Ulta Beauty, Inc. ULTA Buy Target: $ Current Price: $251.21

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1 Ulta Beauty, Inc. ULTA Buy Target: $ Current Price: $ v Investment Thesis ULTA Beauty (ULTA), a beauty and cosmetics retailer with in store salons, has pulled back over 20% from their high last month due to cosmetic discounting at the major department stores for the first time. News of the discounting sent ULTA into a tailspin even though ULTA is one of the fastest growing retailers with a double-digit growth rate with plenty of upside. Management recently increased their store target from 1,200 to 1,400-1,700 stores while opening ~100 new stores each year. We believe that ULTA is an ideal value investment. They are quickly expanding their competitive advantage by offering an excellent rewards program, a new store credit card, improving margins, more online sales and crucially - less discounts. While their competitors are offering more promotions to drive traffic, June and July were some of ULTA s least promotional months this speaks to both their growth and margin potential. ULTA s fundamentals are marching forward while their competitors are desperately trying not to fall backwards. Catalyst Pricing: We believe the market has overreacted to the potential headwinds for ULTA s business model. This 20%+ pullback in the stock price presents an ideal buying opportunity for a company with impressive growth and long term potential. Source: Bloomberg, JWC Research Weekly Chart Loyalty Program: The ULTA loyalty program has been enviably successful. Their members typically remain impressively loyal and now that ULTA is rolling out the MAC makeup brand typically only offered in MAC stores we expect their loyalty program, with the help of their new store credit card program, to continue to grow at an impressive rate. *Please see disclaimer at the end of this report. Source: Stockcharts.com 2017 JWC Research. All rights reserved. No part of this report may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying or by any information storage and retrieval system, without permission in writing from JWC Research. Page 1 July 31, 2017

2 What is the JWC Confidence Score The JWC Confidence Score is designed to quickly give our clients the key bullish and bearish points based on the JWC Research process - scoring the industry, operations, management team and valuation. The JWC Confidence Score utilizes 100 as a baseline score. The analyst then scores each segment of their analysis, decreasing it for bearish signs and increasing it for bullish signs. The graph shows a recap of this analysis with the company score being an average of the four sections. The JWC Confidence Score is continually monitored and updates are released based on any changes to the JWC Confidence Score. JWC Confidence Score Industry: 90 Bull: The nature of the beauty industry insulates it from the effects of Amazon as consumers typically want to see it in person before they buy. And once a customer finds their product, they tend to remain loyal. Bear: Heavy discounting from department stores is creating headwinds that have driven ULTA down ~20% since early June. This could have an impact on near term earnings. JWC Confidence Score Operations: 140 Bull: Their in-store salon and wide product offering has allowed for impressive double digit growth and customer loyalty. Bear: Although they have a wide product offering, a large portion of their sales comes from a few key brands. This creates some supplier leverage that could be an issue if not properly managed. Management: 100 Bull: Management has consistently bought back stock and we expect this favorable trend to continue. Bear: An independent director sold ~$200 million worth of ULTA last September. That was 30% of his stake and was sold at $ less than today s price. Valuation: 100 Bull: Free cash flow has been solid and is improving. Management has done a good job controlling costs and maintaining growth. We expect this to continue. Bear: We are not fans of a capital structure that has zero debt in a historically low interest rate environment. We believe some additional debt could improve growth in a meaningful way without threatening the balance sheet. Ulta Beauty, Inc. (ULTA): 110 Bull: The growth of ULTA is being overlooked in the recent stock price downturn. We believe that the street will recognize this in the coming quarters as department stores normalize pricing. Bear: Department stores have long been the go to for cosmetics and are fighting to maintain relevance. Ultimately, we believe ULTA will continue to grow at a substantial rate, but it s possible that department stores stick with price discounting longer than expected. Page 2 July 31, 2017

3 Company Description ULTA Beauty is the largest beauty retailer in the United States that provides a bright and open store environment that encourages guests to enjoy discovering new products and services. It offers more than 20,000 products from approximately 500 wellestablished and emerging brands. Their beauty products include cosmetics, fragrance, skin care products, hair care products and salon services. As of January 28,2017, they operated 974 retail stores across 48 states and the District of Columbia (Figure 1), as well as e-commerce website. Industry Overview Competition: The competitive landscape has shifted in the beauty retail industry with the two primary pain points being e-commerce and drugstores. E-commerce sales, fueled by Amazon, is a threat to traditional department and retail stores. On one hand, consumers shifted away from department stores in favor or beauty, cosmetics and fragrance stores. On the other hand, they opt for the convenience and wide selection of products offered online. Online prices are usually lower due to much reduced overhead and labor costs. Figure 1. Store Count Source: Company Filings Drugstores and mass merchandisers have also begun to offer a variety of beauty products at a much lower price, some of which also utilize natural and organic formulas. Additionally, the retail giants Target and Walmart have even expanded their cosmetic product lines, some of which are exclusively made for them. That s the bad news. The good news: Women between the ages of represent the largest percentage of the industry s customer base. This demographic is growing from both a numbers and disposable income perspective. Many of these women prefer the convenience and experience that beauty stores like ULTA and Sephora offer. This remains a leading reason why ULTA has continued to post sector leading same store sales over the past few years and is expected to continue to do so. Beauty Trend: The competitive landscape of going organic and pursuing healthy lifestyles has intensified in recent years. Demand for natural ingredients and naturally produced beauty products will continue to inspire product innovation and spur investments in research and development, ultimately creating new k Page 3 July 31, 2017

