Ulta Beauty, Inc.
Q3 2014 Earnings Call Transcript

Published: 5 Dec 2014

[Operator:]

Greetings, ladies and gentlemen, and welcome to the Ulta Beauty Third 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. Thank you. You may begin.

[Laurel Lefebvre:]

Thank you. Good afternoon and thank you for joining us for Ulta Beauty's third 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 the 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. We make references during this call 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. I'm pleased to announce the Ulta team delivered excellent sales and earnings growth in the third quarter. To recap the numbers, sales grew 20.5% and we delivered a 9.5% total company comp on top of the 6.8% comp in the third quarter of 2013, both including the impact of e-commerce growth. Our 9.5% comp was nicely balanced between transactions and ticket. The key drivers of our performance were continued strength in prestige and mass color cosmetics, the successful introduction of new products and brands, a more effective and well-executed marketing strategy, double-digit comps in our salon business, and rapid growth in e-commerce. Ulta.com performed very well, driving 46.7% comp sales growth. Gross margin was healthy as we continue our efforts to deliver more targeted offers and moderate our reliance on broad-based price discounts. Earnings per share were up 30% to $0.91 versus $0.70 of GAAP EPS last year. Scott will cover the detailed financial results for the third quarter and our guidance for the fourth quarter in a moment, but before that, I'd like to provide an update on our six strategic imperatives. As you know, we recently updated our strategic plan and five-year financial target and provided additional insight into the components of our long-range plan at our Analyst Day in October. We believe this plan represents a strong set of strategic imperatives and specific initiatives that will allow Ulta to continue its market share gains and deliver strong sustainable sales and earnings growth. Now I'll spend a few minutes updating you on activities underlying each of the six strategic imperatives. The first imperative is to acquire new guests and deepen loyalty with existing guests. As we discussed, we believe that one source of future growth is through the acquisition of new guests. In order to do that, we know there's an opportunity to first drive awareness of Ulta as well as clarity about the overall Ulta experience. In the past several months we've sharpened our brand positioning, developed an advertising campaign, and began an in-market test to measure the impact of TV, print, radio and digital advertising in six representative markets around the country. We recently completed the tests and are now analyzing to trend out data. Preliminary indications are positive, and we expect this test to influence our marketing strategy for 2015. Another key aspect of this brand-building strategy is to leverage PR, to increase awareness and establish Ulta as a leading beauty authority. We continue to drive millions of earned media impressions in the third quarter through broadcast and print PR opportunities in support of grand openings and product launches. In addition, throughout the month of October, we partnered with The Ellen DeGeneres show to highlight our longstanding support of the Breast Cancer Research Foundation. The total number of media impressions Ulta received from the Ellen partnership approached 500 million In addition, due to increased awareness of Cut-A-Thon, our salon teams provided 26% more free haircut, with a donation to the BCRF than last year. We raised millions of dollars this year for BCRF, a cause important to our guests and our associates. And we've taken an important step towards increasing awareness of Ulta. Another critical initiative in support of the first strategic imperative is growing and further leveraging our loyalty program and CRM capabilities to increase loyalty and grow share wallet with our members. At the end of the third quarter, our ultimate rewards program had grown 16.1% year over year, reaching 14.5 million active members. Our strong comp growth across retail, salon and e-commerce was driven by loyalty member sales growth. Average sales per member increased compared to last year, equally influenced by greater shopping frequency and higher spend per transaction. We continue to increase the effectiveness of our targeted CRM campaigns in order to drive incremental sales, improve retention and engage members and our service offerings. Now on to the second strategic imperative, which is to differentiate by delivering a distinctive and personalized guest experience across all channels. A key initiative is assessing higher staffing levels to determine the impact on sales and the guest experience. During the third quarter we tested different labor models with increased customer-facing hours in 60 stores across the country. Similar to the advertising tests, we're currently measuring several financial and customer satisfaction and retention metrics to assess how to incorporate a more effective labor model as we go forward. An additional side, we've also been busy improving the guest experience. We've introduced live interactive chats with key vendors on a regular basis. We've launched a new iPad app and add a content to the site to inspire, educate and share. We've also implemented a new technology on Ulta.com to enable video commerce or shoppable videos, where guests can click to buy merchandise shown in videos that are created by passionate Ulta bloggers. Our third strategic imperative is to offer relevant, innovative and often exclusive products that exist our guests. Newness continues to be a significant driver of our business and our merchandising team is doing an excellent job at expanding and curating our portfolio. During the third quarter we rolled out across the chain a specialized fixture to house an exclusive collection of makeup brushes in partnership with It Cosmetics. With 66 SKUs across multiple price points, these brushes have been an instant hit with our guests. We also launched a premium skin care Algenist, hair care brand Keranique, as well as new fragrances from Michael Kors. We rolled out popular color cosmetics brand BECCA to 282 stores as well. With its broad range of shades, this brand is a great addition to our portfolio and very relevant to women of color. Looking ahead to the holiday season, we're excited about the many exclusive holiday items we've introduced in partnership with our prestige brands, and a strong gift repurchase program to support our [indiscernible] offering [ph]. We recently introduced a bath collection for the Ulta brand, with new fragrances and packaging. We've also significantly upgraded our gift card program and merchandising in time for the holiday season. So we believe our merchandise assortment, combined with a robust marketing plan, anchored on a Gift Gorgeously theme that includes radio, advertising, PR, social, digital and in-store marketing, will resonate with our guests. Now moving on to the fourth strategic imperative, delivering exceptional services in three core areas

