TIVP003: Ulta Beauty (ULTA): A Beautiful Compounder w/ Shawn O’Malley

24:56But the stickiness of its in-person experience is that the next generation of customers will be key to its ongoing success. Brick-and-mortar stores have an inherently higher cost structure than Amazon, leaving Amazon with more capacity to sustain lower prices. For women with products they are loyal to and buy on a recurring basis, Amazon is the more attractive option. Ulta, though, is likely better for discovering new products. And the more Ulta can make the in-person experience unique, exciting, and personalized, the more they can turn a competitive disadvantage into an advantage. There's a lot of consumer spending research that basically concludes that the longer you hold a product in your hand as you try it out, the more you feel as though you already possess it and must then go purchase it.

25:38So there's a secret genius to Ulta making it so that you can try on a ton of products whenever you walk into a store. Another big part of Ulta's success in keeping customers coming back is its rewards program. Ulta's rewards program is just incredible. With more than 95 % of sales coming from loyalty members, results speak for themselves. Even better is that Ulta is reimbursed for a certain percentage of points if customers use an Ulta credit card, reducing some of the costs to run the program. All in all, it's a super powerful tool for keeping customers captive in Ulta's ecosystem. Just looking at their website from signing up for free, you can unlock$5 off a purchase and get a free birthday gift as well.

26:18And then there's a$15 e-reward that can be used on the website. After purchasing a gift card, 40 % holiday sales promos, coupons, mystery gift rewards, free bonus accessories in certain bundles that Ulta calls gifts with purchases, and a ton of other stuff like that. There are also holiday gift guides and sponsored product promotions like makeup palettes tied to the movie Wicked and an Ariana Grande perfume set. It's just fun, and even though I'm nowhere close to the target demographic, it doesn't take much effort for me to see why mothers and daughters and women everywhere love it. With the loyalty program, there are all kinds of offers too for earning extra points on certain purchases that go toward milestones like becoming a platinum member, which entitles you to exclusive events, a higher points multiplier on spending, special product offers, bonus points, and more.

27:02To level up the platinum tier, you've got to spend $500 in a given year. And then the next tier is the diamond tier for$1 ,200 in annual spending. Diamond members get an even higher points multiplier, allowing them to stack up points faster for redemption, a$25 annual reward for beauty services, early access to new products, an additional birthday gift, and more things like that. Though I can see why this is really compelling to some people. They're giving you a decent amount of value back while also making people feel special. If you spend$100, you get 100 points, which is worth$3 back. Basically, as you spend more, you get more points back, incentivizing the company's most engage customers to keep spending more and more since the points can only be redeemed on purchases.

27:43After 2000 points, you'd earn$125 off, in addition to the$100 off you already earn from hitting different milestones along the way. By offering three levels, Ulta does two things. It keeps the rewards program simple for customers and adds an element of gamification. With the Ulta co-branded credit card, shoppers get an extra point for every dollar they spend, on top of getting 20 % off their first order with the card. So having the card effectively doubles the points you can earn through Ulta's already pretty generous loyalty program. The loyalty program is very much Ulta's competitive advantage, especially in retaining engagement among the most avid beauty enthusiasts.

28:19Sephora is arguably Ulta's biggest competitor, so I dug through the Sephora subreddit to see what Sephora diehards love most about the brand. I'll talk about Sephora more in a moment, but I was shocked that on a Sephora fan page, beauty enthusiasts who spend thousands of dollars per year on cosmetics were bashing Sephora for its stingy loyalty program, saying the consumer's loyalty program paled in comparison to Ulta. And that makes perfect sense. Sephora is very much a higher-end luxury brand, so of course they don't want to offer too many sales or discounts that will dilute their brand's perception.

28:51But that just means Ulta has a structurally superior rewards program because they can be much more generous with giving away free stuff that earns them goodwill with customers. And on TikTok, influencers do all kinds of Ulta-themed challenges, Ulta makeovers, to shopping sprees. And with 1.2 million followers on the platform, I take that to be a pretty good indicator of how well Ulta is resonating with the next generation of beauty shoppers. For context, Sephora does have 1.6 million followers on TikTok, but Sephora is also much more of a global brand. Given that Ulta really only operates in the US, its following is pretty impressive.

29:24And it's worth mentioning that Sephora's prices are on average 54 % higher than Ulta's, so they seemingly are catering to a mostly different demographic. In practice, though, my impression is that many women shop at both, which is something I have validated after I visited both stores recently myself and talked to folks who shop there. One store might have the makeup brand they prefer, while the other may have their preferred skincare products. Beauty enthusiasts today use cosmetics to create their own unique identity after decades of being told specifically who certain brands were for. Now, plenty of women blur the lines simultaneously using$7 mascara from Ulta and$85 makeup foundation from Sephora.

