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California Beauty’s Ray of Light

California is proving that its reputation as the Golden State is well earned, at least when it comes to beauty innovation and investing.

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Beauty Inc issue 04/10/2009

Juice Beauty chief executive officer Karen Behnke fields more phone calls from investors itching to grab a piece of her San Rafael, Calif.-based organic skin care brand than many people receive from their next of kin.

“I am literally getting a call a day. It has not slowed down, not at all,” she says. Gently, she tells her suitors Juice Beauty is not for sale by repeating this well-worn refusal: “Thank you for calling. We’re not ready for anything like that. We are well financed. Our cash flow is high. We have got a lot of work to do.”

Behnke’s experience seems so two years ago, when the mergers and acquisitions market sizzled with activity. But today, concerns about consumer spending and the shaky retail environment have stalled deal making. The credit freeze has paralyzed much of private equity, and tanking valuations have kept sellers on the sidelines. The latest M&A figures from Thomson Reuters tell the story of deal erosion. Across all industries in the U.S., the number of deals plunged from 11,303 to 9,358 from 2007 to 2008 and to less than 1,500 through March 23 of this year. That would result in around 6,000 for 2009 if the rate of M&A doesn’t pick up.

The pursuit of California brands, such as Juice Beauty, suggests that the tide could be turning, though. Interest in beauty and personal care transactions hasn’t died. The recession, while steamrolling longheld business assumptions, hasn’t shaken an underlying faith in the potential of well-positioned brands. In fact, that faith may be stronger than ever.

“Beauty is one of those areas where women are treating themselves, even in this economy,” says Sarah Chung, author of the Beauty Information on Demand report, about deals in the sector. “As long as consumer appetites are not satiated, entrepreneurs will continue to respond, and people will want to participate in the market. There is nothing inherently wrong in the beauty industry.”

As banks start to loan cash again, industry watchers say the pace of deals is poised to pick up. “There is some latent demand now,” says Michael Farello, a partner at Catterton Partners, the Greenwich, Conn.-based private equity firm with beauty investments in Niadyne and Zeno. “There has been a lull for the last six months, and it feels like we’re coming out of that lull.”

If a new beauty gold rush is in the near future, it’s likely the suits will be looking to California to strike it rich. It’s familiar territory. The state has given birth to numerous brands coveted throughout the years by investors of all classes. Recent examples include PureOlogy, bought by L’Oréal, Smashbox Cosmetics, owned partly by TSG Consumer Partners, and the publicly traded companies Physicians Formula and Bare Escentuals.

Current market conditions could spark a heated California sweepstakes. The state has been a fertile breeding ground for budding brands in many promising categories, particularly at-home beauty devices, natural/organic products, ethnic beauty and personal care, and the larger skin and hair care fields. In a culture in which fascination with celebrities continues unabated, the Hollywood connection doesn’t hurt. And the state’s technological capabilities make it a leader in cutting-edge beauty products.

“It is just such a hotbed,” says Scott Elaine Case, managing partner at VMG Partners, a San Francisco private equity fi rm with mineral cosmetics brand Colorescience in its portfolio. “I can’t imagine a better place for cosmetics and skin care than California.” Adds Jeremy Johnson, chief executive officer of Irvine, Calif.-based makeup brand Too Faced, “People are really looking to California for the next trend.”

With around 34 million people, California is the most populous state in the nation, giving it an internal market unequaled in the country. Nearby states—Washington, Oregon, Nevada and Arizona—offer ample opportunity to solidify a significant regional presence. West Coast residents also have a taste for beauty. In a WWD list of average annual household spending on personal care products published in 2007, four of the top five metro areas were located on the West Coast. Orange County and Los Angeles-Long Beach claimed the number-one and number-two spots.

“Women in California wear makeup…lots of it,” writes Wende Zomnir, co-founder and executive creative director of Newport Beach, Calif.-based Urban Decay, in an e-mail. “Many East Coasters, even those in the beauty business, forgo it on a daily basis.”

