INVESTMENT THESIS
We are reiterating our BUY rating on Ulta Beauty Inc. (NYSE: ULTA), a leading retailer of cosmetics and fragrances, with a target price of $295, raised from $255. Despite pressures from the coronavirus pandemic, we expect Ulta’s strong customer base and omnichannel expansion to drive a return to growth in FY22.
Growth in the mass and prestige U.S. cosmetics market has been decelerating following several years of strong growth, and the negative trend is expected to continue in the near term. Cosmetics account for about half the company’s business, and despite recent weak industry trends, Ulta’s market share in cosmetics has grown and further gains appear likely over time. The company has used influencer partnerships, media partnerships, social media and other digital platforms, as well as traditional print and radio advertising, to substantially expand consumer engagement and drive sales- and position itself as the retailer with ‘All Things Beauty, All in One Place.’ It has boosted online sales through the Ultra Beauty app, attracted consumers by offering a wide range of ‘tester’ product samples, and benefited from partnerships with a range of cosmetics and fragrance manufacturers. In addition, the company has used its salon service, which attracts high-spending customers, to drive sales at its brick-and-mortar stores. Ulta is expanding personalization services like ‘virtual try-on’ to hair color, lashes, and skin analysis; on the Ulta Beauty app, it recently launched GLAMLab, a virtual makeup ‘try-on’ experience as well a virtual skin care analysis tool.
RECENT DEVELOPMENTS
On December 3, Ulta Beauty posted fiscal 3Q21 EPS of $1.64, down from $2.23 a year earlier but $0.15 above consensus. Revenue fell 7.8% to $1.55 billion due to COVID-19-related pressures, and came in $10 million below the consensus estimate. Comp sales declined 8.9%, with a 15.4% decline in the number of transactions, partially offset by 7.6% growth in the average ticket. E-commerce comps grew 90% in the third quarter.
In response to the pandemic, the company took steps earlier this year to increase financial flexibility, including drawing $800 million on its $1.0 billion revolver, deferring merit increases, cutting marketing and other discretionary spending, suspending buybacks. It also reduced planned store remodels and new store openings by about half. All stores reopened by mid-July at limited capacity, and in September, the company repaid the $800 million previously drawn from the revolver.
The 3Q gross margin decreased to 35.1% from 37.1% a year earlier, reflecting a shift in the channel mix and the deleveraging of fixed store and salon costs on lower sales, offset in part by lower promotional spending and higher merchandise margins. Adjusted operating income was 8% of sales, down from 10% a year earlier. SG&A costs rose slightly to 26.8% of sales from 26.7%. Merchandise inventory declined to $1.4 billion from $1.6 billion, primarily due to slower sales, offset in part by the addition of 21 net new stores. Average inventory per store was down 12.5%.
Ulta and Target recently announced an agreement to open makeup and skincare shops inside 100 Target stores beginning in the fall of 2021. Additional locations will be added in subsequent years. The new 1000-square-foot shop-in-shops will feature personalized services such as Ulta’s GLAMLab.
Management withdrew its FY21 earnings guidance earlier this year due to pandemic-related uncertainty. It currently expects fourth-quarter comps to be down 12%-14%, but said that it had difficulty projecting results for the remainder of the quarter. It also reduced its capex estimate to $150-$160 million from $180-$200 million. It reiterated its expectation for approximately 30 new store openings this year (versus 80 last year) and five relocations (previously reduced from 75 net new stores). The company opened 17 stores in 3Q and closed 19, and now has a total of 1,262 stores. Given the acceleration in e-commerce, management is evaluating its long-term plans for store openings, closings and remodels. Ulta has temporarily suspended plans to expand into Canada.
EARNINGS & GROWTH ANALYSIS
The company now has one reportable business segment, which includes retail stores, salon, e-commerce and ‘other.’ In fiscal 3Q21, cosmetics accounted for 45% of sales; skincare, bath and fragrance for 26%; haircare products and styling tools for 21%; services for 4%; and other for 4%.
E-commerce sales growth slowed from more than 200% in 2Q to a still strong 90% in 3Q. Ulta launched a ‘buy online, pickup curbside’ program in April, and the service accounted for about 16% of 3Q online orders.
Although cosmetics sales have faced pressure due to reduced makeup use during the pandemic and delays in new products, the company’s lash, brow and eye products continue to perform strongly. Sales of services declined 30% in 3Q, though this was still an improvement from 2Q as the average salon ticket has risen substantially as stores have reopened. The top-performing category in 3Q was fragrance and bath, supported by new product launches. The skin care category has also grown strongly, helped by expanded floor space, stepped-up marketing efforts, and ‘do-it-yourself’ home beauty trends.