30:02And so Sephora came to the US from France in 1998 and changed the beauty game by selling a wide range of luxury cosmetics brands at a time when department stores only carried a few of their favorites. The full gauntlet of prestige beauty brands were now available under the same roof for the first time in the US, which is similar but different to how Ulta took things one step further and not only unified some prestige beauty brands, but also offered a mixed selection of lower-end cosmetics too. While the two do compete directly in some ways, they've also carved out their own ecosystems. Sephoras are primarily based in traditional shopping mall department stores, where Ulta is more akin to a suburban Sephora.

30:39Though it's not as simple to say that Sephora is for the cities and Ulta is for the suburbs. Seemingly in defiance of that reputation, Ulta has taken the fight directly to Sephora's home turf after opening a store in downtown Manhattan a few years back. On Instagram, Ulta has 7.2 million followers versus 22.5 million for Sephora. So Sephora is doing very well there. There's definitely a lot of competition in the beauty space, but like I said, I take it to be a decent sign that Ulta holds its weight on social media. It's not like the brand is fading into irrelevancy by any means. It's also not a complete viral sensation either though, but people are very passionate about its products.

31:16There's an entire subreddit with nearly 100 ,000 members devoted to simply reviewing and discussing Ulta's product catalog, inquiring about the membership program, and sharing tips and tricks to maximize loyalty points. Again, Sephora's social media cloud outpaces Ulta here too. With almost 800 ,000 members in its subreddit, Sephora just has a massive cult following. Every time I've checked Ulta's social media following on a different platform, I've been impressed, but I've been blown away by Sephora's. As I mentioned, Sephora is a more expensive store, And that makes sense given that the company is owned by LVMH, one of the world's largest luxury conglomerates with brands like Louis Vuitton, Epiphany, Marc Jacobs, Hennessy, and Christian Dior.

31:56Looking more at Ulta's business breakdown, the company earns about 41 % of its revenues from cosmetics, 19 % from skincare and haircare products, 15 % from fragrance and bath, 3 % from services, and 3 % from other things like kickbacks on its credit card, unspent gift card funds on royalties from its partnership with Target. To promote these product sales, Ulta spends about 4 % of its revenues on advertising across all forms of media, from magazines to television and social media. As I dug deeper through the company's filings and read some of the risks it reports, it was interesting to see inventory shrink highlighted so specifically.

32:32It's an industry word for products that are lost to damage or theft, but apparently there's been a meaningful uptick and shrink since the pandemic, and that has had a measurable impact on profit margins. Unfortunately, this is sort of just a cost of doing business and retail, but I was surprised to learn how much shrink can fluctuate on a year-to-year basis. For Ulta in 2023, shrink lowered gross profit margins by 0.4%, or around$16 million. Another common pain point for retailers comes from primarily selling other brands' products. Given the company's dependence on product sales and reliance on other brands, I do find it slightly concerning that the company doesn't have any long-term supply agreements with its brand partners.

33:08Essentially, Ulta relies on maintaining good relationships with the brands it sells. If for whatever reason, a major brand is unable to supply enough product inventory to meet Ulta's needs or pulls its products altogether from Ulta, that could have major consequences for Ulta's business. In the globalized world we live in today, it's not common to find companies that completely control their own destinies, but there is another degree of interdependence with retailers that is just worth mentioning. I don't see anything on the horizon that would make me worry about the relationships Ulta has with its brand partners, but structurally, that dynamic of codependence will always be there.

33:42In recent years, more than 50 % of Ulta's revenues have come from its top 10 brand partners, so there are some key relationships there that produce most of the company's sales. As is common in retail generally too, Ulta earns a non-trivial amount from so-called vendor allowances. These allowances include advertising support, markdown allowances, purchase volume discounts and rebates, reimbursement for defective merchandise, and contribution towards certain selling and display expenses such as slotting fees, which vendors pay to secure specific shelf space or premium locations within a store. Vendor allowances are common in the retailing industry and are typically recorded as reductions in the cost of goods sold, which helps pad gross profit margins.

34:22I wasn't familiar with vendor allowances before studying Ulta since it's the first retailer I've ever really dug deeply into, so I was surprised at how substantial they can be. For Ulta last year, vendor allowances were worth$140 million. Financially speaking, Ulta is in good shape all around. Most of its liabilities are in long-term leases for its stores, which definitely can resemble long-term debt. But the key difference being that this isn't borrowed money for the sake of having borrowed money, these are obviously commitments that are necessary to run the business. And they also don't charge interest either, which is nice.

