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Sally Vs. Ulta: The Perfect Hedge?

Posted: Oct 22, 2009 11:16 AM by Will Ashworth

Tickers in this Article: PJM, MED, LUX, ACV, ULTA, SBH

Women like to look good. So much so, they spend $75 billion annually on beauty products and salon services. Naturally, with this much money at stake, the competition is intense. Two specialty retailers duking it out in this hotly contested space are Sally Beauty Holdings (NYSE:SBH) and Ulta Salon, Cosmetics and Fragrance (Nasdaq:ULTA).

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Both seem to be holding their own in this economy, but beauty is in the eye of the beholder. Under the surface lies the possibility for the perfect long/short hedge. Why don't we see which is which?

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Latest Results
Highlights in the third quarter for Alberto-Culver (NYSE:ACV) spin-off Sally Beauty include same store sales growth of 2.6%, adjusted earnings per share up 23.1% to $0.16 from $0.13 and operating margins growing by 90 basis points to 12.2%.

Over at Ulta, same store sales were down 1.7%, earnings per share were up 67% year over year and operating margins increased 80 basis points to 3.7%. Based on these latest results neither seems to qualify as a short at this point. We'll need to dig deeper.

A Huge Amount Of Debt
Checking out both companies' balance sheets, Sally's total debt at the end of June was $1.7 billion. Hardly consoling, management stressed that it paid off $30 million during the quarter. At these levels, that's a rounding error. The company needs to do better. Fortunately, for existing shareholders, almost $1 billion of the outstanding debt is at interest rates between 2.25-4.75%. If interest rates rise, watch out below.

Ulta on the other hand is sitting pretty with just $66 million in debt, quite the contrast. Now do we have the makings of a long/short hedge? Possibly, although you won't believe who the short is.

Cash Flow Is King
A casual glance at Ulta's business model when compared to Sally's might suggest it's on sounder financial footing given its significantly lower debt levels. That would be a false assumption. Yes, its debt levels are lower, but so too are its profitability and cash flow. Based on the trailing twelve months, Ulta's free cash flow yield is 5.2% versus 13.8% for Sally.

In terms of free cash flow margins, Sally wins again by 290 basis points, 7.4% to Ulta's 4.5%. If that's not enough, just look at their latest quarterly operating margins. Sally's were 850 basis points higher. Further, Ulta made $72 million in capital expenditures in the trailing twelve months to generate $50.2 million in operating income. Sally, on the other hand, spent $36.1 million to generate $291.7 million in operating income. In the last four fiscal years, Ulta made $316.7 million in capital expenditures compared to $181.5 million for Sally. That's almost double the spending to generate far less cash.

Although Sally inherited a great deal of debt in its spin-off, it's a more profitable business than Ulta and should be able to manage interest payments in the future. In my opinion, though it may be contrary to the majority position, Ulta appears to be the weaker of the two. A look at its stock price may seal the deal.

Specialty Retailers YTD

Company	YTD Returns
Ulta Salon (Nasdaq:ULTA)	110.0%
Sally Beauty Holdings (NYSE:SBH)	31.3%
Luxottica (NYSE:LUX)	47.7%
Medifast (NYSE:MED)	324.8%
PowerShares Dynamic Small Cap Portfolio (NYSE:PJM)	11.86%

YTD Stock Returns
Those who short stocks take into consideration how much a target has appreciated in a given period, perhaps looking for those overbought gems prime for the taking. Year to date, Ulta's stock is up an impressive 110%. Compare that to 31.3% for Sally. Ulta's appreciation likely provides enough margin of safety to warrant a short, although it's close.

If my decision were based on price alone, a more likely short candidate would be Medifast (NYSE:MED), the weight-loss company, whose stock sits at an all-time high and is up 343% this year. Medifast has come a long way in a few short years but it isn't a $25 stock.

The Bottom Line
While it appears a case can be made for a long/short hedge with Sally long and Ulta short, in the end, I won't recommend making this trade. A more compelling argument can be made for a long position with Sally and another company as a short, like Medifast. (For more, see Commodities: The Portfolio Hedge.)

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By Will Ashworth

Will Ashworth lives and works in Toronto, Canada. He's worked in and around the financial services industry for much of his adult life. He loves investing and is passionate about helping others learn how to put their money to work.

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