Target Won't Solve Ulta's Big Problem

Target Corp. (TGT, Financial) and Ulta Beauty Inc. (ULTA, Financial) have decided to enter a partnership whereby Ulta Beauty will open shops inside Target stores.

The presence of Ulta's e-shops in Target stores is certainly an opportunity for the large retailer to expand its offerings to its customers. As Ulta noted on the announcement of the partnership:

"The durable strategy we have built has made Target a top retail destination. The ease and convenience of our stores and fulfillment services provide broad reach and relevance for the curated brands our guests love," said Brian Cornell, chairman and CEO, Target. "In partnership with Ulta Beauty, a company that shares our deep guest focus, we are able to expand our growing beauty business with new, exciting brands, an immersive experience, and loyalty benefits to transform how our guests shop for all their beauty needs."

It's also an opportunity for Ulta to expand its presence in the U.S. market:

"Ulta Beauty at Target reflects further evolution in our omnichannel strategy, rooted in unlocking the potential of our physical and digital footprints, creating more seamless shopping opportunities for our loyal guests, and continuing to lead the beauty industry. More than ever before, now is the time for innovation in retail," said Mary Dillon, CEO, Ulta Beauty. "This partnership is an amazing way to further reimagine guest experiences with a partner who shares our company values. We are thrilled to bring our beauty expertise, unparalleled assortment, and digital innovation to life in a new channel to delight and deepen loyalty with our existing guests and introduce Ulta Beauty to new guests."

However, in my opinion, a partnership with Target won't solve Ulta's big problem, which is that it is running out of profitable opportunities to expand in the U.S. market. This puts a sock in its high-growth strategy; after sacrificing shareholder value for growth, running out of expansion opportunities will likely further make a weak case for investors.

Ulta Beauty has experienced strong revenue growth in the last three years, beating Target by a big margin, as shown in the table below:

Source: GuruFocus

The problem is that this expansion has been destroying rather than creating value. The return on invested capital (ROIC) has fallen below the weighted average cost of capital (WACC) as of the most recent quarter, while Target's ROIC remains above its WACC:

Source: Compiled from GuruFocus on November 10, 2020

Of course, this is in large part due to the short-term negative sales impact of the Covid-19 pandemic. However, several analysts, incluidng John Zolidis, aren't that optimistic about the impact of the partnership on Ulta's growth.

The average Ulta store is about 10,000 square feet, so the Target partnership will produce the equivalent of 10 new stores for fiscal year 2021, or 100,000 square feet in total. Zolidis commented:

"This represents a growth of 70 bps on ULTA's current retail footprint. We would assume that the productivity of this space would be lower than in an ULTA store as TGT's overall productivity is lower and ULTA's space will be co-joined with other competing beauty products. If ULTA were to do $400 in sales per square foot vs. $578 that it did in its own stores in FY19 (including e-commerce sales) this would equate to $40M in annualized revenues. This would be about 1/2 of a percentage point of FY19's total revenues."

Zolidis isn't that optimistic about the impact of the partnership on Ulta's margins either:

"The margin profile of these sales will also not be the same as a sale in an ULTA store. As we read the release, Target will hire and train the employees. Normally, in an arrangement like this, shop-in-shop revenues could be hit by 20%-25% of revenues to cover "rent" utilities, and labor. With a 50% merchandise margin, ULTA's $40M in incremental revenues could therefore equal $10M in EBIT contribution in an annualized first year. This represents 1% of the $901M in EBIT ULTA produced in FY19."

Zolidis' conclusion, which I fully agree with, is that the Target deal is not material to Ulta in 2021 but does give it another growth channel. However, the attempt to expand via this channel reflects the lack of new store opportunity that is otherwise available for Ulta in the U.S.

Disclosure: I own shares of Target

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