Ulta Beauty, Inc.
Q2 2014 Earnings Call Transcript

Published: 12 Sep 2014

[Operator:]

Greetings and welcome to the Ulta Beauty Second Quarter 2014 Earnings Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Ms. Laurel Lefebvre, Vice President, Investor Relations. Thank you. You may begin.

[Laurel Lefebvre:]

Thank you. Good afternoon and thank you for joining us for Ulta Beauty's second quarter 2014 conference call. Hosting our call are Mary Dillon, Chief Executive Officer, and Scott Settersten, Chief Financial Officer. Also joining us are Janet Taake, Chief Merchandising Officer, and Dave Kimbell, Chief Marketing Officer. Before we begin, I'd like to remind you of our company's Safe Harbor language. The statements contained in this conference call which are not historical facts may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual future results may differ materially from those projected in such statements due to a number of risks and uncertainties, all of which are described in the company's filings with the SEC. During this call we make references to the metrics free cash flow, a non-GAAP financial measure defined as cash provided by operating activities, minus purchases of property and equipment. I'll now turn the call over to Mary.

[Mary Dillon:]

Thank you, Laurel. Good afternoon everyone. We're delighted to announce very strong second quarter results and to share the outcome of our updated strategic plan and financial targets. I'll talk about our long-term vision, five-year financial targets, and strategic imperatives today, then following up with more detail at Analyst Day in Chicago next month. First, a quick review of the second quarter headlines. We grew the top line 22% and drove the best comp we've achieved since the second quarter of 2012. Total company comparable sales were 9.6%, on top of an 8.4% comp in the second quarter of 2013, both including the impact of Ulta.com. Strength in Prestige and Mass cosmetics, boosted by some very successful new products and brands, as well as rapid growth in e-commerce, drove these exceptional results. We are pleased to see transaction growth contribute more than ticket growth to our same-store sales. Solid gross margin performance reflected strong sales of Prestige and professional healthcare categories, coupled with fewer discounts compared to a year ago. Earnings per share grew 34%, with strong flow-through from better-than-expected sales, healthy product margins, and some benefit from the timing of marketing expenses. Scott will discuss the second quarter in more detail and the outlook for the rest of 2014 in just a few moments. Now I'd like to walk you through a review of our strategic planning process and our new five-year financial targets. As a reminder, we set out several months ago to refresh our strategic plan. This process was led by me and my full senior team. We formed a fact-based, guest-centric and total enterprise view of the guest experience that we want to deliver in the future, and determine what is required to do so. We feel confident about the opportunity to continue to drive growth and guest satisfaction in the years ahead. Our approach was to understand Ulta's current strengths and opportunities and then project guest needs, the potential competitive set, and the omni-channel landscape of the future. We defined Ulta's path from the perspective of brand positioning, guest experience, product and services portfolio, and store and e-commerce expansion plans. We also projected the IT and supply chain requirements to achieve our strategy, then consider the financial impact of all those factors to establish a five-year plan that delivers sustainable growth and strong shareholder returns. To summarize the primary outcomes of this work, we've identified six strategic imperatives as the foundation of continued strong growth. We've identified areas of focus and investment that give us confidence that we can maintain strong top and bottom-line growth rates. We developed a five-year financial model to support this strategic framework. And finally, we developed a capital allocation strategy. We think about the strategic plan as evolutionary, not revolutionary. At the outset, we recognized that our core business model is strong. The original insight of our founders that women want a shopping experience that reflects the entire range of her beauty purchases is still very relevant today, almost 25 years after the first store opened. So the core of what Ulta is all about is not changing. This is about sharpening our view and getting even more focused on delivering a relevant and differentiated business model that drives sustainable profitable growth. In fact, we believe many of the key drivers of our past results still have plenty of runway and will continue to deliver, namely new store growth, expansion of our Prestige assortment, a strong, compelling loyalty program, a clear guest target, a woman we refer to is a beauty enthusiast. She represents about half of the spend in the beauty category, she's highly engaged in newness and discovery, a highly differentiated offering, with an unmatched breadth of assortment across categories, brands and services, and rapid e-commerce growth. We also agreed on key opportunities we want to focus on to ensure long-term sustainable growth. And those include increasing Ulta's brand awareness and acquiring more new customers, becoming less reliant on discount and overtime in a careful and measured way, and developing the omni-channel capabilities our guests expect us to offer to keep pace with the marketplace. Examples of these capabilities will include ordering in store and delivering to home, and checking availability of inventory online, as well as others. We established our vision for the future of Ulta, to be the unmatched beauty authority, by providing women a compelling, unique and on-trend array of products and experiences. We aspire to become the favorite beauty destination, the most loved and admired by our guests, associates, communities, partners and investors. Supporting this vision, we articulated six strategic imperatives that we believe will drive sustainable growth for Ulta. One, acquire new guests and deepen loyalty with existing guests. Two, differentiate by delivering a distinctive and personalized guest experience across all channels. Three, offer a relevant, innovative and often exclusive products that excite our guests. Four, deliver exceptional services in three core areas

[Scott Settersten:]

