Sally Beauty, Ulta Or J.C. Penney: Does Ugly Go To The Bone Or Not?

by: Jenks Jumps

In the '90s, the phrase "smokes and cokes" was coined when tobacco and soft drink companies were top performers as investors faced recession. Also on the list? Cosmetics. Yes, beauty, too, is a recession-proof industry.

Our club is a "ladies only" membership. Sometimes we invest in "what we know"; sometimes we learn something new. Recession or not, there's reasonable anxiety around how much longer the markets will climb. It's only natural the subject of recession-proof industries and thus cosmetics and beauty emerged. Sally Beauty Holdings (NYSE:SBH), Ulta Salon, Cosmetics and Fragrance (NASDAQ:ULTA), department stores, drugstores and mass discounters all provide beauty products for consumers. But, do any deserve a spot in the portfolio?

Sally Beauty Holdings is an international specialty retailer and distributor of beauty supplies. It has a segment that retails professional product direct to consumers and a segment providing exclusive product through distributors to professionals. Retail represents 74% of storefronts while professional stores under the name of Beauty Systems Group (BSG) represent 26%. North America hosts 90% of the stores while 10% are operated in the United Kingdom, Belgium, Chile, France, Ireland, Spain, Germany and the Netherlands. Sally is the elder to Ulta, operating since 1964.

Ulta Beauty hit the scene in 1990 with a novel approach - one-stop shopping for all beauty products and services. Prestige products traditionally found only in department stores were offered without the pressure of commissioned sales personnel. Mass products found at drugstores and mass merchandisers were offered right alongside the prestige products to make the shopping experience efficient. Professional products and services were offered as well. As a comparison, Sally stores average 1700 square feet while Ulta stores average 10,000. Sally stores stock between 6,000 and 9,000 unique items while Ulta stocks more than 20,000. Ulta is operating on a growth plan to establish 1,200 stores in the United States and is only 46% complete with 550 stores.

For fiscal year 2012 which ended in September, Sally increased revenue 7.8% to $3.52 billion. Earnings per share (EPS) grew 8.8% to $1.24. Sally generated $298 million in operating cash flow which was used for expansion and $200 million in share repurchases. On March 5th, Sally approved an additional $700 million for buybacks. While Sally refinanced its long-term debt in 2012 garnering better interest rates and maturity dates, it is still a significant and beastly position, especially when compared to debt-free Ulta. Sally has $1.6 billion in debt and only $148 million in cash.

On the other hand, Ulta experienced an ugly truth on February 14th when its CEO departed to take the reins at Michaels. Ulta immediately named an interim CEO. But, shares still dropped 13% on the news and have not yet recovered.

Ulta reports full-year earnings March 14th. It is expected to generate $2.2 billion in revenue for fiscal year 2013 which ended in January. That figure represents a greater than 24% increase. Through three quarters, it has already logged $1.46 billion. On January 4th, Ulta reported holiday sales for seven weeks of the final quarter at $475 million. During the same release, fourth quarter guidance was reaffirmed. Full-year EPS is expected to tally $2.66, an impressive 40% improvement. Yet, the compound annual growth rate (CAGR) for the past five years equates to the same 40%. Ulta, at 7.55%, edges out Sally in profit margin at 7.35%. Revenue and income growth is definitely being driven by store expansion with a CAGR of 18% since 2006. As outlined earlier, Ulta is not even halfway through its plan.

In February, Sally reported earnings for the first quarter of 2013 and missed analyst expectations. Revenue increased 4.7% over 2012 to $905 million. Gross margin and operating margin both expanded. EPS improved to $0.32 compared to $0.29 for the prior year quarter. Analysts were expecting $0.34. In all fairness, Sally's growth in 2012 was record-setting when compared to the prior year. Management did not expect to be able to achieve such levels in 2013 but did still expect low single-digit growth which was achieved. Per the earnings call transcript, the miss was attributable to softness in "merchandise categories that continue to be a challenge".

Another item of note in the call is the observation made by CEO Gary Winterhalter concerning competition with Ulta:

Well, first of all keep in mind that ULTA in their salon professional area is competing in the brands that BSG carries. So if there is any share transfer, it would be from salons in those brands and it would affect BSG's comps, not Sally. So obviously, with the strength of BSG comps, I really don't think a lot of that is happening.

The beauty market in the United States is estimated to be a $100 billion market. If Sally is not experiencing a loss of market share to Ulta, Ulta's share gain may be coming from Macy's (NYSE:M), J.C. Penney (NYSE:JCP), Walgreen (WAG), CVS Caremark (NYSE:CVS), Wal-Mart (NYSE:WMT), Target (NYSE:TGT) or a combination of them all.

Sephora (OTCPK:LVMHF) was founded in France in 1970 and offers a broad range of beauty products in an open environment. The Sephora retail concept more closely resembles Ulta's than Sally's. Sephora opened its first U.S. Store in 1998. To date, over 300 Sephora boutiques have been established. In 2006, Sephora began opening smaller stores averaging about 2000 square feet inside JCP. As well, JCP offers professional salons in 950 of its stores. However, over the past year, the traffic trend at JCP decreased 13%. Contrast a struggling JCP and an Ulta offering a fun and inviting experience and it is easily viable that Ulta picked up market share from JCP. The question is whether Ulta can maintain that consumer's loyalty.

It is certainly no secret JCP is undergoing what could be termed in beauty terms as a makeover. Analysts have even termed the process ugly, even ghastly, as consumers just did not buy into the changed pricing and promotional strategies. But, the key point is that it is still a "process" and the doors aren't closed. If JCP can remake itself into the retailer CEO Ron Johnson envisions, "famous for irresistible style at incredible value every day", JCP could be as attractive a turn-around story as financial or homebuilder stocks. The process is expected to continue through 2016 via store remodeling and merchandising consolidation.

According to Thomson Reuters, analyst projections for long-term growth at Sally is just over 17% based on organic industry growth, store additions, and gross margin expansion. Projections for Ulta are over 24% based primarily on store additions and new product and service offerings. While JCP is expected to deliver negative EPS through 2013 and 2014, its long-term growth projection is 35%.

None of the three offer a dividend nor have plans to do so. Sally is focused on share buybacks and retirement. Ulta is focused on square footage expansion. JCP is focused on recovery. So, investment decisions would be solely based on share price appreciation.

Using YPEG to determine fair values, Sally's current price on March 12th is right on target. Ulta, on the other hand, is priced more like a growth stock at about 5% above YPEG value. With negative EPS, a YPEG for JCP is moot.

A daring investor who wanted extraordinary price appreciation, who was willing to bear the risk and who has money to park for at least five years could wager on JCP's makeover plans and get in at the lowest price since 1990. While Sally Beauty offers an international presence, its projected growth rate is less than the two and it carries a much higher debt level. Even considering it does not yet have a permanent leader, investors interested in an aggressive growth story and subsequent price appreciation would have a better chance with Ulta and its proven track record.

Ugly may indeed go clear to the bone. But, beauty is still in the eye of the beholder. And, each of the three, in its own way, can be viewed as both ugly and beautiful.

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.

Additional disclosure: I may recommend Ulta to my investment club at the April meeting.