34:55Most of its other liabilities are things like unearned and deferred revenues, where the company has collected payment but has not yet delivered the products or services as promised, such as with unused loyalty program points, as well as inventory financing and other shorter-term liabilities. Otherwise, the company generates a very healthy amount of cash from operations, giving it more than enough room to fund its business, invest in growth and remodelings, and aggressively buy back stock too. It also has little actual debt, a nice cash cushion, and a revolving credit facility it can lean on as needed to borrow up to$800 million on not losing any sleep at night over Ulta's financial health.

35:31To facilitate its sales, in addition to its storefronts, Ulta operates four regional distribution centers that support both in-store and e-commerce orders and two fulfillment centers that support e-commerce orders only. In 2023, Ulta opened its first market fulfillment center, as they call it, which is smaller than their regional distribution centers, and focuses on their most productive products. Additionally, approximately 400 stores help fulfill e-commerce orders as part of their ship from store program. In other words, Ulta has a network of distribution and order fulfillment centers who deliver inventory to stores or fulfill online orders, and they use their stores to ship products between locations to fulfill orders as well.

36:10Here's another quote from Ulta's management pulling the thread a bit further on its supply chains. Inventory is shipped from our suppliers to our distribution centers, fast fulfillment centers, and market fulfillment centers. We replenish our stores with such products primarily in individual quantities, which allows us to ship less than an entire case when only one or two of a particular product is required. Our distribution centers, fast fulfillment centers, and market fulfillment centers use warehouse management software systems to manage inventory to support product purchase decisions. Product is delivered to stores using a broad network of contract and local final mile carriers.

36:46And then supporting all of its in-store operations, Ulta has 56 ,000 associates, but less than half are full-time. I think they're treated pretty well too, at least for the full-time workers. Ulta gives them a fairly generous 4 % 401k match, disability and life insurance, tuition reimbursement, paid time off with additional time off for extended illnesses, mental health, counseling services, financial planning assistance, and discounts on all retail products and salon services. On Glassdoor though, Ulta has just a 3.4 out of 5 rating and only 56 % would recommend that others work there. People report that there can be pretty demanding expectations and goals for credit card or loyalty program signups that can quickly lead to burnout and the pay for associate jobs is nothing to write home about.

37:30One commenter said they loved working at Ulta, but not for Ulta. They added, beyond the specifics of working for the location I'm at, corporate is not the greatest. Corporate and district level management is hyper focused on numbers instead of taking a holistic view of the business. At times, what is demanded of you as a manager is not what is in the best interest of the store team. Very rarely do I encounter a week in which I have enough hours to complete everything required of me. Take an isolated review like that with a grain of salt, but I definitely was not inspired by the reviews I came across.

38:02For the type of job that it is, I do think Ulta offers pretty decent benefits, but it sounds like the day-to-day workflow has left many frustrated. This is a yellow flag for me. It's not like Ulta workers have unionized or that the company is having serious staffing issues. And Ulta apparently has the highest retention rate it's ever had for store associates. But I do think workplace culture is an important part of a company's long-term success. And there's definitely a disconnect between how management talks about employee satisfaction and what I'm seeing from actual employees. Still, Ulta's track record speaks for itself.

38:34Its financial results have largely been pretty stellar. To show how well Ulta has done, I'm going to take a quick tangent to talk about John Huber and Walmart. It's all relevant to the story here with Ulta. John Huber of Sabre Capital Management is one of my favorite investors to study, and he has a really compelling framework for assessing the rate at which companies compound their intrinsic value. And that is to look at the incremental returns on capital that a business is able to generate. I'm referencing his writings here, so I'll be sure to link to his full blog posts in the show notes. He outlines that, however precisely we measure returns on invested capital, aka ROIC, it usually only tells us the rate of return that the company is generating on capital that has already been invested, sometimes many years ago.

39:17Obviously, a company that produces high returns on capital is a good business, but what we want to know is how much money the company can generate going forward on future investments. The first step in determining that is to look at the rate of return the company has generated on incremental investments more recently. He continues by saying that, one very rough back of the envelope way to think about a company's returns on incremental capital is to look at the amount of capital the business has added over a period of time and compare that to the incremental growth in the company's earnings. Walmart, for example, earned$14.7 billion of net income in 2015 on roughly$111 billion of debt in equity capital, which is about a 13 % return on capital.

