Chit Chat Stocks - Ulta (Ticker: ULTA) with Ethan Tucker

Episode Date: August 31, 2023

Ulta Beauty, Inc. (ULTA) is a major cosmetics and beauty retailer, thriving on a devoted customer base and industry trends, but facing competition and changing consumer preferences. Listen as Brett and Ryan ask questions about the company, its business model, and valuation. Enjoy the show! ***************************** Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney  Subscribe to our Substack to receive free show notes and charts that go along with every episode: https://chitchatmoney.substack.com/ Interested to see more of Ethan's work? Find their Twitter here: https://twitter.com/TheGarpInvestor?s=20 Contact us: [e-mail] Timestamps Ulta | (2:02) Revenue Growth | (4:24) Valuation | (17:28) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. This is our Thursday deep dive episode where we interview an analyst to discuss a single stock or industry. And today we have on the show, Ethan Tucker. He is really just an individual investor who does a really good job analyzing investments and managing his own portfolio. He puts all his research up on thegarpinvestor.com. And I came across his work on Twitter, really liked what he was saying and asked him to come on the show to talk about Ulta Beauty because it has been a really strong compounder over the last decade. And the stock has sold off a little bit and it seems to trade a reasonable price. And he goes through basically the whole business, why he thinks it's durable and why he thinks this business

could continue to grow. And really there was a lot to like, I thought about Ulta. It's honestly one of those stocks that I was really interested in even prior to Ethan bringing it up. So I'm glad we talked about it. I think that's it. Without further ado, here's our interview with Ethan Tucker. Welcome to Chit Chat Money. On this show, host Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital. And Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guest

is not formal advice or recommendation. Now, please enjoy this episode. Okay, welcome in. Today, we are joined by Ethan Tucker, also known as the GARP investor on Twitter, which we were just talking about. Quite a good handle there. And today, we're talking about Ulta Beauty, I think is the full name, but it's the Ulta cosmetics business. Probably, I'm guessing the largest cosmetics business in the US, but I guess, how'd you come across it as an investment and how long have you followed the company? Well, first off, thanks for having me on. I've been interested in Ulta probably four or five years now. I think, first off, I just see it driving around. But I think someone posted it on Twitter probably three,

four years ago, and it just sort of piqued my interest. I like the economics. So I started following it and added it to my watch list. I probably have a watch list of a hundred or so companies that I like to follow and just been following it off and on. And then over the last year or two, I've really dug into the business. And full disclosure, I am a shareholder now, and i've owned shares probably six to nine months now people are aware of the ulta beauty business they're aware of the brand they've driven by the stores or the if they're the core shopper they've been there can you explain the basic economics of the business how the business works where do they operate are they really diversified across the country and you know what are they actually selling

to their customers? All right. So Ulta is the biggest specialty beauty retailer in the country. They have about 1,400 locations nationwide. They're in pretty much every large geographic area in the United States. They have not crossed US soil as far as I understand. They haven't moved into Canada or Mexico yet, though I think international expansion is a big opportunity for the company. Revenue-wise, you're looking at about a $10.5 billion trailing 12-month business. Net income was roughly $1.2 billion or so. They have good gross margins. You're looking at a mid 40s gross margin business with a mid-teen operating margin. If you compare that to other large big box retailers, say a Target, I was looking, Target has gross margins in the mid

20s and operating margins in the single digits. So you're looking at a company with a lot of pricing power, probably about double that of Target. So the business has good economics and I think they're just ready to grow even more and open up more stores. Today's episode is presented by the Science of Hitting Investment Research Service. The Science of Hitting was founded by Alex Morris, who spent a decade working as a buy-side equities analyst before launching his own service in early 2021. You've heard him here on the show a number of times, but Alex produces really, really high quality equity research. And in addition, he provides a hundred percent transparency into all his portfolio decision-making. We were

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It seems like when I think about Ulta, I think about just basically the name in beauty retailing. Seems like kind of a simple model, but Ulta's grown sales by 16% a year for the last decade. so i guess kind of a broad question but why have they been able to do that what do you think's made them so successful i think there's some their success comes from a few different ways number one they have a good replicable model that over the last 10 years really what you've just seen is them opening up more stores i don't know the exact numbers but they've gone from like 800 to 1400 over X amount of years. Also, they've been good at driving same store sales. So even though they're opening up new ones, old boxes are doing better and better each and every year.

