Warren Buffett transformed Berkshire Hathaway into a global giant through strategic acquisitions and wise investments. Despite historically avoiding technology stocks, Berkshire surprised Wall Street in 2016 by disclosing a stake in Apple (1.16%). Even more unexpected were the subsequent purchases that turned Apple into its largest holding.
Last year, Buffett described Apple as a “better business” than any other owned by Berkshire. However, great businesses do not always translate into smart investments. In the second quarter, Berkshire sold 389 million Apple shares, reducing its stake by half, and initiated a small position in the lesser-known Ulta Beauty (-0.32%).
To clarify, Berkshire still commits 30% of its stock portfolio to Apple, though this marks a significant decrease from 51% in the same quarter the previous year. Also noteworthy is that less than 1% of the portfolio is allocated to Ulta, distinguishing it from long-standing investments.
Here’s what investors should understand about these stocks:
1. Apple
In the third quarter of fiscal 2024, ending June 29, Apple delivered strong financial results. The company not only surpassed overall sales and earnings estimates but also exceeded sales expectations across every major product category except Macs. Revenue rose 5% to $85.8 billion, gross profit margin increased by 174 basis points, and GAAP net income climbed 11% to $1.40 per diluted share.
Looking forward, Apple is well-positioned to sustain this momentum, with a strong foothold in various consumer electronics markets, including personal computers and smartphones, and a significant presence in several service areas. Apple operates one of the fastest-growing advertising businesses and leads the mobile app store market. Last year, the App Store’s revenue was more than double that of Alphabet’s Google Play Store.
However, Apple faces several challenges. The Digital Markets Act in Europe requires it to support third-party app stores, potentially undermining its dominance. Additionally, Apple has lost so much smartphone market share in China (its third-largest market) that it no longer ranks among the top five vendors. Moreover, iPhones account for 45% of total revenue, yet the company has not surpassed the iPhone sales record set in the first quarter of 2022.
Furthermore, although Apple commands significant brand authority in consumer electronics, it has not launched a new viral product since AirPods in 2017. Without innovation, Apple may struggle to surpass mid-single-digit sales growth. Earnings might grow faster due to the company’s historical investment in stock buybacks, but growth reliant on share repurchases signals limited prospects.
None of these issues are deal-breakers per se. The primary concern is the disparity between Apple’s growth prospects and its current valuation. Wall Street anticipates earnings growth of 8.6% annually over the next three years, which makes its valuation at 33.5 times earnings seem exorbitant. This results in a PEG ratio of 3.9, significantly above the three-year average of 2.6. Such a high valuation might explain why Warren Buffett reduced his stake in Apple.
2. Ulta Beauty
Ulta operates over 1,400 stores in the United States, offering around 25,000 products ranging from mass-market to high-end items from approximately 600 brands. In recent years, Ulta has secured a leadership position among U.S. beauty retailers through store openings, effective marketing, appealing loyalty benefits, and e-commerce investments.
Ulta’s second-quarter financial results were disappointing. Revenue grew by less than 1% to $2.6 billion, and same-store sales declined by 1%. Meanwhile, the gross margin shrank by 100 basis points, and GAAP earnings fell 11% to $5.30 per diluted share. Management also lowered its full-year outlook, forecasting a 1% decline in revenue and an 11% drop in earnings.
According to a recent note by Morningstar analyst David Swartz, Ulta’s underwhelming performance and guidance are attributed to competitive pressures, primarily from the rapid expansion of Sephora stores within Kohl’s locations. However, he believes the company will recover, forecasting Ulta will expand its store base by about 20% over the next decade while achieving same-store sales growth of about 4%.
Despite facing challenges, Ulta’s stock is more reasonably priced than Apple’s. Wall Street expects Ulta’s earnings to grow at 9% annually over the next three years, making its current valuation of 15 times earnings fair. This results in a PEG ratio of 1.6, slightly above the three-year average of 1.5.
I believe patient investors can follow Berkshire’s lead and invest in a small position in Ulta stock today. However, small is the operative word. I would start with no more than 1% of my portfolio and strategically increase my position during market pullbacks. Investors should remember that Ulta has not outperformed the S&P 500 over the past three and five-year periods.
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