Ulta Beauty, Inc.
Q2 2015 Earnings Call Transcript

Published: 28 Aug 2015

[Operator:]

Greetings and welcome to the ULTA Beauty Second Quarter 2015 Earnings Conference Call. At this time all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. 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 Second Quarter 2015 Conference Call. Hosting our call are Mary Dillon, Chief Executive Officer; and Scott Settersten, Chief Financial Officer. Also joining us is Dave Kimbell, Chief Merchandising and Marketing Officer. Before we begin, I would 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 may make references during this call to the metric free cash flow, a non-GAAP financial measure defined as cash provided by operating activities, minus purchases of property and equipment. During the Q&A session, we kindly request that you ask just one question to allow us to have time to respond to all of you during the hour scheduled for this call. I'll now turn it over to Mary.

[Mary N. Dillon:]

Thank you, Laurel. Good afternoon, everyone. I'm pleased to report excellent second quarter results for ULTA Beauty, with strong sales momentum and better than expected earnings growth. To recap the headlines, sales grew 19.4% and we achieved a 10.1% total company comp on top of a 9.6% comp in the second quarter of 2014. Transaction growth accounted for about two-thirds of our comp, with average ticket growth contributing about a third. We continued to gain market share across all of our categories, with both Prestige and Mass Color Cosmetics achieving the strongest growth. Each of our businesses contributed healthy comp sales

[Scott M. Settersten:]

Thanks, Mary. Good afternoon, everyone. Second quarter sales were $877 million compared to $734 million last year, an increase of 19.4%. Comparable sales increased 10.1%. The retail comp was 8.8%, the salon-only comp was 10.1% and ecommerce growth was 43.4%. The total company comp was driven primarily by traffic strength, with transactions up 7% and ticket up 3.1%. Similar to the trend we've seen for the past few quarters, ticket was driven by higher average selling price as a result of strong sales in Prestige categories and less reliance on broad discounting. Retail-only comparable transactions were very healthy, up 6.3%, even stronger than what we achieved in the first quarter. Ecommerce growth was driven primarily by traffic, but average ticket also increased. Gross profit dollars were up 18.2% to $306.5 million, but gross profit margin deleveraged 40 basis points to 34.9% from 35.3% last year. Gross profit benefited from improvement in product margins due to higher mix of Prestige products, offering a more complete assortment on Ulta.com, and less discounting overall. These benefits, however, were offset by planned supply chain investments including the startup of our new distribution center in Greenwood, Indiana. SG&A expense increased 16.6% to $183.9 million, down 50 basis points as a percentage of sales to 21% versus 21.5% last year. The key driver of this improvement was marketing expense leverage, partly due to stronger-than-expected sales, but also as a result of concentrating more of our marketing expense later in the year. We still plan to keep marketing as a percentage of sales flat for the full year, since we will be ramping up our marketing spend in the second half to drive brand awareness through national television and radio campaign. Pre-opening expense was $4.1 million compared to $3.6 million last year, driven by 20 store openings, one relocation and two remodels during the quarter compared to 19 new stores opened and four remodels completed during Q2 2014. Operating income increased 20.9% to $118.5 million. Operating margin was up 20 basis points versus last year to 13.5%. Our tax rate was 37.5% versus 38.1% last year, driven primarily by the impact of accounting for equity compensation transactions. Net income increased 22% to $74.2 million or $1.15 per diluted share versus $60.8 million or $0.94 per diluted share last year. Turning to the balance sheet and cash flow, inventories were $705.7 million at the end of the quarter compared to $541.5 million at the end of Q2 2014, up 14% on a per-store basis. Excluding the investment in inventory to stock the new DC in Greenwood, inventory per door was up 10.9%, roughly in line with our comp growth. This increase was related to maintaining strong in-stock levels for our fastest-turning SKUs to support our rapid sales growth, the addition of new brands and the rollout of Clinique and Lancôme boutiques. Capital expenditures were $80.6 million for the quarter, driven by our new store opening program, merchandise fixtures and supply chain and system investments. We are on track to spend about $300 million in CapEx this year. Depreciation and amortization for the second quarter were $39 million, and are expected to be about $170 million for the full year. We ended Q2 with $475 million of cash and short-term investments. The company repurchased approximately 291,000 shares at a cost of $46 million during the quarter under our 10b5-1 plan as part of our program to return cash to shareholders. As of the end of the quarter $286 million remained available under the $400 million share repurchase program. We expect to continue to offset dilution with our 10b5-1 plan and still have the flexibility to repurchase opportunistically beyond that. Turning now to guidance for 2015, in terms of our outlook for the full year, based on our strong performance in the first half, we are raising our sales and earnings expectations for the year. We expect to open approximately 100 stores in 2015 and remodel four stores. We plan to grow e-commerce sales in the 40% range. We expect to drive comparable sales in the 8% to 10% range. We expect to deliver earnings per share growth in the high-teens, from the $3.96 of adjusted EPS we delivered in 2014, which excludes the $0.02 non-recurring tax benefit in Q4 of last year. This guidance includes planned supply chain and systems investments, and assumes we continue to repurchase shares to offset dilution. We expect to de-leverage on the gross profit line and modest leverage on the SG&A line, and operating margin is expected to be about flat. As a reminder, much of the investment related to our supply chain project will hit gross profit, including higher depreciation expense, which you'll really begin to see in the third quarter. We expect our tax rate to be approximately 38%. We expect to spend capital on a $300 million range and to generate free cash flow similar to last year's performance. We're very pleased to raise our annual comp guidance and earnings outlook to deliver high teens earnings growth while making significant investments in the business to drive sustainable, long-term market share gains and shareholder value. Moving on to specific guidance for the third quarter; we expect sales to be in the range of $869 million to $883 million compared to $745.7 million last year. We anticipate achieving comparable sales in the range of 8% to 10% versus 9.5% last year. We expect to open 44 stores in the third quarter versus 50 stores opened in Q3 last year, so pre-opening expense should expected to be down slightly. Earnings per share are expected to be in the range of $1 to $1.05 versus $0.91 for Q3 last year. We anticipate a tax rate of 36.9% and a fully diluted share count of approximately 64.2 million. And with that, I'll turn the call over to our conference call host to begin the Q&A session. Operator?

