There is no doubt that Ulta Beauty (ULTA) is one of the best retailer stories in this era, as the company has truly earned its reputation, driven by years of simply incredible organic growth as well as store openings. As investors were counting on Ulta to post same-store sales growth as high as, or even in excess of, 15%, the recent slowdown towards the 10% has resulted in a minor disappointment.
Nonetheless that kind of growth remains simply very impressive, as the risk-reward has only improved, in my opinion. This follows the sluggish performance of the shares, which combined with growth has resulted in severe valuation multiple compression.
An Incredible Growth Story
Ulta has delivered incredible growth as the company has grown its sales from less than a billion in 2007 to $5.3 billion on a trailing basis. Even better, the company has grown its operating margins from levels in the mid single digits to percentages around 13-14%. The quality of growth has been impeccable, as most of the growth is driven by very impressive comparable sales growth. Comparable sales have grown anywhere between 8% and 16% in each of the past five years.
The store count has grown to little over a 1,000 as Ulta aims to take a greater share of the beauty market, as there are 70,000 buying places in the US according to Ulta's recent investor presentation. Point-of-sale locations include grocery stores, drug stores, mass merchandise, department stores, and many other outlets. While the company has a small share in terms of the locations at which beauty products are sold, the +$5 billion revenue numbers reveal that the market share in dollars is much more substantial. After all, the total US beauty market comes in at $134 billion a year, as a wide assortment, innovative line-up, loyalty membership, focus, exclusivity agreements and strong e-commerce operations drive the outperformance.
Investors have recognised this growth and earnings potential as shares have risen by a factor of 6 times over the past 10 years. Shares traded at $30 in 2007, and actually fell to a low of $5 during the crisis in early 2009. Ever since, a multi-year momentum run pushed shares up to levels as high as the low $300s in June. Ever since, investors acted with caution and took profits as shares had fallen back to levels in the $230s ahead of the release of the second quarter results. At this moment of writing, shares are trading at $225 per share, down 25-30% from the highs.
Momentum Cooling Down?
After a very strong 2016, in which comparable store sales rose by 15.8% for the year, and by 16.6% in the final quarter, it was pretty close to impossible to duplicate this performance.
Comparable sales growth came in at 14.3% in Q1 of 2017 in what has been a very solid quarter. The company raised the full-year guidance in terms of comparable sales growth by a point to 9-11%, driven by e-commerce growth of 50% versus a previous expectation of 40% growth. Earnings per share growth were seen in the mid-20s. Based on earnings of $6.52 per share in 2016, that growth implied that earnings were seen around $8.15 per share.
While the first-quarter results (released on 25th of May) gave reasons to be upbeat, shares have lost ground ever since. When the company released its second-quarter results late in August, shares had already retreated in the $230s, as the results triggered a negative reaction. Comparable sales growth slowed down to 11.7% in Q2, as the slower pace of growth limited the increase in margins, with operating margins being up 50 basis points for the quarter, coming in at 14% of sales.
The second-quarter results made that comparable sales growth came in at 13.0% in the first six months of the year. The company sees comparable sales growth slowing down to 9-11% in Q3, yet it raised the full-year comparable sales outlook to 10-11%. If the company delivers on 10% growth in Q3, the full-year guidance calls for a slowdown to roughly 6% in the final quarter of the year, or actually a little bit better given that the quarter is seasonally stronger.
Continued acceleration of e-commerce growth could make that earnings per share growth actually come in as high as the high-20s. Based on a $6.52 per share number and 27-28% growth, earnings per share might hit $8.31 hit year. With shares trading at $225, multiples have fallen to 27 times forward earnings at these levels. This marks a near 10 times multiple compression from the +$8 earnings per share guided when shares still traded at +$300 in May.
Buybacks and required capital spending to grow the business have depleted some of the cash holdings, now standing at $273 million. The company has no debt but does have $388 million in deferred rent obligations for a relatively flattish net cash position.
Slower Growth Has Been Priced In?
Ulta Salon is the leader in the beauty space and continues to defy the laws of gravity, like it has done for a long time already, as it is growing its business at an incredible pace. The question is what sales and margins can look like in the future, as I think that margins are at a very high level already.
The company has the potential to continue to grow the footprint by opening more stores, drive e-commerce sales growth and comparable sales growth. Sales growth is currently still trending around 20%, as it seems reasonable to assume 10-15% growth in the coming five years which could result in a near $10 billion business by 2022/2023. At such a point in time, it is easy to argue that Ulta is very established business, even more established as it is today.
If we assume that margins come in at a more normalised range of 10-14%, I see potential for after-tax earnings of roughly $700 million to $1 billion in that case, equivalent to $11-16 per share based on the current share count. This does not take into account cumulative earnings power of $3-4 billion seen in the coming five years, although net capital spending runs at $200 million a year at this point.
That leaves potential for $2-3 billion in repurchases in the coming years, equivalent to retire roughly 10 million shares at these levels. If those buybacks could cut the share count from 62 to 52 million, a $13-19 earnings per share number sounds realistic. At the midpoint of $16 per share and after applying a market multiple + very modest premium, that warrants a $300-350 valuation some five years from now. At the midpoint of that range, that leaves upside of 45% in the coming five years for returns of roughly 8% per year.
No Buyer Yet, Keeping A Close Eye On The Action
Based on the discussions and calculations above, I am attracted to the retreat in the shares, on top of the great business which Ulta is. That being said, I am not attracted to the potential returns going forward yet. If we see a $325 per share as fair value number by 2022/2023, and require returns of 12-15% per annum, I only become a buyer if shares hit the $160-180 range, levels last seen in early 2016.
Given the confidence which I have in the business and its CEO Mary Dillon, I am anxiously waiting a further pullback, as the retreat to the lows $200s in August was not steep enough for me to pull the trigger. Despite some emerging doubts, or perhaps just a reset in terms of valuation multiples, the long-term thesis remains good. This is driven by a strong business, management team and a millennial generation which embraces selfies/experiences/video and social media.
Being able to buy this company with $8.30 per share in earnings power at a 20-times multiple ($160-180 region) seems like a done deal given the strong financial position, competitive advantage, and continued growth prospects.
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.