by Will Ashworth | June 20, 2013 11:11 am
Coty’s (COTY) recent IPO flop (down 1.1% in its first four days of trading) got me thinking about the unpredictability of the beauty industry.
The average first-day return for IPOs in 2013 is 12%, considerably higher than Coty’s debut. And if any stock were destined for a strong first day, Coty surely should have been it. Peers such as Avon Products (AVP) and Sally Beauty Holdings (SBH) have been on fire in 2013, up 64% and 30% year-to-date, respectively.
Yet Ulta Salon (ULTA) has been on a roller-coaster ride all year: starting out at $98, then dropping into the low $70s in March before returning to the mid-$90s in June.
In February, CEO Chuck Rubin left the company to head up Michaels Stores, which looks set to go public any day now. Rubin’s departure, combined with soft first-quarter guidance, caused its stock to tank but has since rebounded nicely.
It’s definitely a Jekyll-and-Hyde stock. But is the stock more Jekyll or Hyde? We’ll decide after looking at a few pros and cons.
Financial Strength: The balance sheets of Ulta Salon and Sally Beauty are like day and night. ULTA has $293 million in cash and no debt. Sally Beauty, on the other hand, has net debt of $1.57 billion. In the first six months of fiscal 2013 through March 31, Sally Beauty paid $53.4 million in interest; Ulta, naturally, paid none. Making matters worse, Sally repurchased $313 million of its shares in the first six months of fiscal 2013 when it could have repaid some of its debt instead. Ulta also repurchased $37.3 million of its shares in Q1 2013, but it had no debt and nine times the cash required to make the purchases.
Growth: In its Q1 report out June 11, interim CEO Dennis Eck mentioned that ULTA plans to open 125 stores in 2013, many with either a Clinique or Lancôme boutique in them. In Q1 it opened net 26 stores, increasing its square footage by 24% to 6.12 million square feet. The additional stores were partially responsible for its 23% increase in revenue year-over-year. Also helping out were retail and salon same-store sales growth of 5.3%, along with a 70% increase in same-store online sales. With a new and improved e-commerce platform making an appearance sometime in the fall, Ulta is poised to take market share. Although its margins shrunk slightly in the quarter, it still managed to grow diluted EPS by 20.4% year-over-year to 65 cents. With 576 stores open and a long-term goal of 1,200 in the U.S., 30% annual EPS growth over the next few years is definitely achievable.
Potential Market: Ulta has just 2% of the $100 billion salon services and beauty products market. Its 10,000-square-foot locations provide one-stop shopping for women looking to buy beauty products and get their hair done at the same time. It’s a concept that saves women time and money — a key to success in any business. With an affluent and loyal customer base, its pricing power is a critical piece of its profitable growth. As a Canadian resident, I’m confident that if the real estate were available, its format would be successful here. With the typical store costing $1 million to open with a two-year payback, Ulta could add another 60 locations north of the border.
Volatility: As I mentioned in the beginning, its stock has been up and down like a yo-yo in 2013. In fact, since July 2011, it has experienced short-term 10% declines in the price of its stock on eight occasions in slightly less than two years. Given the stock’s proclivity for extreme volatility, it’s a difficult proposition for the average investor to know when to buy. While timing the market clearly doesn’t work, it would be tough to swallow if you bought its stock just before a 10% drop.
Funny Money: Say what you will about CNBC’s Herb Greenberg, but the longtime market skeptic is often right about companies he views as fishy. I’ve seen his handiwork scuttle one of my own investments back in 2001. He’s got a nose for trouble. In a recent CNBC video, Greenberg trots out several problems with the company’s business, including inventories that are rising faster than sales — an indication the company isn’t in control of its financial affairs. With no CEO on the job and the firm on its third CFO in a short period of time, Ulta is exhibiting all the signs of a company that’s about to implode … if you believe Herb Greenberg’s take on things.
Rudderless: Cynics would suggest that not having a CEO for four months isn’t a big deal because most head honchos add little value to the average large company. Ulta is a business with more than $2.2 billion in revenue and growing by the day. It needs a captain to organize the troops, provide a vision of the future for all stakeholders and generally ensure the company continues to meet and exceed customer expectations. It’s a quaint thought to think that the employees will continue to do their jobs effectively without guidance, but ultimately there needs to be someone at the top that’s held accountable. Interim CEO Dennis Eck is doing a fine job, but until the interim tag is removed, he’s a lame-duck chief executive.
This is a difficult decision. While I don’t disagree with some of Herb Greenberg’s concerns about the company, I still believe it has an excellent business model. Greenberg worries about the low margins of e-commerce but I think he really meant the cosmetics business in general. Margins are razor-thin for cosmetics, and that’s why e-commerce makes so much sense for Ulta.
Women might get their hair done once or twice a month. However, they likely use cosmetics on a daily basis. They can’t always be running to the closest Ulta to pick up products. That’s where the online business comes into play. I don’t care how you slice it; it costs less to sell a tube of lipstick online than it does in the store. To keep profits moving in the right direction, it has to have an e-commerce platform. No ifs, ands, or buts.
So should you buy Ulta Salon? I think I would — with one caveat.
I would buy only after a decline in its stock price of more than 10% in a given month. This way you use its volatility to your advantage. In addition, I’d continue to pay close attention to what’s happening at the top. That one event could affect its stock price more than anything else, including its financial performance.
As of this writing, Will Ashworth did not own a position in any of the aforementioned securities.
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