Let the M&A rumors begin!

Now that a federal court has ruled in favor of the mega merger between AT&T Inc. (NYSE:T) and Time Warner Inc (NYSE:TWX), analysts and investors alike are speculating that a lot of companies will start using their big tax savings on acquisitions. 

Within that theme, here’s an M&A rumor you probably haven’t heard yet, but is nonetheless plausible: e-retail giant Amazon.com, Inc. (NASDAQ:AMZN) acquiring cosmetics retailer Ulta Beauty Inc (NASDAQ:ULTA).

Sound far fetched? It actually isn’t.

The logic is pretty straightforward. The grocery and cosmetics industries have a ton of parallels. Amazon’s growth strategy in grocery included acquiring the premiere bricks-and-mortar player in the field. Consequently, it isn’t that big of a jump to say that Amazon’s growth strategy in cosmetics also includes buying the industry’s premiere brick-and-mortar player.

Who might that be? Ulta.

As such, of all the M&A rumors I’ve heard, a marriage between Amazon and Ulta is actually among the most sensible in the group.

Here’s a deeper look.

Why It Makes Sense For Amazon

The logic for why Amazon would buy Ulta is simple and makes a ton of sense.

Amazon is presently making big moves in the cosmetics industry, much like they were making big moves in the grocery industry a few years ago. But just as Amazon’s nascent grocery business of a few years ago struggled to gain mainstream traction, Amazon’s nascent cosmetics business of today has been equally challenged in growing market share.

Why?

Because the grocery and cosmetics industry are very similar in that they aren’t easily Amazon-ed. They are touch-and-feel industries. Although online grocery shopping is a thing, consumers simply prefer to buy groceries in-store. Same with cosmetics. They like to touch, to feel, to try.

That is why e-commerce penetration at Ulta is just 10%, versus 20%, 30% and higher at traditional clothing retailers like American Eagle Outfitters (NYSE:AEO), Express, Inc. (NYSE:EXPR), Abercrombie & Fitch Co. (NYSE:ANF), and Urban Outfitters, Inc. (NASDAQ:URBN). 

Moreover, the cosmetics industry is one where brand value really matters. Again, this is similar to the grocery industry. In the same way that consumers prefer to buy groceries from a trusted brand at a trusted store-front, consumers also only buy cosmetics from a trusted brand at a trusted store-front.

Whole Foods was the most-trusted, premiere brand in grocery. Ulta is the most-trusted, premiere brand in cosmetics.

As such, all the boxes are checked. From an e-commerce penetration and brand importance perspective, the cosmetics industry is just like the grocery industry. Ulta is the Whole Foods of the cosmetics industry. Amazon acquired Whole Foods. Therefore, as Amazon makes bigger moves into cosmetics, an acquisition of Ulta isn’t out of the question.

Valuation for ULTA Stock

Amazon paid a 25%-plus premium for Whole Foods.

A similar premium should be awarded to Ulta, a company that, like Whole Foods, is currently in the cooling off stage after several years of red-hot growth. A 25% premium would imply a takeover price of around $300 from current levels.

By my numbers, assuming 15% revenue growth over the next five years through healthy comparable sales growth and unit expansion as well as margin stabilization, Ulta stock’s standalone value is $250. Thus, assuming this acquisition has a 20% chance of happening, I think ULTA stock should trade around $260 today.

Bottom Line on AMZN/ULTA Acquisition

As with any M&A rumor, this is just pure speculation.

But the logic is there. And Amazon isn’t the type of company to sit back and skip on the cosmetics opportunity in the U.S. because e-commerce penetration is low. They didn’t do that in grocery. They won’t do that in cosmetics.

As of this writing, Luke Lango was long T, AMZN, ULTA, EXPR, and URBN.