This ridiculously cheap Warren Buffett stock could make you richer

Warren Buffett once told investors to “be fearful when others are greedy and be greedy only when others are fearful.” That’s why it was alarming when Buffett’s Berkshire Hathaway (BRK.A -1.17%) (BRK.B -1.27%) began selling many of his top positions — including Apple and Bank of America — in recent months and has increased its cash holdings to a record high.

This change suggests that the market is overheated and heading for a pullback. It wouldn’t be too surprising, since S&P 500 it trades only about 3% below its all-time high and looks historically expensive at 22 times forward earnings.

Image source: Getty Images.

However, Berkshire still bought some shares as it pared back its other holdings. One of these stocks is the cosmetics retailer The ultimate beauty (ULTA -0.32%). In the second quarter, it bought 690,106 shares of Ulta for $266 million at an average price of about $406. That’s equal to 1.5% of Ulta’s stock and represents 0.1% of Berkshire’s portfolio.

Warren Buffett has yet to make any money from the new investment. But at $380 a share, its stock still looks ridiculously cheap at 15 times forward earnings — and it could bounce back once the market heats up again.

Ulta Beauty’s Business Model

Ulta Beauty went public in 2007 and carved a niche for itself with its in-store salon services, a wide range of high-end to low-end products, partnerships with popular brands such as Kylie Jenner’s Kylie Cosmetics, and campaigns of social media marketing targeting younger customers. It also quickly opened new brick-and-mortar stores as it expanded its loyalty program.

Unlike LVMHhis (LVMUY -0.20%) Sephora, which has been tied to JC Penney’s dying stores and struggling malls for years, Ulta has been opening large standalone stores. It also opened several shop-in-shops in Aimhis stores for the past three years.

From fiscal year 2007 to fiscal year 2019 (which ended in February 2020), Ulta’s revenue grew at a robust compound annual growth rate (CAGR) of 19%. Its gross margin expanded from 31.1% to 36.2% and net income grew at a CAGR of 32%. It has increased its total number of stores since the end of the year from 249 locations to 1,254 locations.

So why did the bulls retreat?

Ulta suffered a major slowdown during the peak of the pandemic as it temporarily closed brick-and-mortar stores and people bought fewer cosmetics. However, it continued to open new stores throughout this slowdown in fiscal 2020.

The company quickly recovered in fiscal 2021 and 2022 as those headwinds dissipated, and its gross margins expanded both years as it opened even more stores. But in fiscal 2023, its comparable-store sales growth slowed to single digits, gross margin contracted and its real expansion slowed slightly.

Data source: Ulta Beauty.

Ulta mainly attributed this slowdown to inflationary headwinds and a tougher promotional environment. At the end of fiscal 2023, it predicted that in fiscal 2024, its comps would grow 4% to 5%. But it reduced that guidance in the last two quarters, and now expects that decline 0% to 2% for the whole year. Analysts expect its revenue to remain roughly flat.

As its top-line growth slows, Ulta plans to step up its own promotions and increase investment in new store openings, remodeling, IT infrastructure and supply chain. The pressure is expected to squeeze its gross and operating margins, and analysts expect earnings per share (EPS) to fall 10% for the full year. That’s why Ulta shares have retreated more than 30% since hitting a record high of $567.18 in March.

Why is Warren Buffett investing in Ulta right now?

Ulta faces near-term challenges, but should heat up again as the macro environment improves. It’s still solidly profitable, carries no interest-bearing debt, and launched a new $2 billion buyback plan (compared to a current market cap of $17 billion) in March. It had $1.6 billion left in that authorization at the end of the second quarter.

Ulta ended the quarter with 43.9 million Rewards members, up 5% from a year earlier, and continues to open new brick-and-mortar stores. That expanding foundation could make it a great discount to its current valuations — so investors should heed Buffett’s example and buy this unloved retail stock.