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Executives

Allison Malkin – ICR, Inc.

Lyn P. Kirby – President, Chief Executive Officer & Director

Gregg R. Bodnar – Chief Financial Officer & Assistant Secretary

Analysts

Brian Tunick – JP Morgan

Neely Tamminga – Piper Jaffray

Lizabeth Dunn – Thomas Weisel Partners

Erika Maschmeyer – Robert W. Baird & Co., Inc.

Samantha Panella – Raymond James

Daniel Hofkin – William Blair & Co.

Jillian Caruthers – Johnson Rice & Company

[Henry Compellin] – Oppenheimer & Co.

[Anthony Lebosinski] – Sidoti & Company

Ulta Salon Cosmetics & Fragrances, Inc. (ULTA) Q2 2009 Earnings Call September 3, 2009 5:00 PM ET

Operator

Welcome to the Ulta second quarter 2009 results conference call. At this time all participants are in a listen only mode. A brief question and answer question will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host Allison Malkin of ICR.

Allison Malkin

Before we get started I’d like to remind you of the company’s Safe Harbor language which I’m sure you are all familiar with. The statements that are 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 or 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 will make references during this call to the metric free cash flow, a non-GAAP financial measure. Free cash flow is defined as net cash provided by operating activities less purchases of property and equipment. A reconciliation of free cash flow to US GAAP equivalent has been provided in exhibit five of our earnings release which is also available on our website and has been filed with the SEC on Form 8K.

Now, I’d like to turn the call over to Ulta’s President and CEO Lyn Kirby.

Lyn P. Kirby

Thank you for joining us to discuss our second quarter fiscal 2009 results. On the call with me today is our Chief Financial Officer Gregg Bodnar. Following my opening remarks, Gregg will review our second quarter financial highlight and outlook. Then, I will provide some closing comments and turn the turn over to the operator so that we can answer the questions that you have for us today.

We are pleased to deliver second quarter sales and earnings that exceeded our expectations reflecting a sequential improvement in comp store sales and earnings performance as compared to the first quarter. For the second quarter net sales increased 9.8% to $273.5 million. Comp store sales declined 1.7% slightly exceeding our guidance and following a 3.7% increase last year. So, on a two year basis comp store sales are up 2%. Comp customer traffic increased 2.2% and earnings per diluted share increased to $0.10 as compared to $0.06 last year.

The economic environment stabilized somewhat in the second quarter and while our performance given the environment was good we are certainly not satisfied and we would expect to deliver strong results in a more robust economy. That said, we attribute our strength in this difficult consumer spending environment to the successful execution of the key strategies we outlined at the beginning of the year which included the development of exciting new customer propositions to entice consumers to make a trip to Ulta, the introduction of new brands and products, a reduction in expenses that will permanently impact our cost structure and cash flow management strategies including our planned reduction in stores.

During the quarter we successfully reached existing and new customers and drove a 2.2% increase in comp store traffic through exciting events such as our back to school hair care leader sale, the introduction of new brands including Benefit Cosmetics, CARGO Cosmetics, [CEDO] Hair Care and Dr. Perricone skin care. Products exclusive to Ulta such as the $15 Bare Minerals discovery kit. We also increased traffic by continuing to drive our fragrance business through gift with purchases such as our spa wrap at mother’s day and our cooler at father’s day and new introductions such as Ed Hardy’s Love & Luck, DKNY’s Fresh Blossom and for men fragrances such as Only The Brave which we introduced and performed very well at father’s day.

Finally, we continued to utilize our private label to offer compelling value propositions and to introduce new products such as Ulta’s Professional Nail Color and our Ulta 52 piece blockbuster with a $150 value for $17.99. As a result of these initiatives we drove a 2.2% increase in comp store traffic during the second quarter without making any incremental investments in marketing. However, as we saw in the first quarter, we experienced a great response to our marketing coupons which had a 30 basis point impact on gross profit margin versus last year.

