TIVP003: ULTA BEAUTY (ULTA): A BEAUTIFUL COMPOUNDER
W/ SHAWN O’MALLEY
19 January 2025
In today’s episode, Shawn O’Malley (@Shawn_OMalley_) breaks down what you might call a beautiful compounder. That is, Ulta Beauty, one of America’s largest retailers for cosmetics, skincare, and hair care products, with an impressive track record of generating returns on capital while benefiting from industry trends where beauty enthusiasts increasingly see beauty products as being key to their wellness and self-care routines.
Shawn outlines what has worked well for Ulta, why its customers are so loyal, how it survived disruption from Amazon, his thoughts on the company’s valuation, and finally, his decision on whether to add the company to The Intrinsic Value Portfolio he’s building each week on the show, plus so much more!
Prefer to watch? Click here to watch this episode on YouTube.
IN THIS EPISODE, YOU’LL LEARN:
- How Mary Dillon made Ulta into an e-commerce giant.
- What customers love about Ulta.
- How Ulta compares to Sephora and other competitors.
- Why Ulta has been able to generate such impressive returns on capital.
- Whether the company can continue growing.
- How Ulta stacked up 44 million members in its loyalty program.
- What makes the in-person experience at Ulta so special.
- What’s attractive about Ulta’s current valuation.
- And much, much more!
TRANSCRIPT
Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.
[00:00:00] Shawn O’Malley: Hey, hey. Welcome back to The Intrinsic Value Podcast. Three weeks into my hunt to build a portfolio of the best intrinsic value compounders for long term investors, I’ve yet to find my first bet. I started with Madison Square Garden Sports Corporation, the holding company that owns the Knicks and Rangers, which has compounded its value at impressive double digit rates.
[00:00:19] Shawn O’Malley: But I passed on it since that value is only an estimate of what the teams could sell for, not based on the actual profitability of the underlying business. Madison Square Garden is a trophy asset, and that’s compelling, but not something I felt confident enough in going forward to invest in. And last week, I reviewed Coupang, the so called Amazon of South Korea.
[00:00:39] Shawn O’Malley: There was a lot to love about the company, but I couldn’t wrap my head around its growth prospects and given the scale of its logistics and technology, I just felt I was too far behind in my circle of competency to understand that company with any real conviction. This week, I’ve got my eyes on another candidate for the intrinsic value portfolio.
[00:00:57] Shawn O’Malley: One you might say has been a beautiful compounder. I say beautiful literally there because I’ll be covering the investment thesis for Ulta Beauty, ticker ULTA, deconstructing its business model and trying to estimate its intrinsic value. Ulta is one of the largest brick and mortar cosmetics retailers in the US with some truly impressive economics.
[00:01:19] Shawn O’Malley: The company has average returns on equity of over 50 percent in the past five years and more than 26 percent returns on invested capital, had average revenue growth of over 14 percent per year in the last decade. In both 42 percent gross margins, all while trading at a reasonable price to earnings ratio, with a 5 percent plus free cashflow yield.
[00:01:39] Shawn O’Malley: I’ll break down what those numbers mean and more in today’s episode, including with my evaluation of Ulta decision on whether to add it to our portfolio or not. With that, let’s jump into the story of Ulta, one of America’s most powerful beauty brands.
[00:01:55] Intro: You’re listening to The Intrinsic Value Podcast by The Investor’s Podcast Network. Since 2014, with over 180 million downloads, we’ve learned directly from the world’s best investors. Now, we’re applying those lessons to analyze businesses and investment opportunities every week, helping you uncover intrinsic value. Now for your host, Shawn O’Malley.
[00:02:28] Shawn O’Malley: Today, I’m covering Ulta Beauty, a company whose track record of compounding returns is nothing short of beautiful. My hope is to break down everything you could possibly hope to know about the business, estimate its valuation, and decide whether to add it to our intrinsic value portfolio. Ulta is a cosmetics retailer offering hair care, skin care, body care, makeup, and fragrance products.
[00:02:50] Shawn O’Malley: If you’re not familiar with it, the ladies in your life probably are, at least if you’re a listener based in the US. Beauty is an enduring part of the human experience, something that is not likely to be automated away or replaced by AI. And brick and mortar beauty retailing isn’t going away anytime soon, either.
[00:03:31] Shawn O’Malley: It did, however, sell out of that position in the third quarter, presumably in pursuit of opportunities that they thought could generate even higher returns. But with almost 1, 400 stores across the country, Ulta is a common sight nationwide and a popular destination for women of all ages. Since its listing in 2007, Ulta’s stock has compounded at a market beating rate of 16 percent per year.
[00:03:53] Shawn O’Malley: As we’ll talk about more later on though, the stock’s price appreciation has understated the extent to which the business’s intrinsic value has compounded given that its price to earnings ratio has fallen to 17 after spending most of the last decade in the 20 to 30 range and well higher during the euphoria of 2021.
[00:04:10] Shawn O’Malley: In fact, its price to earnings valuation isn’t too far above the low it hit during the pandemic induced market crash of 2020. It’s a very attractive setup for the stock and one I’m excited to dive further into. Ulta was founded 34 years ago in 1990 and is headquartered today in Bolingbrook, Illinois.
[00:04:28] Shawn O’Malley: Richard George and Terry Hansen started the company together, with George being inspired to launch a beauty retailer that offered products at multiple price levels as opposed to either targeting the low end or high end. Since its beginning, what has made Ulta stand out is its offering of drugstore and high end cosmetics, as well as everything in between.
[00:04:47] Shawn O’Malley: It is a universal practical beauty retailer. Ulta became well known for its open and inviting store layouts, balancing a shopper friendly environment with salon and related beauty services. Most credit Mary Dillon with transforming the company though after becoming CEO in 2013. Under Dillon, Ulta became a serious player in digital retailing, building out a revamped website and mobile application for shoppers, while prioritizing customer analytics.
[00:05:11] Shawn O’Malley: Before she hit the scene, online sales made up half a percentage point of total revenue. Less than a decade later, that figure had risen to 25 percent and was boosted significantly by the pandemic. Under Dillon’s leadership, overall sales would continue to expand, maintaining a 20 percent or higher growth rate from 2013 to 2017.
[00:05:30] Shawn O’Malley: At the same time, she positioned Ulta as a company that cares, one that increasingly offered sustainable and ethically sourced products at a time when those concerns are becoming much more top of mind for consumers. The four key pillars that Ulta certifies its products are whether they have clean ingredients, are cruelty free, vegan, and whether they’re wrapped in sustainable packaging.
[00:05:50] Shawn O’Malley: Dillon is hard to replace, and she was much loved on Wall Street for her track record in beating quarterly estimates. But really, she was loved by almost everyone she interacted with. She had a truly rare combination of humility, composure, confidence, and friendliness. She could reportedly command the attention of an entire room by just walking into it.
[00:06:09] Shawn O’Malley: An analyst at the investment bank, Piper Sandler, once said that, quote, she changed Ulta’s entire brand image from being a drugstore retailer into something completely different. Another investment banker said, quote, I remember being at an event when Mary walked into the room, and I watched the heads of Estee Lauder, L’Oreal, Elizabeth Arden, and Bare Minerals.
[00:06:28] Shawn O’Malley: I watched all of them turn and look. I remember thinking, something is changing at Ulta. Mary is changing things at Ulta he adds I think to Mary’s credit. She’s figured out a way to establish and reinforce those relationships to reassure Estee Lauder and L’Oreal Lux and those premium brands and beauty that it’s okay to coexist in an environment with Morphe and Makeup Revolution and e. l. f. and Covergirl and Revlon. It doesn’t degrade the value of Estee Lauder to be in the same space as those value price brands. The same reason that H& M can fit in a shopping mall next to a Burberry or next to a Gucci store or a Louis Vuitton. Why? Because the same woman that’s carrying a Louis Vuitton handbag is wearing a pair of jeans from H&M.
[00:07:10] Shawn O’Malley: I find that super fascinating and sort of funny to get such insightful commentary on beauty and fashion from investment bankers. Dillon not only firmed up relations with premium brands, but also turned Ulta into a destination for up and coming products. Ulta became the partner of choice for many hot new brands looking to sell through brick and mortar storefronts for the first time.
