The Bull Case For Ulta Beauty Inc.

With Quiver Quantitative’s recent institutional holdings data, we can see that many hedge funds and asset managers have increased their stake in Ulta Beauty Inc. ULTA. Firms such as Fidelity Investments, Arrowstreet Capital, and Alyeska Investment Group have all added to their ULTA positions recently. Most notably, Fidelity Investments increased shares held by 22% (as filed 03/31), bringing their total ULTA holdings to 1,652,512 shares worth around $736.5 million dollars at current market prices. With this in mind, we took a closer look at some of the reasons why many investors may be bullish on Ulta Beauty.

Ulta Beauty Inc. operates within the large and growing U.S. beauty products and salon services industry. This market reached $172 billion dollars in sales in 2022, according to Euromonitor International and IBIS World Inc. Additionally, in 2022, the beauty products market was valued at $104 billion dollars, with Ulta Beauty’s management believing to hold around 9% market share in the industry. Ulta Beauty’s main competitors include traditional department stores, specialty stores, grocery stores, drug stores, mass merchandisers, as well as e-commerce platforms of pure-play e-commerce companies and national retailers. The beauty products market is highly fractured along with the salon services and products market, which Ulta Beauty also operates in and largely competes with chain and independent salons.

Ulta Beauty Inc. is the largest specialty beauty retailer in the United States, selling cosmetics, fragrances, skin care products, hair care products, and salon services. Founded in 1990, Ulta Beauty has developed a unique specialty retail concept that offers a wide range of brands at different price points for their target customer base, which they call “beauty enthusiasts”, a consumer that is passionate about the beauty category and uses beauty for self-expression and self-investment.

The beauty enthusiast is a large customer base to cater to, and Ulta Beauty does a great job of serving the customer base's needs. Ulta Beauty estimates that these beauty enthusiasts make up around 80% of beauty product and service spend in the United States and account for 65% of Ulta Beauty’s sales.

Ulta Beauty’s assortment of over 25,000 beauty products from over 600 beauty brands across a variety of price points and categories gives shoppers plenty of options to search for. Ulta Beauty carries the widest range of beauty products on the market, giving it a competitive advantage to competitors, especially considering their customer base of “beauty enthusiasts”. With such a wide range of products to choose from, these beauty enthusiasts keep coming back to Ulta Beauty through a best-in-class loyalty program. Ultamate Rewards, Ulta Beauty’s loyalty program, allows shoppers to earn points on every dollar they spend on products and beauty services at Ulta Beauty, purchases on private label and co-branded credit cards, and purchases at Ulta Beauty locations inside of select Target stores. These points can be redeemed for discounts on any product or service at Ulta Beauty, great for their customer base of beauty enthusiasts with recurring and sticky spend on beauty products.

With more than 95% of total sales coming from members, Ulta Beauty has one of the largest moats within the specialty retail space as their customer base is extremely loyal through their best-in-class loyalty program. With such a deep understanding of their customer’s preferences and behaviors, Ulta Beauty is able to efficiently personalize shopper experiences, recommendations, and promotions for customers.

In addition to understanding their customer base very well, Ulta Beauty’s store footprint and leading digital experiences offered through its website and mobile application provide customers and shoppers with value that makes their shopping experience positive and makes them want to return. Ulta Beauty operates over 1,350 free standing locations, often located in high-traffic locations. In addition to these stand alone locations, Ulta Beauty offers 350 Ulta Beauty at Target shop-in shops that offer customers curated prestige beauty product offerings. With Ulta Beauty’s bright, open store design, customers are easily able to discover new products and services. Additionally, the store’s open layout makes it flexible and easy to change in response to consumer preference changes and changes in merchandising strategy, allowing Ulta Beauty to operate its stores very efficiently.

Ulta Beauty’s digital experiences and technology offers a personalized and innovative experience for customers. Shoppers are given an array of fulfillment options (buy online pick-up in store, buy online pickup curbside, ship from store, ship from distribution center, and same-day delivery) that give customers the luxury of convenience. Additionally, Ulta Beauty’s innovative digital experiences (virtual try-on and skin analysis tools) leverage augmented reality (AR) and artificial intelligence technology (AI) to provide customers with personalized experiences, further showing Ulta Beauty’s commitment to giving customers the best experience possible when shopping online or in their stores. This calculated dedication to customer’s has clearly paid off, and we believe that it will continue to be a strong competitive advantage for them.

Beauty enthusiasts, Ulta Beauty’s targeted customer base, prefer to transact in store, evidenced by Ulta Beauty’s member data and guest insights. Due to this, Ulta Beauty plans to strengthen their omnichannel retail experience through an increased physical store footprint, further enhancement of digital innovation, and growth of their buy anywhere, fill anywhere capabilities. Ulta Beauty plans to offer an industry-leading omnichannel platform to unlock breakthrough customer engagement.

