Ulta Salon Crashes Down: Buying Opportunity?

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Beauty retailer Ulta Salon, Cosmetics & Fragrances (NASDAQ: ULTA  ) was looking rather ugly on Friday as the stock dropped by more than 20% on a disappointing earnings report. The retail environment is notoriously challenging lately, and competition from players like Sally Beauty Holdings (NYSE: SBH  ) and (NASDAQ: AMZN  ) is a considerable risk to watch, so the stock could remain under pressure in the short term.

On the other hand, the market seems to be overreacting to the news from a long-term point of view; Ulta is still performing rather well and positioned for substantial growth over years to come. The recent drop in Ulta Salon may easily be considered a buying opportunity for opportunistic investors who are not afraid of short-term volatility.

Not glowing anymore
The company delivered a sales increase of 22.3% versus the prior year to $619 million. This was within management's projected range of $613 million to $623 million, but below Wall Street analyst's expectations of $623 million for the quarter. Comparable store sales were still quite strong with an increase of 6.8% versus the same quarter in the prior year.

Diluted earnings per share grew by 18.6% to $0.70, excluding severance charges, earnings per share would have been $0.72 during the quarter. This was also below analyst´s expectations of $0.74 per share, but not too bad at all in comparison with the $0.59 per share the company gained in the third quarter of fiscal 2012.

Gross profit margins increased 70 basis points to 37.4%, but operating margin fell to 11.8% versus 12.1% in year-ago quarter due to higher SG&A expenses and increased pre-opening costs during the quarter.

The company added 55 new stores during the quarter, a quarterly record for Ulta Salon. New openings can be a drag on profitability as new stores usually have lower margins than those with a longer history. On the other hand, increased geographical presence and brand recognition are important growth drivers in the long term.

The company's loyalty program membership grew 18% year over year to reach 12.5 million active members, so the company is still gaining traction among consumers.

Guidance for the coming quarter was below expectations though: the company expects net sales in the range of $853 million to $867 million, compared to $758.8 million in the fourth quarter of fiscal 2011 and 895 million forecasted on average by analysts. Same store sales are expected to increase 7% to 9% during the quarter.

Ulta expects fiscal fourth-quarter profit between $1.07 to $1.10, materially lower than the $1.24 per share expected by Wall Street analysts.

Management believes the retail industry will remain under pressure during the quarter, and that is the main reason the company gave for the disappointing guidance.

"Earnings per share guidance for the fourth quarter of fiscal 2013 is lower than previous expectations, primarily as a result of softer retail sales trends at the end of the third quarter which are expected to continue, as well as the Company's plans to maintain strong market share gains during a highly competitive and promotional holiday selling season."

Beauty is in the eye of the beholder
If the recent disappointment is due mostly to industry-wide factors like weak consumer spending, the slowdown should be transitory and the dip in Ulta Salon could represent a buying opportunity for investors. On the other hand, if Ulta is facing more permanent problems like losing market share versus the competition, then things could be much more complicated.

Fortunately for investors in Ulta, competitor Sally Beauty Holdings is not doing any better. On the contrary, the company reported a sales increase of 2.7% for the last quarter on the back of a growth rate of 0.4% for the period. If anything, Ulta seems to be materially outgrowing Sally Beauty by a considerable margin. has been gaining participation in several product categories over the last years and the company is unquestioningly the most disruptive force the retail industry has seen in the last decade. The online retailer´s competitive drive, efficient operations and low pricing policy is always a risk for any company in the industry, and Ulta is no exception to the rule.

However, Ulta is doing remarkably well when it comes to online sales. The company has completely redesigned its website and expanded e-commerce fulfillment capabilities to a second distribution center in Chambersburg, PA. E-commerce sales grew by a whopping 74.4% during the last quarter, representing 170 basis points of the total company same store sales increase of 6.8%. If Amazon is hurting Ulta, that is not showing on the company´s e-commerce performance.

On a long-term basis, it's worth considering that Ulta provides the kind of product assortment and customer experience that only a specialized retailer can deliver. Instant gratification, store design and team of experienced sales associates as well as licensed stylists and estheticians are key differentiating factors benefiting Ulta in the competition versus Amazon and other retailers.

Bottom line
All in all, industry headwinds look like the main reason for the recent disappointment. It´s hard to tell how long these kinds of economic factors can affect a company or a sector but they tend to be temporary by nature. As long as Ulta can sustain its competitive strengths and differentiation versus the competition, chances are the recent setback will turn out to be a buying opportunity for long-term investors.

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