In the second quarter of 2024, renowned investor Warren Buffett made a rare move by investing in a beauty stock - $Ulta Beauty  (ULTA.US)$ .

According to the 13F report, Buffett's Berkshire Hathaway bought 690,106 shares of Ulta, valued at $266 million.

Ulta Beauty was a strong performer in the U.S. stock market. But this year, its stock price fell 45% from its peak before the news, making it one of the worst performers in the S&P 500 index.

Why did ULTA's stock drop so much this year? What did Buffett see in this beauty stock? What can we expect in the future?

This article will help answer these questions.

Why did ULTA's stock drop so much this year?

Ulta Beauty is a U.S.-based beauty retail chain that went public in 2007. It is currently one of the largest beauty retail brands in the country, with almost 1,400 stores nationwide.

Unlike traditional beauty stores, Ulta sells both high-end and mass-market products, offering a wide range of choices. Additionally, Ulta provides various salon services, giving beauty consumers a unique experience.

Another highlight of Ulta is its strong membership rewards program (Ulta Beauty Rewards), which offers cashback points. This has significantly enhanced member loyalty, with 43 million members by the end of 2023.

These factors fuelled Ulta's rapid growth, with sales revenue increasing from $755 million in fiscal 2007 to $10.21 billion in fiscal 2023. Ulta's stock price has also surged, climbing from just over $30 when it first went public to a peak of $574.76, making it a standout performer in the market.

However, maintaining its leading position in the industry is not easy. In 2024, Ulta faced several challenges, causing its stock price to drop from a high of $562.8 to a low of $318.17. The main reasons are:

1. Increased competition: Ulta faces significant competition in the cosmetics retail market, particularly from its main rival, Sephora, owned by LVMH. Sephora's new strategy of opening around 1,000 'store-in-store' locations within Kohl's has pressured Ulta's market share and stock performance.

2. Slowing market growth: In April, Ulta's management observed a slowdown in the global cosmetics and luxury markets, lowering Ulta's annual revenue growth forecast to 3-4%, with an estimated fiscal 2025 revenue of $11.5 billion, which is more pessimistic than the 5% market expectation.

Why did Buffett buy ULTA?

Buffett's investment strategy typically favors companies with competitive advantages, good management teams, and reasonable valuations.

According to Wall Street analysts, Buffett's reasons for buying Ulta may include the following:

1. Relatively low valuation: Ulta's stock price declined this year, making its valuation relatively low. The Price-to-Earnings (P/E) ratio is a common metric for measuring valuation. When Ulta's stock price dropped to $318, its P/E ratio was 12.31 times, much lower than its three-year average of 20.59 times.

2. Shareholder returns: Ulta is prioritizing shareholder returns, announcing a $2 billion stock buyback plan in March, with $1.8 billion still available as of early May. This focus is supported by consistent free cash flow, which exceeded $800 million in four of the past five years.

3. Large membership base: The cosmetics retail industry has relatively low entry barriers, so Ulta's moat lies in its large membership base, which continues to grow. The company's membership has increased from 6 million in 2007 to 44.2 million last year, with member spending accounting for over 95% of total sales.

4. Defensive nature amid economic weakness: This year, concerns about economic weakness potentially reducing consumer spending have led to weak stock prices for many consumer goods companies, such as Nike and Lululemon. However, cosmetics are a unique category, possibly more resilient during economic downturns due to the "lipstick effect." While consumers may cut back on big-ticket items, the demand for affordable luxury items could boost, making Ulta's wide range of products less affected by economic pressures.

What to watch next?

Buffett's initial investment in Ulta is very small, only 0.1% of his portfolio, and we can't infer his strategy from this alone. We'll need to see if he buys more Ulta shares in the future.

Investors should also monitor Ulta's fundamentals for improvements. If revenue growth rebounds and earnings exceed expectations, the stock price could rise.

From a technical analysis perspective, Ulta's daily stock chart shows an "M-top" pattern, usually suggesting a possible downward trend. At one point, Ulta's stock price broke below a key level called the "neckline." However, after Buffett's investment news came out, the stock price started to bounce back.

The $375 neckline might act as a resistance level, so investors can watch in the short term whether Ulta's stock price can break through and stay above this level.

Additional Disclosures: This content is also not a research report and is not intended to serve as the basis for any investment decision. The information contained in this article does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Furthermore, there is no guarantee that any statements, opinions or forecasts provided herein will prove to be correct.