Description

I believe the time is right to short Ulta Cosmetics, a purveyor of mid-market and prestige cosmetics, a mediocre retailer at an outrageous multiple.

Here are the bullet points:

1)      Valuation leaves no room for error.  The current store base of 550 stores can produce revenues of around $2.6b, with an operating margin of 13% implies $3.10 of earnings (32x).  The likely potential store base of 1,000 stores could produce $5b of sales, at 15% OM is perhaps $6.75 of earnings.  At a 14x multiple this would get close to the current share price; however, this requires around $10/share of investment to build out, so even if these stores were all built today the stock would only be worth $85.  Please note that the company believes they can build 1,200 stores, but only if new malls are built to accommodate these stores—since I do not believe this is likely, and since the company used the 1,000 store goal for many years, I think this is a more reasonable assumption.

2)      Competition is increasing.  Sephora boutiques are opening in JC Penney, and are doing well.  Amazon Beauty is ramping up and offers lower prices than Ulta.  The presence of Amazon, as well as the availability of many of Ulta’s products in mass merchants, department stores, and drug stores, means that margin increases from the current level will be hard fought.

3)      Comps don’t tell the whole story.  Because of a relatively new store base, and the maturation of existing stores, the reported “comp” masks a more important trend of decelerating sales/store.  This metric took a heavy hit in 2009 and predictably rebounded in 2010.  For the last 6 quarters, this metric has grown: 6.5%, 5.2%, 6.7%, 5.0%, 3.3%, 2.2%, and the guidance for 4Q implies -2% (adjusting for the 14 week quarter).  The decelerating trend seems to have been missed or ignored by “analysts”.  In fact, average weekly sales per store predicted for q4 are flat with those of Q4 2007.

4)      Inventory is through the roof.  Inventories hit $463m this quarter, up 30% yoy, and are forecast by the company to increase “low double digits” per store in q4.

5)      CFO resignation is a red flag.  The recent CFO, selected after a long search, resigned immediately (i.e., no “two week notice”) after under two months on the job.  No comment was made about the reasons for this resignation at the time or on the recent earnings call.  I have spoken with this CFO at two of his past roles and always thought he as straight-shooting and competent.

6)      Given the tax law changes, there is a decent shot that the remaining Chanel family holdings will be sold by year-end.

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