[Scott Settersten:]

Thanks, Mary. Good afternoon everyone. Third quarter sales were $745.7 million, compared to $618.8 million last year, an increase of 20.5%. Comparable sales increased 9.5%. The retail comp, which includes salon, was 8.2%. The total company comp was driven by a healthy combination of transaction and ticket, with transactions up 5.4% and ticket up 4.1%. The ticket increase was driven entirely by average selling price, as our business continues to mix up to more prestige categories, and we succeed in our efforts to rely more on our CRM capabilities and targeted offers versus broad-based couponing. Retail-only comparable transactions were up a solid 4.4%. Gross profit dollars were up 21.6% to $281.8 million, and gross profit margin increased 40 basis points to 37.8% from 37.4% last year. The primary drivers of this improvement were leveraged on fixed store costs and a strong comp and higher product margins, offset by incremental supply chain costs due to our expanding e-commerce business. SG&A expense increased 19.7% to $181.1 million, down 20 basis points as a percentage of sales to 24.3%, versus 24.5% last year or 24.2% excluding the severance charge last year. Despite our investments in the test-and-learn initiatives like the payroll and brand awareness marketing tests, we were able to leverage SG&A due to the stronger-than-expected top line, which drove payroll and marketing expense leverage, offset by deleveraging corporate overhead expense. The corporate overhead deleverage was primarily driven by a higher variable compensation expense due to better-than-expected performance, as well as depreciation of IT systems and consulting expense. Pre-opening expense was $6.6 million, compared to $7.5 million last year, driven by 50 store openings, compared to 55 new stores opened during Q3 2013. Operating margin increased 80 basis points to 12.6% versus 11.8% last year. Interest income was $254,000 net of credit facility fees. Our line of credit remains undrawn. Our tax rate was 37.3%, versus 37.7% last year. This tax rate favorability added less than a penny of earnings per share and was due to the impact of equity compensation on our tax rate. Net income increased 30.1% to $59.1 million or $0.91 per diluted share, versus $45.4 million or $0.70 per diluted share last year, or $0.72 per share excluding the severance charge last year. Turning to the balance sheet and cash flow. Inventories were $709.7 million at the end of the quarter, compared to $582.3 million at the end of Q3 2013, up 5.8% on a per-store basis. We achieved our goal of keeping inventory per door growth below comp growth despite investing an additional inventory on bestsellers ahead of the holiday selling season, to keep pace with our strong sales momentum. In-stock levels are strong and we have not experienced any meaningful issues from the recent West Coast port delays. Capital expenditures were $78.4 million for the quarter, driven by our new store opening program, supply chain investments and systems. We are on track to spend $265 million in capital for the full year. Depreciation and amortization for the third quarter were $33.7 million. We ended the quarter with $395 million of cash and short-term investments. The company repurchased approximately 86,000 shares at a cost of $10 million during the quarter under our 10b5-1 plan, as part of our program to return cash to shareholders. In terms of specific guidance for Q4 2014. We expect to generate sales in the range of $997 million to $1.014 billion, compared to $868.1 million last year. We anticipate achieving comparable sales increase in the range of 68%, versus 9.2% last year. Recall that comp performance from last year's Q4 benefited by approximately 200 basis points due to the negative impact that Super Storm Sandy and the timing impact of the 53rd week of fiscal 2012. New store openings in the fourth quarter are already complete, with 10 stores opened versus 11 stores opened in Q4 last year. So, pre-opening expense is expected to be flat. Earnings per share are expected to be in the range of $1.21 to $1.26, versus $1.09 for Q4 of 2013. We anticipate a tax rate of 37.9% and a fully diluted share count of approximately $64.6 million. Turning to the outlook for the full year 2014, based on the strong performance of the first three quarters, we are raising our earnings growth expectation to the low 20s percentage range for the full year. Full-year comparable sales are expected to be in the range of 8% to 9%. As a reminder, the long-term plan we announced in September laid out our five-year financial targets. We expect to open 100 stores per year, grow e-commerce to 10% of our sales, drive comparable sales in the 5% to 7% range, and grow earnings per share in the low 20s percentage range each year. However, we expect the reduction of this growth rate in the mid-single-digit percentage range in both 2015 and 2016 due to planned supply chain and systems investments. Operating margins are expected to remain flattish for the next couple of years, before heading up towards our long-term mid-teens target. We plan to provide specific guidance for next year, as usual, on our Q4 call in March. And finally, for fiscal year 2015, we plan to accelerate our earnings announcement calendar to be more in line with our peers and expect to announce our quarterly results about one week earlier than our historical practice. The dates for next year's earnings announcements are posted on the Investor Relations page of our website. And with that, I'll turn the call over to our conference call hosts to begin the Q&A session. Operator?

