On August 15, 2024, Berkshire Hathaway, the investment company led by Warren Buffett, revealed its second-quarter holdings, sparking intrigue among investors with the unexpected addition of Ulta Beauty (referred to as "ULTA"). Traditionally, companies involved in the cosmetics business have seldom graced Berkshire's investment portfolio, making this move particularly noteworthy.

Berkshire acquired approximately 690,000 shares of ULTA, which translates to around $266 million, equating to just 0.1% of its total portfolio valueThis allocation hints at a mere observation position rather than a significant investmentHowever, for value investors, the mere fact that Berkshire has engaged with a company like ULTA compels a deeper examination.

What makes Ulta Beauty a subject of fascination is its operational prowess

Positioned as the largest beauty retailer in the United States, ULTA provides salon services alongside a diverse range of beauty and hair productsIt boasts an impressive inventory of over 25,000 products across more than 600 brandsOperating primarily within the domestic market, ULTA has established a robust physical presence with 1,385 stores nationwide, predominately in mid-sized cities and suburban areasThis allows ULTA to capture a significant 9% of the American beauty products market share, dwarfing its closest competitor, Sephora, which holds a mere 6%.

The company's remarkable growth trajectory is evident when examining its financials since going publicULTA's revenue surged from $755 million in 2007 to a staggering $11.207 billion by 2023, while net profit followed suit, jumping from $23 million to $1.291 billion over the same period

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This impressive growth translates to a compound annual growth rate (CAGR) of 18.4% for revenue and an astonishing 28.6% for net income—an outstanding performance save for the downturn during 2020 due to the pandemic.

What stands out further is ULTA's profitability, reflected in its return on equity (ROE), which has skyrocketed from about 16% at the time of its IPO to an impressive 60.91% by the end of 2023. Such figures suggest that ULTA's net profit growth consistently surpasses its net asset growthNotably, the company implemented only one modest dividend payout of $62 million before 2012, primarily choosing to reinvest profits—which has evidently yielded high returns and echoes the company's operational excellence.

The investment community has reaped substantial rewards from ULTA, as its market capitalization has ballooned from about $1.9 billion at IPO to a current valuation of $19 billion, while its price-to-earnings ratio has plunged from an exorbitant 83x to a more palatable 15.7x.

Central to ULTA's success is its exceptional customer experience

The company operates under a “one-stop” beauty retail model, adeptly catering to a wide array of beauty-related needs in a single locationIts business strategy can be likened to the concept of “IKEA for beauty.” ULTA employs several strategies to achieve this goal.

First, the majority of ULTA stores are located in suburban areas or small towns where rent is lower and store sizes are larger—averaging around 974 square metersIn contrast, Sephora's store locations are often upscale and centrally positioned, averaging around 500 square meters.

This strategic choice of expansive operational space allows ULTA to feature a remarkably extensive assortment of products and servicesIn its stores, customers can find over 20,000 SKUs, covering virtually all popular beauty products, with rapid turnover that poses a challenge for smaller competitors

Additionally, ULTA offers products in a wide price range, catering to consumers of all demographics.

Second, ULTA boasts a robust loyalty program, with member counts reaching 43.3 million by the end of 2023—accounting for nearly 25% of American womenIn contrast, Sephora's global membership stands at approximately 34 millionImpressively, sales from loyalty members comprise 95% of total sales, indicating exceptional customer loyalty.

Finally, ULTA’s integration of beauty salons transforms the shopping experience into a more entertaining engagement, providing customers with an array of value-added services while enhancing brand loyaltyCustomers utilizing salon services often show a higher propensity to try new products and exhibit increased visit frequencies compared to typical shoppers.

Ultimately, ULTA's focus on delivering a high-quality shopping experience has fostered a loyal consumer base, solidifying its competitive edge.

Nevertheless, the road ahead may not be without challenges

On August 29, 2024, ULTA released its second-quarter financial report, highlighting net sales of $5.278 billion in the first half of the year—a modest 2.2% year-over-year increaseHowever, net profit fell by 12.59% to $566 million, demonstrating the impact of reduced gross margins and rising operating expenses.

In the realm of chain retail, comparable store sales serve as critical indicators of performanceAn analysis of ULTA's comparable store sales growth over the past five years paints a clearer picture of the company's current environment.

