Anticipating a Prettier Picture

 | Jun 13, 2013 | 9:00 AM EDT  | Comments
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ulta

On Dec. 27, I stuck my neck out and slapped a $120 price target on the shares of Ulta Salon, Cosmetics & Fragrance (ULTA).

Perhaps I was still giddy from the holiday eggnog? At the time, the stock was trading at $65.51 and it seemed like a pretty ridiculous idea. Even though the stock suffered a major downdraft in February and was beaten senseless in mid-March, I'm sticking with my price target. There are still six months left to get to $120.

Is this a risky pick? You betcha, especially in this environment where investors have decided that the market is headed lower and the economy is slowing. High multiple names are under pressure. But I'm sticking with ULTA because of its highly differentiated business model.

Ulta's stores are located in off-mall locations and have become destinations for consumers seeking a wide array of beauty products. The stores are approximately 10,000 square feet and carry as many as 20,000 items. Finally, ULTA allows the big cosmetics brands to build "brand boutiques", which allows the majors to showcase their entire cosmetics line, further enhancing the store's destination image. In contrast, Sephora is located in expensive malls, has a smaller footprint, carries fewer items and doesn't allow the major brands much opportunity to showcase their products. ULTA's other competitor -- Sally Beauty (SBH) -- targets hair and makeup professionals with smaller 7,000 square foot stores. Sally's makeup line tends toward lesser known brands and generics.

I'm not ignorant of the arguments the bears have made. Herb Greenberg lambasted the company on CNBC. I think Herb made some legitimate points, however I view ULTA as a high growth retail story and things can get bumpy along the way. The company currently has  an interim CEO and ULTA has had several chief financial officers. OK, that's not ideal, but the company is close to naming a new CEO and the stock will head higher once that person is named as the uncertainty surrounding the selection recedes.

In addition, inventory is growing faster than revenue, but that's not unusual for a high growth retailer that is building lots of new stores. The company is in the process of building 125 new stores this year, so inventory is going to grow as the company adds square footage. When you stock new stores with inventory, inventory grows faster than sales because the new stores are not open yet. Eventually, inventory comes back in line as the stores open for business.

Herb is also concerned about the lack of free cash flow. Again, that's not unusual. If Herb wants free cash flow, he should wait until October, when the free cash flow numbers spike. Historically, free cash flow falls in the summer and rises in the winter.

Finally, Herb is worried about weak gross margins. Gross margins were down 100 basis points. But that's also not unusual for a high growth retailer as expenses rise as the company builds out its footprint. Remember, the company is also building out new distribution centers and adding a whole new supply chain computer system. As those systems are built out, expenses will come back down.

Revenues rose 23% to $582.7 million and same-store sales rose 6.7%. Ecommerce sales rose 70% off a small base. On the conference call, the company lowered its second-quarter guidance slightly, from $590 million to $584 million.

The stock popped on the earnings news as shorts covered their positions. I would expect the stock to settle lower after the excitement has died down. I would add to my position in the $85-$88 area. It wasn't pretty, but in the last five years, ULTA is up more than 650%. I'm sure there will be more ugly corrections over the next five years, but I'm betting that ULTA's differentiated business model will prevail longer term.

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