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Ulta Salon Cosmetics & Fragrances, Inc. (NASDAQ:ULTA)

Q3 2009 Earnings Call

December 3, 2009 5:00 pm ET

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

Lizabeth Dunn – Thomas Weisel Partners

Daniel Hofkin – William Blair & Co.

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

Randy Konik – Jefferies & Co.

Samantha Panella – Raymond James

[Evron Habbelman – Wells Fargo Securities]

Jillian Caruthers – Johnson Rice & Company

Analyst for Neely Tamminga – Piper Jaffray

Henry Kerpellen – Oppenheimer & Co.

Anthony Lebiedzinski – Sidoti & Company

Operator

Welcome to the Ulta Salon Cosmetics & Fragrance third quarter fiscal 2009 results conference call. (Operator Instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host Allison Malkin of ICR. Thank you. Ms. Malkin you may begin.

Allison Malkin

Thank you. Good afternoon. Before we get started I would like to remind you of the company’s Safe Harbor language which I am 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 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 its US GAAP equivalent has been provided in exhibit five of our earnings release which is available on our website and has also been filed with the SEC on Form 8K.

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

Lyn Kirby

Thanks Allison. Thank you for joining us to discuss our third 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 third quarter financial results and fourth quarter 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 better than expected third quarter sales, earnings and free cash flow, building upon our positive momentum from the first half of the year. We attribute our strong third quarter performance to the continued successful execution of our core marketing and merchandising strategies and better than expected performance of our expense management and working capital reduction initiatives.

For the third quarter net sales increased 11.5% to $284 million. Comp store sales increased 1.5% exceeding our guidance and following a 2% increase last year, so on a two-year basis comp store sales are up 3.5%. Gross profit margin increased 70 basis points to 31.9% which included a 40 basis point increase in merchandise and marketing margins. We also exceeded our guidance with earnings per diluted share increasing to $0.14 as compared to $0.09 last year.

As we have previously communicated, we take a fresh look at each quarter and create a marketing strategy that is right for the environment. The rapid deterioration of the economic and consumer environment in third and fourth quarter last year caused us to react with additional marketing strategies with very little lead time. As this year has progressed we have become more experienced operating in and have been able to increasingly plan for this challenging economic environment which is demonstrated in our comp performance.

The marketing and merchandising calendar created for third quarter 2009 delivered a 1.3% increase in comp store traffic which follows a 6% increase in comp traffic in the third quarter 2008 and a 0.2% increase in average ticket which is the first positive growth in average ticket we have reported since third quarter last year. Importantly, this performance was delivered while increasing merchandising margins by 40 basis points and decreasing our marketing expense by 50 basis points versus last year. The improved third quarter marketing rate was achieved through efficiencies, not through a reduction in marketing events.

The merchandising and marketing programs in the third quarter included a very successful fragrance event early in the quarter that continued to drive momentum in the category. The strength of the fragrance event helped deliver positive fragrance category comp for the quarter which is a great result when compared to the rest of the industry. Our positive performance in the fragrance category is encouraging as fragrance is a key driver of holiday gift purchases.

We also experienced a significant improvement in our styling tools category. As you know, styling tools are a somewhat discretionary purchase and have been more affected by the tough economy. While comp trends continue to trail the prior year, the improvement we experienced during the quarter is encouraging for Holiday as styling tools are another example of a key gift giving category.

We optimized major new brand and new product introductions. We continue to be pleased with the early performance of Benefit Cosmetics and Philosophy Bath and Fragrance brand. The quarter also included our launch of Bare Escentuals new matte foundation and our first ever Bare gift-with-purchase offer developed exclusively with Ulta. Both of these new Bare Escentuals offers performed very well for us. The improved performance in fragrance and styling tools and the continued growth of Prestige [cart] and skin were key drivers of our average ticket growth during the quarter.

We continue to utilize private label to drive customer count at affordable margins by offering compelling value propositions to our customers such as our private label blockbuster, a $200 value for $19.99 and our Ulta Cosmetics 15-piece free gift with purchase, a $72 value. In addition, during the quarter we expanded our private label offering across bath, skin and cosmetics, more than doubling the new line extension versus third quarter last year.

The quarter included the successful launch of our first ever social marketing campaign. Our Windows of Love event supported a great cause, raising $600,000 to support the Breast Cancer Research Foundation founded by Evelyn Lauder while assisting us to create a powerful and long lasting emotional connection with our customer. This was demonstrated through dialogue with our customers both online through social websites as well as in our own stores. Looking ahead we plan to hold this event next year as an effective way to connect emotionally with our customers and to support an important cause.