Since 2019, ULTA has maintained a rapid expansion in store openings, with a five-year compound growth rate of around 2.5%. Not even the pandemic could stifle this growthFrom 2021 to 2023, however, net sales growth slowed to 40.3%, 18.28%, and 9.78%, respectively

When stripping out the impact of new store openings, comparable sales growth figures reflect a concerning trajectory: 37.9%, 15.6%, and 5.7%.

These figures indicate a trend of deceleration in same-store performance despite ongoing expansion efforts.

Delving further into the components, from 2021 to 2023, ULTA's sales growth figures showed a gradual decrease: 30%, 10.8%, and 7.4%, while the growth of average transaction value ebbed from 6% to 4.3%, eventually dipping to -1.5%. By the second quarter of 2024, both sales and average transaction value witnessed declines of 1.8% and a marginal increase of 0.6%, respectively.

This slowdown in growth can be attributed not just to high base effects but also to waning foot traffic and stagnating transaction values

Customer influx primarily relies on new product releases; in light of a sluggish consumer market, ULTA's strategy has been to expand its SKU offerings while accelerating the introduction of new products, emphasizing cost-performance advantagesThis approach explains the revenue growth amidst declining average transaction values.

The underlying challenge stems from intense competition in the beauty retail landscapeULTA’s market share faces constant threats, compounded by a cautious spending environment fueled by high inflation in the United States.

Amidst these challenges, CEO David Kimbell has stated that the company is proactively addressing issues in five key areas: enhancing product assortment, leveraging social media for influencer marketing, improving digital experiences, boosting member loyalty, and establishing promotion activities.

Despite ULTA’s current performance headwinds and the resultant plummet in share prices, which have driven its valuation down to historical lows, Berkshire has potentially found its opportunity to invest

Buffett’s oft-quoted philosophy of “be fearful when others are greedy and greedy when others are fearful” seems to be exemplified in this investment.

What could have attracted Buffett to ULTA? Several factors may come into play:

First, ULTA’s beauty retail business aligns with Buffett’s preference for straightforward, sustainable business models that reflect minimal volatilityIts operations form a crucial segment within his zone of competence.

Buffett’s past investments reveal a pattern of favoring retail businesses with similar supply chains, including the likes of Nebraska Furniture Mart, Jordan’s Furniture, and jeweler Helzberg Diamonds, not to mention later larger investments such as Walmart, Costco, and Home Depot

The core factor behind their success lies in their ability to provide consumers with high-quality, reasonably priced products.

Second, ULTA showcases a remarkable historical performance and boasts considerable future potentialFounded in 1990, the company has consistently demonstrated astonishing growth capabilities and innovation.

Buffett places significant emphasis on companies’ competitive advantagesWhile the retail industry is not without its challenges, requiring robust management to innovate and build differentiating barriers, ULTA’s 33 years of operational history attests to its capability to do soHence, Buffett appears unconcerned about transitory declines in performance.

Moreover, the beauty market is vast and relatively fragmented

In 2023, Sephora’s global revenue approximated $16.1 billion, yet ULTA amassed $11.2 billion in U.Ssales alone, suggesting that there is ample growth opportunity if it ventures internationally.

Third, ULTA's commendable financial metrics and low valuation are compellingA key financial gauge for Buffett is ROE, which stood at 60.91% in 2023, while its price-to-book ratio lingered between 7 and 8 times, reflecting yields of 7.6% to 8.7%. Against the broader context of high valuations in the U.Sequity market, ULTA seems increasingly undervalued.

Furthermore, the company reports strong free cash flowAfter its swift expansion in earlier years, ULTA's capital expenditures surged but have since declined significantly, with free cash flow reaching $960 million in 2023—indicating a solid net profit quality

Furthermore, with current annual capital expenditures of around $400 million dwarfed by revenue levels exceeding $10 billion, this signifies a business model favored by Buffett that does not require substantial capital outlay for continued growth.

Lastly, ULTA has been consistently engaging in stock repurchase initiativesSince its IPO in 2007, ULTA’s total shares have shrunk from approximately 56.7 million to 47.11 million by the end of August 2024. As of March 2024, the board authorized a new buyback plan capped at $2 billion, having already repurchased $480 million worth of shares and 1.1 million shares thus far.

Buffett values the strategic buybacks undertaken during periods of undervaluation, which not only showcases prudent capital allocation but also emphasizes management’s commitment to enhancing shareholder returns.

In conclusion, ULTA serves as a compelling case study for Buffett's investment philosophy amidst its various attributes warranting close observation