Ulta Q1 Earnings Reaction: All Dressed Up With Nowhere To Go

Summary

• Ulta Beauty reported a predictably bad first quarter, with a loss of $1.39 per share and a Y/Y revenue decline of ~33%.
• Not only were stores closed, Ulta also faced an additional headwind - with nowhere to go, there was simply not as much demand for cosmetics.
• Moving forward, stores are already reopening and more importantly workplaces, events and society as a whole are slowly reopening, meaning demand for cosmetics should normalize.
• The crisis seems to have also accelerated Ulta's already promising push into omnichannel and interest in its Augmented Reality offering, GLAMlab.

At this point, we're all familiar with the "work from home" trade, a previously unlikely combination of SAAS stocks like Slack (WORK) and Zoom (ZM) mixed with pizza deliverers like Papa John's (PZZA) and Domino's (DPZ) which have outperformed the market. We also all know the flip side of this trade where retailers of all stripes have suffered declining revenues as a result of the shutdowns/closures related to the COVID-19 pandemic. Let's be honest, if someone hasn't, they probably wouldn't be reading Seeking Alpha, so there's no need to take a deep dive into that theme here.

While big box retailers selling consumer staples like Walmart (WMT) that have been able to stay open and serve the public have thrived, it really should be no surprise to anyone that sales at other types of "non-essential" retailers have declined, as they literally have not been able to open for business and foot traffic has been non-existent. This is an obvious headwind facing retailers in the "consumer discretionary" space.

Q1 Performance

Image Source: Globalcosmeticnews.com

Ulta Beauty (NASDAQ:ULTA) is one such company (I've previously written a longer/more in-depth description of Ulta's business which you can read here, as this article is meant more to serve as an update on the current situation). Ulta reported Q1 results after the bell on May 27th, and results were ugly, although again that is what one would expect, as the company closed all of its stores on March 19th. The company saw year-over-year revenue decline by 32.8%. The typically profitable company reported GAAP EPS of -$1.39, missing analyst estimates by $2.17. While there is the aforementioned obvious reason for this, there's also an additional "demand killer" right now that is hurting Ulta specifically - so what is it and why am I feeling optimistic?

Nowhere to Go - the Crocs Factor

Not only does Ulta have its stores closed - unlike other retailers such as, for example, Wayfair (W) or Lowe's (LOW), the pandemic and its associated closures have also killed a lot of the necessity for its key products. To understand why, I want readers to think about Crocs (CROX).

Image Source: Crocs.com

It's telling that Crocs was the only top-30 footwear retailer to see an increase in sales last month - confined to their homes, people aren't buying expensive dress shoes or high heels; they are buying and wearing comfortable, brightly-colored plastic clogs. Even better, not only are people buying more, but now there's also the added bonus that they don't have to worry about snide comments since no one sees them wearing them! While this unprecedented time is perhaps the ideal environment for a business like Crocs, it is less than desirable for companies like Ulta which traffic in goods that people, in essence, use to improve their appearance for the public eye. Think of it as almost the anti-Crocs!

With a large number of people "working from home", consumers are understandably "dressing down" as the new normal. Not only are people working from home, but events like weddings, proms, graduations and even just informal events like birthday parties or get-togethers have been canceled. I obviously don't want to speak for women and recognize that they are far from a homogeneous demographic (quite the understatement, I know!), but if a large segment of women aren't going into the office, aren't attending events like weddings and graduations that have been canceled, and aren't even able to go out for dinner or a night out on the town with friends, they aren't going to be buying as much makeup. It may seem simplistic, but think about what a powerful headwind that is for a company where cosmetics make up 51% of its merchandise! Why would women use (and thus buy/replenish) makeup when they are stuck at home with nowhere to go and no one to see?

The Good News

The good news is that this is a well-positioned company facing a fleeting headwind as opposed to a struggling company facing a structural one, such as Hertz (HTZ). Most states, outside of the hardest-hit areas of the country, are slowly reopening and people are returning to businesses that were previously closed. As things reopen, Ulta seems to have a sensible, flexible approach to reopening its 1,264 stores and should stand to benefit from pent-up demand.

On the Q1 earnings call, CEO Mary Dillon outlined the progress Ulta has made thus far in reopening its stores in various stages: "Last month, we began the reopening process with the launch of curbside pickup. And on May 11, we reopened 180 stores to guests, including many with salon services. As of today, 840 Ulta Beauty stores or about two-thirds of the fleet offer curbside pickup. 333 stores or about a-quarter of the fleet are open to guests for retail, and 283 of those stores are open with salon services. While it's early in the reopening process, we've seen stronger-than-expected sales in reopened stores, and we're seeing great guest engagement with our salon services with many appointments booked several weeks out." (Speaking for myself, I know I am getting desperate to get a haircut once barbershops open again, so I'm not surprised that Ulta is booked!).

