Has Ulta Beauty Stock Fallen Too Far, Too Fast?

In a twist of fate, the past year has been very good for Estée Lauder (EL -0.28%) shareholders, while investors in the once high-flying Ulta Beauty (ULTA -2.73%) suffered.

On this episode of Industry Focus: Consumer Goods, Vincent Shen and senior Motley Fool contributor Asit Sharma reach into the listener mailbag and explain their theories of why these two skincare and makeup companies are seeing their stock market fortunes diverge. 

A full transcript follows the video.

This video was recorded on April 17, 2018.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Tuesday, April 17th, and I'm your host, Vincent Shen.

First thing for today, I want to thank everyone who wrote in regarding our show last week and our coverage of Estée Lauder. Lots of great feedback and inspiration, too, for this episode. Before we get into that, though, let me welcome my guest for today. Calling into the Fool HQ studio via Skype is senior Motley Fool contributor, Asit Sharma. Great to have you back again!

Asit Sharma: Thanks, Vince! Hey, listeners, I'm going to use a word to describe how I'm feeling today which I rarely use. I'm feeling fabulous. And since I really feel that way, I can say that without too much embarrassment.

Shen: [laughs] Well, that's going to be following our theme in terms of the stocks and companies we're going to talk about today. In case you missed our discussion last Tuesday, we dedicated the episode to Estée Lauder. That company came onto our radar as a result of being one of the best-performing stocks in the consumer and retail space in the past year. The stock was up almost 80%. And not only that, but this is a more than a $50 billion company. It's even rarer to see a large-cap name enjoy such an incredible run in just one year. That's a really interesting business. If you missed the show, definitely go back and check it out.

But as a follow-up to that episode, we have a related listener question. That brings us back to the skincare and cosmetics industry. It's been a while since we've actually turned to the mailbag during our show. Here's the question we received from listener Joseph. He said:

We hold Ulta and have watched its stock go on sale over these months, unfortunately. It was interesting that Estée Lauder hadn't listed them as a competitor. I guess these companies thrive together, then. Both are staking their growth on premium products like MAC, for example. I hadn't anticipated anything like the decline in Ulta, and I'm further surprised at its contrast with Estée Lauder. Can you square the market's perspective here?

For listeners, to have a little big picture context, keep in mind that Estée Lauder shares are up nearly 80% in the past year, as I mentioned previously, and management has been putting up very strong guidance for the next several years with double-digit earnings growth, accelerating top line growth. On the flip side, Ulta Beauty, ticker ULTA, its shares have declined about 20% over the same timeframe, and that slide actually increases to 25% if you go off the all-time high that the stock hit last May. Given that both of these companies specialize in skincare and cosmetics, why the big divergence in their performance and results over the last year is definitely a fair question.

Before I hand it off to you, Asit, to introduce the company and provide a little bit of an overview of that business, I wanted to note that we discussed Ulta previously on Industry Focus last June, and we had named it as one of our picks for best-in-class brick-and-mortar retail, and that was pitched by our summer intern at the time, Addie. So as part of our Ulta discussion now, we're going to be able to look back and see how much has actually changed in just a year's time, and call out some of the things that we discussed last summer, and we'll get back to that. Asit, kicking things off for us, can you give us a quick overview of this business?

Sharma: Ulta was founded in 1990, and it bills itself as the largest beauty retailer in the U.S. It has 20,000 products available in its stores spanning over 500 brands. This company hits all price points, from entry-level up to prestige beauty products. Ulta has 1,074 stores in 48 states, and this is primarily how it distributes products. The typical store is an open layout store, it's around 10,000 square feet, and most Ulta stores have in them an in-house full-service salon, which is about 950 square feet. 

Ulta reaches out to its customers through pretty traditional channels. It uses mail advertising, newspaper inserts, traditional marketing. The really interesting thing about its marketing reach, however, is that it has 28 million customers that are enrolled in its loyalty program, and the company says that it gets 90% of sales from these customers who are enrolled in that program. So, that was very impressive to me. That's called the Ultamate Rewards program. 