Thanks, Mary. Good afternoon everyone. Second quarter sales were $734.2 million, compared to $601 million last year, an increase of 22.2%. Comparable sales increased 9.6%. The retail-only comp was 8.3%, with the follow-on [ph] business comping slightly higher at 8.4%. E-commerce growth of 54.9% added 130 basis points to comp. We were very pleased with the balance between transaction and ticket increases, with transactions up 5.8% and ticket up 3.8%. The ticket increase was driven by a modest increase in units per transaction, but mostly by higher average selling price due to strength in Prestige categories and less discounting overall. Retail-only comparable transactions increased 5%, a significant acceleration compared to the first quarter. Since we're spending quite a bit of time on this call discussing the strategic plan and long-term financial targets, we thought we would share a condensed version of our usual discussion of our business drivers. From a real estate perspective, we opened 19 stores during Q2, ending the quarter with 715 stores. We also completed four remodels. New store productivity remained strong, and we're also seeing solid comps in our more mature stores, as all classes of stores are benefiting from the momentum in new brand and product launches. On the merchandising front, newness continues to be a major driver of our business. After rolling out It cosmetics and Mally to every store during the first quarter, these new brands were solid contributors to our growth. We are also pleased with the success of our chain-wide expansion of Urban Decay, and excellent results in our Clinique, Lancome and Benefits boutiques. Exciting new product launches during the quarter included an innovative liquid foundation from Bare Minerals, a highly anticipated eyeliner to complement Benefits, best-selling [indiscernible] mascara, as well as new fragrances like Armani C and Marc Jacobs Daisy Dream. To update you on our loyalty program and CRM, we now have 14 million active members and are very pleased with the performance of the markets that were converted to the ultimate rewards points-based program in February. Having all customers on one platform allows us to communicate the benefits of the loyalty program more efficiently, and deliver CRM campaigns across the entire loyalty customer base, compared to just half our customers before the conversion. On the marketing side, second quarter highlights included our Love Your Hair event, which we enhanced with content more focused on education and benefits, versus just price promotions. We also saw excellent results from our semiannual event promoting jumbo sizes of hair care products at great prices. Finally, turning to Ulta.com, we continue to see strong performance from our e-commerce business. In July we released exciting new features and functionality to the site, designed to enhance the discovery and browse experience, with the addition of rich editorial content. New pages for Get Inspired, Beauty Consultation and Share & Play, focused on trends, new arrivals, best kept secrets, advice and social content. We added online booking capability for our salon appointments for all stores. We also began to host live chats on Ulta.com, featuring some of our vendor partners like the founders of the brand Carol's Daughter and Tart, which were very well-received by our guests. Finally, we released our first iPad app in July, designed to provide our guests with a unique opportunity to browse, discover and share our products. Turning back to the P&L. Gross profit dollars increased 22.3% to $259.3 million. Gross profit margin was flat year over year at 35.3%, primarily driven by stronger-than-expected sales of Prestige cosmetics and professional healthcare products, as well as a modest rent and occupancy leverage on higher-than-expected same-store sales. This was offset by slight deleverage in supply chain expense due to costs associated with the expansion of e-commerce fulfillment capabilities in our Chambersburg distribution center. SG&A expenses rose 17.4% to $157.8 million, down 90 basis points as a percentage of sales at 21.5% versus 22.4% last year, primarily due to leverage on strong sales as well as timing of marketing spend. We also pushed some of the planned expenses related to test-and-learn initiatives later in the year. About half of our earnings outperformance in the quarter was due to the impact that SG&A expenses moved later in the year. Preopening expense was $3.6 million compared to $4.8 million in Q2 of 2013, driven by 19 store openings during the quarter, compared to 33 new stores opened last year. Operating margin increased 120 basis points to 13.3%, versus 12.1% in Q2 of last year. Net income increased 35.4% to $60.8 million or $0.94 per diluted share, versus $44.9 million or $0.70 per diluted share last year. Earnings per share grew 34.3%. Turning to the balance sheet. Inventories were $541.5 million at the end of the quarter, compared to $461.2 million at the end of Q2 2013, driven by 106 net new stores opened since August last year. Inventories were flat on a per-store basis as our supply chain and store teams continue to keep inventory very clean. Capital expenditures were $55 million for the quarter, driven primarily by our new store opening program, as well as supply chain and IT investments. And depreciation and amortization for the quarter were $31.9 million. We moved $100 million of the cash on our balance sheet to short-term investments, with a maturity of less than 12 months, and as a result ended the quarter with $363 million in cash. Our free cash flow year to date is about $39 million, and we're well on track to generate more than $100 million in free cash flow this year. With a very strong first half of the year under our belt, we are raising our view of our full-year performance. We anticipate comparable sales to increase in the 7% to 8% range, and total sales to increase in the 20% range for the year. We expect that earnings per share will be in the 20% range this year, excluding any impact related to share repurchase activity. We expect to invest about $265 million in capital in 2014. Turning now more specifically to the third quarter of 2014. We expect sales to increase in the range of $724 million to $736 million, versus $618.8 million last year. We expect comparable sales to increase in the range of 6% to 8%. Preopening expense is expected to come in around $7.1 million, with 50 stores planned to open in the third quarter. We expect to achieve earnings per share in the range of $0.79 to $0.84, compared to $0.70 in Q3 of last year. Our tax rate is expected to be approximately 38.2% and our fully diluted share count will be approximately $64.8 million excluding any potential share repurchase activity. With that, I'll turn the call over to our conference call host to begin the Q&A session. Operator?

[Operator:]

Thank you. Ladies and gentlemen, at this time we are conducting our question-and-answer session. [Operator Instructions] Our first question is coming from the line of Mr. Brian Tunick with JPMorgan Chase. Your line is now open, you may proceed with your question.

[Brian Tunick:]

Yes. Thanks very much, and congratulations. Two questions. One, maybe just more color on the SG&A timing shift, how that's changed, and what we should be thinking there. And then maybe on the, Mary, if you could talk about the 1,200-store target. I know in the guidance you talked about 100 stores a year. But just ahead of the Analyst Day I guess, can you talk about sort of it's at least 1,200 in the big format and then small markets can add to that? And does that change as you think about e-commerce becoming 10% of sales? Just curious about what you think long term about the 1,200 store target.

