2023-10-03 00:41:13 ET
Summary
- The beauty industry is incredibly resilient regardless of economic cycles. Beauty products are all but cyclical.
- ULTA Beauty builds on a solid past foundation, with revenue, free cash flow, net income, and EBITDA all growing at a steady pace.
- ULTA's growth may decelerate in the future due to slower store expansion and limited room for profit margin expansion, but the industry tailwinds, likely international expansion, and strong branding make it an attractive investment.
- High ROIC, organic growth and no debt make ULTA a low-risk investment at its current stock price.
The 10-Second Investment Thesis
My title for this article says it all. I have zero knowledge of beauty products and as a self-admittedly Neanderthal who will mindlessly use marble soap to wash his hair if the shampoo bottle runs empty, I will not pretend I did a ton of research on what Ulta Beauty ( ULTA ) sells in their stores. I consider all beauty things beyond what is necessary for detailed hygiene as non-essential stuff. Yet, I recognize that is a problem in my brain. I look at both sides of my bathroom countertop, and while I see a safety razor and a bottle of hair gel on my end, my wife's corner looks like rush hour in downtown New York with all kinds of small bottles and containers whose identities are as obscure as it gets. And I believe she is likely more frugal than the average woman. This stuff, whatever it is, sells really well. Whoever placed beauty companies in the consumer cyclical category clearly shares some of my Neanderthal genes. I know this is my anecdotal experience. Does reality support my perspective? Looking back to 2004, the only year that saw negative growth in the cosmetics industry was 2020 (Figure 1), and we all know what happened there. A noticeable (and expected) dip happened in 2008 and 2009 as well, but other than that, it seems to me that this stuff is as much of a staple as bread. As an investor, I like that, even if I am not a consumer myself.
Figure 1: Annual Growth of Cosmetics (Statista)
Numbers Over Products
My ideal investment is a highly predictable one, entered in at a good price. Shocker, I know. Sounds simple, yet, the market is what it is because investors get excited when prices go up and panic when trends reverse, making these good deals quite elusive for most of us. Psychology at play... I was not excited about ULTA at $550 but at recent prices, I am starting to pay attention.
I like to look at the story the numbers tell, even if I don't completely understand the business. I am breaking the circle of competence rule, but I don't care. I think it's nonsense because I understand very little in life anyway.
The Past
Past performance is not predictive of what the future holds. Basics, I know. Yet, looking at the past is essential. If I can't find a solid foundation in the past, it's more like a gamble to me. While the data from Statista in Figure 1 above is reassuring, the growth of ULTA is far above the overall industry. Revenue growth since 2008 has been around 20% per year. Then, 2020 came, and that perfect streak was broken, but things seem to be returning to normal. Revenue is great, but let's cut to the chase, what really matters is hard cash. No concerns on that front either. Free cash flow has grown at a roughly 37% compounded annual rate, therefore, faster than revenue itself. Net income and EBITDA follow the same trend. Solid past foundation? Check! It's not one of those companies that are all about revenue growth but have no free cash flow to show for it. Palantir, ahem...
What is more impressive is that growth did not happen on the back of debt. In fact, the company has none (Figure 3). The liabilities, currently sitting at about $1.8 Billion are operating leases related to ULTA's physical retail footprint across the United States. The hard cash the business spins out year after year is being put to good use, not in the form of dividends that the company does not pay, but in share buybacks and more growth. How good is the company reinvesting in itself? The Return on Invested Capital ((ROIC)), currently at nearly 30% is three times higher than the Cost of Equity ((COE)) which is the same as the Weighted Average Cost of Capital ((WACC)) due to the absence of debt in the balance sheet. Paying 10% for capital and getting a return of 30% is something most companies can only dream of. For reference, that is comparable to Google ( GOOGL ) which has an ROIC of 30.9% and a WACC of 11.2%. What's more, looking at Figure 3 below, the goodwill is so insignificant that it is barely visible. I am one of those people who does not like to see a lot of goodwill on the balance sheet. It feels a bit like bad cheating because more often than not it reveals that companies overpay for growth that would otherwise not experience. With ULTA, it's all organic growth. The two recent acquisitions ULTA made were of two tech companies to improve customer experience and the sums involved were not material.
