"Wisely, and slow. They stumble that run fast."- William Shakespeare
I have recently opened a short position in Ulta Salon (ULTA). The logic behind this trade is not that complicated. On a top-down level, Ulta falls within a category of stocks, namely hot momentum retail, whose time to become market underperformers has finally arrived. And from a bottom-up view the company's shares are both absolutely and relatively expensive, key metrics look to be starting to taper off or reverse after a period of multi-year outperformance, and the store count is starting to reach what looks like an intermediate saturation point. Consequently, I expect the stock to fall 25% from its recent highs.
A Momo Retail Correction
Lululemon (LULU), Under Armour (UA), Whole Foods (WFM), Chipotle Mexican Grill (CMG), Ulta, Michael Kors (KORS), and Coach (COH) are all perfect examples of stocks that fit into the same category. They are hot momentum retail names that share the following common traits.
1) Strong Same Store Sales Trends since 2009
2) Expanding operating margins since 2009
3) Robust revenue growth since 2009
4) Exceptional EPS growth since 2009
5) Story stock cult following appeal based on the "I walked into the store and it was busy as hell" approach to investing
Put these five factors together and you should not be surprised to discover that all these names trade at eye popping multiples. But there is a pretty good explanation for this. Outside of Michael Kors, which is a recent IPO, all the above-mentioned stocks got absolutely obliterated in late 2008-early 2009. Lulu's shares saw $2, Under Armour $8, Ulta $4, Coach $11, Chipotle $35, and Whole Foods even reached $7.
Pretty crazy prices when you consider that these brands were all (Whole Foods excluded as it was experiencing some liquidity issues) just starting to heat up when the financial crisis arrived. Now if you fast forward about three years exactly from the bottom for most of these names you'd discover that this whole group started peaking out this past spring. This peak has not been driven by any major blowups, but rather by the simple fact that the comparables for most of these names have gotten a lot tougher. Not really a problem for most stocks, but for a momentum train with lofty multiples that is all you need for a valuation reset. Coach was the first to crack, then Chipotle, and now it would seem the timing is ripe for the whole gang to correct.
On a sector-wide basis, I had up until recently been focusing most of my short selling on the tech space. Since Sept 14th, shorting tech stocks has been for the most part like shooting fish in a barrel. But as is often the case with sector-wide issues the first month or so is easy, but after that things get a lot trickier. To me tech is no longer a compelling sector-wide short. The networking names have taken their beating, Web 2.0 now looks like an IPO graveyard, the short everything related to the PC trade has been milked to the extreme (unless you're parked in MSFT and waiting for the inevitable cracks to emerge), the iPhone ecosystem has been blown up (SWKS, CRUS, AAPL, etc.), and pretty much every big cap technology name you can think of has taken a decent beating (INTC, GOOG, IBM, VMW, EMC…..). The same can't be said of the momo retail space. Up until late last week most of the group had been doing fine and flirting within striking distance of all-time highs. But after Whole Foods' earnings, the bleeding started to pick up, and I frankly expect it to continue for at least a few more weeks, if not into the early part of next year.
What to Look for When Shorting this Space
1) Pay very close attention to same store sales on a relative and not absolute basis. Hot retail names go through stretches during which comparable sales explode. When you get a couple of quarters that indicate the rate is start to flatline you know tougher comps are coming.
2) Pay close attention to operating margins. When a retail brand is hot operating margins expand consistently and can reach freakish outlier status. While not always the best indicator, getting a feel that robust margin expansion is ceasing really helps timing an entry point.
3) Listen carefully to management's tone as it almost always tips off when one robust expansion phase is coming to an end. Anyone listening to CMG's April conference call got all the warnings they needed from management about where comps were heading. Things like 'we are going to be facing tougher comps' or 'focusing more on product investment instead of chasing revenue' are good examples of leading indicators.
If you do all of the above, figuring out when to short or exit a long in such a stock should be somewhat easier. Also, know the investor base you are dealing with. Hot brands are not owned by value investors. They attract the momentum crowd which is always looking for headline beats and raised guidance. These investors are paying no attention to anything else, and are quite a fickle bunch. So, you need to be a little early beating them to the door, because when they decide to leave they do so in hurry.