[Mary Dillon:]

Sure, Brian. Thank you. And let me start with the store question. So as I said, you know, we're reiterating that our target has been continue to be, you know, at least 1,200 stores. And that, we think about that as really our current 10,000 square-foot format in our suburban type market. And we'll talk more about this at Analyst Day, but one of the things that we're learning about right now is the small store format that we're opening up two this year. We're going to learn about that. So, you know, given how our stores are performing, we think that's a pretty good target, possibly conservative target. If we find the small format of interest, those would largely be incremental to our 10,000 square-foot format. We're starting those in some rural [ph] markets and in the future potentially urban markets. You know, that would be down the road. You know, new stores continue to be a great investment and they continue to perform. And we think about, relative to our strategic plan, getting more stores is a great way for us to get more guests. Beauty is a business that really is contingent on an experience that is -- that involves the physical experience. And as we see our guest experience in the future being able to delight our guests, obviously stores and e-commerce can work really well together, we think, to deliver on that. You know, our store expansion is always going to be contingent on finding high-quality sites. We have a very robust and rigorous process. But we continue to see plenty of excellent real estate opportunities in the years to come.

[Scott Settersten:]

And as far as the SG&A question is concerned, as we mentioned in our prepared remarks, roughly half of the beat [ph] for the quarter is SG&A related kind of expenses, so, call it $0.05 roughly. You know, half of that is marketing, the other half is test-and-learn. So the test-and-learn program was delayed a little bit, more than what we expected when we gave second quarter guidance. So we thought it was better to wait until we had those projects properly scoped and metrics aligned, so we knew how to measure success with the completion of the test period. And on the advertising and marketing side, these were efficiencies that were identified by our marketing teams that we, in the first half of the year or second quarter, that we expect to redeploy in fourth quarter, to drive smaller new customer acquisition kind of activities.

[Brian Tunick:]

Very helpful. See you in a couple of weeks.

[Scott Settersten:]

Thank you.

[Operator:]

Thank you. Our next question is coming from the line of Daniel Hofkin with William Blair & Co. Your line is now open. You may proceed with your question.

[Daniel Hofkin:]

Good afternoon, and I'll add my congratulations. Just wanted to, first, with regard to the comp, and obviously very strong performance, where are you seeing kind of the most upside across the age of stores? Is it pretty balanced, or is it more newer comping stores? Just that would be my first question.

[Scott Settersten:]

Dan, I would say, you know, the general rule of thumb is, when you have strong performance being driven by these new brand launches and exciting new things that merchants are bringing into the business, it really - rising tides lift all boats in this business. I know I've said that before to many of our investors. I mean you just - it's not a single class of store or vintage of stores, or older stores versus newer stores. It really helps drive productivity in the whole fleet.

[Daniel Hofkin:]

Okay, great. And then with regard to the long term, I find it particularly impressive on the top [ph] sales outlook. Obviously some of that is that the new plan includes e-commerce, whereas I think [indiscernible] three to five did not. But could you comment on what are some of the things that, you know, what are some of the components of that, or, you know, what are the things that you expect to kind of help drive a stronger underlying comp versus --

[Mary Dillon:]

Sure. You know, first of all, we're in a growing industry, right? Especially the Prestige side of beauty has been showing good growth, and we participate heavily in that. As we look at our guests and look at her needs in the future, we believe that there's more market share that we can gain with the beauty enthusiasts and that our insights about how to meet her needs continue to deepen every day. So in that sense we think there's plenty of opportunity for growth. We also know that, we've talked about this, the majority of our current growth is coming from our current loyalty members, which is great. And they love what Ulta has to offer. But an area of opportunity for us is, a big part of our test-and-learn this summer, or this fall now, is about how do we get new guests to become aware of and try or either - or retry perhaps Ulta. So we think about it almost as a relaunch of the Ulta proposition, and again there's plenty of women that are in this consumer segment that we believe would be very attracted to our proposition. So, new guest acquisition, e-commerce growth as you said, store growth, all the six strategic imperatives are largely around driving a different way to drive growth.

[Daniel Hofkin:]

Great. Best of luck. See you guys soon.

[Mary Dillon:]

Thank you.

[Operator:]

Thank you. Our next question is coming from the line of Aram Rubinson with Wolfe Research. Your line is now open, you may proceed with your question.

[Aram Rubinson:]

Thanks so much for taking the question. I wanted to ask you a bit about your current capabilities. We hear a lot about investments a little bit last year, this year, and obviously for the next two. Can you just give us a sense as to what you're capable of today and what you'd like to be capable of, whether it's warehouse management systems or merchandise systems or financial systems or distribution? Just can you give us a little bit of a lay of the land of where you are now with all of these capabilities and what you think you're missing and where you'll be in those couple of years that you can do that you can't do now?

[Mary Dillon:]

Yeah. Well, first of all, Aram, our business is obviously running pretty darn well today, right? So we obviously have some core capabilities that we're using every day to execute the business. What we have identified is a couple of things. One, as everybody knows, retail is changing rapidly in terms of guest expectations. So the omni-channel aspect of our capability is one we need to invest in to grow. We anticipate that the guests in the future is going to want a seamless experience and one that we don't necessarily offer today. It's not a big barrier to our growth, I'd say, as you see the performance that we're having. But we know that that's going to be something that she's going to need to have in the future. So, a more seamless ability to, you know, buy something, you know, bring it back to the store, order in store, have it shipped at home, be able to know in advance what we have in inventory in our stores. So, all those kind of basic shopping and retail capabilities are part of what we'll be investing in. Also, you know, just a part of this investment is really just around growth. As we continue to go down this growth path, which is a strong growth path, and we continue to drive a number of stores, we need more capability in the system. And so that's part of the investment too, which are just pretty straightforward. And also we just think overall end to end we could have a more efficient system than we have today. So, whether it's how we receive our orders and work with our vendors, how our stores are stacked as the product comes in to the stores, there's -- and how we reforecast and replenish, we know that there's ways that we can be smoother, I guess faster, have less out-of-stocks, you know, all those things that we know will just help our business be more a better experience for guests and drive some efficiencies in the long run.

