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Ulta Beauty
Ulta is the leading specialty retailer of beauty products in the U.S. The company sells over 25k cosmetics, fragrances, skincare and hair care products from more than 600 brands within their stores. Ulta also provides services like salon, skin, brow and makeup. With over 1,300 stores in all 50 states, the company commands over 7% of the beauty market. Ulta has over 35.9M active members in the company’s loyalty program called Ultamate Rewards. These customers have made a purchase online or in-store over the trailing 12 months.
Ulta stores are located in suburban strip mall environments that service 50k-100k nearby households. A typical store has roughly 10k sq. ft. of space, of which 950 sq. ft. is dedicated to a full-service salon. While many other retailers have increased the size of new stores in recent years, Ulta has stayed true to its size for the past decade. However, there has been an evolution inside the store with more space dedicated to “boutiques” of prestige brands like Benefit, Clinique, Lancome and MAC.
The company’s target customer is a beauty enthusiast that likes to explore the latest beauty trends in-store (while purchasing services) and refresh her beauty regimen online. The beauty enthusiast likes to shop for products in both the mass and prestige categories, especially after trying the prestige products in-store (usually with the help of an associate). The customer is from a household with average income greater than $65k, shops at Ulta Beauty multiple times per year and spends over $200 annually.
Salon customers are the company’s best customers. More than half of salon customers make a retail purchase at the day of service and spend 3x more than non-salon customers. Ulta is happy to provide salon services since salon products also command the highest margins. Omnichannel customers are also favored. These customers shop 4x more than online only shoppers and 2.5x more than in-store only shoppers. As of 2020, Omnichannel was 18% of the total customer base.
In the early 2010s, Ulta was in growth mode, opening over 100 stores per year from 2012 to 2018. This was especially impressive early on, given the small base of stores at the end of 2011 (449). This store expansion rate combined with double digit same store sales growth led to total company revenue growth in the low-to-mid +20s% from 2010 to 2017.
During this period of growth, the company took market share from grocery and mass merchant retailers. Customers were attracted to Ulta’s large selection, ancillary services in-store and value proposition as curating the best that mass and prestige brands have to offer. The company has many permanent and temporary exclusive brands that are sold at Ulta and a private label brand called the Ulta Beauty Collection that participates in the mass category. In 2020, private label and permanently exclusive products were 5.5% of revenues.
Ulta has also taken market share by embracing online and digital commerce. The company offers all the typical eCommerce features like buy online pick up in store, curbside pickup and store to home delivery. Through the Glam Lab function on the company’s mobile app, shoppers can try on hair, lashes and brows virtually as well as undergo a skin analysis. Even though eCommerce is margin dilutive (20-40bps headwind in 2018) compared to in-store sales, the company has heavily invested into its eCommerce capabilities. Ulta considers its eCommerce business as mostly incremental as most customers shop in-store to take advantage of the services and recommendations from store associates. eCommerce has grown at a +55% CAGR from 2016 to 2020.
Starting in 2018, the company’s revenue growth rate decelerated due to lower store growth (both in terms of absolute units and as a % of the base) as Ulta got closer to saturation in the U.S. Same store sales growth also slowed as the makeup category faced challenges.
Ulta was negatively impacted by the Covid related lockdowns in 2020 but demand trends rebounded nicely in 2021. Same store sales were -17.9% in 2020 after many years of high-single-digit to low-double-digit growth. Because the company had already heavily invested in the Ecommerce business prior to Covid, this segment was able to make up for some of the lost demand. Ulta has specifically called out future investments for its distribution capabilities, especially with the rollout of more Fast Fulfillment Centers, which are solely dedicated to eCommerce orders. These Fast Fulfillment Centers are less expensive and faster to build, less complex to operate, and requires less of an upfront inventory investment.
Coming out of Covid, Ulta laid out the new growth and margin objectives for the company at the 2021 Analyst Day. From the 2019 base, the company is expecting to grow top line at +5%-7% CAGR until 2024, +3%-5% same store sales growth, with operating margins near 13%-14%.