[00:07:29] Shawn O’Malley: Under Dillon’s guidance, Ulta’s storefront more than doubled while operating income tripled and net income quadrupled. Alas, she did step away in 2021, and Dave Kimbell has since succeeded her. Incredibly, from her first earnings call to her last, 20 million increase in loyalty program members for a total of more than 33 million shoppers.
[00:07:50] Shawn O’Malley: Today, the loyalty program has risen even further to over 44 million members, and the company wants to have 50 million by 2028. Every piece of the business improved under Dillon, and she really scaled the company from a successful regional operator to being a nationwide destination. She changed the culture of the organization, bringing more women into leadership and board positions, and committing to diversity initiatives that have strengthened Ulta’s perception amongst customers, such as pledging to have at least 15 percent of the store’s products to be sourced by black owned businesses.
[00:08:20] Shawn O’Malley: In more subtle ways, changes like insisting that customers be referred to as guests reverberated across the organization, fostering an atmosphere that has evidently resonated with shoppers, or guests, as Dillon would say. So Dave Kimbell has had big shoes to fill in terms of how he’s done so far. The website comparably gives him a C minus rating based on responses.
[00:08:42] Shawn O’Malley: They’ve apparently collected from over a thousand Ulta employees who gave him a score of just 63 out of 100. I don’t really know to do with that information other than to say that based on what’s happened with the stock, the market seems to agree. The company’s price to earnings ratio has steadily contracted since he took over, to see as a collapse of faith in Ulta’s prospects.
[00:09:03] Shawn O’Malley: Valuation multiples for the stock have been absolutely pummeled in the last three years, and that, at least in part, surely is a reflection CEO. Whereas Mary Dillon had earned the market’s trust and was given the benefit of the doubt, sentiment has seemingly swung in the opposite direction under Kimbell.
[00:09:19] Shawn O’Malley: It’s little surprise, then, that Kimbell retired within the last two weeks, ending his three year stint as CEO. Keisha Steelman will now take over as CEO, getting promoted from being the company’s chief operating officer. It’s obviously too early to say what type of leader she’ll be, so I’ll be carefully watching this.
[00:09:36] Shawn O’Malley: Today, Ulta offers 25, 000 products from approximately 600 established and emerging brands. Its store footprints are made intentionally to be open and bright, making it easier for shoppers to discover new products. Nearly every store has beauty services, including a full service salon and eyebrow bar, in case you’ve ever wanted your eyebrow styled.
[00:09:55] Shawn O’Malley: In addition to its freestanding locations, usually in popular shopping malls, Ulta has a partnership with Target, where it runs around 500 mini Ulta stores from within Target locations. Over time, they’re hoping to expand Ulta’s presence into over 800 Targets. A typical Ulta store has 10, 000 square feet, with around 1, 000 square feet carved out for a salon, and can be found in what are known as power center shopping malls.
[00:10:19] Shawn O’Malley: These are shopping centers with three or four so called big box anchored tenants that occupy most of the square footage. The number of smaller retailers nestled in between. Some examples of anchor tenants are brands like Home Depot, Best Buy, and Nordstrom Rack. Obviously, these anchor tenants draw the crowds of people in, and then more specialized retailers like Ulta benefit from that foot traffic.
[00:10:39] Shawn O’Malley: These centers typically have ample parking and are pretty convenient, and that you can park right near the store you’re hoping to go into, versus the maze of traditional shopping malls where you might spend 20 minutes wandering just to find the store you want. Around 13 percent of all shopping malls in the US are power centers, and if you’ve ever been to an Ulta or seen the type of centers they’re located in, I think you can easily imagine what they look like.
[00:11:02] Shawn O’Malley: Last year, Ulta either remodeled or relocated 25 stores, while opening 33 new ones and closing 3 locations. Back in 2017, the company was growing at 100 plus stores per year. Now they have nearly 1, 400 stores in the U. S., with a goal to reach between 1, 500 and 1, 700 total. California has the most Ulta locations at 170, with Texas in second place with 131, and Florida in third with 99.
[00:11:27] Shawn O’Malley: So, Ulta’s presence is truly coast to coast. The average cost to open a new Ulta store is 2, 000, 000, which includes everything from capital costs of construction to the inventory and other pre opening expenses. And once up and running, an Ulta store is typically staffed with a general manager, services manager, and 3 or 4 associate managers, along with approximately 28 full and part time associates, including 4 to 8 prestige consultants and 5 to 10 licensed salon professionals.
[00:11:54] Shawn O’Malley: For online shoppers, Ulta offers options to pick up products in store, curbside, or even same day delivery. And I thought this was pretty cool, too, in the app, they use augmented reality that enables you to try on products virtually or have your skin type analyzed. Basically, you get your skin assessed, then Ulta builds a recommended set of skincare products to use.
[00:12:12] Shawn O’Malley: Or you can just play around with their glam lab and virtually try on thousands of different products. So again, I thought that was all pretty cool and innovative. Honestly also is definitely not trying to shove technology down your throat at all. But from what I’ve seen, these are all pretty practical implementations of technology.
[00:12:29] Shawn O’Malley: Their app actually has over 20 million users, so it’s clearly been popular amongst oldest customer base. Here’s a line from the company’s most recent annual report on the type of customer Ulta hopes to cater to. We define our target consumer as a beauty enthusiast. The consumer is passionate about the beauty category, uses beauty for self expression, experimentation, and self investment, and has high expectations for the shopping experience.
[00:12:53] Shawn O’Malley: We estimate beauty enthusiasts represent approximately 65 percent of shoppers and account for more than 80 percent of beauty products and services spend in the U. S. The report continues by outlining Ulta’s overall strategy, so I’ll just keep reading from it verbatim. Quote, we target beauty enthusiasts across multiple demographics and shopping behaviors.
[00:13:12] Shawn O’Malley: Beauty enthusiasts have a deep emotional connection with beauty and historically this connection has not diminished in softer economic environments. Our proprietary consumer research confirms engagement with the beauty category remains strong. The COVID 19 pandemic and subsequent recovery drove unprecedented disruption, which provided beauty enthusiasts the opportunity to develop new beauty regimens, many of which consumers are sustaining.
[00:13:35] Shawn O’Malley: Despite the disruption caused by the pandemic, beauty enthusiasts continue to demonstrate their commitment to the in person shopping experience, while also embracing the use of online shopping to supplement discovery and convenience. At the same time, rising competitive pressures and a dynamic operating environment will require strong execution and continued investment in innovation to further our leadership position.
[00:13:58] Shawn O’Malley: They also mentioned how beauty has become commonly associated with self care and wellness. Many women see painting their toes or doing a face mask as a reward for making it through a long day or week. And based on Ulta’s internal research, approximately 65 percent of consumers see the beauty category as being significantly connected to wellness.
[00:14:17] Shawn O’Malley: And for them, beauty isn’t all about superficially how they look, it’s about how they feel. Beauty is tied to emotional and spiritual health for them. At least that’s how Dave Kimbell put it to CNBC in an interview. As an example of that, Kimbell says that fragrance sales didn’t fall off during the pandemic, even though people were locked at home, because many people wear perfume for themselves, not for others.
[00:14:39] Shawn O’Malley: They like how it makes them feel, and they don’t necessarily even care if they’re stuck at home and no one else will know that they’re even wearing it. There was some serious corporate mumbo jumbo in that last passage I read, but it is interesting to hear how they think about their target demographic, their shopping habits, and their resiliency during downturns.
[00:14:55] Shawn O’Malley: I’m not at all surprised, because in a recession, my impression is that there are a lot of other things women would want to cut back spending on before they make changes to their beauty routine. These beauty enthusiasts cherish more than just the chance to try products directly in the store. Ulta has found that shoppers love to connect with each other and Ulta provides the space and atmosphere for them to do so.
[00:15:16] Shawn O’Malley: Last year, 76 percent of Ulta’s loyalty members transacted solely in person. Because of that, Ulta pays very close attention to its store layout and is constantly trying to optimize it. Here’s another passage from the company’s annual report. Outline the changes they’re making to store layouts. While our traditional layout is organized by price point with prestige, makeup, and skincare on one side of the store and mass makeup and skincare on the other, our new layout brings together light categories with intuitive adjacencies to magnify our differentiated assortment.