The margins have also been stable, if not improving over the years, which is a great sign and supports the idea of predictability I mentioned. The steady gross margin of about 36% has recently improved to close to 40% and the profit margin has grown from 7.6% in 2013 to the current 11.8% (Figure 4). More on margins in a moment.
The Future
I am convinced beauty products are going to remain as non-discretionary as they have been so far. I can't let my disregard for these products fool me. People are going to keep buying them. McKinsey & Company projects a 6% annual growth for the overall beauty market between 2022 and 2027 (Figure 5), a figure a tad bit higher than the historical growth shown in Figure 1. It looks like there has been a melding of beauty and wellness in recent years and that this is and will remain a catalyst for the sector.
Figure 5: Growth of the Global Beauty Market (McKinsey & Company)
The question is not so much how much the industry will grow, but what we can expect to see from ULTA. Can we expect the 20% annual growth we saw between 2010 and 2019 moving forward? I will ignore 2020 for obvious reasons. With the lift of COVID restrictions, ULTA saw a growth of 18% from fiscal year 2022 to 2023, which is close to that historical 20%. However, growth in the trailing twelve months ((TTM)) has only been 5%. From a big-picture perspective, growth seems to be decelerating. We can see it both on a 10 and 5-year rolling revenue CAGR (Figure 6).
I am skeptical that the company will hit that 20% mark consistently. For instance, the number of stores, although still increasing, is doing so at a slower rate (Figure 7). The company opened around 100 new stores per year in the United States between 2014 and 2019, but that number dropped to 44 new locations in 2022 and 47 new stores in 2023. If we take the more recent trend of about 50 stores per year, given ULTA's known goal of 1700 stores in the United States, it will take about 7 years to get there. Taking the most recent, and also the highest to date revenue per store of $7.5 Million, in 7 years the total revenue would be about $12.8 Billion, which would correspond to a meager 3.3% annual growth, totally out of line with even the worst numbers in Figure 6. Since the company only operates in the United States, that does not look like a tailwind.
Figure 7: ULTA Store Locations (Author)
Maybe we will see an expansion of margins and that's where value is. Gross and net margins have improved over the years. I have my reservations here as well. Yes, margins have improved, but I don't expect them to improve much further. Over the last 10 years, revenue has grown at about 16.5%, but the cost of revenue and SG&A have kept up with a growth of 15.7% and 17.2% respectively. Cost of goods sold and SG&A eat up about 60% and 23% of Revenue. For some perspective, Estee Lauder's ( EL ) profit margin, although currently at 6.3% has historically hovered around 10% to 13%, expectedly similar to ULTA's. Unless ULTA has a magic trick, I don't see room for significant profit margin expansion.
The Catalysts
The growth will likely come through a few different avenues:
- Expected industry growth. The expected 6% growth according to McKinsey & Company is, coincidentally, the same growth that ULTA has experienced in revenue per store for the last 10 years. If we haircut the future growth to 5% to be on the conservative side, in 10 more years, assuming ULTA reaches its goal of 1700 stores in the United States, the total revenue will sit around $17.5 Billion. As a base for revenue per store growth, I assume $6.3 Million, which is the last 3 year's average. Now, we would be looking at a 5.5% CAGR compared to TTM revenue a decade from now.
- Inevitable International Expansion. ULTA has considered expanding to Canada in 2021 but suspended that move. However, I think this will eventually happen. With a goal of 1700 stores in the United States, we are looking at one ULTA location for about 196 thousand Americans. If the ambition in Canada were to cover a proportionally similar number of people, we would expect about 200 stores north of the border. Given the population distribution in Canada, I think that is optimistic and I will run with 120 stores in 10 years' time. Assuming the same revenue per store of $6.3 Million, we would add about $760 Million to the total revenue in 10 years, bringing the growth for this period to 6% per year. Canada is a destination ULTA has admitted to having thought about, and for that reason, I feel confident it will happen in light of the consequential slowdown in the United States. Expansion to other countries, although plausible, I will treat it as speculative and will not consider it for the time being.
