In 2001, Leonard Lauder, one of the heirs of the Estee Lauder fortune, posited that lipstick sales and the growth of the economy were inversely correlated. Essentially, if the economy was hurting, lipstick sales improved. The posit went on to be coined as the LipStick Index.
Investors and business leaders have tried for decades - if not centuries - to develop indicators to enable decision-making. Were there an indicator or a set of indicators with a 100% win rate, everybody would be a billionaire.
The Lipstick Index has the same fallibility. For instance, here is how Ulta Beauty’s (ULTA) sales fared during the early parts of COVID-19.
Now, ULTA doesn’t break down its lipstick sales, however, we can see the carnage in the numbers - debunking to a certain extent the Lipstick Index. Estee Lauder fared none the better. So, another famous economic indicator goes down the dustbin of history.
Ulta Beauty
Ulta Beauty was founded in 1990 to operate specialty retail stores selling cosmetics, fragrances, haircare and skincare products, and related accessories and services. Nearly every store features a full-service salon. As of August 3, 2024, the Company operated 1,411 stores across 50 states.
On August 14, a 13-F filed by Warren Buffett’s Berkshire Hathaway revealed Berkshire had bought 690,000 shares of ULTA worth $266.3 million as of June 30. Wall Street analysts were not far behind in issuing upgrades.
On the surface, ULTA looks cheap with a P/E of 15.32. However, I wonder if Buffett initiated the position. Or was it one of his underlings? In any event, I believe they bought a dud.
On August 31, 2024, ULTA reported its Q2 earnings and missed across the board. The CEO, Dave Kimbell, attributed the disappointing results to:
More value-conscious consumers.
Increased competition.
Normalizing demand after the pandemic.
ULTA is addressing the challenges by
enhancing its digital presence, and loyalty programs.
replacing its ERP platform
working on supply chain optimizations.
This brings us to differential disclosures. Different disclosures can be classified as the company saying one thing in one press release/regulatory filing/earnings call, and saying the opposite in another.
Differential Disclosures
Consider this statement:
As such, we believe that period-to-period comparisons of our results of operations should not be relied upon as an indication of our future performance.
Source Q2 10Q PDF page 18/19
I used some colorful language on X after reading this line, however, consider this statement:
The comparable sales decrease of 1.2% for the 13 weeks ended August 3, 2024 was driven by a 1.8% decrease in transactions and a 0.6% increase in average ticket.
Source Q2 10Q PDF page 20
So, what happened here? On one page ULTA says results are incomparable, but they report comparable sales on the next page. Somebody is either clueless or somebody is ethically challenged. Which is it? I don’t know.
Project Soar
Now, let’s look at another case of differential disclosure.
… the ability to execute our operational excellence priorities, including continuous improvement, Project SOAR (the replacement of our enterprise resource planning platform), and supply chain optimization …
Source Q2 10Q PDF page 15
For the uninitiated, enterprise resource planning (ERP) platform replacement would fall under technology spending and be recorded as CAPEX in the Investing Section of the Cash Flow Statement. Now, consider this statement.
The decrease in net cash used in investing activities in the first 26 weeks of fiscal 2024 compared to the first 26 weeks of fiscal 2023 was primarily due to lower capital expenditures for information technology systems and supply chain investments ...
Source Q2 10Q PDF page 22
This is another case of differential disclosure. It raises questions about management’s ethics.
Analysing Financials
Berkshire’s 13-F was when ULTA hit my radar, however, I wanted to evaluate the Q2 results due in two weeks on August 31. As discussed, the earnings missed across the board. However, a kneejerk reaction to one quarterly result would be foolhardy. Hence, I eyeballed the financials. A few things stood out:
CFFO < NI in Q2.
DPO rising, i.e. delaying vendor payments.
GM declined QoQ.
Note
CFFO = Cash Flow from Operations
DPO = Days Payables Outstanding
GM = Gross Margin
QoQ = Quarter-over-Quarter
YoY = Year-over-Year
Observations on the table:
CFFO < NI in the quarter that ended in May should have been the first warning that operations were deteriorating. Even if CFFO goes below NI, it needs to be evaluated further and should not be the “end all and be all” of it.
CFFO was below NI again in Q2. If one didn’t go digging after the Q1 earnings, one should look after the Q2 flag.
Even though DPO increased by 2.4 days, it did enable ULTA to manage its CFFO.
Income Statement
So, ULTA was flagged for deteriorating operations. Let’s analyze the income statement from various angles. Firstly, let’s analyze YoY numbers.
Observations:
Revenue growth is slowing down, no wonder the multiples are depressed.
Margins and costs are being managed well. That is good to see.
Net Income growth is worse than Revenue growth. Red Flag.
“Diluted EPS” is being held up by share buybacks. There is nothing untoward here; just an observation and a “good to know” item.
Now let’s dig into the quarterly numbers for the last six quarters.
Apart from controlling its SG&A, everything else is deteriorating. This is a trainwreck, an absolute deterioration in operations confirmed by the 1.2% drop in comparable sales in Q2. However, is there any seasonality in play here?
Seasonality
Our business is subject to seasonal fluctuation. Significant portions of our net sales and profits are realized during the fourth quarter of the fiscal year due to the holiday selling season. To a lesser extent, our business is also affected by Mother’s Day and Valentine’s Day. Any decrease in sales during these higher sales volume periods could have an adverse effect on our business, financial condition, or operating results for the entire fiscal year.
Source Q2 10Q PDF page 24
All right. Let’s analyze the seasonally strong periods with comparable periods in previous years.
Again, apart from SG&A being under control and some tax benefits, everything else points to operational deterioration. While valuation metrics may indicate a value stock, it can get cheaper.
Looking Forward
ULTA does have a strong balance sheet to support its initiatives for the upcoming holiday season - its strongest quarter ends in late January or early February (fiscal Q4). ULTA will be building up inventory in the hope of having a stellar holiday season. It remains to be seen if they can achieve that. Given the continuous operational deterioration, it seems ULTA has lost the proverbial connection with its customers. What about growth via store expansion?
ULTA is already in 50 states. Currently, it has 1411 stores, and in the long term, it hopes to support 1,500 to 1,700 stores in the US. However, what is the pace of new store openings?
The pace of new store openings is also slowing down. Operationally, ULTA looks to be headed for further deterioration unless it can up its digital game and expand internationally. However, this is a commodity business and would require capital to expand internationally. It will be a slow grind.
Verdict
I still can’t “wrap my head around” why Berkshire bought ULTA. In any event, I expect ULTA to underperform the market over the next 12 to 18 months.
Disclosures: Here are our internal governance rules to ensure no conflict of interest. For companies we write about:
No existing position.
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How much voting rights do they get with those many shares? BRK maybe hoping for turnaround by influencing the board?