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Investment Thesis
In my last article on Ulta Beauty (NASDAQ:ULTA), I mentioned that I was surprised by the sudden downward revision of the cosmetics and beauty chain’s FY24 outlook, issued by management at the last Retail RoundUp conference. The reason this downward revision surprised me at the time is because it came just a few weeks after the company set its full-year expectations in its disappointing FY23 earnings report.
Since then, the Company’s stock price has fallen below the $408 level where I projected the Company’s stock price to be, as shown in Exhibit A below.
Exhibit A: Ulta Beauty’s stock price performance since the author’s last coverage (Seeking Alpha)
My current analysis of Ulta Beauty doesn’t show any significant improvement since my last coverage. Demand for the company’s products has yet to recover, and inventory levels, while relatively high, appear to remain within bounds.
But based on my new estimates, it seems like most of the pessimism about the stock has been priced in. My analysis predicts the company’s shares will remain range-bound over the next few months, and I’m currently recommending Ulta Beauty as a Hold with a lower target price.
Ulta feels increased competition, but demand remains elusive
Excluding fiscal 2020, which was a time of pandemic lockdowns, Ulta Beauty recorded its lowest quarterly growth rate ever in Q1 FY24 at 3.5% year-over-year. This revenue growth rate means that Ulta Beauty increased its total sales to $2.73 billion in Q1 FY24. The problem for Ulta at this point is its cosmetics sales, which fell 1.2% to $1.14 billion in Q1. This is one of the key issues for Ulta to solve, because cosmetics now accounts for a quarter of the company’s revenue and is on a downward trend, as can be seen in Exhibit B. In 2019, cosmetics accounted for half of the company’s revenue.
Exhibit B: Ulta Beauty Revenue Share by Revenue Segment (Company Filing)
In further explaining possible reasons for the decline in cosmetics and makeup sales, Ulta management said at a growth stock conference that the company faces competitive pressure in the prestige beauty market, particularly due to weakness in its makeup and hair care stores.
Ulta Beauty operates across a broad range of price points, selling products at a range of prices from mass-market to luxury, but it is still struggling to regain share and capture demand in the luxury cosmetics market. During the first quarter earnings call, Ulta executives pointed to competitive pressures, saying, “The number of places to buy beauty, especially luxury cosmetics, has increased significantly, with more than 1,000 new distribution locations opening in the past two years,” a strong reference to the 1,000 stores recently opened through a partnership between LVMH-owned Sephora (OTCPK:LVMHF) and Kohl’s (NYSE:KSS).
What’s encouraging to me is that at least two of the five categories in Ulta’s beauty business — fragrance and skin care — grew by 15% and 8%, respectively. New exclusive fragrance brands led to strong growth, while the popularity of face masks and skin care in general helped drive strong skin care sales.
Inventory levels need further improvement
In my view, inventory levels remain high at this Bolingbrook, Illinois-based beauty chain. In analyzing Ulta’s product inventory levels from the company’s filings, as shown in Exhibit C below, the company’s fiscal first quarter 2024 10-Q filing shows that inventory levels are again showing some increase.
Exhibit C: Ulta Beauty’s inventory levels remain high (company filings)
Ulta Beauty’s inventory grew 8.8% in the first quarter to $1.91 billion, faster than the 3.5% sales increase in the quarter, suggesting the company is struggling to clear inventory, according to Exhibit C. “We expect growth to normalize going forward,” management said in the first-quarter earnings call. [they] “We’ve made progress throughout the year.”
Until inventory levels normalize, this will continue to negatively impact the company’s operating cash flow and ultimately its ability to generate free cash from operations. In the first quarter, the company’s unlevered free cash, estimated from operating cash flow and capital expenditures, fell to $914.2 million, just below $1 billion.
Exhibit D: Ulta Shareholder Return Trends and Past 12 Months (SA & Company filing)
The company also said it has used $200 million of its $2 billion share repurchase program to buy back about 588,000 shares, leaving it with ample room to repurchase shares if the stock price falls further.
Alta’s valuation suggests slight decline
Management noted that with relative strength in the second half of the year, the first half of fiscal 2024 is still expected to see low single-digit growth, but that the second half of fiscal 2024 is expected to see low to mid single-digit growth, primarily due to the introduction of new brands and easier comparability when looking at the second half of fiscal 2023 results.
In our previous report, we estimated our target price for Ulta using an inverse DCF model, given its lower growth rate. We continue to assume a terminal growth rate of 2%, but reduce the discount rate to 8% in line with our estimates.
Currently, the market appears to be estimating Ulta’s free cash flow growth at approximately 4.4% CAGR, which is lower than the 5.5% growth I observed in our last coverage. This is closer to the free cash flow growth I was expecting from Ulta. At the time, I said that given historical guidance and Ulta’s unique consumer challenges, I expected Ulta’s free cash flow growth to be in the 3-4% range.
Figure E: Ulta’s valuation model suggests there is some room for decline (Author)
Assuming Ulta’s free cash grows at a 4% CAGR, a fair value for Ulta stock would be in the $365-$370 range, which would be roughly a 5% downside from current levels.
Risks and other factors to consider
Monitoring inventory levels is important at this time as it gives management more room to optimize the free cash they return to shareholders. Monitoring inventory levels and management’s comments can also provide an indication of the likelihood of a recovery in demand levels for the company’s products.
For now, we expect the stock to remain range bound for at least a few months until the company announces its Analyst Day conference, which is expected to be announced sometime in October, but the date has not yet been announced.
Note: LVMH, a competitor of Ulta and parent company of Sephora, is scheduled to report its first-half fiscal 2024 results on Tuesday, July 23. Any significant comments about LVMH’s selective retail business could make Ulta Beauty move. Ulta Beauty is scheduled to report second-quarter earnings on August 29 after the market closes.
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Ulta Beauty appears to still be having challenges winning back customers in some of its revenue areas, particularly its makeup and cosmetics division, and overall inventory levels also suggest the company is still having trouble moving stock, putting a strain on free cash.
However, from a valuation perspective, I believe Ulta will likely remain range-bound over the next few months, and with the company forecasting low single-digit growth for the rest of the year, the worst seems to be priced in.
I currently recommend Ulta Beauty as a hold.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