As we saw in the second quarter the improvement in our comp store performance was driven entirely by our retail business. In Salon, the new keratin treatment service and Runway Your Way strategy that we introduced in the third quarter are bringing new customers into our salons which is good news. However, it has not been enough to offset the impact of the decrease we are continuing to experience in overall Salon customer visits due to the challenging economy.

As a result, the Salon business remained a negative comp for the quarter. As a reminder, the Salon is a service business and we have the ability to flex the expense structure with the business trends.

On the web we continue to post significant double digit increases in the third quarter and we expect this trend to continue for holiday. We continue to expand our assortment at Ulta.com and improve the site shopping experience with increased functionality including customer reviews and ratings online and an improved checkout process which were introduced in the third quarter.

Finally, in the third quarter we were pleased with the performance of new stores which continued to perform to our new store model. During the quarter we opened 12 new stores ending the period with 345 locations. In November we completed our store program. For the fiscal 2009 year we opened 37 new stores and expanded square footage by 11% over fiscal 2008.

With our experience this year navigating this economy and having more time to plan for challenging economic environments we have developed an exciting merchandising and marketing program to drive our performance for the fourth quarter. We have planned for a very competitive and highly promotional environment but believe we have impactful events and several new and exciting set of strategies for Ulta in the key weeks leading up to holiday.

For marketing, we plan to utilize TV for the first time. Our television advertising will cover 150 stores representing more than 40% of our overall store base during the key days leading up to Christmas. With ads that focus on product and value to drive store traffic and transactions from both new and existing customers. We also plan to air commercials on Hispanic radio in our top Hispanic trade areas and we have planned a new online marketing event for the Countdown to Christmas theme that we are excited about and believe will create some nice buzz in the marketplace.

Most importantly we will continue to execute the successful marketing and merchandising strategies that have been delivering results for us through the third quarter. We have planned high impact events and compelling value propositions throughout the season on some of our best brands including Bare Escentuals, OPI, Chi and Sebastian. For example, through strategic buying we are able to offer an exclusive for Ultra Chi Flat Iron at our lowest price ever at $79.95. This was offered on the front cover of this week’s marketing and our early consumer response has been great.

In addition we will be offering exciting exclusives to Ulta such as the launch of a new line of Ed Hardy styling tools and accessories, Bare Escentuals Jewel collection, a Smashbox blockbuster and OPI holiday colors. We will also be advertising the new brands we introduced in 2009 including Benefit Cosmetics, Philosophy Bath and Fragrance, Cosmedicine, CARGO, Phyto and Korres skin care. Of course we have new fragrances such as Couture Couture by Juicy and Hearts and Daggers by Ed Hardy.

We expect to continue the positive momentum in fragrance that we saw in third quarter which is important as fragrance is a key gift giving category during holiday. As we have done historically we have planned two major fragrance gift with purchase events in the fourth quarter including our very successful Annual Bathrobe program. As we did in the third quarter we expect to maintain comparable marketing impressions with cost efficiencies allowing us to reduce marketing spend as a percent of sales as compared to prior year.

Finally, as in the third quarter we also expect to improve our merchandising margin. Last year as you may recall compared to the marketplace we made a modest 90 basis point margin investment in response to the economic environment. With more time to plan this year we expect to recover a meaningful portion of that margin investment.

In summary, we expect to be able to compete effectively in what we believe will be an aggressive promotional environment and we expect our efforts to lead to a solid fourth quarter performance at Ulta which is reflected in our guidance. While we have some flexibility with our marketing programs, if the environment becomes as deeply promotional in the key weeks leading up to Christmas as it did last year we will judiciously balance the growth on the top and bottom line of the business. As importantly, if there is more positive consumer spending than expected we have developed strategies with our suppliers to allow us to adjust our inventory on key gift giving items as well as on basic stock.

Since our last call we have continued to build our 2010 new store pipeline and expect to increase our square footage growth next year. We remain confident in our 1000 store opportunity long-term.

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

Gregg Bodnar

Thanks Lyn. Our third quarter results were driven by better than expected sales and margin performance due to the continued innovation and successful execution of our marketing and merchandising strategies combined with our focus on expense management and cash flow initiatives.

Despite the ongoing challenging economic environment we delivered another quarter of sequential improvement in retail sales performance. This combined with our prudent expense management has enabled us to exceed our third quarter targets resulting in sales and earnings above our guidance range.

Now beginning with the review of the income statement. Net sales increased 11.5% to $284 million from $254.8 million in the third quarter last year. Sales growth was driven by the addition of 41 new stores since the third quarter last year and a 1.5% increase in comp store sales. This follows an increase of 2% last year resulting in a two-year comp store sales gain of 3.5%. Comp store sales growth was driven by a 1.3% increase in traffic and a 0.2% increase in average ticket.

