Ulta Beauty: Great Business, Greater Opportunity (NASDAQ:ULTA) (2024)

Thesis

The human desire to be desirable will always exist.

Ulta Beauty, Inc. (NASDAQ:ULTA) solves how to be loved the same way Costco (COST) solves how to be fed.

Ulta doesn’t sell beauty products.

They sell beauty.

Big difference.

Ulta

Now that you all have seen my girlfriend in the main image, it's worth mentioning that Ulta has been a 100-bagger stock going back to its 2009 low of $4.11 per share. In that time span, the company’s EPS has increased 60-fold. Simply put, Ulta has been one of the greatest investments in recent history. As a result, its stock has historically traded at a significant premium, as its average P/E during this time span has been 30x.

Buying great businesses at expensive prices is risky. Investors should constantly strive to buy great businesses discounted, which can only be accomplished via patience and discipline. Great investors recognize that the gap between a company’s intrinsic value and its market price is risk. In order words, buying a stock worth $482 at $575 is riskier than buying it at $482, which is riskier than buying it at $381.

Are We Late to the Party?

The bad news is, yes, we are late to the party.

The good news is that the party is still going strong.

I group investible stocks into two categories:

1. Compounders
2. 50¢ Dollars.

Over the past fifteen years, Ulta would’ve best been categorized as a compounder due to its EPS increasing 60-fold. However, expecting this feat to repeat, which would take the MCAP to a staggering $1.1T, is not prudent by any measure. So, of course, I wouldn’t classify Ulta as a compounder.

However, that doesn’t mean Ulta can’t be a great investment. A 50¢ Dollar is a stock, that for whatever reason, is trading at half its intrinsic value, and in a sane market, should be expected to double within 2–3 years.

Ulta doesn’t quite represent a 50¢ Dollar because it isn’t discounted by 50% (great companies rarely go on that type of sale), but I’d say it’s an 80¢ Dollar. In other words, Ulta is trading at about 80% of its intrinsic value (implying about 25% upside).

If your pride tells you to skip this party because you missed the start and middle, I’d reconsider. There is no shame in being late to the party. Investors shouldn’t be deterred from a stock simply because they missed the big growth phase. In fact, you don’t have to take my word for it; take Peter Lynch’s from his book, One Up On Wall Street:

Back to Microsoft, a 100-bagger I overlooked. That high-tech juggernaut posted explosive earnings almost from the start. Microsoft went public in 1986 at 15 cents a share. Three years later you could buy a share for under $1, and from there it advanced eightyfold. If you took the Missouri “show me” approach and waited to buy Microsoft until it triumphed with Windows 95, you still made seven times your money. You didn’t have to be a programmer to notice Microsoft everywhere you looked.

And I don’t have to be a make-up connoisseur to notice Ulta everywhere I look. I’m not just imagining things – there are over 43 million members in Ulta’s loyalty program. For frame of reference, Starbucks (SBUX) has 34 million members. I mention Starbucks because I’d be willing to bet there is a lot of overlap between Ulta rewards members and Starbucks reward members, and Starbucks is a massively popular brand, so I found this to be an interesting comparison.

Why Did People Leave the Party Early?

I am trying to keep this party analogy going as long as I can, simply for my own entertainment. I suppose I could (should) rephrase this as “why are investors currently selling the stock?”

The answer is because Ulta's management changed tunes in regard to their forward guidance during their Q4 2023 earnings call in March, and then struck substantial fear in the market after they slightly worsened guidance during the J.P. Morgan Conference in April.

The company states the following issues are causing revenue growth to slow to 4-5% and operating margins to fall beneath 15%:

1. Challenged consumer
2. Increased competition.

Someone Change the Station

High rates, high debt, high inflation, high five me if you’ve heard this half a million times before…. Talk about a broken record. Since we’ve established this party is far from over, there’s still time to change the DJ.

The reality is, the beauty industry is not as discretionary as most think – I’d be willing to bet a solid foundation is as solid of a foundation to most women as their nutrition. Women don’t look up the Fed Funds Rate before deciding if they’re going to buy a concealer that day. Despite all macro circ*mstances, women will make room in their budget for beauty products.

Lastly, yes, there is increased competition, but when is there not? Ulta's management team has been superb, and I have confidence in their ability to navigate a more challenging environment, whether that's a challenged consumer or challenged marketplace.

Value Play vs. Value Trap?

Here is your step-by-step guide on how to figure out if Ulta (or any stock) is a value play or a value trap:

Step 1: Identify the core problem

Step 2: Figure out if the core problem is ephemeral or permanent.

