Retail stocks sometimes get a bad rap for their cyclicality and the fact that it is difficult to predict which ones have the potential to truly take off. However, the successes have a long track record of providing outsized returns for investors – and not just during bull markets.
So how should investors go about sorting through the mediocre retail stocks to find the good investments? Unfortunately, it is not as simple as picking the stocks of companies that sell appealing products. Even Peter Lynch, one of the most successful fund managers in modern history, once made the mistake of picking a retail stock based on liking the product, and he came to regret it when the company failed to take off.
There is no one-size-fits-all formula for picking retail stocks, since the category is broad and a lot depends on the market in which a retailer operates. Even so, we can learn a lot from comparing how similar retailers have fared in relation to each other.
Thus, this discussion will take a look at two famous competitors in the beauty industry, Ulta Beauty Inc. (ULTA, Financial) and Sally Beauty Holdings Inc. (SBH, Financial). The goal is to look for what led Ulta’s stock to astronomical growth while Sally’s shares remained mostly flat over the past couple of decades, despite the two companies operating in the same sphere.
Personalization
One of the first differences that stands out between Ulta and Sally from the customer’s perspective is that Ulta is all about personalization. Ulta has a wider variety of products, more special deals/coupons tailored to the customer, stylists on hand to teach about products and answer questions, etc. In other words, it tries to cater to the mass market, appealing to as many customers as possible, while making the shopping experience feel personal.
Sally does not go for as much variety or personalized marketing. It is the better choice for bulk buying, and for customers who are “in the know” in the beauty industry. If you are a professional stylist or have complex styling needs that can only be met by highly specialized products, such as hair glue that can hold up to a ballet recital, Sally is the way to go. However, the market for these products is smaller than Ulta’s target market.
Marketing
Tying into personalization, Ulta began spending big to integrate customer data and mass data analytics into its marketing strategy before Sally did. Ulta leverages this data to level up its loyalty program and offer ads and coupons that customers are more likely to bite on.
Ulta also has a focus on social media marketing, which is more important for the beauty industry than most other retail sectors because of the sheer overwhelming variety of beauty products on the market. Combined with how expensive even the cheaper products are, customers tend to scour the internet for information and reviews on products before buying, so getting people talking about products on social media is great for business.
E-commerce
These days, a good e-commerce logistics network is no longer just an added bonus, it is basically essential for retail success. In this regard, Ulta and Sally are mostly neck-and-neck, and both beauty retailers even offer same-day delivery in select heavily populated cities. Otherwise, the likes of Amazon (AMZN, Financial) with its same-day or next-day delivery might take more market share purely by merit of being more convenient.
Financials
Just as important as a retailer’s products and marketing efforts is the state of its financials, both in terms of profitability and balance sheet strength. The more money a company can earn per dollar invested, the more of a compounding effect its growth will have over time, and the stronger its balance sheet, the less it will be weighed down by debt in the future.
Ulta has a GuruFocus profitability rank of 10 out of 10 and a financial strength rank of 7 out of 10. Its return on capital is 51.67%, which is higher than 87% of other retailers, and its interest coverage ratio of 4,086 shows it should have no trouble managing its debt. It has a solid operating margin of 16.05%, despite a mediocre gross margin of 39.62%, which means it is good at managing operating expenses. Margins have also been steadily improving.
On the other hand, while Sally’s profitability rank is also high at 8 out of 10, it has a financial strength rank of just 4 out of 10. The company’s return on capital is 21.5%, which is better than 66% of other retailers, but its interest coverage ratio is 3.82, meaning the debt is weighing down its balance sheet. Its gross margin is excellent at 50.3%, but the operating margin is 9.19%, showing higher operating expenses. The gross margin has been mostly flat over the years, but the operating margin has been declining slowly.
Takeaway
There are four main takeaways investors can get from comparing Ulta Beauty with Sally Beauty. The first is that the best retailers to invest in are those whose products are attractive and accessible to a broad total addressable audience.
Second, good marketing is key, especially personalized marketing, though the approach to marketing will vary depending on the type of retailer.
Third, profitability is essential to long-term growth as earnings compound over time. Revenue growth without profitability just destroys shareholder value, and while it is more likely to pay off in the tech sector, retail is less forgiving.
Lastly, when it comes to maintaining the ability to survive hard times and continue investing in growth, a retailer needs a strong balance sheet. Debt is a lodestone that becomes heavier and more difficult to deal with over time, and before they realize it, good companies can find it limits their options.