Those that have followed Ulta would know that this is a meaningful step down from the high growth period up to 2018. Furthermore, margins have been under pressure since 2018 as the makeup category has faced waning demand and the company has grown more in recent years through margin dilutive channels like eCommerce and boutiques of certain prestige brands. Ulta has been responding to the margin pressure through cost optimization and better operating measures.
Why is it a good business?
As the largest specialty retailer within the beauty category, Ulta benefits from scale advantages and intangible assets. The scale advantages aren’t explicit (like leverage in a high fixed cost model) but they help the company to offer a superior assortment of goods to its customers with better economics. Scale increases buying power over its supplier base.
But more importantly, with scale Ulta is able to procure certain brands in the prestige category for its customers. As the store base increased over time, the company was able to add more prestige brands like Benefit, Clinique, Lancome and MAC through its boutiques in the stores. At the 2018 Analyst Day, the company revealed the store penetration data on certain key prestige brands from 2015 to 2018. Estee Lauder and MAC were not available in stores in 2015, but increased their penetration of stores by 2018. In the same timeframe, Clique and Lancome went from low 20s% penetration to almost 80% and over 60%, respectively.
Ulta has been able to introduce and steer more of its customers’ spend towards the prestige category over the years. At the 2016 Analyst Day, Ulta showed that new customers usually migrate from 100% spend in the mass category to 40% mass/60% prestige over 5 years. This is important because this builds customer loyalty and the margins on prestige products are higher than products from the mass category. It is worth noting that Ulta has felt some margin pressure from the growth in prestige because of its boutique model, which does come with higher operating costs.
Through its scale, the company is also able to establish exclusive retail partnerships with certain brands. In 2018, Ulta became the exclusive retailer for Kylie Cosmetics, which was one of the hottest selling beauty lines at the time. Scale also helps with being able to offer private label products. Similar to most specialty retailers, private label has higher margins than branded and the company is able to be in control of the full development cycle of the products.
Ulta is also able to offer its Ultamate Rewards loyalty program to customers and gather data on its customer’s purchasing patterns. Rewards members account for 95% of total revenues. Signing up for the membership is free and members can earn points for their spend. Ulta further increased its ability to analyze its customer’s purchasing patterns through its private label credit card which was launched in 2016. As of 2020, there are over 4.5M cardholders.
Although Ulta does benefit from these advantages, there are reasons to believe that the business isn’t as good as some of the other retailers that we’ve analyzed previously. Beauty as a category changes much more frequently than other categories like home improvement, auto parts or even general consumer staples. Trend changes happen quickly and while there are many long established beauty brands such as Estee Lauder, Shiseido, L’Oréal and others, many new brands emerge each year, taking share in a low growth industry.
Furthermore, with the rise of social media influencers that launch their own make-up lines, retailers are more reliant on partnering with these influencer brands to bring that newness to the stores. Ulta even mentions the number of Instagram followers that new brand ambassadors have on its earnings calls.
Continuous innovation and newness are required for a beauty retailer to stay relevant to its customer base. This is evidenced by the low penetration rate of Ulta’s private label brand at just 5.5% of revenues in 2020 (including permanently exclusive products). In contrast, private label represents 29% of revenues for Tractor Supply, 50% for O’Reilly, 1/3 at Five Below, 20% at Home Depot.
However on the positive side, for the reasons above, the threat from mass merchant and online retailers is relatively low. Although most beauty items are high in value to weight ratio (at least compared to home improvement goods), most prestige brands would be reluctant to sell through Amazon or Walmart because of the potential for brand dilution. Furthermore, prestige brands partner with Ulta to be able to offer a specifically curated set of products that are offered in a boutique format with the store, something that can’t be replicated online. Ulta also has the advantage of product availability with over 25k products sold in the store.
Returns on incremental capital?
Over the past 10 years, Ulta has spent almost 95% of its capital on capex, 4% on pre-openings and 1% on acquisitions. From 2017 to 2019, Ulta spent almost 40% of capex on new stores and more than 25% on fleet related investments. The balance was for IT systems and supply chain investments. Looking ahead from 2022 to 2024, Ulta plans to only spend just over 20% of its capital on new stores, but to increase spending on its fleet, IT systems and supply chain by almost 10% each.