It also has e-commerce sales. Everyone has to know, whether you're a brick-and-mortar store or a mixed-blend type of retailer, you have to be in e-commerce. These sales comprise roughly 10% of revenue. In the last year, Ulta sold about $5.8 billion worth of products, and about 10% of that, about $580 million, was through e-commerce. Now, that channel is growing at a pretty rapid clip, about 65% a year. Of course, it's still very small compared to the traditional brick-and-mortar layout that it has.

Competition, the company doesn't really list direct competitors in its annual report, but since it straddles this whole realm of entry-level to high-end products, its competitors exist as freestanding mass merchandisers, drug stores, also boutiques. So any physical retail outlet that you can think of that might sell beauty products is a potential customer to Ulta. And that's a general overview of this company.

Shen: Thank you. There's a few things you brought up that I'd like to touch on again, add a little bit more detail. The square footage for these stores, you mentioned about 10,000 square feet on average for an Ulta location, about 10% of that dedicated to the in-store salons and salon services that they offer. I realize that we bring up square footage pretty often when talking about these brick and mortar retailers, and it can be hard to contextualize that number. So just to give our listeners an idea, 10,000 square feet is a little bit bigger than your typical Apple Store. 

The layout of these stores, as you mentioned, Asit, allows the customer to have an exploratory experience. They think a lot about the format and how that can impact the customer experience in store and how that drives sales. And with the approximately 1,100 stores that they currently have in their network, in 2018 they're expected to see another 100 openings, so they're still opening new locations at a pretty rapid pace. Management believes that overall, the U.S. can sustain about 1,700 locations, so you have an idea there of the long-term runway that this company has in mind, in terms of their store expansions.

Then, going back to that Ultamate Rewards Program, because it's a really powerful part of the story for this company, it's something that was called out specifically in our show last summer as one of the strong points for the company. You mentioned the 28 million customers, how over 90% of the revenue for this company comes from its Ultamate Rewards members. It reminds me a little bit of how important, for example, Prime members are to Amazon. I see some parallels here, because members of this loyalty program provide the company with a lot of data, a lot of analytics. And it gives the company a greater opportunity to offer something they've described as personalized one-to-one service to each member of the program. And as we discussed last week with Estée Lauder with skincare and cosmetics, these product categories and this space, they really thrive and benefit from that high-touch service. And it wasn't surprising to hear during the last earnings call that management is going to be investing more at Ulta in its workforce and their training to provide the higher-level service that customers appreciate, if not expect, for certain prestige brands and products.

Something else that really came up as a strong aspect for this company in that prior episode when we talked about Ulta, again, was going back to e-commerce. The revenue for that channel grew about 65% in their fiscal year 2018, accounting for about a tenth of the top line. It seems to be accelerating very quickly. I think for the fourth quarter specifically, it was 14% of the top line. And it's not massive, but still a very significant, important driver of overall growth for the company, and they actually hit that 10% milestone, in terms of their e-commerce digital channel, about two years ahead of schedule. That channel is now expected to make up a larger part of the revenue than management had originally thought that it would. 

There is a bearish side to this. We know that all these brick-and-mortar retailers right now are racing to grow their digital capabilities. That channel does come, sometimes, with its own basket of problems. So for Ulta, the growing e-commerce business is often cited as a headwind for the company's profitability, the issue there being that the online store is typically more promotional, it's also less profitable overall than the brick-and-mortar channel. So that e-commerce growth has contributed to the company's declining margins, and that trend is likely to continue moving forward as a company. Overall, the company has abandoned the goal that they set a few years ago of reaching a consistent 15% operating margin. Right now, it seems like they're settling for something closer to about 13%. So it's interesting to see how e-commerce, as important as it is, can be kind of a double-edged sword at times. On this show, Asit, we've often praised companies for growing that channel, but I don't think we've addressed enough the fact that the problems that Ulta experiences with reduced profitability in e-commerce is common to a lot of other retailers that we talk about, too.

