Ulta Beauty Stock: Time To Re-Accelerate (NASDAQ:ULTA)

Ulta Beauty (NASDAQ:ULTA) is America’s largest beauty retailing specialist operating over 1,300 stores. Ulta Beauty has shown impressive growth and strong financial performance over the past decade with outstanding returns on invested capital over 30%. Recently, the stock has come down by about 30% this year trading below $400 which could be a good buying opportunity.

Next to a broad decline in the retail sector, analysts expect that growth will slow down because the company has saturated the US market. The market has now re-rated this business as a mature value stock with lower multiples (forward P/E of 15) instead of a growth stock like it was in the past (forward P/E > 20). However, we believe that Ulta Beauty has room to re-accelerate growth with international expansion on the horizon.

Based on our analysis, we rate ULTA as a buy below $400 per share. In the bull case where international expansion plans are announced, we could see substantial future growth and a multiple expansion. In the bear case where international expansion does not happen, there is limited downside because the stock trades around fair value for a mature retail business. While the margin of safety is not as large as we would like it to be for a deep value investment, this is a wonderful business trading at a fair price. The underlying financial performance has been very good even during recessions, and we anticipate international expansions presenting a bright future ahead for ULTA.

Company Overview

Ulta Beauty is a retailer that specializes in selling beauty and self-care products such as cosmetics, skincare, fragrances, and hair care. The company sets itself apart because of its in-store experience with knowledgeable sales staff and in-store services such as haircuts and style advice for women. Because beauty products are more experiential and have high involvement, this specialty status and their in-store experience are important for consumers.

Ulta Beauty is managed well and the company has shown to be innovative. During corona, they invested a lot in their online presence with their website and mobile app with in-store pickup to drive extra sales. Ulta Beauty now has an omnichannel strategy of interacting with their customer through online and offline channels, which I think is a wise move because a lot of engagement and sales growth is happening in online channels. For example, they created an augmented reality app called “GlamLab” to try make-up online using your camera. They also have a well-functioning loyalty program with 95% of their sales coming from a loyal member base, in a somewhat similar model to Costco. Overall, I think that the company has a very good marketing strategy as shown by their loyal consumers who enjoy using their products and services.

While beauty products are commonly labelled as discretionary spending, a lot of women would disagree and see it as priority. Beauty and self-care are high involvement categories that women are happy to spend a lot of time and money on. Spending on beauty products has been resilient in previous recessions, such as during the 2008 financial crisis. The beauty market is very large and expected to grow into the future. The beauty segment is therefore very attractive because it is a growing and resilient sector, with more premium and experiential products, which allows for consistently high margins and more loyalty from consumers who care about the brand and the service experience.

Competitors

Sephora is the biggest competitor of Ulta Beauty in the US, this company is owned by France-based LVMH which is the largest luxury holding in the world. Similarly to ULTA, Sephora has a great in-store experience, a loyalty program, and they have invested a lot in its digital presence. Moreover, Sephora is already active in markets abroad while ULTA is still only active in the US. Sephora is roughly 50% larger than ULTA, for FY2023 they are projecting $15 billion in revenues versus ULTA’s FY2022 revenues of $10 billion. The main reason for this is that Sephora is already a global business with operations in Europe, China, and the US among other markets. They are targeting 20 billion in revenue in five years’ time because of international expansions mostly in China. LVMH does not report earnings for Sephora specifically, but their “selective retailing” segment which includes Sephora grew at 25% YoY in Q3 2023 claiming to be taking market share from competitors.

Sephora recently overtook ULTA as the main shopping destination for teens, according to a recent survey by Piper Sandler. However, ULTA and Sephora were both still miles ahead of the competition as specialty retailers in terms of favorite destination. I would say that Sephora and ULTA are very similar businesses but that there is enough room for both to be successful in the US market. Importantly, Sephora is already active globally and ULTA should follow suit capturing markets where Sephora does not (yet) have a strong position. Sephora is a strong competitor and in some ways ULTA is lagging. Moreover, ULTA does not have a strong international conglomerate like LVMH behind it for special product deals or (financial) support like Sephora has.

Next to Sephora, ULTA is competing against non-specialty retailers such as pharmacy stores (CVS), supermarkets and big-box retailers such as Walmart. Moreover, purely online retailers such as Amazon are popular options for consumers. These players offer a (limited) range of products at cheaper prices, but they are not specifically focused on beauty. As a competitive advantage against these businesses, ULTA offers a superior in-store experience and expertise with their products. As a result, they can charge higher prices and have a more loyal customer base. Moreover, beauty enthusiasts and people with specific needs, such as different skin tones, are willing to pay more and they are also more likely to shop at specialty retailers such as Ulta Beauty.