We have appropriately planned our merchandise and strategies to offset the modest margin impact from increased coupon redemption during the third quarter and we believe we will deliver an increase in merchandising margin for the third quarter. Despite passive traffic, we experienced a 3.9% decline in average ticket as compared to the second quarter last year resulting in a 1.7% decline in comp store sales.

As I have said many times in the past, we have categories such as hair care and skin care that are consumable and therefore prompt repeat purchase and others such as higher priced styling tools, fragrance and salon services that are more discretionary and continue to be impacted by this economic down turn which in turn impacts average ticket. Although still negative we did experience a strengthening in our comp store sales performance versus the first quarter and this was driven entirely by our retail business.

Importantly, on a comp store basis we grew market share during the quarter across each major category. We grew share in skin, fragrance, professional hair care and [inaudible]. Our market share gains of course are further enhanced with the continued expansion of our store base. In addition to our solid top line performance we made progress on our core financial strategies during the quarter.

We continued to make great progress on our cost savings initiatives. We have raised our full year target by $3 million to approximately $18 million in savings this year. We achieved a 9.8% reduction in inventory per store positioning us to decrease inventory per store by 9% at year end which is ahead of our initial targets of down 5% to 7%. And, we delivered $40 million of free cash flow for the first six months of the year driven by improved working capital management, reducing store programs and lowering store investment.

As we look ahead, we expect the economic environment remained challenging and consumers to continued spending cautiously for the remainder of this year. However, we believe that we remain well positioned as begin the second half of the year. We will continue to focus on profitable market share gains while carefully managing expenses. We will accomplish this by continuing to invest judiciously, develop top line growth with bottom line profitability, by executing our core strategies, by expanding our square footage by 11% this year and continuing to carefully manage our costs.

In third quarter we will continue to drive traffic and market share in our retail business through new brand introductions including philosophy fragrance and bath which has just been opened in 246 stores, through the introduction of new products an existing brands such as Matte Mineral Foundation from Bare Essentials, through the continued launch of new fragrances such as DKNY’s Delicious Art and the new Dolce & Gabana collection of fragrances and Lola from Mac Jacobs.

We will offer 16 in store events with Urban Decay international makeup artists who will tour stores during the third quarter. We will continue through the excitement in our private label with a 15 piece gift with purchase across our comestics line and new private label bath products such as body whip for back to school. Of course, we will continue to drive exciting value propositions throughout our marketing campaign. This motivation in new and existing brands will anniversary a strong third quarter launch calendar last year. Because of the exciting merchandise and brand opportunities we will not invest in additional marketing in third quarter.

In fact, based on our ability to achieve greater efficiencies as we leverage our growth. We expect our third quarter advertising rate to be below last year’s rate even as we delivered more impressions versus last year. In addition to our traditional traffic driving events, we have a new event in the third quarter that I would like to share with you. Also, you’ve heard me to peak to four Esthetics, escape, education and entertainment. This year we added a fifth E for empowerment.

In keeping with our commitment to empower woman, we have planned and in store vent in October for breast cancer awareness month. During a third week period we will invite woman to share their stores about their battle with breast cancers and their unsung heroes who supported them. These stories will be displayed on six miles of our store front windows across our 330 plus stores. In so doing we hope to encourage those who are fighting breast cancer and all of those who support them.

This campaign will be accompanied by an online campaign that we expect to great quite a buzz. During this tier period we will also be asking customers for donations to the breast cancer research foundation with appropriate gifts of thanks for their donations. We believe this event is a way to empower woman, to strengthen the emotional command and in our brand while giving to an important cause.

Within salon we have aggressively pursued new initiatives to gain market share as we expect consumers to continue to defer services in this economy. As we mentioned during our first quarter call we tested a new salon service with encouraging results which will launch in the third quarter. The new salon service is a carotene treatment which eliminates up to 95% of frizz and curl from hair. We will offer this service at a special introductory value compared to the suggested retail price of $250 a service. While consumers are cutting back on their spending, our test of this service indicates that the consumers are willing to spend for something new if it offers compelling features and value.

