Ulta Beauty Inc. (ULTA, Financial) is a beautifully simple, growing business with great management and trading at the right price
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Ulta, however, is also a fallen angel.
It is an angel because it is a fantastic, highly profitable business. Return on invested capital is in the 40s, while the operating margin is in the low teens for a non-franchise retail business.
It is a fallen angel because the stock was crushed after the second-quarter earnings announcement, having lost 40% of its value.
What does Ulta do?
Ulta is a chain of beauty stores that sell cosmetics, skin care and hair products that respectively account for 51%, 21% and 19% of total revenue. It opened its first store in 1990 and has since expanded to 1,200 stores selling 25,000 products from more than 500 brands for $7 billion in sales, all in the U.S.
Management thinks Ulta can grow its store base to between 1,500 and 1,700 locations. The company also has a loyalty program that has 32 million members enrolled. Its revenue from digital channel accounts for about 10% of sales and is growing at a rate of 20% to 30%.
Ulta is a supermarket of beauty products. It carries products from mass-market brands such as Maybelline New York to premium brands like Lancôme. Around 6.5% of 2018 revenue was from exclusive products. The top 10 vendor partners, such as Estée Lauder Companies (EL, Financial), L’Oréal (XPAR:OR, Financial) and Shiseido (TSE:4911, Financial), represent more than 60% of sales.
According to CEO Mary Dillon, Ulta has “a brand that's known and loved, a loyalty program, omni-channel capabilities, digital capabilities, and a lot of the exclusives.” These are Ulta’s competitive advantages.
What is the problem?
As almost always, the significant drop in the share price was due to a negative change in outlook. During the second-quarter conference call, management downgraded full-year guidance on revenue growth, comp sales and margins, which put a stop to the uptrend of earnings estimate revisions.
Source: Seeking Alpha.
Why is the stock a buy?
Ulta is executing very well in the (currently soft) cosmetics market. During the second-quarter earnings conference call, CEO Mary Dillon said the company was outperforming the rest of the cosmetics market and expected share gains in the second half and beyond. The market softness was confirmed by Estee Lauder’s weak North America sales, which declined 4% in the most recent quarter.
But makeup, like food, is consumable. There is also no reason to believe that the softness indicates a secular trend. I believe the problem is temporary in nature after a few years of very strong growth in the category.
Ulta still has a lot of room to grow, especially through market share gains. Although guidance was down, the company still expects 9% to 12% top-line growth and 6% to 7% comparable sales growth.
I also found the following chart in Ulta’s presentation interesting.
First, in the $90 billion beauty market, the specialty beauty category only has 15% market share, of which about 50% is Ulta’s by my estimate. Second, the category has aggressively taken market share, particularly from department stores and grocery stores. Third, within the specialty beauty category, Ulta ($6.7 billion in sales), LVMH’s (MIL:LVMH, Financial) Sephora ($2.5 billion in sales by my estimate) and Sally Beauty (SBH, Financial) ($4 billion in sales) are the three major players.
Sephora is a bit like Ulta. But with less than $3 billion in sales, it nests in LVMH, which of course is known for the renowned Luis Vuitton and Christian Dior brands. I doubt the cosmetics retailer gets too many resources and attention from its parent. Sally Beauty is in haircare products only and not growing. So Ulta is naturally the leader of the category. It is likely to lead the market share gains of the entire category.
Another reason the stock is a buy is because Ulta is just a fantastic, simple business.
When compared to the some of the biggest and best retail chains in U.S., Ulta ranks second in sales per square foot and first in operating profit per square foot. Beauty is a good category (Sally Beauty is also very profitable). Ulta is the dominant player in the space.
What is even more beautiful is that it has one of the lowest store counts and no sales from international markets. This means far more growth opportunities are ahead compared to other chains listed here.
Valuation
Ulta’s valuation is attractive against its own history. The trailing price-earnings ratio is not far above the 2009 financial crisis level. The price-sales ratio is at the lowest level since the operating margin climbed up to a stable 12%. Let’s keep in mind that the company is still growing its top line around 10% even when 50% of its revenue is in what is likely to be a cyclical down market.
Even though Ulta has the great profitability compared to other chains and more room for growth, its valuation is now among the lowest except for that of Sally Beauty. Also note that Ulta, along with Home Depot (HD, Financial), Ross Stores (ROST, Financial) and Costco (COST, Financial), does not use adjusted earnings. Its balance sheet is also one of the simplest I have ever seen with no debt and a very small number of intangibles.
Therefore, Ulta, with the best profitability and growth among the above stores, deserves a 22 times earnings multiple. Coupled with low double-digit earnings growth (9% to 12% revenue growth and share buybacks), I expect Ulta to have at least a 15% return from the current level.
Ulta and Home Depot are both dominant players in their duopoly categories. Home Depot now accounts for 40% of the $245 billion U.S. home improvement market. If Ulta could do the same, it would have $36 billion in sales of the $90 billion beauty products industry, more than five times the current level. Also, do not forget international markets. Beauty brands are global, but Ulta has no international sales. In brief, the company has the potential to be a multi-bagger.
What keeps me up at night?
Ulta listed the health of the economy as its biggest risk factor. But after doing some research, I do not believe the risk is as big as I feared. During the financial crisis, Ulta’s comp sales were still positive. The operating margin was down but resilient.
The 2009 down cycle was also not as bas as I feared for its more mature peer Sally Beauty.
Even Ulta’s largest supplier, Estee Lauder, whose earnings lean toward higher-margin prestige brands, didn’t fare too badly during that period either.
After several years of strong growth driven by proliferation of social media and product innovations, the cosmetics market in the U.S. went into negative territory this year.
Ulta's management appeared to have spotted the slowdown as early as 2017. Have women started to wear less makeup? I don’t really know, but a secular trend is slowly in the making. In the worst-case scenario, if the cosmetics category is experiencing a secular decline, there will be other categories to gradually make up for it. For example, skin care is having strong growth while cosmetics is weak. A few years ago, it was the opposite. As Ulta provides the most comprehensive beauty products offering, it has much more flexibility in dealing with changes in the beauty industry than almost anybody else.
Disclosure: I own shares of Ulta Beauty.Ă‚
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