Description

Ulta Beauty, Inc. is a best-in-class, industry-leading business available in the market today at a discount to quantifiable intrinsic value. Current prices provide long-term investors with the opportunity to own an excellent business for a reasonable price as it goes through a period of temporary turbulence.

Company Overview: Ulta Beauty, Inc. is a specialty retailer of cosmetics, fragrance, haircare, and skincare products founded in 1990. The prototypical store is ~10k square feet and features a full-service beauty salon onsite, allowing Ulta to offer beauty services to its customers in addition to products. The company was founded in 1990 and is headquartered near Chicago, IL. Ulta has 1,213 stores in 50 states as of August 3, 2019 and is on pace to add 80 in FY 2019. The business is seasonal with a Q4 sales peak for the winter holidays. 95% of customers participate in the company's loyalty program, which provides the company with customer-level data it analyzes to drive up engagement and average ticket size. The company's strategy has been highly successful to-date, and the company now represents ~24.5% of the U.S. Prestige Beauty market (up 210bps from prior year) and ~7% of the $87Bn U.S. Total Beauty Products market while generating exceptional returns for shareholders over the past decade.

Situation Overview: Up until last week, Ulta has been riding a multi-year expansion of the beauty market as U.S. consumers have devoted more and more dollars per capita to skincare, haircare, and cosmetics. Cosmetics account for roughly half of Ulta's business on a revenue basis today and carry the highest gross margin, meaning the category drives the majority of Ulta's profitability. During its Q2 2019 earnings call after the close on Thursday, ULTA pulled back its 2019 EPS guidance by 8% and warned analysts of a sharp pull-back in cosmetics in the first few weeks of Q3. The revised EPS guidance for 2019 represents ~9-10% YoY growth but more importantly implies low-single-digit EPS growth in the second half of the year. The stock received more than 5 analyst downgrades in response and shares dropped more than 30% the next day, the largest single-day decline in their history. Ulta last changed hands at $235.70 in after-hours trading on Friday, representing just under 20x the revised EPS guidance of $11.86-12.06. However, the company still has no debt, an industry-leading market position, ROIC over 30%, attractive long-term growth prospects, and an aggressive stock repurchase program. Therein lies the opportunity.

Ulta's long-term competitive position would benefit from a recession: Beauty is a discretionary and cyclical category and Ulta will experience SSS, EPS, and likely share price declines in a recession. I avoid macroeconomic forecasting wherever possible, but given the yield curve has essentially inverted it's worth belaboring this point a bit. Although a recession would temporarily impair Ulta's earnings power, many of the company's competitors are structurally disadvantaged due to high debt levels and exposure to weaker non-beauty categories (e.g. major department stores) or otherwise poorly capitalized (e.g. mom and pop beauty retail shops and salons) and are likely to go bankrupt in an acute recession. With no debt and a fairly clean balance sheet, Ulta should gain significant share during the next recession even if consumers temporarily delay beauty purchasing by using up their existing inventory or forgoing purchasing. In the meantime, Ulta's significant share repurchase program should allow it to create significant value for shareholders if the stock price declines further -- the planned $700M share repurchase in 2019 represents ~5% of today's market cap at $235.70 with 59.3M fully diluted shares. The combination of stock repurchases and improved market position should drive significant improvement in Ulta's per share earnings power during a recovery despite a temporary blip in a recession.

Long-term growth targets are achievable: Please see the below table breaking down my LT growth targets for cash flow to equity in low and base cases which I'll later use to feed valuation assumptions. Through the last cycle (2007-2018), Ulta grew operating income at a 30% CAGR and grew diluted EPS at a 33% CAGR, but current investors do not need to assume anything nearly as heroic to make the stock attractive as a long-term investment. In the paragraph below I will breakdown my low and base case assumptions for 7-year go-forward growth rates.

My low case assumes a brick and mortar SSS growth rate of 1% (below the rate of inflation and significantly below the 4% brick and mortar SSG delivered in the Q2 2019 "miss") and my base case assumes 4% (in-line with the most recent quarter). My low case assumes e-commerce growth of 1% (half of the 2% SSG e-commerce contributed in Q2) while my base case assumes 2% (in-line with MRQ). I assume that new stores contribute ~3% annual growth in my low case (assumes management only reaches the low end of their saturation target of 1,500-1,700 stores in 7 years, which represents ~42 stores per year or roughly half of their 80 new stores in 2019) and ~5% in my base case (high end of saturation target in 7 years, or ~70 stores per year - still below current new store pace).

In the base case, I assume gross margin can contribute 0.5% annual CF growth, which is conservative given ULTA's average gross margin expansion of 43bps annually from 2007-2018. Gross margin expanded 40bps in the MRQ, or $6.6M, equal to 2.2% of the quarter's FCF before adjusting for taxes. I also assume in the base case that management gets 0.5% annual CF growth from SG&A leverage, which is similarly conservative given ULTA's average SG&A leverage of 26bps annually from 2007-2018.

In the low case, I assume that management is able to counteract the effects of SG&A deleverage and lower growth through growth capex and/or other expense reductions. To quote the CFO on this, "there was a time before [the recent growth wave] where Ulta operated very effectively, and very well performed, produced some really great financial results on much lower comps. So we're no stranger to operating in a tougher, lower, growth kind of environment and that's just the kinds of things that we're pivoting towards right now." So in short, the low case assumes 5% sales growth with flat margins, but I believe that 5% cash flow growth through the cycle would be exceedingly disappointing for this business.

Valuation and Recommendation: At $235.70, the stock is available for just under 20x this year's revised EPS guidance range of $11.86-12.06. Under the base case laid out above, if you believe ULTA can grow 2019 share repurchases of $700M (proxy for cash flow to equity) at a 12% CAGR over the next 7 years, capitalizing in year 7 with a 2.5% perpetuity growth rate and an 8% CoE discount rate, this investment should yield a 15% 7-year IRR from today's levels. Said differently, Ulta trades at a ~30% discount to intrinsic value today assuming an 8% equity discount rate. In the low case of 5% 7-year cash flow growth, the investment still yields a 9% IRR and trades in-line with intrinsic value today.

While I do believe the long-term risk/return is asymmetrically positive today, beauty retail is a procyclical category and there is a real possibility that shares will become cheaper over the next 12 months. Management didn't provide much backup for its guided same-store growth reacceleration in Q4, which spooked analysts on the latest earnings call. To the extent that Q4 misses or 2020 guidance disappoints, I think there is a very good chance the stock will gap down again. Accordingly, I'm recommending initiating a small 100-200bps position today with buy prices in the +/-200 range in the event of further price declines (<17x 2019E EPS of ~$12).

Catalyst

Share repurchases, recovery in US cosmetics market, further market share gains