[00:15:46] Shawn O’Malley: In the new layout, categories flow from prestige to mass with delineated fixturing showcasing each segment. In addition, this new layout features elevated gondolas to showcase key iconic and service brands and new beauty bars that offer our brow and makeup services, support in store events and highlight beauty in action.
[00:16:04] Shawn O’Malley: We believe this new layout better reflects how our guests shop and will simplify exploration and shopping. For context, prestige there refers to higher end brands where mass makeup is cheaper, more everyday stuff. So Ulta is taking a more integrated approach to its store layout, where high end products aren’t as clearly separated from lower end ones.
[00:16:24] Shawn O’Malley: The company actually has multiple different teams devoted to improving store layouts, including a planogram team that produces detailed schematics showing product placement throughout the store. A visual team that works with their merchandising team to strategically place promotional items. All stores receive centrally produced merchandising planners who direct how things are laid out.
[00:16:43] Shawn O’Malley: So this is not a franchise model where operators are given a ton of discretion to make changes to the stores. The customers that Ulta really wants to attract more of are those who shop both in person and online. These omni channel shoppers, as they’re called, make up 18 percent of Ulta’s total loyalty program members, but they spend nearly three times as much as customers who only shop in person.
[00:17:05] Shawn O’Malley: Overall, beauty and salon services was a 181 billion industry in the US in 2023, with 112 billion of that coming from cosmetics, skincare, haircare, fragrance, bath and body, styling tools, and other toiletries. And Ulta reportedly has a 9 percent market share in that 112 billion market, and a less than 1 percent share of the 69 billion salon industry.
[00:17:28] Shawn O’Malley: As the world began to reopen a bit in 2021 and with stimulus checks in people’s pockets, the beauty industry saw a surge of growth that is now normalizing again, as the beauty industry has returned to low to mid single digit growth. During the first year of the pandemic, Ulta’s revenues fell from 7. 4 billion to 6. 1 billion, bounced back to a record high of 8. 6 billion the following year, and have continued to climb higher since, reaching 11. 3 billion in the past year or so. While that is some impressive resilience, as the company’s percentage growth rate has dropped off each year since that huge recovery in 2021, I think there’s some angst on Wall Street on what quote, unquote normalized growth will look like from here.
[00:18:07] Shawn O’Malley: And even though operating profit margins are higher than in 2019, margins have contracted some from their pandemic era peak. So whenever you have declining margins over a period of time and slowing revenue growth, even if it’s just the business returning to a more normal environment after the pandemic, you’re going to have some investor unease, especially among the cohort of investors who obsess over quarterly results.
[00:18:28] Shawn O’Malley: In terms of how Ulta fares and downturns, since it is clearly a company that relies on discretionary spending, I’m not sure that 2020 is all that informative for us. We know that Ulta’s beauty enthusiasts primarily prefer to shop in person, so to what extent the sales drop off in 2020 was because of penny pinching or simply being unable to visit stores is unclear, so I wouldn’t argue by any means that it is not an economically sensitive stock.
[00:18:53] Shawn O’Malley: Like any retailer, Ulta lives and dies by the business cycle, even if it has grown consistently for the last decade. I don’t play the game of trying to forecast when the next recession will come, but as Ulta’s expansion has slowed generally in the last few years, I’d imagine in the next recession we’ll truly see just how well Ulta holds up.
[00:19:12] Shawn O’Malley: That is to say, when there’s not a pandemic to blame or when the company wasn’t already expanding its footprint aggressively fast. To better understand Ulta’s relative performance, I put together a list of 15 publicly traded comparison companies for Ulta so we can better understand how it compares.
[00:19:28] Shawn O’Malley: Unsurprisingly, Coty and L’Oreal have much higher gross margins, meaning that their profits are higher initially after only accounting for the cost of goods sold and no overhead or anything else. I say that’s not surprising because Coty sells higher end fragrance brands like Hugo Boss, Gucci, and Burberry.
[00:19:46] Shawn O’Malley: Coty itself is not a retailer though. L’Oreal is also considered a high end luxury brand, and the fact that it earns a 73 percent gross margin reflects that, compared with the 42 percent gross margin that Ulta earns. But Ulta actually sells L’Oreal products, so they’re just different businesses. And then e. l. f. is another of the major beauty stocks, and has much higher margins, but like Coty, it’s not a retailer, so it’s not as good of a cop for Ulta. Relative to other brick and mortar retailers, Ulta fares much better. Its gross margins are in line with companies like Victoria’s Secret, Burlington Coat Factory, and Land’s End, and well above retailers like TJX, Dick’s Sporting Goods, Ross, Urban Outfitters, and Footlocker.
[00:20:28] Shawn O’Malley: More important though is the net income margin that these companies can earn. They all start with different gross profit margins, but how does Ulta compare in converting revenues and gross profits into bottom line earnings? The answer is pretty well. In my comp list, only Lululemon and L’Oreal had higher net income margins.
[00:20:45] Shawn O’Malley: For every dollar that Ulta earns, eleven and a half cents converts to earnings for shareholders. Relatedly, the free cash flow margin is a similar metric that strips out some of the paper accounting effects of non cash items like depreciation. On that front, Ulta again sits near the front of the pack with a more than 9 percent free cash flow margin while a handful of its comps earn negative or near zero cash flow margins.
[00:21:09] Shawn O’Malley: So really on some very key business metrics, Ulta beats out true retailers across a range of product categories and only higher end names like Lulu and L’Oreal with fairly different business models have higher margins. I see that as a testament to the quality of Ulta’s business model and management’s efficiency in running the company.
[00:21:27] Shawn O’Malley: The elephant in the room here, as I look at other retailers, is, of course, Amazon. Amazon is a real competitor, but there’s something to be said about the experience of going to a store, too. Chatting with employees, testing lotions, smelling perfumes, comparing makeup shades these are all things that add value to the experience, as opposed to just ordering everything online.
[00:21:48] Shawn O’Malley: Hair cutting and hair dyeing services at certain stores also add to that same in person experience. Thus far, Ulta has proven to be one of the few retailers that are relatively resistant to the Amazon effect. But the stickiness of its in person experience to the next generation of customers will be key to its ongoing success.
[00:22:04] Shawn O’Malley: Brick and mortar stores have an inherently higher cost structure than Amazon, leaving Amazon with more capacity to sustain lower prices. For women with products they are loyal to and buy on a recurring basis, Amazon is the more attractive option. Ulta though is likely better for discovering new products.
[00:22:21] Shawn O’Malley: And the more Ulta can make the in person experience unique, exciting, and personalized, the more they can turn a competitive disadvantage into an advantage. There’s a lot of consumer spending research that basically concludes that the longer you hold a product in your hand as you try it out, the more you feel as though you already possess it and must then go purchase it.
[00:22:39] Shawn O’Malley: So there’s a secret genius to Ulta making it so that you can try on a ton of products whenever you walk into a store. Another big part of Ulta’s success in keeping customers coming back is its rewards program. Ulta’s rewards program is just incredible. With more than 95 percent of sales coming from loyalty members, results speak for themselves.
[00:22:58] Shawn O’Malley: Even better is that Ulta is reimbursed for a certain percentage of points if customers use an Ulta credit card, reducing some of the costs to run the program. All in all, it’s a super powerful tool for keeping customers captive in Ulta’s ecosystem. Just looking at their website from signing up for free, you can unlock $5 off a purchase and get a free birthday gift as well.
[00:23:19] Shawn O’Malley: And then there’s a $15 ere reward that can be used on the website after purchasing a gift card. 40% holiday sales promos, coupons, mystery gift rewards, free bonus accessories in certain bundles that Ulta calls, gifts with purchases, and a ton of other stuff like that. There are also holiday gift guides and sponsored product promotions, like makeup palettes tied to the movie Wicked and an Ariana Grande perfume set.