During the quarter we opened 12 new stores ending the third quarter with 345 stores and expanding square footage by 14% from last year’s third quarter. We continue to be pleased with the performance of our 2009 class of new stores.

Gross profit dollars in the third quarter increased 13.9% to $90.5 million from $79.5 million last year. Gross profit margin was 31.9%, an increase of 70 basis points over last year. Gross margin expansion was driven by a 40 basis point improvement in merchandise margins primarily driven by our ability to plan the third quarter marketing and merchandising strategy to this challenging economic environment rather than being in more of a reactive mode as the economy significantly deteriorated in the third quarter of last year.

Supply chain operational efficiencies provided a 60 basis point improvement for the quarter. These increases in gross margin were offset by a 20 basis point de-leverage in fixed store costs. The de-leverage from fixed store costs is decreased versus previous quarters due to stronger sales and comparatively lower square footage growth.

SG&A expenses were $73.7 million or 25.9% of net sales compared to $65.2 million last year. The 30 basis point de-leverage in SG&A compared to the prior year was due to 170 basis point increase in incentive compensation expense which was largely, but not completely, offset by 50 basis points leverage in marketing, 40 basis points in store operating expenses and 50 basis points in G&A before the impact of incentive compensation expense. We remain on track to achieve annual permanent cost savings of approximately $18 million this year.

Pre-opening expenses totaled $2.2 million in the third quarter which compares to $4.7 million in the third quarter of fiscal 2008. The decrease in pre-opening expense was due to the planned reduction in our 2009 new store program. The reduced pre-opening expense was also slightly better than our expectations driven by better leverage in our new store advertising costs and lower labor costs. Better than expected sales growth and margin expansion along with our planned lower store opening program led to a 52.9% increase in operating income to $14.7 million or 5.2% of net sales from $9.6 million last year.

Interest expense decreased to $0.4 million from $1.1 million last year driven by the lower borrowings. The effective tax rate for the quarter was 40.6% compared to 40.9% in the prior-year period. Net income for the quarter increased 68.6% to $8.5 million or $0.14 per diluted share from $5 million or $0.09 per diluted share last year.

Now turning to the balance sheet and cash flow results. Merchandise inventories at the end of the quarter were $274 million compared to $268.9 million at the end of the third quarter last year reflecting an increase of $5.1 million due to the addition of 41 new stores versus a year ago and the benefit from our inventory management initiatives. As a result of these initiatives, we have achieved an average inventory per store reduction of 10.2% from the prior-year quarter. Just as a reminder, these initiatives are primarily leveraging our supply chain inventory and have no impact on our store in-stock position or consumer experience.

We remain comfortable with both the level and composition of our inventories headed into the fourth quarter and believe we are well positioned for the holiday shopping season.

Regarding debt, during the quarter we were able to pay down $26.3 million on our credit facility balance. This was driven by our focus on aggressively managing working capital levels, specifically on inventory receivables and lower capital expenditures on planned fewer new stores. Outstanding borrowings as of October 31, 2009 were $39.2 million and our debt to equity ratio was a very modest 14%. As of quarter end we had $160.8 million of availability on our credit facility which provides a credit capacity of up to $200 million.

We achieved free cash flow of $25.4 million for the quarter and $65.5 million for the first nine months of fiscal 2009. Typically we would expect to increase our borrowings under the credit facility during the third quarter as we fund our seasonal inventory build in advance of the holiday period. This year, however, we intentionally float inventory slightly later in the quarter and as a result the payment of some of these goods flowed into the fourth quarter which improved our free cash flow position for the third quarter and optimized our supply chain network.

Based on the progress of our cash flow initiatives we now expect to generate approximately $75 million of free cash flow in 2009 which exceeds our previous target of $50 million.

Capital expenditures for the quarter were $19.6 million and depreciation and amortization for the quarter was $15.4 million. Regarding our outlook we are pleased to see continuing improvement in our comp store sales trends compared with the second quarter which were driven entirely by our retail business. However, we expect the macro environment to remain challenging and consumers to spend cautiously for the remainder of the year.

Before I discuss our fourth quarter guidance, as a reminder I will quickly highlight our performance during last year’s fourth quarter. During the 2008 holiday period we were competing for gift giving share in one of the most extraordinarily promotional environments anyone has seen. We chose to maintain a balance between driving sales and earnings and delivered earnings per share of $0.21 which represented a 9% decrease from the prior-year period on a 5.5% comp decrease. While we were not happy with these results we did not see the deep negative comps and dramatic declines in merchandise margin and operating profits that most of the rest of the industry experienced.