The next thing I'd say of why they've been able to grow is they have leveraged celebrity influencers and partnerships. So they have a big partnership with Kylie Jenner. Kylie's obviously a big name and they sell a lot of her products i think in 2022 they reached an agreement with who was it rihanna for her fenty brand so i think that's been a big driver of sales so i i think they're just going to continue to leverage these big name influencers and try and make partnerships when they can you think okay i have like a half-baked thesis that sure it's like the world of social media and kind of i don't know more and more people wanting to look good for everyone else and social media kind of amplifying that do you think that's been a tailwind for them

i think absolutely that's been a tailwind just what we've seen on things like tiktok you see all these, not on my TikTok, but on others, you see a lot of these makeup tutorials, things of that nature. And I think that drives additional sales. Women will talk about what foundations they like, what lipsticks they like, and Ulta is the best place to buy them. So I think that drives incremental sales. Yeah, it is quite interesting. And you mentioned that they have a partnership with all the big brands out there, all the individual ones that come from these up-and-coming celebrities do they have their own brands do they have like a comparative one of say like the Kirkland signature for Costco do they have that

Ulta or are they strictly okay we're selling just third-party any third-party beauty product that meets our standards so Ulta does have their own proprietary brand in-house a lot as you say like Costco's Kirkland brand. I was unable to find numbers on exactly what that looks like. But I think you have to assume the margins on an in-house brand always look a little better than if you have to buy it from a third party. But you don't want to cannibalize your own sales of those third party brands. So it's a give and take of how much you want to push your own brand versus selling others aren't there they're they have like a salon segment too don't they like within the stores am i getting that right yeah so every ulta salon or every ulta store has a built-in

salon in it and i don't think the salons themselves are huge money makers but what it does do is drive sales of their products that customers who use their salon services, they say are likely to do five additional trips to Ulta every year, and they'll buy three times as much as the average consumer. So it's great for driving sales. Maybe the salon itself doesn't do too much to the bottom line do you know what the split is or do they do they provide what the split is in terms of like revenue by category like is it a lot of makeup and skin products fragrances hair stuff like do they give that stuff out you know yes so i actually took this from their annual report They have cosmetics listed at 42%, hair care products at 21%, skincare at 17%, fragrance at 14%, services at 3%, and others another 3% and change.

Yeah, and if you're hearing that, any listeners, Ethan came prepared with notes, which we greatly enjoy. So thank you for that. Let's talk competition, though. So I think one, maybe the big question when, at least that came to my mind, when he first said they had really strong margins compared to a broad-based retailer like a Target or a Walmart is why. So why are they able to take that margin versus their suppliers? And I think the big way that comes into play is the competition.

So what does the competitive landscape look like? Are they immune to online competition? I think if I'm looking at it, a lot of these products could be sold by Amazon. It's not like it's a auto parts retailer or something that it's really difficult to sell online. I'm sure they have a big online business as well. So what makes them immune to other online competition and what sets them apart and lets them earn this, you know, outsized margin.

All right. So we got a bunch of questions there. I'll try. I think it's more of just competitive advantage, margin, all that stuff. Yeah. So competitive advantage one, they just have the scale. Ulta's the largest player in the game right now. They have 1,400 locations. Their largest competitor is Sephora, who also has about 1,400 locations. They're owned by LVMH, so obviously they're one of the big gorillas in the room. Sephora focuses a little more on the premium side, whereas Ulta goes both for premium and sort of the everyday consumer. The main competitive of advantage I think Ulta has over say an online retailer is I believe consumers want to go in and

actually feel and see the product itself that when you buy a lipstick or something you don't want to rely on you don't want to rely on the pictures online you want to see it in person and get just the right shade I know a lot of women are very particular about exactly what makeup they want And if it's, you know, a tenth of a shade off, they don't want it. So I think that's what drives people to shop in stores versus online. In terms of them over their competition, you know, if you look at them, say, versus Walmart, Walmart has their own cosmetics department. But they can only dedicate so much of their square footage to that department, whereas Ulta is an entire big box dedicated straight to that. If you look at some other big box retailers like Floor & Decor, you know, they've been able to eat market share in the flooring department from Home Depot because Home Depot can only dedicate so much square footage to flooring, whereas Floor & Decor can have an entire big box dedicated to it.