[Aram Rubinson:]

So if I can just drill down into that just a little bit. So I mean, are we on automated replenishment? Do we have some kind of store scheduling for labor? You know, just trying to figure out, we have the space optimization program, do we have price optimization, are all these things kind of totally new or they -- I'm just trying to understand whether you have these capabilities or not.

[Scott Settersten:]

Yeah. You know, I don't know if we want to go through a specific laundry list of what's in and what's out, Aram, but I will say what you described predominantly we don't operate in that kind of environment today. So we've got good systems in our stores, over the last couple of years we've made some investments in store laboring, and we're working on test management in the stores. We're just about ready to finalize our rollout with a new POS system which we think will be best-in-class, kind of check-out experience for our guests. So, again, early stages of that. On the supply chain and the merchandise organization, I think you've heard and I think many of our long-term investors have heard us say that we still do things kind of the hard way. We muscle through a lot of things, that we know factually that there's better, more efficient ways to do that, whether it's forecast and replenishment, which Mary mentioned, and helping our vendors help us forecast the business and get it to our DCs more effectively, and getting it to our stores, right, in the right kind of what I would say delivery mode, boxes or shelf-ready, you know, so that we can take time out of the backroom and get into more guest-facing time.

[Aram Rubinson:]

I appreciate that color. Thank you.

[Operator:]

Thank you. Our next question is coming from the line of Oliver Chen with Citigroup. Your line is now open, you may proceed with your question.

[Oliver Chen:]

Hi. Congratulations on solid results. Regarding the outlook for the gross margin. Your inventories are under really good control at this point. The gross margin comparison, you know, as we look at it, is a little bit harder than easier in the fourth quarter. Is the expectation that you'll be able to keep promotions under control versus last year? And how are you seeing kind of the promotional environment unfold as we approach holiday?

[Mary Dillon:]

Okay. Oliver, thank you. You know, the promotional environment, right, that's -- we expect that as we get into the holiday, there'll continue to be a competitive promotional holiday. I don't think there's any reason that that will, you know, it's always going to be like that, right? The overall sentiment right now, consumer sentiment, is strong, and I think we hear retailers feeling pretty optimistic about their inventory situation going into holiday. But nonetheless, we know that's a competitive time. You know, we're also seeing some success. And again, I would say we're walking before we run, but we're I think every day getting at how we can use some of our tools like our CRM capabilities to be more targeted with our offers and drive value in ways that are less about price discounting. So, you know, would we need to be more promotional than last year, I doubt it. Will it be a promotional holiday? We'd expect that. But we feel, as you can see in our guidance, optimistic about the rest of the year.

[Scott Settersten:]

And Oliver, I would just add, as far as rate goes, again gross profit margin rate overall is flat year to year in the quarter. You may recall, last quarter call we mentioned loyalty program, right? It's still going to be a headwind for us for the rest of the year. There's still some product mix challenges that we had. We did a good job this quarter overcoming some of that, and we have more of that planned for the rest of the year, so we'll do our, you know, do the best we can to make sure we keep that all in balance.

[Oliver Chen:]

Okay. And Mary, on the product side, you know, one of the strategic highlights is the focus on hair, skin care -- skin health and brows. Was that is that consistent with how you had been or are there categories that you may deemphasize as you focus on these three?

[Mary Dillon:]

Yeah -- I'm sorry, go ahead.

[Oliver Chen:]

I was also just curious about, you know, articulating your thoughts on your competitive advantage versus department stores.

[Mary Dillon:]

Sure. Okay. Well, first of all, that strategic imperative actually was talking about services. And actually one of the earlier questions was about levers for growth, and I should have mentioned we do see that our services are absolutely one of the areas that strategically are important to us, to your point, one of our points of differentiation, and we believe an area that we could focus on to drive future growth. Our salon guest -- salon is a small part of our business today, as you know. That's our best guest though. She comes more frequently, she spends more, and she loves the experience. And we've kind of carved out three pillars that we think we can -- we excel in today and can excel in even more in the future. And it's about hair, basically cut and color, and also hair services that involve trends like braids, things like that. On the skin side, as you know, we have a partnership with Dermalogica and we have trained aestheticians in our stores. Small part of our business today in terms of that service. We know that could be -- it will be an area of growth. And then lastly, brows, particularly through our partnership with Benefit and their brow bars. So we look at those three pillars of service as areas that we will focus on and drive [indiscernible] today how to drive more new guests to try our salon and come back. And those often, not as much as I'd like, but often have products attached to them. So you can imagine that's a great flywheel for us. So that's an area that really dovetails I guess with your second question which is, you know, part of the work we do in strategic plan is just really step back and say, what is our competitive advantage today and what would it be in the future? And, you know, it's a competitive industry. Everybody is interested in beauty. It's a growth industry. But we've got advantages that we think we can really push and accelerate. And it is about this total guest experience that we think we'll get even better as we allow our associates in store to have even more guest-facing time, as our, perhaps, our systems get more efficient and some of the ways that Scott described. So, you know, Ulta should be able to give an experience that's very different and unique, different than the department store, different than mass outlets and different than other specialty stores. And that, you know, we plan that that would be kind of our core. We differentiate and we'll lead with that.

[Oliver Chen:]

Thank you. Best regards.

[Mary Dillon:]

Thank you.

[Operator:]

Thank you. Our next question is coming from the line of Gary Balter with Credit Suisse. Your line is now open, you may proceed with your question. Mr. Balter, your line is now open. It appears there's a connection issue with Mr. Balter's line. We'll move on to the next question coming from the line of Matthew Fassler with Goldman Sachs. Your line is now open, you may proceed with the question.

