Makeup Cannot Cover Up The Overvaluation At ULTA

| About: Ulta Salon, (ULTA)

Summary

E-commerce growth for beauty products is growing rapidly.

Online sales growth will see tremendous competition in the long-term.

ULTA’s stock will come down when sales growth underperforms.

Ulta Salon, Cosmetics & Fragrances (NASDAQ:ULTA) is well-covered by analysts and management as a mid-cap growth story. The stock continues to break 52 week highs and is up 41% year to date. While the company maintains an interesting story, the equity is not an attractive buy at its current price. Investors are overpaying for the retail business at e-commerce growth prices.

Company Background

Ulta is a specialty retail beauty chain with 874 total stores across the United States. Ulta's mission is to be a one-stop shop, holding all the beauty, cosmetic and hair needs anyone could desire in one convenient location. The company was founded in Illinois originally as a drug store in 1990. Ulta's recently appointed CEO, Mary Dillon, has a wide variety of consumer retail experience, ranging from McDonald's to PepsiCo, making her well-equipped to manage the corporation.

The company now offers more than 500 brands within their store, the most popular of them being Bare Minerals, Coty (NYSE:COTY), Estée Lauder (NYSE:EL), L'Oréal (OTCPK:LRLCF) and Procter & Gamble (NYSE:PG). Within this product mix, Ulta has established their own brand which makes up for about 6% of total sales.

The beauty industry is a $127 Billion market in the U.S., with $74 billion in the beauty product market and $53 billion in salon services. Ulta's revenue stream is made up of 5 different sectors selling over 20,000 beauty products: cosmetic, fragrances, skin care, salon care/nail care/ hair care, and other. The breakdown of Ulta's profits is as follows: 41% skin care/hair care/nail salons, 11% skincare, 10% haircare,10% cosmetics, 5% fragrances, and 23% other. A lure for new customers has been Ulta's ability to operate hair salons within retail stores, widening its product mix. Speak to any cosmetics buyer (mostly women) and they will always tell you to try before you buy. An excellent model that has worked wonderfully at Ulta salons.

Ulta's loyalty rewards program, Ultamate Rewards, has been drawing customers back to its store versus other competitors such as Sephora (J.C. Penney), Sally Beauty Holdings (NYSE:SBH), and Macy's (NYSE:M). Ulta has more than 19.4 million customers enrolled in its rewards program, offering discounts and deals exclusive to its members sent via text message or email. Member transactions makeup for over 80% of total Ulta sales. The company has also mimicked a loyalty strategy found at many large retail anchor stores: Ulta private branded credit cards.

It is worth mentioning that Ulta salons have a unique characteristic where you will find 90% of the locations are stand alone or outside of shopping mall centers. This would be a failing strategy for many retailers but has proved successful for Ulta.

Ultra Earnings

The company recently announced impressive first quarter results back in May with a 23% increase in sales. Best said from Mary Dillon, CEO, "We are off to a phenomenal start to the year." Comparable retail sales grew 13% while e-commerce jumped up 38%. Growth in retail always comes at a cost; increasing inventory purchases. 89 net new stores have resulted in $180 million more inventory with average inventory per store increasing 14.5%. The company has been able to operate more efficiently by increasing margins by 150 basis points this last quarter.

With the e-commerce platform, Ulta is able to mimic the Amazon model. Customers would prefer to shop virtually with 20,000 products available on-demand then the pre-selected inventory available in retail. This large selection of inventory gives consumers the feeling they are shopping at a niche version of Walmart/Jet.com or Amazon. E-commerce sales are growing at an astonishing +30% rate, quarter over quarter, but they are only ~5% of total sales. As a tech enthusiast, it is important to note that more than 50% of the website traffic is via mobile.

Investment analysis

A huge advantage Ulta maintains is that they have almost no long term debt and managed to stay cash-rich since its IPO in 2007. For any investors, this is a huge plus because of the strength of the balance sheet. Unfortunately I found a few underlying problems that could be serious for growth investors in the future: sales growth, # of new stores, and the share repurchase activity.

The company did provide guidance that sales growth will be 10-12% and e-commerce growth will be in the neighborhood of 40%. Past quarters had sales growth above 20%, suggesting a significant drop in future revenue. Real estate activity in the first quarter also showed that new stores dropped to 13 in Q1 2016 when compared to 24 new stores, year over year, in Q1 2015. Although Ulta believes it is still on track to open 100 new stores by the end of 2016.

Also a $425 million share repurchase program was announced in March 2016 in which $200 million was spent to buyback stock. Fortunately the stock has had quite the upward run in the past few months, making the repurchase very profitable but what's to say for the remaining $219 million? At $260 per share, the company could lose significant value if the stock price moves against them, which is likely at the current valuation.

Conclusion

I have not been able to identify any near term catalysts to qualify this as a short but investors be aware that a slowdown in growth will result in a drop of the stock price. With a simple DCF model, a 18-20% sales growth for the next five years would imply a stock price at $190-200, with an 18x EBITDA multiple. In the most recent guidance, the CEO stated annual growth rate will be closer to 10-12%. Growth at 12% would cut the stock price in half to $130 per share. Since this is primarily a brick and mortar retailer, it makes sense to mention that Sally Beauty Holdings, Macy's, J.C. Penney, and Nordstrom (NYSE:JWN) trade at 9x, 5x, 10x, and 6x EBITDA, respectively. At 22x EBITDA, Ulta trades more like Amazon (NASDAQ:AMZN), 35x, than a traditional retailer (Source: Yahoo! Finance).

I like the growth story but the company's valuation does not justify a buy here. If you are a current investor or short shares of Ulta, it is worth noting that second quarter earnings will be released on August 25th.

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.

Additional disclosure: At the time of this commentary Vijar Kohli, his family and/or clients of Golden Door Asset Management held no positions in the stocks mentioned - although positions can change at any time. Vijar Kohli is the Portfolio Manager of Golden Door Asset Management, LLC, a registered investment advisor specializing in individual and high net worth individual private wealth management. For more information on investing with Golden Door Asset Management, LLC please visit our website, www.goldendoorasset.com. Golden Door Asset Management, LLC is a New Jersey LLC, with its principal office located in Manalapan, NJ. Vijar Kohli is also the publisher of CareStocks, a newsletter focusing in on healthcare services, medical equipment, technology and real estate stocks. More information to the newsletter can be found at www.carestocks.com. © 2015 Golden Door Asset Management, LLC. All rights reserved.

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