In a surprising move, Warren Buffett added cosmetic retailer Ulta Beauty (NASDAQ: ULTA) to Berkshire Hathaway 's portfolio in the second quarter. Buffett isn't afraid to own retailers in his portfolio, holding Walmart shares for over 20 years before exiting the position in 2018. However, it has not been a big focus of his in recent years.
The only other retailers currently in Berkshire's portfolio are e-commerce giant Amazon and flooring and tile retailer Floor & Decor . Buffett also previously owned home furnishings retailer RH , but sold out of the stock at the end of 2022.
Let's look at what might have attracted Buffett to Ulta's stock.
1. Depressed valuation
Berkshire was picking up shares of Ulta on the cheap in the second quarter -- during this period, Ulta stock was down 33% year to date. Of course, it has seen a bit of a jump since news broke of Berkshire's purchase, but the stock is still off by about 20% on the year, and it currently trades at a forward price-to-earnings (P/E) ratio of 13.
ULTA PE Ratio (Forward 1y) data by YCharts
That's a big discount from the multiple the beauty retailer has traded at in the past few years. Buffett and his team love a bargain and they clearly thought Ulta's stock had gotten placed on the discount rack.
The stock has been pressured this year largely due to increased distribution, both in-store and online, from prestige brands. This caused Ulta to reduce its sales and operating margin outlook for the year. However, the investment team at Berkshire must feel these current headwinds are manageable.
2. A resilient and growing category
The beauty category as a whole continues to grow nicely. The category saw rapid expansion the past three years, and growth is expected to continue, although at a more moderate pace. For its part, Ulta expects the category to grow in the mid-single-digit range this year. As the largest specialty beauty retailer in the country, Ulta benefits from this category growth.
At the same time, beauty has historically also been one of the most recession-resistant categories. This phenomena has become to be known as the "lipstick effect," which was first discussed by economic and sociology professor Juliet Schor in 1998 in her book The Overspent American. Schor noticed that during periods of economic stress, women would splurge on small luxuries such as lipstick. This theory has held up in a number of recessionary periods since, including during the Great Recession, when cosmetic sales increased as other categories such as clothing saw sale declines.
During the pandemic, this spending shifted more toward moisturizes and fragrances since people were wearing masks, but the spending stayed within the beauty category. Amid recent signs of the consumer starting to weaken, spending on fragrances and lipstick have both shot up. According to data from Adobe , online fragrance sales were up over 19% from January to May of this year, while online lipstick sales soared over 37% during the same period.
3. The category leader
One of the hallmarks of Ulta's business model is that it sells beauty products across a wide spectrum of prices, offering both luxury, prestige, and mass-market brands in a single store. This gives it one of the best assortments for shoppers, while also being able to serve customers across income demographics.
It also attracts younger customers to its stores and allows them to trade up to prestige brands as they begin to earn more income, as well as for customers to mix and match between mass and prestige categories. For example, it wouldn't be out of the ordinary for a customer to buy a high-end skincare product while at the same time buying her favorite lipstick from e.l.f. Beauty . In fact, according to Circana, over 90% of prestige beauty brand buyers also purchase mass products, while 35% of mass buyers will splurge and buy a prestige brand. At Ulta, they can do this all within the same store.
4. Ramping up growth
Despite experiencing some near-term headwinds, Ulta has a number of levers it can pull to help ramp up growth. The company has one of the strongest loyalty programs in the retail space, with 95% of its sales coming from loyalty members. This gives the company a tremendous amount of data to help direct additional advertising and promotions toward its customer base.
At the same time, while prestige distribution has increased, there is no other retailer that can offer the assortment that Ulta does across beauty categories. Ulta is also adding new and popular brands, with plans to add at least 25 new brands to its assortment this year. It also plans to amplify its social media presence and increase collaborations to help drive traffic to its stores and online.
And while the company is not rapidly growing its store base, it is still looking to add between 60 to 65 new locations this fiscal year. That's still between 4% to 5% growth in its store count, which is solid.
Image source: Getty Images
Overall, it is easy to see why Buffett and his team were attracted to Ulta. With the stock still inexpensive, it's not too late for investors to buy shares too.
John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Geoffrey Seiler has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Adobe, Amazon, Berkshire Hathaway, Ulta Beauty, Walmart, and e.l.f. Beauty. The Motley Fool recommends RH. The Motley Fool has a disclosure policy .
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