In addition, we are also very excited about our new marketing strategy for salons. It gives us the potential to solidify Ulta’s position as the leading authority in the salon business. The strategy is called runway your way. We have created a partnership with stylist Rodney Cutler who styles for runway shows for fashion houses such as Marc Jacobs, Mumu and Cynthia Rowley. Rodney has developed three unique haircuts for Ulta for the fall season adapted from the runway so that the styles are wearable for every woman. All Ulta stylists have been trained on these cuts which will be launched at the end of September to our customers. Our intention will be to update the collection with Rodney for each spring and fall season.

Regarding our web business, we expect to continue the positive momentum at www.Ulta.com. While still a relatively small part of our business overall, second quarter sales grew at double digit rates and we expect this trend to continue through 2009. In second quarter we expanded our assortment and continued to improve the shopping experience with our increased functionality including automatic cross selling and product recommendation.

In third quarter in addition to the ongoing development about online shopping experience, we expect to improve delivery time for our customers while also reducing shipping expenses through more efficient shipping processes. Regarding our store expansion, we continue to plan to open 35 new stores in fiscal 2009 increasing square footage by 11%. In the second quarter, we are pleased with the performance of new stores. We opened 13 stores and added two new states Connecticut and Mississippi ending the quarter with 333 locations. For the third quarter, we expect to open 12 stores.

As we look forward, we are seeing real estate opportunities in existing centers as new center development has slowed and continue to be opportunistic with regard to new site selection. As we said in our last call, we believe there is an opportunity to accelerate our square footage growth in 2010 depending on the availability of quality sites that meet our investment model. We remain confident in our 1,000 store opportunity long term.

Now, I’d like to turn the call over to Gregg to review our financials in more detail.

Gregg R. Bodnar

Our second quarter results were driven by better than expected sales performance due to the successful execution of our marketing and new brand introduction strategies combined with our continued focus on expense management and cash flow initiatives. Improved retail sales performance as compared to the first quarter and prudent expense management together have enabled us to exceed our second quarter targets in a challenging consumer environment resulting in earnings above our guidance range.

Now, beginning with a review of the income statement, net sales increased 9.8% to $273.5 million from $249.1 million in the second quarter last year. Sales growth was driven by the addition of 50 new stores since the second quarter last year. Comp store sales decreased 1.7% which follows an increase of 3.7% last year resulting in a two year comp store sales gain of 2%. Comparable store sales included a 2.2% increase in comp store traffic offset by a 3.9% decline in average ticket.

Our customer shopping trends remain consistent with what we saw in the first quarter. She is visiting our store more frequently but spending less per visit as she cut back on more discretionary items. During the second quarter we opened 13 new stores ending the second quarter with 333 stores and expanding square footage by 18% from last year’s second quarter. We continue to be pleased with the early performance of our 2009 class of new stores.

Gross profit dollars in the second quarter increased 7.3% to $78.5 million from $73.1 million last year. Gross profit margin was 28.7% a decline of 70 basis points to last year. This decline was primarily driven by 130 basis points of fixed store deleverage resulting primarily from our new store program. The fixed store deleverage is net of 30 basis points of temporary rent relief we received in a dozen stores where co-tenant vacancies triggered temporary rent reductions.

We also experienced a 30 basis point decrease in profit margin due to higher customer redemption rates for our marketing coupons which was expected and consistent with the first quarter. The decreases in gross profit margin were offset by an 80 basis point improvement in our supply chain due to cost reductions and operating efficiencies. The 70 basis point decrease in gross profit for the quarter was better than expected and better than what was reflected in our guidance.

The improved performance is primarily attributed to less deleverage of fixed store cost due to stronger sales, higher efficiency and lower operating costs in our supply chain, slightly higher merchandise margins and the temporary rent relief I just mentioned. SG7A expenses were $66.3 million or 24.2% of net sales compared to $61.9 million or 24.8% of net sales last year. The 60 basis point improvement in SG&A primarily represents improved leverage in store and corporate overhead expenses as a result of our focused expense management.

