For Ulta Beauty, E-commerce Growth Is a Double-Edged Sword

Investors want to know why Ulta Beauty (ULTA 0.13%) -- once a retail darling and high-flying stock -- is down 25% from its all-time highs.

In this segment from Industry Focus: Consumer Goods, the team discusses the major pillars of Ulta's successful retail model: the Ultamate Rewards loyalty program and a strong e-commerce business.

A full transcript follows the video.

This video was recorded on April 17, 2018.

Vincent Shen: The square footage for these stores, you mentioned about 10,000 square feet on average for an Ulta location, about 10% of that dedicated to the in-store salons and salon services that they offer. I realize that we bring up square footage pretty often when talking about these brick and mortar retailers, and it can be hard to contextualize that number. So just to give our listeners an idea, 10,000 square feet is a little bit bigger than your typical Apple Store.

The layout of these stores, as you mentioned, Asit, allows the customer to have an exploratory experience. They think a lot about the format and how that can impact the customer experience in store and how that drives sales. And with the approximately 1,100 stores that they currently have in their network, in 2018 they're expected to see another 100 openings, so they're still opening new locations at a pretty rapid pace. Management believes that overall, the U.S. can sustain about 1,700 locations, so you have an idea there of the long-term runway that this company has in mind, in terms of their store expansions.

Then, going back to that Ultamate Rewards Program, because it's a really powerful part of the story for this company, it's something that was called out specifically in our show last summer as one of the strong points for the company. You mentioned the 28 million customers, how over 90% of the revenue for this company comes from its Ultamate Rewards members. It reminds me a little bit of how important, for example, Prime members are to Amazon. I see some parallels here, because members of this loyalty program provide the company with a lot of data, a lot of analytics. And it gives the company a greater opportunity to offer something they've described as personalized one-to-one service to each member of the program. And as we discussed last week with Estée Lauder with skincare and cosmetics, these product categories and this space, they really thrive and benefit from that high-touch service. And it wasn't surprising to hear during the last earnings call that management is going to be investing more at Ulta in its workforce and their training to provide the higher-level service that customers appreciate, if not expect, for certain prestige brands and products.

Something else that really came up as a strong aspect for this company in that prior episode when we talked about Ulta, again, was going back to e-commerce. The revenue for that channel grew about 65% in their fiscal year 2018, accounting for about a tenth of the top line. It seems to be accelerating very quickly. I think for the fourth quarter specifically, it was 14% of the top line. And it's not massive, but still a very significant, important driver of overall growth for the company, and they actually hit that 10% milestone, in terms of their e-commerce digital channel, about two years ahead of schedule. That channel is now expected to make up a larger part of the revenue than management had originally thought that it would.

There is a bearish side to this. We know that all these brick-and-mortar retailers right now are racing to grow their digital capabilities. That channel does come, sometimes, with its own basket of problems. So for Ulta, the growing e-commerce business is often cited as a headwind for the company's profitability, the issue there being that the online store is typically more promotional, it's also less profitable overall than the brick-and-mortar channel. So that e-commerce growth has contributed to the company's declining margins, and that trend is likely to continue moving forward as a company. Overall, the company has abandoned the goal that they set a few years ago of reaching a consistent 15% operating margin. Right now, it seems like they're settling for something closer to about 13%. So it's interesting to see how e-commerce, as important as it is, can be kind of a double-edged sword at times. On this show, Asit, we've often praised companies for growing that channel, but I don't think we've addressed enough the fact that the problems that Ulta experiences with reduced profitability in e-commerce is common to a lot of other retailers that we talk about, too.