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  • Glenn

Ulta Beauty: Don't underestimate the lipstick effect.

Opdateret: 11. mar.

We are most likely facing economic headwinds in the near future. Hence, I'm investigating companies that could farerelatively well in these conditions. One such company that has been picked by investment bankers to do so is Ulta Beauty.In this analysis, I will investigate if now is the time to add Ulta Beauty to the portfolio.

This is not a financial advice. I am not a financial advisor and I only do these post in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.

Since I have attended the workshop with Phil Town, I have decided to change the layout of my analyses a bit. I will do some more calculations and also briefly go through why the company has meaning to me. If you want to read more about how I evaluate a company, please go to "MY STRATEGY" on my website.

For full disclosure, I should mention that at the time of writing this analysis, I do not own any shares in Ulta Beauty. I did own shares at some point but sold them last year for a 78% profit. If you are interested in viewing the shares I own or if you would like to copy my portfolio, you can find instructions on how to do so here. Since I sold my shares, Ulta Beauty has been on my watchlist, but I haven't made a decision to buy shares yet. Despite myliking for the company, I will maintain an unbiased analysis. If you want to purchase shares or fractional shares of Ulta Beauty, you can do so through eToro. eToro is a highly user-friendly platform that allows you to get started with as little as $50.

Ulta Beauty was founded in Illinois in 1990 and is now the largest beauty retailer in the United States. They are divided into different segments: Cosmetics (42% of sales), Haircare products (21% of sales), Skincare (17% of sales), Fragrance and Bath (14% of sales), Services (3% of sales), and Accessories and Other (3% of sales). While most of these segments are obvious, it should be noted that the services segment is that their shops are equipped with a salon that offers skin treatments. They offer more than 25.000 products from more than 600 beauty brands including their own brand. They have more than 1.350 stores scattered across the United States, which I believe is a proof Ulta Beauty having developed a strong brand moat. Furthermore. Ulta Beauty has a very committed customer base, with 40 million people participating intheir loyalty program. This further supports the idea of a strong brand moat.

Their CEO is Dave Kimbell. He joined Ulta Beauty in 2014 and held various positions until he became CEO on June 2nd, 2021, taking over from the previous CEO, Mary Dillon, who is now the CEO at Foot Locker. Prior to joining Ulta Beauty,he held positions in companies such as PepsiCo and Procter & Gamble. As Dave Kimbell has only been the CEO of Ulta Beauty for a short period of time, it is impossible to judge him based on the results. However, he has shared his leadership philosophy, which he defines as "leading with the heart. Care, compassion, empathy, and inclusion are more important than ever." It means that Dave Kimbell finds it important to understand what is going on in the lives of consumers and Ulta Beauty team members. He wants to transform that into a formula for success. He aims to establish Ulta Beauty as a highly engaging, inviting, and inclusive environment that offers price points suitable for all customers. I believe that focusing on providing a positive customer experience while offering products at various price points is a good strategy.However, since Dave Kimbell has only been the CEO for one year, it is too early to determine if he is the right person for the job.

I believe that Ulta Beauty has a strong brand moat. However, it is still too early to judge the management. Now, let us examine the numbers to determine if Ulta Beauty meets our criteria for having a strong competitive advantage. In case you want an explanation about what the numbers are, you can have a look at "MY STRATEGY" on the website.

The first numbers we will investigate are the return on invested capital, also known as ROIC. We want to see a 10-year history, with all the numbers being above 10% in each year. Ulta Beauty has consistently delivered great numbers. Fiscal 2020 and fiscal 2021 were lower than usual, but this was during the pandemic when Ulta Beauty had to close their shops during lockdowns. Hence, I will give them a pass on those two years, as lockdowns obviously affected the results. Since the pandemic, Ulta Beauty has returned to delivering impressive Return on Invested Capital (ROIC), which is very encouraging to see. It suggests that Ulta Beauty is a great company, as they have managed to deliver a ROIC above 20%in all years unaffected by the pandemic.

The following numbers represent the book value + dividend. In my previous format, this was referred to as the equity growth rate. It was the most important of the four growth rates I used in my analyses, which is why I will continue to use it in the future. As you are accustomed to seeing numbers in percentage form, I have decided to provide both the actualnumbers and the percentage growth year over year. Ulta Beauty has consistently increased its book value every year forthe past 10 years, with the exception of fiscal year 2022. I will give Ulta Beauty a pass for the numbers in 2022, as the company made significant investments in their IT system during that fiscal year. It is nice to see that Ulta Beauty is back to growing its equity in fiscal 2023. All in all, I'm encouraged by these numbers.

Finally, we will investigate the free cash flow. In short, free cash flow refers to the cash that a company generates after it has covered its operating expenses and capital expenditures. Levered free cash flow is the amount of money a company has remaining after paying all of its financial obligations. I use the margin to provide a clearer understanding. Free cash flow yield refers to the amount of free cash flow per share that a company is projected to generate in relation to its market value per share. Ulta Beauty is experiencing growth in their free cash flow every year, except for fiscal year 2021, which was negatively impacted by the pandemic. I am particularly encouraged by the numbers for fiscal year 2022. It is even more impressive considering capital expenditures have increased from $152 million in fiscal year 2021 to $172 million in fiscal year 2022, and further to $299 million in fiscal year 2023. It is great to see Ulta Beauty growing its free cash flowlike this. Leveraged free cash flow and free cash flow yield have also reached new levels in the last four years.