We currently expect to achieve annual cost savings of approximately $18 million which as Lyn mentioned earlier represents an improvement of $3 million from our initial plan. Pre-opening expenses totaled $2 million in the quarter which compares to $4.1 million in the second quarter of 2008. The reduced new pre-opening expense was slightly ahead of our expectations and was driven by lower labor costs. Strong sales growth combined with solid SG&A leverage and our planned lower store opening program led to a 42% increase in operating income to $10.2 million or 3.7% of net sales from $7.2 million or 2.9% of net sales last year.

Interest expense decreased to $.6 million from $1 million last year reflecting lower borrowings and interest rates. The effective tax rate for the quarter was 40% compared to 40.4% in the prior year. Net income for the quarter increased 55.9% to $5.8 million or $0.10 per diluted share from $3.7 million or $0.06 per diluted share last year.

Now, turning to the balance sheet and cash flow results, merchandise inventories at the end of the quarter were $209.2 million compared to $197 million at the end of the second quarter last year. Average inventory per store decreased 9.8% from the prior year quarter. The per store inventory decrease is the result of specific inventory management initiatives put in place in fiscal 2009. The $12.2 million increase in inventory was due to 50 new stores opened in the last 12 months. We remain comfortable with both the level and composition of our inventories as we enter the third quarter.

Regarding debt, during the quarter we were able to pay down roughly $35 million on our credit facility balance. This was driven by our focus on aggressively managing working capital levels, specifically in inventory and receivables and lower capital expenditures on fewer planned new stores. Outstanding borrowings as of August 1, 2009 were $65.5 million and our debt to equity ratio was a very modest two times. As of quarter end we had $120.8 million of availability on our credit facility. As a reminder, our credit facility provides borrowing capacity of up to $200 million.

We achieved free cash flow of $34.5 million for the quarter and $40.1 million for the six month period. Based on our progress on the aforementioned initiatives, we now expect to generate approximately $50 million of free cash flow this year. Capital expenditures for the quarter were $17.5 million and depreciation and amortization for the quarter was $16 million.

Regarding our outlook, we are pleased to see a continuation of the signs of stabilization in our comp store sales. We have also experienced a slight improvement in our comp store sales trends quarter-to-quarter driven entirely by our retail business. Having said that, consumers remain cautious and there continues to be limited visibility in to future consumer spending trends.

For the third quarter fiscal 2009 we currently estimate net sales in the range of $270 to $278 million compared to actual third quarter net sales of $254.8 million in fiscal 2008. This assumes comparable store sales decrease 1% to 4% compared to an increase of 2% in the third quarter of last year. As previously noted we have seen a stabilization and slight improvement in our sales trends driven by the impact of our marketing strategies new brand introductions. Consistent with our approach in prior quarters the wider comp sales range continues to reflect the uncertainty regarding whatever potential unexpected impacts to current consumer trends.

Income per diluted share for the third quarter of fiscal 2009 is estimated to be in the range of $0.08 to $0.11. This compares to income per diluted share of $0.09 for the third quarter of last year. Our third quarter EPS guidance at the midpoint of our range reflects a gross margin decline of approximately 20 to 30 basis points and deleverage in SG&A of approximately 70 to 80 basis points. This SG&A deleverage is driven by 100 basis point increase in bonus compensation expense versus the third quarter of 2008.

With regard to our new stores, we continue to plan to open approximately 35 new stores in 2009. As we look forward we are seeing real estate opportunities in existing centers as new center development has slowed and continued to be opportunistic with regard to new site selection. As we said on our last call, we believe there’s an opportunity to accelerate our square footage growth in 2010 depending on the availability of quality sites that meet our investment model.

With the strength of our balance sheet we remain well positioned to capitalize on these opportunities in our fiscal 2010 program. We also remain confident in our ability to obtain our 1,000 store long term potential. With respect to capital expenditures we continue to expect capital expenditures to be in the range of $72 to $74 million.

Now in closing, we continue to believe the consumer spending environment will remain difficult and uncertain. We have and will continue to take the necessary actions to control what we can control. We will continue to manage the business to drive earnings and generate free cash flow and reinforce our already strong balance sheet and liquidity position.

