Ulta Beauty: Don't underestimate the lipstick effect.

The lipstick effect is a theory that suggests that 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 a correlation between economic downturns and increased sales in the beauty industry, mirroring the trend observed during the Great Depression. Ulta Beauty is the largest beauty retailer in the United States, which suggests that they should benefit from the lipstick effect and perform well in all economic environments. The question now is whether it is the right time to buy shares.

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.

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 my liking 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 on investing with as little as $50.

The Business

Ulta Beauty was founded in Illinois in 1990 and is now the largest beauty retailer in the United States. The company offers branded and private label beauty products, including cosmetics, fragrance, haircare, skincare, bath and body products, professional hair products, and salon styling tools through its Ulta Beauty stores, shop-in-shops, Ulta.com website, and mobile applications. The company also provides beauty services such as hair, makeup, brow, and skin services at its stores. They are divided into different categories: Cosmetics (41% of sales), Haircare products (19% of sales), Skincare (19% of sales), Fragrance and Bath (15% 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 Ulta Beauty Services offers full-service hair salons in nearly every store and operates brow bars in most of their stores. Additionally, the company provides makeup and ear piercing services through its salons. In addition, they offer skincare services in approximately 150 locations. With over 1.380 stores scattered across the United States, I believe this is proof of Ulta Beauty having developed a strong brand moat. Furthermore. Ulta Beauty has a highly dedicated customer base, with 43 million people participating in their loyalty program. This further supports the idea of a strong brand moat.

Management

The CEO is Dave Kimbell. He joined Ulta Beauty in 2014 and held various positions until he became CEO on June 2, 2021, succeeding the previous CEO, Mary Dillon, who is now the CEO at Foot Locker. Prior to joining Ulta Beauty, he held positions at companies such as PepsiCo and Procter & Gamble. He has previously shared his leadership philosophy, which he defines as "leading with the heart." "Care, compassion, empathy, and inclusion are more important than ever." Dave Kimbell considers it important to understand 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. Dave Kimbell has only been the CEO for a few years, but as you will soon see, he has delivered impressive results during his tenure. However, his employee rating at Comparably is only 63/100, which puts him in the bottom 30% of similar-sized companies. A quick search on Google reveals that employees generally preferred former CEO Mary Dillon. A former employee mentioned that Mary Dillon was a people-oriented leader, while Dave Kimbell is an operations-focused leader. Nonetheless, his focus on operations is evident in the numbers I will be sharing shortly. This is why I give him the benefit of the doubt, considering he has also faced macroeconomic headwinds while serving as the CEO, which may have made it more challenging for him to prioritize being a "people's leader."

The Numbers

The first numbers we will investigate are the return on invested capital, also known as ROIC. We require a 10-year history where all figures exceed 10% each year. Ulta Beauty has consistently delivered impressive results, maintaining a Return on Invested Capital (ROIC) above 20% in nine out of ten years. ROIC was underwhelming in fiscal 2021, but this was during the pandemic. Ulta Beauty's fiscal year runs from February to the end of January the following year, meaning the 2021 numbers are from the period February 2020 to the end of January 2021. Since the pandemic and Dave Kimbell's appointment as the CEO, Ulta Beauty has consistently achieved a remarkable ROIC exceeding 55% for three consecutive years, which is highly impressive. ROIC has decreased slightly in the past two years, but it is not a cause for concern as only a few companies manage to deliver a ROIC above 55%.

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 actual numbers and the percentage growth year over year. Ulta Beauty has consistently increased its equity every year for the past 10 years, with the exception of the fiscal year 2022. I will give Ulta Beauty a pass for the numbers in 2022, as the company made significant investments in its IT system during that fiscal year. Ulta Beauty has increased its equity every year since fiscal 2022, which is encouraging. Another positive indicator is that Ulta Beauty achieved its highest equity ever in 2024.

Finally, we will analyze the free cash flow. Free cash flow, in short, refers to the cash that a company generates after covering its operating expenses and capital expenditures. I use levered free cash flow margin because I believe that margins provide a better understanding of the numbers. Free cash flow yield refers to the amount of free cash flow per share that a company is expected to generate in relation to its market value per share. It is not surprising that Ulta Beauty has managed to maintain a positive free cash flow over the past ten years. Ulta Beauty has experienced some years with a slight decrease in free cash flow, but it is not a cause for concern. For example, free cash flow decreased in fiscal year 2024, yet it remains at the second-highest level in the past ten years. The levered free cash flow margin reached a new high level in 2019 and has remained quite consistent ever since. However, it is slightly concerning that Ulta Beauty has delivered its lowest levered free cash flow margin since 2018 in fiscal year 2024. Free cash flow yield is at its highest level in ten years, indicating that the shares are trading at attractive valuations. However, we will revisit this later in the analysis.

