e.l.f. Beauty, Inc. (ELF) FY 2022 MD&A

Item 7. Management’s discussion and analysis of financial condition and results of operations.

You should read the following discussion and analysis of our financial condition and results of operations and our consolidated financial statements and related notes thereto included elsewhere in this Annual Report.

Overview and Business Trends

We are a multi-brand beauty company that offers inclusive, accessible, cruelty-free cosmetics and skincare products. Our mission is to make the best of beauty accessible to every eye, lip and face.

We believe our ability to deliver 100% cruelty-free, premium-quality products at accessible prices with broad appeal differentiates us in the beauty industry. We believe the combination of our fundamental value equation, digitally-led strategy, as well as our world-class team’s ability to execute with speed, has positioned us well to navigate a rapidly changing landscape in beauty.

Our family of brands includes e.l.f. Cosmetics, e.l.f. SKIN, Well People and Keys Soulcare. Our brands are available online and across leading beauty, mass-market, and clean-beauty specialty retailers. We have strong relationships with our retail partners such as Walmart, Target, Ulta Beauty and other leading retailers that have enabled us to expand distribution both domestically and internationally.

For additional information regarding our business, see Part I, Item 1, “Business.”

COVID-19 Pandemic

The beauty industry and our business were impacted in the years ended March 31, 2022 and March 31, 2021 by the COVID-19 pandemic. There could be continued impact on the industry and our business results until consumers return to normal shopping patterns and quarantine and/or social gathering restrictions are removed. In addition, a current vessel and container shortage globally could delay future inventory receipts and, in turn, could delay deliveries to our retailers and availability of products in our direct-to-consumer e-commerce channel or could increase our shipping costs. Such potential delays and shipping disruptions could negatively impact our results of operations through higher inventory costs and reduced sales. Throughout the COVID-19 pandemic we have focused on the following areas to address the impact on our business: supporting the health and safety of our employees and community; minimizing disruption to the supply chain; and keeping adequate levels of liquidity and flexibility within our credit facility.

Tariffs

Tariffs have impacted the majority of products that we import from China to the United States. We have taken various steps to help mitigate the impact of tariffs including price increases, negotiating lower prices with our suppliers in China, and exploring potential new suppliers outside of China.

Components of our results of operations and trends affecting our business

Net sales

We develop, market and sell beauty products under the e.l.f. Cosmetics, e.l.f. SKIN, Well People and Keys Soulcare brands. Our net sales are derived from sales of these beauty products, net of provisions for sales discounts and allowances, product returns, markdowns and price adjustments.

Year over year changes in net sales is driven by a number of factors, including color cosmetics and skincare category performance, levels of consumer spending, and our ability to drive awareness of and demand for our products. Within our existing retailer accounts, we are able to drive growth by increasing sales per linear foot supported by marketing investments and continued innovation, as well as through expanding space and door penetration. While we have distribution with a number of key retail accounts, we expect to continue to grow through improved sales per linear foot in our existing space, expanded space allocation with our current retail accounts, as well as adding new retail customers.

Our business faces challenges and uncertainties, including our ability to introduce new products that will appeal to a broad consumer base, our ability to service demand, the ability of our major retail customers to drive traffic and keep products in stock, our ability to continue to grow our customer base and competitive threats from other beauty companies.

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Our largest three customers, Walmart, Target and Ulta Beauty, accounted for 26%, 23% and 12%, respectively, of our net sales in the year ended March 31, 2022. No other individual customer accounted for 10% or more of our net sales in the year ended March 31, 2022. National and international retailers comprised 90% of our net sales. The remaining 10% came from our direct-to-consumer e-commerce channels in the year ended March 31, 2022.

The primary market for our products is in the United States, which accounted for 89% of our net sales in the year ended March 31, 2022. The remaining 11% was attributable to international markets, primarily Canada and the United Kingdom.

Gross profit

Gross profit is our net sales less cost of sales. Cost of sales includes the aggregate costs to procure our products, including the amounts invoiced by our third-party contract manufacturers for finished goods as well as costs related to transportation to our distribution center, customs and duties. Cost of sales also includes the effect of changes in the balance of reserves for excess and obsolete inventory. Gross margin measures our gross profit as a percentage of net sales.

