By The Valuentum Team
Who says being beautiful isn't important? Well, if Ulta Salon's (NASDAQ:ULTA) recent performance is any indication, the market for beauty products may never be better than it is today. For those that don't know about the company, Ulta Salon is the US' largest beauty retailer and a key stop for those seeking fragrance, skin care, cosmetics, hair products and salon services. The company that prides itself on "All Things Beauty, All in One Place" is doing a lot of things right of late, and we point to a culture of personalized service and a top-performing rewards and e-commerce (apps) platform for the reasons why.
Image Source: Ulta Salon
Frankly, it's hard not to like what Ulta Salon has accomplished, and its financial performance has been nothing short of fantastic in recent years. Net sales, comparable store sales and earnings per share have all exploded higher, and the massive $127 billion beauty market in the US offers Ulta Salon a long runway of growth. Its associates are engaged, and omni-channel opportunities remain robust. There may be little to derail the company, particularly as it ramps up awareness among consumers. Millennials, for one, are a large and growing segment, and teens tend to prefer Ulta Beauty. The seeds are planted among the young, and the company is poised to grow into a strong oak in years to come.
Ulta Salon's third-quarter 2016 results, released December 1, were absolutely phenomenal. Revenue advanced 24% in the period thanks to a 17% gain in same-store sales, driven mostly by transaction growth, but average ticket was up nicely as well. Very few companies are growing same-store sales anywhere near that pace, and there is no better way to describe the showing as downright impressive. Diluted earnings per share advanced more than 24% in the period, and the company raised its bottom-line guidance for the year as a result, now calling for "earnings per share growth in the high twenties percentage range." We really don't think Ulta Salon could be doing better.
That said, such fantastic performance comes with a hefty price tag -- its stock price. Ulta Salon is trading at nearly 32 times 2017 expected earnings (that's 2017 earnings), meaning investors are paying up for such fantastic expansion prospects. The risk is that any slip up in same-store-sales performance in any given quarter could send the stock tumbling 5%, 10% or more. Ulta Salon has set itself a high bar, and even if it can't meet expectations, the company is in a class by itself when it comes to growth potential.
Ulta's Investment Considerations
• Ulta Salon is one of the largest beauty retailers that provides one-stop shopping for prestige, mass and salon products and salon services in the US. The firm offers a combination of over 20,000 prestige and mass beauty products. The company was founded in 1990 and is based in the suburbs of Chicago, Illinois.
• Ulta Salon is partnering with Google (GOOG, GOOGL) on a same-day delivery program in select markets. Consumers will likely have to pay up for the service, adding significant value to Ulta's e-commerce segment, which is already expected to grow revenue by 40% in fiscal 2016.
• Ulta Salon is doing a lot of things right, as evidenced by its approximately 13 million customers that are members of its loyalty program. The firm's broad selection of merchandise and well-trained beauty advisors are driving customer retention. Its multichannel guests spend 2.4x to 4.3x more than single channel guests, showing the value of a omni-channel approach. Nevertheless, shares look pricey.
• Ulta has shifted its marketing mix away from broad discounts toward its loyalty program and customer relationship management. The strategy appears to have paid off as aided brand awareness has expanded to 84% in 2016 from 61% in 2011. The loyalty program helps drive differentiation, customer retention, and increases sales frequency and spend.
• The company has roughly 875 stores. Ulta Salon intends to expand its presence and grow its store base to approximately 1,200 locations. Adding new products and services, while increasing its digital business are other goals.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Ulta Salon's 3-year historical return on invested capital (without goodwill) is 26.5%, which is above the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Ulta Salon's free cash flow margin has averaged about 3.4% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Ulta Salon, cash flow from operations increased about 15% from levels registered two years ago, while capital expenditures expanded about 32% over the same time period.
We think Ulta Salon is worth $186 per share with a fair value range of $149.00 - $223.00. Shares are too rich for our taste.
The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 16.7% during the next five years, a pace that is lower than the firm's 3- year historical compound annual growth rate of 20.9%.
Our model reflects a 5-year projected average operating margin of 15%, which is above Ulta Salon's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 7.4% for the next 15 years and 3% in perpetuity. For Ulta Salon, we use a 10.8% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $186 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Ulta Salon. We think the firm is attractive below $149 per share (the green line), but quite expensive above $223 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Ulta Salon's fair value at this point in time to be about $186 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Ulta Salon's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $253 per share in Year 3 represents our existing fair value per share of $186 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
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.