Debt

Another crucial aspect to investigate is the level of debt, particularly whether a business has a manageable debt that can be paid off within a 3-year period. We calculate this by dividing the total long-term debt by earnings. However, it isn't possible to calculate the debt ratio for Ulta Beauty, as they have no debt. In fact, Ulta Beauty has not had any debt since 2009, which I believe is a great sign.

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Risks

As with all other investments, there are risks involved when investing in Ulta Beauty. One risk is the dependence on brand partners. Ulta Beauty is a retailer, which means its business is primarily selling third-party products to customers. Ulta Beauty does not have long-term supply agreements with brand partners. Therefore, the company's success relies heavily on maintaining strong relationships with its brand partners. Ulta Beauty's business is significantly reliant on the willingness and ability of its brand partners to provide a diverse selection and ample volume of products for stocking their stores. Some of these brand partners may lack the capacity to supply Ulta Beauty with enough merchandise to align with its growth plans. During fiscal 2023 and fiscal 2022, merchandise supplied to Ulta Beauty by its top ten brand partners accounted for approximately 55% and 56% of Ulta Beauty's net sales, respectively. The loss or reduction in the amount of merchandise provided to Ulta Beauty by any of these key vendors or other brand partners could significantly impact Ulta Beauty's business, financial condition, profitability, and cash flows.

Competition. Ulta Beauty faces 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. Ulta Beauty has been gaining market share in prestige brands over the past years, which is the main focus of Sephora's sales. However, Ulta Beauty did not manage to gain market share in fiscal year 2024. Management mentioned that Ulta Beauty continued to face pressure from the expansion of beauty distribution points in the prestige segment. Furthermore, competition is increasing as Sephora has partnered with Kohl's, leading to the opening of stores at strip centers. This move is significant because strip centers have traditionally been Ulta Beauty's territory, while Sephora has primarily focused on malls.

Shrink. The risk of inventory loss (also known as shrink) is inherent in the retail business. Ulta Beauty has historically experienced inventory shrinkage due to damage, theft (including organized retail crime), and other causes. While some level of inventory shrink is unavoidable, Ulta Beauty continues to experience elevated levels of inventory shrink relative to historical levels. This has adversely affected its results of operations and financial condition, and could continue to do so. Shrinkage continues to increase, as it rose by 40 basis points as a percentage of sales in fiscal year 2024. To protect against increasing inventory shrinkage, Ulta Beauty has implemented specific operational and strategic measures that could potentially harm their reputation, guest experience, and financial performance.

Reasons to invest

There are also plenty of reasons to invest in Ulta Beauty. One is opening new stores. In 2023, the beauty products industry totaled approximately $112 billion. Ulta Beauty estimates that they only had a 9% share of the $112 billion beauty product industry. In 2023, the salon services industry totaled approximately $69 billion. Ulta Beauty estimates that they had less than a 1% share of this industry. Thus, there is plenty of room to capture market share. One way to achieve this is by opening new stores. Management remains confident in Ulta Beauty's ability to open and operate between 1.500 and 1.700 traditional Ulta Beauty freestanding locations in the U.S. Ulta Beauty is planning to open between 50 and 55 net new traditional stores in fiscal 2025. Furthermore, management is optimistic that the small-format store prototype could provide Ulta Beauty with an opportunity for additional growth. They plan to open 10 of these stores in fiscal 2025. Finally, management is also optimistic about the partnership with Target and has opened an additional 155 Ulta Beauty at Target locations, concluding fiscal 2024 with a total of 510 shops.

The loyalty program. Loyalty programs are beneficial for businesses because they establish an emotional connection between customers and the business. Furthermore, loyalty program 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 its loyalty program every year. It has grown from 28 million members in 2017 to 43 million members by the end of fiscal 2024. Ulta Beauty expanded its loyalty program by 8% in fiscal 2024. Management has mentioned that loyalty members shop more frequently and spend more on average. It is also worth noting that 95% of total Ulta Beauty sales are made by their loyalty members. Management aims to organize events to attract new members, utilizing Ulta Beauty's distinctive data insights to broaden targeting and enhance member engagement. 