For the fourth quarter of fiscal 2009 we currently estimate net sales in a range of $362-376 million. This assumes comparable store sales at a range of a decrease of 3% to an increase of 1% compared to a decrease of 5.5% in the fourth quarter of last year. As we have previously noted, we have seen an improvement in our sales and traffic trends in the third quarter driven by the impact of our strategic marketing and merchandising initiatives which is reflected in our guidance range. Consistent with our approach in prior quarters, the wider comp sales range continues to reflect the uncertainty regarding any potential, unexpected impact to current consumer trends as well as the uncertainty regarding the ultimate level of gift giving expenditures this holiday season.

Income per diluted share for the fourth quarter fiscal 2009 is estimated to be in a range of $0.22 to $0.26. This compares to income per diluted share of $0.21 for the fourth quarter of last year. The midpoint of our EPS guidance range reflects gross profit margin expansion of approximately 50 basis points and de-leverage in SG&A of approximately 50 basis points. This de-leverage is driven by 80 basis points increase in incentive compensation versus the fourth quarter last year.

With regard to new stores, as Lyn mentioned we have now completed our 2009 new store program with the opening of our final three stores in the early fourth quarter. The final count was 37 new stores which included two additional stores compared to our previous guidance. The two additional stores will have a minimal impact on 2009 sales. We will also be closing two stores after the holiday as part of our normal real estate upgrade process.

Since our last call we have continued to build our 2010 new store pipeline and expect to increase our rate of square footage growth next year. We remain confident in our ability to attain our 1,000 store long-term potential.

With respect to CapEx we expect capital expenditures to be approximately $71 million for the year.

In closing, we continue to believe that the consumer spending environment will remain difficult. We have and will continue to take the necessary actions to control what we can control. We will continue to manage the business driving our earnings and generating free cash flow and reinforcing our already strong balance sheet and liquidity position.

Now I would like to turn the call back over to Lyn.

Lyn Kirby

Thanks Gregg. We do not know the ultimate level of promotional activity that will occur in the marketplace or the ultimate level of consumer spending this holiday season. Accordingly, we have provided a wider guidance range for the fourth quarter. We believe we have created a compelling marketing and merchandising program that consumers will find exciting this holiday season. We are confident we have identified the right strategies to continue our positive performance during a challenging fourth quarter environment.

With that I would like to turn the call back over to the operator and we can begin our question and answer portion of the call.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Brian Tunick – JP Morgan.

Brian Tunick – JP Morgan

The TV obviously seems pretty impactful here. We are curious is it now that you are comfortable with where the size of the chain is, or the advertising rate came down? Maybe just talk about why you have decided now to do TV and what kind of message we will be seeing in a couple of weeks. Will it be brand specific or price driven? Then maybe if you want to talk a little bit more about the private label penetration that helped the gross margin and where we think private label can grow next year.

Lyn Kirby

On the TV, it is actually both of the reasons you spoke to. We are a big enough chain that in key regions around the United States it actually is financially viable for us to spend money. It is why it is not 100% of the chain at this point in time but in those areas where it makes the most sense for us. It is not so much the ad rates are great at all at the moment, we are finding it actually a very competitive environment to purchase TV in and hence the reason we are keeping it very surgical so that we can get the optimal return on it.

On the message itself, the message is definitely brand specific and product specific. It is exciting value but offered in a very brand enhancing manner and environment. We hope that we will be able to attract certainly an additional visit from existing customers but also reach a customer base that we can’t necessarily reach with our existing marketing alone.

Gregg Bodnar

On private label penetration it was up slightly in the quarter. It was not the single biggest driver of the improvement in gross margin compared to last year. It still represents about 5% of our business on an annual basis. We do believe there continues to be longer term potential there and we will describe those initiatives more carefully as we head into giving guidance for 2010 in March.

Lyn Kirby

A little more broadly on the merchandising margin expansion we did experience, certainly a little bit was the private label as Gregg spoke to but it was also a mix shift. It was part of the strategy for the quarter that we went after in terms of mix shift. We also have flat coupon redemption versus prior year. We are finally anniversarying some of that coupon redemption that was impacting some of the margin opportunity. So there is a couple of other factors in the margin improvement.

Brian Tunick – JP Morgan

If we are assuming 13% square footage growth next year. Is that what you mean by an acceleration?

Lyn Kirby

We are not ready to comment on our 2010 program at this point in time. What we can tell you to give you some comfort is that we do have 40 stores that have been approved, 40 sites for next year at this point in time. Stay tuned on the final guidance when we come back at the beginning of next year.

Operator

The next question comes from the line of Lizabeth Dunn – Thomas Weisel Partners.

Lizabeth Dunn – Thomas Weisel Partners

So were Salon and styling tools the only segments that comped negatively? And do you have, I am sorry if I missed it, specific marketing events targeted towards fragrance to drive that business during the holiday?