[Matthew Fassler:]

Thanks so much and good afternoon. My first question relates to capital. Obviously you talked about the SG&A impact of some of the investments you're going to make. Can you talk about, as the store growth I guess flattens out, whether the investments that you're making, contemplate, any kind of bump in CapEx? And then also related to capital, you talked about buying back stock at least at the level you'd need to offset dilution. What is the typical dilution you would see in a given year from options issuance?

[Scott Settersten:]

As far as the CapEx question is concerned, we're projecting $265 million for 2014. You know, directionally that might be at a slightly more elevated rate over the next couple of years as we get through the supply chain cycle here event. But we expect it to moderate once we get past 2016, generally speaking. And as far as dilution, or dilution is concerned, we'd expect that to be roughly maybe 1 percentage point, Matt, you could estimate, is what the buyback dilutive offset would be.

[Matthew Fassler:]

Got it. One other quick financial question, then a strategic one. As we think about the $0.05 or so that you deferred from the second quarter to the remainder of the year, should we think about it as being roughly half and half Q3, Q4 based on the comments you made earlier?

[Scott Settersten:]

Yeah, I think that's a good approximation.

[Matthew Fassler:]

Great. And then finally, I think you'll have an extensive strategic discussion in Chicago in a few weeks, but very briefly on mobile, on the -- you piqued my interest and you talked about having the iPad app, which on the one hand I guess you're not the first retailer, on the other hand it speaks to the opportunity. Can you talk about how you think your customer in your category deploys mobile differently than for other retail categories and what you think its potential is relative the online business that you've been doing already?

[Mary Dillon:]

Sure. Well, you know, obviously mobile is a growing part of our business as it is for everybody, and we know that that's increasingly a way that our guests engage with our brand as well as others. Probably one of the biggest opportunities for us with mobile is the ability for her to be learning about content, about brands and products and services, whether she's in our store and not in our store, or outside of our store, as well as for our associates. You know, a part of our technology plan is to allow them to have more access to mobile technology in the stores so that she can be an even bigger expert on every brand that we offer than she is today, frankly, our associates. It's hard to be able to do that all the time. Having more access to mobile information helps get us to the same position that our guests are in. Mobile transactions are continuing to grow as a percentage of our transactions, and we'll expect that to continue to happen.

[Matthew Fassler:]

Got it. Thank you so much.

[Operator:]

Thank you. Our next question is coming from the line of Ike Boruchow with Sterne Agee. Your line is now open, you may proceed with your question.

[Ike Boruchow:]

Hi everyone. Congrats on a great quarter. Thanks for taking my question. Mary, I want to -- can we dive in a little bit on the new marketing -- new customer acquisition side and things you've been doing and tests you've been doing regionally with some new marketing, new CRM capabilities? And then to take that a step further, could you comment on the traffic increase you saw in the quarter and maybe how much of that was new customer traffic and how that compares to the prior couple of quarters?

[Mary Dillon:]

Well, you know what, really at the Analyst Day we'll have more color on some of the tests-and-learns and the experiments that we're doing. There's a couple of different things going on. One is that we have an end-market advertising test that just started in several markets, to see just in a general way, can we drive new customer acquisition through basically driving awareness, through a more mass media and digital media kind of approach? So that's something that just started, and we'll know a lot more about that soon. And that's one way. We know that basically top-of-mind awareness for Ulta is not as high as it can be. And we believe that by driving that awareness and positioning the brand in a way that, you know, we represent, which is this great place for women to discover [indiscernible] beauty, that we think there's upside there. So we'll learn more about that. And certainly, Dave Kimbell and his team are also using our CRM capability to run I guess several small-scale experiments right now around how can we either get, you know, guests who aren't coming as often as we'd like, to see what could incent her to come more often, or using multiple forms of either social marketing to see if we can target new prospective guests to try Ulta. So a lot of that is in process. And we feel optimistic that that'll be part of our growth strategy going forward.

[Ike Boruchow:]

Can you comment -- are you already beginning to see some of the fruits of your labor on new customer acquisition front?

[Mary Dillon:]

You know, most of our sales right now are really being driven by our current guests, and she's coming more often and spending more, which is great. So it's really I'd say early stages. Now our e-commerce business is one of the ways that we are seeing some new customer acquisition, and that again will be an area for growth for us as well.

[Ike Boruchow:]

Got it. Thanks everyone.

[Mary Dillon:]

Thank you.

[Operator:]

Thank you. Our next question is again coming from the line of Gary Balter. Sir, your line is now open, you may proceed with your question.

[Gary Balter:]

Thank you. I'll try again this time. First of all, congratulations. Following up on Ike's question a little bit, Mary, when you first came and met with a lot of the sell side people, one of your concerns was that Ulta isn't as well-known as [indiscernible] and you were trying to figure out, how do we improve that? Obviously you've had great traffic drivers this quarter. As you, without giving all the answers today, October 15th meeting, what's your perception now of Ulta? Do you feel that you've made some nice progress in terms of the customer understanding who you are and have you closed the gap a lot and if you changed your perception of it?

[Mary Dillon:]

Okay. Thank you, Gary. You know, I would characterize that less of a concern that I saw and more of an opportunity, and I still see it today, because I think we're really in the early stages of driving that new customer acquisition. So, you know, most of what we're doing right now, we're refining the tactics that we've used previously, and I think getting even better at them, but they're largely targeted at our current loyalty members, and that's largely where our growth is coming from, which is great. It says that our current guests love us, they're coming more often and spending more, and we're getting growth on e-commerce, and some of that is new guests. But, you know, we believe again why we're confident about the long-term targets that we're providing is that there's still that opportunity. So I would say really, Gary, I wouldn't feel -- I don't think it's very different today in terms of the awareness and sharpness of the perception of Ulta. But we have done the work to identify more insights about our current guests, prospective guests, and how to position and really drive awareness to the brand. And we'll know more [indiscernible] so I don't want to over-promise. You know, we don't know yet what the response will be. But that work is still in process. And we'll know a lot soon.

