Beauty Is a Beast for This Cosmetics Company

Ulta Salon, Cosmetics, & Fragrance   (NASDAQ: ULTA  ) is under new leadership, and the entire third quarter belonged to the new CEO Mary Dillon, formerly of U.S. Cellular. Ulta was of course thrilled to get her, believing her to be the "ideal person" to guide Ulta's next stage of growth, but the next phase of growth turned out to be less robust than anticipated. Ms. Dillon presided over her first full quarter conference call and Ulta promptly shed 20% of its share price.

Sally Beauty Holdings (NYSE: SBH  ) is also in the bricks and mortar retail beauty business,and is also a wholesaler. Sally has managed to grow to over 3,400 stores and $3.6 billion in revenue. Like Ulta, recent sales trends are down, and Sally's same-store sales for 2013 came in at negative 0.6% after years of positive comps.

Regis (NYSE: RGS  ) has been struggling with negative same-stores sales and declining revenue for years. While the main Regis business is salon care, it does have some implications for Ulta with 6% of its revenue coming from in-store salons. Both Sally and Regis are off their 52-week highs.

Gloomiest conference call this year?
The third quarter conference call was notable for the number of times Ms. Dillon mentioned promotional environment (Wall Street-speak for deep discounting), deceleration, headwinds, uncertain, moderation of/lower growth, and competitive environment. In fact, the word promotional was mentioned more than a dozen times in the first half of the call.

In the back half of the call headwinds became the buzz-word mentioned at least five times. Throw in a few "decelerations," "slowing growths," and "competitive environments," and you have a call guaranteed to make a bad impression on analysts and investors.

Ulta has been in business since 1990, had a successful IPO in 2007, but didn't catch fire until the fourth quarter of 2010 when revenue growth and same-store sales began to soar. As a retailer, revenue growth and same-store sales are key metrics investors watch, and 2010 was a turning point for Ulta.

Annual growth

Store performance

*calculated from SEC documents with proprietary spreadsheet

Growth in operating income and net income exceeded revenue growth as margins improved. Ulta was a company any momentum/growth investor would love, and the stock rocketed up.

Net and operating margins more than doubled over four years

*calculated from SEC documents with proprietary spreadsheet

At the end of 2009 Ulta hit $22, and by the end of 2010 it was up 54%. By 2012, it was in the mid-$90's and a momentum investor's dream backed by excellent numbers and returns. It now sits in the low $90's after a disappointing third quarter took it down from its all-time high near $133. Margins contrtacted slightly and same-store sales were halved from their 2012 highs. The biggest blow came from weak guidance -- store openings will decelerate, margins are going to continue to shrink, and revenue growth will slow. These are the pillars that supported the premium prices, and they are crumbling.

The company has long warned that same-store sales in double-digits are not sustainable in their filings: "We do not expect our 11% fiscal 2010 comparable store sales increase to continue into the future. Our long-term annual comparable store sales increase target is 3% to 5%."

Same-store sales have been drifting down over the past year, but it wasn't until the third quarter's gloomy guidance and missed earnings that investors began to question Ulta's ultimate growth story. In the third quarter, Ulta finally missed guidance and same-store-sales declined to mid-single digits -- levels not seen since 2009. The company reported earnings per share of $0.72 instead of the $0.74 expected, and guided to fourth quarter EPS of $1.07 to $1.10 with revenue at $853 to $867 million. The consensus estimates were $1.24 and $894.82 million, respectively, and much higher than guidance. Same-store sales will range between 7% to 8%. At the low end, revenue growth drops to 12% and EPS growth would be 5%. The 5% growth in EPS indicates that promotional discounting will continue, and you should expect margins to continue to underperform.

Same store sales fell off year-over-year and traffic was negative

*calculated from SEC documents with proprietary spreadsheet

The negative traffic numbers in the third quarter are concerning and may indicate the number of new stores opened are likely poaching customers from older locations. Comps were definitely compromised. The other troubling trend is revenue growth lags store growth and comps by a wider margin -- one interpretation is new store sales are taking off more slowly. Overall, expansion was too fast and that was a major talking point in the conference call. The numbers  support that.

Per CFO Scott Settersten: "Historically stores have – our new store program is way over delivered what our initial expectations were. So, naturally in an environment where comps are bit more challenged, there is going to be some kind of headwinds on those new stores I mean there are not immune to what's going on with the macro consumer environment."

What's the story?
Ulta opened 114 stores in the first nine months of 2013 and 55 stores in the third quarter alone. New stores need inventory but inventory levels have been climbing faster than revenue, and the company is sitting with more inventory per store than it has held in over two years. And that's even accounting for a third quarter holiday inventory build.

Inventory increases over four years were the model of impeccable inventory management, but slipped in 2012 

*calculated from SEC documents with proprietary spreadsheet

Over the past four quarters, UIlta has lost its tight grip on inventory, and it appears to be piling up in stores (high per store stocks) and warehouses. The slow moving inventory was a warning that all was not well at Ulta, and the lowered guidance for its fourth quarter and the miss in the third quarter are not surprising.

Quarterly inventory build and it's not pretty

*calculated from SEC documents with proprietary spreadsheet

Third quarter inventory increases moderated but stores were left with overstocked shelves. The days inventory on hand are at record levels. With weak forward guidance, the high levels of inventory may start to negatively affect cash flow, tying up working capital. Slower growth will require less cash and the curtailment in the number of new stores looks like a good decision even if not entirely welcomed by the market.

Back to the future
If growth has been too fast and is unsustainable, Ulta will not be worth what investors were paying. We will need to reset expectations if this looks like a trend and not a blip. It's hard to know if retail is simply hitting a sticky spot or if bricks and mortar beauty retail is reaching saturation. The third quarter was a glimpse into the limits of Ulta's growth and the pullback in price was a rational reaction by a usually irrational market.

We can make an educated guess at revenue growth in 2014 with some numbers given in the conference call.

If square footage grows by the estimated 15% in 2014 and guided same store sales are 7%, you would think growth would be around 22% (comp growth added to growth in square feet). However, Ulta's revenue growth consistently lags same store sales plus square footage growth by an average of 6%. That would indicate revenue growth of around 16% in 2014 -- well off the 20%+ increases in revenue investors have come to expect over the past two years. If growth continues to decelerate, Ulta's price will have a new normal, but it's impossible to guess what premium investors will be willing to pay.

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