After Losing Some Altitude, Is Cosmetics Chain Ulta Salon Still Worth Betting On?

Ulta Salon, Cosmetics & Fragrance (ULTA 0.74%) has found great success, and gained a national footprint, by filling the middle-market industry gap between high-end department stores and low-end drug stores and discount retailers.  The company has benefited from an aging population's seemingly unabashed vanity and general desire to retain a youthful outward appearance, offsetting the effects of Father Time.  However, Mr. Market shaved a bit off of Ulta Salon's shine in December after the company noted weakening customer traffic and lowered its near term profit expectations. So, is it still a good bet for investors?

What's the value?                                                                                                                                                                                 Ulta Salon provides one-stop shopping for its customers' cosmetics needs, offering roughly 20,000 products across a broad range of price points and categories, including hair care, skin-care, and bath and body products.  The company's stores are primarily self-service operations, but Ulta has been trying to move upscale lately with in-store L'Oreal and Estee Lauder branded boutiques.  While the boutiques require more staff to move their merchandise, they have allowed Ulta Salon to capture additional market share as customers have anecdotally gravitated toward premium brands in their purchasing decisions.

In fiscal year 2013, Ulta Salon's growth has continued unabated with a 23.3% top-line gain that was aided by higher comparable-store sales, including a whopping 72.2% increase in its online channel.  The company has also generated double-digit growth in its salon-services segment, a high-margin business that effectively utilizes Ulta Salon's store square footage and provides additional soft-selling opportunities.  On the downside, though, Ulta Salon's push into the premium cosmetics space, an area dominated by the nation's department stores, has led to higher marketing costs which have hurt its operating margin.

Of course, investors shouldn't overlook Ulta Salon's recent weak traffic trend, a data point that likely sparked the recent stock sell-off.  Unfortunately, the company doesn't seem to be an industry outlier, as major competitor Sally Beauty Holdings (SBH 1.23%) has also reported weakening comparable-store sales results and traffic flows in fiscal year 2013, especially in its U.S. geography.

While Sally Beauty focuses more on the salon professional customer base, primarily via its CosmoProf store operation, its large network of roughly 3,400 Sally Beauty retail stores increasingly cater to retail customers, evidenced by the 7.4 million active members of its Beauty Club Card loyalty program.  In fiscal year 2013, the company posted a slight top-line gain thanks to a further increase in its store network, but its per-store sales growth tapered off sharply versus the prior-year period which included a negative performance in its U.S. segment.  Near-term future growth is looking a little tepid for Sally Beauty too, as management only forecast a 1%-3% comparable-store sales gain in fiscal year 2014.

Looking for a value story                                                                                                                                                                     The trouble with a high-growth story like Ulta is that inevitably it must downshift into a lower gear. While Ulta's management forecast a further 19% increase in the company's store base in fiscal year 2014, any reduction to that plan due to negative customer traffic trends would likely impact its stock valuation, as the stock is priced for growth.  As such, investors might want to look for a margin of safety with a turnaround value story in the cosmetics sector, a situation which appears to be unfolding at Revlon (REV).

One of the best-known brands in the cosmetics business thanks to celeb spokes-models like Halle Berry, Revlon has long been a mainstay in the mass merchandise channel with discount kingpin Wal-Mart accounting for roughly 22% of the company's sales.  While top-line growth has been a challenge for Revlon, it has been whittling down its large sales and marketing organization which has resulted in steadily higher operating margins for the company over the past five years.  More importantly, Revlon's improving financial profile has allowed it to plot a growth strategy which is highlighted by its recent acquisition of Colomer Group, owner of the Creative Nail and American Crew brands. The acquisition positions Revlon for greater exposure to the higher margin spa and salon professional customer base.

The bottom line                                                                                                                                                                                       Despite poor investor reaction to its latest results, Ulta Salon continues on a business growth trajectory as it pushes toward its goal of 1,200 stores around the country, which would give it an operating footprint similar to department store competitors like Macy's and J.C. Penney. However, Ulta's earnings growth over the next five years will undoubtedly be slower than it was over the past five years, likely leading investors to lower the price multiple that they will pay for those earnings.  As such, a value story like Revlon might provide a better risk/reward ratio for investors looking for cosmetics industry exposure.