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[Premium Unlocked] e.l.f. x Activist Collaboration?
Some 13D filings carry more signal than others
Welcome to the Nongaap Newsletter! I’m Mike, an ex-activist investor, who writes about tech, corporate governance, the power & friction of incentives, strategy, board dynamics, and the occasional activist fight.
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Update (7/2/2020): Now that ELF and Marathon have settled, I’m unlocking this post. In this post, I explain why I think Marathon is going to pursue a proxy contest with the likely outcome being a settlement. Keep in mind this post was in early May 2020 before Marathon nominated a slate of director in late May.
Overall, this is a good example of an activist investor using the nomination deadline as leverage to drive changes at a company.
Original Post (5/7/2020):
Activist investor Marathon Partners recently filed a 13D for e.l.f. Cosmetics (ticker: ELF) that piqued my curiosity. The key to analyzing 13D filings is to think through how the 13D filing fits within the investment lifecycle of the activist, the company, and governance windows (i.e. nomination deadline, annual meeting, etc.). When you take those factors into consideration, some 13D filings carry more signal than others.
Upon further examination of Marathon’s 13D filing, I believe Marathon is setting the table to run a proxy contest at ELF. It’s hard to know for certain, but I wouldn’t be surprised if Marathon and e.l.f. Cosmetics end up collaborating on an activist settlement very soon.
Note: Cosmetic brands collaborate with influencers all the time. Technically, activist investors are “influencers”. Why not collaborate with an activist?
Spilling the tea on ELF
I previously wrote about the governance and activist situation at e.l.f. Cosmetics in December 2019 where I walked through an “activist game theory” exercise on ELF and speculated on potential outcomes. I believe the key takeaways of the write-up remain valid today.
Back in December, I felt the company was in corporate governance “checkmate” (they still are) and likely put themselves into play in 2020 (assuming an activist pursued a proxy contest):
Put it all together and ELF has put themselves into play whether they realize it or not. An activist settlement is the most reasonable outcome, because I doubt the Directors up for re-election (Sabrina Simmons, Kirk Perry, and Maureen Watson) are willing to stake their professional reputations to protect this management team, and have their oversight failings paraded around in a contested election.
The real question now is “What are the terms of settlement?”
As we entered 2020, the stock ran to the $19s in February which (in my opinion) lessened the likelihood of strategic alternatives (a key driver of pursuing a proxy contest).
Going under 5% ownership also meant Marathon could fully exit their position in ELF without anyone knowing until May 2020 (when they file their Q1 2020 13F). The lack of activist visibility/catalyst made the stock less attractive to me given the company’s poor governance track record.
Overall, I thought the activist opportunity at ELF was closed due to price appreciation, but the COVID-19 crisis would reopen the window.
COVID-19 Resets the Beauty Landscape and Reopens the Activist Window
The COVID-19 crisis hit ELF’s stock pretty hard with the stock price dropping from the $19s in mid February to the $8s by mid March. Despite significantly depressed tracked channel demand due to COVID-19, ELF continues to outperform the category and the stock has settled in the $11s - $12s.
While COVID-19 remains a tough situation, it creates some interesting opportunities for ELF. The last time mass cosmetics was a share gainer to prestige cosmetics was in 2007-2009 during the global financial crisis. We could see a similar trade down and share shift to mass cosmetics due to COVID-19 tightening personal budgets. If that happens, ELF should be a big beneficiary given the brand is already a relative out-performer in mass cosmetics.
Also, many independent cosmetics brands (who are largely based in California) were forced to close operations due to California’s stay-at-home mandate. This gave ELF an opportunity to capitalize on incremental stay-at-home online demand while others were shut down. ELF’s operations were exempt from closure due to being a supplier to Target and Walmart. (This is based on my read of the essential business rules. I could be wrong on why they remained open but ELF definitely stayed open.)
Stay-at-home closures also financially weakened independent brands and a challenged economic environment could give ELF an opportunity to acquire brands at attractive prices. ELF still needs to be disciplined on M&A and balance their own liquidity needs, but a major reason why CEO Tarang Amin (stubbornly) maintains a high cost base at ELF is to eventually pursue a multi-brand platform strategy. The problem is the company has been pursuing this strategy for over 6 years with little to show for it (aside from paying management handsomely to wait) which has created serious friction with shareholders who want cost cuts and desire more financial discipline.
Finally, ELF’s stock price weakness due to COVID-19 reopened the window for an activist to get involved. The combination of a languishing stock price and ELF remaining relatively well positioned to outperform within mass cosmetics makes the company an attractive risk-adjusted activist target.
Marathon Goes Back Over 5% Ownership and Files 13D
I consider Marathon’s most recent 13D filing a meaningful signal that activism at ELF is going to escalate. Crossing over 5% ownership ahead of ELF’s May 21 earnings release and May 29 director nomination deadline was a major “tell”.
By crossing over 5% ownership, Marathon essentially told management they’re “back” and disclosed they’ve acquired ~1.4m in additional shares (and options). This buying is a pretty aggressive reversal from the selling Marathon was doing earlier in the year.
Marathon could have stayed under 5% to maintain nimbleness and confidentiality, but they clearly (in my opinion) made an explicit decision to go over 5% to file a 13D and (presumably) signal a serious commitment to re-engage as an activist:
The Reporting Persons have engaged, and plan to continue to engage, with the Issuer’s management and Board of Directors regarding opportunities to significantly enhance shareholder value.
Generally speaking, when an activists files a 13D ahead of the nomination deadline, the primary topic that’s going to be discussed is terms of settlement for Board seats and/or other changes (while the company is under threat of a proxy contest).
The Nomination Deadline is Negotiating Leverage
When it comes to activist engagements, the nomination deadline is when activists have the most negotiating leverage to drive changes at the company. I’d say most activist negotiations and settlements occur around the nomination deadline.
In order to have negotiating leverage and be taken seriously, the activist must demonstrate they can and will run a proxy contest. An activist demonstrates proxy contest credibility with their track record (they’ve done a proxy contest before) and/or by nominating a quality slate of directors.
The reason why nominating a slate of quality directors signals credibility is it requires a lot of work to source high quality candidates. Submitting a director slate also makes the fight “real” for management and for the directors who are up for re-election. Don’t underestimate the psychology of having your reputation and decision-making exposed in a proxy contest. There’s a reason why things tend to move quickly towards settlement once an activist slate is submitted.
We don’t know for sure if Marathon is going to run a proxy contest or if they have nominated a slate of directors, but let me reiterate again activists don’t randomly file 13Ds ahead of the nomination deadline. It’s an explicit decision that signals commitment to run a proxy contest. This is activism 101 people!
At this point, I would operate under the assumption Marathon is getting proper advice on their 13D filing and is indeed prepared and willing to proceed with a proxy contest.
Settlement on the Horizon?
Luckily for us, we’ll probably know this month if a settlement or proxy contest is on the table. Earnings are May 21 and the nomination deadline is May 29. This tends to create a sense of urgency. There will also be pressure on the company to have a go-forward plan communicated on the earnings call (although they could kick the can with a “no comment”).
If I were to guess on timing, I’d expect some clarity on the activist situation by the last week of May. If I were a betting man, I’d anticipate a settlement over a proxy contest.
How the stock will react to a settlement announcement will depend on the terms of the settlement. We don’t know what exactly Marathon wants or what ELF is willing to give, but we do know Marathon has been pushing for either cost cuts or a strategic alternative process for some time.
Also keep in mind Marathon acquired December 18, 2020 call options with a $15 strike price. This gives us some visibility into their thinking on the floor valuation of their desired agenda.