Lyn Kirby

As you know, we really don’t comment on any individual category performance other than if we think there is a shift in the trend that is important for you to understand. Hence the commentary on the Salon styling tools and the fragrance category particularly as that is a shift in the trend we have been seeing in the earlier quarters this year. Beyond that we can’t for competitive reasons we speak to give you any more color than that. In terms of the fragrance category we do historically do two major fragrance events in the fourth quarter. We intend to anniversary both of those. We have already anniversaried the first one from the quarter and we break the second one in the not too distant future which is the robe that we do in the holiday season. Of course we do have exciting newness. It is not just our marketing events but we have some exciting newness in the fragrance category as well for the holiday season.

Lizabeth Dunn – Thomas Weisel Partners

Can you talk about the sensitivity next year to an improvement in sales trends in the SG&A line like if we get into an environment where you are consistently comping positively and growth is accelerating a little bit? What sort of SG&A growth should we be thinking about? If you can’t provide that specifically what sort of categories will you be leveraging and where might you need a little bit more investment?

Gregg Bodnar

Let me describe the way I normally do and I think this will help you. As we look into next year and we are developing and finalizing our plans, I would expect very, very low single digit comp that we would be able to start to leverage SG&A. We have made a lot of progress this year in permanently altering the structure of the business so none of that is going to come back into next year. We do as we have the last couple of years have some specific strategic projects in the technology area as we continue to improve our technology platform and more importantly looking forward continue to add business value in that particular area.

So low single digit, very, very low single digit to start to leverage. There is nothing extraordinary if you will in terms of one-time meaningful investment next year. It truly is just a continuation of continuing to develop our technology platform like we have been for the last couple of years.

Operator

The next question comes from the line of Daniel Hofkin – William Blair & Co.

Daniel Hofkin – William Blair & Co.

Looking at obviously your practice this year has been to sort of look at the current comp trend and allow for the possibility of unforeseen events going forward. Thinking about comparing to last year I seem to recall it was principally kind of leading up to Christmas where the environment had gotten especially challenging. Just wondering if you might be able to provide some general commentary given some of the other retail results we saw out this morning what November might have looked like or just some sense for what things at least quarter to date how that is progressing, if there is anything you can share regarding that.

Gregg Bodnar

As we kind of have done in our practice of giving interim monthly results last quarter what I would tell you is we were down 5.5% last year and we have continued to say and believe to be the case this was more relevant in this consumer environment as we cycle those results from last year is our current trends. So coming out of the third quarter with a plus 1.5% comp and understanding the trends we were running at the time leading up to this call we have set a comp guidance range of about the results we achieved in the third quarter. Then the wider guidance range is exactly as we have stated. Achieved in the third quarter and then the wider guidance range is exactly as you have stated and is exactly as we have stated in the past. At the end of the day we don’t know if there is another consumer event that might be a distraction for them or ultimately what their level of gift giving purchases are going to be for the quarter. Thus the wider comp guidance range.

Daniel Hofkin – William Blair & Co.

So just to paraphrase that, it is not anything you have experienced or seen thus far. It is just kind of allowing for either a continuation or the possibility of something unforeseen going forward as you have been doing?

Gregg Bodnar

Yes, the wider comp guidance range is consistent with our prior practice.

Daniel Hofkin – William Blair & Co.

Secondly, within the gross margin any other color you may be able to provide being what you and Lyn discussed within the merchandise margin and the shift in the sales mix?

Gregg Bodnar

If you take the components of the third quarter margin performance we were up about 70 basis points. About 40 basis points driven by pure merchandise margin. We talked about the mix and some of the strategic buys that were opportunities we were able to plan in advance unlike last year’s third quarter. Fixed store expenses represented about 20 basis points of de-leverage which has been coming down quarter-to-quarter because we are getting into the slower square footage growth for the 12 months behind us. Then the rest of the improvement to get to the 70 basis points was really out of the supply chain and the continuation of the initiatives that have been executed thus far this year.

Daniel Hofkin – William Blair & Co.

Just regarding mix, so I am clear on that, that is separate from the strategic buys?

Gregg Bodnar

There were two elements that drove the 40 basis point improvement in merchandising gross margins. One was the planned strategy that drove sales into higher mix categories. Private label was one that we mentioned. The other was the opportunity to plan for some of the strategic buys to improve our margin compared to last year.

Operator

The next question comes from the line of Erika Maschmeyer – Robert W. Baird & Co., Inc.

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

Could you talk a bit about your declines in inventory per store? I know those have come through your supply chain. How long do you expect these declines to last and what inning are we in these improvements and how do you think about them throughout the year in 2010?