39:56Not bad, but what we really want to know is what it will earn on new investments of capital going forward. Let's imagine we were looking at Walmart as a possible investment back in 2006. At that point in time, we would have wanted to make three general conclusions. How much cash Walmart would produce going forward, how much of it we would see in the form of dividends and buybacks as shareholders, and the portion of which we didn't receive, what rate of return would the company get by keeping those funds and reinvesting them? Estimates to these questions would help determine what Walmart's future earnings power would look like.

40:28So let's look at how Walmart did over the subsequent 10 years. In 2006, Walmart earned$11.2 billion on roughly$76 billion of capital, which is a return of around 15%. In the next 10 years, the company invested roughly$35 billion of additional debt in equity capital, and it grew earnings by about$3.5 billion. So from 2006 through 2015, Walmart saw a rather mediocre return of about 10 % on the capital that it invested during that time. Hubert tells us that a company will see its intrinsic value compound at a rate that roughly equals the product of its ROIC and its reinvestment rate. So the intrinsic value compounding rate equals ROIC times the reinvestment rate.

41:10This is the main driving factor behind how a company's intrinsic value compounds, but what management does with the cash that's not reinvested can make a big difference for value per share too, in terms of whether it sits idly or is redistributed as dividends or buybacks. If Walmart retains 25 % of its capital and reinvests that capital at a 10 % return, we'd expect the intrinsic value of the company to grow at a rate of around 2.5 % per year. If you're pulling up Walmart's stock chart over this past decade, you might be surprised then by how it is done. While the company's returns on invested capital aren't much better, shareholders have fared well thanks to large buybacks and the price to earnings ratio rising considerably, juicing stock price returns.

41:51Going back to Ulta, the company has been reinvesting around 27 % of its earnings back into the business while dedicating the rest to buybacks. On the capital they have invested in the business, the returns are around 70%. Thus, the company has compounded its net income at around 17.5 % per year for the last decade and has probably compounded its intrinsic value by a similar amount. Yet the stock's 10-year annual return is much lower because the price to earnings ratio that it trades at has contracted from 32 in 2014 to around 17 today. In other words, the company has compounded its intrinsic value at nearly 20 % per year based on the returns it has generated on incremental investments.

42:29Yet the market has soured on the company as growth has slowed and so investors are willing to pay half as much for a dollar of the company's earnings. That has correspondingly been a major headwind to Ulta's price performance. But if the company can continue to reinvest that same percentage of its free cash flows into opportunities that are similarly profitable, then the company should generate a return that matches the rate at which it has compounded its intrinsic value, which would be amplified further by potential increases in the price to earnings multiple. Or at least we can find comfort in knowing the stock probably won't see its price to earnings ratio get cut in half again, so the stock won't have the same headwinds opposing it.

43:04In this spirit, I want to share one of my favorite quotes from Warren Buffett, which comes from his 1992 letter to shareholders. He says, leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. Let's take a quick break and hear from today's sponsors. Hey, it's Sean O'Malley, just popping in with a quick message. If you like this podcast, well, I've got great news for you. We've got a handful of other shows for you to explore, from learning about Bitcoin to embracing a richer, wiser, happier lifestyle.

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46:46All right, back to the show. And as we've seen, Ulta has been able to deploy meaningfully large amounts of capital at very high rates of return, which immediately makes the stock attractive to me. But past performance is no guarantee of future performance. So that's what I'm keen to try and figure out with Ulta. Before we go ahead with that, though, let me just say that returns on incremental capital are important, but not everything when it comes to intrinsic value. A company with a ton of pricing power, for example, could generate incredible returns by doubling prices, even if it effectively reinvested almost nothing into growing its business.

47:17There are some wonderful companies out there that have a combination of pricing power and excellent returns on incrementally invested capital. One I can tell, Ulta does not have both working in its favor. Instead, Ulta is positioned as a more affordable beauty retailer relative to, say, Sephora, which restricts how much they can raise prices by in any given year. I don't say that as a reason to write off Ulta by any means, especially since it has been so effective at earning returns at capital, but it's just something to be aware of. But Ulta has been pretty aggressive about buying back stock, especially over the last year as its valuation has cheapened across a number of metrics.

47:51In the first half of 2024, the company repurchased 1.1 million shares at a cost of$497 million, which comes up to an average price of$450 per share. And after the company announced a$2 billion share repurchase program in March 2024, it has around$1.5 billion of spending that it's still authorized to do. So I'd expect that management will only be more aggressive about reducing the share count since the stock has fallen, which benefits all remaining shareholders by giving them a bigger slice of ownership over the company. Ulta has been a steady repurchaser for years now with a buyback yield climbing from 3 % in 2018 to 5.5 % today with a peak of almost 9 % in 2020.

