2023-10-19 11:54:42 ET
Summary
- After a decade of market outperformance leading to April of 2023, Ulta's stock has plummeted by over 30%.
- I've seen many explanations for the selloff, including increasing theft, normalizing demand, and a tougher consumer environment in light of higher rates and student loan payments restarting.
- While those are valid reasons, I believe they miss the forest from the trees. The real cause for the selloff, in my view, is Ulta's defensive approach towards geographic expansion.
- As the company approaches the 1,400 U.S. locations mark and net openings slow down, investors are questioning Ulta's remaining domestic runway, and management is yet to announce an international strategy.
- After three years focused on operational efficiency and building a digital presence, I expect management will go on offense and announce a major international plan next year.
Just a few months ago, Ulta Beauty ( ULTA ) stood as a standout investment of the past decade, nearly doubling the returns of the S&P 500. Half a year later, Ulta's outperformance has all but vanished. The stock has plummeted by more than 30% from its April peak, and frankly, I haven't seen anyone with a good explanation why.
Understanding the reasons for the selloff is key to deciding whether this once-impeccable company trading at a historically low 15x P/E is as attractive as it seems on paper.
So, let's dig deeper.
Company Overview
Ulta Beauty is one of the two largest specialty beauty retailers in the United States, along with LVMH-owned Sephora ( LVMHF ). Unlike Sephora, Ulta Beauty operates only in the United States.
Ulta is "the premier beauty destination for cosmetics, fragrance, skincare, hair care, and salon services". In its stores, Ulta offers more than 25,000 beauty products from over 600 well-established brands, across a variety of categories and price points.
The beauty retailer operates over 1,360 branded locations, which are relatively large with an average of nearly 10,500 square feet per store. In addition, Ulta has 412 shop-in-shops at various Target (TGT) locations, where the two companies operate under a revenue-sharing arrangement.
Ulta has a vast loyalty program with nearly 42 million members, who are responsible for 95% of the company's total sales. The Ultamate Rewards program enables members to earn points for every dollar spent at Ulta and provides unique discounts.
Sharp Decline Since April
On April 28th, Ulta's stock reached an all-time high at $551 a share. The selloff started at the end of that month and intensified with a 10% decline following the company's first-quarter report, primarily due to revenue numbers that came below expectations.
Over the call, a major shrinkage (theft) problem was mentioned, but full-year guidance was upgraded, and comparable sales remained high at 9.3%, overcoming tough comparisons following two years of extraordinary growth.
In the second quarter, the company upgraded its guidance once again, but it also reaffirmed higher inventory shrink and higher supply chain costs, as well as saw an increase in SG&A as a percentage of sales. Furthermore, management was quite clear about the second half of 2023 being much worse in terms of growth and operating margins.
On paper, the headwinds detailed above shouldn't cause as harsh of a selloff, which resulted in Ulta trading at a historically low valuation in terms of its price-to-earnings ratio. Looking at Ulta compared to a group of (not perfect) comparables, however, we can see that it still trades at a premium over most of its peers.
Understanding The Selloff
In my view, Ulta's temporary problems are an issue, but they are certainly not the main concern. The real problem lies in Ulta's unimpressive expansion plans. Let's take a look at the following graph.
From 2012 to 2018 store expansion began to decline. In 2019, this rapid pace began to decelerate, dropping to 86 new stores. Looking ahead to 2023, the company anticipates an even more significant reduction, planning to open fewer than 30 stores in total.
In its 10-K, the company claims it has the potential to grow its footprint in the U.S. to between 1,500 to 1,700 locations, and its Target shop-in-shops, which are excluded from the above graph, to 800. Simple math, the company's lower end of the range suggests an additional 120 Ulta locations, and 450 additional target shop-in-shops, which are naturally not as important to the company's results.
What was once the annual count of new openings, is now the remainder of Ulta's total pipeline. In short - Ulta has a saturation problem in the U.S., and in light of this problem, you've probably noticed the big elephant in the room.
Ulta's Reluctancy To Expand Into International Markets Clashes With U.S. Saturation
Before COVID-19 hit, under the former CEO's leadership, Ulta had plans to expand into Canada. Those plans were halted . Then, in June of 2021, David C. Kimbell was appointed as the company's new CEO. Two months later, the company had an Analyst Day , in which Kimbell set forth his strategy under the following framework:
Companies like to use all kinds of fancy words in their presentations. Not to disrespect the company's ESG and culture ambitions, from a shareholder's point of view, this slide can really be narrowed down to - One, remain relevant; Two, build a digital presence; and Three, improve operational efficiency.
