A Clear Winner in a Cutthroat Business

If you want a business where demand never decreases and margins are high, you can't do better than cosmetics. And while there are only a dozen or so publicly traded cosmetics companies that are serious plays, there are thousands of private companies elbowing in on this growing market.

Two of the biggest winners have been Ulta Salon, Cosmetics, and Fragrance (NASDAQ: ULTA  ) and Estee Lauder  (NYSE: EL  ) (NYSE: NUS  ) , but a new kid on the block might have them looking over their shoulders. Target  (NYSE: TGT  ) has positioned itself as a rival with its purchase of DermStore Beauty Group. DermStore is an online skincare and hair care e-commerce platform with three beauty product sites and more than 750 brands, expecting in excess of $100 million in sales this year. 

The Wall Street Journal noted this buy isn't a needle mover for Target, as it garners $70-billion plus in annual sales. Bloomberg Business Week explained the draw of DermStore as a provider of high-quality, how-to beauty digital content that consumers crave. 

The clear winner
Should Ulta be threatened by this arriviste? Considering Ulta carries more than 20,000 stock keeping units, or SKUs, of hair, skin, and fragrance products at its 609 US brick-and-mortar stores, I hardly think so. Also, it is somewhat of a destination beauty retailer, in that brick-and-mortar shops offer salon services as well as trained cosmeticians strolling the stores.

Ulta shouldn't worry too much about losing online market share to Target, as its 10 million loyalty members can rack up freebies and benefits by continuing to shop at Ulta. During the second quarter, online sales grew the top line by a stunning 72%, contributing to overall top-line growth of 24.8%.

The stock has recovered after a midyear slump when the company was searching for a new CEO. Leading her first conference call, CEO Mary Dillon said, "Our second-quarter performance highlights many of the reasons I decided to join Ulta. We operate in an industry that's growing and important to our guests. Ulta has a differentiated (italics mine) format that resonates with customers." Dillon herself has been buying stock--more than 22,000 shares in July, always a good sign from a new CEO.

Differentiated is the operative word. While the company has beauty salon rivals like Regis Corp and beauty-supply retailer Sally Beauty, there is no one place like this one-stop beauty shop. Department stores may have the cosmeticians and the prestige brands, but they don't have the mainstream brands and hair styling tools, or the breadth of selection.

In addition, the company rolled out an imaginative and humorous digital and social media campaign in which women were invited to share their beauty mishaps to Beauty LOLs. This brand awareness campaign struck just the right note of humor and commercial appeal. Also, it is reminiscent of Target's DermStore beauty how-tos.

Ulta is one of the best at integrating omni-channel in beauty. On the call, however, Jeffrey Severts, senior vice president of marketing, warned the company has redesigned the website and that will take down the online top-line growth number in the third quarter.

Not to worry, the company is opening new brick-and-mortar stores at a brisk clip, with another 70 through year end and 90 for 2014. What is most encouraging is that margin improved by 50 basis points even as selling, general, and administrative expenses rose by 40 basis points.

At first, a rise in SG&A expenses and an inventory increase of 45.6% might look alarming (like some of those Beauty LOL's). It was driven by 50 new store openings, the opening of another e-commerce fulfillment center in Washington, DC, and the openings of an already successful new concept--150 in-store prestige brand boutiques supporting Estee Lauder's Clinique (100 shops) and Lancome (105 by year end).

This collaboration with Estee Lauder is a win-win for both, as Estee Lauder sells its pricey Clinique skin care and 25 other cosmetics and fragrance brands to the "prestige market," duty-free shops, department stores, etc. Estee Lauder enjoys high gross margin (83%, more than twice Ulta's 39.1%). According to the NPD Group, US prestige sales growth came in at 8% although globally it was softer.

Estee Lauder is a global prestige cosmetics and fragrance purveyor, so the NPD statistic makes Ulta look better without the exposure to Europe that took down global numbers for prestige brands. Also, despite Estee Lauder's high gross margin, the net profit margin comes in at 10.1% to Ulta's 7.7%.

The Foolish takeaway
Ulta's brick-and-mortar stores are subject to the same challenged consumer pressures as the rest of retail, but loyalty members are shopping more and generating higher tickets. Ulta is a concept that works with high-end shoppers or value seekers in good or bad economies, with bricks or clicks. Buy on a pullback if you can get one.

The retail space is in the midst of the biggest paradigm shift since mail order took off at the turn of last century. Only those most forward-looking and capable companies will survive, and they'll handsomely reward those investors who understand the landscape. You can read about the 3 Companies Ready to Rule Retail in The Motley Fool's special report. Uncovering these top picks is free today; just click here to read more.

 


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