Gregg Bodnar

We are planning for some further opportunities primarily still focused in the supply chain as we head into next year. It won’t be of the same order of magnitude so as we indicated we will plan in this year down on a per store basis at about 9%. Then we will have similar opportunity we will plan for next year, just not for the same order of magnitude.

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

Could you talk a little bit longer term about your potential timing for the 1,000 store target? Do you anticipate getting back to 20-25% unit growth after 2010 when the environment normalizes a little bit or I guess can you talk about your decision making process here?

Lyn Kirby

The decision making process is basically the same as what we have always used which is quality first, not number of stores. It will really unfold as the environment unfolds and the opportunities. We are in the position where we can be opportunistic. If there are multiple sites that become available as some retailers might perhaps fail that is always opportunistic for us. But we will continue with the strategy of driving our growth in existing centers. If new center development is still slow in a slow economic environment we still have considerable opportunity in existing centers as demonstrated with the program this year and with the pipeline we have begun to build for 2010.

So it really is not as if there is a rate that we are targeting year-to-year at this point. It is more that it will unfold. Having said that, we do expect some increase in rate for next year’s program versus the levels we delivered this year.

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

Can you give any color on your comp trend during the third quarter?

Gregg Bodnar

We don’t report comps on a monthly basis and have not disclosed our inter-quarter trends in the past.

Operator

The next question comes from the line of Randy Konik – Jefferies & Co.

Randy Konik – Jefferies & Co.

Can you give us some color on what you think the promotional environment looks like out there thus far in the holiday season? Are you seeing a rational pricing environment thus far? Then I guess a question for Gregg. You have done a very good job of generating free cash flow. If we think longer term here is there some sort of sustainable minimum level of free cash flow that you think the business can now generate over the long-term now?

Lyn Kirby

Let me answer your first question. Relative to the promotional environment so far it is exactly what we have been expecting. We have seen great literally today and earlier this week some discounting in the beauty category from some other retailers. So that is very much what we had expected and planned for. No surprise there. As it relates to the broader retail environment and the broader department store environment again so far very much what we have expected. We are certainly planning for more promotional activity than what we have seen up to this point in time in the season and we are well prepared for what we think we will see.

Gregg Bodnar

As it relates to long-term free cash flow keep in mind the biggest driver of that is going to be the rate of increase in our store program, as we look forward with some slight increase next year we do expect with the continuation of some of the initiatives, some of which I referred to earlier on the working capital side, we will be in a good positive to generate free cash flow again next year. Then with an assumed sort of gradual increase back to our normal rate of square footage expansion that we have historically performed at I would expect that free cash flow generation will be more of a reality in the years following 2010.

But the biggest driver of that is going to be the change in the rate of square footage growth and the offsetting benefit to that which is the fact that our store investment where it has historically been $1.6 million to build a new store with all of the progress we have made so far in the last 18 months we are probably closer to $1.1 million.

Randy Konik – Jefferies & Co.

On the working capital line items you have gotten some benefit from payables and inventory, etc. Do you see that becoming a use of cash next year? Any comment there?

Gregg Bodnar

I think with the rate of expansion of square footage growth along with some of the other initiatives we will be executing next year I don’t expect the increase in store count to be a big drag on free cash flow.

Operator

The next question comes from the line of Samantha Panella – Raymond James.

Samantha Panella – Raymond James

With respect to the 0.2% increase in average ticket, can you give us some color on that and sort of what you are seeing spending habits with your customer relative to what you see in [ave trans]?

Lyn Kirby

Again, not too much color on anything too specific but in terms of what we are seeing it is certainly average selling price more than units in the third quarter and it is predominately across the categories we spoke to; the fragrance category and Prestige cosmetics and color continue to be strong performers for us. So that is versus prior year and versus the trend that we have seen in the last couple of quarters the styling tools category is helping lift the average ticket versus the prior couple of quarters as well.

Samantha Panella – Raymond James

Gregg, with respect to the TV ads how is that impacting SG&A in the quarter?

Gregg Bodnar

What we have effectively done is taken some of the efficiencies we would have otherwise realized in the fourth quarter specifically in the advertising line and reinvested in the TV campaign. We are not going to disclose the dollar amount of it because it would give some indication in terms of the size of the program but it is a very modest impact in the fourth quarter.

Operator

The next question comes from the line of [Evron Habbelman – Wells Fargo Securities].

[Evron Habbelman – Wells Fargo Securities]

First, as you are signing new leases for next year can you update us on what you are seeing in terms of rent out there? Especially given you will be opening more in existing centers versus new centers and how that is going to look for you year-over-year? The second question, with the acceleration in the rate of square footage growth obviously we are going to think about the de-leverage of the fixed store expenses again. I know you have talked about you have lowered the cost to build a new store but are there any other initiatives to potentially lower that de-leverage such as maybe accelerating the time to get the store open and things like that?

