With the market fraught in uncertainty right now, Ulta Beauty (ULTA)‘s stock price has experienced a tumble and is now trading at pretty low valuations with a PE ratio of <15. This presents significant buying opportunities for the money-making machine and dominant beauty retailer in the United States.
Ulta Beauty has only fallen below <15x forward PE 3 times since going public, in: December 2008 (GFC), March 2020 (Covid-19), October 2023.
But why exactly is the share price dropping and is there anything fundamentally changing for the company that you should be aware of before entering a position?
In this analysis, I will offer my own investment thesis and thoughts on investing in the company.
Table of Contents
Company Overview
Ulta Beauty (ULTA) is the largest beauty retailer in the United States. What I really like about the company is that they have a very strong “cult-like” following for their stores and products. They have over 1,300+ stores and are constantly adding new stores every quarter, although the store growth rate has declined slightly in recent years.
Their current business is very much concentrated within the USA. Their website doesn’t even allow international traffic to access them (I had to use a VPN just to download their investor relations reports).
Business Model
Ulta Beauty’s main business model lies in their stores all across the United States. They offer over 25,000+ products and hold around 600 brands. There is still runway for growth of the company, and even the potential to expand their business internationally.
Strong Membership & Loyalty Program
They have a strong rewards and loyalty program and you can see that 95% of their sales are from recurring customers and the number of members they have are on the rise year on year (with the exception of 2020 which was likely due to Covid outbreak). The company has a very strong and loyal customer base.
Service Model
In their investor relations presentation, the company highlights one of their of the key differentiaion method that helps them to stand out from other traditional beauty stores is their focus on services like salons and other beauty services.
These services actually give a platform for them to upsell their products and increase the average spending of each customer.
Growth of Stores
From this graph we can see that Ulta Beauty is still very much focused on growth in the United States. Whilst they are still opening new stores year on year, the rate at which they are opening up new stores is slowing down, which is expected for a large company.
Financials
- Revenue – strong revenue growth trend with a 9.82% CAGR over the past 5 years
- Free Cash Flow – good growth at 8.87% CAGR over past 5 years
- Retained earnings – very strong, over $1 billion
- Dividends – no dividends (still focused on growth)
Net Income Margins
The sector average is close to 8%. In contrast, ULTA’s current net income margins are at 12% which is at healthy levels and superior to competitors. They have a dominant position in the market and strong bargaining position with suppliers.
Share Buybacks
One thing I love about ULTA beauty is they spend a portion of their free cash flows on frequent share buybacks to return value to investors. This raises EPS and increases value for investors.
Since the company doesn’t pay dividends, share buybacks are their main way of returning value to investors.
Debt
It’s not often we find a business with zero debt. Ulta Beauty is an amazing cash flow machine with zero debt on their balance sheet. I love that ULTA has such strong cash reserves that it doesn’t need debt to grow their company.
In the current high interest rate environment, this also means that Ulta Beauty won’t be affected by paying higher interest expense as compared to their competitors who rely heavily on debt to open new stores.
Even in the face of declining prices, ULTA is still in a very strong position. The fact that they have huge cash reserves and zero debt allows them the option to do many things.
- Share buy backs – they have very frequent share buybacks to return value to shareholders.
- Expand internationally
- Pay dividends – Personally I’m hoping they don’t pay dividends and allocate their funds to more long-term growth or share buybacks
The company also hasn’t shown a lot of interest in expanding internationally, with their main sales channels limited only to USA, so I wouldn’t place too much hope on this front.
I think share buybacks would be our biggest best especially if stock price continues to drop. This will help to raise EPS.
ULTA raised their EPS guidance in the last quarter. At this price levels, if the company continues to buy back stock it could mean the EPS guidance may rise in the next earnings call on 7 Dec 2023.
Return on Invested Capital (ROIC)
ULTA has a high ROIC sitting at just above 30%. The solid metric shows that management has been very effective in deploying company funds for growth over the long-term.
The overall financial health of Ulta Beauty is looking very strong. All metrics show that management is proficient in managing the cash reserves of the company and are smart in allocating capital for investments as well as to create value for investors.
Main Problems faced by Ulta beauty
Rising Labor Costs
Selling, general and adminsitrative expense percentage has been rising at a 2% jump from the previous year (2022-2023) – which will inevitably eat into net income margins. I believe this is likely due to inflation and is set to trend high in the retail industry for awhile with the current labor market situation. Even similar large retail chains like Costco (COST) and Target (TGT) are also experiencing a similar trend.
That said, it’s definitely a metric that we want to monitor going forward to ensure that this trend isn’t consistent for too long and increasing too quickly.
There hasn’t been any big downward change in earnings guidance, however the stock is declining rapidly. This may be a case of market pricing mismatch.
Valuation (PE Analysis)
The mean PE ratio is 23.3x and we are currently sitting at a low level of 14.5x in October 2023, almost close to their all-time lows of 10x earnings. This presents a huge potential return if the stock eventually bounces but to the mean of 23.
Based on the company’s current financials, I’m not seeing any major issues why it can’t bounce back to the mean. The company has good margins, stable growth and a steady business model. In short, nothing has really changed funamentally since the stock price has been on a decline.
The company even increased their sales guidance in the previous quarter.
Upside Potential
Based on my valuation models, I estimate an upside potential of 15% per year for Ulta Beauty. My investment thesis at this point is to hold the stock for the next 10 years at my current cost basis of roughly $390.
These estimates are made based on ULTA holding up to their management’s estimate earnings.
Quick Thoughts On Current Market Environment
Interest rates will likely stay at current high levels for the last quarter of 2023. In such an environment, stocks tend to drop as investors move funds out into fixed investments because the risk-free rate is at a high.
As a contrarian investor, this is actually the time when I’m more “greedy” to enter the market since the fall in stock prices presents amazing buying opportunities.
Since the Fed hasn’t yet reached it’s target of 2% inflation (we’re sitting at around 3.70% in September), I’m also estimating a probability of one more rate hike by the Fed in the near term. But my bet is that will be the maximum they will go.
Price of stocks may continue to fall, including tickers like Ulta Beauty (ULTA), but I will be slowly accumulating my positions at this point in time.
Final Thoughts – My Personal Thesis on Ulta Beauty
I bought a position in ULTA beauty several days ago.
In my opinion, the stock is at an extremely undervalued range right now and presents a very good buying opportunity with strong upside potential. Whilst long term growth may be slowing down, Ulta Beauty is still a very strong name with a consistent “cult-like” following.
Although it is a very large company, ULTA is still growing and expanding their stores every quarter. However the company has yet to show any indication or interest of expanding outside of the USA. I believe the company will continue to grow at a stable rate, but will eventually slow in the future.
At the point of writing, ULTA makes up 3.2% of my portfolio. Technical analysis also shows a strong support around $350 mark and if the stock continues to drop, I may add on to my position up to a maximum of 7% of my portfolio.
Disclaimer: this article is a summary of my personal thoughts and my own investment thesis for the stock, and does not constitute as financial advice. Before investing, always do your own due diligence and consult a professional before buying or selling securities.
Full Disclosure: I am a shareholder of ULTA at the time this was written.