K-Beauty's H2 Performance Rebounds, Accelerating US Offline Entry

Until the Q2 earnings announcements, the cosmetics sector showed a distinct seasonal pattern of strong first half and weak second half. However, with the full-scale effect of US offline channel entry, it has moved away from the year-end inventory adjustment trend. Consequently, earnings estimates are being revised upwards, primarily for ODM manufacturers.

Given that offline channels account for 85% of the US market, offline entry is crucial. As K-Beauty companies shifted from online-centric to full-scale entry into offline channels, new order volumes significantly increased. This success in the US market is serving as a stepping stone for expansion into the European market.

Driven by this growth, the year-on-year growth rate for the second half is expected to approach 35%. With strengthening performance momentum, the undervalued appeal of the K-Beauty industry is becoming more prominent.

Brand companies have a dollar-based cost expenditure structure and utilize their dollar reserves held locally to minimize the impact of exchange rate fluctuations.

Tariffs and rising oil prices due to the Middle East war led to a more than 30% surge in P and PP prices. Nevertheless, cosmetic brand companies internally absorbed this rising cost burden. Cosmetics have relatively low costs, allowing for significant operating leverage when sales are strong, with minimal margin erosion.

Due to logistics shortages in Europe and other regions, air transport of cosmetics surged. This led to a significant proportion of cosmetics air cargo, to the extent that it was identified as a major factor in improving Korean Air's performance in its earnings announcement.

Unlike brand or manufacturing companies, trade band companies like Silicon2 are inevitably hit by exchange rate declines. Trade band companies have no reason to hold dollars locally and must convert all transactions to KRW to purchase products from brand companies. Therefore, a significant portion of Silicon2's gross profit margin increase stemmed from exchange rate effects.

Hydrogel lines are the only core category with a difficult automation process. Line setup costs have significantly increased from 200-300 million KRW in the past to over 500 million KRW currently. Moreover, due to automation difficulties, approximately 30 personnel and a large space of 30 meters are required. Securing specialized operators and R&D personnel is also essential, limiting production to a few companies such as Genic, Cosmax, Cosmecca Korea, Englewood Lab, and IQure.

In the US, sunscreens are classified as over-the-counter drugs (OTC), leading to very strict regulations. Only one new ingredient has been approved, adding to the existing six, for a total of seven permissible ingredients. This contrasts sharply with Korea, where over 20 ingredients are used to improve texture. Therefore, companies with local factories in the US market are expected to benefit from new ingredient approvals.

They are pioneering the US market by introducing Korean-style cushion products.

Korea Kolmar has started supplying basic and high-priced products to top global luxury brands. While previous luxury products made by Korean companies were around $30-40, this marks the first time in history that a $150 product is being supplied and sold as 'Made in Korea' luxury.

In the past, Western countries were hesitant to adopt Korean cushions due to hygienic aversion to repeatedly using puffs. However, a new luxury brand launched a cushion in the US in May this year, receiving positive feedback. This signals that Westerners are beginning to accept cushions, and if successful, order volumes could significantly increase, expanding opportunities for mass brands.

There are many interesting products across diverse categories not easily found in other markets. High-performance products priced around $20-30 are receiving great reviews in the US market.

Notably, the top 2-3 ODM companies already have fully booked production schedules and can no longer accept new orders. Consequently, the Q3 and Q4 earnings outlook is very positive.

The Mexico subsidiary began operations in July, and due to strong demand, a Brazil subsidiary will also be established in December. Brazil is one of the world's top three cosmetics markets, offering high growth potential for K-Beauty.

Counterfeit products are a major cause of declining brand trust and reduced sales. In 2015 and 2016, a problem arose where half of Korean indie and mass brand products crossing borders were mixed with fakes. Cases of delayed entry due to the spread of Korean counterfeit products are increasing in Southeast Asia and the Middle East. Local and global major companies are expected to raise ingredient issues and strengthen registration regulations to protect their domestic markets.

Pum-Tech Korea resolved internal bottlenecks as of Q2. Its 6th factory is scheduled to begin operations in October, with Q4 revenue expected to increase significantly. In particular, BuKook TNC is experiencing a shortage due to high entry barriers in tube production, which is leading to an increase in operating profit margins.

However, the growth momentum of the cosmetics industry remains valid, and the supply shortage situation continues. Therefore, utilizing the current adjustment period to purchase quality stocks is recommended.