Specialty Chains Show The Beauty of Retail Oligopolies

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Even in the depths of a recession, a slight change to your look, like a fresh splash of color on your hair, nails or eyes, can make you feel like a million bucks.

It's a quiet fact. But it has been enough to keep the health and beauty industry -- to the surprise of many analysts -- purring during the recent economic downturn.

Hard times may, in fact, have helped what supply and salon chainUlta Beauty ( ULTA ) says has grown to a $96 billion industry, by coaxing women and men to small, feel-good splurges like a new lipstick or a workout supplement.

"If someone is tight on what they have to spend they might see a hot new color but instead of spending $50 or $100 for a blouse they can spend $4 or $5 for a lipstick or nail polish so they don't have the guilt factor," said Ulta CEO Chuck Rubin.

And Americans aren't just pampering themselves. Dogs and cats have graduated from being guard animals and rodent exterminators to being members of the family. Owners are spending accordingly, helpingPetSmart ( PETM ) to gather an increasing share of the pet supply chain.

The combination has driven the stocks in IBD's specialty retailers group to one of the top performances among industries over the past 12 months. The group ranked No. 13 out of 197 industry groups on Friday. Two of its leaders, Ulta Beauty andGNC Holdings ( GNC ), are on the IBD 50 list.

Mutual funds have played a leading role in helping to drive those gains.

"Performances have been phenomenal relative to the market overall," said Peter Dixon, portfolio manager of Fidelity's Select Retailing Portfolio. "People should be attracted to the industry because there feels like there always is a brand people want to buy; there are always opportunities to make money in specialty retailers."

1. Business

Many specialty retailers matured during rapid expansion in the 1990s, according to Scott Mullinix, portfolio manager of the Nuveen Mid-Cap Growth Opportunities Fund.

The fund owns positions in PetSmart, GNC and Ulta Beauty. While mature markets mean the end of the line for many growth stocks, it holds specific advantages for some specialty retailers.

"They've become oligopolies and they've learned how to grow beyond square foot growth," he said.

Retailers make money in one of three ways, Mullinix says: by having the lowest prices, the best selection or best customer service. Successful companies have one or two of those attributes, he said. It's nearly impossible to have all three.

PetSmart offers 10,000 products for dogs, cats, birds, fish and other pets. While many of the toys, leashes and grooming products can be found online, shipping large amounts of heavy pet food to feed a Labrador can be expensive.

A nail polish or bottle of shampoo would not be expensive to ship, but the beauty retailers beat big-box retailers likeTarget ( TGT ) andWal-Mart ( WMT ), and online retailers by the breadth of the products they offer.Sally Beauty Holdings (SBH) offers 78 shades of hair color vs. the 12 you typically find at a drugstore. Ulta Beauty offers 20,000 products in stores and online and Sally Beauty offers 8,000 to 10,000 per store.

Navigating the world of supplements can be confusing. What protein product should an Ironman triathlete buy for maximum performance? What vitamin combination is best to stay healthy during flu season? GNC and Vitamin Shoppe employees can answer those questions and more, encouraging consumers to come to their stores for expert advice.

Specialty retailers often outflank online, big-box and discounter competitors by offering the added value of special products or advice to entice consumers to their stores.

2. Market

Choice is a luxury of upper-middle class consumers. Both GNC and Vitamin Shoppe say their customers are well-educated with higher-than-average income. Specialty retailers in general focus on attracting young consumers and making them customers for life.

"As people are getting older, they want to buy more vitamins," said Kurt Frederick an analyst from Wedbush Securities. "The younger generation that shops at GNC is very fitness focused."

More than 40% of GNC's customers are 35 or younger. The company reports that 80% are under 55. In 2011, GNC held 26% of the sports nutrition market. It expects its share to grow to $1.3 billion by 2017.

GNC has 3.5% of the supplement market share and Vitamin Shoppe has 2.7%. Specialty retailers have 36.7% of the overall market. Mass marketers, including big box retailers and drug stores, still hold another third of the market. The rest is fragmented among smaller shops and online retail.

Shampoo isn't a discretionary -- i.e., optional -- good, but during the recession many consumers have switched from high-end brands to slightly cheaper names.

"A lot of those people that traded down to more affordable salon brands found that those brands were just as acceptable as the really high-end brands," said Sally Beauty CEO Gary Winterhalter. "But in the history of the industry people haven't switched from Paul Mitchell to VO5 if a person really believes that a prestige brand works better; they aren't going to switch all the way down to a mass market brand."

The variety of shampoos and other products Ulta and Sally Beauty offer allow them to get customers at all price points.

The American Pet Products Association says spending on pets will grow about 4% in 2012 to $52.87 billion. PetSmart has 14% of the pet food, toy and pet product industry. And it is growing.

"Customers are concerned about the health and welfare of their pet and (these) oligopolies are defensive because people aren't going to stop feeding their pet. We like PetSmart a lot," Mullinix said.

3. Climate

Mullinix can rattle off a laundry list of some specialty retail's attractive attributes. Near the top, their limited exposure to global economic problems. PetSmart, Vitamin Shoppe and Ulta Beauty operate domestically and the majority of GNC and Sally Beauty stores are in the U.S.

Also, when it comes to consumers, wealthy often equals healthy.

"If you only study higher-end consumer you see that they are getting healthier, and consumers with money want organic and healthy products" Mullinix said. "Healthy offerings are a consumer growth industry."

The aging baby boomers are trying to ward off the effects of aging with vitamins and supplements along with healthy eating to promote longevity and continue living active and fulfilling lives.

4. Technology

Smartphone subscribers in the U.S. have risen 13% since October to 101.3 million, according to market research firm comScore. Retailers have been capitalizing on consumers' growing dependence on the technology.

There is an app for pretty much everything these days. GNC's LiveWell app not only lets customers buy products but also helps them to find stores, get special deals and learn more about a product. Sally Beauty and PetSmart have similar apps all available for free.

GNC reported a 34.1% increase in first-quarter online sales vs. fourth-quarter sales.

New technology also allows specialty retailers to improve inventory management, track customers' orders and monitor web viewings to better target consumers with the right products, according to Frederick.

5. Outlook

Fund managers aren't very optimistic about the retail sector in general, but are bullish on specialty retailers.

"I don't have a very high confidence level in the retail industry, because I would have to have confidence that unemployment would drop and disposable income would rise," Dixon said. "But I do have confidence in companies in the industry."

Mullinix is expecting the healthy lifestyle trend to continue to rise.

"My confidence level in the industry is high. You've got disciplined companies operating in specific sectors," he said.

• Upside: Unique product offerings of defensive goods like shampoos and pet food and a knowledgeable staff keep customers coming back to specialty retailers.

• Risks: Consumer spending could drop if unemployment rises. Companies in international markets could be adversely affected by the mounting problems in Europe and slowing growth in some developing markets.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas

Referenced Stocks: GNC , PETM , TGT , ULTA , WMT

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