[Operator:]

At this time, we'll be conducting a question-and-answer session. First question comes from the line of Stephanie Wissink from Piper Jaffray. Please proceed with your question.

[Stephanie Schiller Wissink:]

Thank you. Good afternoon, everyone. I have two questions for you. Mary, if you could just start with some of the new brand initiatives. We've seen some of the roll-outs in stores as well as some of your digital communication. Can you talk about some successes there and how you're thinking about strategically deploying those across some new initiatives for the back half? And then just a question on the DC; could you remind us, once that DC is fully up and running, what the total store capacity will be of your existing infrastructure and when you may need to invest again to support the next roll-out of some of the smaller format stores? Thank you.

[Mary N. Dillon:]

Well, let me just say that the newness that you asked about, I think it's really – we constantly know that our guests are interested in news and innovation. And as I mentioned, there's several things that were quite successful in the quarter. So brands like Benefit and Urban Decay with a smoky palette, brands like Anastasia, across all categories, Redken Frizz Dismiss, Mix is a hot brand. So there was really a lot of newness as well as existing brand newness, new brands and just core brand growth. And how that works in terms of our platforms in terms of marketing is that's really where we bring it all together is just making sure that our guests get to understand what we have that's new and exciting. I think our marketing tactics are breaking through the herd in even better ways all the time. So that's going to be a core part of what we do, and I think we're getting better at it all the time, more efficient and more effective. In terms of distribution centers, so, this new DC will serve the 400 stores, 45,000 ecommerce orders. We're planning another distribution center that's in development, in construction right now in Dallas that will open next year. And that will be sufficient for the capacity that we need for some period of time. We'll continue to evaluate that. Whether it's small or large stores, we would anticipate that to be covered in the network that we're defining. But certainly that's fluid as we continue to grow and look out to the future; we'll continue to evolve that strategy and our needs.

[Stephanie Schiller Wissink:]

Thank you. Best of luck.

[Mary N. Dillon:]

Thank you.

[Operator:]

Our next question comes from the line of Oliver Chen from Cowen & Company. Please proceed with your questions.

[Oliver Chen:]

Congratulations on really spectacular growth here. Regarding the holiday plans and inventory optimization, which categories are most ripe for that process and will that impact holiday? And some retailers are potentially, in different categories are potentially over-inventoried in the marketplace, so how should we think about the main catalyst for you in holiday at large and what might be most different on a year-over-year basis?