As Ulta enters the next phase of the company’s life cycle, the company’s focus will go from new store expansion to improving efficiencies with its existing store base. Other successful retail companies have done this as they’ve entered this phase. Home Depot reached store saturation in 2008 and was able to grow revenues (+6.9% CAGR from 2010 to 2020) by increasing its online/omnichannel sales (+38% CAGR) and increasing engagement with the pro customer. It also helps that housing has had a nice recovery since 2012.
In terms of unit economics, Ulta has consistently maintained a payback period of ~2 years, even as new store costs have fluctuated over time. New store opening costs have ranged between 1M (in 2013) at the low-end and 1.6M (in 2017) at the high-end. Costs are dependent on the in-store fixtures net of landlord contributions and initial inventory management. As of 2018, the cost has remained close to $1.4M net of all these benefits.
The average new store sales maturation over the first 5 years has changed over time as well. In 2018, new stores averaged $3.5M in revenues in year 1 and ramped up to 5M in revenues by year 5. This implies a same store sales growth of 9.3% over the 4 year period. Assuming slightly higher than corporate average EBITDA margins at year 5, EBITDA is estimated to be $900k-$1M by year 5 for a new store, which would imply a return on capital 65%-70% for year 5. This is inline with the 2 year payback period since years 1 and 2 would have lower EBITDA margins as the new store is ramping up to maturity.
Comparing this to other retailers that we’ve analyzed, Ulta’s payback period is similar to Dollar General’s (and the other dollar stores) but much longer than the king of new store economics, Five Below. Of course, it’s not just about new store economics as many of the most successful retailers have grown their existing store base above market growth rates through innovation and process power.
We estimate that Ulta has generated returns on incremental capital between 40%-50% for the 5 years prior to 2020. Due to the store closures during Covid in 2020, the returns were negatively impacted. 2021 has turned out to be a better year and we’ll get a sense of what the numbers were after the company reports 4th quarter earnings. Going forward however, due to the lower new store opening and same store sales growth expectations, we estimate that the returns on capital will come down for the company.
Reinvestment potential?
With 1,302 stores as of 3Q 2021, Ulta is close reaching its target of 1500-1700 stores in the U.S. That number has moved up over the years from 1200 in 2013 to 1400-1700 starting in 2016 and now 1500-1700 since 2019. Because the target has moved higher, even as the company has increased its store base by 100+ per year from 2012-2018, the number of existing stores as a percentage of the TAM has ranged from the mid 60%s to high 70%s since 2014. Ulta is projecting to open 50 stores per year through 2024 (after opening just 30 and closing 20 in 2020). Ulta is also testing a smaller 5k sq. ft. store format in smaller markets to serve as beauty discovery destinations.
One of the byproducts of getting closer to saturation is same store sales growth deceleration. For Ulta, there are three main reasons for this. First, the company is opening fewer new stores as a percentage of the existing store base, which means that the natural same store sales ramp from new stores will have less of an impact on the total same store sales growth of the company. As we mentioned in the previous section, a new store on average will grow same store sales by +9.3% from year 1 to year 5. By comparison, this is much higher than the projected +3%-5% from 2022-2024 for the company. Stores in years 6 to 10 comp at +6.5% and stores over 10 years comp at +3% on average.
Second, most of the new store builds will be in existing markets going forward. In 2013, only 67% of new stores were in existing markets, but by 2020 almost all new stores are in existing markets. This means there is naturally more cannibalization of the existing store base from the new stores.
And third, new stores now start at a higher revenue base due to the increasing brand awareness from existing and new customers. In 2014, new stores started at revenues of $2.8M in year 1 and ramped up to $4M by year 5. In 2017, new stores started at $3.1M in year 1 and ramped up to $4.5M by year 5. And by 2018, those numbers moved up to $3.5M and $5M, respectively.