As mentioned above, with 95% of sales coming from 40.2 million active Ultamate Rewards loyalty program users and robust proprietary customer research capabilities, Ulta Beauty knows its customers better than anyone else. With these research capabilities, Ulta Beauty has acknowledged that social media and influencers play a big part in beauty enthusiasts' connection to beauty. Ulta Beauty plans to build out their brand purpose and build a creator and content ecosystem to deliver compelling beauty entertainment to drive brand awareness. Additionally, they plan to continually innovate the Ultamate Rewards loyalty program and use member data to drive increased personalization and sales conversion. Ulta Beauty understands that beauty enthusiasts enjoy the experience of trying and discovering new products. Therefore, management plans to continuously engage this customer behavior by offering a curated and inclusive assortment of leading beauty and self-care products that tap into relevant beauty trends. Ulta plans to engage these customers and drive growth by maximizing growth in key categories (makeup, skincare, haircare, and fragrance), driving growth of cross-category strategic platforms (Conscious Beauty at Ulta Beauty, the Wellness Shop, and SPARKED at Ulta Beauty), differentiating their product assortment through exclusive brands and products (i.e. Ulta Beauty Collection, their private label), and increasing profitability through assortment management, inventory productivity, and promotional optimization. Management understands that cost pressures from rising wages, transportation costs, and expected secular headwinds from channel and category mix shifts are dampening growth. Due to this, they are upgrading their enterprise resource planning platform and enhancing their supply chain network to increase agility, speed, and cost-efficiency. By optimizing their cost structure to enable scale, developing agile operating systems to enable more informed decision making, and building new capabilities to win in the rapidly advancing omnichannel commerce world, Ulta Beauty is building a sizable competitive advantage. Simply put, Ulta Beauty knows its customers better than anyone else, and they are making strides to unlock maximum engagement with their customer base who evidently have sticky and recurring beauty product spend. 

Management is solid and their capital allocation priorities are shareholder friendly. During the fourth quarter of 2022, management repurchased 722,983 shares at an average price of $454.20 dollars per share, repurchasing around $328.6 million dollars worth of shares in the fourth quarter of 2022 alone. In March of 2022, the Board of Directors authorized a 2022 share repurchase program where the company may repurchase up to $2 billion dollars worth of shares. As of January 2023, there was still $1.1 billion dollars remaining for share repurchases. In addition to these large share buybacks, management is also incentivized well. Named Executive Officers (NEOs) are compensated with a yearly cash base salary, annual cash incentive plan bonus based on an EBT (earnings before taxes) goal, and a long-term incentive plan that rewards NEOs in performance based shares (50% of award value), stock options (30% of reward value), and RSUs (20% of reward value) based on EBT and revenue growth goals. With around 90% of shareholders voting in favor of this executive compensation plan, it seems like shareholders are more than happy with Ulta Beauty’s executive payment plans that incentivize growth in earnings and revenue (which management sees as a measurement of growth). Evidently, management’s capital allocation practices are very shareholder friendly, with their well-prioritized NEO incentive plans aligning well with long-term growth in shareholder value.

Ulta Beauty is a very efficient business. It operates at a ROIC of 41.3% and a ROE of nearly 67%. With a WACC of 9.9%, Ulta Beauty has a ROIC to WACC ratio of around 4x, showing the business’ ability to generate returns far greater than their cost of capital. With such an efficient business, Ulta Beauty is able to reinvest its cash back into the business at favorable rates of return, rapidly compounding intrinsic value and handsomely rewarding shareholders.

Analyzing Ulta Beauty’s income statement, we can see some stellar sustained growth in revenue, gross profit, and earnings. Since 2014, Ulta Beauty has grown its revenue at a CAGR of around 16%. Additionally, Ulta Beauty has grown its gross profit of a CAGR of 19% in the same time frame. This large increase in gross profit over the last decade can largely be attributed to expanding gross margins. In 2014, gross margins sat at 35%, whereas they now sit at 43.5% on a LTM basis. In terms of earnings, Ulta Beauty has grown EPS and EBITDA at high CAGRs throughout this decade. Since 2014, EPS has grown at a CAGR of around 26%, with EBITDA growing at a CAGR of around 18% in that same time frame. The stellar EPS growth within this decade can largely be attributed to share buybacks. Since 2014, shares outstanding have fallen around 22.5% from 64.3 million shares outstanding in 2014 to 49.8 million shares outstanding today.

Looking at Ulta Beauty’s balance sheet, we can see that the company is in very good financial health. The company has no long term debt and holds around $636.5 million dollars worth of cash and equivalents on hand. Additionally, like mentioned above, the company is a cannibal, consistently buying back shares to return excess cash to shareholders.

Looking further at Ulta Beauty's cash flow statement, we can see stellar sustained growth in net income and free cash flow, showing the business’ ability to efficiently generate cash from its operations. Since 2014, Ulta Beauty has grown its net income at a CAGR of around 22%, with free cash flow growing at a CAGR of 29% in that same time period. This increase in free cash flow can largely be attributed to expanding free cash flow margins. In 2014, free cash flow margins represented 3.8% of revenue, compared to today where LTM free cash flow margins represent around 10% of revenue. As we can see, Ulta Beauty operates very efficiently and is able to generate large amounts of cash from its operations, which it can then use to reward shareholders via dividends, share buybacks, or reinvestments back into the business that allow it to rapidly compound its intrinsic value, increasing shareholder value.

Finally, after conducting a reverse discounted cash flow (DCF) model analysis, we can see that Ulta Beauty is trading at share prices that imply a 9.65% growth rate in free cash flow over the next 10 years, using a perpetuity growth rate of 3% (largely in line with US GDP growth) and a discount rate of 10%. Since 2014, Ulta Beauty has grown its free cash flow at a growth rate of 29%, largely attributed to expanding free cash flow margins, as discussed above. With a free cash flow growth rate like this over the past 9-10 years, it seems that a 9.65% free cash flow growth rate is cheap, however, there are a multitude of factors to consider. If free cash flow margins are able to incrementally expand over the next 10 years, then this may be an attractive price to enter a position at. However, if free cash flow margins stay flat and / or decline, or secular headwinds affect Ulta Beauty’s business model (straining it’s ability to generate cash from operations), then this current implied growth rate may be high.

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