[Mary N. Dillon:]

Well, thank you, Oliver. I'd say broadly speaking of course holiday we've been focused on for months. We're excited about it. It's clearly something that is important to us and to our guests as well. I guess what I would say is that we just try to be clear about making sure that we've got adequate inventory for what we expect to be our top volume items. And we think we're in good position to do that. So I would say that that we look at that as a core part of how we do business. Given our growth trends, and I think our ability to really understand what's going to move, we don't have big concerns about things that don't work during holiday, I think historically we've been able to manage that really well and have a low amount of products that don't work well. But, so I think we're in good shape there. Is there anything you'd want to add to that, Scott?

[Scott M. Settersten:]

No, I would just add that really we don't have any concerns about our inventory position. Again, very little in the way of seasonality and what we carry in our stores. I think we probably have one of the best-in-class in retail as far as the ability to work through discontinued product or clearance things and partnering with our brand vendors to do that in the most profitable way possible.

[Oliver Chen:]

Okay. And just a quick follow-up on the mobile front, is there any – where are you in the innings of like innovation there, and what are the next chapters for us to look forward to as this customer seems really engaged on the mobile frontier as well?

[Mary N. Dillon:]

And I'll let Dave take that.

[David C. Kimbell:]

Yeah, that's great, Oliver. Yeah, mobile obviously is continuing to grow for us and for – it's increasingly the way consumers want to engage with brands and shop. For us in the second quarter, about 60% of our traffic came through our mobile applications, mobile website, and about 25% of our sales. So it's, we're well past the early innings on the impact that it's having in the marketplace, and we're continuing to optimize the experience in our total digital footprint, which mobile is a critical one. We're improving our app pretty significantly and trying to make that shopping experience easier when she's on our mobile website. All of the changes that we're making around trying to increase conversion and increase average order, that we're doing both on the desktop service as well as mobile are having an impact. So we're trying to sharpen how the offers that we're highlighting, the way we can personalize e-mails that then drive her to the mobile website. So a lot that we're doing we think it will increase, continue to increase. It's clearly the way that she wants to shop and it's a big area of focus for us going forward.

[Oliver Chen:]

Thank you. Best regards.

[Operator:]

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

[Daniel H. Hofkin:]

Good afternoon. I'll echo the terrific results. Just a little more color, if I could. In a general trend within retail and omni-channel, retailers obviously, e-commerce sales and sometimes coming at the expense of the in-store business; clearly that does not seem to be happening with you guys seeing actually an uptick. Just curious what you feel like – you talked about marketing. Are there any, a couple of things that you feel like are incrementally resonating even a little bit more with the consumer? And then lastly, I'll just editorialize I'm assuming that the Donald Trump look is not one of the fall and winter looks that you guys are considering?

[Mary N. Dillon:]

We took that one off the table. That's funny. On the e-commerce omni-channel, let me just start broadly and then maybe I'll ask Dave to add some specifics. But I think a couple of things. One is that we're clear that for us, two things, one is that the multi-channel shopper is our best shopper. She's driving a lot. It's really a pretty incremental business for us. And the core insight is that the experience to go shop for beauty is one that largely women want to have happen in the physical bricks and mortar space. In our play, what we're trying to do is make the store experience just so inviting with the right products and the right level of service across the board, and we think that's working for us and is very sustainable. She likes to come and explore and to try and to spend time there with services as well. Obviously, that's something you can't get done online. So for us, we see that as the core part of our business; e-commerce is working in a way that kind of neat because it's incremental. So the shoppers that we have that are shopping both online and in store are by far our best shoppers. They're, for example, maybe coming nine times a year versus store-only, which is like four times a year. That's only a small percentage of our guests that are actually doing that, so we like that. We think growth in e-commerce, obviously, is going to be incremental and profitable for us and fits with the consumer insight and the model that we're building.

[David C. Kimbell:]

I'll just to add to that, certainly, we look at total omni-channel customers, the one that we're most focused on continuing to grow. And so most of the marketing efforts that we're doing are driving both online and in-store activity. So that Mary mentioned some of the advertising programs in the second quarter, a fair amount of radio advertising, enhanced digital advertising, both of which through our analysis drives both in-store and online activities. Certainly, within the digital space itself, our social media activity has increased quite a bit. Our PR is much stronger. We're doing more with social influencers to drive greater engagement. And then, as we roll, as Mary mentioned, roll into the third quarter beyond into other tactics that we historically haven't used like TV. We think all of those will contribute to driving a more loyal guest. She is very attracted to our loyalty program. And that behavior then gets her shopping in both channels, and that's the behavior that we want to continue to drive. And we've had some success doing that so far.