[00:23:41] Shawn O’Malley: It’s just fun and even though I’m nowhere close to the target demographic, it doesn’t take much effort for me to see why mothers and daughters and women everywhere love it. With the loyalty program, there are all kinds of offers too for earning extra points on certain purchases that go toward milestones like becoming a platinum member, which entitles you to exclusive events, a higher points multiplier on spending, special product offers, bonus points, and more.
[00:24:04] Shawn O’Malley: To level up the platinum tier, you’ve got to spend 500 in a given year, and then the next tier is the diamond tier for 1, 200 in annual spending. Diamond members get an even higher points multiplier, allowing them to stack up points faster for redemption, a 25 annual reward for beauty services, early access to new products, an additional birthday gift, and more things like that.
[00:24:25] Shawn O’Malley: Though I can see why this is really compelling to some people. They’re giving you a decent amount of value back while also making people feel special. If you spend 100, you get 100 points, which is worth 3 back. Basically, as you spend more, you get more points back, incentivizing the company’s most engaged customers to keep spending more and more since the points can only be redeemed on purchases.
[00:24:45] Shawn O’Malley: After 2, 000 points, you earn 125 off, in addition to the 100 off you already earned from hitting different milestones along the way. By offering three levels, Ulta does two things. It keeps the rewards program simple for customers and adds an element of gamification. With the Ulta co-branded credit card, shoppers get an extra point for every dollar they spend, on top of getting 20 percent off their first order with the card.
[00:25:08] Shawn O’Malley: So having the card effectively doubles the points you can earn through Ulta’s already pretty generous loyalty program. The loyalty program is very much Ulta’s competitive advantage, especially in retaining engagement among the most avid beauty enthusiasts. Sephora is arguably Ulta’s biggest competitor.
[00:25:24] Shawn O’Malley: So I dug through the Sephora subreddit to see what Sephora diehards love most about the brand. I’ll talk about Sephora more in a moment, but I was shocked that on a Sephora fan page, beauty enthusiasts who spend thousands of dollars per year on cosmetics were bashing Sephora for its stingy loyalty program, saying the consumer’s loyalty program paled in comparison to Ulta.
[00:25:43] Shawn O’Malley: And that makes perfect sense. Sephora is very much a higher end luxury brand. So of course, they don’t want to offer too many sales or discounts that will dilute their brand’s perception. But that just means Ulta has a structurally superior rewards program because they can be much more generous with giving away free stuff that earns them goodwill with customers.
[00:26:02] Shawn O’Malley: And on TikTok, influencers do all kinds of Ulta themed challenges. Ulta makeovers to shopping sprees and with 1. 2 million followers on the platform, I take that to be a pretty good indicator of how well Ulta is resonating with the next generation of beauty shoppers. For context, Sephora does have 1. 6 million followers on TikTok, but Sephora is also much more of a global brand.
[00:26:22] Shawn O’Malley: Given that Ulta really only operates in the US, it’s spalling is pretty impressive. And it’s worth mentioning that Sephora’s prices are on average 54 percent higher than Ulta’s, so they seemingly are catering to a mostly different demographic. In practice though, my impression is that many women shop at both, which is something I have validated after I visited both stores recently myself and talked to folks who shop there.
[00:26:43] Shawn O’Malley: One store might have the makeup brand they prefer, while the other may have their preferred skincare products. Beauty enthusiasts today use cosmetics to create their own unique identity, after decades of being told specifically who certain brands were for. Now, plenty of women blur the lines, simultaneously using 7 mascara from Ulta, and 85 makeup foundation from Sephora.
[00:27:04] Shawn O’Malley: And so Sephora came to the U. S. from France in 1998 and changed the beauty game by selling a wide range of luxury cosmetics brands at a time when department stores only carried a few of their favorites. The full gauntlet of prestige beauty brands were now available under the same roof for the first time in the U. S., which is similar but different to how Ulta took things one step further and not only unified some prestige beauty brands, but also offered a mixed selection of lower end cosmetics too. While the two do compete directly in some ways, they have also carved out their own ecosystems. Sephoras are primarily based in traditional shopping mall department stores, where Ulta is more akin to a suburban Sephora.
[00:27:41] Shawn O’Malley: Though it’s not as simple to say that Sephora is for the cities and Ulta is for the suburbs. Seemingly in defiance of that reputation, Ulta has taken the fight directly to Sephora’s home turf after opening a store in downtown Manhattan a few years back. On Instagram, Ulta has 7. 2 million followers versus 22. 5 million for Sephora, so Sephora is doing very well there. There’s definitely a lot of competition in the beauty space, but like I said, I take it to be a decent sign that Ulta holds its weight on social media. It’s not like the brand is fading into irrelevancy by any means. It’s also not a complete viral sensation either, though.
[00:28:15] Shawn O’Malley: But people are very passionate about its products. There’s an entire subreddit with nearly 100, 000 members devoted to simply reviewing and discussing Ulta’s product catalog, inquiring about the membership program, and sharing tips and tricks to maximize loyalty points. Again, Sephora’s social media cloud outpaces Ulta here too.
[00:28:32] Shawn O’Malley: With almost 800, 000 members in its subreddit, Sephora just has a massive cult following. Every time I’ve checked Ulta’s social media following on a different platform, I’ve been impressed, but I’ve been blown away by Sephora’s. As I mentioned, Sephora is a more expensive store, and that makes sense given that the company is owned by LVMH, one of the world’s largest luxury conglomerates with brands like Louis Vuitton, Tiffany, Marc Jacobs, Hennessy, and Christian Dior.
[00:28:58] Shawn O’Malley: Looking more at Ulta’s business breakdown, the company earns about 41 percent of its revenues from cosmetics, 19 percent from skin care and hair care products, 15 percent from fragrance and bath, 3 percent from services, and 3 percent from other things like kickbacks on its credit card, unspent gift card funds, and royalties from its partnership with Target.
[00:29:17] Shawn O’Malley: To promote these product sales, Ulta spends about 4 percent of its revenues on advertising across all forms of media, from magazines to television and social media. As I dug deeper through the company’s filings and read some of the risks it reports, it was interesting to see inventory shrink highlighted so specifically.
[00:29:34] Shawn O’Malley: It’s an industry word for products that are lost to damage or theft. So apparently there’s been a meaningful uptick in shrink since the pandemic, and that has had a measurable impact on profit margins. Unfortunately, this is sort of just a cost of doing business in retail, but I was surprised to learn how much shrink can fluctuate on a year to year basis.
[00:29:50] Shawn O’Malley: For Ulta in 2023, shrink lowered gross profit margins by 0. 4 percent or around 16 million. Another common pain point for retailers comes from primarily selling other brands products given the company’s dependence on product sales and reliance on other brands I do find it slightly concerning that the company doesn’t have any long term supply agreements with its brand partners. Essentially Ulta relies on maintaining good relationships with the brands it sells. If for whatever reason a major brand is unable to supply enough product inventory to meet Ulta’s needs or pulls its products altogether from Ulta I could have major consequences for Ulta’s business.
[00:30:26] Shawn O’Malley: In the globalized world we live in today, it’s not common to find companies that completely control their own destinies, but there is another degree of interdependence with retailers that is just worth mentioning. I don’t see anything on the horizon that would make me worry about the relationships Ulta has with its brand partners, but structurally, that dynamic of codependence will always be there.
[00:30:44] Shawn O’Malley: In recent years, more than 50 percent of Ulta’s revenues have come from its top 10 brand partners, so there are some key relationships there that produce most of the company’s sales. As is common in retail generally too, Ulta earns a non trivial amount from so called vendor allowances. These allowances include advertising support, markdown allowances, purchase volume discounts and rebates, reimbursement for defective merchandise, and contribution towards certain selling and display expenses, such as slotting fees, which vendors pay to secure specific shelf space or premium locations within a store.
[00:31:16] Shawn O’Malley: Vendor allowances are common in the retailing industry and are typically recorded as reductions in the cost of goods sold, which helps pad gross profit margins. I wasn’t familiar with vendor allowances before studying Ulta, since it’s the first retailer I’ve ever really dug deeply into, so I was surprised at how substantial they can be.
[00:31:33] Shawn O’Malley: For Ulta last year, vendor allowances were worth 140 million. Financially speaking, Ulta is in good shape all around. Most of its liabilities are in long term leases for its stores, which definitely can resemble long term debt, but the key difference being that this isn’t borrowed money for the sake of having borrowed money.
[00:31:50] Shawn O’Malley: These are obviously commitments that are necessary to run the business, and they also don’t charge interest either, which is nice. Most of its other liabilities are things like unearned and deferred revenues, where the company has collected payment but has not yet delivered the products or services as such as with unused loyalty program points.
[00:32:07] Shawn O’Malley: Well as inventory financing and other shorter term liabilities. Otherwise, the company generates a very healthy amount of cash from operations, giving it more than enough room to fund its business, invest in growth and remodelings, and aggressively buy back stock too. It also has little actual debt, a nice cash cushion, and a revolving credit facility it can lean on as needed to borrow up to 800 million dollars on not losing any sleep at night over Ulta’s financial health.
[00:32:33] Shawn O’Malley: To facilitate its sales, in addition to its storefronts, Ulta operates four regional distribution centers that support both in store and e commerce orders, and two fulfillment centers that support e commerce orders only. In 2023, Ulta opened its first Market Fulfillment Center, as they call it, which is smaller than their regional distribution centers, and focuses on their most productive products.
[00:32:54] Shawn O’Malley: Additionally, approximately 400 stores help fulfill e commerce orders as part of their ship from store program. In other words, Ulta has a network of distribution and order fulfillment centers who deliver inventory to stores or fulfill online orders, and they use their stores to ship products between locations to fulfill orders as well.
[00:33:11] Shawn O’Malley: Here’s another quote from Ulta’s management, pulling the thread a bit further on its supply chains. Inventory is shipped from our suppliers to our distribution centers, fast fulfillment centers, and market fulfillment centers. We replenish our stores with such products primarily in individual quantities, which allows us to ship less than an entire case when only one or two of a particular product is required.
[00:33:31] Shawn O’Malley: Our distribution centers, fast fulfillment centers, and market fulfillment centers use warehouse management software systems to manage inventory to support product purchase decisions. Product is delivered to stores using a broad network of contract and local final mile carriers and then supporting all of its in store operations Ulta has 56, 000 associates, but less than half are full time.
[00:33:55] Shawn O’Malley: I think they’re treated pretty well, too. At least for the full time workers Ulta gives them a fairly generous 4 percent 401k match, disability and life insurance tuition reimbursement, paid time off with additional time off for extended illnesses, mental health, counseling services, financial planning assistance, and discounts on all retail products and salon services.
[00:34:14] Shawn O’Malley: On Glassdoor though, Ulta has just a 3. 4 out of 5 rating, and only 56 percent would recommend that others work there. People report that there can be pretty demanding expectations and goals for credit card or loyalty program signups that can quickly lead to burnout, and the pay for associate jobs is nothing to write home about.
[00:34:32] Shawn O’Malley: One commenter said they loved working at Ulta, but not for Ulta. They added, beyond the specifics of working for the location I’m at, corporate is not the greatest. Corporate and district level management is hyper focused on numbers instead of taking a holistic view of the business. At times, what is demanded of you as a manager is not what is in the best interest of the store team.
[00:34:53] Shawn O’Malley: Very rarely do I encounter a week in which I have enough hours to complete everything required of me. Take an isolated review like that with a grain of salt, but I definitely was not inspired by the reviews I came across for the type of job that it is. I do think Ulta offers pretty decent benefits, but it sounds like the day to day workflow has left many frustrated.
[00:35:12] Shawn O’Malley: This is a yellow flag for me. It’s not like Ulta workers have unionized or that the company is having serious staffing issues. And Ulta apparently has the highest retention rate it’s ever had for store associates. But I do think workplace culture is an important part of a company’s long term success.
[00:35:27] Shawn O’Malley: And there’s definitely a disconnect between how management talks about employee satisfaction and what I’m seeing from actual employees. Still, Ulta’s track record speaks for itself. Its financial results have largely been pretty stellar. To show how well Ulta has done, I’m going to take a quick tangent to talk about John Huber and Walmart.
[00:35:44] Shawn O’Malley: It’s all relevant to the story here with Ulta. John Huber of Sabre Capital Management is one of my favorite investors to study, and he has a really compelling framework for assessing the rate at which companies compound their intrinsic value. And that is to look at the incremental returns on capital that a business is able to generate.
[00:36:01] Shawn O’Malley: I’m referencing his writings here, so I’ll be sure to link to his full blog posts in the show notes. He outlines that however precisely we measure returns on invested capital, aka ROIC, it usually only tells us the rate of return that the company is generating on capital that has already been invested, sometimes many years ago.
[00:36:19] Shawn O’Malley: Obviously a company that produces high returns on capital is a good business, but what we want to know is how much money the company can generate going forward on future investments. The first step in determining that is to look at the rate of return the company has generated on incremental investments more recently.
[00:36:34] Shawn O’Malley: He continues by saying that, One very rough, back of the envelope way to think about a company’s returns on incremental capital is to look at the amount of capital the business has added over a period of time and compare that to the incremental growth in the company’s earnings. Walmart, for example, earned 14. 7 billion of net income in 2015 on roughly 111 billion of debt in equity capital, which is about a 13 percent return on capital. Not bad, but what we really want to know is what it will earn on new investments of capital going forward. Let’s imagine we were looking at Walmart as a possible investment back in 2006.
[00:37:08] Shawn O’Malley: At that point in time, we would have wanted to make three general conclusions. How much cash Walmart would produce going forward, how much of it we would see in the form of dividends and buybacks as shareholders, and the portion of which we didn’t receive, what rate of return would the company get by keeping those funds and reinvesting them?
[00:37:25] Shawn O’Malley: Estimates to these questions would help determine what Walmart’s future earnings power would look like. So let’s look at how Walmart did over the subsequent 10 years. In 2006, Walmart earned 11. 2 billion on roughly 76 billion of capital, which is a return of around 15%. In the next 10 years, the company invested roughly 35 billion of additional debt and equity capital, and it grew earnings by about 3. 5 billion. So from 2006 through 2015, Walmart saw a rather mediocre return of about 10 percent on the capital that it invested during that time. Huber tells us that a company will see its intrinsic value compound at a rate that roughly equals the product of its ROIC and its reinvestment rate. So the intrinsic value compounding rate equals ROIC times the reinvestment rate.
[00:38:11] Shawn O’Malley: This is the main driving factor behind how a company’s intrinsic value compounds, but what management does with the cash that’s not reinvested can make a big difference for value per share too, in terms of whether it sits idly or is redistributed as dividends or buybacks. If Walmart retains 25 percent of its capital and reinvests that capital at a 10 percent return, we’d expect the intrinsic value of the company to grow at a rate of around 2. 5 percent per year. If you’re pulling up Walmart’s stock chart over this past decade, you might be surprised then by how it is done. While the company’s returns on invested capital aren’t much better, shareholders have fared well thanks to large buybacks, and the price to earnings ratio rising considerably, juicing stock price returns.
[00:38:53] Shawn O’Malley: Going back to Ulta, the company has been reinvesting around 27 percent of its earnings back into the business, while dedicating the rest to buybacks. On the capital they have invested in the business, the returns are around 70%. Thus, the company has compounded its net income at around 17. 5 percent per year for the last decade and has probably compounded its intrinsic value by a similar amount, yet the stock’s 10 year annual return is much lower because the price to earnings ratio that it trades at has contracted from 32 in 2014 to around 17 today.
[00:39:23] Shawn O’Malley: In other words, the company has compounded its intrinsic value at nearly 20 percent per year based on the returns it has generated on incremental investments, yet the market has soured on the company as growth has slowed, and so investors are willing to pay half as much for a dollar of the company’s earnings.
[00:39:38] Shawn O’Malley: That has correspondingly been a major headwind to Ulta’s price performance. But if the company can continue to reinvest that same percentage of its free cash flows into opportunities that are similarly profitable, then the company should generate a return that matches the rate at which it has compounded its intrinsic value, which would be amplified further by potential increases in the price to earnings multiple.