- The Brand. This one is hard to assess, but branding power is often a pitfall for value investors like me who value numbers above all else. My previous assumptions brought me to the expected growth for the industry, but ULTA has beaten that over and over with ease. Initiatives like bringing the ULTA experience to Target ( TGT ) stores and the fact that 95% of sales are made to Ultamate reward members are likely catalysts for growth above my expectations. I will likely be accused of still being too conservative, but given the decelerating growth in Figure 6 paired with my innate pessimism, I ran with a 7% annual growth for the next 10 years. Under this scenario, the company will double its revenue within the next decade.
Price Is What You Pay, Value Is What You Get
I already laid down most of my assumptions for my own valuation, emphasis on my own . At the risk of being too conservative, an investment needs to be attractive enough for me to jump in. That means an internal rate of return of about 10% or more and the belief that any potential downside is limited. I have no doubts that ULTA is a high-quality company, but buying any high-quality company at too high a price will inevitably lead to lower returns. The projections based on my assumptions are shown in Figure 8.
Figure 8: Revenue and Free Cash Flow Projections for ULTA (Author)
As usual, I introduce corrections in my free cash flow projections based on the standard deviation for free cash flow growth in the previous decade. However, given ULTA's consistency in free cash flow growth, those corrections in 2026 and 2029 in Figure 8 above are barely noticeable. For terminal value, I usually go for a hybrid approach where I average the mean free cash flow multiple over the last 10 and 5 years with a perpetual growth approach. The 95% confidence interval for free cash flow multiple in the last decade is between 33.97 and 37.58. I would not feel comfortable applying a terminal multiple in this range. In the last 5 years, the 95% confidence interval for this multiple dropped to between 19.86 and 22.72. This is more reasonable, yet, I still haircut my multiple to 18, which landed me on a terminal value of about $34.8 Billion, representing 60.8% of the present value of the next 10 years' cash flows. The resulting internal rate of return ((IRR)) based on the last closing price of $399.45 per share is 10.2%. I initiated my position on September 26 at an average price of $392.63 dollars per share, coincidentally my fair value estimate assuming a discount rate of 10.44%, which is ULTA's current cost of equity for an equity risk premium of 4.4%.
From an earnings perspective, Figure 9 shows the confidence intervals for the price-to-earnings multiple during the last 10 and 5-year periods. Regardless of what period we look at, if PE were a random variable, the probability of seeing the current PE is only 7% if we take into account 10 years of historical data and a bit higher at 10.7% if we look at the last 5 years (top red arrows). If the ULTA is still a high-quality company with good growth prospects as I believe it is, I look at these numbers as indicative of both a low downside risk and a good entry point to buy the stock. The graphs at the top right corners of the tables in Figure 9 show that the earnings growth tends to converge with revenue growth. From this perspective, taking my previously assumed 7% yearly growth for the next decade and an exit PE multiple of 18, the fair value for ULTA stock would be about $460 per share (bottom left arrow). From this earnings valuation approach, the stock is undervalued.
Averaging my discounted cash flow approach with the discounted earnings approach, I would guess the fair value to be around $426 per share. Clearly, I felt more comfortable buying close to the $400 mark as I did recently.
Final Considerations
My favorite type of company provides products and/or services that are not cyclical and have a faithful customer base. This makes for the most predictable and lowest-risk investments. Up until recently, I would not have thought of cosmetics and beauty products as consumer staples, but a dispassionate analysis of trends reveals that this is a highly resilient sector still with good growth prospects. Being the largest retailer in this space, with outstanding returns on invested capital, ULTA is a reliable free cash flow generator that is likely to provide shareholder value for years to come.
For further details see:
Ulta Beauty: The Resilience Of Non-Essentials