[Daniel H. Hofkin:]

That's great. Thanks. Best of luck.

[Operator:]

Our next question comes from the line of Simeon Siegel from Nomura. Please proceed with your question.

[Simeon A. Siegel:]

Thanks. Good afternoon and congrats. Sorry if I missed it, within the traffic increase, can you share the breakdown between new customers versus increased frequency of existing shoppers? And then maybe can you talk about where you're still sourcing those customers from? And then just, Scott, given the moving pieces, can you help with the magnitude of the gross margin impacts over the next several quarters? Thanks.

[Scott M. Settersten:]

Yeah, I guess I'll start. We don't really break out new customers versus existing. I mean we bifurcate the top; we talked about the fact that the majority of the comp, two-thirds of it was transaction or traffic based with the remainder being average ticket, and that was primarily driven by average selling price. So units were relatively flat year-over-year, more Prestige again, less promotion, which is driving the basket increase overall.

[David C. Kimbell:]

I'd say we are excited; we're really pleased with both, though, our new traffic, our new guest acquisition rate. Mary in her comments mentioned that our membership grew to 16 million guests or about 18%, and that was driven by healthy increases in new guests as well as strong retention, increase in retention of the existing guests. So we feel like we're both attracting new and then keeping even more of our existing guests engaged in our proposition.

[Scott M. Settersten:]

And a little color specific to 2Q as far as margin goes, we're very happy to see core product margins in our retail business, which again is more than 90% of our total sales, continue to expand. Prestige mix helped, less promotion overall helped. We did have a little bit of headwind; we didn't have as much fixed store leverage in the second quarter is what we saw earlier in the year or what we saw in a year-ago period. We also had a litany of other smaller items that affected the quarter; again we normally don't get into this level of detail, but salon for example, we mentioned in the script, Mary did, about some training for our salon associates for the fall trend look. We pulled forward some expenses there, so that was a bit more of a headwind than what we expected. And we also had the startup of the DC, which negatively affected gross profit in the quarter.

[Simeon A. Siegel:]

Great. Thanks a lot. Best of luck for the rest of the year.

[Scott M. Settersten:]

Thank you.

[Operator:]

Our next question comes from the line of Rupesh Parikh from Oppenheimer. Please proceed with your question.

[Erica A. Eiler:]

Good afternoon. This is Erica Eiler on for Rupesh. Congrats on the really – another nice quarter. So I just want to get back to e-commerce here, I mean it sounds like you've clearly done a lot to enhance the customer experience online. I was hoping maybe you could talk a little bit more about what you're seeing from consumer purchases online, specifically maybe what the Mass/Prestige mix of products looks like online versus in stores? And then also just wondering if perhaps consumers are buying more staple-like products, maybe their foundations or go-to mascaras versus maybe shaded goods or skincare products that consumers may want to experiment with in stores? That would be great. Thanks.

[David C. Kimbell:]

Yeah. Great questions. Again we're very pleased with our overall e-commerce success, and we see a lot of runway going forward. Specifically, some of the questions, we don't really break down between categories, but what I would – your question about Mass versus Prestige what I would say is that the – a key part of our total proposition, e-commerce, anywhere, in our brick-and-mortar and e-commerce stores is All Things Beauty, All in One Place, the breadth of assortment, the breadth of price points, the breadth of categories, that certainly is what drives our business and differentiates us and we see that within the e-commerce space. So largely I'd say the assortment and the engagement that we have in our brick-and-mortar stores is largely reflected on e-commerce. There were some categories in e-commerce that we've talked about in the past that we didn't have as full an assortment, but much of that gap has been closed, largely in our professional hair care. So we see that really reflecting what we see in the in-store environment. For staples versus trying new things, I'd say it's a bit of both. We certainly don't see only staple or replenishment-type items being bought online. That is happening, but what we find, particularly with those guests that are, that we talked about that are omni-channel guests that are really our best guests, she's shopping more frequently in total across both our retail stores and our e-commerce site and she's buying items that, yes, she can – maybe that are replenishment, but she's also indulging in things that she hasn't tried that are new items. She wants to get a purse; she wants to go online right when new offers are up and available. So she's doing a bit of both, and that's absolutely the types of things that we're encouraging. We'll find it, make it easier for her going forward to replenish those favorite items, but also continue to highlight news and exclusive and first-to-market items that get her excited when they come out.