[Operator:]

Thank you. Ladies and gentlemen, we will now be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Simeon Gutman with Morgan Stanley. Please proceed with your question.

[Simeon Gutman:]

Thanks. It's Simeon Gutman, Morgan Stanley. Nice quarter, everyone. Two questions. First, on gross margin and gross margin management. You'd talked about getting better at I guess promotions and targeting and being more selective. If you do what you did this quarter, to drive some of the improvement, and you run it out over the next few, should we see gross margin expansion similar to what we saw in this quarter? And then my second question is, if you see next year better gross profit dollar growth, either through sales or through better gross margin, could -- are there investments either -- you mentioned supply chain and systems, are there any of those investments that you can accelerate just to pull them forward if the business is performing better?

[Scott Settersten:]

Yes, Simeon. I guess I'll take a crack at the first one here. As far as gross profit expansion was concerned for the third quarter, as I look out at the next couple, specifically the fourth quarter, I wouldn't expect to see the same kind of expansion that we just saw in the third quarter. I mean the fourth quarter, I think you know the holiday season's a little bit different animal for us, you know, with the competitive set kind of changing. We have again a large number of new stores entering into the overall base here, so there's a bit more fixed store cost deleverage coming in the fourth quarter that will drift the next couple of quarters as well. So again we think our guidance includes all those ramifications and we think it's prudent under the circumstances. As far as thinking forward a little bit about investments, I mean it's, you know, you heard us describe all of this at our Analyst Day back in October. It's a pretty aggressive plan. There's a lot of heavy lifting as far as the investments are concerned, over the next couple of years. I think we're probably as accelerated [ph] probably as we feel comfortable at, at this stage in the game. Of course we'd always course-correct as we see things change in the business.

[Simeon Gutman:]

Thank you.

[Operator:]

Thank you. Our next question comes from the line of Gary Balter with Credit Suisse. Please proceed with your question.

[Unverified Participant:]

Hello. It's actually Andrew [ph] on for Gary. Congrats too on a fantastic quarter. My question is regarding prestige brand wins. This quarter your market share gains from department stores seem to accelerate, and in response we heard companies like Estee Lauder mention that they're going to expand their assortment with the specialty channel. Could you just comment on your outlook for prestige brand wins, particularly as the smaller format stores lessen channel conflict?

[Mary Dillon:]

Thank you, Andrew [ph]. We're really thrilled with the performance of the brands that we've been adding to the mix, and I think I've talked about one example, cosmetics was a big win for us in the quarter, with the expansion of the brush line and whatnot. There's many examples of that. We continue to just look forward at our growth and we think we are a great place to grow. We're pleased with the performance that we have with our brands and we'll always look to continue to really I guess best meet our guest needs. And if she continues to be interested in more prestige brands, we'll continue to look at those as well. So, thank you.

[Unverified Participant:]

Congrats.

[Operator:]

Thank you. Our next question comes from the line of Aram Rubinson with Wolfe Research. Please proceed with your question.

[Aram Rubinson:]

Hi, thanks. Two questions. First, now that Q3 last year is in the rearview mirror, can we do a little post-mortem on what exactly happened then? Didn't know if you get any extra clarity as you kind of cycle through it.