Gregg Bodnar

A couple of things. Consistent with what we have said in the past, as we are building the 2010 program we are seeing a reduction in rents versus historically what we would be spending on a cost per square foot basis which typically range about 15%. It depends on the real estate. The extraordinarily high quality real estate is still closer to historical cost per square foot just because of the scarcity value. So if you go up the East Coast as an example. Mainstream real estate we are seeing about a 15% decline in cost per square foot.

As it relates to the mix between existing versus new centers we had a balance this year of about 45-50% in existing centers and the rest in new centers. As we head into next year with the slowdown in development of new centers I would expect most of the expansion, about 90% to be in existing centers. As it relates to de-leverage going forward certainly the lower cost structure from a rent standpoint is going to help that.

The lower build out cost that we were talking about, going from the $1.6 million to $1.1 million to build a new store is also going to help put some downward pressure on the overall new store costs, a big portion of which is sitting in fixed store expenses. Then as it relates to a leverage point going forward, I think the combination of all of that will take us to a point where we can start to leverage fixed store costs with a slight increase in square footage expansion next year in a low single digit comp.

Operator

The next question comes from the line of Jillian Caruthers – Johnson Rice & Company.

Jillian Caruthers – Johnson Rice & Company

Another question on your fourth quarter comp guidance. If you look at your guidance on a two-year stack even at the high end, it is showing quite an acceleration from year-to-date trends. If you could talk about anything different you are seeing because I know you addressed the promotional environment that is expected and things of that nature.

Gregg Bodnar

It is more about, and I mentioned this to one of the other questions, it is really more about what our current trends are. The fact that consumer gift giving is down in the fourth quarter of last year, in our mind that has set a new low point or starting point for gift giving. So if we were down 5.5% last year and part of that was gift giving, I don’t expect the consumers based on all the reports that I am reading and I am sure you are reading as well, part of it increased their level of gift giving spend. That is why as it relates to the fourth quarter we believe the current trends are more relevant than the 2-year stack comp you are referring to.

Lyn Kirby

I will remind you if we do see more optimism from consumers out there than what we are planning for. We do have some flexibility in our inventory strategy to be able to satisfy that increase in consumer spend if it does in fact occur.

Jillian Caruthers – Johnson Rice & Company

If you could talk about Benefit, I know you have had some good response there. You mentioned about 25% of your store base has a full assortment of that product. Where do you stand now and are you still fine tuning it for the holidays?

Lyn Kirby

No more fine tuning. We are locked and loaded for holiday at this point. We do have about 133 stores at this point that have Benefit Boutiques. The boutiques are either the traditional boutique that you have seen as part of the store. It could be a boutique off the wall of the store so the same 200 square feet or it could be what we are calling a linear boutique which is a specially designed gondola run for Benefit. So we have that in about 133 stores and basically in the rest of the store base we have more of an [étagère] and cap presentation of a more limited selection of the line and we will be gradually transitioning into the boutique strategy over the next 18 months.

Operator

The next question comes from the line of Analyst for Neely Tamminga – Piper Jaffray.

Analyst for Neely Tamminga – Piper Jaffray

I am wondering if you could talk a little bit more about your promotional cadence heading into holiday. Should we expect more couponing or are you working with your vendors in advance for more product promotion?

Lyn Kirby

Because we are anniversarying that heavily deteriorated economy from last fourth quarter it is not about the couponing as we saw in the third quarter. We actually did not see an increase in coupons over prior year, coupon redemption rates did not impact the margin and we are not expecting that behavior in the fourth quarter and nor are we planning to put any significant increase in coupons out in the market. What the focus for value is more focused on is where you were just a second ago which is strategic buys that we have made with our key vendors and then offering that value through to our customer base. A really good example I had mentioned is on the front cover of our newspaper insert literally this week we had a Chi flat iron out there for just a little below $80, at $79.95 and we are seeing very good consumer response. When the value is there. There is not resistance to the average ticket.

Analyst for Neely Tamminga – Piper Jaffray

Curious if there has been any change in the Prestige and the overall category has been trending?

Lyn Kirby

Again, we don’t comment too specifically on it but we have in the past commented on the trade downs from Prestige to mass as there were more brands available. Not a reflection on the brand strategy but on the availability of mass brands. We are seeing some stabilization of that trend at this point in time. It is not that it is going back the other way so much as we are not seeing it continue to trade down.

Operator

The next question comes from the line of Henry Kerpellen – Oppenheimer & Co.

Henry Kerpellen – Oppenheimer & Co.

In the press release you mentioned you expect the holiday season to be challenging and I was wondering if you could comment on whether you think that is going to be more or less than what you saw last year?

