Ulta Beauty, Inc. (ULTA) CEO Mary Dillon on Q3 2018 Results - Earnings Call Transcript

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About: Ulta Beauty, Inc. (ULTA)
by: SA Transcripts
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Earning Call Audio

Ulta Beauty, Inc. (NASDAQ:ULTA) Q3 2018 Earnings Conference Call December 6, 2018 5:00 PM ET

Executives

Laurel Lefebvre - Vice President, Investor Relations

Mary Dillon - Chief Executive Officer

Scott Settersten - Chief Financial Officer, Treasurer and Assistant Secretary

David Kimbell - Chief Merchandising and Marketing Officer

Analysts

Lauren Frasch - Wells Fargo Securities, LLC

Simeon Gutman - Morgan Stanley

Joseph Altobello - Raymond James & Associates, Inc.

Anthony Chukumba - Loop Capital Markets

Rupesh Parikh - Oppenheimer & Company

Oliver Chen - Cowen and Company

Simeon Siegel - Nomura Instinet

Stephanie Wissink - Jefferies & Company, Inc.

Christopher Horvers - JPMorgan

Dana Telsey - Telsey Advisory Group

Mark Altschwager - Robert W. Baird & Co.

Erinn Murphy - Piper Jaffray

Michael Goldsmith - UBS

Brian Tunick - Royal Bank of Canada

Michael Binetti - Credit Suisse

Operator

Greetings, and welcome to the Ulta Beauty Third Quarter 2018 Earnings Results 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]. As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Laurel Lefebvre, Investor Relations, Vice President. Thank you. You may begin.

Laurel Lefebvre

Thank you. Good afternoon, and thanks for joining us for Ulta Beauty’s third quarter 2018 conference call. Hosting our call are Mary Dillon, Chief Executive Officer; and Scott Settersten, Chief Financial Officer. Also, joining us is Dave Kimbell, Chief Merchandising and Marketing Officer.

Before we begin, I’d like to remind you of the company’s Safe Harbor language. The statements contained in this conference call which are not historical facts, may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual future results may differ materially from those projected in such statements due to a number of risks and uncertainties, all of which are described in the company’s filings with the SEC. We make references during this call to non-GAAP earnings adjusted for the impact of lower tax rate and one-time bonuses.

During the Q&A session, we respectfully request that you ask one question only please to allow us to have time to respond to as many of you as possible during the hour scheduled for this call.

I’ll now turn the call over to Mary.

Mary Dillon

Thank you, Laurel, and good afternoon, everyone. Ulta Beauty’s strong performance in the third quarter reflects continued market share gains across all major categories, acceleration in our overall comp driven by healthy traffic, excellent new store productivity and robust e-commerce growth.

To summarize the headlines, total sales increased 16.2%. We delivered 7.8% comp sales growth on top of 10.3% comps in the third quarter of 2017. Diluted earnings per share of $2.18 grew 28%. We just shared a lot of news at our Analyst Day last month, and today, I’ll reiterate some of the information we discussed about each of our strategic imperatives, which position us to deliver industry-leading financial results.

I’ll begin with our efforts to drive loyalty and to take our brands to the next level. We grow our Ultamate Rewards loyalty program to $30.6 million active members at the end of the third quarter, a 15.3% year-over-year increase. Loyalty member sales now represent more than 95% of our total revenues.

We continue to benefit from the high engagement of our Platinum and Diamond level guests, garnering more than 40% share of wallet from these two tiers combined. These guests are over three times more likely than our average guests to be omni-channel shoppers and take advantage of our services offering. They also have extremely high retention levels at more than 96%.

Going forward, we expect to increase our focus on driving higher sales per member and personalization is the next major tool for growing share of wallet. Our vision is to make every guest touchpoint personalized and relevant, building tools and capabilities to develop a closer connection to our guests, so they feel even deeper loyalty to the Ulta Beauty brand.

We’re just in the early innings of personalization, and we’re building expertise, both internally and through acquisitions to bolster our capabilities in this area. More on this topic in a bit. We also continue to grow our credit card portfolio and see a sustained business sales for our guests, who hold the Ulta Beauty credit card. Sales of gift cards grew 35% in the quarter, driven by expanding distribution and other retailers this year, as well as strong growth in our own stores.

We continue to grow awareness of the Ulta Beauty brand, now reaching all-time highs at 55% for unaided and 92% for aided awareness for the quarter. These milestones are supported by significant improvements on important brand attributes such as being considered exciting, fun, inspiring, experts in beauty and on trend.