International expansion. Ulta Beauty will expand into Mexico in fiscal 2026 because the Mexican beauty market is sizable, growing, and offers significant opportunities in the beauty industry. Ulta Beauty's research suggests that there is a strong awareness of the Ulta Beauty brand among local beauty enthusiasts in Mexico. The company has also observed significant engagement from Mexican consumers in its stores located near the Mexican border. Ulta Beauty will enter Mexico through an asset-light partnership by forming a joint venture with Axo, a highly experienced operator of global brands. Axo is also present in other Latin American countries, which may allow Ulta Beauty to expand into other countries in the future. Ulta Beauty believes that international expansion represents an incremental long-term opportunity for the company.

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Valuation

Now it is time to calculate the share price. I perform three different calculations that I learned at a Phil Town seminar. If you want to make the calculations yourself for this or other stocks, you can do so through the tools page on my website, where you have access to all three calculators.

The first is called the Margin of Safety price, which is calculated based on earnings per share (EPS), estimated future EPS growth, and estimated future price-to-earnings ratio (P/E). The minimum acceptable rate of return is 15%. I chose to use an EPS of 26,03, which is from the fiscal year 2024. I have selected a projected future EPS growth rate of 8%. Finbox expects EPS to grow by 6,1% in the next five years, but I'm more optimistic. Additionally, I have selected a projected future P/E ratio of 16, which is double the growth rate. This decision is based on Ulta Beauty's historically higher price-to-earnings (P/E) ratio. Finally, our minimum acceptable rate of return has already been established at 15%. After performing the calculations, we determined the sticker price (also known as fair value or intrinsic value) to be $222,26. 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 $111,13 (or lower, obviously) if we use the Margin of Safety price.

The second calculation is known as the Ten Cap price. The rate of return that a company owner (or stockholder) receives on the purchase price of the company essentially represents its return on investment. The minimum annual return should be at least 10%, which I calculate as follows: The operating cash flow last year was 1.476, and capital expenditures were 435. I attempted to analyze their annual report to calculate the percentage of capital expenditures allocated to maintenance. I couldn't find it, but as a rule of thumb, you can expect that 70% of the capital expenditures will be allocated to maintenance purposes. This means that we will use 304,5 in our calculations. The tax provision was 405. We have 48,324 outstanding shares. Hence, the calculation will be as follows: (1.476 – 304,5 + 405) / 48,324 x 10 = $326,24 in Ten Cap price.

The final calculation is called the Payback Time price. It is a calculation based on the free cash flow per share. With Ulta Beauty's Free Cash Flow Per Share at $21,44 and a growth rate of 8%, if you want to recoup your investment in 8 years, the Payback Time price is $246,29.

Conclusion

I believe that Ulta Beauty is an intriguing company. Management has achieved impressive results over the past three years. However, there are uncertainties surrounding employee satisfaction. Hopefully, this will become a key focus for management in the future. Ulta Beauty is a retailer, which means they are dependent on brand partners, nd while Ulta Beauty doesn't have any long-term agreements with its partners, it is the largest beauty retailer in the U.S., which means that partners will prioritize Ulta Beauty. However, one risk associated with this dependence is that if Ulta Beauty's brand partners cannot keep up with the demand, it could impact Ulta Beauty's financials. Competition poses a long-term risk, especially as Ulta Beauty has gained market share in prestige brands, a domain traditionally dominated by Sephora. Furthermore, Sephora has opened stores at strip centers, which have traditionally been Ulta Beauty's territory. Thus, competition is something to be monitored. Another aspect that needs to be monitored is inventory shrinkage, as Ulta Beauty is currently facing higher levels of shrinkage compared to its historical data. This ongoing issue could further impact its financial condition and operational results. Ulta Beauty still has plenty of room to gain market share and will do so by continuously opening stores. There is still room for its traditional freestanding stores in the U.S., but Ulta Beauty will also increase the number of small-format stores and its stores at Target. Ulta Beauty continues to expand its loyalty program year over year, which will result in more growth as its loyalty members shop more frequently and spend more on average. Finally, Ulta Beauty is expanding internationally, which will increase its addressable market. I believe there are many reasons to appreciate Ulta Beauty, and purchasing shares below the Ten Cap price of $326 could prove to be a promising long-term investment.

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