Existing distribution channels are robust growth platforms for the state’s wealth of entrepreneurs. A handful of influential boutiques— Apothia and Studio BeautyMix, Vert, Planet Blue and Kalologie, to name a few— help incubate fledging brands. DuWop and Stila developed a following in those boutiques before branching out nationally, for instance.

Natural and organic-oriented stores also have substantial and expanding footprints in California and surrounding states, including large chains like Whole Foods and Trader Joe’s and a group of smaller players, most notably Pharmaca.

Alternative distribution channels— infomercials and the Internet— are increasingly popular, with Dr. Howard Murad of skin care brand Murad and Leslie Blodgett, ceo of mineral makeup powerhouse Bare Escentuals, becoming household names as the result of infomercials.

Juice Beauty offers a prototype for up-and-coming California brands. Behnke, who cobbled together around $5 million from 15 individuals to fund the company, is a serial entrepreneur. She launched Juice in 2004, after launching and selling the health education and wellness program provider Execu-Fit Health Programs to PacifiCare Health Systems. In its first three years, Juice’s revenues went from $200,000 to $12 million; Sephora is its anchor retailer, and the brand continues to post monthly sales increases.

Buying a brand like Juice Beauty could enable private equity firms or strategic buyers to catch the natural and organic wave. “There is a fair amount of interest in smaller niche brands, particularly with an organic/natural bent,” says Michael Kollender, managing director and head of consumer investment banking at Stifel Nicolaus in New York.

Kenneth Grand, who founded Alba Botanica, now owned by the Hain Celestial Group, and bought Carpinteria, Calif.-based Earth Essentials in 2002, says, “Whatever is leading the pack is going to be where the money is going to be flowing. If the natural segment continues to grow as robustly as it has, there will be money chasing that space.”

The natural and organic category is one of the few with growth, as more consumers adopt healthier lifestyles. The Nutrition Business Journal estimates the U.S. natural and organic personal care and beauty market was $7.9 billion last year, up from $7.3 billion in 2007 and $6.2 billion in 2006. Whole Foods’ same-store sales fell 4 percent in the first quarter, but industry sources maintain the Whole Body department is outperforming the store as a whole and could be notching 7 to 10 percent comps of late.

“Our body care department is doing a little better than the rest of the store,” confirms Jeremiah McElwee, the senior global coordinator for Whole Body. “I’ve heard a lot of people theorize that would be expected because people [continue to] take care of themselves, and it’s their one little luxury. I don’t know if that is true or they are very loyal and won’t back off their purchases.”

Like beauty shoppers, investors haven’t exited the category. Clorox, which purchased Burt’s Bees in 2007 for $925 million, is said to be eyeing additional natural brands to extend its reach. Private equity firms from Highland Capital Partners to TSG Consumer Partners to North Castle Partners, which
recently acquired Petaluma, Calif.-based Depth Bath & Body and wrapped it into a company called Mineral Fusion Natural Brands, report they are actively scouring companies in the category.

Some of the California-based brands said to be garnering interest include EO, 100% Pure, Josie Maran Cosmetics, Collective Wellbeing, ShiKai, Hugo Naturals, California Baby and Erbaorganics. Other brands in the natural and organic space include Method, Erbaviva, Lather and Yes To Carrots, which started in Israel and moved its headquarters to San Francisco after obtaining $14 million from San Francisco Equity Partners and Simon Equity Partners.

The at-home beauty device category is also under scrutiny by investors. California’s focus on medical technology and its concentration of venture capital firms investing in the sector has encouraged a proliferation of device brands. The National Venture Capital Association, which tracks beauty brands receiving venture capital funds, reports that the largest beauty deal last year was for $30 million and involved Pleasanton, Calif.-based Tria Beauty, marketer of at-home laser hair removal systems, and a smattering of venture capital firms, including Vivo Ventures, Global Venture Capital and Incubic Venture Capital.