Now, I’d like to turn the call back over to Lyn.

Lyn P. Kirby

In summary, we are pleased with our second quarter results although we still believe that in a better economy our results would be stronger, we are optimistic regarding our optimistic regarding our opportunities to drive market share gain, solid profitability and free cash flow during the second half of 2009. Longer term we expect the strategies and programs we are implementing this year as well as the significant opportunities we see for expansion in our store base and brands to enable us to increase our long term profitability.

We continue to believe we are doing well navigating this difficult economy while simultaneously positioning our company for stronger performance when the economy improves. Now, I’d like to turn the call back over to the operator to begin the question and answer portion of the call.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Brian Tunick – JP Morgan.

Brian Tunick – JP Morgan

I guess a question for each of you, Lyn maybe talk about I know fragrance was a weak category last holiday, can you talk about are there any big fragrance launches that you see happening in Q4 of this year and have you changed your marketing or gift with purchase plans given what you think or see the department stores starting to do? Then maybe Gregg, can you talk about the number of leases you’ve already signed for next year and what are the lead times to be able to sign and be able to open a store so we can just get some idea if 45 or 55 or 60 could be the number of new stores next year.

Lyn P. Kirby

Let me take the first part first, as it leads to the fragrance business we do have some exciting new fragrances for fourth quarter. We expect to be anniversarying the newness from last year as well as the continued flow through of some really exciting fragrances from third quarter this year going in to fourth quarter. So, we feel great about the newness availability. On the gift with purchase strategy we continue to see traction with that strategy for our customers. We continue to develop fresh new exciting gifts with purchases to continue to stay motivational to our customer base and have appropriately planned that in our fourth quarter.

Gregg R. Bodnar

Brian, on real estate we continue to see lots of opportunities that keep coming to us as we continue to diligently review those through the process and as you would expect we’re being certainly much more careful as we go through and evaluate each one of these. As we typically think of it in terms of the number of deals that we have approved at this point in time, we have about 26 deals approved at this point in time, we have a significant number that we’re going through as we speak and we also have a meaningful number that the deal makers are continuing to work on to get those ready to present to us. As far as the lead time goes, we usually have until early part of next year to get something finished and documented to still get it open in 2010.

Brian Tunick – JP Morgan

If I could just ask Lyn, do you see the department stores being at all any more rational as we’ve come in to the back half?

Lyn P. Kirby

When you say rational are we talking about the beauty business, the apparel business, just what aspect are we talking about?

Brian Tunick – JP Morgan

More about the beauty and fragrance business.

Lyn P. Kirby

As you may recall we did see some discounting in fourth quarter around the holiday season last year from department stores, the first time we had ever seen that as well as some specialty competitors. We continue to see that run through first quarter but it has absolutely diminished in second quarter. I’m not sure if that’s your definition of rationality but we have certainly seen less of that straight across the board discounting Brian.

Operator

Your next question comes from Neely Tamminga – Piper Jaffray.

Neely Tamminga – Piper Jaffray

Just two questions, actually one real question and then a housekeeping one. The in store boutique strategy I think is a big picture longer term strategy for Ulta. If you go way back to the road show from the IPO to where you are today and where you will be for the next couple of years it’s not just about the stores you are growing it’s the productivity improvement within those stores.

So, I was just wondering can we take just a moment to kind of review where you guys are maybe this year versus last year in terms of how you look at the store base ranging from the one brand in store boutique to in some cases up to four in store brand boutiques, how you’re sizing up the store that way. Then, maybe next year, if you’re willing, what that might look like in to the cap ex plan, etc. next year. Then, if I can get it upfront, just the housekeeping questions, Gregg so that I understand your bonus accrual practices that you were indicating for Q3 was that for just Q3’s performance or is that actually the full back half?

Gregg R. Bodnar

I’ll take the second one first Neely, as you remember last year this is the point in time where the economy really feel apart, the consumer went in to paralyze. At that particular point in time we would have adjusted our bonus expense last year reflecting where we thought we would have finished the year.

