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Better Buy: Nike vs. Ulta Beauty

My, how quickly things change. One minute it's February, the market is crashing, and bargain prices for proven stocks abound. Next minute it's September, the market is hitting new all-time highs, and many stocks feel too expensive.

For two examples of expensive stocks, look at athletic-apparel company Nike (NYSE: NKE) and makeup retailer Ulta Beauty (NASDAQ: ULTA). Consider the price-to-earnings valuation metric. From both a trailing and a forward perspective, these stocks trade at historically high valuations.

NKE PE Ratio (Forward) Chart

NKE P/E Ratio (Forward) data by YCharts.

When earnings drop, a stock's P/E ratio goes up. This partly explains why these stocks look expensive: The coronavirus pandemic has hurt the bottom line. But the market is clearly rewarding both Nike and Ulta Beauty with high valuation multiples, anticipating success. This being the case, it's imperative these companies live up to elevated expectations. Which company has the better chance for growth that justifies its valuation?

The case for Nike

Here's a possible investment thesis for Nike: It expects to continue growing sales at a high-single-digit pace annually. It's pushing digital and direct-to-consumer sales, which should provide deeper consumer insight, allowing for better-trending products and stronger inventory management. The improved operations should lead to earnings-per-share growth in the mid-teens. And a growing bottom line provides a buffer for further increasing a dividend that's grown more than 50% over the last five years.

Three young people are jogging on a bridge.

Image source: Getty Images.

Nike's future is undoubtedly focused on digital sales. For proof, consider that management used the words "digital" and "digitally" 79 times on its conference call to discuss results for the fiscal fourth quarter of 2020. On that front, management is pleased that 30% of sales are now transacted digitally, two full years ahead of schedule. The next milestone it's targeting is 50% of sales.

Part of the strategy to get to 50% digital sales is by investing in small "mono-brand" company-owned stores. The company opened a basketball mono-brand store in Beijing in 2017, allowing customers to try Nike basketball products on an in-store basketball court. These stores push the digital connection point, and the company believes it provides better service to customers. Nike plans to open between 150 and 200 of these locations.

There's risk for Nike in pursuing this route. As a trailblazer, there's no guarantee the return will be worth the investment. But from an operational standpoint, there are advantages to having a high percentage of sales transacted digitally. Customers are turned into data points, allowing the company to monitor purchase frequency and fashion choices, which can drive inventory management.

It's early, but I'd say Nike's ongoing goal of mid-teen-percentage annual EPS growth is attainable.

The case for Ulta Beauty

Here's a possible investment thesis for Ulta Beauty: The company operates brick-and-mortar retail stores that theoretically could be disrupted by bigger e-commerce competitors. But by offering hair, makeup, and eyebrow services, it provides something that can't be replaced with an online experience. These services get customers in the door, where the cosmetic products can then be sold. It has 1,264 locations as of the second quarter of 2020, but plans to expand to 1,500 to 1,700 in the U.S. long term. This expansion should provide future revenue and earnings growth.

A woman browsing cosmetic products in a store.

Image source: Getty Images.

To its credit, Ulta Beauty has a large, loyal customer base. There are 31.9 million active loyalty members, defined as someone who's made a purchase in the past year. While this number fell 4% year over year last quarter, it's possible this is only because store closures prevented people from making a purchase. If active loyalty members start climbing again next quarter, that would be a good sign.

Other active loyalty members who couldn't get into stores made purchases online for the first time. An omnichannel customer is someone who shops both in-store and online, and omnichannel loyalty members grew 21% from last year.

These metrics demonstrate that Ulta Beauty resonates with consumers and it's not being disrupted by something else. The company is permanently closing 19 underperforming locations, but every chain is likely to have a couple of laggards. In the bigger picture, it's resumed opening new locations and can grow its footprint in the U.S. by 19% to 34% long term.

A confused man stands against a chalkboard displaying question mark symbols.

Image source: Getty Images.

The winner

Neither the Nike or Ulta Beauty investing thesis will blow you away with growth, and that's a slight problem considering their pricey stocks. To be clear, I'm not sure either stock will beat the market. I believe Ulta Beauty has upside. But given my uncertainty on which is the more likely market-topper, I'll take Nike's track record. It's come out ahead of the market over the past five years, unlike Ulta Beauty, and has a long history of earnings growth, a crucial element of market-beating returns.

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Jon Quast has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Nike and Ulta Beauty. The Motley Fool has a disclosure policy.

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

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