December 13, 2023
At Fairlight we scour global markets for the highest quality businesses, which typically means companies displaying a long track record of high returns on capital, organic revenue and earnings growth, and low leverage. Generally, retailers have not met our quality hurdles given the competitive intensity of the industry, low margins and fickle nature of their customers. However, a recent portfolio addition, Ulta Beauty has managed to build an unusually deep competitive advantage (in the retail industry) based on its differentiated culture which has led to some exceptional financial outcomes. Over the past two decades Ulta has compounded revenues at 17% p.a. and earnings at 28% p.a. while generating cash returns on capital invested over 30% and operating margins approaching 15%.
Dominant US beauty retailer
Ulta is the largest distributor of beauty products and services in the US with 1,400 stores spread across mainly suburban areas. It is the only retailer with a product offering that crosses all beauty categories and price points, from mass to luxury. Ulta boasts one of the largest loyalty programs in the US with over 42m members (45% more members than Starbucks), which represents >95% of customer spend. Beauty shoppers are attracted to Ulta’s omni-channel one-stop-shop, consolidating their highly fragmented shopping baskets into one purchase that earns loyalty points instead of inefficient shopping missions spread across many brands, retailers and distribution channels. Ulta stores aim to delight and engage guests, providing an environment to explore trends, discover and trial new products, seek expert advice and receive salon treatments in-store.
In addition to exceptional financial performance, what makes this beauty retailer shine is a true people-first culture, providing a moat we believe is widening over time and difficult for competitors to replicate. Given its intangible qualities, culture as a source of competitive advantage can be notoriously challenging to measure and is therefore often ignored by investors. As the research process progressed, it became evident to Fairlight that Ulta’s alignment of corporate values with a special customer experience has produced remarkable (and measurable) outcomes including accelerating store productivity and attractive financial returns.
People-first culture with leading retention
While every corporation has a set of values listed on their website, Ulta’s corporate behaviours and actions clearly demonstrate a culture that is permeating all organisational levels. Values of diversity and inclusion are modelled by top leadership where the Board and the C-suite are majority female-led and racially diverse. A culture of care and acceptance is elevated within formal communications, prominent in strategic planning, and reinforced by recruitment policies, where candidates are assessed for fit based on shared values.
Embedded within Ulta’s culture is the importance of upholding the store associate, recognising their pivotal role in facilitating a positive store environment that is inclusive and non-intimidating, and promoting the corporate mission, “all things beauty to everyone”. Leadership is constantly asking “how can we support associates in delivering the best store experience for the guest?”, so they feel valued and empowered. Corporate associate retention of 91% and store associate retention of 62% clearly demonstrate the tangible benefits of the company culture. Ulta’s success in retaining employees is particularly noteworthy where retail peers report associate retention rates of 40% given the transience and impermanence typically observed in the sector. During COVID management also opted to reinvest in its employees by awarding store associates a “discretionary appreciation bonus” in recognition of outstanding performance during the pandemic.
Ulta’s product offering also demonstrates its corporate values, a core example being Ulta’s commitment of 15% of assortment sourced from Black-owned and founded brands. Further, Ulta eschews the traditional retail commission-based remuneration, training associates to recommend products without bias in a way that is uplifting rather than judgemental. Humanity and respect permeate all levels of the organisation including corporate, product and store, supporting associates to feel authentic about their own experience, which is then reflected in a welcoming store experience where customers love to shop.
‘Cultural flywheel’ produces customer loyalty
“People are obliged to give back to others in the form of a behavior, gift, or service that they have received first” – Robert Cialdini
Cialdini is revered in psychology and finance for delivering important lessons in human behaviour. The lesson of reciprocity can be translated to the corporate level – when a company treats employees with care and respect, they often reciprocate by demonstrating loyalty and exceptional work ethic. Resulting service outcomes are likely to provide positive utility to customers, who in turn are more likely to reciprocate with increasing spend. Reciprocity becomes circular, and in the case of culture it can provide a source of moat that is difficult for competitors to replicate.
Where “helping others” is the baseline at Ulta, reciprocation can occur fluidly across the organisation, and the people-first culture supports associates feelings of value, acceptance and empowerment. A “cultural flywheel” is produced, where associates’ are well-positioned to create an engaging, inclusive and positive store environment. In turn, Ulta’s guests have reciprocated driving consistent traffic growth, membership growth and retention, ultimately translating into high store productivity, sales and market share.
The connection between superior corporate cultures and high ROIC has been examined in recent academic studies. In 2023, The Wharton School studied 2,900 constituents of the MSCI and found over a three-year period, employers with employee-focused cultures are associated with a 4.0% higher ROIC on an absolute basis than counterparts who do not. In 2018, Tudor Investment Corporation’s proprietary research demonstrated that over a five-year period, companies that look after staff and customers, and produce quality products, typically earn an average 7% higher ROIC and heavily outperform those that don't.
The Fairlight View
Given our high hurdles for business quality, it has been rare that a consumer-facing retail business has been considered for portfolio inclusion. However, it is our view that Ulta Beauty has built a sustainable competitive advantage based primarily on its differentiated people-first culture which has led to the exceptional financial performance of the past two decades. Similar results can be observed in a handful of customer-facing, large cap compounders, such as Costco and Home Depot, who have built unique corporate cultures that underpin wide moats and superior financial performance. While culture can be difficult to analyse, it is clear to us that the very best companies can leverage an advantage in culture to deliver excellent shareholder returns over the long term.