4 Industry Overview (continued) products with higher price points and improved margins. The industry has already proven increasing demand for higher-end products, which have remained popular among millennials. We believe that new formulas will serve as a catalyst and continue to grow sales and profits. Customer Service: Young generations (ages 20-35) now shop for experience instead of materials. To cater to their needs, retailers must be creative and come up with exceptional ideas or events, both in-store and online, to establish unique customer experience and drive traffic. It is much more convenient to order a piece of furniture online and have it delivered to your home with free shipping than going to the store. However, for skincare products, trying on is a plus or even a necessity for sensitive skin before you confirm that it suits your skin type and decide to make a purchase. Therefore, skilled staff must demonstrate their care for customers during the personalized service and it will encourage repeated sales through customer loyalty. Wrap Up: The beauty industry has struggled recently as department stores, once the leaders in the customer experience segment of the market, have drastically discounted their beauty products to stay relevant in a struggling retail environment. Yet despite this last-ditch effort, consumers continue to shift away from department stores to specialty beauty stores like ULTA and Sephora. We believe this trend will continue as beauty stores continue to expand their product offerings (Figure 2) and they will pick up many of the millennials that are starting to hit the job market. Figure 2. Acceleration of Major New Brand Additions Source: Company Presentation Page 4 July 31, 2017

5 A Quick Look at Operations Growth: ULTA currently operates 990 stores in 48 states that are located primarily in strip malls in suburban areas. They have started to invest in urban site selections and hope to continue their success in developing both suburban and urban markets. Their stated goal is growing their store count to stores over the next few years. Current expectations are growth of ~100 new stores annually. With their current $471 million in cash and short term investments, and an average cost of $1.4 million for a new ~10,000 square foot location, ULTA has enough cash to fund over 300 stores today. Consequently, we expect the 100 new stores a year to be an achievable goal. Rewards: 90% of the revenue comes from loyalty program members and there has been rapid growth in Loyalty Program Membership recently. To continue loyalty program growth, Ulta recently launched their co-branded and private label credit card, which reinforces their goal on the loyalty membership program. They believe that the embedded benefits of opening a credit card with Ulta will help them provide special offers and retain more loyal customers. Figure 3. E-commerce Sales Source: Company Filings, JWC Research Competitive advantage: What separates Ulta from their competitors is the experience that one gets when shopping at Ulta. Each Ulta location is equipped with a full-service salon and brow bar. Combine that with the Glam Lab mobile app and a customer loyalty program which offers monetary rewards instead of points, Ulta is well positioned to keep expanding their footprint across all America regardless of the retail headwinds triggered by Amazon. (continued ) Page 5 July 31, 2017

6 A Quick Look at Operations (continued) Online Presence: ULTA s e-commerce operations play an increasingly important role to the business. As of January 2017, annual e- commerce sales reached $345 million, which accounts for 7.1% of total sales and 56% growth from $221 million from the previous year (Figure 3). Management aims to achieve 10% e-commerce penetration by The key for the sales resides in its brand portfolio. With more than 20,000 products from around 500 brands priced moderate to higher-end, anyone who walks into the store will be able to identify their favorites with the assistance of Ulta s trained staff. In addition to the wide selection of merchandise, Ulta recently introduced an app called Glam Lab where customers can test the product and try on make-up digitally (take a selfie and apply makeup to your picture). Customized Services: A key to Ulta s success is their full-service salons and they have been working on raising the awareness of it (Figure 4). In 2016, salon sales increased 15.2% to $241,1 million, representing 5% of total company sales. Per a company survey, brow bar and salon guests spend almost three times as much as non-salon guests, and shop two times more than non-salon guests. We believe that Ulta s professional in-store salon and brow bar are what differentiate them from both online and the typical brink and mortar retailers. Figure 4. Pillars of Service Offerings Source: Company Presentation Page 6 July 31, 2017

