Aug. 18, 2024 at 8:00 am ET

Ulta Beauty sells everything from mass-market beauty products to luxury cosmetics and fragrances found at department stores. Photo: Bing Guan/Bloomberg News

Berkshire Hathaway’s BRK.B 0.83%increase; green up pointing triangle Warren Buffett has famously advised investors to be greedy when others are fearful. This past week, the company scooped up shares of Ulta Beauty ULTA 3.12%increase; green up pointing triangle, which landed in the discount bin after spooking the market. The stock still looks cheap.

Ulta Beauty is an off-mall, large-format retail chain (a typical store is about 10,000 square feet) that sells everything from mass-market beauty products to luxury cosmetics and fragrances one might expect to see at department stores. Its shares have jumped 15% since Berkshire Hathaway disclosed in a filing post-market close on Wednesday that it held about $266 million worth of the retailer’s shares at the end of June.

Ulta Beauty, which was founded in 1990, and LVMH-owned Sephora, which opened its first U.S. store in 1998, changed the way customers shopped for makeup. Before their entry, shopping for beauty products typically happened at department stores, where a lot of items were locked up behind the counters and trying anything on involved an interaction with a store employee, says Simeon Siegel, equity analyst at BMO Capital Markets. Ulta Beauty and Sephora freed up that experience, opening up samples so that customers could try everything on without needing to ask for help, though they do have employees who can provide assistance if shoppers need it.

The retailer certainly has the business fundamentals that value investors would like. Despite being a relatively mature business, it has increased its top line at a compound average growth rate of 11% over the past five years. It also has an attractive margin profile, largely thanks to lower rents and operating costs that come with its off-mall presence, according to Siegel. Its operating margins are close to 15%—roughly double that of a composite of retailers that are part of the S&P 500 and comparable to off-price retailers such as TJX Cos.

Ulta has a healthy balance sheet and has been an effective capital allocator: Its return on invested capital has averaged over 26% over the last five years, above Costco’s 18% average. It has a fairly diversified product range, both in terms of price range and category, which means it isn’t as vulnerable to one-off beauty trends or a change in economic conditions.

While the company’s shares soared in the self-care obsession-fueled postpandemic years, they took a big hit in March after the company gave full-year earnings guidance that fell just a touch below Wall Street expectations. They gradually edged even lower after Ulta Beauty lowered guidance again in late May. But the market reaction did seem outsize compared with the actual numbers: Before Berkshire Hathaway’s disclosure, Ulta’s shares had dropped 42% since its March earnings call. Yet earnings-per-share expectations for the current fiscal year have only declined about 5% and revenue expectations are just 1.4% lower, according to analysts polled by FactSet.

The tricky part, of course, is figuring out how much fear is actually warranted. Ulta Beauty does have some real threats on the horizon: The retailer said in its late-May earnings call that it lost market share in prestige brands, noting that “more than 1,000 new points of distribution” have opened in the past two years. Much of this is probably referring to Sephora, which has opened up inside more than 900 Kohl’s KSS 2.76%increase; green up pointing triangle department stores since 2021 and will end the year in more than 1,000 Kohl’s stores. Another emerging threat is Amazon.com, where luxury cosmetic brands have been broadening distribution.

Newsletter Sign-up

Markets P.M.

Agenda-setting analysis and commentary on the biggest corporate and market stories from our Heard on the Street team.

Ulta’s heady growth days are probably behind it: In the 2010s, the retailer added about 100 stores every year, but that has slowed to 30-50 in recent years. The company sees a runway for 1,500 to 1,700 more stores in the U.S.

Nevertheless, the format itself seems to have a built-in moat against online and direct-to-consumer selling: Makeup and fragrance is a category that shoppers want to try out, and preferably with variety across different brands. Ulta’s supply-chain scale, relationships with vendors and a good pipeline of exclusive partnerships (its latest includes a Kylie Jenner fragrance) are difficult to replicate, according to a recent report from Oliver Chen, equity analyst at Cowen. Importantly, it has a very loyal base of customers. The sales headwind from the aggressive Sephora additions should subside somewhat by 2025, when Kohl’s is expected to have opened a Sephora in all of its 1,100-plus locations.

Even after the recent bump, the company’s shares trade at about 14 times forward-12-month earnings, 44% below its 10-year average. It is among the cheapest retailers in the S&P 500 on that measure, only slightly more expensive than beleaguered electronics retailer Best Buy.

That is a very attractive price for a still-growing retailer with a lot of inner strength and a few surface-level blemishes.