Ulta Beauty is Too Cheap To Ignore

Ulta Beauty (NASDAQ: ULTA) is a retailer defying the odds. While many retailers have struggled since the introduction of e-commerce, Ulta’s sales have risen sharply over the last decade. Its share price has mirrored its business performance, rising nearly 1300% over that time frame, making it one of the top-ten performing US stocks of the decade. But Ulta’s stock lost some of its shine towards the end of last year- with the share price falling 25%-  after the company cut its full-year outlook for 2019.

Investors were also spooked by an industry-wide slow-down in cosmetic sales. But with Ulta Beauty shares trading at only 23 times earnings now, I believe it is way too cheap to ignore.

What caused the sell-down?

The first thing to note is Ulta still remains a fine business. Ulta has consistently won market share from other beauty retailers in the country and that has not changed. The only problem now is Ulta could suffer some near-term earnings volatility due to the downcycle of cosmetic sales in the US.

In the latest 2019 third-quarter earnings conference call, CEO Mary Dillion explained:

“Like other consumer categories, makeup has experienced a number of up and down cycles. The most recent growth cycle began in 2014, driven by new application techniques and looks like contouring, highlighting and brow styling, and new products such as pallets, minis, and travel sizes. The rise of social media influencers, video tutorials and selfies also contributed to strong growth in the category.

After several years of robust growth, the category began to decelerate in 2017 and turn negative in late 2018, resulting from a lack of engaging newness and incremental innovation. This negative trend has continued through 2019 with further deceleration in the most recent quarter.”

But there are reasons to be positive…

Despite the near-term challenges, there are still good reasons to be bullish about Ulta. 

The numbers are still really good

First, even though Ulta had a poor third quarter by its high standards, the company still delivered decent results. Total sales increased by 12% and comparable store sales increased by 6.2%. Diluted earnings per share, excluding last year’s tax benefit, increased by 11.5%.

Despite the decline in cosmetics sales in the broader US market, Ulta still posted low single-digit growth in that category. That just goes to show that Ulta continues to drive meaningful market share growth across the cosmetics category.

According to data for February through July, Ulta captured 24.5% of the prestige beauty market (as tracked by NPD Group, an American Market research company). That’s 2.1 percentage points better than last year.

Cosmetic sales will rebound

Cosmetics remains Ulta’s largest revenue contributor at around 50%, so a market-wide sales decline will no doubt impact Ulta’s business. But the downcycle will eventually come to an end.

Dillion, who has been extremely candid and frank with shareholders, believes that innovation and new products will help aid the turnaround. She said in the latest earnings conference call:

“We continue to believe that the headwinds facing the makeup category are largely cyclical, resulting from a lack of incremental innovation and compelling newness. We remain confident that makeup category will return to growth, but recognize that it will take time.”

Other categories picking up the mettle

Yes, cosmetics is an important part of Ulta’s business but Ulta is not just about cosmetics. In fact, its other segments in total make up about 50% of sales. One of the strongest growth categories in recent years is skincare. Suncare, prestige, and mass-market skincare products each delivered double-digit growth in Ulta’s most recent reporting quarter. 

Gen Z spending habits are also shifting towards skincare as young women increasingly decide to go for a more natural look. The Gen Z demographic is more engaged in skin care products than other cohorts were at the same age.

Haircare and fragrance are also both expanding. The performance of these other categories should help to reduce the impact of the slowdown in cosmetic sales.

Ulta is growing its membership base

At the end of the 2019 third quarter, Ulta had 33.9 million active members in its Ultamate Rewards program. That’s 11% higher than it was last year. The growing member base shows that Ulta is still attracting new customers to its shops.

On top of that, once customers sign up, they receive points, which can then be redeemed for gifts, giving them extra incentives to shop at Ulta.

The beauty segment is not as impacted by e-commerce

While Ulta’s online sales increased by around 20% per year in the latest quarter, brick and mortar sales still make up the bulk of the company’s business.

Fortunately for Ulta, according to a survey by Piper Jaffray, 91% of female teens still prefer in-store shopping for beauty products versus online. Consumers still prefer the in-person experience of testing colours, fragrances, and textures when it comes to beauty products.

As such, until augmented reality (AR) can truly replace the in-person experience, I don’t foresee Ulta losing significant market share to online sales channels.

Rewarding shareholders

Ulta has also been rewarding shareholders by using the cash generated from its business to buyback shares. The total number of outstanding shares dropped by close to 4% in the quarter ended 2 November 2019 from a year ago. With shares trading at a low valuation (I will touch on this later), I think it makes perfect sense for the company to continue using its spare cash to buy back shares.

Ulta is sitting on slightly over US$200 million in cash and has no debt (if we exclude its operating lease liabilities), giving it the financial muscle to continue to pursue share buybacks in the future.

More importantly, its business remains a cash cow. The beauty retail giant generated operating cash flow of US$634 million, US$779 million, and US$956 million in fiscal 2016, 2017, and 2018, respectively. And in the first 39 weeks of fiscal 2019, Ulta’s operating cash flow was up 2.8% from the year before to US$558 million.

The reliable stream of cash flow will enable the beauty retailer to continue reducing its outstanding share count further.

Valuation

As you can see, despite Wallstreet’s skepticism about Ulta, I think there are still numerous reasons to believe its long-term growth is intact.

On top of that, shares of Ulta are trading at what I would consider extremely low valuations. The company expects to earn diluted earnings per share of at least US$11.93 in fiscal 2019. Ulta currently trades at US$273, which translates to around 23 times that earnings projection.

An earnings multiple of 23 is much lower than LVMH (which owns Sephora), Loreal, and Estee Lauder – they trade at 33, 38 and 42 times earnings respectively. 

As such, barring a market-wide collapse, it is hard to see how Ulta can suffer a further compression in its earnings multiple.

More importantly, Ulta’s problems are likely short-term in nature. Cosmetics sales will rebound in the future and in the meantime, other beauty segments are picking up the slack.

On top of that Ulta looks likely to continue to win market share as it targets to open more stores in the coming years.

Over the longer term, Ulta has built lasting brand appeal and partnerships with some of the most loved beauty brands in the world. Despite being a dominant retailer in the US beauty industry, Ulta’s market share in the beauty products market was just 7% in 2018. This small share means the company should have room to grow much bigger.

With all that said, while I think it is reasonable for investors to be cautious about near-term sales volatility, I think Ulta’s valuation and long-term prospects are just too good to ignore.

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