[Gary Balter:]

Thank you.

[Operator:]

Thank you. Our next question is coming from the line of Neely Tamminga with Piper Jaffray. Your line is now open, you may proceed with your question.

[Neely Tamminga:]

Great. Good afternoon. Just two quick questions [indiscernible] specific here. On the new POS system, what are some of the key functionalities that are making you guys really excited about launching this new POS system? Number one. And number two, what sort of kind of key metrics or problems or KPIs, however you want to look at it, on the e-commerce business are you looking to address over the next couple of years? I mean is it really kind of about, you know, bounce rate, sort of email campaigns? Is it about cart abandonment? Like give us some sense of what you're going to improve on the e-commerce side too? Thank you.

[Mary Dillon:]

Okay, thank you. On the POS front, I'd say a couple of key categories of benefits. One is speed of transaction which we know, you know, there's always a little bit the learning curve, but our associates are, the ones who are using it, love it, and they are seeing the benefits of it. So we know that that'll help speed the transaction, as well it's going to give us the ability to have more information of our guest when she comes in. So over time we believe that that's going to help us to even be more personalized in terms of what we offer her. And so -- and also one of the capabilities is going to be to be able to order in the store and have it delivered to your home. So we think about, for example, on our small store tests, you know, those are smaller stores, not going to carry every single SKU. So the ability for our guests to be able to still have access to everything that we sell will be a benefit as well. Those are just a few of them. Dave, do you want to comment on the e-comm metric?

[David Kimbell:]

Yes, absolutely. You know, as we look at e-commerce, first of all, we're really pleased with the results that we've had so far. We're really just about a year into kind of the relaunch of our site, and really happy with that. And because we're really still relatively new, and there's a lot of foundational pieces that we're really still very much focused on, driving traffic, we continue to have success in getting new customers [indiscernible] customers that come to our site. We saw traffic increase pretty significantly in the second quarter last year through -- this year through sharper, more sophisticated customer acquisition efforts. So we'll continue to do that. You know, our conversion rate through optimization of our site experience, we really significantly improved a year ago, and we're continuing to fine-tune that experience through that check-out process, the way the cart works, we're making improvements to that site experience to make sure we're, as you mentioned, limiting cart abandonment and maximizing conversion. And AOB [ph], as we get -- as we improve our merchandising approach, get learnings about what's working in the e-commerce environment, maximize the understanding of our best guest and how she's experiencing both our brick-and-mortar retail and our online, and personalize and customize our marketing to her, we think we're making progress on AOB [ph] through our merchandising, and we'll continue to do that. So a lot of it's really foundational, and we're going to continue to focus on those efforts going forward.

[Neely Tamminga:]

Fantastic. Thank you. Best of luck.

[Operator:]

Thank you. Our next question is coming from the line of Evren Kopelman with Wells Fargo. Your line is now open, you may proceed with your question.

[Evren Kopelman:]

Thanks. Good afternoon. Two questions. First, on the comp growth, the strong comp growth in the quarter. How -- do you have a sense of how much that conversion of [indiscernible] people to the new loyalty program in the first quarter, how much that is helping traffic this year as people are getting more emails [indiscernible] some things like that? And the second question is on the e-commerce. Can you discuss how you expect the product mix and the margin to evolve over your long-term horizon? Thanks.

[Scott Settersten:]

You know, as far as the comp drivers for the quarter, we -- I guess I will tell you, we're not going to be able to, you know, disaggregate the comp [indiscernible] versus not, or new versus old customer, existing customer. We can say with certainty that typically, historically what we saw when we implemented the loyalty programs, that it took a while for the customers to kind of come back. The sales performance was a little weaker on conversion. And then we kind of cycled back through the course of like a full one-year period, we kind of get the comp back. This time, again hopefully we learned some lessons on our last conversion cycle, this time we've seen sales kind of maintain. So we haven't seen any degradation or any weakness in sales with those people that have been converted. So that was a really great sign for us that the conversion has gone very well. As far as product margin mix is concerned, I think we're talking about 2014, Evren. You know, we talked overall on margin rate, that we still have this loyalty headwind. We will expect to have that forward to the remainder of 2014. We're still seeing one of our more important categories, professional nail, has been a bit weaker than what we are expecting this year, so that's a headwind on our margin rate as well. Again the merchant team is working hard to try to mitigate that. We saw some of that in the second quarter, with better performance than we're expecting. And we'll continue to do that in the back half of the year.

[Evren Kopelman:]

Thank you.

[Operator:]

Our next question is coming from the line of Joe Altobello with Oppenheimer. Your line is now open. You may proceed with your question.

[Joe Altobello:]

Thanks. Good afternoon. Just want to start with e-commerce. You guys talked about earlier the 10% of sales. How does that benchmark against some of your peers and what they're doing today for example? And then secondly, in terms of the required investment to get there, are we talking a step function or is it more incremental investment on the infrastructure side to allow for that 10% of sales from e-commerce? Thanks.

[David Kimbell:]

Yeah. I think competitively we feel, you know, there's a wide range of our competitors and we're actually probably not as much focused on where our competitors are. We think 10% is a really both attainable and smart place for us to be. Our focus within e-commerce, as we've talked before, is to make sure we're serving our customer where she needs this, where she wants to be served, but also finding ways to get her to experience our full breadth of offerings including our in-store products and services. And we think that the 10% is the right guide path to get us -- target to get us to that. As far as the investments?

