Ulta Beauty Inc. (ULTA, Financial) is a leading specialty retailer in the United States. The company, which was founded in 1990, offers a mix of prestige and mass beauty products through 1,257 stores, as well as online through its website and mobile app (e-commerce accounted for 12% of Ulta's sales in 2019). The company also offers a full service salon in its stores, which meets a need for some customers and can drive business to the other side of the house (selling beauty products). As shown below, the unit count has nearly quadrupled over the past decade – during a period where many brick-and-mortar retailers have been battening down the hatches as they faced a changing competitive landscape, largely at the hands of e-commerce giant Amazon (AMZN, Financial).
In addition to adding roughly 900 new stores, Ulta has also reported strong same-store sales (comps): over the past 10 years, comps have increased by roughly 10% per annum, with the worst performance over the period at up 5% in 2019. (Note that new stores, as they work their way to 100% productivity over the course of a few years, have been a material contributor to same-store sales growth for Ulta.) The end result has been a roughly 65% increase in sales per average store over the past decade, from $3.7 million per unit in 2009 to $6.1 million per unit in 2019. Collectively, these factors have driven a six-fold increase in revenue over the past decade.
Revenue growth, combined with an improvement in gross margins and slight operating leverage, has resulted in a 30% compounded annual growth rate for operating income over the past decade. Diluted earnings per share has followed suit, climbing from 70 cents per share in 2009 to $12.2 per share in 2019 - a CAGR of 34% (with help from a lower effective tax rate and a growing emphasis on repurchases, with the share count down 10% over the past four years).
Ulta competes in a fragmented market that offers distribution through many channels, including specialty retail (like Ulta), drug stores, department stores and e-commerce. As noted in the annual report, management estimates that it holds roughly 8% market share of the $89 billion beauty product industry. Most notably, the company has doubled its share in cosmetics over the past five years (this is also its largest category at 50% of revenue). Those gains also came during a period when prestige makeup led the category's growth by a wide margin, benefiting Ulta. The combination of these two factors has been the primary driver of the company’s impressive revenue growth. (It is a smaller player in categories like skincare and fragrances, with low single-digit share.)
As noted earlier, Ulta has significantly expanded its footprint over the past decade. As a result, the company is only a few hundred units away from its long-term target (1,500 to 1,700 stores in the United States). Said differently, it is likely to reach saturation in the U.S. within four or five years at the recent pace of unit growth (the impact of Covid-19 will likely delay that). Longer term, management has shared plans to expand internationally, beginning with Canada (plans for an omni-channel offering by 2021). It’s still early, but a successful rollout in Canada could provide some hope that the company will still be able to add new units for years, or even decades, to come. Ulta’s success or failure in Canada is something I’ll be watching closely over the next several years.
While the company’s historic growth has been impressive, I think it’s safe to say that the results over the coming decade are unlikely to be anywhere near what they achieved in the past decade.
First, as just discussed, the company is approaching saturation in its home market - and plenty of retailers have shown that successfully replicating a retail concept abroad is far from assured. That presents some reinvestment (capital allocation) risk as we look to the years ahead.
Second, I remain concerned about the potential long-term risk from online competitors like Amazon. I appreciate the arguments for why the makeup category may be less susceptible to this risk, particularly due to product quality concerns when dealing with third-party sellers – but I’ve also followed Amazon long enough to know that with enough time and effort, they often find a way to deliver for their customers (and negatively impact competitors). Last year’s exclusive deal for Lady Gaga’s beauty brand, Haus Laboratories, is one recent example that suggests the e-commerce giant has its sights on being a presence in this market long term.
Third, I worry about the growth of emerging, digitally-native brands selling directly to consumers. The ability to market products through influencers and celebrities on platforms like Instagram and YouTube, along with the ability to complete a transaction through a Shopify (SHOP, Financial) enabled store, has become a legitimate competitor to products sitting on retail shelves. (Note that Ulta has taken action to try and capitalize on these developments: consider the 2018 partnership with Kylie Jenner, with the Kylie Cosmetics product line available in all Ulta stores and online.)
Finally, as I discussed earlier, Ulta benefited from a market tailwind over the past several years, particularly within prestige cosmetics; nothing I’ve read leads me to believe we’ll see a return to outsized growth in that vertical. (On the other hand, the majority of prestige beauty products are still sold in department stores, which may present opportunity for additional share gains by companies like Ulta). If lackluster cosmetics growth leads to industry mix shift toward categories like skincare, that could also be a problem for Ulta because they under-index in those areas (and skincare has lower profit margins for Ulta than cosmetics as well). For what it's worth, management told investors during the fourth-quarter conference call that they expected the U.S. makeup category to continue to be challenged in 2020 - and that was before the impact of Covid-19 was fully appreciated.
Conclusion
All of Ulta’s stores have been closed since March 19 due to the pandemic. While they are likely seeing benefits in the e-commerce business, that’s unlikely to offset the revenue declines from brick-and-mortar locations (for what it’s worth, e-commerce has lower operating margins as well for Ulta). In addition, a period like this may ultimately accelerate changes in consumer behavior (for example, more willing to shop online than before), which could bring to light some of the risks I’ve outlined above. For those reasons, even though the stock does not appear particularly expensive at roughly 18 times trailing earnings, particularly relative to what Mr. Market has been willing to pay for it in the past, I’m going to remain on the sidelines for now.
It's worth highlighting that the company ended 2019 with half a billion dollars in cash and equivalents, along with publicly announced plans to repurchase $1.3 billion worth of stock in 2020 - but that plan will likely be altered given the current state of the business.
One final point. In researching Ulta, I’ve seen analysts argue the business will benefit from the struggles of competitors, most notably department stores. Essentially, as retailers like J.C. Penney (JCP, Financial) and Macy’s (M, Financial) continue to face headwinds, Ulta will take share. And while I appreciate that argument, I think it’s a bit short-sighted. Here’s my question: and then what?
Not to overstate the analogy, but I think it’s similar to the arguments that were made a decade ago about Barnes & Noble (BKS) when Border’s went bankrupt. It’s not wrong – but it misses the bigger picture. To give you a better idea of what I’m getting at, think about the beauty products business on a continuum from best positioned to worst positioned – from on-mall department stores to digitally-native brands or e-commerce. Along that spectrum, where does Ulta belong?
The pessimistic take would be that Ulta becomes the next iteration of the traditional mall retailers (names like Victoria’s Secret and Bath & Body Works). One of the most concerning data points I’ve seen is that Ulta’s legacy (five-plus years old) stores have recently seen same-store sales turn negative, compared to mid-to-high single-digit comps for this same class a few years ago. Simply put, an inability to stabilize and improve this would be a major concern for Ulta.
On the other hand, the company may find a happy medium. It could be among the select group of retail that has survived, and even thrived, in a changing world. Arguably, success of this kind would require investment to support a stronger online presence (with shipping options that are on par with best-in-class e-commerce), continued partnerships with digitally native brands (or even ownership given the company’s robust cash generation) and sustained focus on salon to drive traffic (currently, only about 5% of Ulta's customers use the salon services). In short, Ulta needs to continue improving what it offers to customers inside and outside of its stores.
Which path is the company likely to take over the next five to 10 years?
I’ll leave that one for readers to answer.
Disclosure: None.
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