Lyn Kirby

Overall we are planning for not I will say the deeply discounted, the deeply extraordinary deep discounts of last year. We think that the marketplace has bought inventory in a different fashion by and large to what they did last year. But nonetheless, it is one of the things we cannot control and hence one of the factors for us putting a wider guidance range in there than what we have in the last couple of quarters. So it is possible. We are planning for a very aggressive promotional environment but are not necessarily believing we are going to see quite that level of extraordinary discount we saw last year.

Henry Kerpellen – Oppenheimer & Co.

So an improvement essentially from what you saw last year but not anything dramatic essentially?

Lyn Kirby

An improvement from last year. If I wanted to put two bookends on it, not as aggressive as last year but deeper than 2007 is what we are planning for.

Henry Kerpellen – Oppenheimer & Co.

Piggy backing on your comment about the guidance, I am still trying to figure out for same store sales guidance in the fourth quarter you are saying down 3 to positive 1%. You did 1.5% in the third quarter and yet you also have an easier comparison in the fourth quarter. I am just trying to figure out how you came to that same store sales guidance for the fourth quarter.

Gregg Bodnar

As we had mentioned we believe the current trends in this environment are more representative if you will. We finished the third quarter at a plus 1.5%. That is taking into consideration we said the top end of our guidance range was 1%. The fact that we have expectations out there for a consumer environment in a gift giving space to be flat to down slightly would suggest the comparison for the fourth quarter is less relevant and to us what is more meaningful is the current trends we are running. As it relates to the bottom end of the guidance range it is as simple as what we have described in the past. We are not sure if there is another consumer event that will be a distraction around the corner that will cause the consumer to pull back on spending. We can’t be entirely sure in this economic environment what her ultimate level of gift giving spend will be in this fourth quarter. So the easier comparisons last year I think the consumer has set a new precedent in terms of what their ultimate level of gift giving is. So it doesn’t make for necessarily an easier comparison and that’s why the current trends are more relevant.

Henry Kerpellen – Oppenheimer & Co.

The traffic trends while they were positive in the third quarter there was a slight deceleration from what you saw in the second quarter. I was just wondering if there was any commentary you could provide around that?

Lyn Kirby

The commentary is actually strategy for the quarter. As we begin to develop our marketing and merchandising strategy for the quarter we take a look at the prior year. In the third quarter of the prior year we had a 6% increase in count and we had a decrease in average ticket. So as we strategize the third quarter this year the biggest opportunity we believe in average ticket and not to expand aggressively on the customer count. We have been very aggressive in going after the customer count third quarter of last year not just in reaction to the economic environment and the deterioration but we had planned for investment in count anticipating a lot of hesitancy during that pre-election time period. So with that resource investment in the baseline to count we put a modest amount to drive count in the third quarter of this year and we aggressively drove against the opportunity to drive average ticket and hence some of the focus on the categories that I have been speaking to on the call that are clearly higher ticket categories; fragrance, the styling tools category and the continued focus we have on Prestige color and skin.

Operator

The next question comes from the line of Anthony Lebiedzinski – Sidoti & Company.

Anthony Lebiedzinski – Sidoti & Company

I just wanted to follow-up on the previous question with the free cash flow. It sounds like you expect the positive free cash flow next year but perhaps not to the same level you are seeing this year?

Gregg Bodnar

It definitely will not be at the same level we experienced this year. It will ultimately depend mostly on the rate of expansion of our new store program.

Anthony Lebiedzinski – Sidoti & Company

You mentioned the CapEx on average is about $1.1 million versus $1.6 million before? Is that correct?

Gregg Bodnar

No, the total new store investment. Historically about 18 months we would spend about $1.6 million between CapEx, inventory and pre-opening costs to open a new store. At this point in time based upon all the initiatives we are now pushing the $1.1 million which helps obviously as we start to expand square footage again helps to buffer some of the cash flow impact.

Anthony Lebiedzinski – Sidoti & Company

So what has driven the half million decrease?

Gregg Bodnar

There has been numerous things. One, we have reduced the cost per square foot to build new stores and we have strategically done that over the last 18 months with no impact to the consumer experience. We also, have you have heard us talk about, taken about 10% of the inventory cost to build a new store or fill a new store and our pre-opening costs have progressively come down over time.

Operator

There appear to be no more questions in the queue at this time. I would like to turn the floor back over to management for closing comments.

Lyn Kirby

Thanks again for joining us today. On behalf of all of us at Ulta I would like to wish you all a very happy holiday and New Year and we look forward to speaking to you on our next call which will be in March of next year. Thanks everybody. Goodnight.

Operator

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

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Source: Ulta Salon Cosmetics & Fragrances, Inc. Q3 2009 (Qtr End 10/31/09) Earnings Call Transcript
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