[Mary N. Dillon:]

Yeah, and I'll just add, and I mentioned this in the script, our CRM capability gives us the ability to really get – to experiment a lot with how to get more personalized and more customized on what we e-mail, to whom, and really allow her to try things whether it's Beauty Breaks or just e-mail that introduce her to new products. So it's really a nice way for our guests to learn about new products and try new categories that they wouldn't have before.

[Erica A. Eiler:]

Great. That's really helpful. Thanks for the color.

[Operator:]

Our next question comes from the line of Simeon Gutman from Morgan Stanley. Please proceed with your question.

[Simeon Ari Gutman:]

Thanks. Nice results. Mary, you mentioned evolving labor model in your prepared remarks. Can you update us on your thoughts there? I think at Analyst Day, you suggested you might experiment in some areas in the labor model. And then connected to it, you're being very successful with CRM and marketing. Curious in places where you're testing increased labor if you're seeing a benefit above and beyond some of the success you're seeing with CRM and targeting?

[Mary N. Dillon:]

Thank you, Simeon. Just stepping back, let me just kind of big picture-wise I guess what I would say is that as we think about it, Kecia Steelman, who's our Head of Store Operations and her leadership team, we've got a very experienced set of store operators, and we're really focused on continuous improvement and excellence in operations and guest service kind of across the board. So while the payroll test is kind of a piece of it, just to give you a broader perspective, I mean, we're really kind of thinking about how do you put the guests and the associates serving the guests in the center of kind of everything we do, and really a holistic approach to – improvements, whether it's people, processes or tools. So that's everything from identifying the right talent, training and development, store processes, best use of labor hours as we kind of talked about there, all to kind of just really improve that guest experience. So the payroll test is just a part of it. We're learning things. We've extended it to another 60 stores. We've gotten some specific learnings, things that we're trying that are differently. I don't want to get more specific on it than that because we're still learning, but certainly, we're measuring impact on sales and units per transaction and whatnot. It's kind of a combination of art and science. It'll be core to just what we do all the time. So there's no big kind of aha in one specific thing coming out of it, but think about it as just a piece of a broader focus on how do we get better every day, and what we do in store to serve our guests.

[Simeon Ari Gutman:]

Okay. Thank you.

[Operator:]

Next question comes from the line of Matt McGinley from Evercore ISI. Please proceed with your question.

[Matthew Robert McGinley:]

Thanks for taking my question. My first one is on the inventory. When we look at that 30% inventory growth you had, I think you said 16% of that was related to getting a DC in stock, and I assume some of that would be safety stocks. I wonder what the, of that 16%, how much is in stock versus safety stock? And does that normalize over the year, or do we really need to get past the DC that opens in 2016 to see those growth rates drop? And the second one is on advertising. With the testing you were doing last year, I know you were happy with those tests, and you expressed how good they were in the test-market stratagem. So my question is as you didn't do as much advertising in the second quarter, did those markets where you did the tests in continue to outperform the rest of the company or the company average?

[Mary N. Dillon:]

Yeah, I'll start with that. I'm not, I wouldn't want to comment about kind of all the specific learnings. Clearly, we feel good about what we've learned, and it's been, we've been I guess modifying our marketing mix for some period of time, with Dave's leadership and his team. So what I'm excited about is that our marketing is getting more efficient and effective every day. And that's really critical for us through the long term to drive short-term results and to create a long-term, strong brand and brand equity. So that like, I'd say in the last quarter, seeing we added radio advertising. We did a lot of PR. We did a lot of digital. We also continued tactics that we've always done like tabs and magazines. All of those are getting more effective and efficient with less reliance on discounting. In addition now, as I mentioned, next, this really starting next month, we're going to layer in national television advertising. We learned from the in-store tests that that was going to be effective for us, and so we're going to add that to the mix. So just I guess I feel confident in saying that we got a lot of good learnings out of the tests, and now we're moving forward, implementing all those learnings as we go. But again, it's art and science. So this won't – there's never actually one answer and it's never any one stopping point, right. We'll continue to evolve as we go.