Last quarter, we discussed the launch of our new brand purpose, “The Possibilities are Beautiful”. This is a new articulation of our brand platform, celebrating the emotional and inclusive power of possibilities at Ulta Beauty. We believe we’ve moved past the point of driving awareness of the concept of Ulta Beauty, All Things Beauty, All in One Place, to one of being able to create a true emotional connection with our current and prospective guests. This is how great brands create loyalty and drive growth over the long haul.

To support the launch, we commissioned a consumer study to understand beauty standards and perceptions of beauty today, in order to facilitate this important discussion. We brought this to life with a partnership with NBCUniversal’s platforms, including NBC, E! and Telemundo, which garnered millions of impressions and engagement with our brand.

As part of our efforts to connect more closely with the key consumer segments of millennials, Latinas, Gen Z and African-Americans, we’ve launched specific efforts to drive awareness with each group. For example, we’re partnering with ESSENCE and Girls United to increase academic potential, confidence in leadership of young women’s aged 12 to 17, and leveraging partnerships with influencers and media partners that are most relevant to these consumer groups.

In addition to our new brand equity campaign that launched a few months ago, we began running new holiday commercials with the theme, Shine Brighter, in early November focused on Ulta Beauty as a destination for both grooming and gifting.

Let me turn now to an update on our merchandise assortment, focused on innovation, differentiation, exclusivity, relevancy and speed to market. During the third quarter, we benefited from double-digit comp growth in mass cosmetics, prestige skin care, fragrance, prestige boutique brands and sun care. Prestige cosmetics showed modest improvement in comp sales performance compared to the prior quarter, suggesting encouraging stabilization of our largest category.

We’re positioned in Ulta Beauty as the partner of choice for brands across the beauty spectrum from classic brands to established indie brands to new and emerging brands and we believe there are significant opportunity to grow each of these groups in multiple expressions and formats.

As we’ve recently launched an emerging brands team, focused on identifying new and often digitally-native brands. The team has developed customized processes to onboard and incubate smaller or emerging brands of partnerships with all areas of our business in order to ensure successful launches of these brands, which are often not accustomed to a retail environment.

We’re excited to be participating in the rapid rise of influencer and celebrity-driven brands. Kylie Cosmetics is off to a strong start, with 28 SKUs launched in-store on November 17 – excuse me, November 17 and were carried the assortment online. We also announced the introduction of four Kim Kardashian West Fragrances for holiday, which launched in-store only. Both brands have been very supportive of these launches with a series of social media posts by Kylie and Kim, who each have 120 million Instagram followers.

Kylie also made a personal appearance in one of our Houston stores the weekend of the launch. Other examples of influencer-led brands are the launches of Beauty Bakerie, Juvia’s Place and expansion of Morphe. Morphe is now in 10 feet with an elevated presentation in all stores, and we launched an exclusive collaboration on November 16 with James Charles, an influencer with over 10 million Instagram followers.

Our holiday plan has been well executed by the teams with many exclusive products and kits; elevated gift for purchase offerings for fragrance; and a strong Black, Cyber Monday offer; as well as our early December Beauty Blitz program. Combined with the new holiday television and radio creative in-store marketing, we’re confident that we have implemented a comprehensive merchandising new marketing plan to position Ulta Beauty as a compelling destination for holiday shopping.

Now touching on our services business. Salon sales grew 10.7 % and comp 3.5 %, driven by average ticket increases and benefiting from increased traffic in our stores. To update you on the roll out of our service optimization program, our new services model is now in over 30% of the chain. We continue to see encouraging results and we will continue to roll it out to additional markets in early 2019.

This program was built to attract and retain top stylists to provide exceptional services. The components of services optimization, our compensation design to retain top talent, industry-leading internal trading and education, simplified menus, transparent pricing, as well as dedicated field teams focused on business and technical training to support our 8,000 stylists.

We continue to roll out the skin bar Ulta Beauty and now have this format in 174 stores. We plan to have 188 stores with the skin bar by year-end, and 50 of them will be multi-branded offering services with brand partners, Dermalogica, Murad, Kate Somerville and Kiehl’s. Early results are promising for increased product sales, as well as guest satisfaction.

We’re now testing a new salon appointment booking tool in partnership with technology start-ups groups. We developed an enhanced tool for booking appointments for all services, including hair, skin, brows and makeup. The booking tool is faster and easier to use and elevates guests engagement. We expect to roll the booking tool out through 2019, with further enhancements to the platform teed up for next year.

