Ulta Salon - Sell-Off Is Warranted Based On Structural Slower Earnings Growth

Dec. 8.13 | About: Ulta Salon, (ULTA)

Investors in Ulta Salon (NASDAQ:ULTA) are not having a beautiful day after the company is warning for the important fourth quarter earnings and growth into the coming year.

As the company most likely will cut or scrap its long term earnings growth target of 25% next year, investors are readjusting their valuation on the company triggering a violent but well-deserved sell-off.

Third Quarter Results

Ulta Salon generated third quarter revenues of $618.8 million, up 22.4% on the year before. Consensus estimates for revenues stood at $622.1 million.

Net earnings rose by 19.1% to $45.2 million, resulting in diluted earnings advancing to $0.70 per share. Excluding severance charges, earnings per share came in at $0.72 per share missing consensus estimates by two cents.

CEO Mary Dillon commented on the third quarter performance, "The Ulta Beauty team delivered solid top line growth, with particular strength in our on-line sales, despite a challenging environment. We also made significant progress on our growth strategies, including opening a record number of new stores, seamlessly rolling out a new e-commerce site while maintaining strong top-line momentum, completing this year's roll-out of Clinique and Lancôme boutiques, and continuing to launch new and exclusive products and brands."

Looking Into The Results..

Revenue growth was mostly driven by new store openings as comparable store sales growth, those stores which are open for at least 14 months, came in at 6.8%.

On the back of sales leverage, gross margins jumped up by 70 basis points to 37.4% of total sales. It is very disappointing to see operating expenses increase by 120 basis points despite the sales leverage, coming in at 24.5% of sales. Even when excluding one-time severance payments, costs rose by 90 basis points.

As a result, operating income trailed revenue growth. Operating earnings rose by 18.9% to $72.9 million as margins fell by 30 basis points to 11.8% of total sales.

..And Ahead

Fourth quarter revenues are seen between $853 and $867 million, which implies that revenues are expected to increase by merely 13.3% on the year before. Note that last year included 53 working weeks, which "inflated" fourth quarter revenues by some $40 million. Adjusting for this revenues are seen up by 19.6%.

Comparable store sales growth is expected to reaccelerate towards 7-9% on an annual basis, partially thanks to easier comparables on the back of the impact of storm Sandy last year.

Diluted earnings are seen between $1.07 and $1.10 per share, up slightly from the $1.00 per share reported last year which included the $0.05 positive impact from the extra working week. Softer sales trends and a highly competitive and promotional selling season are hurting earnings growth and impacting margins.

Note that analysts were looking for fourth quarter revenues of $893.6 million and earnings of $1.24 per share.


Ulta Salon ended its third quarter with $240.9 million in cash and equivalents. The firm does not operate with any debt, resulting in a solid net cash position.

Revenues for the first nine months of the year came in at $1.80 billion, up 23.3% on the year before. Earnings rose by 22.4% to $132.2 million. Full year revenues are seen around $2.66 billion, as earnings are seen around $200 million.

Factoring in losses of 20% on Friday, with shares trading around $94 per share, the market values Ulta Salon at $6.2 billion. This values operating assets of the firm at $6.0 billion, the equivalent of 2.2 times annual revenues and roughly 30 times annual earnings.

Ulta Salon does not pay a dividend at the moment.

Some Historical Perspective

Despite the strong sell-off, long term investors have still seen great returns. Shares were sold to the general public at $18 per share in 2007 and have steadily risen to highs around $130 in November. Ever since, shares have seen a 30% correction over the past month as shares are still trading with modest year to date gains.

The reason behind these returns is solid growth. Between 2009 and 2013 Ulta Salon is on track to more than double annual revenues towards $2.7 billion. Earnings are seen up five-fold to $200 million this year as dilution in recent times has been limited.

Investment Thesis

In general, shares which see strong momentum are always vulnerable to some sort of a correction, something which clearly happened at Ulta Salon recently. The second quarter earnings report, released in September of this year pushed shares up through the $100 barrier. Shares saw continued gains towards $130 per share in the month following. Yet this third quarter earnings report, accompanied by the poor earnings guidance send shares tumbling below the $100 mark again, with all of this happening in less than three months time.

Back in September, when Ulta Salon released its second quarter results, I had a look at the company's prospects. Trading around $117 per share, I concluded the stock has become too beautiful after strong momentum. I noted that inventory growth by far outpaced revenue growth, although the company explained this on the back of prestige boutique store openings.

Incoming CEO Mary Dillon was hired to boost awareness of the brand and thereby comparable sales growth. The loyalty program and opening of boutique stores are a crucial part of this strategy. The 55 store openings, represents an incredible 44% of total planned openings for 2013, and appear to be putting some stress on the organization.

Despite the long term earnings growth trajectory of 25%, I concluded to play it safe and stay on the sidelines at 33 times earnings at the time of the second quarter earnings. With full year earnings per share growth seen at 14% this year, investors are not pleased. This is even more so the case as the company anticipates similar earnings growth in 2014, far below the 25% long term target.

Therefore, Ulta Salon is evaluating its long term financial plan, and will update the market in 2014. Most likely the long term goal of earnings growth of 25% will need to be revised downwards, putting pressure on the valuation of the firm which is to a large extent based on growth.

For this reason alone, the sell-off does not result in a clear opportunity to me. The slower growth appears to be structural and shares remain anything but cheap at 30 times earnings. I remain on the sidelines.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.