2023-12-05 11:28:06 ET
Summary
- After the earnings, the stock jumped; it is still a buy.
- We have here a quality company at a reasonable price.
- Management incentives aligned with shareholders.
- Even after a 24% price increase from my last article, I still believe there is an opportunity.
- The great Sephora poses a risk, as well as the valuation, which seems a bit tricky.
My Thesis
About two months ago, I wrote an article about Ulta ( ULTA ), delving into its business attributes that have fueled its compound growth over the last decade. Since then, the market experienced a rally, and in the latest earnings report, Ulta raised its guidance slightly, leading to a 10% jump in the stock. The stock has surged by 24% since my recent article, prompting me to conduct an updated valuation to assess if it's still a buy. Additionally, I plan to include aspects that I did not cover in the previous article.
Management and Incentives
So, that's a part I haven't touched on in the recent article, and it is very important. Ulta has been led since June '21 by David Kimble, who boasts vast experience in the retail space and has been with Ulta since 2014. Although not a founder, Kimble has a significant stake in the game, in my view. While he may not hold even 1% of the company, I believe a substantial part of his wealth is tied to Ulta stocks. According to the recent proxy, he holds slightly above 100k stocks, many of which are options with the right to purchase at a very low price. His stake at Ulta could be in the tens of millions. Since this is his first role as a CEO at a large company, I would venture to say that most of his net worth is in the company's equity.
Ulta also boasts an impressive incentive plan, with 87% being performance-based and 65% in equity, aligning Kimble's interests with shareholders. This compensation is based on Earnings Before Tax, Revenue, and Total Stockholder Return. As an investor in Ulta and someone seeking long-term value creation, I would appreciate if one of the compensation parameters were a form of Return on Capital, much like Lowe's ( LOW ), which compensates for long-term goals through Return on Invested Capital.
SBC accounted for about 9% of operating cash flow, which, while not reaching the pinnacle, isn't the lowest I've observed either. Its elevation was primarily due to the drawdown in operating cash flow. Generally, it remains relatively low, and I haven't even touched on the share count reductions yet.
Valuation and Growth
Ulta operates in the Beauty & Personal Care market, projected to grow at 3.32% (CAGR 2023-2028). In my bullish, though not overly optimistic scenario, I assume Ulta will gain some market share and grow comp sales by approximately 5% annually. This growth could be driven by the increasing pace of Ultimate members, evidenced in the last 5 years (go to my previous article for details) and the previous quarter, with comp sales boosted by both online and in-store traffic, as well as store relocations. Additionally, I factor in a projected 2% annual store opening rate (this without the increasing Target ( TGT ) locations), slightly below recent years but within the 2023 guidance range. This totals a 7% top-line growth, a reasonable figure.
The focus then shifts to Free Cash Flow per share growth. Adding a 3-4% reduction in share count through buybacks, consistent with historical trends, and assuming a 1.5% annual margin growth, aligning with historical rates, brings us to a solid 11.5-12.5% FCF per share growth rate. This, in my view, is realistic and depends on management's capital allocation toward buybacks and store openings.
Moving to the Weighted Average Cost of Capital calculation, the result is a 9.9% WACC, to be used in the upcoming Discounted Cash Flow analysis.
wacc (author)
I'm utilizing the average Free Cash Flow margin from the last five years, which stands at 8.5%, along with the full-year revenue consensus . Additionally, I've incorporated a reasonable 2% terminal growth rate.
Assuming a 12% FCF per share growth rate, the stock appears undervalued by almost 10%, with an intrinsic value of $536. While this might not represent a significant discount, I believe that buying a high Return on Capital company at a reasonable price is akin to a bargain, especially considering the typical premium associated with such quality businesses. As the great Charlie Munger used to say, buying great businesses at a fair price is better than a cheap price for a good business.
In a less optimistic scenario, considering no market share growth, a 3% market growth, no margin growth, and a slight reduction in buybacks due to increased investment (to boost market share), we ended up with an 8% FCF per share growth. At these rates, the stock seems overvalued by 21%, with an intrinsic value of $400.
We have two scenarios. I believe the first is more likely, making the stock a buy in my view. I don't find the growth rate unreasonable.
The latter case is not overly bearish either. So, for an investor seeking a 40% under intrinsic value, this might not be the ideal opportunity, and they should consider moving on.
While the latter case is less optimistic, the stock remains undervalued by historical multiples, trading below its 5-year averages. It's essential to note that these averages were influenced by the zero-interest-rate policy (ZIRP) era.
From another perspective, considering the average FCF margin with forecasted full-year revenue, we get a 4.5% FCF yield, a reasonable price for a company boasting over 40% Return on Capital Employed.
Conclusions and Risks
Even after the recent earnings hike and a 24% increase from my recent article, I still consider the stock a BUY. I believe a fair price for a company with up to 40% ROCE is a good deal. Additionally, I trust that the CEO has strong incentives to continue serving us, the shareholders.
Certainly, this isn't without risks. The pre-earnings price was evidently less risky, and the valuation might not be considered a bargain by every investor. The primary risk I identify is the growing popularity of the formidable Sephora ( LVMHF ). Other considerations include potential impacts from changes in the economic environment, although the beauty industry tends to be resilient. Furthermore, being in the retail sector, the omnipresent threat from giants like Amazon ( AMZN ) poses a perpetual risk to any retailer.
I'd be interested to hear your thoughts on this business.
For further details see:
Ulta Beauty: Still A Buy After Updating Valuation Post Earnings