Neely Tamminga – Piper Jaffray

So it covers the full back half.

Lyn P. Kirby

Neely, on the boutiques middle of the year last year we had rough and tough about 130 doors with boutiques. At the same time this year we’ve got about 190 or so doors with one boutique and we’ve got roughly bout 80 stores with two boutiques and that of course is primarily the combination of Benefit and Bare by in large. We’ve got a very small handful of stores, some of our larger stores maybe roughly around 10 or so with multiple boutiques, so with three or four boutiques.

As we look forward to next year we certainly will continue to roll benefits across the majority of our chain with that boutique strategy. Depending on the availability of other prestige brands, we certainly have a gain plan developed on how we would do multiple boutiques and more stores if that opportunity was available to us.

Operator

Your next question comes from Lizabeth Dunn – Thomas Weisel Partners.

Lizabeth Dunn – Thomas Weisel Partners

I was wondering if you could update us on competition? We’ve seen from the drug store competitors some real interest in prestige as a category. How are you thinking about those? Also, competition from the Sephora inside JC Pennys?

Lyn P. Kirby

In terms of the drug stores let me just to go the heart of the drug store competition right now which is on the [mass] business. We continue to see ourselves remaining extremely competitive on [mass] business and we are watching with interest some tests that Walgreens has been particularly public on as they reduce selection in their drug stores. So, at the very heart of our competition there we continue to watch that very closely.

As it relates to a couple of tests that are going on in terms of expansion in to prestige from the drug stores, we are going to watch it very closely as I am sure you are. It’s at a very modest number at this point, extremely modest and I am not seeing too much indication that there’s going to be a rapid expansion. As I take a look at the brand selection that the drug stores have in those test stores, it is more the what I would call specialty brand selection and not at all department store brands at this point. Again, we will of course watch that very closely but we’re not seeing it as a significant threat at this point in time given the magnitude of what that test is.

Sephore inside of JC Pennys we of course watch very carefully and continue to keep our eye on that. As you would know if you’ve done, as I’m sure you have checked, the selection of brand availability of the Sephore inside of JC Pennys is not consistent with what they have in their free standing stores. So, we certainly watch it, we’re obviously very familiar with JC Pennys real estate expansion strategy so that one we watch extremely closely but right now it is a different brand selection in those stores.

Operator

Your next question comes from Erika Maschmeyer – Robert W. Baird & Co., Inc.

Erika Maschmeyer – Robert W. Baird & Co., Inc.

I’m wondering if you can comment on comp trends quarter to date and also maybe comment on whether you’re still seeing prestige brands above the company average?

Lyn P. Kirby

In terms of the prestige brands, prestige as I think we’ve mentioned before, still remains one of our highest growth categories and continues to remain that both as we expand brand selection as well as penetration with the customer base so that does remain an above average trend for us. In terms of the quarter to date trend, we are not going to speak quarter to date but we are certainly very happy with our business quarter to date but we really feel that it is appropriate for us to pull back from offering quarter to date trends on these calls.

What I would suggest is what’s very indicative of how we feel our business is, is to take a look at the guidance range that Gregg gave and they certainly indicate a positive shift in the comp numbers versus the prior quarters guidance and that is the best indication of how we feel about the business quarter to date. Gregg would you have anything to add?

Gregg R. Bodnar

Erika if you look back over the last couple of quarters we tried to provide that information to give folks some further insights to the trends. We’ve seen two quarters of consistent trends. We’ve seen stabilization in our business and we’ve seen some slight quarter-to-quarter improvement and that’s reflected in the comp guidance we’ve provided for the third quarter.

Erika Maschmeyer – Robert W. Baird & Co., Inc.

If you could just comment on your private brands, you sounded optimistic on them and it sounds like you’re adding additional categories. Are you increasing penetration there or is that still around 5% of your revenue?

