One of the best stories in retail over the past few years has been Ulta Beauty (NASDAQ: ULTA), the leading cosmetics and beauty specialty retailer in the country. However, that story came to a screeching halt the week before last when Ulta reported its second-quarter earnings.
Ulta uncharacteristically missed analyst estimates for both revenue and earnings per share, and lowered its full-year guidance as well. Management now expects full-year earnings per share between $11.86 to $12.06, down from prior guidance between $12.83 to $13.03, with comparable store sales growth targeted for 4% to 6% this year versus prior guidance of 6% to 7%.
When a high-flying growth stock shows a big deceleration like that, the result can be ugly. That was certainly the case for Ulta's stock, which crashed some 30% after the earnings release. However, now that Ulta has predicted a lower growth trajectory, should current investors sell, hold, or buy more? And if you don't own Ulta shares, should you go bargain-hunting?
Legend of the fall
Fortunately for investors, the dropoff doesn't appear to have anything to do with Ulta's execution or competitive position -- those appear to be intact. Rather, the problem appears to be the overall cosmetics category, which is slowing down as a whole.
Though Ulta labels itself as the retailer with "all things beauty, all in one place," it does generate some 50% of its revenue from cosmetics. Making matters worse, prestige cosmetics, which are among the highest-margin products Ulta sells, showed a bigger slowdown than mass cosmetics.
On the conference call with analysts, CEO Mary Dillon said:
Over the past several years, we've seen strong growth in cosmetics driven by new rituals and application techniques like considering and brow styling and innovative new product formats like Liquid Lip, Palette and Minis. This innovation resulted a new makeup routines requiring new products, which drove strong incremental growth. The most recent cycle of innovation is just not driven those behaviors, resulting in a soft cycle for the cosmetics category in the US. As innovation and newness price the market has not driven the expected growth.
Management also said that the makeup category actually declined by mid-single digits for the first six months of 2019, and has "become more volatile recently" -- that's management-speak for "gotten worse."
While negative growth would be a disaster for a formerly high-multiple stock like Ulta, Ulta did grow its cosmetics category in the low single-digits. While that's far below its growth over the past few years, it's still well ahead of the industry, meaning Ulta is taking market share.
Management went on to characterize the current phenomenon as a "cycle," and expressed confidence that the category would once again return to growth; nevertheless, it appears the cosmetics slump will last for the next few quarters at least. Dillon pointed to hope for a better growth outlook by the second half of 2020, once the company "laps" the current slowdown.
Should you buy in?
With the 30% drop, Ulta's stock valuation has now dipped below 20 times trailing earnings -- a multi-year low. At the midpoint of the lowered guidance, Ulta is projecting EPS growth of just 8.7% for fiscal 2020.
As you can see, even that growth rate is well above the long-term projections from other retailers such as Target (NYSE: TGT) or Best Buy (NYSE: BBY). Though as you can also see, both Target and Best Buy are cheaper on a PE basis. Interestingly, Walmart is more expensive and has lower growth prospects, though Walmart is likely seen as more of a "safe haven" and recession-proof stock than Ulta.
It appears Ulta's EPS growth projections haven't yet been adjusted down, as it's unlikely the company will achieve 17%-plus EPS growth going forward. Still, it appears that the stock has already very quickly re-rated to this "new normal" EPS growth rate in the high-single digits.
To me, that means that much of the bad news is likely priced in at this point. Should Ulta management be correct, and the cosmetics category does return to growth in a year, the recent sell-off could very well end up looking like a bargain opportunity; however, it's too soon to tell just yet, and I don't expect the stock to go back up to previous levels anytime soon until a rebound in cosmetics is "proven."
On the positive side, Ulta is still growing its other categories at a healthy rate, and also said that its UltaMATE rewards members continued to grow at a double-digit pace. Therefore, Ulta should continue to outperform the beauty space long-term.
While the cosmetics sector appears to be pausing after a big growth surge over the past few years, in the age of Instagram and social media, it doesn't seem like a category in long-term decline. As such, I think Ulta shares are a hold for now, but a buy for the long-term, and those without a position may wish to initiate a position at these levels.
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