[Scott M. Settersten:]

And with respect to the inventory, it was roughly $20 million at the end of the quarter which I'd say is all safety stock because we weren't servicing any stores out of that DC at that point in time, right. We started subsequent to quarter-end, so I would say we expect that to be kind of the high watermark on a per door basis for fiscal 2015. We expect to see some moderation now the second half of the year, and should stay roughly in that zone as we cycle through next year with another DC stacked on top. So once we get through 2016, again with all of the systems we're putting in place

[Matthew Robert McGinley:]

Okay. Thank you.

[Operator:]

Our next question comes from the line of Chris Horvers from JPMorgan. Please proceed with your question.

[Christopher Michael Horvers:]

Thanks. Good evening. So wanted to follow up on the gross margin question; how significant was the DC start-up costs and the 50 bps? And would you consider it one-time? And then on a related note, can you provide some color on the magnitude of the marketing shift out of 2Q? And whether those dollars spread roughly equally in the back half?

[Scott M. Settersten:]

Yeah. I guess with respect to the gross margin, I'm not going to quantify the basis points here. We try to steer away from specific P&L line guidance. But it's going to be much more significant in the third quarter than it was in the second quarter, okay, so just directionally second quarter, a lot of payroll costs, right. We've got rent expense running through the P&L because we're in start-up mode, but the depreciation doesn't really start and that's really going to be the significant incremental cost, run it through the gross profit line starting in the third quarter, all right, for all the investment. And again, we called that out in our investor communications, right, it's upwards of $60 million, so it is a significant step-up from what we've done historically. Marketing, kind of along the same lines, we're not trying to get too specific on what dollars moved where, but it's significant. I mean we saw some in the first quarter, we called that out. We saw more in the second quarter. And again, it's a result of us being smarter during the quarter. We're seeing sales trends, and if we see an opportunity to pull back we will do that. And we'll keep the dry powder for when the ducks are flying, so to speak. So fourth quarter there's a lot of shopping, a lot of new guests coming into a lot of new stores that we're opening during the course of the year, and we're going to deploy the marketing where we think it makes the most sense.

[Christopher Michael Horvers:]

And then – and just going back to the gross margin question, so understood, the depreciation steps up but you don't necessarily have the other items sitting in there like the Salon training which would pressure gross margin. I guess what I'm trying to understand is could gross margin in the back half be down in similar magnitude as it was in the second quarter?

[Scott M. Settersten:]

I don't think I want to get to that level of detail. Again, I would just say though there's always, every quarter is kind of standalone. There's ins and there's outs. The Salon we mentioned this time because that was a bit of an unusual item; e-commerce was strong, right, that Leader Event (47

[Christopher Michael Horvers:]

Thanks very much.

[Operator:]

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

[Joseph Nicholas Altobello:]

Thanks. Hey, guys. Good afternoon. Just first question, I just want to go back to the inventory line for a second, I think Scott, you mentioned earlier obviously that that's going to remain a bit elevated here with the new DC coming online. When do you expect the year-over-year increase in per door inventories to migrate back to basically same-store sales growth? Is that next year?

[Scott M. Settersten:]

Well, I'd say we're going to be in the neighborhood this year. I mean look at the comp that we're posting, it's an 11% comp so you're looking at ex that $20 million of start-up inventory I'd call it, we're at the comp level. So it's not – I wouldn't view the inventory as being out of control in any way, shape or form. I mean we feel very comfortable with the inventory that we have. Again, there's little seasonal or fashion risk to the inventory. I mean to be frank, we spend most of our time trying to figure out how to stay ahead of the trend usually when we're chasing inventory. So with the cash and the balance sheet strength we have, we're not going to be shy about making some bets going into the fourth quarter, right, on hot products. So we're – I would say generally speaking there's nothing to see here, right. We're very comfortable with our inventory position.

[Joseph Nicholas Altobello:]

Okay. That's good to hear. And then secondly in terms of your decision to go into national TV advertising for the first time, why now? Is this something that you view as a natural extension of your marketing strategy? Was it something that was sort of debated internally? Or was this just an obvious move on your part? Thanks.

