2024-01-04 18:29:43 ET
Summary
- Following a 27% surge without significant fundamental surprises since my previous article, I no longer view Ulta as a value play.
- Investors should look beyond the seemingly low P/E ratio, and understand Ulta's growth trajectory is materially different from what it was a few years ago.
- The company's reliance on UB Media and digital is alarming, as those are still small and highly unlikely to move the needle in the short term.
- Without an international expansion, Ulta won't be able to leverage its number one value proposition to reaccelerate growth, and will probably grow in line with the industry.
- I downgrade the stock to a Hold and encourage investors to wait for higher certainty regarding the company's growth prospects.
Ulta Beauty, Inc. ( ULTA ), a specialty beauty retailer, has seen its stock rise by nearly 30% in a span of less than two months, between its October 2023 lows and December of that year.
Despite the sharp upswing, Ulta ended the year essentially flat, significantly trailing the market's ~25% gains.
Investors should now ask themselves whether Ulta remains attractive at these levels, as many of the problems that caused the initial selloff are far from being solved.
Revisiting The Causes For The Selloff - Growth Deceleration In Light Of Geographic Saturation
Right around its October lows, I named Ulta one of the best value plays in the market, despite several concerns I had about the company's growth trajectory. I claimed that with such an undemanding price, investors were basically getting a free option on Ulta's potential international expansion, as well as its UB media initiative.
Following the stock's sharp incline, I no longer view Ulta as a value play, despite what its historically low P/E might suggest. The company has plenty of struggles to deal with, primarily geographic saturation and increasing competition, and its ability to reaccelerate growth remains highly uncertain.
In my view, despite what many investors seem to think, Ulta experienced a justifiable selloff, as the company's growth continued to plummet. Ulta is no longer a high-teens growth story, and therefore what seems to be an extremely low multiple relative to its historical levels is more reasonable than what appears on a shallow look.
As I wrote in my previous article, Ulta has a much more fundamental issue than a mere macroeconomic slowdown.
The company's value proposition relies heavily on its physical stores, as there are plenty of cheaper or more convenient options to shop for beauty online, from the likes of Amazon.com, Inc. ( AMZN ) and others.
Historically, the beauty category has grown at a low to mid-single-digit pace, yet Ulta was able to surpass those numbers by a wide margin, as it consistently conquered more and more market share, primarily due to geographic expansion.
Between 2015-2022, Ulta grew revenues at a 15% CAGR, and nearly doubled its footprint from 675 stores to 1,308, reflecting an annual unit growth of nearly 8%.
Today, following two years of exceptional growth post-pandemic, Ulta is opening locations at a much slower pace, and its revenue growth has declined to mid-single-digits.
What's Baked Into The Current Price?
Ulta is a high-quality business and an industry leader in the fast-growing beauty category. The beauty industry is arguably one of the most attractive spaces for a retailer, as it enjoys the same resiliency of staple essentials like household products and groceries, but it sees higher margins and constant innovation, which supports strong demand and higher profitability.
Specifically for a player like Ulta, the characteristics of the industry are even more appealing, because it has plenty of horses in the race, meaning it is generally complacent as to which brand is the hottest at a given time, due to the fact it sells all of them. With a dynamic and highly competitive industry, Ulta is like the picks and shovels of the gold era. Beauty enthusiasts come to its stores to try new products, experience Ulta's services, and engage with the hottest brands.
Taking all of that into account, it could be argued that Ulta should trade at a premium over general retailers like Walmart Inc. ( WMT ) or Target Corporation ( TGT ). Generally, a specialist retailer should be measured by the strength of its industry, and Ulta's industry is as good as any.
And yet, we can see Ulta right in the middle of the pack among specialty retailers like The Home Depot, Inc. ( HD ) and Tractor Supply Company ( TSCO ), as well as general retailers like Walmart, Target, Dollar Tree, Inc. ( DLTR ), and Dollar General Corporation ( DG ).
In my view, this is a clear statement from the market, saying that Ulta isn't the best way to capitalize on the beauty category, due to increasing competition and more importantly, a lack of an attractive growth story.
Don't Get Tricked Into The Historically Low Multiple Story
Let's take a look at Ulta's historical P/E ratio. This is how it trended post-pandemic-related closedowns:
And this is how it trended prior to the pandemic:
You can see that all along the way, the stock was trading at a P/E ratio of at least 20x. Therefore, it shouldn't surprise us that plenty of analysts are looking at Ulta's current 18.5x valuation and come to the conclusion it's cheap.
But here's what they don't show you (forgive me for the not-so-aesthetic graph):
Ulta's PEG ratio today, which takes into account both the P/E ratio and the company's growth, shows that Ulta is the most expensive it's been in the last decade. So it all comes down to whether or not can Ulta reaccelerate growth.
Can Ulta Reaccelerate Growth?
If you gave a bunch of MBA students a case study about Ulta and asked them what should Ulta do to reaccelerate growth, I'm assuming the number one answer would be to expand internationally.
Beauty is a global product, and no reason comes to mind with regards to why shouldn't Ulta's recipe for success fit other developed markets. And yet, if it's so simple, why is management not doing it?