[00:39:57] Shawn O’Malley: Or at least, we can find comfort in knowing the stock probably won’t see its price to earnings ratio get cut in half again, so the stock won’t have the same headwinds opposing it. In this spirit, I want to share one of my favorite quotes from Warren Buffett, which comes from his 1992 letter to shareholders.
[00:40:13] Shawn O’Malley: He says, leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. And as we’ve seen, Ulta has been able to deploy meaningfully large amounts of capital at very high rates of return which immediately makes this talk attractive to me. But past performance is no guarantee of future performance. So that’s what I’m keen to try and figure out with Ulta. Before we go ahead with that though, let me just say that returns on incremental capital are important, but not everything when it comes to intrinsic value.
[00:40:44] Shawn O’Malley: A company with a ton of pricing power, for example, could generate incredible returns by doubling prices, even if it effectively reinvested almost nothing into growing its business. There are some wonderful companies out there that have a combination of pricing power and excellent returns on incrementally invested capital.
[00:40:59] Shawn O’Malley: From what I can tell, Ulta does not have both working in its favor. Instead, Ulta is positioned as a more affordable beauty retailer relative to, say, Sephora, which restricts how much they can raise prices by in any given year. I don’t say that as a reason to write off Ulta by any means, especially since it has been so effective at earning returns on capital, but it’s just something to be aware of.
[00:41:20] Shawn O’Malley: But Ulta has been pretty aggressive about buying back stock, especially over the last year, as its valuation has cheapened across a number of metrics. In the first half of 2024, the company repurchased 1. 1 million shares at a cost of 497 million, which comes out to an average price of 450 per share. And after the company announced a 2 billion share repurchase program in March 2024, it has around 1. 5 billion of spending that it’s still authorized to do, so I’d expect that management will only be more aggressive about reducing the share count since the stock has fallen, which benefits all remaining shareholders by giving them a bigger slice of ownership over the company. Ulta has been a steady repurchaser for years now with a buyback yield climbing from 3% in 2018 to 5.5% today with a peak of almost 9% in 2020.
[00:42:06] Shawn O’Malley: The buyback yield is just a percentage of the company’s market capitalization that the company repurchases in a year. So clearly with Ulta, these are pretty significant percentages, even net of stock-based compensation. Since 2014, Ulta has shrunk. Its share count from 64 million to 47 million, but differently.
[00:42:22] Shawn O’Malley: Ulta share count has shrunk by 3% per year on average. So not only does Ulta have a strong track record of earning attractive returns on invested capital, but management has been focused on returning remaining cash flows to shareholders, further enhancing their experience. In terms of what Ulta can do incrementally with its capital, historically, this has typically gone toward either remodeling or relocating existing stores and expanding into new locations.
[00:42:47] Shawn O’Malley: It has also made sizable investments in its IT systems, supply chains, and just general store maintenance. I’d expect that playbook to mostly stay the same. Pour 30 to 40% of free cash flows and do improving existing locations or spawning new locations to reach management’s goal of adding another 200 or so locations while expanding distribution and fulfillment centers as needed to accommodate Ulta’s growing e-commerce business.
[00:43:08] Shawn O’Malley: That is why I, for the most part, expect Ulta to continue earning very attractive returns and capital. This is not a company that’s dramatically growing, but it is growing and I expect it to continue being disciplined about doing so. Nothing about its formula for success is dramatically changing. They’re also testing out stores with a 5, 000 square foot footprint, which is about half the size of their normal locations, so that could be really interesting and enable them to set up shop in places they wouldn’t have previously considered.
[00:43:33] Shawn O’Malley: And with Target having nearly 2, 000 stores, Ulta only has a presence in a quarter of them, so even just expanding into half of all Target stores would be a massive growth opportunity. There is a risk, though, of course, that in some ways the Target partnership could backfire on them. If, for example, the deal with Target isn’t renewed because Target thinks they can cut Ulta out and directly incorporate prestige brands themselves, that would really hurt.
[00:43:55] Shawn O’Malley: You could also just say, too, that Ulta is allowing customers to leave its ecosystem, where it captures most of the profit and can better control the experience. So the target partnership isn’t entirely a good thing, nor would further expansion of it be objectively positive. The only other wrinkle here is that the obvious thought is, if Ulta primarily operates in the US, what’s keeping it from expanding overseas?
[00:44:16] Shawn O’Malley: Or at least, it could surely expand into Canada, or even maybe Mexico, right? These would be foreign endeavors, but not literally overseas. It’s not a leap to say that the US and Canada are extremely similar, and in theory, it could probably add another 50 or 100 locations there. This is actually something Ulta has toyed around with for years, but ultimately has kept delaying.
[00:44:35] Shawn O’Malley: In short, because any international expansion, even to a destination as similar as Canada, is just challenging. There are subtle logistical and cultural differences, entrenched competitors, and other barriers that make it easier said than done. After unveiling a Canadian expansion in 2019, the company took a step back a year later after COVID 19 threw a wrench into its plans and instead opted to focus on the familiar, not feeling it was the time to venture abroad.
[00:45:01] Shawn O’Malley: Several years later, management no longer makes any real mention of Canada other than referencing that generally it could be a source of growth in the long term. Instead, they flirted with the idea of expanding into Mexico, which, honestly, I don’t really understand. Mexico is a dramatically different culture, with, just practically speaking here, much less discretionary income per capita, so I don’t see the rationale for prioritizing it over Canada.
[00:45:24] Shawn O’Malley: Perhaps the thinking is that, where Canada is already a developed beauty market, Mexico is a fast developing country, where consumers increasingly have the extra money to spend on beauty products. And Ulta wants to position itself as an early leader in that market. I sort of get that perspective, it’s just so hard to do international expansion well, and I’d rather see them get some traction in a more true peer country before looking south, but we’ll see what happens.
[00:45:47] Shawn O’Malley: Neither of them are core strategic priorities at this point in time, but the company did announce that it is hoping to build out a few locations in Mexico this year. So the expansion is apparently being done as a joint venture with Group AXO, a major retailer distributor in Mexico. If that pans out and becomes a real substantial investment, that’s when I’d see a potential inflection point in their incremental returns and capital could either go really well or really poorly.
[00:46:10] Shawn O’Malley: And based on how sentiment surrounding Ulta has fallen off this year, it’s safe to say that markets don’t seem inspired by the plan. In an article about the potential Mexico expansion, Neil Saunders, a managing director at Global Data told Retail Dive that quote, there is no doubt that the days of heady increases and beauty are behind us.
[00:46:28] Shawn O’Malley: Consumer spending is under more pressure, and there’s a lot more competition thanks to the expansion of rivals like Sephora and Target, as well as a raft of DTC specialists. Against this backdrop, Ulta’s forecast suggests it will more than hold its own in the year ahead, which, in our book, is a good result.
[00:46:45] Shawn O’Malley: So, we’ve talked a lot about Ulta’s business model, financials, supply chain, and employee relations, but let’s bring it all together and try to figure out whether the company is fairly valued, and what types of returns we should expect as potential investors. Let me just say that Ulta competes in a tough industry with few barriers to entry, but it’s not typically the setup for a great compounder.
[00:47:04] Shawn O’Malley: But Ulta clearly has a blend of competitive advantages that have sustained its impressive returns. Otherwise, its profit margins and outsized market share would have already been competed away. Its competition ranges from Amazon, as I mentioned a bit earlier, to national and regional retailers, boutiques, drugstores, salon chains, pure play e commerce marketplaces, and even direct response TV channels like QVC, where they sell their products on air.
[00:47:27] Shawn O’Malley: Given the vast array of places a person can purchase beauty products from, it’s pretty amazing that Ulta has a nearly 10 percent market share. I’m sure this is what attracted Berkshire Hathaway to Ulta too, because Ulta fits pretty squarely into what you might call a boring business. Not to say that the beauty industry isn’t interesting or exciting at all, I just mean that this is a reliable industry that’s not going anywhere.
[00:47:47] Shawn O’Malley: People, not just women, will always want skincare, makeup, haircare products, and Ulta has an excellent reputation in this space with eye popping customer loyalty. I’ve said it a few times, but having 95 percent of sales come from customers enrolled in its rewards program is just incredible, and what Ulta does is understandable, too.