Altas are each about 10,000 square feet. If you look at them against Sephora, let's say, Sephora is only about 5,000 square feet. So each store is double the size. I think you raise a good point, which is there's an element to this business that is hard to do online, like fragrances, for example. If I go in and I want a cologne, I think I'd like to smell the cologne first. or, you know, for cosmetics, makeup for girls, it might look a little different on your face than it looks at someone else's face. So I do think there's that element. The only, I guess, maybe pushback is my thought here is that if, if people try it on in person in the Ulta store and then they like it and they say, okay, I know this product, this is what I'm going to get each

time. Then maybe they go to the low cost online provider. What is Ulta doing in terms of online efforts? Do they have a big online presence? What kind of omni-channel capabilities have they rolled out? Yeah. So they've made a big push into e-commerce. As far as I understand, do not break down what is e-commerce versus in-store sales but i think they like their e-commerce platform as you brought up it's omni-channel so what they're looking to do like tailors is drive online sales to be picked up in store and then once you set foot in the location you're likely to pick up some other items while you're there so that drives incremental sales um the real thing they're doing though is they've developed a rewards program a lot like the starbucks loyalty

program if you've ever seen that but what that's able to do is they have i believe it's 40 million members in their ultimate or in their rewards program which gives which it's actually bigger than the starbucks rewards royal loyalty program which blew my mind yeah that that is amazing well they've done a great job of driving engagement with their rewards program. I've never used it myself, but I think a lot of people really like the program. They get discounts, but also more importantly, it gives Ulta all the data for, you know, text messages, email,

any contact information. So they're able to blast out marketing material to all their rewards members, which has driven a lot of sales. Now let's get back to the financials. You mentioned a little bit of the numbers there, but what are maybe the key ones today that you're looking at as an investor? How have their margins expanded over time? How much cash are they generating today? What do you think are the important numbers that investors need to know? So we've talked about margin, but I think the

most important thing to look at is the trend of the margin, that if you go back about a decade, Ulta was, they had a gross margin in the low 30s. And now, as I said, that's gotten up into the mid-40s. And the question is, how have they been able to do that? I can't answer exactly, but my guess is because as they've grown in scale, they've been able to lean on their suppliers and get better pricing, thereby enabling them to sell at better margins. So both gross and operating margins have followed that trajectory. So in my mind, free cash flow is always the most important metric. This year, we saw Ulta with a net income of around $1.2 billion with depreciation at another $250 million or so. So you're talking about $1.5 billion in operating cash flow. They had about

$300 to $350 in CapEx. So you're talking roughly $1.2 billion in free cash flow. And that leaves a question of what do they do with all that cash well thus far the last decade we've seen ulta pretty much use all their free cash flow towards share buybacks they've driven down the share count immensely and what i love about it is the simplicity pretty much all they do is they open up new stores and with excess cash they buy back shares yeah really simple model i mean we're doing the share cannibal theme this month so i guess it's perfect that we add them to the mix what looking at the shares outstanding right now i wanted to get uh sorry that's yeah right right you get the number up real quick what uh maybe i guess this will lead into we can talk

about management as we go towards the end because we haven't had much yet on that but what does the valuation look like i mean if they're repurchasing shares it's a big part of the formula here hopefully it's at a discounted valuation uh what are the earnings multiples look like here and what do you think about the valuation? So right now, I think Ulta is trading at about or just under a 20 times free cash flow multiple. So essentially a 5% return. Is that a great value? Depends on who you ask and what kind of company it is. But I think Ulta is providing pretty good value for what you get today. I think the company is going to continue to grow and buy back more shares. And at least in my mind, a happy owner and we'll be

happy owning or will be happy i bought it today but i guess we'll see i also i wanted to ask about uh the kind of stores within a store concept because i know they've been doing that with target i think they've talked about that partnership um can you maybe explain what that is and do you think it's a good idea do you think it's something they should continue to pursue Yeah. So Ulta piloted a program with Target to open a store within a store. So if you go into a Target, I don't know how many square feet it is, maybe a thousand, but they've dedicated a small footprint to essentially a small Ulta. And it has all the best-selling cosmetics and fragrances and anything else you might need. I think they don't break out how many sales it's

doing. But I imagine management's been pretty intent on going forward with this program. So I think the numbers probably look pretty good. Ulta management seems to be pretty conservative. And if the numbers weren't showing, if it wasn't getting a good return, I don't think they'd continue growing the store count with them. But ultimately, what I think it does is Target's a much bigger name than Ulta. And I think it brings brand awareness to Ulta. So even if you don't buy it there, by stepping into a target, you see the Ulta name and you're more likely to go to their website and then buy it from them in the future. Yeah. The brand awareness component isn't something that immediately comes to mind. You mentioned management there. What are your overall