48:31The buyback yield is just the percentage of the company's market capitalization that the company repurchases in a year. So clearly with Ulta, these are pretty significant percentages, even net of stock-based compensation. Since 2014, Ulta has shrunk its share count from$64 million to$47 million. But differently, Ulta's share account has shrunk by 3 % per year on average. So not only does Ulta have a strong track record of earning attractive returns on invested capital, but management has been focused on returning remaining cash flows to shareholders, further enhancing their experience. In terms of what Ulta can do incrementally with its capital, historically, this has typically gone toward either remodeling or relocating existing stores and expanding into new locations.

49:12It has also made sizable investments in its IT systems, supply chains, and just general store maintenance. I'd expect that playbook to mostly stay the same, poor 30-40 % of free cash flows and do improving existing locations or spawning new locations to reach management's goal of adding another 200 or so locations while expanding distribution and fulfillment centers as needed to accommodate Ulta's growing e-commerce business. That is why I, for the most part, expect Ulta to continue earning very attractive returns and capital. This is not a company that's dramatically growing, but it is growing, and I expect it to continue being disciplined about doing so.

49:45Nothing about its formula for success is dramatically changing. They're also testing out stores with a 5 ,000 square foot footprint, which is about half the size of their normal locations. So that could be really interesting and enable them to set up shop in places they wouldn't have previously considered. And with Target having nearly 2 ,000 stores, Ulta only has a presence in a quarter of them. So even just expanding into half of all Target stores would be a massive growth opportunity. There is a risk though, of course, that in some ways the Target partnership could backfire on them. For example, the deal with Target isn't renewed because Target thinks they can cut Ulta out and directly incorporate prestige brands themselves.

50:19That would really hurt. You could also just say too that Ulta is allowing customers to leave its ecosystem where it captures most of the profit and can better control the experience. So the Target partnership isn't entirely a good thing, nor would further expansion of it be objectively positive. The only other wrinkle here is that the obvious thought is if Ulta primarily operates in the US, what's keeping it from expanding overseas? Or at least, it could surely expand into Canada or even maybe Mexico, right? These would be foreign endeavors, but not literally overseas. It's not a leap to say that the US and Canada are extremely similar, and in theory, it could probably add another 50 or 100 locations there.

50:56This is actually something Ulta has toyed around with for years, but ultimately has kept delaying. In short, because any international expansion, even to a destination as similar as Canada, is just challenging. There are subtle logistical and cultural differences, entrenched competitors, and other barriers that make it easier said than done. After unveiling a Canadian expansion in 2019, the company took a step back a year later after COVID-19 threw a wrench into its plans and instead opted to focus on the familiar, not feeling it was the time to venture abroad. Several years later, management no longer makes any real mention of Canada other than referencing that generally it could be a source of growth in the long term.

51:35Instead, they flirted with the idea of expanding into Mexico, which honestly, I don't really understand. Mexico is a dramatically different culture with just practically speaking here, much less discretionary income per capita. So I don't see the rationale for prioritizing it over Canada. Perhaps the thinking is that where Canada is already a developed beauty market, Mexico is a fast developing country where consumers increasingly have the extra money to spend on beauty products. And Ulta wants to position itself as an early leader in that market. I sort of get that perspective. It's just so hard to do international expansion well and rather see them get some traction in a more true peer country before looking south, but we'll see what happens.

52:12Neither of them are core strategic priorities at this point in time, but the company did announce that it is hoping to build out a few locations in Mexico this year. So the expansion is apparently being done as a joint venture with Group AXO, a major retailer distributor in Mexico. If that pans out and becomes a real substantial investment, that's when I'd see a potential inflection point in their incremental returns in capital could either go really well or really poorly. And based on how sentiment surrounding Ulta has fallen off this year, it's safe to say that markets don't seem inspired by the plan.

52:42In an article about the potential Mexico expansion, Neil Saunders, a managing director at Global Data, told Retail Dive that, quote, There is no doubt that the days of heady increases in beauty are behind us. Consumer spending is under more pressure, and there's a lot more competition thanks to the expansion of rivals like Sephora and Target, as well as a raft of DDC specialists. Against this backdrop, Ulta's forecast suggests it will more than hold its own in the year ahead, which in our book is a good result. So we've talked a lot about Ulta's business model, financials, supply chain, and employee relations.

53:15Let's bring it all together and try to figure out whether the company is fairly valued and what types of returns we should expect as potential investors. Let me just say that Ulta competes in a tough industry with few barriers to entry. It's not typically the setup for a great compounder, but Ulta clearly has a blend of competitive advantages that have sustained its impressive returns. Otherwise, its profit margins and outsized market share would have already been competed away. Its competition ranges from Amazon, as I mentioned a bit earlier, to national and regional retailers, boutiques, drugstores, salon chains, pure play e-commerce marketplaces, and even direct response TV channels like QVC where they sell their products on air.

