2023-09-04 08:12:17 ET
Summary
- Ulta Beauty has maintained strong sales and EPS growth despite challenging macroeconomic conditions.
- Margins have slightly contracted due to increasing costs, but overall profitability remains comparable to past averages.
- ULTA continues to return value to shareholders through share repurchases, potentially signalling undervaluation.
- We maintain our "buy" rating.
Ulta Beauty, Inc. ( ULTA ) operates as a retailer of beauty products in the United States. We have started coverage on the company in December 2022 with a "buy" rating. The primary drivers of our bullish outlook have been the outstanding demand for ULTA's products, despite the challenging macroeconomic environment, the reduced costs and the improving margins in 2022.
Since then, despite the strong rally in early 2023, the stock price has declined by almost 12%, significantly underperforming the broader market, which has gained as much as 15% in the same period.
Analysis history (Author)
The aim of today's article is to assess, whether the main reasons for our initial buy rating are still intact or not. To do so, we will be primarily focusing on the latest earnings report and its potential implications for the financial performance of ULTA in the coming quarters.
Sales
While the macroeconomic environment has remained challenging in the first half of the year, once again ULTA has managed to achieve sales growth. Many firms in the consumer discretionary space have been struggling with weak demand and declining sales, but ULTA is different.
Income statement (ULTA)
While growth has definitely slowed compared to the prior years, the firm has still managed to come in in line with consensus revenue estimates . At this point, it is important to appreciate that a large percentage of this growth has been driven by the comparable sales growth, indicating that the demand for ULTA's products has remained solid and that the firm has sufficient pricing power.
Net sales increased 10.1% to $2.5 billion compared to $2.3 billion in the second quarter of fiscal 2022 primarily due to increased comparable sales, strong new store performance, and growth in other revenue. Comparable sales (sales for stores open at least 14 months and e-commerce sales) increased 8.0% compared to an increase of 14.4% in the second quarter of fiscal 2022, driven by a 9.0% increase in transactions and a 1.0% decrease in average ticket.
We believe that from a sales and demand perspective, our initially established bullish thesis is still intact. Looking forward, we expect the macroeconomic environment to improve already in the first half of 2024, especially from a consumer perspective. While consumer confidence in the first half of 2023 was still relatively weak, it has improved substantially in the second half of the year. In our opinion, this is likely to have a positive impact on the spending behaviour of the consumer in the near future, potentially propelling further demand for ULTA's products.
U.S. Consumer confidence (tradingeconomics.com)
Before moving on to our next section, important to highlight that the company has revised both its revenue and EPS outlook upwards for 2023.
Margins
While in our previous article we have been praising the firm for managing to expand the margins despite the macroeconomic headwinds, now we cannot do so anymore.
In Q2 2023, margins have been contracting, due to the rapidly increasing cost of sales, higher inventory shrink, higher supply chain costs and higher SG&A expenses, including higher corporate overhead due to strategic investments, higher store payroll and benefits, and higher store expenses.
Gross profit increased 7.1% to $993.6 million compared to $928.2 million in the second quarter of fiscal 2022. As a percentage of net sales, gross profit decreased to 39.3% compared to 40.4% in the second quarter of fiscal 2022, primarily due to lower merchandise margin, higher inventory shrink, and higher supply chain costs, partially offset by strong growth in other revenue and leverage of store fixed costs. Selling, general and administrative (SG&A) expenses increased 12.4% to $600.7 million compared to $534.5 million in the second quarter of fiscal 2022. As a percentage of net sales, SG&A expenses increased to 23.7% compared to 23.3% in the second quarter of fiscal 2022, primarily due to higher corporate overhead due to strategic investments, higher store payroll and benefits, and higher store expenses, partially offset by leverage of incentive compensation.
The following chart shows how the margins have been developing in the past quarters, to illustrate how the profitability of the firm has been evolving.
While the margins have been fluctuating in the past years, the current readings are still comparable to the past averages. For this reason, we do not believe that the recent contraction poses a significant concern in terms of profitability deterioration.
Looking forward, important to assess what factors could be shaping the profitability.
Inventory
In the past quarters, many retailers have been struggling with inventory management issues. While ULTA's inventory has also increased year-over-year, it is more or less proportional to the increase in sales, therefore we do not see inventory management as a significant risk in the coming quarters.
The increase was primarily due to inventory to support higher sales demand, 37 net new stores, product cost increases, and new brand launches.
As a result, it is not likely that significant discounting would be needed to get rid of excess/obsolete inventory, which means that there should be no downward pressure on the margins.
Balance sheet (ULTA)
Inflation
Inflation is naturally another factor that plays an important role in how costs are going to change in the near future. While the most recent readings are still relatively high and far above the long term target rate of ~2%, there has been a clear down trend since the peak in Q3 2022.
U.S. Core inflation (tradingeconomics.com)
We believe that the Fed's aggressive stance on combating inflation and raising interest rates is likely to make this trend continue further in the near term. For this reason, we believe that costs are likely to start moderating in the coming quarters, potentially leading to less downward pressure on the margins.
Returning value to shareholders
In 2022 our third reason for being bullish about ULTA's stock has been the firm's commitment to returning value to its shareholders. While the company still does not pay dividends, they have continued to spend a significant amount of money on buying back their common stock.
Share buybacks (Seeking Alpha)
In general, we consider share buybacks attractive as in some cases these can be a more tax efficient way of returning value to shareholders, and it also may signal that the firm considers its outstanding shares undervalued. In some cases, it can be also a negative signal that the firm does not have enough profitable opportunities to pursue, but we do not believe that this is the case for ULTA, as they have shown impressive growth in the past years.
For this reason, we remain bullish on ULTA from this perspective as well.
Conclusion
Despite the challenging macroeconomic environment, ULTA has once again managed to increase its sales, comparable sales and EPS. The firm has also updated its full year 2023 guidance in the positive direction.
Due to the increasing cost of sales and SG&A expenses, however, margins have slightly contracted year-over-year.
The firm has remained committed to return value to its shareholders in the form of share repurchases.
Because of the recent price decline, ULTA has become more attractive from a valuation point of view than it was in late 2022. While the stock still trades at a premium compared to the consumer discretionary sector median, it is trading at a significant discount compared to its own 5YR averages.
Price multiples (Seeking Alpha)
For these reasons, we maintain our bullish view on ULTA.
For further details see:
Ulta Beauty: Why We Maintain Our Bullish View