New and Exclusive Products Give This Beauty Retailer the Edge

Most retailers have no competitive advantages because their products can be easily be bought from competitors. The same cannot be said about Ulta Salon , a retailer of prestige, mass beauty and salon products and salon services in the U.S. Ulta Salon has consistently delivered returns on invested capital in excess of 20% for the past three years.

'Newness' and 'exclusivity' are key to profitability
Customers are typically willing to only pay premiums on 'new' and 'exclusive' products within a narrow time frame--until the same products are either superseded by newer products or become widely available to all consumers.  

Ulta has historically boasted a robust pipeline of new brands and products. Since 2009, Ulta has added 65 new brands, of which 20 of them arrived on shelves in 2012. In 2013, Ulta launched Lipstick Queen, St. Tropez Self Bronzers, and Perricone MD's skincare line, among other new products. Besides driving higher foot traffic and stronger customer loyalty, Ulta's emphasis on newness helps to position it as the go-to-destination for shoppers.

If you can buy a product at most retailers, you will not be compelled to visit a particular retailer. Hence, Ulta's ability to secure key products for exclusive release and/or sale at its stores becomes another key differentiator. For example, CoverGirl's new Flamed Out product line introduced in June this year, which includes mascaras and shadow pots and pencils, was available exclusively at ULTA Beauty. In April 2012, the CK One Color Cosmetics line was also launched exclusively at Ulta.

Prudent financial strategy
As of the end of the second quarter of fiscal 2013, Ulta remained debt free. Most retailers in the consumer discretionary space have gotten themselves into trouble by loading up their balance sheets with debt in aggressive bids to expand when things are going well. When the economy and consumer sentiment turn southwards, these companies find themselves laden with both on-balance sheet (bank loans) and off-balance sheet (operating leases for stores) debt. In addition, Ulta has generated positive operating cash flow for the past eight years. This suggests that it has no problems funding future store growth from internally-generated funds. 

Looking ahead
Ulta continued to gain momentum in both new product launches and new store openings in the second quarter of fiscal 2013. New launches in the quarter included IT Cosmetics, Jane Cosmetics, Mally Girl, and Meaningful Beauty. If you have any doubt about consumers' receptiveness toward Ulta's 'newness' push, look no further beyond its membership numbers. The number of members signed up with Ulta's loyalty program increased about 19% year-over-year to 12 million active members.

Ulta is also on track with its new store expansion plans. It opened 33 new stores in the second quarter, which brings the cumulative number of stores added year-to-date to 61. This is close to half of Ulta's full year 2013 target of 125 stores, representing approximately a 22% increase in square footage.

Peer comparison
Ulta's peers include Sally Beauty and Walgreen .

Sally competes with Ulta in the salon services & products space. Unlike Ulta, which is largely retail focused, Sally derived about 38% of its fiscal 2012 revenues from professional stylists and salons. This unique customer mix has been the key driver of Sally's gross margin expansion from 44.2% in 2003 to 49.5% in 2012. Most salons and barbershops are small private businesses that buy beauty supplies on a just-in-time basis, which allows Sally the ability to exert pricing power over them. Apart from its margins, Sally's top line growth has been equally impressive. Sally has increased its revenues in almost every single year for more than two decades, from 1990 to 2012.

However, Sally's recent financial performance has been less than impressive. It registered a mere 0.7% growth in comparable store sales in the third quarter of fiscal 2013. Lower foot traffic from non-Beauty Club Card in U.S. stores members was a key contributing factor. This raised concerns that Sally's marketing strategy has been too member-focused at the expense of the broader customer base. Furthermore, Sally's high gearing, with its debt accounting for more than a third of its market capitalization, is another potential red flag for investors.

Walgreen is the U.S.' largest drugstore chain and it has increasingly positioned itself as a health and beauty specialist retailer in recent years. Walgreen's success in the beauty space has been no surprise, given the fact that the lines between the various retailing formats are blurring. Consumers no longer see supermarkets as places for groceries alone, or drugstores as stores purely selling drugs. Walgreen has capitalized on the customer's 10-20 minute wait for medicine in drugstores to cross-sell other beauty-related products and services. Walgreen's Look Boutiques, an in-store upscale beauty boutique concept, had its first boutique opened in 2009, and they now compete with Ulta's stores in the prestige and mass beauty products segment.

Notwithstanding, I will not advise investors to buy into Walgreen as a proxy for the specialty beauty sector. An investment in Walgreen comes with its own set of risks pertaining to drug retailing. There has been increasing pressure to cut prescription drug costs and reimbursement rates from pharmacy benefit managers, government agencies, and health maintenance organizations. In contrast, a pure play beauty retail business like Ulta tends to be surprisingly recession resistant.  Beauty supplies are typically small ticket items which make up a small proportion of the family budget, which makes consumers less likely to stop purchasing these items in recessions.

Ulta has allayed my concerns over issues with most retailers in the consumer discretionary space, which pertain to lack of differentiation and aggressive debt funded store expansion strategy. Ulta sets itself apart from its competitors by focusing on 'newness' and 'exclusivity' in its merchandising strategy. At the same time, it has also minimized its financial risk by relying on operating cash flow to fund its new store openings. 

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Mark Lin 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.

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