This last part is particularly important. In my original Ulta article, I discussed how a large part of what would drive the company forward in the future and differentiate it was its in-store beauty services like salons and "skin bars". (To summarize: these in-store experiences are a key to Ulta's growth because guests using these services are typically spending 3x as much as typical customers. These services also make Ulta a destination for shoppers increasingly looking at shopping as an "experience"). Obviously, due to the risks of spreading coronavirus, these "high-touch" aspects of the business will have to reopen more cautiously, but should eventually lead to better comps and accelerated growth once demand normalizes.

Push Towards Omnichannel and AR Accelerated

Another thing I liked about Ulta was that it was investing in augmented reality as a way to increase business, which seems like a good idea since customers like to "try out" and experiment with beauty products and see how they look before buying them. This could end up paying off sooner than expected. On the Q1 earnings call, CEO Mary Dillon stated that "the opportunity to test and play is an important part of the beauty shopping experience… while we've kept most testers on the sales floor... we've made them unavailable for guest use." While this could hurt Ulta if it didn't have an alternative, its GLAMlab tool is a nice substitute. GLAMlab "allows users to virtually discover and try out thousands of beauty products. Since the crisis began, guest engagement with the tool has increased nearly five times, and more than 30 million shades have been tested virtually." The situation seems like a boon for GLAMlab. This has increased customer engagement for Ulta, and I would imagine that many of the people who tried out GLAMlab during the crisis will continue using it.

Similarly, the crisis has helped to increase customer engagement with Ulta's online business, prompting many customers to try online for the first time. Dillon stated that "We're also very pleased to see that a large number of previously in-store only members engage with us online for the first time. Our omnichannel guests historically have had very strong engagement with Ulta Beauty with nearly three times the annual spend of an in-store only guest. So we're excited about the opportunity to maintain strong engagement with these new guests that are shopping in our omnichannel format as our operations fully reopen."

Dillon believes that this investment in AR and omnichannel will pay off and that many of these first-time users drawn to online by the crisis will stay, saying that "over the last few years, we've invested to expand our digital and omnichannel capabilities. As a result, we've delivered double-digit growth in e-commerce sales. COVID-19 has hastened channel shift across retail, and we believe much of this new consumer behavior will be sticky. So we're focused on how we can move even faster to win in an omnichannel world." CFO Scott Settersten noted that comp e-commerce sales increased over 100% for the quarter. Given this, it seems prudent that Ulta is increasingly leveraging this omnichannel strategy, including pulling forward the completion of its "fast fulfillment" center in Jacksonville, Florida, and expanding its ship-from-store capabilities.

Valuation, Risks and Conclusion

I previously recommended Ulta at $272 at the end of January, shortly before the coronavirus pandemic hit U.S. shores. While the stock price has decreased since then, it has held up better than I would have expected given the circumstances, trading at ~$241 at the time of writing. The stock was down ~2% after the earnings announcement but has bounced back since then. I was hoping for a further irrational drop so that I could add more shares and lower my cost basis, but at the $240 level, about 12% below my original article, and with the dual factors of a global pandemic starting to recede and investments in omnichannel/e-commerce/in-store experiences/AR beginning to bear fruit, I feel that Ulta is a better, long-term investment now than when I first wrote about it in January. (I wish I wrote/bought it at the end of March, but it can be difficult to be that nimble all the time!).

Data by YCharts

As I've made the case that cosmetics sales should pick back up when people have places to go again, the primary risk to this investment thesis would be a resurgence in the pandemic leading to workplaces, events etc. (as well as Ulta stores themselves) being closed for longer than expected or shutting down the economy again. Additionally in the risk/downside department, on the call, Ulta's CFO mentioned that the company was going to be slowing down the expansion of new stores and reassessing how many new stores it would be opening in the future. However, with the focus on investment in e-commerce and fulfillment, perhaps this wouldn't be a bad thing as the company could derive more sales from existing stores.

Lastly in terms of risks, it is always important to look at a company's debt. Leading up to the current situation, Ulta had no significant long-term debt. In response to the crisis, Ulta drew $800 million from its credit revolver, although this seems more like a sensible move to preserve liquidity during the uncertain environment and something that the company can pay off easily enough as opposed to a serious risk.

In conclusion, while this article isn't catching Ulta at its lowest point, I believe that as it reopens stores and its consumers have more places to go, demand for cosmetics will normalize and it will have good leverage to the upside, further bolstered by its e-commerce/omnichannel strategy and its investment in a sticky augmented reality app.

Analyst’s Disclosure: I am/we are long ULTA. 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.

Investing in equities can involve substantial risk. Potential investors should use this article as a starting point for their own research. Before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. I am not a professional/registered financial adviser; investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. This article is for general information purposes only, and should not be relied upon as a formal investment recommendation.