Buy Ulta Beauty And Beat The Bear Market (NASDAQ:ULTA)

One of my biggest regrets has always been not pulling the trigger on acquiring some Ulta Beauty, Inc. (NASDAQ:ULTA) shares when the stock made its first appearance on my personal radar in early 2019. At the time the stock was enjoying years of overperformance thanks to steady growth and a resilient business model. Since then, I argue that the company is even in a better shape, having navigated more than successfully the terribly confusing COVID restrictions. Today the stock is in the enviable position to be basically flat YTD, in a year when the S&P 500 (SPY) is down over 25% and the Nasdaq 100 (QQQ) is down over 35%.

I believe that there are very good reasons for Ulta Beauty’s overperformance compared to the market and at the current valuation still represents a potentially great entry point.

ULTA’s business model is amazing

Ulta is a retailer with over 1,200 stores specialized in the sales of beauty products (skin and hair care, fragrances, cosmetics) of all price ranges, from the entry level segment to the premium one. Over the years the company has put in place very successful strategies in order to increase its brand reach, boost customer’s loyalty and enhance its offering. First and foremost, ULTA has really embraced the omnichannel experience: customers interested in purchasing beauty products can visit one of the company’s brick-and-mortar shops or place an order online (e-commerce sales grew by 35% CAGR from 2017 to 2021). Moreover, Ulta Beauty opened over 100 “shop-in-shops” inside Target locations in 2021 to further capture new audiences.

One of the unique propositions for Ulta has always been offering salon services at its locations (professional makeup, eyebrows and wax, skin care, etc.). Service customers generate 3x higher annual spending compared to non-service buyers. The reason why is that about 50% of these customers tend to also purchase retail products on the day of the service, and they also visit at least 5 additional times an Ulta Beauty store per year.

Another avenue to increase customer’s spending is the Ultamate Rewards Program. Ulta’s loyalty program is adopted by an increasing number of consumers, reaching 38.2 million active members in the latest quarter (10% growth YoY). The growth of this customer cohort is vital for the growth of the business as about 95% of Ulta Beauty sales are actually generated by Ultamate Rewards members. By having such a large group of buyers that joined the reward program the company can gather very useful data on consumer’s behaviour and generate competitive advantage thanks to it.

Ulta’s Q2 2022 confirmed the business’ resilience

For the latest quarter Ulta Beauty posted 16.8% revenue growth to $2.3 billion, very strong growth due to a somewhat easy comparison with last year, when there were still restrictions on the general population and consumers were not experiencing that many events in person. Comparable sales for already existing stores also rose 14.4% thanks to an increase in transactions (8.3%) as well as in average ticket (5.6%).

Great news on the margins side as well: Gross Margins came in at 40.4%, pretty much stable compared to last year while Operating Margins ticked higher at 17% (compared to 16.8% a year before). For the first 6 months of 2022 the company has also posted great Free Cash Flow with about $420 million, up from a year ago ($344 million) which was also a quarter of lower capital expenditures as the company was operating much more frugally due to major uncertainties related to the global pandemic.

In a period when everybody is freaking out about inventories at companies such as Walmart (WMT) and Target (TGT), ULTA’s management was able to keep inventories largely at bay with an increase of 15% YoY. Considering the cost pressures, the need for new inventory for the opening of 29 new stores and the growing demand from its resilient customer base, 15% increase in inventory appears as very well managed compared to over 30% at Walmart and Target. Overall the results were great and proved once again the resilience of the beauty category, as well as the amazing results obtained by this great company.

The valuation is very reasonable for an entry point today

Given the general outperformance of the stock, one could imagine that the company is trading today for sky-high valuations. In reality I argue that ULTA shares are trading today at reasonable valuations considering the quality of the business, the future growth and the consistent share buyback program.

I built a quick Discounted Cash Flow [DCF] model to gauge what is the market expecting from the stock at current valuations. Since 2017 Ulta Beauty grew its free cash flow on a CAGR basis of 8.6% YoY, to the most recent yearly figure of $887 million. By projecting into the next 10 years a more conservative 5% growth and assigning a terminal value for Price to FCF of 20 (below the last 3 years average of around 23), at 10% discount the company would be valued around $18 billion, marginally below today’s valuation of $20.5 billion. On top of this, Ulta has been retiring shares constantly thanks to its shares buyback program: since 2016 the number of shares outstanding declined consistently at an average yearly rate of 2.67% which is positively impacting investors returns.

Despite the shares trading at a moderate premium valuation for the retail sector (Forward PE of 18.71 and Forward PS of 2.09, respectively 49% and 165% higher than the Consumer Discretionary sector as per Seeking Alpha data), ULTA is an amazing business with an increasing moat thanks to its rewards program and the unique combination of omnichannel store and services provider. No wonder that the shares have held very decently this year (-2.12% YTD) despite the overall market turmoil. I believe that today’s price is still very attractive for establishing long-term positions in Ulta and will consider it myself when new liquidity will come in.