Tria Beauty isn’t the only device company making news. Valencia-based Evis Beauty has rolled out its facial light therapy devices to Nordstrom, Bliss and Bloomingdale’s and Laguna Hills-based Pretika’s facial brushes are in CVS and Target. In March, PhotoMedex, developer of dermatological appliances, completed its purchase of Photo Therapeutics, which owns Omnilux. Omnilux uses light therapy to stimulate collagen and treat acne, and PhotoMedex has plans to spread the device via doctor’s offices and retailers, according to Fred Carr, vice president of marketing and business development. The device is being packaged with Perricone MD products. Meanwhile, the Encinitas-based Carol Cole, marketer of microcurrent device NuFace, has garnered investment from the firm Twist New.Brand.Venture helmed by Tina Hedges and Beth Ann Catalano, the duo that helped launch Jonathan Product.

“Devices is a young category, but there’s a wave of belief that the next frontier lies in this world,” says Hedges. Farello of Catterton, an investor in Houston-based acne device company Zeno, agrees. He sees major investment in the category coming from three sources: beauty stalwarts such as the Estée Lauder Cos., L’Oréal and P&G; companies that operate in the drug arena such as Johnson & Johnson and The Blackstone Group, and traditional medical device makers such as Philips. Last year, Mountain View, Calif.-based Reliant Technologies announced a partnership with Philips to develop a laser skin rejuvenation product for home use.

Pretika president Thomas Nichols argues it might be a few years yet before major beauty companies delve deeply into at-home devices as issues about instore placement and pricing get resolved, but Farello asserts that consumers will be privy to a broadening of the category well before that. “We really are at an inflexion point, and you will see a lot in the next 12 to 24 months. Not only with devices on their own, but devices as a part of kits,” he says.

Skin and hair care may not be as dynamic as at-home devices, but they still tempt investors. California-based independent brands that are of interest to investors include Murad, Dermalogica, iS Clinical, Ole Henriksen, Leaf & Rusher, Pur-lisse and Borba, partly owned by QVC-operator Liberty Media Corp. Wannabe buyers of all sorts have contacted Pur-lisse founder Jennifer Yen despite its small size and distribution. “They always want $10 million-plus [in sales], and we’re not there yet,” says Yen, who recently raised an undisclosed amount of private venture funding. “We’re not ready to work with a private equity firm. That’s something I’ll look at in 2010.”

Investors are hoping to replicate the success JH Partners has had with Kate Somerville. San Francisco-based JH executed a merger with Kate Somerville in 2007, when the skin care brand was estimated to generate a total of $12 million in revenues from services at its West Hollywood spa and product sales. Since then, Michelle Taylor, a senior operating partner at JH, says the brand has been growing around 50 percent annually. Kate Somerville is available at Henri Bendel, Sephora, Nordstrom, Neiman Marcus and on QVC. “I love skin care,” effuses Taylor, adding she’s put out feelers in the market for brands in skin care as well as other categories.

Hair care has been a recent priority for Carl Thoma, a managing partner at private equity firm Thoma Bravo, which has offices in Chicago and San Francisco. The company formed Luxe Beauty Holdings to buy Sexy Hair Concepts, a salon-distributed line estimated to generate $70 million in sales. “Whether you’re in a recession or boom time, people care about their appearance,” says Thoma. “When Sexy Hair became available, we were intrigued because we feel that they’ve had success and growth in the professional hair category….There is always the potential that someday you would think about turning it into a consumer brand.”

Adam Goldenberg, co-ceo of Intelligent Beauty, a Manhattan Beach, Calif.-based brand marketer, says that hair care brands with antiaging benefits are on the upswing. Intelligent Beauty has developed the brand Kronos for that niche, and Alterna Professional Hair Care, which is in TSG Consumer partners’ portfolio, fits the profile as well.

Ethnic-oriented beauty brands are another sector generating interest. Packaged Facts estimates the U.S. market for ethnic-specific hair care, makeup and skin care posted a 7 percent increase last year to nearly $2.6 billion. In California, where the minority population stands at more than 20 million, or more than 20 percent of the nation’s total, the market for brands aimed at people of color is considerable. California brands include Haute Face, NYX Cosmetics, Milani, Jordana and Kimble Hair Care Systems.