thoughts on the management team here. I did see that I think a decent chunk of the management team is made up of women, which I think for a cosmetics business is definitely a positive. I guess, what are your overall thoughts there? So I think you're right. They do have a large amount of women on the executive board, which I think is necessary for a company selling primarily two women, though they do have a male CEO. He took the office in 2021. What's his name? David Kimball. But he's been there since 2014, and he worked at Procter & Gamble before that. So I think he brings good leadership experience. And he's, as I said, he's been with Ulta since 2014. So I think by now he knows the company in and out. And at least thus far, he's been a good steward of

capital but i guess the future will tell whether he's a good ceo or not it's probably too early to make that call okay and again can you say maybe i missed it how new is the ceo how long he's been around uh he was first hired by 2021 very new very new sorry yeah I could be wrong, but do you think the management team is that important here? It feels like a business that is simple. Oh, Ryan, no, come on. I know, I know, I know. That's the dangerous path.

But it feels like a business that's pretty simple. So what's the Buffett quote? I'd rather bet on the horse than the jockey. And right now, Ulta's a good horse. but you always need a good manager in place if they run it in if they do something wrong they can run it into the ground a business can always do something incredibly stupid and lose customers that you might not be able to get back so i don't think it can be run by an idiot but i would say ulta does not present the largest challenge from a management perspective they have no debt on

their books. They have good economics and they have a replicable store that can just be replicated over. So the management challenge just isn't that great. Yeah. All right. And you mentioned they have 1,400 stores. I think one thing that comes to mind is what's the opportunity for them to max out their store count in North America? Are they giving out a number? Is it 3,000? Is it 4,000? Is it where we're at today? Have they mentioned anything there? So they've talked about actually in the U.S., what they're looking at is about 1,700 stores, which actually isn't that many more than today. So the real question is, after they reach that 1,700 store count, what's going to happen? Can they find way, you know, they might look to what Sephora is doing and look at some

smaller boxes that instead of going for a 10,000 square foot box, maybe they go to a 5,000. But But as I said, I think the real opportunity is international expansion. A company like Sephora started in Europe and moved over to the US. The question is, can Ulta, a US-centric company, move over to Europe or Canada or China, some of these other markets, and get customers? I guess we'll have to see. I don't know. But it's been so successful here, I don't see why it can't be successful in other markets. Right. Okay. And as we wrap things up, unless Ryan, do you have a follow-up before we go? I just wanted to be reminded again, what's like the market cap slash enterprise value on this? It's about 20 billion. Oh, okay. And about a billion and change in free cash flow?

yeah i'm looking at market caps about 22 billion today and a little over a billion dollars in free cash flow nice okay and again as we wrap things up here we always like to do the pre-born kind of hit the risks after going through the bull thesis what do you think is you're looking at for why an investment in ulta beauty would go poorly going forward say over the next however many years is on your investment horizon? So I think we touched on one or two of the major items. The first being that, are they going to reach saturation of their store count? If they can only get to 1,700 stores, that's 20% larger than it is today. But what happens after that? If the model doesn't work in other markets, all of a sudden the growth trajectory

really slows down. The other thing, as you mentioned before, is the threat of Amazon and other online retailers that, you know, as of now, Ulta has been able to get people to come into the stores, buy products. But what if people decide, I no longer want to go into stores, I only want to buy on e-commerce, and they'd rather do it on Amazon than go to Ulta. So, you know, the business isn't without challenges. I think they're well set up for the future, but you can see scenarios where it doesn't work out and things go the wrong way. Okay. I think that's all the questions we have, Brett, unless you've got any more, he's shaking his head. So that is going to do it. Ethan, for people that enjoyed this interview and people that want to kind of follow your

portfolio and anything else you do, where are the best places for them to find you? Absolutely. So the best place to find me is on my website, thegarpinvestor.com. There you'll see my blog and all my portfolio updates. And then check me out on Twitter, also thegarpinvestor. My DMs are always open. Feel free to talk to me. I'm pretty easy to reach and just like to thank you guys for having me on. Yeah, of course. All right. With that, I'm going to throw a disclosure on this. Brett and I are not financial advisors. Anything we say or discuss here on Chit Chat Money is not formal advice or recommendation. We are, however, general partners at Arch Capital, so clients may have positions in

the securities discussed in this podcast. Thank you all for listening. Thank you, Ethan, again for coming on the show, and we'll see you all next time. Bye.