[Mary N. Dillon:]

Yeah. It's really been part of our thinking all along, and really part of our five-year plan. The first strategic imperative that we described is driving new guest acquisition and more loyal – more sales from our current guests. We know that we have a gap in awareness of our brand relative to our competitors, whether it's aided or unaided. And there's – television advertising is one of the tools, one of the fastest tools to drive awareness. And we've been two years into it now. So it wasn't like we're just going to go and jump and do that overnight. We carefully developed brand positioning, created, tested it, tested the media plan, so feel confident that the time is right. Also I would say we all know it's a very competitive marketplace. It's always been and probably always will be. So striking while the iron's hot I guess. We're in a position to build a long-term sustainable business model here. And we think this is a key part of it is to really keep pressing ahead with the marketing tools to drive both short-term and long-term results. And we feel it's the right time to do it. We're ready to do it.

[Joseph Nicholas Altobello:]

Great. Thank you very much.

[Operator:]

Okay. Next question comes from the line of Kelly Halsor from Buckingham Research. Please proceed with your question.

[Kelly L. Halsor:]

Hi. Thank you for taking my question and congrats on another great quarter. I was wondering if you could talk a little bit more about the Prestige skin care category. It's been a few quarters since you guys have called it out as a top performing category. So what are you seeing in terms of trends and newness of products and brands beyond the rollout of the branded boutiques? Are there any opportunities to add new brands, especially in light of some of the well-known brands recently announcing plans again to do specialty multichannel in a bigger way? And then secondly, could you provide any more color around the cadence of the DC and the store ramp-up? How many stores do you need to get to start to see some leverage on costs associated with that facility? And just any timing around that would be helpful as well. So thanks.

[David C. Kimbell:]

I'll start with the Prestige skin care. Prestige skin care I think is probably aware is not – has been a little slower than historical over the last few years. It has slowed down as a category, although we see it as a critical central category to our overall proposition. And we're excited about the potential. I think it's a mix of great partners that we have in place today. Some of our biggest, strongest brands like Philosophy, Dermalogica, Clarisonic. Dermalogica with our partnership with Skin Services (52

[Scott M. Settersten:]

And, Kelly, the short answer on the leverage question on fixed costs there. We would expect, we expect to see benefits from the Greenwood facility, we expect to see some benefits next year. Of course those will be masked somewhat by adding another new DC in the Dallas area. Meaningfully 2017 I think is where we'd be able to see more presence of leverage on the P&L overall.

[Operator:]

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

[Mark R. Altschwager:]

Good afternoon, and great quarter. I have a bigger picture question. Mary, we've seen growth in popularity of these beauty subscription services. I think one of your competitors actually recently announced a launch in that area. Can you just give us your thoughts on the merits of that model? Is it something ULTA loyalty guests are asking for? Something you could see ULTA doing in the foreseeable future? And maybe any comment on where your capabilities lie there given the new DC investments. Thank you.

[David C. Kimbell:]

Yeah. I'll take that, Mark. We see the real benefit of that whole space as fundamentally driving trial and discovery of products for our guests. And that's something that we've been focused on for a while. We do a lot in that space. We do not currently offer an exact subscription-based model similar to some of the other ones that are out there. And we'll explore all our options going forward, although I'd say what we're really focused on is finding what we think are probably even better ways to drive that discovery and trial. We do a lot with our guests to provide products. We do programs through our e-commerce platform, Beauty Breaks, which are kind of weekly limited-time offers that give half prices and samples associated with it. We have Beauty Bags that are extremely popular that give premium size samples to our guests. And then we feel they're more targeted and more relevant. We often partner those with buy-ins on certain products, so there's a – our customers are more engaged in it. They're expecting these products to come along with it, so their usage we think is really good. We're also experimenting in another variety of different ways again tried this (56

[Mark R. Altschwager:]

Thanks, Dave, and best of luck.

[Operator:]

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

[Dana L. Telsey:]

Good afternoon, everyone, and congratulations on the terrific results. As you think about the new guests that are coming in, whether going to the salon or even in the store with Prestige, do you think these salon guests, how many of them are coming from loyalty programs, how many of them are coming from the marketing efforts that you're putting into place, and what does this mean for conversion into loyalty members going forward? Thank you.

[Mary N. Dillon:]

Yeah, I'm glad you asked that because it's an exciting area for us in terms of growth, future growth, because really a small percentage of our loyalty guests today are using the salon. We're doing a lot. I'd say it's coming from a lot of things. One is we've offered a new online booking service that we know is driving largely incremental new guests, thousands of them, in fact. And then also our marketing programs right now are getting more and more focused on integrating makeup and hair and trend, and they're very exciting. And I think, and we're actually bringing to our store associates this kind of trend training that we talked about, bringing it to life inside the store. And certainly every guest that comes into the – to an ULTA store who is a potential new loyalty member, our in-store – our associates in store are doing a great job of converting them into the loyalty program because they understand that that's important for the business. So all those items will work together we think and will continue to be a key part of our growth story.