Value plays have ephemeral core problems, and value traps have permanent core problems.

Ulta’s Core Problem

Growth across total categories, both in price point and segment, are slowing; especially, in prestige make-up and haircare. The consumer is challenged and there is increased competition.

Is Ulta’s Core Problem Ephemeral or Permanent?

An ephemeral problem is one that affects operations in the short term; it’s transitory. A permanent problem is one that affects the company’s reputation; it’s for life.

With that in mind, let’s address four tenants of reputation: fraud, quality, loss of appeal, and falling out of love.

• Was there any scandal at Ulta? Nope.
• Did Ulta’s store or product quality go down? Nope.
• Has the beauty industry lost its appeal? Nope.
• Have customers fallen out of love with Ulta, the brand? Nope.

And on that last note, here is a stat CEO David C. Kimbell stated at the recent J.P. Morgan Conference:

Our loyalty program grew 8% last year. Our -- we have a metric that we look at that just kind of judges their emotional connection to us. We call it brand love, that reached an all-time high. Our retention of consumers was very strong throughout the year, their engagement in all of our channels, in-store and online, downloading of apps, release. So a lot of positive dynamics on the business.

Achieving nearly double-digit growth in a loyalty program when there are already 43 million members would be impossible if your company had a permanent, structural problem.

Once again, you don’t have to take my word for it. Take Thomas Phelps from his book, 100 to 1 in the Stock Market:

Failure to distinguish between ephemeral earnings fluctuations and basic changes in earnings power accounts for much over trading, [and] many lost opportunities to make 100 for one in the stock market.

Ulta is a value play.

Earnings vs. Earnings Power

To drive this distinction home, here is a quote from Christopher Mayer in his book, 100 Baggers:

Don’t get lost following earnings per share on a quarterly basis. Even one year may not be long enough to judge. It is more important to think about earnings power. A company can report a fall in earnings, but its longer-term earnings power could be unaffected.

This is another way of discussing value plays and value traps. Value plays involve purchasing a stock experiencing a temporary disruption in earnings, where the long-term earning potential remains intact. In contrast, value traps involve buying a stock with a temporary disruption in earnings that is likely to harm the company's long-term earning potential.

Competitive Advantage

Ulta's biggest competitive advantage is (evidently) the stickiness of its business model. Consumers get trapped into Ulta's ecosystem through three avenues:

1. Incredible (most generous) loyalty program

2. Products up and down every price point (ordinary to luxury)

3. Strategic Target partnership (overlap of customer base who are drawn back into the brand when shopping at Target).

There's simply no reason to leave Ulta.

Growth opportunities

My personal forecasted growth rates are higher than the market’s expectations because I believe there are three potential opportunities which will quietly deliver better than expected growth (or at least sustain comparable growth from previous years).

1. UB Media
2. International expansion
3. Store expansion via Target

I believe that beauty product brands will pay heavily to advertise on Ulta’s app, which would add significant, high margin, recurring revenue to the mix for Ulta. So many brands advertise on social media, which is diluted – advertising on Ulta’s app is targeted since everyone on the app has an interest in beauty products. Brands have a strong reason to pursue this avenue because Ulta has over 43 million members on its app.

International expansion could also provide a pleasant boost to growth, but we’ll have to see how that pans out. If Ulta can find a way to resonate with foreign consumers, their values, and what’s important to them, the company should see additional top-line growth.

Lastly, the company has over 500 locations in Targets and will be adding more in the coming years. While these small, curated locations are not primary drivers of growth, they do provide a nice boost to the top line. I think the Target partnership has been a great strategic maneuver to bring back customers who’ve fallen out of habit or don’t have the time to make a separate Ulta trip.

If all else fails, the company’s current $2B stock buyback program is enough to retire almost 11% of existing shares, which provides a nice safety net for investors in case this overall slowdown in growth persists. In fact, going back the last ten years shows that the company has repurchased way more shares than it issued each year.

Valuation

We’ve identified Ulta is a value play, but that doesn’t mean we can pay any price to own its stock. Let’s take a look at Fast Graphs to understand the company’s valuation from an overview perspective.

The stock price, represented by the black line, has approached fair value (P/E of 15). Ulta is a stock that has traded at an average of 30x earnings since inception and 23x earnings since 2018. This is typical of great brands – Starbucks, Nike (NKE), Costco (COST) all trade at 25-30x earnings at most times.

If we agree that the long-term earning power of the company is likely unaffected by today’s disruption, then buying a company like Ulta at a P/E of 15 is a great deal. Even Warren Buffett has said:

It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

Ulta is a wonderful company at a fair price.