Translated into actions, we can say that remaining relevant in a constantly changing beauty market means making sure you sell the hottest, most desirable products, and partner with the correct brands and influencers.
Building a decent digital presence means developing a mobile app, website, and an e-commerce platform, aimed at increasing engagement with the Ulta brand. Lastly, driving operational efficiency means improving the supply chain, utilizing economies of scale to drive leverage, and cutting unnecessary costs.
So really, the strategy is all about maintaining the company's leading position and riding the strength of the growing resilient beauty industry. Less about driving growth, aside from the one outlier here, which is the digital pillar.
Relying on the digital front as a main growth driver somewhat contradicts what seems to be Ulta's true strength, which is the shopping experience in its physical stores.
Our guest insights and member data confirm that beauty enthusiasts prefer to transact in physical stores.
--- Ulta Beauty, 2022 Annual Report (10-K), Page 3
It's quite simple. Ulta, as a retailer, does not offer a significantly unique or differentiated array of products (there are some exclusive arrangements and a private label, but they're an immaterial portion of the business). What Ulta does offer is a beauty-centered experience, along with a compelling value proposition through its loyalty programs.
Online shoppers generally opt for either the most cost-effective choice for their preferred beauty items or the top-notch e-commerce service, both of which are not Ulta's strong suits but align more with the strengths of Amazon ( AMZN ) and Walmart ( WMT ). As evidence, according to the company's 10-K, only 17% of Ulta's loyalty members shopped in both its physical locations and its digital platforms. Furthermore, management stated on an analyst call that more than 75% of Ulta's customers transact only in stores.
Lack Of Focus On Core Advantages
The primary catalyst for Ulta's growth is its physical expansion, and as previously highlighted, this expansion has significantly decelerated. Furthermore, the compounding factors of rising theft incidents and management's dedication to enhancing other competencies have prompted the company to make substantial investments in projects that don't involve expansion. Instead, the focus has shifted towards operational enhancements, including the establishment of new distribution centers.
So, the company is clearly spending heavily on projects that are not significant growth drivers and remains largely silent over a more ambitious expansion plan, with no mention of international goals.
Going over the company's strategy, which I suggest anyone who's considering investing in Ulta do, you get a clear grasp of the company's lack of focus on its true competitive advantage. Detailed on page 3 of its annual report, the strategy is broken down into six pillars, none of which is centered around geographic expansion.
It's important to keep in mind that beauty customers have a wide array of choices when it comes to buying their preferred products. What they truly seek is a destination where they can discover these products, and that's the main value proposition of Ulta.
If Ulta doesn't have intentions to expand globally, investors are left with a growth narrative that heavily depends on increases in same-store sales. However, it's evident that these are beginning to stabilize. Historically, the company's comparable sales growth has fallen within the 6%-8% range, and although it exceeded this historical range during the first half of the year, the management's guidance for the full year indicates a substantial decline in the latter half, with an anticipated 4.5%-5.5% growth.
Valuation (The Value Play)
It's extremely hard to value a company that has been re-rated by the market based on true fundamental merits. What do I mean by that?
I can fairly easily say that if a stock sells off based on some kind of bad headline that has no true effect on its fundamentals, the stock will return to historical valuation as soon as the misguided panic goes away. That's a very common occurrence in the market.
On the contrary, when it comes to Ulta, I believe investors are slowly picking up on a real fundamental issue. If management is going to continue to invest solely in operational efficiency, then the conservative 5%-7% revenue growth targets the new CEO has set during the pandemic remain relevant. And if so, then Ulta is due to trade somewhere in the 15x-17x P/E range in my view.
On that subject, there was a very interesting quote from Scott Settersten, Ulta's Chief Financial Officer, during the second-quarter earnings call :
We are in the business of growing Ulta Beauty for the long term, and so there's plenty of other great growth initiatives out there that we've got in the queue that we're ready to go tackle. As soon as we get through some of more of this, I'd call core transformation work here in '23 and early 2024.
Basically, I think what the CFO is saying, they played defense for three years. In 2024, as Ulta capitalizes on its operational transformation, it will go on offense. And I believe offense means - international expansion.
While I don't personally engage in beauty shopping, it seems highly likely to me that Ulta can replicate its recipe for success in the United States in other regions, commencing with Canada and Europe. To put this into context, Sephora has a footprint of over 2,700 stores across 35 countries worldwide, nearly twice the number of Ulta's stores.
The two beauty giants have already shown they can succeed alongside each other, and I believe Ulta has ample room for geographic expansion if management sets its mind on doing so.
