Ulta Beauty, Inc. (NASDAQ:ULTA), as a profitable domestic retailer, stands to be one of the biggest beneficiaries of the new federal tax law, which will lower the U.S. corporate tax rate from 35% to 21% this year.
However, Ulta investors may not see all of that money just yet. That's because if all your competitors get the same cut, some may try to gain market share by lowering prices and/or upgrading service. In addition, the rise of e-commerce has forced retailers to become omnichannel businesses, needing to invest in physical stores, distribution centers, and fast shipping.
Though Ulta was thought to be coming off a heavy investment cycle, management is doubling down on spending in 2018, in order to stay ahead of the pack in an increasingly competitive environment. Here's how Ulta is spending its tax cut, and what it means for investors.
One of the bigger Ulta headwinds has been a slowdown in prestige cosmetics, Ulta's core segment. While that category slowed overall in 2017, Ulta's top four prestige brands -- MAC, Lancome, Clinique, and Benefit -- were standout performers.
Ulta has been featuring these names in branded in-store boutiques, just as fellow specialty retailer Best Buy has found success with branded boutiques for electronic equipment at its stores.
This year, Ulta will continue installing these boutiques, with another 675 set for 2018 after 700 installations last year, including 200 dedicated to MAC, a top brand the company only began selling last spring.
While prestige cosmetics decelerated last year, skin care, apparently, is on the rise. As such, CEO Mary Dillon said the company will add several new skincare brands this year, such as The Better Skin Co., Crepe Erase, Mamonde, and House 99 by David Beckham. The David Beckham brand, as you might imagine, is geared toward men, and exclusive to Ulta Beauty.
Ulta also plans to capitalize on the trend by adding a new Skin Bar to 180 of the company's roughly 1,100 stores and hiring a dedicated "skin expert" at each, who will be directly responsible for sales of skin care products and services at each location.
Not only will Ulta boost spending on skin care experts, but it will also raise wages and/or employee benefits across the board. In the wake of the tax cuts, Ulta paid store associates a one-time bonus totaling $12.3 million last quarter. And in a world of low 4% unemployment, the ability to attract high-quality employees, especially in a services business like Ulta's, will become increasingly important.
The continued investment in employees will be the biggest cost driver this year; Ulta says it will cause its operating margin to "take a step back" in 2018 by 50 to 70 basis points (though 20 of those points will be driven by an accounting change).
Finally, the company will also continue to invest in digital capabilities and artificial intelligence (AI) to create more personalized offers and optimize inventory. Ulta is already a leader in these types of initiatives, as its e-commerce sales skyrocketed 60.4% last quarter.
Nevertheless, digital and AI will continue to be an ongoing evolution, and the new tax savings have allowed management to accelerate some of this spend in order to stay ahead of both department stores and you-know-who from Seattle. Dillon added, "... imagining what that guest wants 5 and 10 years from now in that intersection of the physical and digital world, that's our job to do."
With all of these investments, management announced it was scrapping its 2019 target of 15% operating margins. In fact, operating margins should decline this year (down 50 to 70 basis points from last year's 13.4%). Nevertheless, management still forecasts earnings-per-share growth in the 20% range, thanks to the lower impact from tax cuts and roughly $500 million in share repurchases in 2018.
In addition, management discussed a cost optimization plan that it will roll out in 2018, which will help to offset some of these increased investments toward the end of the year and beyond. The four pillars of the cost-containment program, it said, are, "indirect procurement, end-to-end operational efficiency, real estate cost, and merchandise margin improvement." Ulta is certainly a great tenant, and could potentially benefit from the same real estate opportunity Starbucks chairman Howard Schultz sees, to potentially permanently lower occupancy costs.
Some may question Ulta's sudden need for more spending as a sign of weakness or tougher competition, but if these moves further grow Ulta's long-term competitive moat, they're the right ones to make. Shareholders should take comfort in management's excellent track record, as well as the company's unchanged earnings profile, even if certain costs shift around a bit this year.