Here's Why Beauty Stocks ULTA and ELF Attract Top Funds

Ulta Beauty, a key player in the beauty retail sector, primarily competes with LVMH's Sephora. Unlike Sephora, Ulta positions itself as a more cost-effective option with a wide price range of products, making it resilient to economic downturns and appealing to a broad customer base.

For the second quarter of fiscal 2024 ending May 4, Ulta Beauty reported a 3.5% increase in sales to $2.73 billion, while profit fell 9.8% to $313 million, with a gross profit of $1.07 billion. The company forecasts full-year sales for fiscal 2024 to be between $11.5 billion and $11.6 billion, with comparable sales expected to grow between 2% and 3%.

Ulta's stock has been under pressure this year due to recession concerns, which have led to a decline in discretionary consumer stocks. Increased competition in the beauty retail sector has also resulted in more discounts and promotions, raising investor concerns about potential margin erosion and slower growth. Prior to Berkshire's disclosure, Ulta Beauty had been among the worst performers in the S&P 500 this year, with shares down 32%.

William Blair analyst Dylan Carden notes that Berkshire Hathaway typically invests in companies that have been hit hard but possess competitive advantages, high free cash flow yields, excellent management, and a focus on shareholder returns.

Long-term, Ulta Beauty's fundamentals remain strong with robust cash flow. As the largest specialty beauty retailer in the U.S., Ulta operates approximately 1,400 stores and offers around 25,000 products. Its loyalty program boasts over 40 million active members. Since 2009, the company's earnings per share have increased 60-fold, and it regularly repurchases shares. Ulta Beauty is also one of the few retailers to expand nationally without incurring debt, with $525 million in cash on its latest balance sheet. Analysts estimate it will generate about $1.1 billion in free cash flow this year.

In the short term, competitive pressures on Ulta are expected to ease. DA Davidson analyst Michael Baker points out that Ulta continues to gain market share in the mass cosmetics category. He believes that Sephora's momentum in opening about 1,000 "shop-in-shops" within Kohl's Corp. stores has largely subsided, suggesting that Ulta may no longer face significant market share erosion.

Additionally, Ulta's valuation is notably appealing, with a price-to-earnings ratio of 14.7, positioning it in the 3rd percentile of its five-year range and significantly below the industry average of 20.86. Berkshire Hathaway typically prefers to purchase stocks with a P/E ratio below 15. For instance, it acquired Apple in 2021 at a P/E ratio of 14 and IBM in 2011 at a P/E ratio of 13.5.

Unlike Ulta, e.l.f. Beauty is a brand renowned for selling affordable and trendy cosmetics. The company has shown exceptional performance, achieving 22 consecutive quarters of sales and market share growth as of the June quarter (the first quarter of fiscal year 2025). In the June quarter, the company reported revenue of $325 million, a 50% increase year-over-year, with a market share gain of 2.6%. Over the past four years, its annual sales have grown at a compound annual growth rate of 38%.

ELF's competitive pricing and keen understanding of market demand are key factors behind its success. The company's products are typically priced at about one-third of other beauty products. By manufacturing in countries like China, where costs are lower, and using minimalist packaging, ELF maintains a gross margin of 60-70%, comparable to beauty giants like L'Oreal.

Moreover, the company excels in social media and online marketing, directly engaging with consumers to gather feedback. This approach not only reduces marketing costs but also enables the development of products better aligned with consumer needs.

Thanks to its robust performance, ELF has also excelled in the capital markets, with its stock price surging over 880% since 2020.

Elf Beauty shares dropped over 25% in two sessions after its August 8 earnings report, driven by disappointing guidance. The company raised its fiscal 2025 forecast to between $1.28 billion and $1.3 billion, indicating 27% growth, down from 77% in fiscal 2024. It also projected Q2 adjusted EBITDA margins in the "low teens," a significant drop from last year's 28%.

JPMorgan sees the recent earnings-driven selloff as a buying opportunity. Jefferies echoed this view in a research note, stating that the 20% decline in Elf Beauty shares since August 8 is overdone, creating an attractive entry point.

Elf's stock rebounded over 9% in two consecutive sessions following Baillie Gifford's announcement on Wednesday of increased holdings in the company.

Over 90% of institutions currently rate Elf as a buy, with an average target price of $235, representing a 47.6% upside from last Friday's closing price of $159.2.

Elf's current P/E ratio stands at 76x, significantly higher than the industry average of 27x and at 50% of its five-year historical range. The high P/E ratio signals market confidence in the company's rapid growth but also poses a valuation risk if that growth slows.

As consumer spending tightens and the trend toward downgrading consumption becomes apparent, cost-effective purchases demonstrate greater resilience. Cosmetics, as an affordable and accessible source of joy, tend to benefit during economic downturns. Ulta Beauty Inc. and e.l.f. Beauty Inc. meet these criteria. The fundamentals and valuations of these stocks vary significantly, making the choice dependent on individual investment strategies.