Lyn P. Kirby

Right now the 5% is a good number to be using but it continues to be a strategy for us longer term to continue to add to that and you can hear some of the additions that we have been making. But, given the growth factor of some of the other big categories in the business, the penetration is harder to shift than the actual growth rate so you know that math. Private label in the short term for us continues to be a great lever for us to pull to be driving profitable traffic to our store. It is part of our ongoing strategy to use that category to drive both traffic and unit penetration on the business.

Operator

The next question comes from Samantha Panella – Raymond James.

Samantha Panella – Raymond James

Just to follow up on the comp guidance, looking at even the high end of your guidance it does appear that the two year trend would worsen from the second quarter, any reason to think that other than being conservative?

Gregg R. Bodnar

What I would say Sam is that we continue to evaluate the trends on our business. I think in this particular environment particularly given what we’re recycling the start of the volatility from last year, we believe it’s more relevant to look at the current year trends and to the stabilization that we’ve experienced there. We recognize that we’re jogging over slightly lower comps than last year but the comp guidance is reflective of what the current trends are which I think what is more relevant to look at as we go throughout the course of this year up until the fourth quarter.

Samantha Panella – Raymond James

Then with respect to the temporary rent relief how many stores did you receive that and how long should that last?

Gregg R. Bodnar

It’s about a dozen and about half of those have been cured or are about to be cured so it will have a small impact on the third quarter.

Operator

Your next question comes from Daniel Hofkin – William Blair & Co.

Daniel Hofkin – William Blair & Co.

A question about the launch of Benefit, obviously that must have been very successful so far. I’m just curious if you could maybe help quantify a little bit what type of a lift you think that you saw that came out around mid quarter as I recall or at least it started to. I’m just curious what sort of a lift you might have seen and I know you guys did not do incremental marketing year-to-year. Then I guess the second question would be looking at the free cash flow performance in the second quarter and your new full year expectation, what’s the main one or two sources of upset there?

Lyn P. Kirby

I’ll take the first part, we’re not going to comment on an individual brand in terms of numbers or specific growth rates but we are certainly pleased with the Benefit launch so let me say that first of all. But secondly, I would remind you that we also continue to see really good strength in the core and existing business so in the quarter we did for example have a back to school leader event around our professional hair care lines. We had a very exciting private label event which was a buy two get two free which led in to some other brands and we have some of our existing brands like Bare Essentials where we offered a $15 discovery kit.

We are pleased with Benefit but there is much more to our business than just an individual brand and new products. One of the great strengths we have of the business is multiple levers to pull depending on the trends of the business, the environment we see and it is one of our core competitive advantages.

Gregg R. Bodnar

Dan, on the improvement in free cash flow, I think as we’ve mentioned the last couple of calls we have a number of initiatives that we’ve been working on that have materialized. Kind of in priority order versus our last guidance on free cash flow, the drivers are rally improvement in net inventory, you’ve seen we moved down in this particular case our improvement versus last year on a per store basis from five to seven to nine. We’ve also seen some benefits in net inventory over and above the gross reduction. Tax planning is another key driver that’s going to benefit us both it did in the second quarter and the rest of the year.

Earnings improvement versus our prior expectations as we’ve experienced in the second quarter and are now guiding to in the third quarter and then the last is really just fundamental working capital management and account receivables. Those are the four drivers.

Operator

Your next question comes from Jillian Caruthers – Johnson Rice & Company.

Jillian Caruthers – Johnson Rice & Company

Could you talk about for the third quarter you’re looking for gross margin pressure of 20 to 30 basis points, can you talk about what’s driving that given you’re not expecting as much rent relief and what not?

Gregg R. Bodnar

If you look at it versus the second quarter, and we’ve talked about this before, part of the pressure we get on gross margin is deleverage from our new store program and the fixed store expenses. As we have slowed down our square footage growth this year we’re starting to diminish that amount. So, in the third quarter I’m expecting about 100 basis points of deleverage. We expect to see about 50 basis points of benefit from our supply chain initiatives and then the rest of it is improvement in merchandise margin.

Jillian Caruthers – Johnson Rice & Company

If you could talk a little bit about inventory per store was down more than expected. You lowered your yearend targets. You quoted specific initiatives and places, could you add a little more detail around that?