And now let me turn to real estate. We opened 42 stores in the third quarter, compared to 48 last year and closed three ending the quarter with 1,163 stores. New stores continue to deliver sales ahead of expectations, and we recently updated our new store model to reflect the strength of the new store portfolio, with year one stores achieving sales of $3.5 million on average and ramping to $5 million by the fifth-year of operation.

With increased confidence in the next several years of store growth, we narrowed our U.S. store target range of 1,500 to 1,700, and we’ll slightly moderate new store openings in the next few years, with plans to open 80 stores in 2019, 75 stores in 2020 and 70 stores in 2021. This moderation is planned in tandem with a greater focus on portfolio repositioning, as the large number of store leases is coming up for renewal in the next several years.

Moving on to our e-commerce sales and our recent efforts to create an innovation ecosystem. Ulta.com sales grew 42.5%, and represented nearly a 11% of total company revenue. E-commerce contributed 340 basis points of the total company comp, driven by transaction growth. Total traffic growth rose close to 36%, with mobile traffic up 44%.

We continue to see strong demand for store-to-door or save the sale program, and we’re now testing buy online, pickup in store in 47 locations. So I’d like to recap some of the important announcements we made at our Analyst Day in November. We described how we’re building an innovation ecosystem with a series of partnerships and acquisitions.

We recently invested in a multi-year strategic partnership with Iterate, a technology solutions company and workflow platform. Iterate helps large companies harness the best digital innovations and allows us to tap into technology talents in Silicon Valley in Colorado, as well as sharing knowledge across industry. Iterate attracts trends, provides research and curate technology partnership opportunities. And for Ulta Beauty, it enables rapid prototyping and gives us access to start-ups that will be most suited to our needs.

In addition to this important partnership, we’re also accelerating innovation by building internal capabilities. For the first time in the company’s history, we made acquisitions of two small tech start-ups, GlamStreet and QM Scientific, to support our digital experience roadmap and develop the innovation pipeline. We welcome these entrepreneurial founders and their teams to Ulta Beauty family. We’re excited to work together with this team to unlock personalization in a differentiated way.

GlamStreet has been a partner for the past two years behind the development of GlamLab, our virtual try and experience in our mobile app. Bringing these capabilities in-house will allow us to move faster in developing our augmented reality offerings. They can buy an AR, AI and machine learning capabilities and focus on virtual makeover solutions, image processing, graphics and effects.

QM Scientific is an artificial intelligence startup, recognized as a disruptor in the retail space. Their capabilities include artificial intelligence, recommendations, computer vision, natural language processing and visual search. Both GlamStreet and QM Scientific bring technology leadership, guest experience focus, capabilities and the right cultural fit with Ulta Beauty.

Connecting these strategic relationships and partnerships start to frame up our approach to digital innovation, an ecosystem where we rely on capable technology partners, more closely with Iterate as an innovation workflow partner and as an extension of our Ulta Beauty team, as well as invest in assets and bring in-house technologies and talents that are core to our future.

We view this structure as an efficient way to accelerate our digital innovation capabilities on our path to deliver world-class digital experiences, including much greater personalization.

And now turning to an update on our supply chain operations. Strong in stock levels, coupled with good control of inventory per door growth, were the highlights of our supply chain team’s performance in the quarter. Our newest distribution center of Fresno is ramping quickly, now serving a 173 stores in 21% of e-commerce orders.

In concert with the continued ramp-up of our three newer buildings, we are reducing activity in our Phoenix, B.C. in preparation for its closure next year. We see a significant opportunity to improve working capital in the years ahead. As part of the efficiencies for growth cost optimization program, we’re launching an SKU rationalization project. We’re also benefiting from better inventory visibility and markdown tools.

Over time, we’ll get the entire supply chain network on a common operating model, as well as continue to drive end-to-end process improvements. As a result, we expect to see modest inventory turn improvement each year over the next several years, with a goal of 50 basis points of improvement over the next five years.

So with that, I’ll turn it over to Scott to discuss in more detail the drivers of our third quarter financials and outlook for the fourth quarter and the full-year.

Scott Settersten

Thanks, Mary. Good afternoon, everyone. I’ll begin with the income statement. Top line growth of 16.2% was driven by a 7.8% comp and strong new store productivity. The revenue recognition accounting standard adopted at the beginning of the year added $10.5 million in sales from the combined impact of income from our credit card program, gift card breakage, as well as e-commerce revenue now being recognized upon shipment, offset by the value of points earnings in our loyalty program.

As a reminder, our retail comparable sales growth is not impacted by the revenue recognition accounting change. Traffic strengthened compared to the prior quarter, with transactions driving the majority of the comp. Total company transactions increased 5.3% and ticket increased 2.5%.

