Ulta Beauty Fairly Priced?

Summary

• A once high growth company slows its roll.
• Stock down more than 30% since last earnings call.
• What's Ulta's estimated worth?

Company History

Ulta Beauty is the largest beauty retailer in the U.S. with almost 1,200 stores. Over 95% of the company’s revenues are derived from beauty products. It operates within a highly fragmented and competitive U.S. beauty products market. The market has been growing slowly over the last three to five years at less than 6%, but Ulta has managed to grow sales in the low to high teens over the last three years. Ulta's growth has come from new stores, same store sales and an increasing amount of online orders.

Competitive Advantage

Ulta has been able to achieve this outstanding growth, in such a slow growing market, because of how it sells to the customer compared with the competition. Ulta sells everything beauty related under one roof in convenient off-mall locations. Furthermore, Ulta focuses exclusively on the beauty market whereas most of the competition does not. The results of Ulta's strategy have shown up in the numbers. Ulta in 2008 had market share of less than 3% for the total beauty product retail market, but currently it has a market share of over 7.5%, which is a CAGR of over 10%. This is impressive for such a slow growth market. Ulta's growth has also been very profitable. Its operating margins have averaged 12.9% since 2012. Its ROE has not only averaged over 25% in the last ten years but has recently increased to over 37%. Competitors in the market average 4.4% in operating margins and a 20% ROE.

Growth

To grow sales even more, management says it plans to open another 300 to 500 stores in the next 4 to 6 years (80 stores per year). I'd guess that some of these stores would be in Canada because the U.S. seems to be near saturation point given the U.S. population and current store counts by state.

The company also plans to keep increasing its same store sales by leveraging its loyalty rewards program and continuing to be innovative with product offerings (i.e.; Kylee Jenner release).

Ulta has augmented SSS growth by also driving more customer traffic to its website.

Yes, Ulta's growth has slowed down in the last few years and it appears that the business will not grow as fast as it once had. The slowdown has been occurring over the last couple of years, mainly due to Ulta's size in the U.S. and to negative growth in the cosmetics category within the U.S. Beauty Market. Management attributes the growth decline in cosmetics to less innovation by the major makeup brands. However, given Ulta's strong competitive advantage in the market and no real threat from competition, I'd expect Ulta to continue growing in the low double digits over the next 5 years as they continue to open new stores and capture more market share. Then I expect their growth rate to taper off after 5 years to be in line with the rest of the U.S. Beauty Market (around 3% growth). In ten years, with this kind of growth and no real threat to it's retail business model, I'd anticipate a 10% market share for Ulta versus the 7.5% they have today.

Profit Margins

After expansion into Canada, I don't really see them expanding into any other countries over the next 10 years. Instead of expanding beyond North America, I'd expect management to focus on operational efficiencies to maintain and even improve margins. At the very least, I'm expecting Ulta to maintain their current operating margins. A recession could adversely impact margins in this industry, but on average margins for Ulta should be around 11.5%.  11.5% is what they averaged historically over the last 10 years, even with the Great Recession.

Reinvestment

In order to achieve this growth and margin stability, Ulta will need to keep reinvesting some of their earnings back into new stores, remodels and refreshes, increased levels of inventory and operations in general. Given the past three years of investments in these categories and their plans for new stores, I'm expecting a reinvestment rate of about 2% of sales in the next 5 years, which tapers off to 1.5% in the next 10 years.

Risk

Ulta operates only in the U.S. with a plan to expand into Canada soon. The company has been very successful at growing the business so far and management has demonstrated that they're good at allocating capital. The nature of the business itself, selling beauty products that have long product cycles and frequent repeat purchases, where there's not much cyclicality in earnings, is the quintessential definition of a low risk business. Furthermore, Ulta has no debt and a healthy balance sheet. Given these factors, I'd say that Ulta's equity risk premium should be around 4% to 5.5%. Given where the 10-year treasury bond yield is at, I'm using a discount rate for Ulta of around 6.5% to 7%.

Value

Based on a 10-year DCF model, with the inputs above, I'm getting an estimated intrinsic value of around $235 per share or over $13.7B for the whole company, which equates to a 5% earnings yield given the trailing twelve months of net income.

Looking at this another way, I used an estimated CAGR for diluted EPS over the next 5 years of around 10.5% and a PEG ratio of 1.75 to a get a PE of 18.4x.  Taking this multiple times an estimated FY 2020 EPS I get a value of around $240 per share in the next year and a half.

The stock currently trades at around $230 per share. If the price continues to go lower, which may very well happen if management cannot figure out the slowing cosmetics category in the short-term, this stock could very likely be a long-term bargain.