tangent on the Spirits Industry

Spirits are an interesting adjacent industry as it has had some high profile celebrities like George Clooney successfully create brands from scratch, but the dynamics are very different. First, shelf space is not an infinite resource. Alcohol is still bought at bars and liquor stores and will never be dominated by e-commerce due to regulatory reasons alone meaning Diageo and Pernod Ricard still dominate scarce shelf space. Second, the traditional advertising model of building brand awareness through advertising still works. It is not important for a whiskey brand to rank at the top of search results. It is far more important that a consumer recognizes Casa Migos at a grocery store shelf or that a bartender recommends Casa Migos to a new customer. Third, there is no outsourced R&D or manufacturing in high-end spirits. Manufacturing aged spirits like whiskey, tequila and wine is still highly complex and mostly insourced. Hailey Bieber cannot credibly create a new whiskey brand overnight, although vodka or gin is still possible. Even if a celebrity brand like Casa Migos takes off, these brands rarely scale without getting acquired by a much larger spirits company. As a result, while the industry has faced issues from changing category preferences and lower alcohol consumption, the issues impacting it are very different to beauty.

Putting it All Together

This is the original CPG value chain and it looks the same with beauty with the only caveat that "education" or guidance and coaching is arguably a separate core function specific to beauty.

This is my assessment of how the different players are doing. As a rule of thumb, you need to be strong in 3 boxes to have a competitive advantage.

Traditional Big Beauty. L'Oréal is the best example of a traditional big beauty player that is still relevant today. At the end of the day, they still do a massive amount of proprietary R&D and manufacturing so those muscles have not atrophied and they are the largest advertiser in the beauty industry. Traditional retail channels are still highly relevant today so this model still works, just not as well as before. Both their R&D and manufacturing advantages are lower today on a relative basis and their marketing advantage is being attacked by ingredients-led high-velocity brands on the bottom of the pyramid and luxury brands at the top.

Fat and Lazy Big Beauty. These are basically most large CPG's with beauty exposure based in the US or UK such as Estée Lauder, Unilever, and P&G. Most of these brands have outsourced R&D and manufacturing and have lost those muscles. Many don't spend adequate amounts on advertising. These companies for the most part are getting demolished by e.l.f. Beauty, Korean cosmetics, luxury cosmetics, and the onslaught of new indie and celebrity brands that are emerging. Their moats are under attack.

Upstart DTC brands. While the DTC model will have selective success, I don't see non-celebrity or non-influencer-backed DTC brands to take meaningful amounts of share. Most will give all of their economics to Google or Facebook and have no durable brand affinity to show for it but given the size of the prize, new upstarts will keep trying. I see Facebook, Google, and to some extent ODMs and ingredients companies as beneficiaries.

Celebrity DTC brands. Here, I see a real and legitimate chance that multiple brands will reach $1bn in revenue. The best brands already have access to tens of millions of customers, have significant advantages around education, and most can leverage this to build a brand. As these brands develop, it is only natural that we start seeing them in retailers (Rhode is launching in Sephora) further cementing their advantage. They are arguably best positioned out of everyone.

Luxury Brands. The luxury TAM is smaller but the margins are higher. Companies like Dior and Chanel already have very successful beauty franchises and as companies like Hermes, Louis Vuitton, and Gucci increasingly expand into beauty, I believe they have a significant competitive advantage. They may lack some of the beauty-specific know-how of big beauty companies which is why they've historically licensed brands to the likes of L'Oréal but this is changing with most luxury brands expressing a desire to do more in-house.

I hope this high level framework gives you some of the major issues facing the beauty industry. At a minimum, hopefully it provides some context to my forthcoming deep dive on Croda.