[Scott Settersten:]

Yeah. We saw most of the step-up in investments back in 2012 and 2013, and I think we've talked about that and called those numbers out. That was really the step function, I think, as you use that term. You know, future investments are embedded in the supply chain numbers that we've given today and built into the overall CapEx that we'll talk about in more detail as we get to the future. So again I wouldn't expect there to be any kind of extraordinary step-up in the investment for that business.

[Joe Altobello:]

Okay, thanks, Scott. And then secondly, in terms of acquisitions, you referenced that earlier. Are you talking more square footage acquisitions or could you guys in fact, you know, purchase brands or partner with companies on brands?

[Mary Dillon:]

Yeah, you know, we haven't defined all that yet, but generally speaking I'd say we would have more of an interest in things that we could -- that would strengthen what we offer to our guests. You know, we think we're pretty darn good at what we do, but we know there's opportunities out there to bring her news in innovation and exclusiveness. So that would be more likely the area we'd focus on. But we don't have anything planned right now.

[Joe Altobello:]

Okay, thanks. See you guys next month.

[Scott Settersten:]

Thank you.

[Operator:]

Thank you. Our next question is coming from the line of Simeon Gutman with Morgan Stanley. Your line is now open, you may proceed with your question.

[Simeon Gutman:]

Thanks. Congratulations. Stepping back a little bit with regard to investments, next couple of years they'll be a little heavier. When they go away, when they subside and earnings growth really accelerates, does that reflect the cost of them just being lifted or does it factor in that the business itself becomes more efficient? So in other words, are you baking in anything -- any benefits in those out years?

[Scott Settersten:]

Yeah. There's definitely benefits from our supply chain investments from some of the other what I'd call just pure P&L kind of charges that we're thinking like marketing, incremental marketing efforts, whether or not we tweet the store payroll model at all which is yet to be determined, we're still testing that. But anything that we would contemplate along those lines we would fully expect to see top-line comp benefits come out of those.

[Simeon Gutman:]

Okay. And then switching gears to product, I think Mary mentioned expand Prestige, which I think has been a focus for a long time. Does the Prestige mix just grow simply by the natural mix shift in the business, you're adding brands, you're introducing new products, or does it contemplate some type of -- some space increase or even reallocation over time?

[Mary Dillon:]

Well, I'd say it's both. I mean what we're seeing is that our guest is really responding to Prestige brands right now. Certainly not only that but that certainly is a strong area of growth for us. And some of the brands that we've launched or new products that had been introduced in some of our brands have done quite well this year. So, you know. And in fact, we've expanded the space for some of those brands. So, you know, we imagine it'll be a pipeline of new products and expansion of existing brands. And what that mix exactly is going to be will be determined as we march forward over time.

[Simeon Gutman:]

Okay. Thanks. Good luck.

[Mary Dillon:]

Thank you.

[Operator:]

Thank you. Our next question is coming from the line of Mark Altschwager with Robert W. Baird. You may now proceed with your question, your line is open.

[Mark Altschwager:]

Hi, good afternoon, and congrats on a great start to the year. Just a couple of quick follow-ups. First, on the gross margin side. I think the comments in the Q, and you mentioned earlier that merchandise margin is about flat, but I was hoping you could parse that out a bit, because it sounds like you benefited from both mix and fewer discounts. So, just trying to understand where you saw the offset there.

[Scott Settersten:]

Yeah. I'm not going to be able to quantify everything for you, Mark. But as I think I'd mentioned earlier here, we still have -- the loyalty conversion is still going to be a headwind for us throughout the course of the year. Product mix, again every quarter has a little bit different lever that we pull as a merchant team, so we try to plan ahead to make sure we have a good balance of ticket drivers and traffic drivers embedded in our marketing materials. We've been able to offset some of the drag that we've seen from some deceleration in Pro Nail. We've been able to offset that. Luckily we've strengthened the Prestige line here over the first half of the year. E-commerce, I know we've mentioned that in the past, I mean e-commerce rate is dilutive to us overall, but that's a business that we're going to continue to compete in very well I believe. And we'll continue to expand merchandising opportunities there as well, which should help mitigate some of that over the long term, as well as continuing to scale up that business will help as well, so.

[Mark Altschwager:]

Thank you. And then just following up on services. As you look at the long-range plan, where do you see services as optimal mix of overall sales, and how does that play into the longer-range margin expectations?

[Mary Dillon:]

Well, we haven't set a specific target yet for the size of services. We know we're going to grow it. We think that, as I said, we have data that shows that our guests who are participating in our services right now are great guests because they come on a frequent basis, they love the experience, and then she often buys other add-on products. So, while services in general are lower margin than our retail products, that guest is a very valuable guest to us. And, you know, we'll continue to look for ways to drive awareness, not just of Ulta as a retailer but Ulta as a beauty authority, with our service as a critical component of that. And that's a very sticky part of the equation for us.

[Operator:]

Thank you. Our next question is coming from the line of John Kernan with Cowen. Your line is now open, you may proceed with your question.

[John Kernan:]

Good afternoon guys. Congrats on a great quarter. Just on the outlook, with ticket and traffic both running in the right direction, why would comps decelerate a bit in the back half of the year? And then, can you help us understand long term what your market share in beauty will look like in five years versus now, particularly in a Prestige offering? Thanks.

[Mary Dillon:]

Well, it would be bigger. I'm just kidding. But I mean we definitely expect it to grow our market share, and that's part of our vision, is that we're going to continue to, you know, really be a stronger player in this industry and we'll grow share. In terms of the outlook for the year, listen, we're really pleased with our second quarter results. And we've reflected that by raising guidance, you know, from a mid-teens to about 20% sales and earnings growth. You know, some of the upside that Scott talked about, some of it was new product launches, which is great, some of it was expense timing shifts, which is fine. We expect to see positive sale and share trends, as we complete the year.

[John Kernan:]

Okay, great. Thank you.

