Ulta Beauty: Don't underestimate the lipstick effect.
Opdateret: 15. jul. 2022
We are most likely facing economic headwinds soon. Hence, I'm investigating companies that could fair relatively well in these conditions. One such company that has bene 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 shares in Ulta Beauty. I did own shares at some point but sold them at a 78 % profit last year. If you want to see what shares I own or if you want to copy my portfolio, you can read how to do so here. Since I sold my shares Ulta Beauty has been on my watch list, but I didn't pull the trigger yet. Despite me liking the company, I will keep this analysis unbiased.
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 (43 % of sales), Haircare products (20 % 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 1.300 stores scattered across the United States, which I believe is a proof Ulta Beauty having developed a strong brand moat. Furthermore. Ulta Beauty has very committed customers, as 37 million people are part of their loyalty program, which further supports the thesis of a strong brand moat.
Their CEO is Dave Kimbell. He joined Ulta Beauty in 2014 and has held various positions until he became CEO June 2nd, 2021, when he took over from previous CEO Mary Dillon that now serves as the executive chair on the board of directors. Prior to joining Ulta Beauty he held positions in companies such as Pepsico and Proctor and 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 life of consumers and Ulta Beauty team members. He wants to transform that into a formula of success, as wants to establish Ulta Beauty to be a highly engaging, inviting, and inclusive environment that provides price points for all customers. I believe that focusing on a good customers experience while having products at all price points is a good strategy. However, as 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 brand moat. However, it is still too early to judge the management. Now let us investigate the numbers to see if Ulta Beauty lives up to our requirements for a strong moat. 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 investment capital, also known as ROIC. We want to see 10 years of history and we want the numbers to be above 10 % in all years. Ulta Beauty has consistently delivered great numbers. Fiscal 2020 and fiscal 2021 were lower than usually but this was during the pandemic, where 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. All in all, I'm very encouraged to see a company that is delivering a ROIC above 20 % in each and every year that hasn't been affected by a pandemic.
The next numbers are the book value + dividend. In my old format this was known as the equity growth rate. It was the most important of the four growth rates I used to use in my analyses, which is why I will continue to use it moving forward. As you are used to see the numbers in percentage, I have decided to share both the numbers and the percentage growth year over year. Ulta Beauty has grown that book value every single year in the last 10 years, except for last year. I will give Ulta Beauty a pass for the numbers in 2022, as Ulta Beauty has invested heavily in their IT system in fiscal 2022. All in all, I'm encouraged with these numbers.
Finally, we investigate the free cash flow. In short, free cash flow is the cash a company generates after it has paid for operating expenses and capital expenditures. Ulta Beauty is growing their free cash flow every year except in fiscal 2021 that was hurt during the pandemic. I'm particularly encouraged about the numbers in fiscal 2022 as capital expenditures has gone from $152 million in fiscal 2020, $172 million in fiscal 2021 to $425 million in fiscal 2022. It is great to see Ulta Beauty growing their free cash flow like this.
Another important thing to investigate is debt, and we want to see if a business has a reasonable debt that can be paid off within 3 years. We do so 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.
As with all other investments, there are some risks when investing in Ulta Beauty. One risk that management mentioned as a short-term risk is price increases in the supply chain. In the earnings call on the first quarter of 2022, management mentioned that high fuel prices will result in higher supple chain costs than initially planned. Higher supply chain costs will hurt margins, and despite Ulta Beauty delivering a 18,7 % operating margin in the first quarter of 2022, management expects operating margin to end between 14,1 % and 14,4 % by the end of 2022. Lower margins mean lower profitability. If these high costs continue moving forward, we will see lower margins in a longer time than just 2022. Economic slowdown. In their 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 solely has exposure 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 and how it will affect consumer discretionary spending, but it is a risk that one needs to be aware of. Their addressable market is decreasing. In their annual report Ulta Beauty reports on their addressable market, and the addressable market has decreased from 2020 to 2021. The U.S. beauty products industry totaled $91 billion in 2021 compared to $92 billion in 2020, while the U.S. salon services industry totaled $58 billion in 2020 compared to $49 billion in 2021. It means the total addressable market has declined by $10 billion in a year. While it could be caused by the pandemic, I believe it is something that one needs to be aware of and something that needs to be monitored moving forward, as you would like the addressable market to increase and not decrease.
There are also lots of potential for Ulta Beauty moving forward. They are gaining market share. While the addressable market is declining, Ulta Beauty is gaining market shares in the U.S. beauty products industry. In fiscal 2021 their market share was 7 %, while their market share in fiscal 2022 was 9 %. It is always encouraging to see a company gaining market share, but another interesting thing is that with only 9 % market share, they have plenty of room to grow. Their market share in the U.S. salon services industry were 1 % in both fiscal 2021 and fiscal 2022. Hence, they are not winning market share as of now, but they have plenty of room to grow. The lipstick effect. The lipstick effect is a theory that when facing an economic crisis consumers are more willing to buy less costly luxury goods. Researchers from Texas Christian University published research in the Journal of Personality and Social Psychology that a downturn in the economy has been linked to an upswing in beauty sales since the Great Depression. Thus, we might see Ulta Beauty outperforming other industries during economic headwinds despite management believing it to be a risk. Their loyalty program. Loyalty programs are good for business as they build an emotional connection for the customers to the business, loyalty members are more likely to spend more per purchase than other customers, and loyalty programs deliver customer insights that can improve personalized marketing campaigns. Except for 2020 that was during the pandemic, Ulta Beauty has increased the customer base in their loyalty program every year. It has gone from 28 million members in 2017 to 37 million in 2021. 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. Due to the uncertainty of whole situation with the Covid-19 pandemic I decided not to use the current EPS, instead I decided to use a EPS of 14, which is lower than fiscal 2022 of 17,98 but higher than fiscal 2020 of 12,96. Estimated future EPS growth rate of 12 (Ulta Beauty expects to grow EPS by low double digits), Estimated future PE 24 (in this case we multiply our predicted growth rate with two, as this is lower than the historical highest P/E) and we already have the minimum acceptable return rate on 15 %. Doing the calculations by using the formula I described in "MY STRATEGY" we come up with the sticker price (some call it fair value or intrinsic value) of $257,98, and we want to have a margin of safety on 50 % , so we will divide it by 2 meaning that we want to buy Ulta Beauty at price of $128,98 (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 1.059. The Capital Expenditures was 425, however once I studied their annual report, I saw that it was only 205 of those that was used on maintenance, which is why we use that number. The Tax Provision was 310. We have 54,482 outstanding shares. Hence, the calculation will be like this: (1810,36 - 96 + 55,25) / 55,39 x 10 = $214,0 in TEN CAP price.
The last calculation is the PAYBACK TIME. I also described in "MY STRATEGY". With the Free Cash Flow Per Share at 14,14 and a growth rate of 12 %, if you want your purchase back in 8 years, the PAYBACK TIME price is $194,79.
I believe that Ulta Beauty is a great company but there are still some uncertainties regarding 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 judgement. 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 regarding the supply chain, and it is never nice to see management lower margins. However, while management is keeping it cautious regarding the economic headwinds, Ulta Beauty might just be able to outperform other sectors if the economic downturn will last for a while. It is no secret that I like Ulta Beauty because they have delivered a consistently high ROIC, and I will open a position in Ulta Beauty if it falls to the TEN CAP price at $214.
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