[Mary Dillon:]

That's your first question. Okay. Hi, Aram, thank you. So I guess there's a few things going on there, right? One is that last year we had this I guess you'd call the fiscal cliff effect that we think had an impact on traffic and consumer sentiment that we saw at the end of the quarter. And we were also cycling up against a very promotional year-ago quarter. And so some of those factors we think actually, you know, that in conjunction with we were starting to pull back a bit in some of our promotional intensity, put those together, we think those are some of the factors that drove some of the impacts to the comp that we saw on that quarter. This year, as we look at it, I think it's obviously overall a much healthier consumer sentiment happening, while there's still pressure on household budget in a lot of ways. Obviously the overall economic outlook and economy, jobs, are more positive. And we are still continuing to really be cautious but smart about balancing our investment and targeted offers with price discounts. We think we're getting a little bit better at that, probably more knowledge as we've done this a little bit more over time. So those are kind of the things. You know, those. And each year, every quarter has something new as it relates to new products, and some are going to perform better than others, right? So that's always a part of the equation. So we feel like we have a pretty good understanding of all that and confident that the drivers that got us to this quarter result are ones that we can - we think we can continue to drive in the future.

[Aram Rubinson:]

And a follow-up was, I don't think this was asked at the Analyst Day, but can you tell us how likely you are to try and incubate brands in something like kind of a VC format and maybe if so, timing or moneys you might allocate to such an endeavor?

[Mary Dillon:]

You know, certainly the notion of having a really robust pipeline of products, so, products and brands that our guests want, that they know of already, and products and brands that we can bring to market, win partnership, or invest in, are all in the consideration set for us. We want to really be known as the beauty authority, and certainly the more things that are exclusive to us, the better over time, right? I don't think that'll ever be the highest part of what we do, but certainly we'll want to grow that. Having said that, we're just really I think beginning to develop that capability, take some investment in time and people to do that. And so that's certainly a focus for us in 2015, is to build our strategy, capability and plans there, because I think it's very exciting and interesting to think about consumer insight combined with great merchandising and retail execution as part of our strategy. But it's early for us yet. We have so many other priorities right now frankly that what we're focused on.

[Aram Rubinson:]

Okay. Thanks so much. Best of luck, and happy holidays.

[Scott Settersten:]

Thank you.

[Operator:]

Thank you. Our next question comes from the line of Ike Boruchow with Sterne Agee. Please proceed with your question.

[Ike Boruchow:]

Hi everyone. Congrats on a great quarter. Thanks for taking my question. Two quick ones. I think the first one for Scott. In terms of the next 18 to 24 months on the investment side, is there going to be, you know, as we model out our quarters, is there going to be some lumpiness that we should keep in mind? You guys talked about the next distribution center opening up and the timing of that. Just curious how we should think about timing on SG&A, if there's anything you can add. And then also, Mary, when we think about ticket growth up 4%, can you comment, is that a function of category mix to prestige, is that a function of less discounts? Is it both? Is it more one or the other? Just trying to understand that a little bit better. Thanks.

[Mary Dillon:]

Let me start with that one because that's actually easier, which is that it really is a combination of both. Ike, I would say that it's a mix of prestige, it's less discounting. Those together have really been the drivers.

[Scott Settersten:]

And as far as the investment cycle is concerned here over the near term, the next 18, 24, 36 months, so I mean, again, clearly we're -- Indianapolis is underway here. That building slated to be online mid-2015, shortly thereafter with a new distribution center in the south, going online approximately the same time of the year in 2016, kind of a carbon copy. So, you know, the short answer is yes, we do expect our quarter-to-quarter performance to be a bit lumpier than it has been historically. And then we've talked to many investors about that over the last couple of years. That's one of the reasons why we've kind of backed away from more detailed guidance that we'd done in the past. As a reminder, most of the investment is going to be flowing through the gross profit line in the P&L. There will be a minor part I think flowing through SG&A for some consulting things. But by and large, all these capital investments will amortize gross profit.

[Ike Boruchow:]

Thank you.

[Operator:]

Thank you. Our next question comes from the line of Daniel Hofkin with William Blair. Please proceed with your question.

[Daniel Hofkin:]

Hi, good afternoon. Can you hear me okay?

[Mary Dillon:]

Yes.

[Daniel Hofkin:]

Okay, great. I'll add my congrats on a great quarter. Just a couple of quick questions. First, as you think about kind of pulling back on some of the broad-based, as you call, the coupon advertising, what, you know, as you see that, where is that kind of manifesting itself? Is that just showing up in a little bit higher average ticket or is there any other impacts through the ticket or traffic dynamic there? That would be my first question.