Ulta is looking it increase the efficiency of the average store by investing heavily in its eCommerce capabilities. The company believes that eCommerce sales are mostly incremental and Ulta is encouraged that omnichannel customers spend more than in-store only or online only customers. Investments to reduce the average fulfillment time has been a priority as of late. The company is also investing to improve execution at the warehouse, which includes things like automated sorting (inbound and outbound) and mobile robots to move inventory more efficiently within the warehouse.
The capex plan for 2022-2024 is for $1.1B-$1.4B in total spend. That’s an average of $367M-$467M per year. Looking back over the past 10 years, 2017 was the peak of capex spend at $441M. Understanding that the company has grown since then, the projected capex spend puts the forward reinvestment rate at similar levels to the 5 year average before 2020. Even though the new store count will be lower (and returns on incremental capital likely lower as well), it’s somewhat encouraging that the reinvestment rate of the company will be similar to recent years.
With a reinvestment rate between 35%-45% and a return on incremental capital between 40%-50%, we estimate that Ulta has increased its intrinsic value between 15%-18% over the 5 years prior to 2020. Looking forward, the intrinsic value growth of the company will be much more dependent on the operating efficiencies and revenue growth within the existing store base. And this transition (other than the few best-in-class) has been difficult for many retailers.
What else is important?
What happened in 2019?
Ulta had increased its new store count by over 100 each year from 2012 until 2018. Starting in 2014, the company benefited from a makeup cycle (apparently even makeup is cyclical) due to the rising popularity of new application techniques and looks. Furthermore the industry benefited from the growth of new influencer make-up brands. Makeup as a category started to decelerate in 2017 and actually showed decline in 2018.
Specific to Ulta, starting in 2019 store count saturation and the challenges in makeup caused deceleration in same store sales for the company. The stock was not the same after that, tumbling to lower multiples off of lower projected earnings. Looking back, there were signals to the decline before the slowing growth rates actually occurred.
First, the company removed its operating margin target of 15% by 2019 on the 4th quarter 2017 earnings call. Just one quarter prior, the company was confident in reaching is previously laid out targets. Ulta stated that the company would need to invest in key growth areas like the prestige boutiques and eCommerce “for the long-term health of the business”. And operating the business for the 15% margin target would “would require underinvestment in areas that we believe will drive robust sustainable long-term growth.”
Second, the company actually slowed its growth in capex spend starting in 2018. Ulta underinvested in 2018 in key areas like supply chain and IT systems when compared to the prior two years. The lower capex spend continued into 2019 and 2020, but that year was partially impacted by the lockdowns related to Covid.
Target partnership
In late 2020, Ulta announced a partnership with Target. Within select Target stores, there will be a 1k sq. ft. area with Ulta branding and signage. Within the designated area, customers will have access to 54 prestige brands, which are new to the stores since Target mainly carries beauty products in the mass category. The rollouts started in the summer of 2021. So far there are just over 100 Target locations with the concept and many more are planned to be rolled out in the future.
The two companies will benefit from this partnership in different ways. Target will own all the inventory and will benefit from the sales lift from selling prestige brand beauty products. Prestige brands do carry higher margins than products from the mass category.
Ulta will benefit from the brand recognition, especially to customers that don’t already shop at Ulta. There are over 100M Target Circle members, and over 75% of members are women. This would imply that there are at least (if we assume all 35.9M Ultamate Rewards members are already Target Circle members) over 40M potential new members to sign up to the Ultamate Rewards program. Shoppers at Target will be able to earn Ultamate Rewards points that can then be used at an Ulta store or on Ulta.com.
It’s still early to see how much benefit Ulta will receive from this partnership, but others are trying the store within a store concept. Sephora, Ulta’s main specialty retail competitor, has a partnership with Kohl’s for a similar store within a store concept.
Optionality
International expansion
Like other retailers that have come close to saturating the U.S. market, expansion into Canada and Mexico is a natural expansion opportunity. Ulta actually already announced plans to expand into Canada in early 2019, but there wasn’t much revealed about the progress of the expansion after that. The company subsequently announced that the Canada expansion would be suspended due to Covid.
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