We have an extensive network of third-party manufacturers (primarily in China) from whom we purchase substantially all of our finished goods. We have worked to evolve our supply chain to increase capacity and technical capabilities while maintaining or reducing overall costs as a percentage of sales.

Historically, we have improved our gross margin largely through changes in our product mix, pricing, purchasing efficiencies and cost reductions in our supply chain. Other drivers of changes in gross margin include fluctuations in exchange rates, changes in customer mix, and changes in the balance of reserves for excess and obsolete inventory, among other things, which may offset the benefit of changes in product mix, pricing, purchasing efficiencies and cost reductions.

Selling, general and administrative

Our selling, general and administrative (“SG&A”) expenses primarily consist of personnel-related expenses, including salaries, bonuses, fringe benefits and stock based compensation, marketing and digital expenses, warehousing and distribution costs, costs related to merchandising, depreciation of property and equipment, amortization of retail product displays and amortization of intangible assets. See “Critical Accounting Policies and Estimates stock based Compensation” below for more detail regarding stock based compensation.

Interest expense, net

Interest expense primarily consists of cash interest and fees on our outstanding indebtedness. See “Financial condition, liquidity and capital resources” below and a description of our indebtedness in Note 8 to the Notes to consolidated financial statements in Part IV, Item 15. “Exhibits, financial statement schedules”.

Other income (expense), net

We are exposed to periodic currency fluctuations given our purchasing and selling activities in various countries. Other income (expense), net is primarily related to foreign exchange rate movements.

Income tax (provision) benefit

The provision for income taxes represents federal, foreign, state and local income taxes. The effective rate differs from statutory rates due to the effect of state and local income taxes and certain permanent tax adjustments. Our effective tax rate will change from period to period based on recurring and nonrecurring factors including, but not limited to, the geographical mix of earnings, enacted tax legislation, state and local income taxes, tax audit settlements, the interaction of various tax strategies and the impact of permanent tax adjustments, such as those related to stock based compensation.

Net income

Our net income for future periods will be affected by the various factors described above.

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Results of operations

The following table sets forth our consolidated statements of operations data in dollars and as a percentage of net sales for the periods presented.

Comparison of the year ended March 31, 2022 to the year ended March 31, 2021

Net sales

Net sales increased $74.0 million, or 23%, to $392.2 million in the year ended March 31, 2022, from $318.1 million in the year ended March 31, 2021. The increase was driven primarily by strength in our national and international retailers. Net sales increased $76.8 million, or 28%, in our retailer channels, offset by a decrease of $2.8 million, or 6%, in our e-commerce channels. From a price and volume perspective, a higher volume of units sold drove $59.4 million of the increase in net sales and a higher average item price within retailer and e-commerce orders drove the remaining $14.6 million increase in net sales as compared to the year ended March 31, 2021.

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Gross profit

Gross profit increased $45.5 million, or 22%, to $251.7 million in the year ended March 31, 2022, compared to $206.2 million in the year ended March 31, 2021. Gross margin decreased from 65% in the year ended March 31, 2021 to 64% in the year ended March 31, 2022. Increased volume accounted for approximately $48.0 million of the increase in gross profit, offset by a $2.5 million decline related to the decrease in gross margin rate. The decrease in gross margin rate was primarily driven by unfavorable foreign exchange rates and elevated transportation costs. These items were partially offset by price increases, cost savings and margin accretive mix.

Selling, general and administrative expenses

SG&A expenses were $221.9 million in the year ended March 31, 2022, an increase of $27.8 million, or 14%, from $194.2 million in the year ended March 31, 2021. SG&A expenses as a percentage of net sales decreased to 57% for the year ended March 31, 2022 from 61% in the year ended March 31, 2021. The increase on a dollar basis was primarily related to increased marketing and digital spend of $15.1 million along with increased compensation and benefits of $5.7 million and increased software subscription costs of $2.8 million.