[Mary Dillon:]

Well, yes, I would say a couple of things. One is that this is not a dramatic wholesale pullback on discounts. We're doing it carefully, I think smartly. What we're doing is looking at frequency and depth of circulation of price-related discounts, but, you know, reducing that, but on the flipside really leveraging our CRM platform and our loyalty program to incent our guests in a more personalized and targeted, think more effective and efficient way, right? So it's a little hard to measure all those impacts at any one moment in time, but certainly where we can see that play out is in ticket improvement, margin improvement, and we think that's working for us. But again, I said this before I believe, walk before you run, so Dave Kimbell and his team are doing a lot of work around just really making sure we continue to fine-tune, test and learn, understand all the demand dynamics, so that we can be, you know, we always need to be a value to our guests, is a way to think about it. And it's -- there's no one exact way to define that, but the more relevant we can be with the offerings and then how we position those and communicate those to her, the more that value equation is less about just, you know, come in because we have a coupon or a discount. That said, a lot of our guests like our coupons at our discounts, right? So it does play out in terms of the ticket dynamic, and we think it's obviously one of the assumptions we build into our long-range plan, is that we'll continue to be able to do that. Because the other place that this plays out is that less money spent on discounting, you know, within the context of our P&L, offers us more opportunity to spend on driving awareness, and the whole new guest acquisition part of our strategy, which is we think an -- we know it's an opportunity to go forward. New guests don't discover you just on accident. Sometimes they do because we also have the store, which is great, but we're investing and testing and learning in actually marketplace programs already that are about using all forms of ways to communicate, whether it's traditional or new media, to drive new guest acquisition. So, some of that sort of efficiencies there will be used to drive new guest growth.

[Daniel Hofkin:]

Great. And then it looked like there were a couple of other brands that maybe you're testing out a little bit, it looked like Clarins in one of your markets, in skin care. Is that specific brand or is that something that you're thinking about as a potential for broader rollout over time or others like that?

[Mary Dillon:]

I'll ask our expert head merchant here to weigh in on that one. Janet?

[Janet Taake:]

Sure. You know, we did just certainly refocused on Clarins in our stores. We've had Clarins, but what we did do -- so technically it's not new, but once again we really focused it more in our Chicago area. It's a beautiful brand. And we're also very thrilled to offer it on our website as well. And that's -- no further information other than that, and we're just really excited to learn more about this beautiful brand in our assortment.

[Daniel Hofkin:]

Great. Thanks. Best of luck in the fourth quarter.

[Scott Settersten:]

Thank you.

[Operator:]

Thank you. Our next question comes from the line of Joe Altobello with Raymond James. Please proceed with your question.

[Joe Altobello:]

Thanks. Hey guys, good afternoon. I guess first question is on the site -- the Ulta.com site. What percent of visitors to your site are loyalty members? And how successful do you think that site has been so far at funneling those visitors into your brick-and-mortar stores?

[Mary Dillon:]

I will ask Dave to take that for us. Dave?

[David Kimbell:]

Yes. I don't think we'll have the exact percentage of guests versus non-guests that visit our site. We know we over-index on our site in our ability to attract new guests, so we get a greater percentage of new members from our site than it represents of our total sales. So it is a strong channel for us to continue to attract new guests. And as we shared a little bit in our Analyst Day, we have a small percentage of our guests that are actively shopping in between the channels today, but we are doing a lot to encourage them and we're seeing growth in that activity. So we continue to bring initiatives into the marketplace designed specifically to get an online guests into our stores, try to drive her in to use our salon service or to shop one of the, you know, one of our brands in stores. And vice versa, when we have a brick-and-mortar customer, make sure that she's aware of our online. Because those guests are some of our best guests and we're going to continue to try to drive that integration across channels.

[Joe Altobello:]

Okay. But is that something that you guys are tracking and measuring on a quarterly basis or a monthly basis?

[David Kimbell:]

Yes. We are certainly tracking them.

[Joe Altobello:]

Okay. Got it. And then secondly, in terms of the consumer environment, I think earlier you guys mentioned that you're very encouraged by what you're seeing so far from a consumer standpoint. This holiday season, how does it look from a promotional standpoint versus last year?

[Mary Dillon:]

Well, you know, this was the crystal ball part of the show, right? Just kidding. But certainly the -- I would say a couple of things on the consumer sentiment. I think it's a mixed bag a little bit. I mean there's certainly positive economic news that create this more upbeat climate, stock market, employment, GDP. But there's also a lot of pressure on household budget. So if you look at increased costs in healthcare, food, rent, technology, and incomes aren't growing that fast. So I think the good news is, either way, Ulta is really well-positioned because of our breadth of assortment, our overall value proposition. So we're seeing that play out. As it relates to the holiday, then I think the same thing rolls forward. We expect it to continue to be a very competitive time. It's always the time of the year that we compete in a broader I guess competitive frame because it's more about gift-giving, and beauty is part of that, right? It's not only that we're competing against beauty retailers. Certainly the last couple of years they've been very promotional. I think what we've been reading in terms of what other retailers are saying so far about the start of the holiday season is we can expect that to continue. So I think that some guests will have more money to spend and some less, but everybody is going to be competing for that share of wallet during the holiday period, and we expect that. We feel well-positioned with what we've got ready for holiday, I would just add that. We've got a really great lineup in terms of our product offerings and our marketing plans, our stores are ready, our DCs are ready, our e-commerce platforms, you know, performing well. So we feel good about it. But we expect it and that's put into our guidance to expect that.