Financial Performance

Over the past decade, ULTA has grown substantially and it is now generating 4 times the amount of revenues it did in 2012, while at the same time improving its net profit margins to over 10%, which is great financial performance. The stock has therefore increased from $100 a share in 2012 to over $400 per share in 2023 outperforming the S&P 500 index by a large margin. The corona lockdowns caused a one-time dip in the earnings because stores had to close down, but this is hopefully a once-in-a-lifetime occurrence. But even under these extraordinary circumstances, ULTA remained profitable.

ULTA has a pristine balance sheet with little to no debt. The company can easily meet its long- and short term debt obligations with a total debt to equity ratio below 100% and a current ratio of 1.6. Moreover, they have grown their shareholder equity substantially over the last decade and bought back stock to return cash to shareholders. The $2 billion in shareholder equity on the balance sheet now represents over 10% of ULTA’s market capitalization.

Over the last quarter, the retail sector as a whole has been in decline because of headwinds such as high inflation that have reduced consumers’ discretionary spending budgets, and “inventory shrink” AKA increased theft from stories. Despite these negative headwinds, the performance of ULTA last quarter was still very good. The company reported same-store sales growth of 8% last quarter, so even without opening a lot of new stores ULTA still managed to achieve 8% growth which is substantial in the current environment that is very tough for most discretionary retailers. While future growth will most likely be lower than it has been in the past (i.e., >15%), ULTA raised its guidance and projects same-store sales growth numbers around 5% for FY2023. Together with 30 new stores, more online sales, and a collaboration with Target, FY2023 sales guidance is 11 billion up from 10 billion last year for 10% sales growth.

Future Growth Opportunities

Looking ahead, future growth in the US market is limited with already one ULTA store per 200.000 people in the USA. The rate of opening new stores has slowed down substantially to just 30 new stores per year down from an average of 200 new stores per year in the years before 2020. Currently, ULTA operates approximately 1.300 stores located across the US, so opening 30 new stores contributes about 2.5% sales growth.

Despite limited potential for opening new stores in the US, there are more routes for growth. For instance, ULTA is selling more with their new digital channels using their website and mobile app. This online channel is expected to grow at higher rates than the physical channels (>10%) and could help to draw more people to its existing stores by using in-store pickup. ULTA does not report exactly how much of their sales are through online channels, but management suggested that it is an increasing amount on the earnings call.

Finally, ULTA announced a collaboration with Target which helps to increase its stores footprint with limited investments. This marketing strategy was also used by Sephora in collaboration with JC penny and turned out to be a great success for them. ULTA’s CEO plans to do the same with this opportunity:

To expand our reach and introduce new guests to Ulta Beauty, we have formed a long-term partnership with Target Corporation to create Ulta Beauty at Target, a “shop-in-shop” concept that offers a curated assortment of more than 60 established and emerging prestige brands across a variety of categories (ULTA FY2022)

This collaboration with Target can significantly add to the top and bottom line of ULTA, adding about 400 more locations although they are smaller in size than ULTA’s own free-standing stores. ULTA receives royalties from these sales at Target locations, but ULTA does not report exactly how much this is. While we cannot estimate the exact contributions of these “shop-in-shop” additions, it is most likely considerably less income compared to opening free-standing stores because they are smaller and Target probably takes a cut of the revenue.

As of January 28, 2023, Ulta Beauty at Target was available in over 350 Target locations and on target.com. Over time, we expect Ulta Beauty at Target to be in up to 800 Target locations, in addition to our freestanding Ulta Beauty stores. (ULTA FY2022)

Taken together, estimating the impact of these three growth initiatives (i.e., 30 new stores, digital channels, Target colab) together with 5% same-store sales growth, this could easily beat current growth estimates of 5-7.5% per year.

International Expansion Plans

While new digital channels and the collaboration with Target can bring in more revenue, the next big wave of growth will need to come from international expansion. The future sales potential of international markets is very large because North America only makes up one fifth of the global beauty market. The company could realistically double its revenues by capturing a dominant market position in other large and growing markets such as Asia-Pacific or Latin America. These markets are growing and are less saturated than the US and the EU, so they represent large and unaddressed markets for ULTA.

