If beauty is in the eye of the beholder, investors found the recent IPO of Ulta Salon (ULTA) an exquisite jewel. The stock was offered to the public on October 25 which was a less than noteworthy day on the market. While the deal price was $18.00, investors bid the price of the stock to a close of 29.82 (up 66%) the first day of trading. A few more days of gains saw the stock hitting an intra day high of 35.60 before beginning its current consolidation.

Traders appear to be enamored with the transition in the cosmetic industry from the large department store model to more dedicated retailers who specialize only in beauty products. ULTA currently has 211 stores in 26 states each with roughly 10,000 square feet of retail space. Most stores include a salon so not only is the company generating revenue from its products, but it is also pulling in a decent amount of sales from the services offered. More importantly, the salon operates as a marketing tool by showing customers the importance and distinctions of the product selection in a hospitable environment.

Management has placed great emphasis on building their stores to create a pleasant and refreshing environment. New employees are taught the importance of “the four ‘E’s” to build an attractive customer shopping experience:

1. Escape – departs from the traditional commission oriented sales approach
2. Education – well trained professionally licensed consultants
3. Entertainment – live demonstrations, customer makeovers, in-store videos
4. Esthetics – easy to navigate stylish stores

While Wall Street was eager to welcome ULTA and quickly placed a pricey multiple on the stock, there are a few things that any investor should be concerned about and at least keep on the radar. The first is the fact that the company has a significant amount of debt on the books. As of the end of the second quarter (Aug 2), the official figure was $55 million. While this number has dropped due to some of the IPO proceeds being applied to debt, it will likely ratchet back up quickly as management proceeds with its aggressive store opening plans. The company has adequate financing in place to open about 2 years worth of stores, but the interest expense could become difficult if margins are compressed. The rate on the line of credit is fairly attractive and the company has managed to enter an interest rate swap to fix $25m at a rate of 5.11%. Still this debt may linger as a risk until cash flow from operations can grow enough to pay down a good bit of this liability.

The other concern involves distribution of the company’s products. While ULTA is currently operating out of one distribution facility, plans are in place to open a second location which should ease the logistical stress. It is important for management to execute well on this front if they will be successful in their expansion plans. In short, 2008 will be all about execution and if the company is able to navigate the growth gracefully we will likely see the stock appreciate tremendously.

At this point, investors should pay close attention to management comments and earnings releases for any indication as to how actual growth is meeting expectations. There is no sell side coverage at this time which presents both an opportunity and a risk. Investors must do their own homework and ascertain what risk and potential rewards are involved in owning the stock. On the other hand, this is precisely the type of situation that rewards those who are able to understand the fundamentals before Wall Street fully uncovers the story.

ULTA Notes

FD: Author has a long position in ULTA