Another important aspect to investigate is the level of debt, specifically whether a business has a manageable debt that can be paid off within a period of 3 years. We do this by dividing the total long-term debt by earnings. However, it isn't possible to do the calculations on Ulta Beauty, as they have no debt. It is another great thing about Ulta Beauty.

As with all other investments, there are risks involved when investing in Ulta Beauty. One risk mentioned in the annual report is macroeconomic conditions. Management has previously mentioned how price increases in the supply chain have hurt margins. Management also expects that labor costs will be higher in 2023, which will decrease margins as well. Of other macroeconomic conditions that can hurt margins, management mentioned inflation, higher interest rates, and transportation costs. Management has guided for a 14,7 % - 15% operating margin in fiscal 2024, which is lower than the 16,1% operating margin they delivered in fiscal 2023. Economic slowdown. In its annual report, Ulta Beauty mentioned that an economic slowdown may affect consumer purchases of discretionary items, such as beauty products and salon services. Ulta Beauty is solely exposed to the U.S. market, and it is likely that we will see an economic slowdown in the United States. We don't know how severe it will be or how it will affect consumer discretionary spending, but it is a risk that one needs to be aware of. Competition. Ulta Beauty has a wide range of competitors, including traditional department stores, specialty stores, grocery stores, drug stores, pure play e-commerce companies, and brands that sell directly to consumers. Their largest competitor, however, is Sephora, as Ulta Beauty is gaining market share in prestige brands, which is the main focus of Sephora's sales. Competition is increasing further as Sephora has now partnered with Kohl's, resulting in the opening ofstores at strip centers. This move is significant because strip centers have traditionally been Ulta Beauty's territory, while Sephora has primarily focused on malls.

There is also a lot of potential for Ulta Beauty moving forward. They are gaining market share. While the addressable market is declining, Ulta Beauty is gaining market share in the U.S. beauty products industry. In fiscal 2021, their market share was 7%, while in fiscal 2023, it increased to 9%. It is always encouraging to see a company gaining market share. However, what is even more interesting is that having only 9% of the market share, they still have a lot of potential for growth. Their market share in the U.S. salon services industry was 1% in both fiscal 2021 and fiscal 2023. Hence, they are not currently winning market share, but they have ample room for growth. The Lipstick Effect. The lipstick effect is a theory that suggests during an economic crisis, consumers are more inclined to purchase affordable luxury goods. Researchers from Texas Christian University published a study in the Journal of Personality and Social Psychology, which found that there is a correlation between economic downturns and increased sales in the beauty industry, similar to the trend observed during the Great Depression. Thus, we might see Ulta Beauty outperforming other industries during economic headwinds, despite management believing it to be a risk. The loyalty program. Loyalty programs are beneficial for businesses as they establish an emotional connection between customers and the business. Additionally, loyalty members tend to spend more per purchase compared to other customers. Moreover, loyalty programs provide valuable customer insights that can enhance personalized marketing campaigns. Except for 2020, which was during the pandemic, Ulta Beauty has increased its customer base in their loyalty program every year. It has gone from 28 million members in 2017 to 40 million in fiscal year 2023. It is also worth noting that 95% of total Ulta Beauty sales are made by their loyalty members.

All right, we have gone through the numbers, potential and risk regarding Ulta Beauty, and now it is time for us to calculate a price for Ulta Beauty. To calculate price, we will need numbers that I have explained in the "MY STRATEGY" section of the website. I do not want to go through the whole calculation here.I chose to use the EPS at 24,01, which is the one from fiscal 2023. The estimated future EPS growth rate is 11% (Ulta Beauty expects to grow EPS by low double digits). The estimated future PE is 22 (in this case, we multiply our predicted growth rate by two, as this is lower than the historical highest P/E). Additionally, we already have the minimum acceptable return rate of 15%. Doing the calculations, we come up with the sticker price (some call it fair value or intrinsic value) of $370,74. We want to have a margin of safety of 50%, so we will divide it by 2. This means that we want to buy Ulta Beauty at a price of $185,37 (or lower, obviously) if we use the Margin of Safety price.

Our second way to calculate a buy price is the Ten Cap price, which is also explained at "MY STRATEGY". To do so, we need some numbers from their financials, keep in mind that all numbers are in millions. The operating cash flow last year was 1.482. The capital expenditures were 475. However, once I studied their annual report, I saw that only 319 of that amount was used on maintenance. That is why we use that number in our calculation. The tax provision was 401. We have 50,364 outstanding shares. Hence, the calculation will be as follows: (1.482 - 319 + 401) / 50,364 x 10 = $310,54 in Ten Cap price.

The last calculation is the Payback Time. I also described in "MY STRATEGY". With Ulta Beauty's Free Cash Flow Per Share at 22,99 and a growth rate of 11%, if you want to recoup your investment in 8 years, the Payback Time price is $302,64.

I believe that Ulta Beauty is a great company, but there are still some uncertainties regarding its management. It doesn't mean that management is bad; on the contrary, Dave Kimbell has delivered great numbers since he became CEO.Personally, I just like a bit more history before I make a judgment. Nevertheless, I think his strategy sounds good and management doesn't keep me from investing in Ulta Beauty. Ulta Beauty will face some short-term challenges due to macroeconomic pressures, and it is never pleasant to see management reduce the outlook on margins. However, while management is keeping cautious regarding the economic headwinds, Ulta Beauty might just be able to outperform other sectors if the economic downturn lasts for a while. It is no secret that I like Ulta Beauty because they have consistently delivered a high return on invested capital (ROIC). I will be opening a position in Ulta Beauty if its stock price falls to the Ten Cap price of $310,54.

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