This past week in our Large Cap Capital Appreciation Portfolio (LCCAP), we sold Chipotle Mexican Grill (CMG) and bought Ulta Salon Cosmetics (ULTA) in its place.
The price of CMG had already fallen precipitously before we bought it, as the company had been reeling from a spate of serious food safety issues. So we knew CMG was a risky bet when we bought it, and sure enough the stock has continued to fall. Although we think that in the long term, CMG will reverse this trend, we were worried by its still-very-high valuation (38.3 is the P/E at the time of writing). CMG is priced for growth, but the company is not really a growth company right now. And with such a high valuation, the stock still has potentially very far to fall. Rather than wait to see when it will finally hit its floor, we’ve exited our position.
With the cash from that sale, we’ve taken up a position in ULTA, another company in the consumer cyclical sector. Like CMG, ULTA is priced like a growth stock (44.6 P/E), but unlike CMG, ULTA appears poised for significant near-term growth.
Ulta is a cosmetics retailer with a salon inside each store. Their niche is to provide multi-dimensional convenience, in location, products and services, and overall store experience. Ulta stores are located in suburban strip malls and they provide a casual, low-pressure, and “fun” atmosphere ideal for shoppers between errands. In addition to location and the fact that it offers salon services within its walls, Ulta really distinguishes itself from other beauty retailers (there is no shortage of them) with its unique high-low product mix. It sells “prestige” brands—those normally sold at department stores, like Clinique and Estée Lauder—alongside mass-market brands like Maybelline and Revlon, which are normally sold at drugstores. The value of this approach is the subject of a recent WSJ article about the company.
On top of its diverse inventory, Ulta offers a simple, friendly rewards program that appears to be wildly popular with its customers and highly effective at engendering loyalty. Even customers who prefer competitor Sephora admit that Ulta’s reward program is much better.
Ulta’s growth has been breakneck. The company plans to open over 100 new stores in 2016, which would bring its total store count to about 970. It’s also finding ways to increase revenue at existing locations. Comparable store sales (comps) for Q1 were up a staggering 15.2% over the previous year, which itself was up 11.2% over the prior year.
The following image shows how strongly and consistently ULTA has grown its sales, operating income, and EPS for the past 5 years.
The averages for ULTA’s industry (specialty retail) are also included above for comparison, but they are unfortunately a bit misleading because they include the ludicrous growth of a few microcaps. When compared directly against the stocks in its industry rather than averages, ULTA lands near the top in all of these metrics.
Its estimated EPS for the current and next year are 22.6% and 22.0%, respectively, and the estimated per annum EPS growth estimate for the next 5 years is 19.7%.
Growth at this pace can be compromising if it isn’t managed holistically. Fortunately, comps alone suggest that the management team has been facilitating the company’s growth in a thoughtful way. And there are other signs that the company is being managed well. The table below shows how sales per employee, operating margins, and returns on capital have all steadily increased in the last 10 years:
This is a company that is operating smarter as well as bigger.
ULTA is also financially healthy, with a financial health grade of A from Morningstar. This is no doubt due largely to the fact that the company has zero debt and is financing its expansion with cash. Yet they have also managed to be free cash flow positive since 2009.
It sounds great, right? We’re not the only ones to think so. The stock is expensive, even for an expensive industry. Some investors such as this one may like ULTA but find it to be simply too rich.
Even though there is no question that the stock is expensive (both the P/B and P/S agree with P/E), there are still a few indicators that suggest it’s not as bad as it could be. Its forward P/E is 32.2, which is still high, but almost 28% less than the trailing P/E of 44.6.
Perhaps more importantly, the valuation is not at a historic high. The 5-year P/E high is 52.7, meaning a precedent has been set for this stock to be expensive and still grow remarkably. Here is a 5-year price chart for the stock:
The highest P/E occurred right around the beginning of this chart. No one who purchased the stock with a multiple of 52.7 and stuck with it through this period is feeling too bad about that choice!
We think ULTA has a great growth story—the company is making interesting and effective choices in a crowded marketspace. It’s also got the financials and performance to back up those choices, and we want to be along for the ride, even if admission is expensive. After all, the LCCAP is a growth-focused portfolio. Let’s just hope that with ULTA, you get what you pay for!
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