Ulta Salon, Cosmetics and Fragrance Inc. (ULTA) is both a retailer and a full service salon company, and its stock is on fire. The shares are up 50% year to date and 300% since 2010. A look at the company's 2011 annual report shows a 22% rise in sales, an 11% increase in same store sales, and, perhaps most notably, a 65% increase in operating profit fueled by a 2.8% jump in margins. The company has $294 million in free cash flow and is debt free. Net income grew 55% from 2010 to 2011 and 59% from 2011 to 2012. During the first quarter, the company beat analysts expectations, reporting earnings of 48 cents per share representing a year over year increase of 46%. I could go on, but the point is made: the company is doing quite well.
There are however, some concerns. As usual, my attention was drawn to the stock because of its high price-to-earnings ratio. ULTA trades at 50 times trailing twelve months earnings and nearly 40 times forward earnings. While these numbers aren't absurdly high, they do assume that the company will be able to maintain its current torrent pace of growth.
If it pans out, that growth will be fueled largely by new store openings. The company opened 61 stores in 2011, up 30% from the 47 it opened in 2010. Moreover the company expects its 'new store growth rate' to be around 20% going forward with the ultimate goal being 1,200 stores (the company had just 467 at the end of the first quarter) which, as CNBC's Herb Greenberg has noted,
"Sounds great on paper, but it's unclear how many years such a rollout will take. Four? Five? Too much can happen between here or there, which is why anytime a company puts what a long-term target on store openings you take it with a grain [of salt]."
It is also critical for the company to maintain same store sales growth given that ULTA attributes the 22% rise in sales in 2011 to a substantial increase in comparable store sales:
Net sales rose 22% to $1.8 billion driven by a 10.9% increase in comparable store sales, representing our second consecutive year of double digit comparable store growth.
Fast forward to the company's most recent 10-Q and, on page 13, the company notes that
We do not expect the low double digit comparable store sales increases to continue into the future. Our long-term annual net income growth target of 25% to 30% is based on comparable store sales increases of 3% to 5%.
We can expect then, that net sales will not likely continue to rise at a 22% clip going forward, meaning the company must continue to increase margins to keep pace with its growth targets.
While investors will not know for some time if the company can maintain its growth rate, what the market does know is that ULTA's largest shareholder (Mousse Partners, which is run by one of ULTA's directors) unloaded two thirds of its entire position in May. This position was worth over $600 million.
Lastly, it is worth noting that ULTA uses a weighted average cost method for valuing inventory. During times of high inventory turnover, the weighted average cost method tends to approximate the First In, First Out (FIFO) cost flow assumption more closely than the Last In, First Out (LIFO) cost flow assumption. This is relevant because, as any first year accounting student knows, use of FIFO during times of inflation results in higher net income. Over the past 3 years, the annual rate of inflation was -- .34% in 2009, 1.64% in 2010, and 3.16% in 2011. This is not at all to suggest that ULTA is intentionally manipulating earnings, it is merely an interesting observation and should be treated as such.
To summarize, ULTA looks like a highly speculative play on future earnings growth. The company's plans for new store openings seem a bit too ambitious, the disposal of the large stake by Mousse Partners is worrisome, the expectation of falling comparable store sales puts pressure on the company to continue to expand margins, and its price-to-earnings multiple assumes the company can continue to expand at its current pace. There are too many assumptions here and not enough room for error. Short ULTA or long ULTA puts.