Warren Buffett surprised investors with his recent purchase of Ulta Beauty (NASDAQ: ULTA) stock. A cosmetics stock seems like an unlikely buy for a portfolio heavy with financial stocks and old standards, but Ulta fits the Buffett model quite well. Let's see why, and if Ulta might be a good pick for you, too.
Ulta isn't really a surprising Buffett pick
Buffett-led Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) opened a new position in Ulta stock in the second quarter with a purchase of 690,106 shares. These shares are worth more than $260 million and account for a 1.4% stake in the company, although they account for only 0.1% of Berkshire Hathaway's equity portfolio.
Ulta is a chain of beauty stores, and I say beauty rather than cosmetics because it has a niche model that's fairly all-inclusive of beauty products and services. It stands out from other cosmetics and beauty companies in two important ways, which gives it the competitive edge that's important to Buffett when he looks for great businesses .
One way Ulta differentiates itself is by offering a broad range of products at different price points. This includes mass brands, historically sold at cheap prices in pharmacies, luxury labels that are usually found in fancy department stores, and indie brands, typically sold through direct-to-consumer channels. Even competitors like LVMH 's Sephora, which feature a similar take-yourself model with many brands under one roof, don't have the breadth of Ulta's massive stores.
The other way Ulta stands out is through its services. It doesn't only offer makeup, skincare, and haircare products, but it also offers an array of salon-style services. In fact, it's making the services more of a priority by having "salon takeovers," where some of its upscale brands "take over" Ulta's salons for a limited time and present the opportunity to try out their products through Ulta salon services. This creates an upward growth cycle, since customers who come in for services also end up buying products.
Ulta is run by a strong management team that uses its capital wisely, another point that Buffett cares about. Its return on invested capital is one of the best in retail, at 57.8% in the fiscal first quarter (ended May 4) and ahead of companies like Home Depot and Costco .
Why is Ulta stock down?
Something else that Buffett cares about is valuation. He steers clear of overvalued growth stocks and tends to buy stocks that are trading below their intrinsic value.
Ulta stock trades at a price to earnings (P/E) ratio of less than 15, although it had reached a three-year low of 12.5 before the news of Buffett's buy lifted it. This is still below the price Buffett paid for it, so you can still call it a bargain.
But if Ulta has so many positive qualities, why is it down 25% this year? That underperformance is mostly due to the economic environment. Growth has decelerated and margins are pressured, and some of its metrics and guidance have come in lower than Wall Street was expecting, which is often a signal to send the price down. Revenue increased about 3.5% in the first quarter, with comparable sales up only 1.6%. It lowered full-year guidance for sales, comparable sales, operating margin, and earnings per share.
But is it really so bad?
Ulta offers luxury and mass brands, so consumers might be switching down, even though they're still shopping at Ulta. In that way, its differentiated model shields it in uncertain times. It has a membership program and incredible loyalty, with 95% of sales coming from rewards members. It's not so different than market-favorite Costco, which reported higher traffic but flat average ticket as shoppers switch down or delay expensive purchases.
That's why Ulta is a bargain and not a value trap. Its high-growth days might be over, but it's still opening new stores and has long-term growth drivers in the loyal beauty enthusiasts that it targets. It's a no-brainer buy at this price.
Before you buy stock in Ulta Beauty, consider this: