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

Q2 2011 Earnings Conference Call

September 8, 2011 5:00 PM ET

Executives

Allison Malkin – ICR, Inc.

Chuck Rubin – President and CEO

Gregg Bodnar – CFO

Analysts

Jill Caruthers – Johnson Rice & Company

Brian Tunick – JP Morgan Chase

Daniel Hofkin – William Blair & Company

Erika Maschmeyer – Robert W. Baird

Samantha Panella – Raymond James

Alex Fuhrman – Piper Jaffray

Evren Kopelman – Wells Fargo Securities

Jason Gere – RBC Capital Markets

Operator

Greetings, and welcome to the Ulta Beauty Second Quarter 2011 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator instructions)

It is now my pleasure to introduce your host, Allison Malkin of ICR. Thank you, Ms. Malkin, you may now 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'm sure you're all familiar with.

The statements contained in this conference call, which are not historical facts may be deemed to constitute forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995. Actual future results may differ materially from those projected in such statements, due to a number of risks and uncertainties, all of which are described in the company's filings with the SEC. We will make references during this call to the metric free cash flow, a non-GAAP financial measure defined as cash provided by operating activities, less purchases of property and equipment.

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

Chuck Rubin

Thanks, Allison. Good afternoon, everyone. Thank you for joining us to discuss our fiscal 2011 second quarter 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 results and provide our outlook. I will then offer some closing comments and turn the call over to the operator so that we can answer the questions you have for us today.

We are very pleased to deliver better-than-expected second quarter sales and earnings, which continued our favorable momentum from the first quarter. Our results included strength across our key financial metrics. Specifically, we increased net sales by 22.6% to $394.6 million. We grew comparable store sales by 11.3% following a 10.8% comp gain in the second quarter last year.

Our comp increase was balanced across categories and continues to be led by increased customer traffic with modest increases in average ticket. We increased our gross margin by 170 basis points, which included a 90 basis point improvement in merchandise margin.

We grew operating income 78% with operating margin increasing by 320 basis points to 10.1% of sales, and we increased net income by 83% resulting in EPS of $0.38 surpassing our guidance of $0.31 to $0.33 per diluted share, and up 73% from the second quarter last year.

We believe our consistent performance results from our compelling store experience; expansive and sought after selection of brands, products and services; our knowledgeable and friendly associates; and our disciplined approach to managing our business.

During the second quarter, we successfully advanced our five key growth initiatives. Let me share just a couple of highlights with you. First, our store expansion continued favorably and included the opening of 21 new stores and 15 remodels. We continue to be pleased with our new store performance and remain on track to open approximately 61 new stores, representing a 16% increase in square footage growth. We're also very pleased with our remodel program, which completely updates our store to our latest prototype, and has generated an attractive payback. For 2011, we have now completed our 17 planned remodels.

Second, we continue to improve our guest offering as we launched new products within existing brands and added new brands. A few examples include the launch of They're Real Mascara by Benefit, which produced our highest weekly unit sales ever in mascara.

In addition, Philosophy continued its strong comp trend, which we were particularly pleased with given the anniversary of its introduction in Q2 last year. This performance was fueled by product innovation across the assortment, and the successful introduction of Philosophy's Mommy & Baby.

We were also pleased with the ongoing strength of Urban Decay and Tarte. Our growth in the nail category continued strongly as we capitalized on new trends in color and novelty, such as Shatter from OPI, which continued to be our top brand.

In men’s, we saw a positive response to our new men's shop, which we introduced in the quarter and encompasses our complete assortment of men’s products in one convenient and inviting setting.

Fragrance sales also saw robust growth driven by the introduction of several new scents including (inaudible), Gucci Guilty Pour Homme, and Justin Bieber Someday.

During the quarter, we set our new fragrance shop, which we believe elevates our offering giving fragrance stronger placement in showcasing our full assortment in an easiest to shop format. Here too we were pleased on our new shop's initial performance.

Professional hair care was another standout in the quarter. We saw positive performance from new brand launches, including Living Proof and AG, and also several long-standing brands such as Pureology.

In regards to our third strategy, we continued to utilize our loyalty database to better target our direct mail and e-mail outreach. In addition, we saw growth in our loyalty database and now have over 8.5 million active guests. We remain focused on advancing our loyalty efforts and expect to see continued long-term benefits resulting from this program.

Fourth, we continue to build upon our successful print marketing efforts by adding greater use of social media, in-store eventing, and testing of new media including radio to highlight customer focused marketing events. For example, in May, we introduced our Love Your Hair event. We successfully showed women the newest ways to pamper their straight, curly, or wavy hair with innovative tools and products best suited for their hair type. This event was supported with new hair products, tools, and salon services, all animated in-store with ongoing demonstrations focused each week on a different hair segment. This combination was successful in driving a double-digit sales increase over our promotion last year that primarily emphasized products only.

We also significantly improved our marketing around fashion trends by using in-store displays, print advertising, and ulta.com to highlight color trend themes like Crazy for Coral and Gold Rush. By cross merchandising key products across our broad category offering, we successfully showed our guests how to make the latest trend right for her. We will continue this effort as we believe our guest relies on us, not only for the broadest assortment of any beauty retailer, but also the beauty authority in what is new and fun.

On our fifth growth initiative, ulta.com continued its growth in both generating online sales and re-enforcing our brick and mortar business. An expanded product offering, greater editorial content in our beauty destination section and events like our lunch hour specials continue to perform well for us. Our e-commerce sales are still very underdeveloped but we continue to believe there is this great long-term runway ahead for ulta.com to both grow revenue and support a multi-channel strategy.

And finally in stores, during the second quarter we continued to improve our guest service levels. This long-term initiative includes simplifying the operations of our store to allow more store labor to be directed to serving the guest, along with providing more time for additional training to our store teams. Our objective is quite simple, to provide the most knowledgeable, most enthusiastic beauty associates in the retail arena. We believe this effort will build upon our already strong existing foundation.

Turning to our salon, we achieved a positive comp in the quarter, yet continued to perform below the rate of retail. During the quarter, we saw increased traffic in our salons as we increased our e-mail and direct mail communications. We expect to enhance our salon performance as we introduce new products and trends. For example, late in the second quarter, we launched a new hair straightening product that our stylists are excited about and we are adding a new feather weave [ph] service in the third quarter to capitalize on this hot trend. We expect these and other newness efforts to provide for improving trends in our salon for the balance of this year.

As we look to the third quarter, we are conscious that the general economy in the surrounding headlines have weighed on consumer confidence, and while we are not impervious to this, we do believe that our strong and flexible business model will allow us to continue to gain profitable market share. In a nutshell, we remain confident in our strategies and our ability to execute well and as such we are expecting a strong year.

With that as a backdrop, let me share with you some of the expected drivers of our third quarter performance. Our store expansion remains on track and includes 26 new store openings during the quarter. We are well on our way to the 61 anticipated new stores this year. As we look to 2012, our store pipeline is in excellent shape with expected square footage growth in the 15% to 20% range we have previously communicated.

In Q3, we will continue to fully integrate our product newness with marketing and store events to create more powerful promotions. To this end, our 21 Days of Beauty event which kicked off this past Labor Day weekend, includes more new products, more exciting events, more beauty steals, and more great products at great values to reward our guests. We will continue to communicate this across all of our marketing media.

Also, during our 21 Days of Beauty, we launched a truly exciting new partnership with Conde Nast. This relationship brings together the power of Ulta’s offering, stores and website with the most iconic fashion and beauty editorial brands.

Some of the specifics of the program include one, offering our customers a $21 annual subscription to receive both Allure and Glamour magazines. This price will be the absolute lowest that a customer can find. Secondly, utilizing the fashion and beauty editorial content of Allure and Glamour, we're also highlighting their brands in our stores and marketing programs. And finally, third, employing a multi-platform marketing approach that will include the various magazine titles of Conde Nast as well as leveraging both organizations’ digital assets.

Continuing with our marketing programs in October, we will support Breast Cancer Awareness Month with our (inaudible) campaign. This effort follows our Windows of Love campaign that we held during the previous two years. This year, our plan has a number of new exciting components including new exclusive products that will benefit the Breast Cancer Research Foundation, a new more expansive marketing outreach in our stores and in all of our marketing pieces, and finally, on October 16, a Salon Cut-a-Thon that we believe will introduce our salons across the country to new guests while also contributing to a very worthwhile fund raising effort.

Supporting these and all of our marketing efforts throughout the quarter will be the further use of our loyalty database allowing us to better target both direct mail and e-mail communications, which thus far this year has proven successful.

Finally in the third quarter, we also expect to complete the basic technology upgrades necessary to allow our transition from the current two loyalty programs to one nationwide loyalty program. Completing this transition will take additional time, but with the basic technology in place we hope to begin that transition in 2012.

Turning to our guest offering, we will introduce a number of new brands across categories. In professional hair products, we will introduce (inaudible), in styling tools Orbit by Chi, and in Prestige skin and color, we will launch nationally both Jabot and Laura Geller. We will also introduce several brand extensions including Tarte's True Blood, Urban Decay's Anniversary Palette, Book of Shadows IV and a restage of Smashbox that includes new products in foundation, powder, and eye color.

In addition, we will see brand extensions from Benefit with Lash Lovelies, and in Bare Escentuals with Ready Eyeshadows. Also exclusively to Ulta is a four piece kit with purchase from Bare Escentuals.

Finally in our product offering, we are especially pleased to announce the introduction of Lancome in prestige color and skin in 29 stores across four markets, including New Jersey, Illinois, Nevada, and North Carolina. As you know, Lancome is one of the most prestigious brands globally and its addition represents a very strong complement to our existing prestige offerings.

We are supporting this test with print and digital marketing to drive sales from existing guests and also hope to broaden our customer reach with these efforts. We believe the addition of Lancome in prestige cosmetics and skin care continues to reinforce Ulta as the authority in beauty.

In ulta.com, we expect to implement several enhancements to improve the guest experience. We recently introduced new consistent branding across our website, new IT enhancements that are expected to increase checkout speed and further improve our search capability and coming is a new product recommendation feature.

Additionally, we will introduce a refill reminder to help our guests recall when it is time to replenish frequently purchased products. Taking a broad look at Q3, we believe we have exciting initiatives in place that will result in third quarter comparable store sales surpassing our previously stated long-term 3% to 5% comp sales goals, and based on strong performance for the first half of the year and our positive Q3 outlook, we also expect our annual net income growth to surpass the high end of our long-term goal of 25% to 30%. In addition, we continue to expect to generate free cash flow.

With that, I'd like to turn the call over to Gregg to review our financials in more detail.

Gregg Bodnar

Thanks, Chuck. We are very pleased with our second quarter results, which exceeded our guidance and were driven by better than expected sales and margin performance and expense management.

During the quarter, we delivered a 22.6% increase in total sales, to $395 million, ahead of our guidance of $378 million to $384 million. Comp store sales increased 11.3%, which was also ahead of our guidance range of 6% to 8%.

We remain very pleased with the performance of our new stores, which continue to exceed our expectations. During the quarter, we opened 21 new stores and completed 15 remodels. We have now completed our remodel program for the year, which included a total of 17 locations. At quarter end, we operated 415 stores, expanding square footage by 18% from last year's second quarter.

Gross profit dollars increased 29.2% to $134.3 million from $104 million last year. Gross profit margin increased 170 basis points to 34%. The increase in gross profit margin was primarily driven by 90 basis points of improvement in merchandise margin, 60 basis points of increased leverage in fixed store cost due to our comp store sales increase, and 20 basis points of improvement from supply-chain efficiencies.

SG&A expenses were $90.8 million, or 23% of net sales, compared to $79.9 million or 24.8% of net sales last year. The 180 basis points of SG&A reduction was driven by leverage on sales growth and continued prudent management of our cost structure. SG&A leverage was approximately 100 basis points excluding the non-recurring compensation charge in last year’s second quarter.

Pre-opening expenses totaled $3.8 million in the quarter, which compares to $1.8 million in the second quarter last year. We opened 21 new stores and remodeled 15 existing locations during the quarter. This compares to 10 new store openings, 1 relocation and 3 remodels last year.

Our better than expected sales growth and margin expansion, combined with our continued prudent expense management, resulted in operating margin expansion of 320 basis points to 10.1% from 6.9% last year. Interest expense was $147,000 and represents fees associated with our credit facility, which we have not used this year.

The income tax rate for the second quarter was 39.5%, which compares to a tax rate of 40.7% in last year’s second quarter, and was in line with our expectations. The lower tax rate was driven by a decrease in non-deductible compensation expense compared to second quarter last year.

Net income for the quarter increased 83% to $23.9 million or $0.38 per diluted share. This includes the additional pre-opening expense from our expanded new store program, which negatively impacted EPS by $0.02 per share. Net income was $13.1 million or $0.22 per diluted share last year, and included a $0.03 per share non-recurring compensation charge.

Now turning to the balance sheet and cash flow, merchandise inventories at the end of the second quarter increased 15% to $258.8 million compared to $224.3 million at the end of the second quarter last year. The increase primarily reflects the addition of 59 net new stores held over the past 12 months.

Average inventory per store declined 1% from the prior year, reflecting the combined efforts of inventory management initiatives, coupled with inventory increases to support the 11.3% comp store sales increase. We continue to effectively manage both the composition and level of inventory to deliver variety and newness to our customer in support of our growth initiatives.

Capital expenditures for the second quarter were $33.2 million, depreciation and amortization was $18.9 million. Our balance sheet remained strong with no debt and $140 million of cash and cash equivalents.

Now, I’d like to turn to our third quarter outlook. We currently estimate net sales in the range of $400 million to $407 million, compared to actual third quarter 2010 net sales of $339.2 million. This assumes a comp store sales increase of 6% to 8%.

We plan to open approximately 26 new stores in the third quarter compared to 30 new stores last year in the third quarter. Income per diluted share for the third quarter is estimated in the range of $0.36 to $0.38. This compares to actual income per diluted share of $0.23 in the third quarter of last year, representing a growth rate of 60% at the midpoint of this range. Income per diluted share in the third quarter of 2010 included a $0.02 per share non-recurring compensation charge.

In addition, gross profit margin – we expect gross profit margin to expand by approximately 50 basis points at the midpoint of the guidance range from last year’s gross profit margin of 35.1%. As we have stated in the past, as we accelerate our new store program throughout the remainder of the year, it will have an expected impact to gross profit margin.

Our gross profit margin will continue to increase, but not at the same rate as the second quarter, as an example. This is a normal and expected impact of our store model and the acceleration of our new store program.

Gross profit margin expansion will continue to be driven by fixed store leverage on a comp store sales growth, merchandised margin improvement and supply chain efficiencies.

We expect SG&A as a percentage of net sales to decrease approximately 170 basis points at the midpoint of the guidance range compared to last year’s rate of 26.6%. You may remember last year our SG&A rate was negatively impacted by approximately 40 basis points as a result of the one-time non-recurring compensation charge. As a result, we expect to deliver up to 250 basis points of operating margin expansion during the third quarter, while accelerating our new store growth program.

We also expect the following for the third quarter, pre-opening expenses to be approximately $4 million, an effective tax rate of approximately 40% compared to 40.9% in the third quarter last year, and fully diluted share count to be approximately $64 million.

Given our strong performance in the first and second quarter and our expectations for the third quarter, we continue to expect our 2011 annual performance to exceed our long-term financial goals.

As we have often discussed, our business model has been built to generate 25% to 30% annual net income growth through the achievement of 3% to 5% annual comp store sales gains, square footage growth of 15% to 20% annually, and operating margin expansion as we progress to our near-term low double-digit operating margin target.

In addition, we expect to exceed the high end of our 3% to 5% long-term target for comp store sales growth by approximately 300 basis points for the full year 2011.

As a result, we also expect to exceed the high end of our long-term net income target for the full year, which assumes the add-back of the 2010 impact of the $0.06 per share related to the non-recurring compensation charge.

In addition, our store expansion initiatives include the opening of approximately 61 new stores, delivering square footage expansion of 16% in 2011. In addition, we continue to expect the following for fiscal 2011.

Our store opening plans by quarter for the remainder of the year is expected to approximate 26 new stores in Q3, and nine new stores in Q4. The corresponding preopening expenses will be approximately $4 million in Q3 and approximately $1 million in Q4.

We expect a full year tax rate of approximately 40% and full year diluted share count of approximately $63.5 million. Capital expenditures in 2011 are expected to be approximately $130 million, which is roughly $30 million higher than our capital expenditure program in 2010.

The increased investment reflects our store expansion program, as well as investments we will make in technology and infrastructure to support our strategies and future store growth. This increase also includes the addition of a third distribution center. We have recently executed a lease for the building. The new facility will be located in Chambersburg, Pennsylvania, and is scheduled to open in 2012. We take a very disciplined approach to infrastructure investments, and expect to open our third DC on time and within budget, as we did our second DC.

Depreciation and amortization will be approximately $77 million. Average inventory per store is expected to decrease by approximately 1% to 3%.

We believe our continued strong performance in the second quarter reflects the solid execution of our strategies and our disciplined approach to growing our business. We are pleased with the results of our efforts and remain focused on driving sales and earnings growth, generating free cash flow, and expanding operating margin.

This year, we expect to achieve a 10% operating margin, which we believe further supports our ability to expand operating margin solidly into the low double-digit range by 2012, 2013 time period.

We also remain confident in our ability to achieve the mid-teen operating margin as we look further up. As we continue to evaluate the use of our cash resources, our focus remains on appropriately investing in the growth of our business, both physical locations and our e-commerce channel in order to maximize value for our shareholders.

Now, I'd like to turn the call back over to Chuck.

Chuck Rubin

Thanks, Gregg. In summary, we are pleased to deliver another outstanding quarter and remain optimistic as we begin the second half of the year. Our strategies are driving strong results. We have a focused and passionate team, and we believe we are well-positioned to continue our favorable sales and earnings momentum in 2011 and longer term.

With that, let me turn the call over to the operator to begin the Q&A portion of the call. Operator?

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Our first question comes from Jill Caruthers from Johnson Rice & Company.

Jill Caruthers - Johnson Rice & Company

The tests you are doing on the Lancome cosmetics, it looks it started to kind of reaching some of those stores in the past week or two. If you could talk about, I know, you have been in ongoing conversations with these companies, kind of what initiated this test, what do you feel like they were open to being on the shelves at Ulta?

Chuck Rubin

Jill, you were going in and out a bit. I think the question is what was behind Lancome getting started with us. We've talked before that our business model is built on having a broad offering, and that the iconic brands are great additions to that, but that our long-term financial expectations could be achieved without them. With that said, we have maintained ongoing dialog with Lancome, and I think that the time was right in our business, and they were impressed with the other brands that we had in our offering, as well as what our stores are like and the customer base that we have.

So, we're excited to have that as part of our offering in those 29 stores, it’s actually 28 right now with a new store opening next month, that will be the 29th store, but we are very pleased to have them as part of that offering.

Jill Caruthers - Johnson Rice & Company

And any insight into kind of the timing of the test or when a potential fuller rollout might be or…

Chuck Rubin

No, we're pleased with where we are right now and as things develop, we’ll keep you apprised.

Jill Caruthers - Johnson Rice & Company

Okay. I appreciate it, and then, just last question, more of a longer term picture type question on your store prototype. As you are adding new brands, you build out brand boutiques in the men’s and store type shop. Do you feel like the box currently is big enough or do you feel like you might see some significant change in the mix as in, per se let's say, decreased mass product or what not?

Chuck Rubin

No, I think the box is big enough. I think the gentlemen who heads up our store design has done a wonderful job of building a very flexible box, and we're able to add boutiques, we're able to size them in different ways, and we've made a number of enhancements to what many of you may have heard us refer to as our level 7 prototype. So, I don’t see the box, which is about 10,000 feet, getting bigger. I do see us being able to make the box more productive as new brands come in or new statements or new services come in over the long term.

Jill Caruthers - Johnson Rice & Company

Thank you.

Operator

Thank you. Our next question comes from Brian Tunick from JP Morgan Chase.

Brian Tunick - JP Morgan Chase

Thanks. Good afternoon everyone, and congrats.

Chuck Rubin

Hi, Brian.

Brian Tunick - JP Morgan Chase

I have a couple of questions, really going to stay on that real estate side. First, if you maybe guys could talk about how many leases you’ve already signed for next year? Give us some idea of new sort of versus existing centers. I know there's been a lot of talk about lack of, I guess, strip center development. So maybe, what’s been happening in your comps and maybe even different classes or co-tenancies? And then, finally, maybe Gregg, it sounds like you’ve taken a year out of the payback of the new stores. Are you still seeing that sort of 17%, 18% four wall [ph] margin for each store at maturity, or has something changed there?

Chuck Rubin

Brian, I’ll take the first few, and then let Gregg pick up on it. We wouldn’t get into details on exact status of the leases, but as we said in the prepared comments, we feel very good about where we are for next year on our pipeline, and we’ve said before that it would be in that 15% to 20% range. So, you can do the math. We feel very good about that.

As far as new and existing, as we’ve talked before and as you would expect, a higher chunk of those new stores are coming out of existing real estate that has been repurposed somehow, and that’s just a state of the general marketplace. There are some seeds out there. It’s too early to call it a real resurgence, but there are a couple of seeds of new development that could be out there in the next few years, but for the near-term, defining near-term as at least 2012, there'll be a higher chunk of existing stores that get redone into an Ulta.

As far as comps across the classes, here again, we wouldn’t break that out, but we’re pleased with our portfolio across the board, both in age of store, as well as the geography of the store. We saw strength across the country in our market. So, it wasn’t one market or one class of store that carried that strong comp in Q2.

Gregg Bodnar

And Brian, on the store model itself, you’re correct. We have taken the payback down to two years. It was up over 3.5 years several years ago, as you may remember. In terms of four wall contribution, it’s certainly – as we've continued to drive operating margin, it has continued to improve as well, because that operating margin not only benefits the new store model but it benefits the existing store. So, they’re performing a little bit better than that 17%, 18% of maturity.

Brian Tunick - JP Morgan Chase

All right. Terrific, great. Thanks very much and good luck.

Chuck Rubin

Thanks Brian.

Gregg Bodnar

Thanks Brian.

Operator

Thank you. Our next question comes from Daniel Hofkin from William Blair & Company.

Daniel Hofkin - William Blair & Company

Good afternoon. Great job once again.

Chuck Rubin

Thank you, Dan.

Daniel Hofkin - William Blair & Company

Question, I guess, follow up on the Lancome, which seems very encouraging. I guess I’d be interested in your thoughts regarding either – and I know you probably don’t want to give much detail on further rollout at this time, but does this affect, maybe positively, implications for other brands of similar stature over time? And then, I guess regarding this test, I guess what – maybe if you could share some insight on what kind of drove the specific markets for these tests?

Chuck Rubin

Look Dan, we’re very pleased to have Lancome in, and the reason that we’ve announced it here is that as it was done now, it was found by an analyst and we didn’t want all of you to get ahead of yourselves on this. It is in 29 stores, in 28 today and 29th coming in a couple of weeks. We're very happy because we think it’s good for our guest, and I think it opens up some new guests for Lancome.

We know that we continue to take market share and that we continue to perform better in our growth trajectory than a department store does. So, I think Lancome and Ulta are both very pleased with where we are and we will see where it goes from there. Getting into any more detail on that, it just wouldn’t be appropriate at this point. As far as the markets, we wanted to have some density of those markets, so that we could advertise and we could put the power of Ulta behind this brand introduction.

We have a very effective marketing machine and that will go to work, as it broke this past Sunday, which was our first ad on our mailer that just began this past Sunday. We will put that marketing machine behind Lancome.

Daniel Hofkin - William Blair & Company

That is great, and then I guess thinking about – one thing I would ask, would you mind, I think you provided this earlier and the audio was going in and out on my end of it. Therefore, would you mind just giving the gross margin and SG&A guidance for the third quarter, just sort of the overall range you expect?

Gregg Bodnar

On gross margin for the third quarter, the midpoint plus 50 basis points, and SG&A, at the midpoint plus 170.

Daniel Hofkin - William Blair & Company

In that plus 170, that is relative to last year's GAAP number?

Gregg Bodnar

Correct, correct. Off of the 26.6 last year.

Daniel Hofkin - William Blair & Company

Okay. That is great. Again, best of luck in the second half.

Chuck Rubin

Thanks Dan.

Gregg Bodnar

Thanks Dan.

Operator

Thank you. Our next question comes from Erika Maschmeyer from Robert W. Baird.

Erika Maschmeyer - Robert W. Baird

Thanks and congratulations.

Chuck Rubin

Thank you, Erika.

Erika Maschmeyer - Robert W. Baird

Could you give a little bit more detail on the Conde Nast partnership? What led to that? What you're most excited about on the timing?

Chuck Rubin

Yes. The power of Conde Nast in the portfolio of titles that they have and their iconic nature in fashion and beauty was really attractive to us. In return, where we stand in the beauty industry and the breadth of what we offer and the strength of our relationship with our guests was very attractive to them. So, we've been talking with them obviously for a little bit, and the relationship has just been kicked off, if you will, this past weekend with our mailer.

I think it has a lot of places that it can go, but what you've seen thus far this week, is we will use their titles, we will use their editorial content on our websites and in store. And as I mentioned in my prepared comments, we’re going to be able to leverage our digital assets. Conde Nast has a subscriber base, I believe somewhere over $50 million, which is very attractive for us to work with them on, and ultimately the magazine offer that we are introducing now with the $21 for an annual subscription to both Allure and Glamour is just a terrific deal for our guests.

So, we are excited about this partnership. We hope that it lasts a long time and we think that we have a clear path of what we hope to achieve in the near-term, and we think over the long-term, it could lead to some very interesting places.

Erika Maschmeyer - Robert W. Baird

Great, and then, your royalty rollout is obviously really exciting. When do you expect to be able to complete that, what are the risks that you are looking at, and are you going to take a break for the holidays to avoid potential disruption or is that not a concern?

Chuck Rubin

Yes. No, let me clarify that, because I don’t want there to be any confusion about this. We are not moving any more stores today from one program to the other. What we have had to do which we are completing in the third quarter is to get the technology platform in place to allow that transition to occur. So, the technology platform we will be in place with this year, we will not convert any new stores for the balance of this year as we do throughout the company. As you get ready for holiday, we essentially stop any new IT enhancements, which you can well respect.

The transition of stores will start to happen at some point in 2012. There is still work to be done on this. So I do not want anybody to think that we will be converting quickly in the early part of 2012 to one program that is not the case. But this technology component, which was necessary to accommodate that transition is nearing its completion, that’s why I wanted to call it out in the comments, because we have been running on two programs for a while, and I know you’ve asked – this group has asked many times, at some point, aren’t we go to move to one. We’re finally getting closer to the point of starting that transition to one.

Erika Maschmeyer - Robert W. Baird

Got it. That is helpful. And then just quickly, timing and potential margin impact from new DC, I know that you expect to get it on time and within budget, but are there certain quarters where you might see a bit more of an SG&A or margin impact than others?

Gregg Bodnar

You know, we’re doing some work to develop now that we’ve got the lease signed, to develop and fit out the inside of the building, start training folks, bringing staff onboard et cetera. So that’s the activity for 2011. Back half of the year impact is, for Q3 and Q4 it’s about a penny in total between the two quarters. For next year, certainly as we ramp that DC up in the first half of the year, start bringing product in and then start shipping to stores as you can appreciate, it will have a drag on gross margin. As we get to the back half of the year, and we get the productivity up in that distribution center and then start to leverage the transportation network capabilities, it will be close to our vendors, it will be closer to our larger group of our stores, we’ll start to get some of the transportation network impact. If you look at it over the course of a 12-month time period, I would expect it to be plus or minus 10 basis points neutral to gross margin over the course of the year.

Erika Maschmeyer - Robert W. Baird

Fantastic. Thanks. Best of luck.

Chuck Rubin

Thank you.

Gregg Bodnar

Thanks Erika.

Operator

Thank you. Our next question comes from Sam Panella from Raymond James.

Samantha Panella - Raymond James

Hi, thanks. And let me add my congratulations as well.

Chuck Rubin

Thanks Sam.

Samantha Panella - Raymond James

Obviously, the comp trends came in better than expected and a lot of that having to do with the traffic. Do you think as you were rolling out some of the new items that's driving the traffic, or just going back to how the business was doing when we talked last time in early June to how it came in at the end, sort of what trends you are seeing? And then also with ticket being flattish, are you seeing any sort of trade down or mix shift in your business?

Chuck Rubin

Sam, you know the trends of what we saw in the quarter was that newness continues to be really important and newness is new brands, it’s new products within brands, it’s new trends, it’s new ways of merchandizing in the stores. So in my comments, I talked about the new men’s shop, which we’re very pleased with and the new fragrance shop, which we’re very pleased with, and all the new products, and the new ways we have tried to harness the different pieces of our marketing approach. So it’s difficult to pick one piece out and say that was the magic sauce, but instead I think, it’s how we collectively put these things together to present newness to our guest. So that’s what is really been the driving force behind our business and we think that will continue as we go forward. In the second part of your question was what again?

Samantha Panella - Raymond James

With respect to ticket being flattish in the quarter, are you seeing any sort of trade down or mix shift in your business relative to last year?

Chuck Rubin

No, really not. So, you know, it was up slightly, but we’re very pleased that the bulk of our comp was driven off of increased traffic. But, no, we’re not really seeing a slow down or a step down, I should say, in what she’s buying today.

Samantha Panella - Raymond James

And then sort a one-off question. I guess, any significance to the name change in your press release referring to yourselves as Ulta Beauty versus the full Ulta Cologne and Cosmetics?

Chuck Rubin

It's a subtle thing that my General Counsel finally allowed me to do. Our customer doesn’t think of us as Ulta Salon, Cosmetics & Fragrance, it’s rather a mouthful, and as we – we need to continue to increase our branding and make Ulta Beauty a stronger brand in itself, and you will see us do that in a variety of touch points and Ulta Fragrance, Cosmetics, & Salon just is not a brand friendly kind of name. So Ulta Beauty is what the customer sees in the front of our store, and it should be what they see in all of our touch points including our financial releases.

Samantha Panella - Raymond James

Great. Thanks guys and good luck.

Chuck Rubin

Thanks.

Operator

Thank you. Our next question comes from Alex Fuhrman from Piper Jaffray.

Alex Fuhrman - Piper Jaffray

Great. Thanks guys. I was just wondering if you could give us an update on what percentage of the current store base now is in your level seven prototype and then maybe how can we think about remodels next year? I know you talked about 15% to 20% square footage growth, but how many remodels for that newest prototype could we see next year? And then given that I mean you have come out with a lot of new innovative prototypes over the years. Should we be thinking about a type eight prototype anytime soon?

Chuck Rubin

You know, Alex, we’ve got just under 80 stores that are below the level six, level seven prototype. So think of that as the current sort of modern store design. Certainly differences between six and sevens, but they are much more subtle in the boutique presentation. As far as remodels go, we finished 17 this year as we stated in our prepared remarks. We are focused on continuing to move as fast as possible towards one store prototype and getting it – the rest of the stores to that current sort of level seven design. So, we do plan to slightly accelerate, the plan is yet to be finalized, our remodel program going into next year as we accelerated it from 2010 to 2011.

Alex Fuhrman - Piper Jaffray

Great. That is helpful, thanks. And then just real quick, I think, you alluded to it in response to Aaron's [ph] question about the loyalty program earlier, but how many of your stores are currently as of this moment in time on the new points-based program as opposed to the older rewards certificate program?

Chuck Rubin

The points-based program is in about 20% of the chain.

Alex Fuhrman - Piper Jaffray

Great. Thanks guys. Good luck.

Operator

Thank you. Our next question comes from Evren Kopelman from Wells Fargo.

Evren Kopelman - Wells Fargo Securities

Thanks. Good afternoon guys.

Chuck Rubin

Hi, Evren.

Gregg Bodnar

Hi, Evren.

Evren Kopelman - Wells Fargo Securities

Can you tell us about the merchandise margin improvements a little bit more, what drove it in terms of maybe how much (inaudible) any part of it or lower promotions year-over-year? And also when you think about (inaudible) and retained by your 15% operating margin goals, you said, we're going to get there half through gross margin, half through SG&A, but the recent strong performance in gross margin, does that change that at all?

Gregg Bodnar

The merchandise margin improvement continues to be driven by the factors we've talked about in the past. Certainly, there's a slight mix benefit. As we continue to manage the inventory, it continues to be cleaner, albeit there's not a lot of clearance in our inventory. It still continues to be a slight opportunity for our merchants to turn that inventory faster and get better sell through, and that also is a driver in terms of selling through better on promotional inventory too.

So, better realized margins in all those cases drive our overall merchandise margin, and as we just continue to leverage our overall growth. So, those are the sort of three or four drivers in merchandise margin. As it relates to our long-term operating goal, I did mention that we expect we'll achieve a 10% operating margin this year. We've stated in the past. You may remember, last quarter, we moved that goal up that we would get to a solid double-digit operating margin in the 2012, 2013 time period.

So, we're well on our way towards that. As you look forward beyond that, towards that mid-teen operating margin, that sort of 15% mid-teen operating margin goal, we do continue to expect that there'll be a relatively equal contribution between gross profit and SG&A, slightly more coming from SG&A just from the natural leverage that’s going to come from our business as we accelerate our store program.

And certainly, we've talked about in the past, each one of those area is going from 10% to 15%. There are specific strategies that we have accomplished multiple phases of and have delivered the improvement we have seen over the last couple of years and we have multiple phases to go, and that’s why it gives us confidence that we can get to that mid-teen operating margin.

Operator

Thank you. (Operator instructions) Our next question comes from Jason Gere from RBC Capital Markets.

Jason Gere - RBC Capital Markets

Good afternoon.

Chuck Rubin

Hi, Jason.

Gregg Bodnar

Hi, Jason.

Jason Gere - RBC Capital Markets

Just I guess following up on the SG&A question, obviously, I understand the natural leverage. You talked about some of the prudent cost savings that you were seeing, and just with the magnitude of the SG&A leverage that we saw in this quarter, can you talk about some of the – I don’t know if these are corporate-wide programs that you have in place or initiatives, but how much of this, some of the overhead reductions can you take out over the next few years as you aim towards that 15% operating margin? How much will come from the overhead as opposed to kind of the SG&A leverage that comes through?

Chuck Rubin

You know, we've talked about that there is multiple programs that are going to drive gross profit expansion and SG&A. Certainly we have a very flexible store model. We continue as those stores drive their productivity to leverage the four wall operating costs within those stores. So, it’s not cost reductions. It’s a very disciplined approach to how we ramp stores up as they grow through their maturity curve. So that’s sort of point number one. We’ve always demonstrated that point in the past that we’ve always made the point real clear that those long-term goals are built off of 3% to 5% comp, and we start to leverage SG&A at a low single-digit comp, okay.

That’s in the four walls of the store, that's in our corporate. It’s just part of that very disciplined approach that we take to managing our business. We get leverage off of advertising, because as we fill in markets, that drives advertising leverage and it also drives G&A leverage, and it also drives four wall store leverage as well. So, they are very specific programs, like we've talked about in the past, Jason. It’s a disciplined approach to managing the business. Those further technology tools that we have put in, in the past that we’re leveraging, and further technology tools that we'll put in the future, like more detailed labor scheduling, more detailed time and attendance tracking, more detailed task management. That answer your question, Jason?

Jason Gere - RBC Capital Markets

No, it does. And then, just a follow-up on an earlier question, and I think there was a part of the question that I’m not sure if I heard the answer, and that might have been done on purpose, but when you talked about Lancome test and maybe how you think about with some of the other prestige players out there, I know you’ve done some tests with Estee Lauder, I’m just wondering if you can kind of maybe refresh our memory, how some of those efforts are going. Can you really – how that the dialog is going with them, and now that they see Lancome testing through, are you more optimistic that you can convince Estee Lauder that Ulta is the shop, the place for high-end prestige in kind of ensuing that relationship?

Chuck Rubin

Jason, I did omit the comment purposely earlier. Our focus is convincing our guest that Ulta is the place for her to shop and putting a portfolio of brands together that we think are appropriate for her. At some point, I hope that we can add additional brands that we don’t carry today. It could be some that you just mentioned, it could be others as well. There’s other brands out there that certainly we would like to add to our portfolio.

Right now, we are focused on the offering that we put forth. Clearly, our results suggest that we’re doing a good job of putting that offering together. In the addition, in those 29 stores of Lancome, we’re really thrilled about, but again, I would remind everybody that we have a very healthy business without these other iconic brands, and it will be a healthy business over the long-term as well. So, we continue to pursue lots of newness, both brands as well as products as well as services. So, that’s the foundation of our success since I’ve been here, and that will be, I believe, the foundation as we go forward.

Jason Gere - RBC Capital Markets

Great, and congratulations on great numbers.

Chuck Rubin

Thanks Jason.

Operator

Thank you. At this time, we have no further questions. I’d like to turn the call back over to Chuck Rubin for closing comments.

Chuck Rubin

Okay, let me thank everybody for joining us on this call and we look forward to speaking with you again when we report third quarter results in early December.

Operator

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

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