53:52Given the vast array of places a person can purchase beauty products from, it's pretty amazing that Ulta has a nearly 10 % market share. I'm sure this is what attracted Berkshire Hathaway to Ulta too, because Ulta fits pretty squarely into what you might call a boring business. Not to say that the beauty industry isn't interesting or exciting at all. I just mean that this is a reliable industry that's not going anywhere. People, not just women, will always want skincare, makeup, haircare products, and Ulta has an excellent reputation in this space with eye-popping customer loyalty. I've said it a few times, but having 95 % of sales come from customers enrolled in its rewards program is just incredible.

54:26And what Ulta does is understandable too. I've tagged along many times on trips to Ulta and I grew up with one just down the street from me, so I can completely get what they do, who they appeal to, and why they remain popular. The business is high quality, part of a reliably growing industry, and tied to an enduring part of the human experience. And even better, its sales are driven by a passionate and loyal customer base who keep on coming back to discover new products and cash in their points. So I see a lot to like about Ulta. I do wish the company had higher rates of insider ownership and a culture where it was clear that most employees truly love working there.

54:59And I do also have some concerns about how well they can expand abroad, yet I mostly feel good about the qualitative aspects of the business. I wouldn't say Ulta checks every box they could dream up for the perfect investment, but that's okay. There's also some promising trends supporting Ulta and the beauty industry more broadly. According to the company's 2024 Investor Day, which I'd encourage anyone curious to learn more about the company to watch. As beauty becomes increasingly intermixed with wellness and self-care trends, Ulta has seen a growing percentage of beauty enthusiasts with each new generation.

55:28There are more Gen Z beauty enthusiasts in millennials and more in Gen Alpha than in Gen Z. Men are also spending more than ever on beauty products, especially for skincare, and they're also doing so at younger and younger ages. The company wants to be the go-to store for men and women of all age groups and all ethnicities. In particular, Ulta is excited about the Hispanic demographic since Hispanics consume the most beauty products per capita. And as the Hispanic population continues to grow in the US, that is an additional tailwind for Ulta and also perhaps explains why they're so interested in expanding into Mexico.

56:03Putting it all together for Ulta's valuation, I see a company that hit some road bumps in 2024, but the extent to which its price to earnings ratio has declined since the pandemic is surprising to me. Even the initial boost the stock saw after an endorsement from Berkshire hasn't really moved the needle much. As such, Ulta looks attractively valued across a few metrics, from its historically low PE ratio to its relatively high free cash flow yield, on top of its track record of generating excellent returns on capital, especially on incremental investments of capital and in buying back shares. Based on the math we did earlier on incremental returns in capital, Ulta has likely been compounding its intrinsic value at around 18 or 19 % per year, and there's a decent chance it can continue doing so.

56:44Even if incremental returns fall off, both in terms of the percentage return and the amount that Ulta is reinvesting as Ulta has fewer attractive locations to expand into. I wouldn't be surprised at all if the company earned incremental returns on capital at say 14 or 15 % per year going forward and compounded its intrinsic value at a similar rate. At the same time, same sort of sales growth has slowed significantly for Ulta as Sephora is increasingly growing at their expense. You can sense this seems to be that Ulta is very much hitting a more mature phase in its business, so there isn't much reason to hope that the price to earnings ratio is suddenly going to dramatically reverse.

57:18Whether it's Macy's offering more cosmetic products, Amazon or Sephora partnering with Kohl's, Ulta is very much under pressure from all sides, but I don't necessarily think that that's anything new either. The pandemic year has pulled forward a lot of growth for the beauty industry and afterwards, valuations have been correcting to reflect that there may be a bit of a hangover. And it's worth mentioning too that Ulta has a real opportunity to expand beyond the suburbs into more rural and small town areas where they are really sort of out of reach of specialized beauty retailers, and Ulta has a chance to be a first mover there.

57:50So CEO Dave Kimball told investors on a call for second quarter earnings last year that more than 80 % of Ulta stores were impacted by one or more competitive openings in recent years, and more than half were impacted by multiple competitive store openings, leading them to revise down their 2024 estimates for Ulta's earnings and revenue. You had to earn a 50 % average return on equity in the last few years, as Ulta has, with no debt to amplify that ROE, the company clearly has some enduringly attractive economics and powerful dynamics underpinning its advantages, which I'd guess come primarily from its customer loyalty and rewards program.