“There is still a lot of room to grow there,” says Jani Friedman, a managing director at San Francisco investment bank Demeter Group. “Hair care has been done more, but there are not a lot of brands targeting women of color in skin care.” In 2007, the Demeter Group arranged for Dr. Susan Taylor’s Rx for Brown Skin, now sold at Dillard’s and Sephora in J.C. Penney, to secure equity capital from San Francisco-based Simon Equity Partners.

Still, growth and opportunity haven’t yet translated to much M&A activity during the downturn. The sour economic mood has stopped most from taking action so far. “[M&A] is about optimism, and there is no optimism anywhere,” says Cathy Leonhardt, managing director at Peter J. Solomon Company. However, companies are crisscrossing California to find their dream brand, and lookers can become buyers if the right opportunities arise.

When will buyers and sellers seize the day to make deals? Kolleder forecasts a “big round of strategics making acquisitions” in the not-too-distant future. Companies that are cash-rich have a hankering to make deals while the market is in their favor. Several sources cite Alberto-Culver, Allergan, Beiersdorf, Henkel, P&G, Clorox, Unilever and Coty as potential buyers.

But their criteria have changed. About 18 months ago, Louis Marinaccio, a managing partner at North Castle Partners, encountered two strategic buyers examining a $10 million personal care company he was looking at. Today, he says, “They are probably out of that market,” duking it out instead in the much smaller field of $50 million-plus brands. Realistically, the anticipated annual growth for those brands, given the new economic paradigm, could be at least half of what it was during the bull market.

Private equity and venture firms also have modified their outlook. Hesitant to take on risk, they are often angling for larger brands with proven performance records. That’s a shallow pool. Vanessa Stanley-Miller, a vice president at San Francisco’s Encore Consumer Capital, which bought MyChelle Dermaceuticals last year, says, “It is really hard to find companies in the $25 million to $75 million range that are still privately held.”

Profitability, always important, is even more so. Tom Stemberg, managing general partner of the Highland Consumer Fund at Highland Capital, says that while he used to be interested in high-growth companies two to three years away from profitability, that time line has shortened to a year or two. On the other hand, investment horizons are lengthening. Marinaccio says North Castle’s horizon could go from three to five years to four to seven years. And firms are intensely vetting brands’ prices and points of differentiation. “Companies must deliver best in class products,” says M. Hadley Mullin, managing director at TSG Consumer Partners.

In the uncertain environment, depressed valuations have made selling unappealing, and healthy brands are waiting it out. Stanley-Miller estimates personal care valuations have come down at least by one times EBITDA, and Leonhardt says that a 10 times EBITDA deal a few years back would be a 6.5 times EBITDA deal today, for instance.

Over the next six to 12 months, though, Stanley-Miller predicts that holdouts will go to market at the lower prices. “That’s why some of the best private equity deals are done during recessionary periods,” she says. Demeter’s Friedman is more sanguine about the prices that brands can get, even in the down market. “If you can show that you are still on a growth trajectory, and you have innovative products coming out on a regular interval, and you have made some milestones over the past year, private equity and strategics still want you, and they are willing to pay for you,” she says.

California private equity firms, including TSG, Encore, JH and VMG, are energetically pursuing personal care and beauty deals. And a nascent crop of competitors is encroaching on their territory. The roughly $1.5 billion infomercial firm Guthy-Renker, which typically develops brands in-house, purchased Scalp Med last year for $15.7 million and has disclosed it would consider further acquisitions. Harry Haralambus, who heads a company called Imastar Corp., has been silently buying stakes of the Los Angeles area brands DuWop and Lola with the intention of expanding their international distribution. Intelligent Beauty’s Goldenberg says the company is on the hunt for brands with annual revenues as low as $500,000 that it believes can turn into $30 million to $50 millions brands via online and television shopping distribution. “There are great investment and buying opportunities out there,” he says. “We think that is going to continue for some time. This environment has created a great buyer’s market.”

 

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