Restructuring expense

Restructuring expenses were $50 thousand in the year ended March 31, 2022. See Note 13 Restructuring and other related costs to consolidated financial statements in Part IV, Item 15. “Exhibits, financial statement schedules” for further details.

Other expense, net

Other expense, net was $1.4 million of expense in the year ended March 31, 2022, as compared to $1.6 million of expense in the year ended March 31, 2021. The change was primarily related to foreign exchange rate movements.

Interest expense, net

Interest expense decreased $1.6 million, or 40%, to $2.4 million in the year ended March 31, 2022, as compared to $4.1 million in the year ended March 31, 2021. This decrease was due to a reduction in our long-term debt as well as a decline in interest rates.

Income tax (provision) benefit

The provision for income taxes increased from a benefit of $2.5 million, or an effective tax rate of (69)%, for the year ended March 31, 2021, to an expense of $3.7 million, or an effective tax rate of 14%, for the year ended March 31, 2022. The change in the provision for income taxes was primarily driven by an increase in income before taxes of $21.7 million. One-time tax benefits related to stock based compensation were consistent between periods.

Comparison of the year ended March 31, 2021 to the year ended March 31, 2020

Net sales

Net sales increased $35.3 million, or 12%, to $318.1 million in the year ended March 31, 2021, from $282.9 million in the year ended March 31, 2020. The increase was driven by strength in e-commerce, international, and our national retailers. Net sales increased $18.1 million, or 7% in our retailer channels and $17.0 million, or 64% in our e-commerce channels. From a price and volume perspective, a higher average item price within retailer and e-commerce orders substantially drove the $35.3 million dollar increase in net sales while volume remained flat as compared to the year ended March 31, 2020.

Gross profit

Gross profit increased $25.1 million, or 14%, to $206.2 million in the year ended March 31, 2021, compared to $181.1 million in the year ended March 31, 2020. Increased volume accounted for approximately $22.6 million of the increase in gross profit, with the remaining $2.5 million driven by an increase in gross margin rate. The increase in gross margin rate was driven by benefits from margin accretive innovation, cost savings, a mix shift to elfcosmetics.com, and price increases partially offset by certain costs related to retailer activity and space expansion, an increase in inventory adjustments, and the impact of tariffs on goods imported from China in the year ended March 31, 2021. The net of these drivers resulted in an 80 basis point increase in gross margin, which increased from 64% in the year ended March 31, 2020 to 65% in the year ended March 31, 2021.

Selling, general and administrative expenses

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SG&A expenses were $194.2 million in the year ended March 31, 2021, an increase of $37.0 million, or 24%, from $157.2 million in the year ended March 31, 2020. SG&A expenses as a percentage of net sales increased to 61% for the year ended March 31, 2021 from 56% in the year ended March 31, 2020. The increase was primarily related to marketing and digital, including costs related to advertising, digital, and organizational costs related to building out our marketing, digital and innovation capabilities of $22.0 million. Additionally, we experienced increased operational costs mainly driven by the increase in e-commerce sales of $6.9 million.

Restructuring expense

Restructuring expenses were $2.6 million in the year ended March 31, 2021, consisting of charges related to the closure of our manufacturing facility in California.

Other expense, net

Other expense, net was $1.6 million of expense in the year ended March 31, 2021, as compared to $0.4 million of income in the year ended March 31, 2020. The change was primarily related to foreign exchange rate movements.

Interest expense, net

Interest expense decreased $2.2 million, or 35%, to $4.1 million in the year ended March 31, 2021, as compared to $6.3 million in the year ended March 31, 2020. This decrease was due to a reduction in our long-term debt as well as a decline in interest rates.

Income tax benefit (provision)

The provision for income taxes decreased from an expense of $6.2 million, or an effective tax rate of 26%, for the year ended March 31, 2020, to a benefit of $2.5 million, or an effective tax rate of (69)%, for the year ended March 31, 2021. The change in the provision for income taxes was primarily driven by a decrease in income before taxes of $20.4 million and an increase in one-time tax benefits of $3.7 million, primarily related to stock based compensation.