Ulta is an interesting retail brand. They discovered a gap in the beauty products retail market and have managed to fill it rather quickly. They are basically a one-stop beauty shop. On one side of the aisle a female shopper can find cheap drugstore brands, and on the other side of the aisle high-end brands usually reserved for department stores, beauty supply boutiques, or chains like Sephora. And unlike a Sally Beauty Supply (SBH), which operates more like a mini-Costco (COST) for cosmetologists, Ulta caters directly to the beauty consumer with every store offering make up artists, salons, and samples. The net result of all of this has been phenomenal growth over the last 4 years.
Same Store Sales
Revenue Growth yr/yr
Eps growth yr/yr
As you can see from the above table, Ulta has been growing at a rather rapid clip. By the end of this year, Ulta will have completed a four year stretch in which revenues grew 83%, net earnings 294%, operating margin 100%, and store count 59%. That's the good news. The bad news is that this rapid rate of growth is now in the past, but the stock hasn't started to reflect that yet. At present ($95 a share as of writing) Ulta's $6.1 billion market cap places the stock at a rich 37x 2012 estimated eps. That means Ulta's current 489 stores trade at roughly 26x trailing twelve month operating profit or are worth about $12.2 million a piece. And the tough valuation metrics don't stop there; Ulta trades at an EV/EBITDA multiple of 18.5x. Not exactly off the charts for a growth stock, but pretty pricey when you consider Sally Beauty Holdings fetches closer to 10x EV/EBITDA and has seen same store sales growth of 7.1% ytd. Add in that Sally's Beauty Supply store network is much more mature and generating nearly twice the operating margins and my argument starts to make more sense. Basically, you can make a compelling case that there has been more of an industry/macro tailwind here that is not being properly accounted for in Ulta's current share price.
Getting the Timing Right
Shorting a stock like this requires excellent timing, and my rationale here is that last quarter's report was a decent signal of a top. Same store sales declined by 200 bps year over year, the first drop of this magnitude in over four years. Furthermore, a big reason for this decline was a sharp drop off in traffic which came in at up 6% versus 11% a year ago. This slow down in comps will persist for the next couple of quarters as Ulta's growth reverts closer to management's longer term 3-5% target. Based on the current 8% full year 2012 guidance, Ulta's second half comps should come in at 6.3%, which would be down about 500 bps over the same period last year.
Some Other Things to Consider
Customer Service - Do enough digging and one of the most common criticisms of Ulta when compared to its peers is that customer service in the stores is lousy. Now you are not going to base a short thesis on bad customer service, but in Ulta's case this does matter more than you think. High-end Department stores, Bath and Body Works, and places like Sephora have generally done a good job of distinguishing themselves on high quality service for the sensitive female beauty shopper. Ulta's one-stop shop approach with 10,000 square foot stores makes providing the same level of service very difficult, and this is a problem because the Ulta shopper typically comes in expecting help unlike the experienced beauty supply buyer that might frequent a Sally Beauty Supply store. To address this issue, Ulta would most likely have to sacrifice margins. I also see this as a problem that will only be compounded by the rapid rate of store openings they are presently embarking on.
Industry Fragmentation - Kind of like one of my core issues with Netflix (NFLX) dominating online video on demand, beauty products, like premium content, will always be a somewhat fragmented market. You will always not be able to find something at one place that you can find at another, and that limits growth. The same goes for Salon services, people are reluctant to change where they get their hair or nails done, and superstore salons will always have a quality bias hurdle to overcome.
Aggressive Expansion - Ulta recently upped their total addressable market size to 1200 stores from 1000. These increases in TAM's usually happen once a management team realizes they have been expanding so quickly that they are approaching what looks like a maturation point. Consequently, they up their targets to send a message to the market that there is still plenty of growth ahead. By my experience, these shifts usually mark a pretty decent cycle growth peak. However, even assuming that is not the case, I think one needs to be quite cautious with respect to a company that has expanded its company owned store base this quickly. Execution problems tend to pop up, and with Ulta set to open a record 52 stores this quarter, I would not be surprised to see some headaches start to develop. Brands often dilute themselves by not taking a more measured approach to growth, and from a red flag perspective Ulta presently fits that bill.
I expect this stock to trade into the mid $70 range by the end of the year. As for the rest of the bunch, I am not shorting Coach or CMG because I have no issues with their valuations anymore. I can't say the same for UA (most overvalued), LULU (most vulnerable), WFM (least stressful for now), or KORS (very pricey). Though I will say Kors remains the hottest brand around so I'm in no rush to bet the farm against it here despite the fact that I don't like the whole space now.