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How the Bears and the Bulls Missed Ulta’s Ugly Transformation

Neither the bulls nor the bears were happy last week when Ulta Beauty (NSDQ: ULTA) fell $37. Short interest in the stock equaled a measly 4% of shares outstanding, a measure of how few bearish bets were wagered against the stock before the quarter. The bulls were left scratching their horns, wondering if the stock would ever bounce back to prior highs.

For the past three years, Ulta Beauty Inc. has been a poster child for momentum investors. Every quarter, revenue and earnings beat analysts estimates. Comp store sales, a measure of how much sales at stores opened for more than a year changed, clocked in slightly higher than expected and guidance was increased.

Management held a conference call with analysts where they expounded on ULTA Beauty’s unique and relevant format and positioning.

Analysts fawned over impressive profit margin growth and expansion of the company’s loyalty program and offered the perfunctory congrats.

Post quarter, analysts increased estimates and the stock obediently rose.

Somewhere along the line after the company reported its March quarter, this sequence fell apart. When the quarter was reported, all went according to script. Management provided the expected bullish commentary, and the stock jumped $22 to $302. All seemed fine as the stock went on to hit an all-time high of $314 in early June.

Then the story line falls apart.

Mid-June an analyst from Guggenheim initiated Ulta’s stock with a neutral rating. I’m not privy to all the details of the report, but a neutral rating on a stock market darling raises the hair on the necks of bulls. He did note the heightened risk of a premium valuation on a stock with high expectations.

Brick and mortar retail stocks started collapsing. One by one, they were flattened by Amazon. The announcement of its purchase of Whole Foods pulverized many consumer goods stocks. Then a rumor of an Amazon partnership with Violet-Grey, a beauty editorial site surfaced.

Yet, the Ulta bulls raged on.

Between the date of its first quarter announcement up until three days before the company’s second quarter earnings date, no fewer than five industry analysts stepped up to recommend the stock.

Here are a few of their taglines:

“Ulta Reaction to Violet-Grey Overdone”

“Ulta Share Pullback a Buying Opportunity”

“Ulta Upgraded to Conviction Buy”

And my favorite:

“Management Meetings Confirm High-Level Rock Solid Story”

My guess is the key word in that last quote is that qualifier, high level. The lower details of how the company would continue to beat comp store sales estimates and earnings were definitely getting murkier.

As with most momentum stocks, only after they start limping, do investors start listening to the bears. On August 21, just three days before Ulta reported its second quarter, Stifel analyst Mark Astrachan, one of the few with a hold rating, cut his price target to $270 after “numerous data points suggest U.S. beauty category growth slowed in 2Q17”. The analyst noted commentary from cosmetic customers such as Macy’s and Sephora, and beauty product manufacturers such as L’Oréal and e.l.f. Beauty as well as scanner data.

The analyst stated, “slowing trends in makeup and mass-priced products are more notable for Ulta as we estimate each category separately accounts for approximately 50% and 40% of sales, respectively”.

The company reported a quarter almost exactly as expected except its comp store sales growth. It missed internal estimates by a hair, something unacceptable for an expensive momentum stock. In addition, estimates for the current quarter were muted, and management admitted that comp store sales had been sacrificed for higher profit margins. This development is bad news. It means the once unstoppable story of higher sales propelled without discounts is coming to an end.

I’m not blaming the bulls or the bears. I myself, missed this short play. I’d been looking for a bearish angle on the stock but was worried the numbers weren’t yet falling apart. It’s alway hard to be bearish on a stock that’s already fallen 33% from its high, but I’ll be following each plot twist in the name.  I’m not sure how this story ends, but my guess is that the next few chapters will be more Frankenstein than Cinderella.

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