[00:48:04] Shawn O’Malley: I’ve tagged along many times on trips to Ulta and I grew up with one just down the street from me, so I can completely get what they do, who they appeal to, and why they remain popular. The business is high quality, part of a reliably growing industry, and tied to an enduring part of the human experience.
[00:48:19] Shawn O’Malley: And even better, its sales are driven by a passionate and loyal customer base. We keep on coming back to discover new products and cash in their points. So I see a lot to like about Ulta. I do wish the company had higher rates of insider ownership and a culture where it was clear that most employees truly love working there.
[00:48:34] Shawn O’Malley: And I do also have some concerns about how well they can expand abroad yet. I mostly feel good about the qualitative aspects of the business. I wouldn’t say Ulta checks every box they could dream up for the perfect investment, but that’s okay. There’s also some promising trends supporting Ulta and the beauty industry more broadly.
[00:48:51] Shawn O’Malley: According to the company’s 2024 Investor Day, which I’d encourage anyone curious to learn more about the company to watch, as beauty becomes increasingly intermixed with wellness and self care trends, Ulta has seen a growing percentage of beauty enthusiasts with each new generation. There are more Gen Z beauty enthusiasts than Millennials, and more in Gen Alpha than in Gen Z.
[00:49:09] Shawn O’Malley: Men are also spending more than ever on beauty products, especially for skincare, and they’re also doing so at younger and younger ages. The company wants to be the go to store for men and women of all age groups and all ethnicities. In particular, Ulta is excited about the Hispanic demographic, since Hispanics consume the most beauty products per capita and as the Hispanic population continues to grow in the U. S., that is an additional tailwind for Ulta and also perhaps explains why they’re so interested in expanding into Mexico. Putting it all together for Ulta’s valuation, I see a company that hit some road bumps in 2024, but the extent to which its price to earnings ratio has declined since the pandemic is surprising to me.
[00:49:48] Shawn O’Malley: Even the initial boost the stock saw after an endorsement from Berkshire hasn’t really moved the needle much. As such, Ulta looks attractively valued across a few metrics, from its historically low P. E. ratio to its relatively high free cash flow yield, on top of its track record of generating excellent returns on capital, especially on incremental investments of capital and in buying back shares.
[00:50:08] Shawn O’Malley: Based on the math we did earlier on incremental returns in capital, Ulta has likely been compounding its intrinsic value at around 18 or 19 percent per year, and there’s a decent chance it can continue doing so. Even if incremental returns fall off, both in terms of the percentage return and the amount that Ulta is reinvesting as Ulta has fewer attractive locations to expand into, I wouldn’t be surprised at all if the company earned incremental returns on capital at say 14 or 15 percent per year going forward and compounded its intrinsic value at a similar rate.
[00:50:37] Shawn O’Malley: At the same time, same sort of sales growth has slowed significantly for Ulta, as Sephora is increasingly growing at their expense. The consensus seems to be that Ulta is very much hitting a more mature phase in its business, so there isn’t much reason to hope that the price to earnings ratio is suddenly going to dramatically reverse.
[00:50:53] Shawn O’Malley: Whether it’s Macy’s offering more cosmetic products, Amazon, or Sephora partnering with Kohl’s, Ulta is very much under pressure from all sides, but I don’t necessarily think that that’s anything new either. The pandemic years pulled forward a lot of growth for the beauty industry, and afterwards, valuations have been correcting to reflect that there may be a bit of a hangover.
[00:51:12] Shawn O’Malley: And it’s worth mentioning too that Ulta has a real opportunity to expand beyond the suburbs into more rural and small town areas where they are really sort of out of reach of specialized beauty retailers and Ulta has a chance to be a first mover there. So, CEO Dave Kimbell told investors on a call for second quarter earnings last year that more than 80 percent of Ulta stores were impacted by one or more competitive openings in recent years, and more than half were impacted by multiple competitive store openings, leading them to revise down their 2024 estimates for Ulta’s earnings and revenue.
[00:51:43] Shawn O’Malley: Yet to earn a 50 percent average return on equity in the last few years, as Ulta has, with no debt to amplify that ROE, the company clearly has some enduringly attractive economics and powerful dynamics underpinning its advantages. Which I guess come primarily from its customer loyalty and rewards program.
[00:52:00] Shawn O’Malley: When I read investors commentary about the stock and line, I see a lot of people fundamentally misunderstanding that Ulta is a retailer and therefore sells brands like Elf and L’Oreal rather than competing with them. In that same vein, there’s a lot of concern over 2024 being an off year for the company, where renovations at some locations disrupted sales and promotional efforts during the summer weren’t as profitable as expected.
[00:52:21] Shawn O’Malley: I could be naive, but to me, these are all clearly short term concerns that are correspondingly weighing on the stock. There’s no free lunch in investing, as they say, and I’m fully aware that the opportunity to buy Ulta at a discount to its intrinsic value exists only because there are clouds fogging up the company’s outlook.
[00:52:36] Shawn O’Malley: You either look at Ulta and see a retailer with no moat, under pressure from a number of tough competitors, with little room left to grow in a mature market, or you see a company with an incredible track record of generating returns, room for modest growth combined with aggressive buybacks to return capital to shareholders, no debt, and just enough economic and industry uncertainty to push investors to abandon the company and thus leave it trading at a barely discounted price.
[00:53:00] Shawn O’Malley: And in a way, what makes investing so tough is that both of these extremes contain elements of truth. As an alternative to looking at just incremental returns on capital, projected at some fairly conservative earnings per share assumptions for the company over the next five years to see where the stock might be trading at based on different price to earnings ratios by 2030.
[00:53:18] Shawn O’Malley: In my model, I assume that 2025 will see a decline in earnings as is expected by most analysts and then grow modestly over the next four years by just 5 percent per year. In that same time, if Ulta continues to buy back around 4 percent of its shares on net each year, which is roughly what it’s been doing since 2020, then the stock would actually generate a near double digit annual return without assuming any improvement and sentiment for the stock that pushes its price to earnings multiple higher.
[00:53:43] Shawn O’Malley: And if there’s any improvement in the price to earnings ratio back toward 20 or higher, then that would tack on an extra few percentage points of return per year. Given the competitive challenges facing Ulta, I want to at least account for the fact that they may not have any real growth after you net out the effects of inflation.
[00:53:59] Shawn O’Malley: Let’s say Ulta’s earnings decline as expected for 2025 and then only grow at the inflation rate of 2 percent until 2030. Doesn’t sound like a recipe for decent returns now, does it? You might be surprised to learn that with no real earnings growth and its PE remaining unchanged, while buying back 6 percent of the company’s stock each year, which is a bit above what they’ve done in the past, but not unprecedented.
[00:54:19] Shawn O’Malley: And especially if they’re not investing more in growth and they’ll have extra cash flow to redirect towards share buybacks, then Ulta could actually still return 8 percent per year, which is very solid for a company that has no real growth. So, as a sort of floor scenario for me, I think that’s just incredible.
[00:54:35] Shawn O’Malley: Not the rate of return by itself, but the fact that even if Ulta has no growth on an inflation adjusted basis, as they continue to be aggressive about directing excess cash flow to buybacks, shareholders can earn an acceptable rate of return still. And the larger the scale of those buybacks are, especially if they’re done strategically, when the stock’s price is depressed, that would create even more value.
[00:54:55] Shawn O’Malley: At the same time, we’re talking about a company that has a phenomenal track record of earning incremental returns on capital and growing net income. So assuming no real growth until 2030 is almost outlandishly conservative from 2014 through 2020. This is a company that has compounded net income by nearly 17 percent a year.
[00:55:11] Shawn O’Malley: So you can see why I say revising down that all the way down to 2 percent is just very conservative. And even in that hypothetical or one with slightly more growth and less buybacks, we can earn reasonably satisfactory returns. To me, that’s a pretty great floor on my expected outcomes and margin of safety.