DCF

To truly value a company, we need to estimate and project all its future discounted cash flows, or DCF. I will present two DCF analyses, one of which is the market case (how the market is pricing this stock based on its future expectations) and the other my base case (how I price the stock based on my future expectations).

Market Case DCF

The market is pricing in 9% long-term growth and 14% operating margins. I find this scenario unlikely. For one, Ulta has averaged 18.4% revenue growth per year going back to 2006. I doubt the growth rate will be cut in half for the next decade. I meticulously went through all the company guidance, projections, and used my own predictions to create the following Base Case DCF, which is how I see the future playing out.

Base Case DCF

Here are the important checkpoints to keep in mind for this Base Case DCF:

• Sales: I took the lower end of company guidance and assumed 4% growth for 2024. Then, due to the growth opportunities I identified earlier in this article, I increased sales growth to average 12% for the remainder of the years. I felt 2/3 of Ulta's historical growth rate was a reasonable estimate that still lies in conservatism.
• Costs: Ulta reiterated a lack of confidence of being to sustain 15% operating margins going forward, so I lowered them to 14% as we are in an inflationary environment, plus, the company is making many investments.
• WACC: Hand calculated to be exactly 11.46%.
• Terminal Growth Rate: Set to 2% to be conservative.
• Misc: Everything else was based on historical averages.

Our Fair Share Price Conclusion

Based on this outlook, Ulta's fair value is $482 per share, which represents 27% upside from today’s price.

Stepping back, sales in ten years are 2.8x higher than today. To put this in perspective, sales today are 4.2x higher than ten years ago. Despite Ulta's massive historical growth, I still believe my projected future growth is well within reason.

Cash Is King

Let’s take a look at Ulta’s net cash position, operating cash flow, and free cash flow.

Spoiler: they’re all in excellent shape.

Net Cash Position

Ulta has $766 million in cash on the balance sheet and zero debt.

Operating Cash Flow

Ulta’s cash flow from operations has always been positive and is 33x higher today from 2007. This is a tell-tale sign of exceptional management. You don’t achieve a feat like this by being a poor steward of capital.

Free Cash Flow

Ulta is producing massive and consistent free cash flows. Combine the incoming cash with the existing cash reserves (and the absence of debt), and the financial health of this company is exceptional.

I always tell clients when I go over the stocks in their portfolio that companies are like people. A company with FCF, cash, and no debt is like a person making hundreds of thousands, with a million in the bank, and no loans. You’d likely not lose a lot of sleep worrying if this person is going to make it financially. The same goes for a company.

Ulta vs. Sephora

There are three reasons I would not buy Sephora over Ulta:

1. You can’t outright buy Sephora – you have to buy its holding company, Moët Hennessy Louis Vuitton (LVMH). This brings unnecessary “diworsification.”
2. LVMH is also expensive, trading at 25x earnings.
3. Ulta has products up and down price points, making it more recession proof and appealing to a wider customer base.

Risks

Ulta has numerous risks that investors must consider.

1. Challenged Customer Risk: Inflationary pressures may destroy many consumers' disposable incomes, reducing Ulta's sales.
2. Competition Risk: The company noted competition, in the form of ever-increasing distributions points, is increasing. This could erode Ulta's margins and reduce their market share.
3. Consumer Sentiment Risk: Beauty product stores are trendy, and there’s no guarantee Ulta remains popular.
4. Global Expansion Risk: There's no precedent to expect global expansion will be well received (or executed). It could cost shareholders a fortune to expand, and there is a chance those losses are never recouped.
5. 10-K Risks: For the company’s set of risks, please click here.

Takeaway

Ulta is to beauty what Costco is to hunger.

Ulta has been a value investor’s dream investment. It’s a company which serves an everlasting desire in society, increased its EPS 60-fold since 2009, buys back its own stock regularly, doesn’t have debt, maintains a healthy cash reserve, and produces massive free cash flows.

Investors have to look at these facts, not the stock price, to determine if a potential investment is worth considering.

All a stock price does is tell you if the person who sold it last was foolish or not; and, in my opinion, selling Ulta at $381 is foolish.

DocShah Financial, LLC is a full service registered investment advisory firm.To have your portfolio created or reviewed by Raul Shah, please click on our website link below.Disclaimer: All writing presented is solely for entertainment purposes and not financial advice. Neither DocShah Financial nor its representatives are responsible for any financial outcome which may occur. We do not give out investment advice to the public nor any any individual, unless they are a client under our advisory services and subject to the terms and conditions which apply.www.docshahfinancial.com