Investment Thesis – Ulta Beauty
During economic downturns, investors often seek investments that can withstand the recession. Hence, our team’s current focus is on companies and stocks that can remain resilient throughout the economic cycle. We found that Ulta Beauty, a cosmetics and beauty retail chain, fully meets this criteria. While makeup may be perceived as an indulgence, Ulta’s resilience in times of slowing consumer spending and escalating inflation presents a compelling case for investment.
The Business Summary
Ulta Beauty, founded in 1990, has a simple and easy-to-understand business model. They have a wide variety of more than 25,000 products from more than 600 brands, sold across 1,300+ stores in high-traffic locations around the US. They sell their products with a very low markup, giving them some of the best prices in retail, with one catch: you need to be a loyalty club member to get the best deals. This gives Ulta Beauty the kind of defensible market strategy employed by the dominant retailer, Costco, where membership confers you access to low-cost products, incentivising more memberships and increasing sales.
Ulta Beauty has products across all the major beauty categories: cosmetics, hair-care products, skincare, fragrance and bath, accessories and services. They also have physical stores, a digital app, and partnerships with retailers like Target. They experience some seasonality, with sales peaking around Valentine’s Day, Christmas, Mother’s Day, etc.
Business Performance
Ulta Beauty has some strong numbers, and their numbers have improved over time. Here is the growth in their gross margins and return on invested capital over the last six years:
| 2018 | 2019 | 2020 | 2021 | 2022 | 2023 | |
| Gross Margin | 35.6% | 35.9% | 41.2% | 31.7% | 39.0% | 39.6% |
| ROIC | 21.7% | 31.8% | 21.5% | 6.7% | 32.6% | 35.2% |
Ulta Beauty owns a relatively large share (almost 10%) of a fragmented industry, with their closest competitor, Sephora, a good distance behind. They have an average net profit margin of 10% and have grown their revenue at roughly 17.6% annually in the last decade. Although growth has slowed slightly in the last two quarters, partly due to rising inflation, we have seen an uptrend in Ulta’s sales over the past seven years. The company also expects to grow at a 6% average for the next few years, which is still a decent rate.
Our Thesis
We believe that Ulta Beauty will continue to post strong profits for the long term, even with modest growth. With a valuation of around 14.6x earnings, they are slightly undervalued relative to their growth potential. This should translate to a healthy return for investors, especially considering management has historically bought back stock aggressively, reducing the outstanding shares and increasing shareholder returns.
We also believe Ulta Beauty has a few sources of competitive advantage: First, they have a large store network with large sizes (over 10,000 square feet), allowing them to carry a wide variety of products. This means they are a speciality retailer with the foot traffic and scale of a mass retailer. It also means they will always be the ideal point of call for a vast market selection. Ulta Beauty already serves almost 25% of all adult women in the United States and owns 39% of the speciality retail market.
Secondly, their loyalty program is best in class and drives most of their sales, with loyalty members accounting for 76% of total revenue and growing. This is almost effectively a captive audience that will continue to drive sales for Ulta.
Thirdly, they have a very strong free cash flow conversion, with 95% of their net income ending up as free cash flow, indicating that they can grow without excess capital commitment.
Lastly, looking at its P/E ratio, the stock currently trades below its 5-year average P/E ratio, showing some buying opportunity and posting significant upside.
Risks
The biggest risk Ulta Beauty faces is competition from Sephora (owned by LVMH), who have enough resources to push their brand aggressively. Another risk is the rise of influencer-driven beauty brands, a model where many social media influencers push their brands through online or e-commerce channels rather than traditional stores.
However, despite these risks, we believe that Ulta Beauty is a compelling investment at these levels and we will be adding it to our long-term portfolio.