Financial condition, liquidity and capital resources

Overview

As of March 31, 2022, we held $43.4 million of cash and cash equivalents. In addition, as of March 31, 2022, we had borrowing capacity of $100.0 million under the Amended Revolving Credit Facility.

Our primary cash needs are for capital expenditures, retail product displays and working capital. Capital expenditures typically vary depending on strategic initiatives selected for the fiscal year, including investments in infrastructure, digital capabilities, and expansion within or to additional retailer store locations. We expect to fund ongoing capital expenditures from existing cash on hand, cash generated from operations and, if necessary, draws on the Amended Revolving Credit Facility.

Our primary working capital requirements are for product and product-related costs, payroll, rent, distribution costs and advertising and marketing. Fluctuations in working capital are primarily driven by the timing of when a retailer rearranges or restocks its products, expansion of space within our existing retailer base and the general seasonality of our business. As of March 31, 2022, we had working capital, excluding cash, of $84.7 million, compared to $39.0 million as of March 31, 2021. Working capital, excluding cash and debt, was $90.4 million and $55.3 million as of March 31, 2022 and March 31, 2021, respectively.

We believe that our operating cash flow, cash on hand and available financing under the Amended Revolving Credit Facility will be adequate to meet our planned operating, investing and financing needs for the next twelve months. If necessary, we can borrow funds under the Amended Revolving Credit Facility to finance our liquidity requirements, subject to customary borrowing conditions. To the extent additional funds are necessary to meet our long-term liquidity needs as we continue to execute our business strategy, we anticipate that they will be obtained through the incurrence of additional indebtedness, additional equity financings or a combination of these potential sources of funds; however, such financing may not be available on favorable terms, or at all. Our ability to meet our operating, investing and financing needs depends to a significant extent on our future financial performance, which will be subject in part to general economic, competitive, financial, regulatory and other factors that are beyond our control, including those described elsewhere in Part I, Item 1A “Risk factors”. In addition to these general economic and industry factors, the principal factors in determining whether our

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cash flows will be sufficient to meet our liquidity requirements will be our ability to provide innovative products to our consumers and manage production and our supply chain.

Cash flows

Cash provided by operating activities

For the year ended March 31, 2022, net cash provided by operating activities was $19.5 million. This included net income, before deducting depreciation, amortization and other non-cash items, of $66.2 million and an increase in net working capital of $46.7 million. The increase in net working capital was driven by a $5.6 million increase in accounts receivable, a $27.7 million increase in inventory, a $10.6 million increase in prepaid and other assets and a $1.5 million increase of accounts payable and accrued expenses, partially offset by a $4.4 million decrease of other liabilities.

For the year ended March 31, 2021, net cash provided by operating activities was $29.5 million. This included net income, before deducting depreciation, amortization and other non-cash items, of $46.4 million and an increase in net working capital of $16.9 million. The increase in net working capital was driven by a $10.5 million increase in accounts receivable, a $10.9 million increase in inventory and a $9.7 million increase in prepaid and other assets, partially offset by a $17.5 million increase of accounts payable and accrued expenses.

For the year ended March 31, 2020, net cash provided by operating activities was $44.3 million. This included net income, before deducting depreciation, amortization and other non-cash items, of $54.3 million and an increase in net working capital of $10.0 million. The increase in net working capital was driven by an $11.5 million decrease in other liabilities primarily related to termination payments on store leases, partially offset by the timing of cash payments related to accounts payable and accrued expenses.

Cash used in investing activities

For the year ended March 31, 2022, net cash used in investing activities was $4.8 million, which was primarily driven by capital expenditures related to new customer fixture programs.

For the year ended March 31, 2021, net cash used in investing activities was $6.5 million, which was primarily driven by capital expenditures related to new customer fixture programs.

For the year ended March 31, 2020, net cash used in investing activities was $35.3 million. This includes $25.9 million paid for the acquisition of Well People, Inc. and capital expenditures of $9.4 million.