7 Management Our View: Management has consistently stuck with their share repurchase program to protect shareholder value (Figure 5). On March 9, 2017, the company announced that they authorized the repurchase of up to $425 million of the Company s common stock. Based on their track record, we believe that ULTA will stick with their share repurchase program. Figure 5. Share Repurchases Historically, ULTA invests their free cash flow primarily in their new store program, brandexpansion and better information technology systems. As they strive to improve their balance between in-store and e-commerce sales, we expect to see more better-thanexpected earnings on their way to a larger store base. JWC Valuation Valuation: In Q1 2017, ULTA delivered another robust quarter with solid sales gains, and their 14.3% same store sales growth went way above the initial guidance of 9%-11%. Our $306 price target is based on our discounted cash flow (DCF) valuation (Figures 7 & 8). We use a WACC of 8.5% and a perpetual growth rate of 3.5%. Source: Company Filings, JWC Research Figure 6. Shares Outstanding ( present) Capital Structure: ULTA generated $261 million in free cash flow in fiscal 2016, after investing $374 million in capital expenditures to help fuel same and new store growth. They currently have a $200 million revolver that is unused and no outstanding bonds. Given their ~$5 billion in revenue and strong free cash flow over the past 12 months, we believe that a moderate amount of debt ($200 to $300 million) could materially contribute to growth without a burdensome interest expense. ULTA became part of the S&P 500 Index in April 2016, which can be viewed as an indication of their strong financial position. Source: Company Filings Page 7 July 31, 2017

8 Figure 7. JWC Free Cash Flow Figure 8. DCF Assumptions Major DCF Assumptions Risk Free Rate (10 yr treasury) 2.29 Equity Risk Premium 6.28 Beta (2 yr avg) 1.01 Country Premium 6.21 Expected Market Return 8.50 Cost of Equity 8.56 Source: JWC Research, Company Filings, Bloomberg Figure 9. Debt Maturity Profile ($ millions) ** **ULTA Currently has no outstanding debt & a $200 million revolver available Page 8 July 31, 2017

9 Risks Growth Plans: ULTA has mapped out a growth plan to open approximately 100 new stores every year, which are predominately located in convenient, hightraffic locations in the hope that they can continuously keep loyal clients, attract new clients and generate steady sales. If they have trouble keeping up with their business strategy, net sales and operating profit will not increase as planned and this would affect our valuation. Figure 10. Estimates & Key Data Vendor Partnerships: ULTA Beauty is currently maintaining an active and strong relationship with more than 400 vendor partners. However, the top 10 vendor partners made a significant contribution to nearly half of the total net sales in fiscal Since ULTA s success is highly dependent on the ability of vendors to offer a unique combination of beauty products and services to the customers, if the key vendors do not perform well, the long-term agreement changes, or vendor partners fail to provide ULTA with enough products to support instock levels, it would be difficult to assume profitability and cash flows for the business. Market Sentiment: Beauty trends are somewhat unpredictable and so are consumers behavior. If ULTA has difficulty identifying products and services in response to beauty trends and consumers preferences in a timely manner, they are losing power to drive store traffic and comparable sales. Additionally, the cost of sales is subject to supply and demand of the market. If there are any disruptions of distribution infrastructure due to costs, ULTA will face challenges in their operations. Source: Bloomberg, JWC Research Department Store Discounts: Department stores have discounted their beauty products to drive consumer to their locations. This has added some pressure to the industry. We believe this is sustainable only for a short while and pricing will revert to the mean. If this takes longer than we expect, this could have a meaningful impact on our valuation. Page 9 July 31, 2017

10 JWC Rating Systems Buy: The stock s total return is expected to outperform the S&P 500 over the next 12 months. Avoid: The stock s outlook and drivers are too unpredictable. This stock should be avoided. Sell: The stock s total return is expected to materially underperform the S&P 500 over the next 12 months. JWC Research Disclaimer JWC Research is an independent investment research provider and is not a member of the FINRA or the SIPC. JWC Research is not a registered broker dealer and does not have investment banking operations. The JWC Research trademark, service mark and logo are the intellectual property of JWC Research Inc. The information contained in this research report is produced and copyrighted by JWC Research, and any unauthorized use, duplication, redistribution or disclosure is prohibited by law and can result in prosecution. The content of this report may be derived from JWC Research reports, notes, or analyses. The opinions and information contained herein have been obtained or derived from sources believed to be reliable, but JWC Research makes no representation as to their timeliness, accuracy or completeness or for their suitability for any particular purpose. This report is not an offer to sell or a solicitation of an offer to buy any security. The information and material presented in this report are for general information only and do not specifically address individual investment objectives, financial situations or the particular needs of any specific person who may receive this report. Investing in any security or investment strategies discussed may not be suitable for you and it is recommended that you consult an independent investment advisor. Nothing in this report constitutes individual investment, legal or tax advice. JWC Research may issue or may have issued other reports that are inconsistent with or may reach different conclusions than those represented in this report, and all opinions are reflective of judgments made on the original date of publication. JWC Research is under no obligation to ensure that other reports are brought to the attention of any recipient of this report. JWC Research shall accept no liability for any loss arising from the use of this report, nor shall JWC Research treat all recipients of this report as customers simply by virtue of their receipt of this material. Investments involve risk and an investor may incur either profits or losses. Past performance should not be taken as an indication or guarantee of future performance. JWC Research officers, employees, agents and/or affiliates may have positions in stocks discussed in this report. No JWC Research officers, employees, agents and/or affiliates may serve as officers or directors of covered companies, or may own more than one percent of a covered company s stock. Page 10 July 31, 2017