Ulta: A Play On Department Store Decline

| About: Ulta Salon, (ULTA)

Summary

Ulta has posted significant growth of over 20% annually in the last few years.

The decline of the department store could open up opportunities for significantly more share shift to Ulta over time.

I'm encouraged by what I see and intend to take a position in the stock.

I have been closely following the fortunes of Ulta (NASDAQ:ULTA) beauty and like very much what I see. They key question that I've had is whether Ulta has overshot its market potential and whether it can still continue its impressive growth trajectory.

There's a lot to like about Ulta. This beauty retailer has seen consistent revenue growth in excess of 20% over the last 5 years. Same-store comp sales were recently reported at an impressive 12%, a number almost unheard of in retail! Ulta's net income and EPS have exhibited similarly solid double-digit growth over this period. It's no surprise that Ulta's return on equity has been well into the 20% range for the last 5 years.

I'm also impressed by Ulta's cash conversion. While capex is high, given the rapid store build-out that the company has been conducting, Ulta's operating cash flow has been more than sufficient to cover this capex and still leave significant free cash flow.

There has been a steady expansion of gross margin and operating margin over the last decade, suggesting an element of pricing power and favorable product mix as well as some scale and purchasing efficiencies being steadily introduced into the business.

Ulta represents a high growth operation that is being incredibly well run, based on the numbers the company has posted.

The key question in my mind remained whether this growth can continue and what the key drivers would be. To answer this question, I started with an assessment of the overall market TAM. Ulta's operations are all primarily US stores. The overall market TAM for the US beauty industry is comprised of $74B in beauty services, fragrances and cosmetics. Ulta's share of this market is still relatively small, at just around 5%.

Grocery and pharmacy retailers have made significant ground in terms of capturing market share in the space while internet-based sales of cosmetics are still in their infancy. What is interesting to note is that department store share of the US beauty industry still remains stubbornly high at almost 12%, or roughly $9.2B. The real question remains how much longer this is likely to be, and who will be the beneficiary of the steady erosion in department store retail.

Data suggests that the larger multiline retailers are likely to be unable to stem the tide of decline. These stores represent archaic relics whose various product lines are under attack. Unfortunately, I don't believe that they will be able to stem the tide of steady bleeding that is taking place as their various product lines get picked apart and optimized online. With bloated cost structures, high inventory costs and shoppers looking elsewhere, the future looks grim for these businesses.

Macy's (NYSE:M) and J.C. Penney (NYSE:JCP) are 2 of the larger players in the beauty market. Macy's has been estimated to have over $3B in annual beauty sales, while J.C. Penney has also made significant efforts to ramp its beauty products through its Sephora partnership. The unfortunate reality though is that the impacts of the momentum shift online appear to have already hit these department store chains.

Macy's announced the closure of 40 of its more than 770 stores earlier this year in what is likely the beginning of a series of waves of store reductions. JCP financials paint a bleak picture. While the JCP CEO remains adamant that no additional stores will be closed, the company has struggled to generate any meaningful free cash flow since 2013. This is a trend that is clearly unsustainable, and at the very least, suggests limited capital for enhancement of the store experience.

As the US department store footprint steadily contracts over the next decade, which I believe it will, that potentially leaves almost $9-10B in North American beauty spending that is going to need to find a new home. While some of this will no doubt make its way toward the internet channel, the department store beauty experience is typically a more high touch, personalized "see, touch and feel experience" that doesn't just lend itself well to being shopped online.

I expect much of this lost volume to eventually make its way over to the specialty beauty retailers such as Ulta. In fact, those specialist beauty retailers with the largest footprint are likely to be the biggest beneficiaries. While Sephora could also be a big contender for that volume, its partnership with J.C. Penney, and the location of select stores inside J.C. Penney, could prove to be somewhat of a liability for the company.

Longer term, I believe Ulta likely also has some promising growth opportunities overseas once it decides to move in that direction. Sephora has stores in over 30 countries, which suggests that Ulta's model should translate fairly seamlessly internationally as well.

Ulta has grown significantly over the last few years, posting some very impressive numbers and seemingly unsustainable growth. However, broader structural trends and the steady decline of the department store may actually see Ulta's growth and volume increase steadily for some years to come.

Ulta trades at a rich forward PE of 31x earnings, but for a high quality stock that is growing revenues over 20% annually with solid returns on equity, that's a price I'm okay with. I'm encouraged and optimistic around what I see in Ulta and intend to take a position in the stock for my Project $1M portfolio.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ULTA over 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.