Cash used in financing activities

For the year ended March 31, 2022, net cash used in financing activities was $29.1 million, driven by $54.5 million of repayment of the revolving line of credit and the term loan facility, and $25.6 million of cash received from net of proceeds from the amended revolving line of credit and the Amended term loan facility.

For the year ended March 31, 2021, net cash used in financing activities was $11.4 million, driven by $11.8 million in mandatory principal payments under the prior term loan facility. This was partially offset by $1.5 million of proceeds from the exercise of options to purchase common stock.

For the year ended March 31, 2020, net cash used in financing activities was $16.7 million, driven by $9.5 million in mandatory principal payments under the prior term loan facility and repurchase of common stock of $7.9 million. This was partially offset by $1.5 million of proceeds from the exercise of options to purchase common stock.

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Description of indebtedness

Amended credit agreement

On April 30, 2021, we amended and restated the prior credit agreement (the "Amended Credit Agreement"), amended and restated the prior term loan facility and the prior revolving credit facility, and refinanced all loans under the prior credit agreement.

The Amended Credit Agreement has a five year term and consists of (i) a $100 million revolving credit facility (the “Amended Revolving Credit Facility”) and (ii) a $100 million term loan facility (the "Amended Term Loan Facility").

All amounts under the Amended Revolving Credit Facility are available for draw until the maturity date on April 30, 2026. The Amended Revolving Credit Facility is collateralized by substantially all of our assets and requires payment of an unused fee ranging from 0.10% to 0.30% (based on our consolidated total net leverage ratio (as defined in the Amended Credit Agreement)) times the average daily amount of unutilized commitments under the Amended Revolving Credit Facility. The Amended Revolving Credit Facility also provides for sub-facilities in the form of a $7 million letter of credit and a $5 million swing line loan; however, all amounts under the Amended Revolving Credit Facility cannot exceed $100 million. The unused balance of the Amended Revolving Credit Facility as of March 31, 2022 was $100.0 million.

Both the Amended Revolving Credit Facility and the Amended Term Loan Facility bear interest, at borrowers’ option, at either (i) a rate per annum equal to an adjusted LIBOR rate determined by reference to the cost of funds for the United States dollar deposits for the applicable interest period (subject to a minimum floor of 0%) plus an applicable margin ranging from 1.25% to 2.125% based on our consolidated total net leverage ratio or (ii) a floating base rate plus an applicable margin ranging from 0.25% to 1.125% based on our consolidated total net leverage ratio. The interest rate as of December 31, 2021 for the Amended Term Loan Facility was approximately 2.3%.

The Amended Credit Agreement contains a number of covenants that, among other things, restrict our ability to (subject to certain exceptions) pay dividends and distributions or repurchase our capital stock, incur additional indebtedness, create liens on assets, engage in mergers or consolidations and sell or otherwise dispose of assets. The Amended Credit Agreement also includes reporting, financial and maintenance covenants that require us to, among other things, comply with certain consolidated total net leverage ratios and consolidated fixed charge coverage ratios. As of March 31, 2022, we were in compliance with all financial covenants under the Amended Credit Agreement.

Off-balance sheet arrangements

We are not party to any off-balance sheet arrangements.

Critical accounting policies and estimates

Our consolidated financial statements included elsewhere in this Annual Report have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of our financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are more fully described in the Note 2 to consolidated financial statements in Part IV, Item 15. “Exhibits, financial statement schedules”, we believe that the following accounting policies and estimates are critical to our business operations and understanding of our financial results.

Revenue recognition

We recognize revenue when control of promised goods or services is transferred to a customer in an amount that reflects the consideration that we expect to receive in exchange for those goods or services. Control of the substantial majority of the products that we sell is transferred at a point in time. Factors that determine the specific point in time a customer obtains control and a performance obligation is satisfied are when we have a present right to payment for the goods, whether the customer has physical possession and title to the goods, and whether significant risks and rewards of ownership have transferred. Delivery is typically considered to have occurred at the time the title and risk of loss passes to the customer.