[Dana L. Telsey:]

Thank you.

[Operator:]

Our next question comes from the line of Mike Baker from Deutsche Bank. Please proceed with your question. I'm sorry, Mike, did you have a question?

[Mike Baker:]

Hi. Sorry about that. I did the old mute thing. You guys talked about in your prepared remarks a metric of sales per e-mail sent out, which is an interesting metric. How long have you – can you give us some more color on that? How long have you measured that? Has the growth accelerated at all? Or what has that looked like in the past? Thanks.

[David C. Kimbell:]

Yeah. We won't get real – the specific numbers on it, but it is something that we've measured for a while, and we're seeing really, really healthy growth. And that growth in effectiveness of our e-mail campaigns is really fundamentally coming from I'd say two places. One is better targeting, so we're understanding our consumers' desires we think a little bit better, and personalizing the e-mails to them. And then, the offers, the items and the creative that surrounds them we think is better as well. So the e-mails themselves are better, better items, better offers, better programs that are personalized in much sharper ways. And those things have really worked well. So we're sending out more e-mails, but we're getting much more effective and efficient in doing it, and we think it will be a big growth driver for us going forward.

[Mike Baker:]

Okay. Thanks. That makes sense. If I could ask one other, just on the supply chain; I assume we're still on line for that, the hit this year to be 5 percentage points relative to your earnings growth. And did that peak? It seems like that's going to peak probably around the third quarter. Is that right?

[Scott M. Settersten:]

That's correct. You got that. Yeah. Third quarter when we flip the switch at the beginning of the third quarter and that's when it was right just doing a store or two, and now we're going to ramp it up, and it will get more efficient over time. And as we get into the fourth quarter it's going to service 130 stores, 140 stores. So at that point it will be more productive and be contributing more, or less drag overall I guess I should say.

[Mike Baker:]

Understood. Thanks very much. Appreciate it.

[Operator:]

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

[Aram H. Rubinson:]

Hello. Thanks for taking my question. It looks like we're in overtime here. A lot of retailers have struggled with trying to reduce promotions and still hold sales. You guys are one of the few where you've actually pulled back on promotions and sales have kind of held or accelerated. I know you are still using pretty blunt instruments when it comes to CRM and customer knowledge. I'm just wondering, is there potentially another round of that as you look at kind of the response that your customers have had to it. Do you think that if we, or you decided to kind of pull that lever again, that you might be able to go another round perhaps a bit more surgical, but kind of almost repeat that same exercise?

[Mary N. Dillon:]

I would say that – I don't know that I envision another big change here. This is a gradual process that we've been working on really for some period of time which is kind of the careful experimentation, testing and learning, trying things differently and changing such that our marketing mix now – I wouldn't say it's blunt instruments so much anymore. I mean I understand your question but I think we now have a really robust array of tools that are getting better and better as it relates to effectiveness and efficiency. So I would just consider this a core part of how we're going to always do our business, which is constantly look for how can we be driving long-term brand equity, which is really important that people understand what ULTA is and they're aware of us, they understand that we are All Things Beauty, All in One Place. And then lots of surgical tools to drive the short-term day-to-day results that we need. So it's an ongoing piece of how we're going to do the business. Dave and his team are all over it. And that's how we look at it.

[Aram H. Rubinson:]

Let me ask it another way, is if you were to look at your level of promotion today versus the brand equity you think ULTA deserves or warrants, do you think those two are in balance now? Or are they still a little out of balance and which way?

[Mary N. Dillon:]

Well, we're really just starting the national television advertising, as you know, so that's another kind of shift in the balance of the mix. I envision that we'll be able to hold our (1

[Aram H. Rubinson:]

Thanks. Good luck with the new DC.

[Mary N. Dillon:]

Thank you.

[Operator:]

Okay, Ms. Dillon, it appears there's no further questions at this time. Would you like to make any closing remarks?

[Mary N. Dillon:]

Yes. In closing I'd just like to say I'm very proud of the excellent results that the associates across ULTA Beauty are delivering while making significant progress on all of our initiatives

[Operator:]

This concludes today's teleconference. Thank you for your participation. You may disconnect your lines at this time.