58:24When I read investors' commentary about the stock in line, I see a lot of people fundamentally misunderstanding that Ulta is a retailer and therefore sells brands like Elf and L 'Oreal rather than competing with them. In that same vein, there's a lot of concern over 2024 being an off year for the company, where renovations at some locations disrupted sales, and promotional efforts during the summer weren't as profitable as expected. I could be naive, but to me, these are all clearly short-term concerns that are correspondingly weighing on the stock. There's no free lunch in investing, as I say, and I'm fully aware that the opportunity to buy Ulta at a discount to its intrinsic value exists only because there are clouds fogging up the company's outlook.

59:01You either look at Ulta and see a retailer with no moat, under pressure from a number of tough competitors, with little room left to grow in a mature market, or you see a company with an incredible track record of generating returns, room for modest growth combined with aggressive buybacks to return capital to shareholders, no debt, and just enough economic and industry uncertainty to push investors to abandon the company and thus leave it trading at a fairly discounted price. And in a way, what makes investing so tough is that both of these extremes contain elements of truth. As an alternative to looking at just incremental returns and capital, projected at some fairly conservative earnings per share assumptions for the company over the next five years to see where the stock might be trading at based on different price to earnings ratios by 2030.

59:42In my model, I assume that 2025 will see a decline in earnings as is expected by most analysts and then grow modestly over the next four years by just 5 % per year. In that same time, if Ulta continues to buy back around 4 % of its shares on net each year, which is roughly what it's been doing since 2020, then the stock would actually generate a near double digit annual return without assuming any improvement and sentiment for the stock that pushes its price to earnings multiple higher. And if there's any improvement in the price to earnings ratio back toward 20 or higher, then that would tack on an extra few percentage points of return per year.

1:00:16Given the competitive challenges facing Ulta, I want to at least account for the fact that they may not have any real growth after you net out the effects of inflation. Let's say Ulta's earnings decline as expected for 2025 and then only grow at the inflation rate of 2 % until 2030. Doesn't sound like a recipe for decent returns now, does it? You might be surprised to learn that with no real earnings growth and its PE remaining unchanged, while buying back 6 % of the company's stock each year, which is a bit above what they've done in the past, but not unprecedented. And especially if they're not investing more in growth and they'll have extra cashflow to redirect towards share buybacks, then Ulta could actually still return 8 % per year, which is very solid for a company that has no real growth.

1:00:56So as a sort of floor scenario for me, I think that's just incredible. Not the rate of return by itself, but the fact that even if Ulta has no growth on an inflation-adjusted basis, as they continue to be aggressive about directing excess cash flow to buybacks, shareholders can earn an acceptable rate of return still. And the larger the scale of those buybacks are, especially if they're done strategically when the stock's price is depressed, that would create even more value. At the same time, we're talking about a company that has a phenomenal track record of earning incremental returns on capital and growing net income.

1:01:26So assuming no real growth until 2030 is almost outlandishly conservative. From 2014 through 2020, this is a company that has compounded net income by nearly 17 % a year. So you can see why I say revising down that all the way down to 2 % is just very conservative. And even in that hypothetical or one with slightly more growth and less buybacks, we can earn reasonably satisfactory returns. To me, that's a pretty great floor on my expected outcomes and margin of safety. To be a bit more optimistic, Volta can grow earnings by up to 8 % a year through 2030, which is still conservative historically in half the rate that they grew at since 2014.

1:02:01While buying back around 4 % of its stock, its shares will generate a 12 % annual return with a flat PE and over 15 % if the PE ratio jumps back to 20. We can play these numbers games forever, but the point being, there's a real floor or margin of safety with this investment that I can feel decent about. Ulta is not a get-rich-quick investment, but that's not my style anyways. This is a company that spits off a lot of free cash flow, which has given them a lot of leeway to reinvest profitably into growing the business while also dumping money into share buybacks. Given how far the P-E ratio has already come down, it could fall a bit further, but I wouldn't expect this to be a major headwind anymore.

1:02:38So like I said, this is a stock where I feel the downside is reasonably well capped. Short of a very dramatic fall off in profitability, which is certainly possible, the company will continue to produce enough cash to aggressively buy back stock, which is an alternative way to boost earnings per share. And while Wall Street is expecting the company to just suddenly not grow at all any longer, I think that between expanding into more target locations, potentially expanding across the US and even into more rural and small towns, and potentially expanding into Mexico and Canada as well, I can see very much how Ulta continues to earn attractive incremental returns on capital, where even if income compounds at half the rate it has in recent years, that would all be gravy for investors buying in at today's prices.