[Joe Altobello:]

Okay. Thanks, Mary. Appreciate it.

[Mary Dillon:]

Sure.

[Operator:]

Thank you. Our next question comes from the line of Matthew Fassler with Goldman Sachs. Please proceed with your question.

[Matthew Fassler:]

Thanks a lot. Good afternoon and congratulations on a great quarter. The first question I want to ask is essentially a follow-up to that. So you spoke about the different promotional tools that you have available to you and how you have deployed them to your advantage. Do you expect to continue to stick with those in the fourth quarter when perhaps the promotional environment tends to intensify and you face more players? Or do you feel like you can use some of your -- or do you have to revert, if I may, to some of the more traditional marketing tactics that you would have used I years past?

[Mary Dillon:]

Yeah, our plan for the fourth quarter is to continue to build on what's working. So I mean certainly one of our best tools is our CRM capability, and that holds true even more during holiday, right, when people are very busy and trying to sort out what to purchase in terms of gifts. One of the things that we've done is we've really -- we've taken our website and organized it around this theme of Gift Gorgeously as a section, and it really makes it easy for people to understand kind of if you're looking for gifts for teens or for men or whatever. So we can communicate to our guests directly via email about gifts and certainly half prices and great products, and we're doing that. And that said, there's also other tactics that we'll continue to use, that are about driving traffic and about great prices. So it's really I think a combination or a continuation of what we've been doing, within an expectation that there's more competition and hence a little more promotion than another quarter.

[Matthew Fassler:]

That's helpful. And then two quick follow-ups for Scott. Scott, can you talk about the magnitude at least directionally of merch margin or product margin expansion that you saw here in Q3 relative to what you saw in the earlier part of the year?

[Scott Settersten:]

Yeah. I mean we started off the year I think guiding, right, expansion and margin over the course of the year. Again in the early part of the year it was smaller part of the mix overall. And we're happy to see that play out the way we expected. So we saw 10 basis points of expansion in merch margin year over year in the third quarter. We don't expect that necessarily to repeat in the fourth quarter. We'll see how it plays out. We have good plans in place we think to try to maintain our momentum there and try to do what we can to expand it. But it is a bit of a different animal in the fourth quarter. And we'll do, you know, what we have in the past, right, to protect our market share gain.

[Matthew Fassler:]

And then finally, just ballpark inventory thought process as we model out yearend.

[Scott Settersten:]

Yeah, we're very happy overall with our inventory. Again we were up 5.8% year over year, which is a little elevated from what we've seen earlier in the year. But we are very confident. Those are ANB [ph] skews that we're buying aggressively because the business is strong and we're confident that that's going to continue through the fourth quarter. So --

[Matthew Fassler:]

Thank you.

[Operator:]

Thank you. Our next question comes from the line of Evren Kopelman with Wells Fargo. Please proceed with your question.

[Evren Kopelman:]

Thank you. Good afternoon. I wanted to ask a little bit about industry product trends. We haven't talked about that very much so far. It sounds like color cosmetics has been an area of strength. Do you expect that to continue for you in the next few quarters? Any other trends you're seeing from a product perspective that we should be watching? Thanks.

[Janet Taake:]

Sure. From prestige, it has been strong for us quarter over quarter for some time now. And a lot of that has really been driven from the evolution of our portfolio over the last several years, the addition of new brands. And we still have brands we've introduced this year that will continue to have increases next year, so we haven't comped over them yet. So there will be opportunity there. And it's been a strong category for us and we feel that it'll continue. And as far as any trends, there are a lot of different trends. And in color specifically, brow has been a very strong trend this year. It continues, along with web. Some of these that we may have mentioned in the past, and face. All categories in color have been strong. Some of it new brand introductions, some of it new innovation, along with skin care mask and serums continue to trend very strong. And there are other things, but those are probably the highlights.

[Evren Kopelman:]

Thank you. And then on the test-and-learn initiatives you've had in place, are those continuing to Q4 and Q1 or are they being replaced by other tests? Just asking more from a -- how to model it from an expense perspective. Thanks.

