Shares of beauty product retailer Ulta (NASDAQ:ULTA) have been flying higher of late, touching a new high on Friday. But the stock's run looks extended to me due in no small part to the company's flat margins. After Q4 earnings, investors have bid the stock up aggressively in the hopes that the company's incredible run of higher comps and margins will continue. But I see cracks in the armor of Ulta's margin growth and that presents a problem for the company's expected earnings growth.
As a note, all data points for this article were taken from Morningstar.
Up first, we'll take a look at the last five years' worth of gross margin data for Ulta to get a sense of its product margins.
We can see a couple of things here that I think are equally important. First, the company's gross margins are fairly low at only 35%. That level is even low for a retailer that sells mostly commodities but is especially low considering that Ulta private labels some merchandise, products which ostensibly have higher margins. Ulta is in a competitive field but its gross margins have always concerned me.
The second thing we can notice is that Ulta's product margins don't move. The last five years' worth of gross margin points are contained in a 60 bps range, microscopic by the standards of other niche retailers. That means Ulta has no levers to pull to grow gross margins because if it did, it would have pulled them already. During this time period, the company has grown exponentially and should have picked up some supply chain and/or procurement leverage but it hasn't; I think this puts a significant dent in the bull case considering the valuation at present.
In addition, the other half of operating margins - SG&A costs - are also mostly stagnant.
While it is beneficial that Ulta's SG&A costs aren't rising as a percentage of revenue, its heavy spending on incentives and marketing keep the level in the 22% area. We can see that the low was put in during 2012 and hasn't been seen since, and while Ulta's current SG&A spending level is certainly fine, it isn't providing the company any leverage in terms of operating margins.
If we combine the two numbers, we can get the spread between them, which approximates operating income.
Unsurprisingly, the company's operating earnings have been flat to down for the past four years as it continues to spend commensurate with its revenue increases and gross margins barely budge. That means the company's EPS growth has to come from revenue or buybacks because operating margins are providing zero growth or less in some years.
So Ulta has flat operating margins, so what? The problem is that current estimates don't allow for such things. Ulta's EPS growth is slated to come in at a 3% premium to revenue growth this year and a 5% premium next year. The company's buyback program is token at best so while that will provide 100 bps or less of EPS growth, the bulk of it would need to come from operating margin expansion. But given Ulta's propensity to spend commensurate with its forecast revenue level, how is that going to happen?
Flat product margins and spending that gains zero leverage year after year is a problem for a company that is expected to produce operating margin gains. Ulta - as great as it has been - has shown no ability to accomplish such things, and at its current valuation, that presents a problem. Even a slight miss on EPS could send the stock tumbling because it is certainly priced for perfection. I don't believe that Ulta has some magical levers it can pull to grow operating earnings because it never has in the past and that means Ulta's EPS targets are at risk. While it is hard to short a stock that is hitting new highs, I think an abundance of caution is warranted at these levels to be sure.
Disclosure: I/we 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.