Gregg R. Bodnar

A couple of things that we’ve been focused on, and this isn’t necessarily in priority order, we expanded our distribution network over a year ago now. We knew there was a greater opportunity to take the safety stock levels down and move inventory through our DCs faster. Along with our supply chain efficiency progress, we’ve made a lot more progress on managing distribution center inventory levels, so not in front of the customer. We’re very comfortable with the safety stock and lead times and the team continues to fine tune those to get some working capital benefit out of the company.

The other benefit is really as we continue to fine tune the inventory levels that we put in to our newer stores from a safety stock level, the assortment is the same but we’ve fine tuned the amount of inventory or depth per SKU that we’ve put in versus a mature store and we’re continuing to make better progress on that initiative versus what we expect. So, no impact on consumer experience and in fact, a slight benefit to in stock levels because we can move inventory through our DCs faster.

Operator

Your next question comes from [Henry Compellin] – Oppenheimer & Co.

[Henry Compellin] – Oppenheimer & Co.

Just had a question about the sequential improvement in same store sales, I wanted to know if that was also occurring in the salon business or was that disproportionately weaker than the sequential improvement in same store sales?

Lyn P. Kirby

The answer is that the improvement was entirely from the retail business from first quarter to second quarter and by in large the salon business has basically remained stable in its negative trend.

[Henry Compellin] – Oppenheimer & Co.

In terms of the average ticket decline, you said that that was 3.9% in the quarter. I wanted to know if you could just talk about some consumer trade down? I think previously you’d highlighted mineral based cosmetics as a particular category, I wanted to see if that was still the case?

Lyn P. Kirby

Yes, that continues to be one of the factors that we see in terms of the average ticket decline. The other factors are also the fragrance category still remains the most discretionary category and therefore our sales are still lower than prior year although we are significantly out pacing the industry and taking market share in that category. The other category that has certainly been hurt by this economy is our high priced styling tools products, products that are north of $100 in terms of their price. So, that continues to run through the average ticket.

Operator

Your next question comes from [Anthony Lebosinski] – Sidoti & Company.

[Anthony Lebosinski] – Sidoti & Company

I was wondering if you could talk about the expense savings that you’re now guiding to of $18 million versus $15 million, where is the additional $3 million coming from?

Gregg R. Bodnar

Two thirds of the improvement is coming out of our supply chain Anthony and the rest is coming out of our core store expense management strategies.

[Anthony Lebosinski] – Sidoti & Company

As far as your real estate is concerned over here, could you talk about just sort of next year the openings that you’re looking to do are they mostly back fills or new markets? And also, has there been any change to the length of your lease terms?

Lyn P. Kirby

In terms of the first part of your question, there’s very little change in the composition of the real estate program that we are expecting. The new to existing market ratio is about the same although you may have heard us stay before we’ve had a very slight uptick in the number of stores that we are opening in single store markets so there’s a very modest uptick. We have had a modest uptick certainly in the last six months between new and existing centers and we have seen a little bit of an uptick in existing centers since the impact to the economy but not a significant uptick from first quarter to second quarter.

Gregg R. Bodnar

Anthony, as we head in to next year, as we talked about, the opportunity really is in existing centers because by the time we get to next year, any of the pipeline that was built for new centers will have been opened so we don’t expect a big mix of our portfolio, unlike the balance in past years, to be in new centers. As it relates to the lease term, we still continue to have a similar structure than what we’ve done in the past. We typically do a 10 year initial lease term and multiples of two or three five year options that are our options for extensions.

Operator

There are no further questions in the queue. I would like to turn the call back over to Lyn Kirby for closing remarks.

Lyn P. Kirby

Thanks again for joining us today, we look forward to speaking to you on our third quarter call in December.

Operator

This concludes the teleconference you may disconnect your lines. Thank you for your participation.

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Source: Ulta Salon Cosmetics & Fragrances, Inc. Q2 2009 Earnings Call Transcript
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