An international expansion to Canada was already planned but it was scrapped because of Covid. Instead of simply going through with it during Covid, they shifted gears and invested in their digital channels which was a very good decision in the end. This decision showed that ULTA has very capable management. Now that covid is behind us, international expansions could still be on the cards for growth ahead starting with Canada as planned originally. There is small note in the FY2022 annual report, suggesting that the company is still considering international expansions for future growth:

Suspension of Canadian expansion. In fiscal 2019, the Company announced plans to expand internationally with an initial launch into Canada. The Company continues to believe international markets provide a long-term growth opportunity. However, as a result of the COVID-19 pandemic, in September 2020 the Company decided to prioritize growth of its U.S. operations and suspended its planned expansion to Canada (ULTA, FY2022)

Canada is a relatively small market compared to the US but a similar one, so it seems like a good first candidate for international expansion for ULTA. Estimating their potential in Canada, using the same store density as in the US of 1 store per 200.000 people, this could be a market for approximately 200 new ULTA stores, which is about a 15% increase in total store count. Additionally, ULTA could consider opening up in Mexico or other markets to grow further. Taken together, the potential of expansion in international markets is huge. If ULTA decides to pursue an aggressive international expansion plan, they could realistically double their revenues from now to 2030 simply by opening a lot of new stores in other countries.

Valuation and Growth Expectations

Analysts are quite negative about ULTA going forward, they expect ULTA’s growth to slow down significantly and margins to contract. Valuation multiples have therefore come down to reflect this more pessimistic growth outlook. Compared to previous years when the company traded well above 20 times earnings, the market has re-rated the company with a forward P/E of 15 putting it in the same range as mature retail companies such as Target.

Down from the past 10 years’ stellar growth rates with a CAGR for revenue of 15% and EPS CAGR of almost 25%, analysts expect the company to start slowing down and grow revenue at just 5% going forward and EPS slightly higher at about 5-10% because of stock buybacks and margin improvements.

However, I think that analysts underestimate the strength of this business and that the company still has a lot of room left to grow. I believe that ULTA is set up for an earnings beat this year with consumers spending big on the holiday season. Moreover, analysts might not be pricing in international expansions because these have not been officially announced yet, but these plans might be on the table for next year and significantly improve growth expectations.

ULTA’s forward P/E of 15 is in line with the general retail industry (e.g., Target), but I believe that ULTA deserves a higher market multiple than the average retail business because of its high returns on invested capital, stable cash flows, higher margins, and strong same-store sales growth. Compared to other retail businesses such as CVS or Dollar General, ULTA has higher margins, a more loyal customer base, and operates in a more attractive segment that has a lot of room left to grow both internationally and domestically.

Anticipating international expansions, we take a more bullish view on ULTA, estimating 10% EPS growth for the next 10 years and adding the $40 of tangible book value per share to the intrinsic value calculation. These assumptions are relatively conservative considering previous growth rates and FY2023 guidance of 10% sales growth with EPS of $25. Using a DCF analysis, we come to an intrinsic value of around $485 per share, against a current price of $380 which is about a 20% margin of safety.

In a more negative scenario, to take care of the downside, we consider a bear case where the company does not expand beyond the US and turns into a mature company. We estimate that the company slows down to 5% EPS growth in the next 10 years and then 3.5% thereafter. We still find that the company is trading around fair value. In this scenario there is not a large downside and the company might start to pay out a 3% dividend yield which will compensate for a possible loss (i.e., 15% dividend yield over 5 years).

Conclusion

Ulta Beauty operates in an attractive segment and it is well managed. The market has downrated this company from a growth stock to a mature business but it still has substantial room for future growth by leveraging their new digital channels and expanding internationally. ULTA has also been impacted by the fact that valuations of the retail sector as a whole have come down because of recession fears with reduced discretionary spending, but the beauty sector has historically been resilient during these times. The 30% drop this year therefore seems excessive and presents us with a buying opportunity.

We believe that the market is underestimating Ulta Beauty and that there is substantial room for future growth and multiple expansion. Announcing a clear international expansion plan next year would increase the growth estimates for this business and possibly lead to a market multiple expansion. The current valuation has a relatively small margin of safety of about 20-25%, but still represents substantial upside. Moreover, aggressive international expansion could result in EPS growth rates substantially higher than 10%, adding to possible upside. Our downside risk analysis indicates that the current price is about fair value in a bearish scenario where the company is maturing and slowing growth, but a re-acceleration of growth could bring substantial upside.

In conclusion, Ulta Beauty is a wonderful business trading at a fair price. If management announces a new plan next year for growth, we could see substantial upward movement but if they don’t then we believe that the stock is fairly valued with limited downside risk. We therefore rate ULTA as a buy below $400 per share because it has a favorable risk/reward ratio.