I'm positive that by the end of 2024, Ulta will announce an ambitious expansion plan that will demonstrate the company's true long-term potential. And that is why the low valuation is so important - I wouldn't recommend betting on this unknown if the valuation wasn't so undemanding.
Ulta is a pure value play, because the downside is quite low, and the upside for long-term investors, in the event the company does expand significantly, is immense. Let's take a look at the following table:
In 2022, Ulta generated a profit of nearly $917,000 per store. In 2030, seven years from now, I expect it will generate a profit of $1.3 million per store reflecting a modest same-store growth rate of 5%. To me, this forecast is sufficiently cautious, given the company's initiatives to enhance operational efficiency likely leading to margin expansion, and its consistent historical same-store growth rate, which remained consistently above 6% during non-pandemic years.
Under the Bear Case scenario, I project Ulta's footprint will total 1,700 locations by 2030. This assumes the company refrains from international expansion and achieves the upper limit of its U.S. objectives by maintaining the store-opening rate seen in 2023.
Under the Base Case scenario, I anticipate that Ulta will embark on international expansion and increase its net opening rate to 60 stores. It's worth noting that the company has already demonstrated the ability to open more than twice that number within a single year.
Under the Bull Case scenario, I assume Ulta returns to its historical 100-stores-per-year pace, with an aggressive worldwide expansion plan.
Taking no multiple expansion into consideration, which is presumably too conservative, we arrive at 6.8%, 9.6%, and 12.0% CAGRs under each respective scenario.
As we can see, at the current valuation, I see market-beating returns under both the Base Case and the Bull Case. And just to emphasize, I believe my same-store growth and exit multiple assumptions are almost unreasonably low. Obviously, if we used higher numbers, the upside would increase significantly.
Risks
To start, let's address the risk associated with the timing of the purchase decision. Ulta is currently experiencing a sharp decline in its stock price, and this decline has occurred even before the expected trough in the second half. Projections for the third-quarter report suggest it will be a challenging one, marked by a substantial drop in operating margin, a decline in EPS, and a noticeable slowdown in revenue growth. Given these projections, it's easy to envision a scenario in which the market responds negatively to this news, despite them arguably being priced in already. Hence, investors should recognize that, like any investment, it's impossible to perfectly pinpoint the bottom.
Moving on to the second point, let's delve into the competitive landscape. Ulta's primary rival is Sephora, which has recently surpassed Ulta as the preferred beauty destination for teenagers. In addition to Sephora, Ulta faces competition from major retailers like Amazon, Walmart, and Target, in addition to the direct-to-consumer activities of beauty brands. Undoubtedly, this industry is marked by intense competition, but Ulta and Sephora possess a distinctive positioning within it. I believe the increasing competitive pressures are another reason why Ulta's historical valuation metrics are now a thing of the past, yet the current valuation already takes that into account.
Thirdly, there's no certainty about an expansion plan. My investment thesis is based on a major expansion plan and such a plan hasn't been announced yet, so there's an obvious risk here. New growth initiatives were at most hinted by the CFO, but there are still a lot of question marks.
Lastly, let's discuss macro. It seems we have to mention student loan payments, higher interest rates, and the possibility of a recession. First, I believe beauty is at the very top of the priority list for shoppers, being as essential as soap and toilet paper. It's likely that some consumers will opt for more budget-friendly brands, but Ulta caters to a wide range of price points and provides an appealing rewards program. Recalling the 2008 economic downturn, Ulta achieved double-digit growth, and its earnings per share rebounded in 2010, reaching a level that was then a record high.
Conclusion
Ulta operates within the remarkably resilient beauty industry, offering essential products across various price ranges. It is widely recognized as one of the premier destinations for beauty shopping and boasts a substantial member base, approaching 42 million.
Under the leadership of the new CEO, there's a strong emphasis on optimizing operational efficiency and bolstering the company's digital presence. This has led to substantial investments, which I view as a defensive strategy rather than an offensive one.
Looking forward to 2024, I anticipate that the management will make a pivotal decision, unveiling an ambitious international expansion plan. This move has the potential to trigger a significant shift in market sentiment. If such an expansion materializes, Ulta will establish a clear and simple pathway to market-beating returns, and then some.
Trading at a historically low 15x P/E, Ulta becomes an attractive value play, and despite several uncertainties, I believe the downside is limited whereas the upside is immense. Consequently, I rate Ulta a Buy.
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Ulta Beauty: Cause For The Selloff Is The Reason It's A Value Play