[Mary Dillon:]

Yeah. Well, just in terms of the actual tests themselves, they're pretty much -- the third quarter was where we did the testing and spent most of the money. There are some that's into the fourth quarter, but a small part of it. Test-and-learn ongoing is going to be part of our mindset, but I don't expect it to be the kind of investment that we made this year frankly because we're really, we're kind of really trying to do a lot at once, and it wasn't planned in our budget. As we look forward, it's part of again how we're going to run the business and it's already built into our guidance in the five-year plan.

[Scott Settersten:]

Just to point a point on that, Evren, so of the $10 million that we described starting out the year, most of that now is in the rearview mirror. There's a bit that's still embedded in the fourth quarter, but it's not worth really discussing. And as Mary said, there'll always -- we will always have an increment built in in future years for test and learn. It will be to the same magnitude that it was in 2014.

[Evren Kopelman:]

Great. Thank you. Happy holidays.

[Mary Dillon:]

Thank you.

[Operator:]

Thank you. Our next question comes from the line of Mark Altschwager with Robert W. Baird. Please proceed with your question.

[Mark Altschwager:]

Good afternoon and thanks, and congrats on a great quarter. Could you talk a bit more about some of the site enhancement you've made that did inspire beauty consultations, share and play, what are the learnings there, and any metrics you can share on traffic and conversion that you've been able to attribute to these initiatives?

[David Kimbell:]

Yeah. I think we've shared specific metrics related to some of those elements. But I will tell you what -- we're very happy with how the site enhancements have continued to improve the experience overall, and we've invested, you mentioned a couple of those, but continuing to look for ways to both engage our customers more in beauty and our brand through our content destination, yeah, the beauty destination that you talked about, video content that we've been bringing online, shoppable videos, a variety of different ways to try to get consumers to see us as -- increasingly see us as a beauty expert and a leader in the space. And we can see content as a way to do that. And that we know has driven traffic and engagement on our side. We've also looked for ways to enhance that shopping experience once we get them there. So I think through our cart overlay and how we're enhancing that, we did that through the third quarter. It is in programs like our salon appointments that Mary mentioned in her script. We've enhanced how we're describing and highlighting promos through some different fly-out capabilities. So we're continuing to both enhance and extend the guest experience to attract her there. And once she's there, convert here. And we believe, you know, and we know, through all of our tracking, that it's working. It continues to drive. We had, as you saw on the results, a very strong quarter, and that was driven at least in part by these enhancements and the continued improvement of our site performance overall.

[Mark Altschwager:]

Great, thank you. And then Mary or Scott, could you just address what you saw on the business around Thanksgiving week and Black Friday? How did your approach differ versus last year, and just biggest takeaways overall from that week? Thank you.

[Mary Dillon:]

Yes, sure. Well, we're really pleased with our merchandise offers, our marketing communications, I'd say, relative to last year. We just continue I think to get more honed at understanding our guests and what she needs and really picking our spots. And so I'm pleased with -- I think the team did a great job, and the traffic and sales that came from it that it drove, we're pleased with. Scott already talked about inventory. We're happy with our in-stock position, which is great, with our website performance which Dave just touched on, our e-commerce fulfillment capabilities worked really well for us. So the guidance that we've given for Q4 does embed already what we saw at the holiday, and we're pleased with it.

[Operator:]

Thank you. Our next question comes from the line of Steph Wissink with Piper Jaffray. Please proceed with your question.

[Steph Wissink:]

Hi. [Indiscernible] --

[Mary Dillon:]

We can't hear you very well. Steph? Operator, why don't we go to the next question, we'll see if we can get Steph back in a bit.

[Operator:]

Our next question comes from the line of Jill Nelson with Johnson Rice. Please proceed with your question.

[Jill Nelson:]

Good afternoon. Could you talk about maybe some initial learnings you've gained from the higher staffing model? I know it's in the early stages, but any initial insight?

[Mary Dillon:]

Yeah. We're going to -- we're still in the process of really looking at the trend-out data, the customer satisfaction metrics. We tested a couple of different staffing type models, different levels. I'll just have to say, we're pleased with the results. Certainly we, you know, we had a hypothesis, I don't think it was hard to confirm, but that the more guest-facing time that we can give our stores, the better in terms of conversion and ticket. And we saw that, really -- now it's really just a matter of, so, to what extent do you want to invest and how much does it return? But we know over time, with the supply chain investments and IT investments, that these, you know, the customer-facing hours will naturally become more available to our associates in stores, it'll just take a while for those to play out. So as we build our plan for 2015, we'll certainly be taking those learnings to consideration. I don't expect that there'll be a whole sale dramatic change to our staffing model, but certainly whether it relates to markets, volume levels, categories, there's a lot that we can play with there.