[Operator:]

Thank you. Our next question is coming from the line of Dana Telsey with Telsey Advisory Group. Your line is now open, you may proceed with your question.

[Dana Telsey:]

Good afternoon everyone, and congratulations. Can you talk a little bit about, as you think about the longer-term investments beyond supply chain over the next two years, how do you see operating margin being impacted, or is that when we should begin to see some leverage in the model?

[Scott Settersten:]

Yes. We expect the operating margin to remain rather flattish over the next couple of years, which we think is an excellent result considering the amount of investments that we're going to be making over the next two years, especially in the areas of supply chain. I alluded to earlier, maybe not as clearly as I should, but we believe that there are significant efficiencies that are going to come out of this supply chain implementation that are going to help drive top line and operating margin performance overall, once we get through the 2016 timeframe. You know, at that point we expect that our operating margin then will start, will start making significant progress towards our mid-teens target, which we've talked about for some time.

[Mary Dillon:]

And let me just add that, we've talked a lot about the investments that we're making this year, and what we're calling "test-and-learn." And those are some experiments around hypotheses that we have about how we can drive the business, investing in things like advertising, advertising in things like more attention to salon, perhaps more guest-facing time in our stores. The reason we're testing it is that, you know, we hold ourselves to a standard of getting a return on that investment. So, you know, as we look at those "investments," the reason that our five-year plan leads to improving that operating margin is that we will only choose the things to "invest in" that drive that kind of return that'll help us -- that will allow us to deliver those results.

[Dana Telsey:]

And as you think of the size of those investments over time, are they going to be bigger at the beginning of this time period, or how do you think of the scale of them?

[Scott Settersten:]

Yes. I mean directionally they're more significant in the near term than they are. So they moderate. Again once we get through -- 2015 and 2016 are the big step-up years I would say, generally speaking. And then they moderate once we get past 2016.

[Dana Telsey:]

Thank you.

[Operator:]

Thank you. Our next question is coming from the line of Jill Nelson with Johnson Rice. Your line is now open, you may proceed with your question.

[Jill Nelson:]

Good afternoon. You saw nice traffic gains which exceeded ticket gains for the first time in quite a few quarters. Could you talk kind of that variance going forward? And how do you see ticket versus traffic playing out in your kind of long-term 5% to 7% comp growth?

[Mary Dillon:]

Well, yes, we're very pleased that we saw the growth in retail transactions that we did in the second quarter. I would just say that long term, short term, every quarter our goal is to really have a good balance between transaction and ticket. And we work together as a team to put plans in place that we believe will continue to do that. So it's not a science, right? So, some quarters, yes, it's going to play out a little differently. Some of our new products, like Urban Decay, Benefit, some of the new products in those lines, launch of It, Mally, they were significant contributors, as well as the strong Pro Hair event, a later event that Scott mentioned earlier. And our marketing and merchandising teams continue to work together to create I'd say even more compelling communications every quarter. So our goal here is to really just maintain that balance going forward.

[Jill Nelson:]

Okay. And then could you talk about kind of the role of Prestige boutiques going forward, kind of your thought process of how many boutiques you're looking at adding and the 100 new stores per year kind of plan and just their role in the long-term goals? Thank you.

[Mary Dillon:]

Sure. Well, we, you know, we - our guests love the Prestige boutiques, we're very pleased with the business. Janet Taake and her team work closely with our vendor partners and those opportunities. And we hope and expect to continue to grow those.

[Jill Nelson:]

Thank you.

[Operator:]

Thank you. Our next question is coming from the line of Janet Kloppenburg with JJK Research. Your line is now open, you may proceed with your question.

[Janet Kloppenburg:]

Hi, Mary; hi, Scott. I want to congratulate you on a great quarter. I just had a couple of quick questions. There's been some talk in the beauty industry over the last couple of weeks that the mass business -- mass brands are being cannibalized by the Prestige business, and Estee Lauder and L'Oreal have both talked about that. I was wondering if you could talk about that change and how that may affect your business going forward, or if you even agree with that trend that is being witnessed by some of the big suppliers. And also I was wondering, on the e-comm being dilutive to margins, if we should expect it to be equally dilutive in fiscal 2015 and fiscal 2016, or if you'll start to get some scale from that channel as we go forward. Thank you.

[Mary Dillon:]

Sure. The categories, you know, I would say, step back and just think about our business model, our guest, what she needs and expects, you know, she is always looking for a balance -- ability to go across the store and to buy different types of products at different price points that meet her needs. So I can't comment on the trend that you're describing that people are talking about. What I would say, in our business we're seeing a good balance there. And so -- and we expect to continue to be able to drive that kind of balance within Ulta. Second question?

[Scott Settersten:]

As far as e-commerce and contribution might be considered, or availability of that business. I mean if we just carve that out as a standalone operating business, I think anyone would be happy to have it. I mean it generates a lot of operating income for the business. We're improving our merchandise rates there, so, gross margin, gross profit margin in general is improving. And we continue to see scale in that business. So these growth rates do that kind of inherently, and we expect more of it in the future.

[Janet Kloppenburg:]

Thank you so much.

[Operator:]

Thank you. Ladies and gentlemen, at this time, I would like to turn the floor back over to Mary Dillon for any closing remarks.

[Mary Dillon:]

In closing, I'd like to thank all of our Ulta Beauty associates in our stores, in our distribution centers, our headquarters. They've all really worked hard for the excellent results this quarter and are working hard to implement the strategies that we shared with you today to continue to drive strong top and bottom-line growth. Go, team Ulta. I also want to thank all of you for interest in Ulta Beauty, and I look forward to speaking with you soon. Thank you.

[Operator:]

Thank you. Ladies and gentlemen, at this time, you may disconnect your lines. This does conclude today's teleconference. Have a wonderful day.