Waiting For A Clearance Sale On Ulta

By Stephen D. Simpson, CFA | June 07, 2011 AAA

As investors in retailers like Talbots (NYSE:TLB) or American Eagle (NYSE:AEO) can easily attest, this is not the easiest environment for retail. Oh true, conditions are better now than a year or two ago, but retailers really need to offer something distinctive in terms of product selection, pricing or shopping experience to draw in the crowds.

To that end, Ulta (Nasdaq:ULTA) seems to have hit on an attractive and differentiated concept - a beauty and personal care superstore format that is competitive on pricing while offering a wide selection and pleasant environment. Like lululemon (Nasdaq:LULU) and its own differentiated products and branding, Ulta is carving out an impressive growth trajectory while many of its rivals are struggling to hold on to what they have.


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Keeping up the Momentum in Q1
Ulta's fiscal first quarter showed no slowdown in the company's momentum. Sales were up almost 21% on a reported basis, with same-store sales up more than 11%. There is a decided lack of direct comps to Ulta (one of the positives in the company's thesis), but anecdotal from the likes of Macy's (NYSE:M), Nordstrom (NYSE:JWN) and Kohl's (NYSE:KSS) would suggest that Ulta's performance is quite a bit stronger than the average department store cosmetics counter.

Ulta was able to lever this topline momentum to stronger profitability. Gross margin improved more than two full points, and operating income jumped more than 67% as the company's operating margin improved by nearly 38% (from 7.3% to 10.1%).

Interestingly, inventory was down more than 1% on a per-store basis. While conservative inventory management is generally a wise move for retailers, Ulta needs to be careful. Clearly there is strong in-store sales momentum here and running out of stock of popular items would invalidate the superstore concept that the company is trying to build.

A Big Industry Ripe For a Shake-Up
There is no obvious reason why Ulta could not shake up the cosmetics industry the way Avon (NYSE:AVP) did so many years ago. Avon took an established sales strategy (door-to-door sales and the "Avon lady") that had not been seriously attempted in cosmetics and did remarkably well with it. Likewise, Ulta is leveraging the superstore concept into a market that is often dominated by in-store counters at major department stores or dingy specialty stores in strip malls.

Likewise, Ulta seems to be succeeding at differentiating itself from alternative retailers like Walgreen (NYSE:WAG), CVS (NYSE:CVS), Target (NYSE:TGT) or Sally's (NYSE:SBH). Ulta offers a much wider selection, a large well-lit (and generally attractive) store footprint, and competitive pricing. So although its true that Target or Walgreen can continue to capture sales from shoppers who are happy to pick up soap or makeup while making an unrelated purchase, it is difficult to see how these stores really compete when that same shopper is heading out with the intention of picking up cosmetics or other personal care products.

Bottom Line - Big Opportunity and Big Valuation
There is a big opportunity in front of Ulta; there is no reason the company could not double its store count to something in the neighborhood of 800, while also gaining share with its existing base. Moreover, as the company grows it will gain ever more leverage with suppliers.

On the other hand, the stock is already richly valued and has enjoyed a lot of Wall Street love. Existing shareholders should hold tight (at least until growth seems to sag), but newcomers to the name should probably hold off in the hopes of a sale - either from a general decline in the post-QE2 markets or some momentary hiccup in Ulta's growth trajectory and expansion plans. (For more, see The Value Investor's Handbook.)

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