Moving on, now, to the heart of Joseph's question -- why the big discrepancy to how Ulta's stock has performed in the past year compared to Estée Lauder. If you had to boil it down, Asit, what's your take here on the differences?

Sharma: One of the primary differences, Vince, is success fatigue, in my eyes. If you take a look at this company since the IPO -- Ulta IPO'd on Oct. 25, 2007. I ran a quick chart of this before the show. Just fast forward a little bit over the last 10 years -- this not quite 10 years, it's actually about 11 years since the IPO. Over the last 10-year period, this stock has returned 1,500%, which puts it in really rarefied air, with some of the names that we talk about, not you and I personally as much on this show but some of our colleagues who regularly cover stocks like Netflix and Amazon. That's tremendous growth. 

Now, if you actually go to the IPO date and take that chart all the way to this morning, this stock has returned about 684%, and that includes that downdraft that you mentioned, Vince. Now, run Estée Lauder beside this company from the IPO date to today on a total return basis, Estée Lauder, which we talked about last week, has returned 685%. They returned 1% more on a total return basis since Ulta IPO'd. And that's a function, again, of Ulta slowing down and this stock coming back. 

And what happened is basically, last year, for the first time in this string of quarters, the company missed its first earnings estimates. I'm not a huge fan of investors overreacting to one or two quarters, but often times, you see people who have been in a stock for a long time -- I'm saying people here, but I'm also referring to institutional investors, corporations, pension funds, etc. -- once they see that the growth story that has propelled the stock something like 1,500% may not be as intact anymore, they tend to start pulling out. And with those outflows, a stock will reset a bit. 

And I think really, that's all that's happening here. Looking at their top line, they grew revenue 21% last year. That included that fast store opening piece that you mentioned, plus comparable sales growth of 11%. So Ulta itself hasn't slowed down so much as it's not potentially going to grow that fast clip, or as fast a growth rate as it has in the past. And some investors want to take profits off the table. I'm going to flip it back to you, Vince. One thing I'm also interested in talking about is competition and how some of those concerns might affect the stock trajectory. But what do you see in terms of why Ulta may have slowed down a bit?

Shen: Sure. I agree with a lot of the points that you made in terms of investors, especially those who have been on this upward roller coaster for a long time, wanting to take some profits, having to reevaluate the prospects and the long-term trajectory for this company, given that some of the growth rates are moderating, their guidance for next year is a little bit lower. I'm sure some investors are disappointed about that, but again, for Ulta, there's a reason why we chose it last year as one of these best-in-class brick-and-mortar retailers, because they are still putting up extremely enviable comparable-sales growth and other numbers. 

But the things that jumped out to me were, on the growth end, some of the things we've talked about in terms of that moderation but also with product mix. If you listen to the leadership at Estée Lauder, they talk about how their focus on prestige brands is really helping them to enjoy some of the strongest growth in the space, and that is the company's primary focus. And Ulta, on the flip side, has risen to prominence by being a one-stop shop for all these different products -- fragrance, skincare, cosmetics, salon services -- but also across a lot of different price points. 

And you would think that the mass market is where Ulta felt the most pain, but that's not necessarily the case. It's interesting, because the company called out specifically prestige skincare, prestige fragrance, and mass-market cosmetics in the last earnings call as really strong categories with double-digit comparable sales growth. Then, meanwhile, prestige makeup actually saw its comps growth cut in half during the fiscal fourth quarter. So there's a lot of granularity here, because prestige makeup is seeing greater competition, weaker demand. However, the makeup segment overall is over half of total sales for Ulta, and it's a smaller portion at about 40% for Estée Lauder. So I think that explains some of the difference in the tone being expressed by the two companies and their management teams in terms of how those things shake out, and how that's affecting their guidance and their growth prospects going forward. 

