A Stock to Buy on Weakness

Harsh is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Things were looking ugly for beauty retailer Ulta Salon, Cosmetics & Fragrance (NASDAQ: ULTA) three months back. Its CEO at that time, Chuck Rubin, had decided to move on and the company’s outlook for the recently-concluded first quarter wasn’t great either. These factors had pushed Ulta Salon close to its 52-week low, but as I’d said then, all was not over for the company.

Cut to the present, and we see that the stock is trading close to its 52-week high in what is a remarkable recovery. The shares received a massive boost earlier this month when the company beat earnings estimates and the fact that it has found a new, full-time CEO would have also contributed to the feel-good factor.

Double standards?

But, is everything as rosy as it seems on the surface for Ulta Salon? Well, it doesn’t seem so. As I said, the company’s shares had spiked after it beat earnings, but then, the estimates were already pretty low. Analysts had originally expected Ulta Salon to earn $0.72 a share, but the estimate was adjusted downward significantly after the company said that it would earn in the range of $0.60-$0.63 a share.

Thus, the fact that Ulta beat its own lowball guidance by posting earnings of $0.65 a share isn’t something which should count as impressive. Moreover, the company once again failed to provide a decent outlook with management calling for earnings of $0.64-$0.67 a share while analysts were originally looking for $0.68. Also, its revenue guidance of $579 million to $589 million is way below the analyst consensus of $590.3 million.

Now, for a stock which is trading at a rich valuation with a P/E of 36 times, a miss on the guidance should have spelled doom like last time, but the opposite was the case this time. So, what was it exactly that propelled Ulta higher this time? Well, the question doesn’t have a straightforward answer. What we should now focus on instead is whether Ulta can garner enough growth to justify its premium valuation.

Growth still intact

Going by the company’s guidance, revenue should increase 21% from the year-ago period if Ulta Salon hits the mid-point of its own guidance. Earnings per share are also expected to jump by a similar figure from the year-ago period. These estimates might be below what analysts are expecting, but they are no doubt impressive on an absolute basis.

However, same-store sale growth will be a sore point. Ulta Salon is looking at same-store sales growth of 4% to 6% for the ongoing quarter, considerably below the 9.3% growth it had clocked in the second quarter last year. It’s quite natural that growth rates won’t stay high forever and the same is happening. Thus, considering this, I’m not sure whether the stock should trade at a level which is similar to when it was growing at a faster clip.

While I’m optimistic about the prospects of the company, I believe that it has run up a bit too much and one should wait for a pullback before initiating a position. I agree that the company is still opening new stores, looking to add 125 new stores this year and add to its existing count of around 580, a growth of more than 25%. Moreover, its e-commerce business grew an impressive 70% in the previous quarter.

But, as I said, the present valuation is on the higher side and with a new CEO coming in, it remains to be seen what direction Ulta will take. If shares would have taken a beating after its recently-released earnings report, then there would have been an opportunity to buy more shares as Ulta is still growing and making some impressive moves.

It is adding more merchandise to its stores, adding more brands and services, and also increasing the number of Clinique and Lancôme boutiques. Ulta Salon is moving into the territory of Macy’s and J.C. Penney’s (NYSE: JCP) Sephora.

Sephora is a pretty well-known brand and has a pretty wide presence in the U.S. Its presence inside J.C. Penney’s stores has certainly expanded its reach, and customers have embraced the store within-a-store concept well. J.C. Penney might not be doing very well, but Sephora probably is and this means that there is a lot of scope for Ulta Salon’s boutiques to grow going forward as it keeps expanding.

A combination of these initiatives should help the company sustain its growth in the long run, but given the fact that it’s been missing estimates on guidance for the past two quarters, it would make sense to keep a close eye on the company’s execution.

Ulta is making a lot of moves and is placed in a better position than peers such as Elizabeth Arden (NASDAQ: RDEN), which doesn’t enjoy the diversity that Ulta has. Arden is primarily known for its Prevage anti-aging creams, apart from celebrity fragrances, and is quite dependent on departmental stores for revenue. The company posted a loss in its most recent quarter and even though it trades at a relatively cheaper 28 times earnings as compared to Ulta Salon, I think it’s not a good bet.

The bottom line

Ulta Salon’s store presence, brand diversity, and ever growing revenue and earnings are points of strength which justify its premium valuation over peers, but now won’t be the right time to buy the stock due to reasons mentioned above.

Considering all these factors, it would be prudent for investors to closely track Ulta Salon and look for any signs of weakness in the near-future. The company is still growing and growing well, but now isn’t a good time to buy into this growth story. As such, keep your eyes open and scoop up Ulta Salon shares when the opportunity arises going forward.

Harsh Chauhan has no position in any stocks mentioned. The Motley Fool recommends Ulta Salon, Cosmetics & Fragrance. The Motley Fool owns shares of Ulta Salon, Cosmetics & Fragrance. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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