[Jill Nelson:]

Okay. And then just to follow up. You talked about 100 full-size store openings for 2015. Could you talk about what that implies about kind of that smaller 5,000 square-foot box? It's still in test or could that maybe an incremental add to the 100 planned for next year?

[Mary Dillon:]

Yeah, it's still, you know, our overall plan in terms of our store growth really was about the traditional store format, the large store format. And we have always said that the small store we would see bee incremental to that. I'm not sure exactly when we're going to start doing more of them. So far we have two. The test is early. We're really pleased with the results. But it is a different operating model. Everything from learning about how to manage the fact that we have fewer SKUs in the stores, so, making sure we can allow our guests to be able to order from the store and have it shipped to her home, you know, different kind of labor model, certainly a different kind of replenishment model. So, all those things will take a little time. We like what we're seeing, but we really want to make sure that, as we expand this concept and we are encouraged about that, but that we really set ourselves up for great success as we do that.

[Scott Settersten:]

And it's really key for us, we want to monitor during the holiday season now because of the spike in sales and the number of footsteps that comes through the door, to make sure we can manage all that, and to the levels that we want, so.

[Mary Dillon:]

But we're encouraged, yeah.

[Jill Nelson:]

Thank you so much.

[Operator:]

Thank you. Our next question comes from the line of Dana Telsey with Telsey Advisory Group. Please proceed with your question.

[Dana Telsey:]

Good afternoon everyone. As you think about the services component, do you have a percentage of sales target from services? And as you look beyond brow bar, are there other services that you may add and how their margin and contribution versus product? And then lastly, given that the salon customers spend 2.5 times more than non-salon guests and shop more frequently, do you see -- how do you see that interacting with the loyalty programs since now they represent less than 7%? Could it be more? Thank you.

[Mary Dillon:]

Yes, absolutely. One of the reasons that it's one of the pillars that we've put into our strategic plan is that we're very excited and committed to the notion of services as a growth driver for us in the future, for all the reasons that you understand, right? So I think, Dave, we mentioned this, this is our best guess. The service salon guest comes more frequently and spends more than any other guest, and it really enhances our beauty authority, and it also enhances the sort of brick-and-mortar reason for being. There's many others than just that, but it's certainly part of the equation, that we think is part of our unique proposition, right, services and breadth of categories and types of brands all in one place. So we've just started I'd say and we're already doing some CRM to make -- get our current loyalty members aware, and we've seen positive response on that. We've added this online booking tool which was, you know, drove a lot of new guest acquisition, which was great. I mean, a small number so far because we just started, but 80% of those folks booking online were new guests to us. So I guess the only thing to think about in terms of the types of services, we want to be really known and great at what we're really known and really great at, which is salon, which is about hair, our brows and our skin services through Dermatologica. There's a lot of growth that could be had within all of those, and that's what our focus is going to be, versus continuing to add new -- as new services would be added within the concept of the service pillars that we already offer. So for example, in hair, you can imagine there's lots of things, whether it's doing even more blowouts, which we do today, or special occasion hair. In brows, we're just doing something just for holiday, which is about blinging out brows -- did I get that right, Janet?

[Janet Taake:]

Yes.

[Mary Dillon:]

But besides tinting, doing fun brow services that add a special holiday sparkle I guess I'd call it. So there's lot of ways I think to grow within the service core that we have today.

[Dana Telsey:]

Thank you.

[Operator:]

Thank you. Our next question is from Steph Wissink with Piper Jaffray. Please proceed with your question.

[Steph Wissink:]

Hi, good afternoon. Sorry about that. Just a question quickly on your mobile traffic to your site. Have you been tracking that? And anything you're learning from your mobile app? Thank you.

[David Kimbell:]

Yeah. We absolutely continue to see that taking -- becoming a bigger and bigger part of our overall business, and yeah, the strong growth in the third quarter, and we've seen that actually continue. So what we're -- we launched a new iPad app in the third quarter. We've seen that increase. We will expect to see there in peak periods that both the traffic can be up to 50% of our traffic, can be through our mobile applications, any of our mobile applications, a little less of the orders, but certainly the traffic engagement and learning of our products would be increasingly on one of our mobile applications. And so we're investing heavily to make sure that's a strong part of our plan going forward.

[Operator:]

Thank you. Ladies and gentlemen, at this time there are no further questions. I'd like to turn the floor back to management for closing comments.

[Mary Dillon:]

I just want to say thank you all for your attention and interest in Ulta, and to all of the Ulta associates for a great job in the third quarter and your readiness and execution for the holiday season. So, thank you very much.

[Operator:]

Thank you. Ladies and gentlemen, this concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.