Ulta continues to increase brand awareness through the use of influencer partnerships, media partnerships, social media, and display placement, as well as through network radio and streaming audio advertising. Ulta has partnered with Kylie Jenner, launching her Kylie Cosmetics product line in November 2018, which has driven incremental sales and traffic. ‘Digitally native’ brands, including Morphe and Kylie cosmetics, have also been strong traffic drivers. In 3Q20, the company launched its first TikTok campaign in support of Millie Bobby Brown’s new line Florence by Mills. The company has also partnered with Iterate, a technology company, and acquired tech start-ups GlamStreet and QM Scientific.
We are lowering our FY21 EPS estimate to $3.39 from $3.69 and raising our FY22 estimate to $10.85 from $10.68. Despite near-term challenges from the pandemic, we expect a return to consistent growth in FY22, driven by the company’s strong customer base, digital innovation, and increased visibility through partnerships.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength rating on Ulta is Medium, the midpoint on our five-point scale. Ulta is not rated by the major credit rating agencies. At the end of 3Q21, Ulta had $560.9 million in cash and short-term investments.
The company repurchased 326,970 shares of stock for $73 million in fiscal 1Q21. It suspended share repurchases in April to preserve financial flexibility during the pandemic, but has said that repurchases could resume in 4Q. At the end of the third quarter, Ulta had $1.58 billion remaining on its share repurchase authorization.
Ulta does not currently pay a dividend and we do not expect it to do so in FY21 or FY22.
MANAGEMENT & RISKS
Ulta Beauty was founded in 1990 by Richard E. George, the former president of Osco Drug. The company’s CEO is Mary Dillon. Ms. Dillon, formerly the CEO of U.S. Cellular and executive VP of McDonald’s, has helped the company to strengthen its reputation with consumers and to significantly boost online sales. Scott Settersten became CFO in March 2013 after previously serving as VP of Accounting. David Kimbell has been the company’s chief merchandising and marketing officer since 2014. He was previously VP of Marketing at Quaker Oats. Under the current management team, Ulta has become the industry’s largest beauty retailer.
Ulta has built customer loyalty through its Ultamate Rewards credit card, which grew 40% last year, and its Ultamate Rewards program, which has grown strongly, despite the 6% decrease in membership this year due to store closures. The most loyal platinum-level customers spend more than $450 a year to receive special offers such as birthday gifts and prelaunch access to new products. The company has driven loyalty through customer engagement, and over 95% of sales are from loyalty members. Management said that average spending has increased to $206 per member over the last year.
Investors in Ulta face a range of risks. The company is particularly sensitive to economic factors such as employment and wage growth that impact discretionary consumer spending. It also faces fierce competition from beauty retailers such as Sephora, Blue Mercury, and e.l.f. Cosmetics, as well as from drug stores and grocery stores in the mass-market category. Target is Ulta’s largest competitor in mass-market cosmetics, while department stores such as Nordstrom, Saks Fifth Avenue, and Neiman Marcus compete on more expensive high-end cosmetics and fragrances. In the e-commerce segment, the company faces competition from low-cost cosmetic subscription ‘boxes’ like Glossybox, Birchbox and Ipsy, which send subscribers a monthly selection of ‘curated’ products.
Meanwhile, the salon business faces competition from chain beauty studios and boutique make-up studios. Sephora, a direct competitor in the make-up studio segment, offers complimentary makeup and hair styling classes, as well as one-on-one ‘makeovers’ with a minimum purchase of $50. Other brands, such as Bobbi Brown, offer customers their own in-house artists and complimentary styling. Drybar, a hair styling chain, offers quick services in a variety of styles starting at $45.
COMPANY DESCRIPTION
Ulta Beauty Inc. is a leading retailer of cosmetics and fragrances with a salon services segment specializing in hair styling and make-up. Based in Bolingbrook, Illinois, the company operated 1,264 retail stores as of February 1, 2020. It also markets cosmetics and fragrances through its website and direct mail.
VALUATION
Ulta shares currently trade at 25.1-times our FY22 EPS estimate, below the five-year historical average multiple of 32.3 and the peer average. We believe that the stock merits a premium valuation based on the company’s growing customer base and strong e-commerce presence, which should boost operating margins over time. Ulta also has the largest market share in the industry, with products across all categories, brands, and price points, and partnerships with high-profile social media influencers. Our revised target price of $295, raised from $255, implies a multiple of 27.2-times our FY22 EPS estimate, still below the five-year average.
On December 10 at midday, BUY-rated ULTA traded at $272.45, down $3.21.
Source: Argus