[00:55:27] Shawn O’Malley: To be a bit more optimistic, if Ulta can grow earnings by up to 8 percent a year through 2030, which is still conservative historically and half the rate that they grew at since 2014, while buying back around 4 percent of its stock, its shares will generate a 12 percent annual return with a flat P. E. and over 15 percent if the P. E. ratio jumps back to 20. We can play these numbers games forever, but the point being, there’s a real floor or margin of safety with this investment that I can feel decent about. Ulta is not a get rich quick investment, but that’s not my style anyways. This is a company that spits off a lot of free cash flow, which has given them a lot of leeway to reinvest profitably into growing the business, while also dumping money into share buybacks.
[00:56:06] Shawn O’Malley: Given how far the PE ratio has already come down, it could fall a bit further, but I wouldn’t expect this to be a major headwind anymore. So like I said, this is a stock where I feel the downside is reasonably well capped. Short of a very dramatic fall off in profitability, which is certainly possible, the company will continue to produce enough cash to aggressively buy back stock, which is an alternative way to boost earnings per share.
[00:56:29] Shawn O’Malley: And while Wall Street is expecting the company to just suddenly not grow at all any longer, I think that between expanding into more target locations, potentially expanding across the U. S. and even into more rural and small towns and potentially expanding into Mexico and Canada as well, I can see very much how Ulta continues to earn attractive incremental returns on capital, where even if income compounds at half the rate it has in recent years, that would all be gravy for investors buying in at today’s prices.
[00:56:56] Shawn O’Malley: Ulta will not be a 10 bagger or even probably a 5 bagger in the next few years, but I do think it’s a stock that we could, with fairly conservative assumptions, earn 10 15 percent annualized returns on over time. That’s not to say I don’t see serious competitive risks, nor am I completely confident in the strength of their moats.
[00:57:13] Shawn O’Malley: That’s also not to say I don’t think the stock would be hit hard by a recession either. It’s just that long term, Ulta is a business I feel pretty confident isn’t going anywhere. Beauty spending is only becoming more common as it becomes synonymous with self care and wellness, plus its returns on capital are strikingly good, and there’s plenty of room for those to come down to competition before they’re no longer attractive.
[00:57:33] Shawn O’Malley: And with how loyal its customers are and the general strength of its brand, I feel Ulta is a fairly safe pick with a good bit of upside potential. I will say though that it’s a stock where the valuation matters a lot, since there’s not a ton of expected growth that’s going to bail you out if you overpay.
[00:57:49] Shawn O’Malley: At a little over 400 per share at the time of recording, I feel good enough about the range of likely outcomes for the stock to say that it’s likely undervalued relative to its intrinsic value, and as such, I want to make it the first addition to our intrinsic value portfolio. I think its fair value is actually probably above 450 per share.
[00:58:07] Shawn O’Malley: For the sake of brevity, I’ll spare you any more numbers and just say that if you’d like to see the model I use to assess the range of expected returns for Ulta, just make sure you’re signed up for our intrinsic value newsletter. There I’ll give a more condensed pitch on the company, share charts and other visuals that I can’t really convey in a podcast format.
[00:58:24] Shawn O’Malley: And like I said, link to a downloadable version of my spreadsheet in case you want to play around with the assumptions I use to model out Ulta’s returns for yourself. In the show notes below, you can sign up if you aren’t already. With that, let me say that I’m really excited to make the first addition to the intrinsic value portfolio with Ulta.
[00:58:40] Shawn O’Malley: To be completely honest, I’m also a bit nervous because building a long term stock portfolio isn’t easy work and it’s definitely not easy to do it publicly either. I will say though that I fully plan to invest personally in any stock that is added to the intrinsic value portfolio and will wait for two weeks after this episode has been published to make any new purchases or further purchases.
[00:58:59] Shawn O’Malley: If it’s a position I already own, which for full transparency with Ulta, this is a company I first researched in November, and thus I have already purchased a small stake in the business. For now, I’m going to give Ulta a 5 percent weight in our intrinsic value portfolio, reflecting that I hope to eventually bring the portfolio to around 20 different stocks.
[00:59:18] Shawn O’Malley: Over time, as stocks fluctuate and certain positions are reweighted, based on my conviction in them, they’ll definitely drift away from 5%, though this is just the starting position, which leaves us with 95 percent cash still in the intrinsic value portfolio that I want to allocate over the rest of the year.
[00:59:34] Shawn O’Malley: Obviously, that means we have many more investment decisions to make and many more businesses to break down. But I do hope you enjoyed learning about Ulta’s business model today, and while adding the stock to The Intrinsic Value Portfolio is not intended as financial advice for anyone to follow. I would love to hear from anyone who has followed the stock and whether they’re bearish or bullish on the company.
[00:59:53] Shawn O’Malley: Ulta is an economically sensitive business, one that has intentionally not diversified beyond its core focus, and I take that to be a good thing, since they really seem to know what they’re doing. On top of that, they’re the only beauty retailer with a full spectrum of products at all prices, so even if there is a recession, they can lean more heavily on their mass market products.
[01:00:13] Shawn O’Malley: If profit margins over the coming quarters fall off more dramatically than expected due to competitive pressures, I could revisit the decision here. But I’m not approaching this with a short term perspective at all. The other elephant in the room here are President Trump’s proposed import tariffs.
[01:00:28] Shawn O’Malley: Sometimes, politics do materially impact markets, and this would very much be the case. Ulta imports most of its products from abroad, with a large dependence on China, so it would either have to raise prices considerably if large tariffs truly go into place, as mentioned, or they’d have to eat those costs and accept lower profit margins.
[01:00:46] Shawn O’Malley: I remain skeptical that tariffs will be implemented on the scale that’s been proposed in political rhetoric, but this would throw a real monkey wrench into the thesis. And of course, it wouldn’t just be Ulta that would be negatively impacted either. 60 percent tariffs on Chinese goods would be unprecedented and devastating to a number of industries, which is why I don’t expect them to happen.
[01:01:04] Shawn O’Malley: Still, this is a company that I will track closely going forward due to some of those concerns, but I hope to own it for the next five years or longer. Next week, I’ll be back here again, evaluating another interesting business and investment thesis and deciding whether it deserves a spot in the portfolio.
[01:01:19] Shawn O’Malley: And so to wrap things up today, I’d like to leave you with one last quote. This one is from Charlie Munger who tells us I’m a very blocking and tackling kind of thinker. I just try and avoid being stupid with my investment in Ulta. I’m more trying to avoid being stupid and just buy a good business without overthinking it.
[01:01:37] Shawn O’Malley: And I am hoping to do something truly genius or novel. That’s all for today, folks. I’ll see you again next time.
[01:01:43] Outro: Thank you for listening to TIP. Make sure to follow The Intrinsic Value Podcast on your favorite podcast app and never miss out on our episodes. To access our show notes and courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decisions, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permissions must be granted before syndication or rebroadcasting.
HELP US OUT!
Help us reach new listeners by leaving us a rating and review on Apple Podcasts! It takes less than 30 seconds and really helps our show grow, which allows us to bring on even better guests for you all! Thank you – we really appreciate it!
BOOKS AND RESOURCES
- Join the exclusive TIP Mastermind Community to engage in meaningful stock investing discussions with Kyle and the other community members.
- Sign up for The Intrinsic Value Newsletter.
- ROIIC Formula: Intrinsic Value Compounding Rate = ROIC x Reinvestment Rate.
- John Huber on calculating the incremental return on invested capital.
- Berkshire Hathaway’s 1992 shareholder letter from Warren Buffett.
- Ulta’s 2024 Investor Day webcast.
- An interview with Ulta’s CEO , Dave Kimbell, on why Ulta is winning despite industry disruption.
- Attend the 2025 Berkshire Hathaway shareholder meeting and meet-ups with The Investors Podcast Network.
- Check out the books mentioned in the podcast here.
- Enjoy ad-free episodes when you subscribe to our Premium Feed.
NEW TO THE SHOW?
- Follow our official social media accounts: X (Twitter) | LinkedIn | Instagram | Facebook | TikTok.
- Browse through all our episodes (complete with transcripts) here.
- Try Shawn’s favorite tool for picking stock winners and managing our portfolios: TIP Finance.
- Enjoy exclusive perks from our favorite Apps and Services.
- Learn how to better start, manage, and grow your business with the best business podcasts.