And something else to keep in mind, too, Estée Lauder at this point is trading at all-time highs. They're not that far off from having double the price to earnings multiple of Ulta. So are these two companies, if you look at them, growing at such different rates with their near and mid-term guidance that would justify such a big difference in their valuations? I would say no. I think that Ulta, also being in a more traditional retail-focused business, a lot of investors these days will see it as more of a weakness, given the retail environment that we've seen in 2016 and 2017, maybe punish the company a little bit more that way, whereas Estée Lauder, as we mentioned last week, touts the diversity of their channels and all these different partners and customers that they can sell through and how that's a strength for the company, we would agree with that. 

So I think that gets to a little bit of the core of some of the differences that we've seen in the prospects for the stocks and how investors are interpreting those different results. If anything, I say to Joseph, and the thing that we've noticed looking at both of these companies in the past couple of weeks is that skincare and cosmetics are a really attractive sector and can be overall, with in this case, multiple great companies to choose from that might have different niches, different areas that they specialize in but overall, again, presenting growth numbers in the retail and consumer space that are just very, very impressive. 

So I'll leave it to you, Asit. Any final thoughts or takeaways you would leave investors with, or Joseph specifically, based on either Ulta or both these companies or however it is?

Sharma: Absolutely. A subtext of Joseph's question is, can these two companies thrive together, and I think you just touched on that, Vince. They actually are pretty complementary. Estée Lauder, for them, Ulta is a distribution channel. Many of the products which Ulta's management cites as faster growing products helping their sales happen to emanate from Estée Lauder. So it's good for both companies when the prestige brand and makeup at Estée Lauder do well. You can own both of these companies. 

I would also say that the world has flipped a little bit, it's like a Shakespeare play right now in that at the end of a Shakespeare comedy, the jesters act as kings and sometimes the kings act as jesters. You mentioned this weird state that we're in with these two companies in that Estée Lauder has an earnings multiple which is trending right now around 35x forward earnings, and Ulta is down to 21x. So some of the skepticism is factored into Ulta, but it's not a bad entry point still. And for Joseph, maybe it's OK to hold the stock.

One last point I do want to make, though, respective to these margins, one layer deeper, why investors are a little bit skeptical. Vince talked about the fact that the company had a long-term growth target for operating margin of 15%, and they've dialed that back to 13%. Because of this massive, 20,000 product inventory the company carries, its gross margin is only about 35%. And out of that 35% of every sales dollar, it has to pay selling expenses, overhead. At the end of the year, it's close to profitability to Estée Lauder. Ulta has a net profit margin of 8.5% to 9.5% in a given year. We talked about last week how Estée Lauder has a 10% net margin. But if you remember from last week, Estée Lauder, because it doesn't have so many physical stores and has these multiple distribution channels, it has a gross margin of 80%. So it has a lot of space underneath that first line to play around with and experiment with. They spend a lot on R&D, etc. So they can react to adverse conditions, maybe, with a little bit more ease than Ulta can. So Ulta really has to manage its costs going forward and try to figure out what its ultimate -- again, bad pun there -- ultimate product mix will be to provide something close to that 15% operating margin that will get them their 10% at the end of the year. 

But last thought, Joseph, it's not a sell here. This seems like a great company, still growing very, very strong, and is worthy of being in your portfolio. But why not buy them both? You can't lose. Estée Lauder, Ulta, good combination in the portfolio.

Shen: Thanks a lot, Asit! I'm really glad that you brought up some of the differences in the margin profile for those two companies, and the different levers that presents for management at each company. If conditions, as you mentioned, become adverse in one space, they can change things up with a little bit more flexibility there, probably, on the Estée Lauder side.

As always, thanks to our listeners for tuning in. We love getting questions like the one we received from Joseph. Always feel free to reach out to us. The email, [email protected], goes to all the hosts. So for any sector, not just consumer and retail, you can reach out to us. We're always happy to take these mailbag-style questions. Thanks, Asit, for hopping on today!

Sharma: Thanks a lot! This was fun.

Shen: People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!