1:03:21Ulta will not be a 10 bagger or even probably a five bagger in the next few years, but I do think it's a stock that we could, with fairly conservative assumptions, earn 10 to 15 % annualized returns on over time. That's not to say I don't see serious competitive risks, nor am I completely confident in the strength of their moats. That's also not to say I don't think the stock would be hit hard by a recession either. It's just that long term, Ulta is a business I feel pretty confident isn't going anywhere. Beauty spending is only becoming more common as it becomes synonymous with self-care and wellness.

1:03:50Plus, its returns and capital are strikingly good, and there's plenty of room for those to come down to competition before they're no longer attractive. And with how loyal its customers are and the general strength of its brand, Veal Ulta is a fairly safe pick with a good bit of upside potential. I will say though that it's a stock where the valuation matters a lot, since there's not a ton of expected growth that's going to bail you out if you overpay. At a little over$400 per share at the time of recording, I feel good enough about the range of likely outcomes for the stock to say that it's likely undervalued relative to its intrinsic value.

1:04:23As such, I want to make it the first addition to our intrinsic value portfolio. I think its fair value is actually probably above$450 per share. For the sake of brevity, I'll spare you any more numbers and just say that. If you'd like to see the model I use to assess the range of expected returns for Ulta, just make sure you're signed up for our intrinsic value newsletter. There, I'll give a more condensed pitch on the company, share charts and other visuals that I can't really convey in a podcast format. And like I said, link to a downloadable version of my spreadsheet in case you want to play around with the assumptions I use to model out Ulta's returns for yourself.

1:04:57In the show notes below, you can sign up if you aren't already. With that, let me say that I'm really excited to make the first addition to the intrinsic value portfolio with Ulta. To be completely honest, I'm also a bit nervous because building a long-term stock portfolio isn't easy work and it's definitely not easy to do it publicly either. I will say though that I fully plan to invest personally in any stock that is added to the intrinsic value portfolio and will wait for two weeks after this episode has been published to make any new purchases or further purchases if it's a position I already own, which for full transparency with Ulta, this is a company I first researched in November, and thus I have already purchased a small stake in the business.

1:05:34For now, I'm going to give Ulta a 5 % weight in our intrinsic value portfolio, reflecting that I hope to eventually bring the portfolio to around 20 different stocks. Over time, as stocks fluctuate and certain positions are re-weighted based on my conviction in them, they'll definitely drift away from 5%. So this is just the starting position, which leaves us with 95 % cash still in the intrinsic value portfolio that I want to allocate over the rest of the year. Obviously, that means we have many more investment decisions to make and many more businesses to break down. But I do hope you enjoyed learning about Ulta's business model today.

1:06:07And while adding the stock to the intrinsic value portfolio is not intended as financial advice for anyone to follow. I would love to hear from anyone who has followed the stock and whether they're bearish or bullish on the company. Ulta is an economically sensitive business, one that has intentionally not diversified beyond its core focus. And I take that to be a good thing, since they really seem to know what they're doing. On top of that, they're the only beauty retailer with a full spectrum of products at all prices. So even if there is a recession, they can lean more heavily on their mass market products.

1:06:38If profit margins over the coming quarters fall off more dramatically than expected due to competitive pressures, I could revisit the decision here, but I'm not approaching this with a short-term perspective at all. The other elephant in the room here are President Trump's proposed import tariffs. Sometimes, politics do materially impact markets, and this would very much be the case. Ulta imports most of its products from abroad with a large dependence on China, so it would either have to raise prices considerably if large tariffs truly go into place, as mentioned, or they'd have to eat those costs and accept lower profit margins.

1:07:11I remain skeptical that tariffs will be implemented on the scale that's been proposed in political rhetoric, but this would throw a real monkey wrench into the thesis. And of course, it wouldn't just be Ulta that would be negatively impacted either. 60 % tariffs on Chinese goods would be unprecedented and devastating to a number of industries, which is why I don't expect them to happen. Still, this is a company that I will track closely going forward due to some of those concerns, but I hope to own it for the next five years or longer. Next week, I'll be back here again, evaluating another interesting business and investment thesis and deciding whether it deserves a spot in the portfolio.

1:07:44And so to wrap things up today, I'd like to leave you with one last quote. This one is from Charlie Munger, who tells us, I'm a very blocking and tackling kind of thinker. I just try and avoid being stupid. With my investment in Ulta, I'm more trying to avoid being stupid and just buy a good business without overthinking it than I am hoping to do something truly genius or novel. That's all for today, folks. I'll see you again next time.

1:08:36Broadcasting.