In my view, as I discussed in my previous article, management is conservatively waiting for the optimal opportunity. Presumably, they want to fully complete their operational transformation, which includes the building of logistic centers, and renovating some of their in-store arrangements and infrastructure. In addition, they're probably hoping for a better macroeconomic environment.
That being said, at some point, I think the company has to take the risk of expanding internationally. It's already way behind Sephora (LVMH) and Douglas, which has 2,200, and 1,850 locations outside the U.S., respectively.
Over time, I think it's safe to say Ulta will have a tough time gaining more share in the U.S., as more and more shopping will be done online. Even today, many Ulta customers go there for initial trying and experimenting but rely on the Amazons of the world for replenishing their chosen products.
Without taking a significant share in the U.S., and without expanding internationally, Ulta will have a tough time growing above the industry's 3%-7% pace, and if that's the case, I believe a multiple expansion back to historical levels is highly unlikely.
Banking On UB Media & Digital Sales
There are two lines of business that Ulta does hope will help drive growth.
The first is UB Media. This is Ulta's attempt to monetize its 42 million loyalty members by selling targeted advertising to beauty brands. Ulta collects and owns a lot of data about its customers, including which products they like, when and where they want to buy them, etc. For a beauty brand, this can potentially be an attractive place to invest some of your marketing dollars. UB Media provides a unique option to market your products to a cohort that is 100% interested in beauty.
There aren't too many examples I can think of where the owner of such a specific and large membership base isn't in a conflict of interest with the potential advertisers it can sell ads to. Think about Starbucks Corporation ( SBUX ) selling ads to other coffee brands, or McDonald's Corporation ( MCD ) selling ads to other burger chains. Doesn't make a whole lot of sense.
However, the difference is as a retailer, Ulta is generally indifferent to which brands are more successful, and it doesn't really compete with those brands, except through its relatively small private label.
I believe UB Media could be a success, but it's still in the very early innings and I don't think it can be relied upon to move Ulta's top-line needle in the near term.
Transitioning to digital, while the segment continued to take share internally in the third quarter, showcasing a comparable sales increase of 10% compared to the total-company 4.5% number, digital is still a small portion of Ulta's business. Previously, management indicated that only 17% of Ulta's loyalty members shop through both physical and digital channels, and more than 75% of Ulta's customers transact only in stores.
It remains to be seen if Ulta succeeds with taking market share in the digital space, but the company is somewhat late on that front, as it's still working on optimizing its digital offering, whereas other players are already years ahead.
To conclude this point, as it currently stands, the two most important drivers for future growth are far from providing any certainty about overall reacceleration. They do have potential, but I don't see them affecting the company's top line materially anytime soon.
Valuation
So we went over Ulta's issues and discussed why the historically low multiple isn't as attractive as it may seem. Now what's left for us to decide is what would be the fair valuation for the company.
Based on what we know about Ulta today, assuming no international expansion, I don't expect Ulta to outgrow the industry pace by a significant margin. Therefore, under the base case scenario, I'm assuming Ulta grows revenues at a 6%-8% annual pace, with a gradually improving operating margin due to operational improvements and higher margin contribution from UB Media.
This is pretty much in line with consensus estimates, which currently expect Ulta to generate EPS of $27 in 2025, reflecting a 17.6x P/E and a PEG ratio of nearly 3.0, based on the consensus expected growth rate of 6%.
The main difference between the base case scenario and the bullish scenario is international expansion. With Ulta generating approximately $7.8 million in sales per store, an additional 10 stores each year could contribute nearly 1% to top-line growth. With zero locations in Europe compared to the potential thousands Ulta could have if it were to expand into the region successfully, the potential of such expansion is huge.
If Ulta does expand internationally, I'd expect underlying growth to accelerate to at least 10%, reflecting 40 openings a year, over time. This would reduce the PEG ratio to 1.7x based on current levels, assuming the international business is somewhere around breakeven in 2025.
Let's go back to the unattractive graph from before. We can see that in more optimistic, higher certainty times for Ulta, back when growth was primarily fueled by geographic expansion and market share gains in the U.S., the stock has mostly traded below the 1.6x PEG threshold.
Today, even if we take into account the bullish scenario, the stock reflects a number that's higher than that, despite the uncertainties and higher risks.
When I published my previous article with a Buy rating, the stock was 30% lower and the probability of an international expansion announcement was higher, primarily based on management comments, insinuating a major announcement could come in 2024.
Since then, management hasn't provided any further details, and it doesn't seem like they plan to announce such a plan in 2024, as they now expect continued investments in operational improvements well into the second half of the year.
As such, I believe the stock is no longer attractive at these levels.
Conclusion
Following a 30% surge since its October lows, Ulta's valuation now reflects growth acceleration in 2024.
In my view, such acceleration is far from being a certainty, as management remains silent about expansion plans and remains focused on operational efficiencies. The company's reliance on UB Media and its digital platform as major growth drivers is in my view not enough, as those lines of business are too small to move the needle in the near term.
At current levels, too many unknowns need to go in the right direction for Ulta to provide market-beating returns. Therefore, I downgrade the stock to a Hold.
For further details see:
Ulta Beauty: No Longer A Value Play (Rating Downgrade)