Greenberg: Putting Lipstick on Ulta

SAN DIEGO (TheStreet) -- The saga continues: No stranger to readers of this blog or my Reality Check newsletter, where it has long been red-flagged, Ulta Salon's (ULTA) stock is one of the most confounding among retail stories. 

Its shares have remained remarkably resilient, even in the recent rout, as CEO Mary Dillon made the rounds with New York analysts this week to discuss the company's makeover. It's not that the company, in the midst of a strategic review, is broadcasting that it is making widespread changes.

But in his report earlier this week reiterating his "outperform" on Ulta, after hosting investor meetings with Dillon, analyst Gary Balter said he was impressed with her plans to "reinvest in infrastructure, brand positioning, marketing and customer relationships..."

In other words, a costly makeover that even Balter concedes "is on improving results over the next five years, not on the quarter."

Investors, of course, give lip service to being patient for long-term results, but aside from Amazon (AMZN) (where patience may be wearing thin) they rarely do.

Ulta, for example, has been suffering from sluggish traffic as it appears its customers are shifting to lower-margin purchases online. Among the changes, the company is testing a smaller store format. Of course, that flies in the face of what the company was supposed to be -- "a beauty superstore." That's how it described itself in its 10-K until the last 10-K, from last April, where the word "superstore" disappeared.

But perhaps more troublesome is this: What was it that Dillon saw that caused her to shift her assessment of the company shortly after taking the job?

On her first earnings call, in September, she said, "We have a solid long-term growth strategy."

A quarter later: "We are also focused on the long-term view and are currently conducting an in-depth and future-focused strategic planning process to align and prioritize our growth strategies, as well as the additional investments we will need to make to remain a high-performance and high-growth Company."

Whatever she found, it appears she is trying hard to distance herself from her promotional predecessor, Chuck Rubin, who moved to privately held Michaels Stores

Among the things she may have stumbled on include the company's quiet use of uniform capitalization accounting. As one analyst who tracks the company explained, "Unicap (as it's called) is a legal but seldom used accounting convention that allows a company to capitalize some everyday business expenses such as a buyers' salary into inventory, allowing a growing company to overstate current reported EPS."

It works in the company's favor as long as business and inventory is growing; it backfires when the growth stops, which results in slowing inventory growth -- leading ultimately to one less lever that can be used to inflate earnings.

When I asked the company about it last September, for a piece I never wrote, a spokesman from an outside PR firm (after consulting with the company) responded:

Unicap accounting is a GAAP accounting rule widely used by retailers that requires a company to capitalize the expenses related to acquiring the inventory, and expense it as you sell through that inventory.

Would I be able to share some other retailers who use unicap accounting to show that is typical to use this sort of accounting method?

That I wanted to see, because I knew few companies used it -- and those that had tended to ultimately have nasty surprises. Among them, West Marine  (WMAR) and Warnaco (which was acquired by PVH  (PVH) last year).

A few days later, after hearing nothing, I received this:

We have been making attempts to get information from ULTA's auditors to get their view on how widespread unicap accounting is amongst their client base.

That's because it's not. 

Which gets back to the question of what Dillon saw?

Obviously, it appears somewhere along the line she was delivered the bad news that earnings growth had been artificially propped up. And she must have realized that the superstore concept for cosmetics had limited potential.

"And I would bet," says one longtime bear, "she is now better understanding that for prestige brands the supplier sets the price and thus no one has a price advantage and thus much of the prestige business is largely dependent on service, and in the mass market Ulta is the price laggard versus drug stores."

Reality: Not a pretty picture. Inventory per store is still growing (the good news) but total inventory growth has started to decelerate (bad.) Margins are already showing signs of stress and with Unicap-gone-bad stories that often means inventory write-downs are a quarter or two away. Wall Street, no doubt, wants to give Dillon the benefit of the doubt. But even as she prepared to unveil a five-year plan, it simply may not be enough to cover up the blemishes as they start to show.

-- Written by Herb Greenberg in San Diego

Herb Greenberg, editor of Herb Greenberg's Reality Check, is a contributor to CNBC. He does not own shares, short or trade shares in an individual corporate security. He can be reached at herbonthestreet@thestreet.com.

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