In the normal course of business, we offer various incentives to customers such as sales discounts, markdown support and other incentives and allowances, which give rise to variable consideration. The amount of variable consideration is estimated at the time of sale based on either the expected value method or the most likely amount, depending on the nature of the

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variability. We regularly review and revise, when deemed necessary, our estimates of variable consideration based on both customer-specific expectations as well as historical rates of realization. A provision for unclaimed customer incentives and allowances is included on the consolidated balance sheet, net against accounts receivable.

Impairment of long-lived assets, including goodwill and intangible assets

We assess potential impairments to our long-lived assets, which include property and equipment, retail product displays, and amortizable intangible assets, whenever events or circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of an asset is measured by a comparison of the carrying amount of an asset group to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of the asset group exceeds its estimated undiscounted future cash flows, an impairment charge is recognized as the amount by which the carrying amount of the asset exceeds the fair value of the asset. There were no impairment charges recorded on long-lived assets during the years ended March 31, 2022 or March 31, 2021.

We evaluate our indefinite-lived intangible asset to determine whether current events and circumstances continue to support an indefinite useful life. In addition, our indefinite-lived intangible asset is tested for impairment annually. The indefinite-lived intangible asset impairment test consists of a comparison of the fair value of each asset with its carrying value, with any excess of carrying value over fair value being recognized as an impairment loss. We are also permitted to make a qualitative assessment of whether it is more likely than not that an indefinite-lived intangible asset’s fair value is less than its carrying value prior to applying the quantitative assessment. If based on our qualitative assessment it is more likely than not that the carrying value of the asset is less than its fair value, then a quantitative assessment may be required.

The goodwill impairment test consists of a comparison of each reporting unit’s fair value to its carrying value. The fair value of a reporting unit is an estimate of the amount for which the unit as a whole could be sold in a current transaction between willing parties. If the carrying value of a reporting unit exceeds its fair value, goodwill is written down to its implied fair value. We are also permitted to make a qualitative assessment of whether it is more likely than not that the fair value of a reporting unit is less than its carrying value prior to applying the quantitative assessment. If based on our qualitative assessment it is more likely than not that the carrying value of the reporting unit is less than its fair value, then a quantitative assessment may be required. We have identified a single reporting unit for purposes of impairment testing.

We have selected October 1 as the date on which to perform our annual impairment tests. We also test for impairment whenever events or circumstances indicate that the fair value of goodwill or indefinite-lived intangible assets has been impaired. No impairment of goodwill or our indefinite-lived intangible asset was recorded during the years ended March 31, 2022 or March 31, 2021.

Stock based compensation

Stock based compensation cost is measured at grant date, based on the fair value of the award, and is recognized on a straight-line basis over the requisite service period for all awards that vest. We estimate the fair value of employee stock based payment awards subject to only a service condition on the date of grant using the Black-Scholes valuation model. The Black-Scholes model requires the use of highly subjective and complex assumptions, including the option’s expected term and the price volatility of the underlying stock. We estimate the fair value of employee stock based payment awards subject to market conditions on the date of grant using a Monte Carlo simulation model.

We recognize compensation expense for awards with only a service condition on a straight-line basis over the requisite service period, which is generally the award’s vesting period. Compensation expense for employee stock based awards whose vesting is subject to the fulfillment of both a market condition and the occurrence of a performance condition is recognized on a graded-vesting basis at the time the achievement of the performance condition becomes probable. We account for forfeitures as they occur.

The expected stock price volatility for common stock was estimated by taking the average historic price volatility for industry peers based on daily price observations over a period equivalent to the expected term of the stock option grants. Industry peers consist of several public companies in our industry which are of similar size, complexity and stage of development. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury implied yield at the date of grant. The weighted-average expected term is determined with reference to historical exercise and post-vesting cancellation experience and the vesting period and contractual term of the awards.

We have no current plans to pay a regular dividend.

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New accounting pronouncements

See Note 2 Summary of significant accounting policies to the Notes to consolidated financial statements in Part IV, Item 15. “Exhibits, Financial Statement Schedules” for information regarding new accounting pronouncements.

We comply with any new or revised accounting standards on the relevant dates on which adoption of such standards is required for publicly traded companies that are not emerging growth companies.