The retail-only comp of 4.4% was balanced between traffic and ticket. Ticket growth was driven by increases in average selling price, with units per transaction flat. Including the salon comp of 3.5%, the combined retail in salon comp was 4.4%.

Turning to gross profit. Margin was flat year-over-year. The new revenue recognition accounting standard added about 50 basis points to the gross profit line. So the underlying 50 basis points of deleverage were a bit more than we were forecasting going into the quarter.

Some of the factors driving this deleverage were the same dynamics we’ve been experiencing all year, including the mix of e-commerce sales; the mix of lower-margin prestige brands; investments in our salon business and supply chain deleverage, driven by the Fresno distribution center opening; as well as higher freight costs, which weighed on the P&L by about 10 to 15 basis points as we called out at our Analyst Day.

Overall, promotions were fairly flat year-over-year, with lower circulation of some of our print catalogs and newspaper inserts and three weeks of our postcard 20% offer this year, compared to four weeks of the same offer last year, offset by increased digital marketing.

The primary driver of the delta between the original plan and our actual results was the clearance event that began at the end of the second quarter and continued into the first several weeks of the third quarter. It took us longer than expected and we took deeper markdowns than expected, to sell through the discontinued inventory to clean up our back rooms, to get our stores ready for all the great new launches ahead of holiday.

While the clearance event did pressure marginally more than planned, we’re happy with the end results and are in great shape for Q4. The margin rate headwinds that I described were partially offset by planned leverage of rent and occupancy expenses.

Moving down to SG&A. We deleveraged by 140 basis points, including 70 basis points of impact from the revenue recognition accounting standard. The remaining 70 basis points were due to deleverage of store payroll, primarily related to the prestige brand expansion, as well as deleverage of marketing expense.

This was due to timing of advertising spend for our new campaign, and we anticipate marketing expense to be flat as a percentage of sales for the full-year. These pressures were partly offset by slight leverage in corporate overhead.

Operating margin was 10.8% of sales and was down 130 basis points from last year’s Q3 operating margin of 12.1%, with 20 basis points attributable to the revenue recognition accounting change. Diluted EPS grew 28% to $2.18, with about $0.02 of earnings due to a lower than expected tax rate related to equity compensation.

Turning now to the balance sheet and cash flow. Total inventory grew 10% and was flat on a per store basis, well below comparable sales growth, as we continue to benefit from improved inventory systems and processes, as well as the clearance event that began at the end of the second quarter and ran for the first few weeks early in the third quarter.

Capital expenditures were $115 million for the quarter, driven by new stores, investments and systems, prestige brand roll outs, merchandise fixtures and supply chain investments. We ended the third quarter with $296.9 million in cash. We repurchased 451,000 shares to our 10b5-1 program at a cost of $119 million during the third quarter. $283 million remained available on the $625 million authorization as of quarter-end.

Turning now to guidance for the quarter and full-year. For the fourth quarter, we expect sales to be in the range of $2.085 billion to $2.103 billion versus $1.938 billion last year. Recall that, last year’s fourth quarter included an extra week worth $108.8 million and about $0.14 of earnings.

We expect comparable sales to increase in the range of 7% to 8% versus 8.8% last year. Our comparable sales will compare weeks 40 through 52 this year with the same period last year, so that 53rd-week drops out.

E-commerce sales are expected to grow in the mid-30s percentage range, compared to 60.4% last year, or 50.4% on a comparable 13-week basis. We plan to open approximately 11 new stores in the fourth quarter, compared to 16 in Q4 last year, and remain on track to open 100 net new stores this year. Q4 preopening expense is expected to be slightly lower as a rate of sales compared to last year.

Diluted earnings per share are expected to be in the range of $3.50 to $3.55 versus $3.40 last year on a GAAP basis, or $2.75 adjusted for a lower tax rate, the impact from the revaluation of deferred taxes and related one-time bonuses last year. Operating margin is planned to deleverage, including the roughly 20 basis points related to the revenue recognition accounting standard consistent with the impact we’ve seen so far this year.

The tax rate for Q4 is expected to be 24%. This does not include any assumptions for the tax rate impact of share-based compensation accounting, which is difficult to forecast. Our fully diluted share count is estimated at $60.3 million.

For the full-year, we are maintaining our outlook for comparable sales and earnings per share, which we updated at our Analyst Day a month ago. We plan to open 100 new stores, all approximately 10,000 square feet. We’ll complete 15 remodel and relocation projects. We expect to grow e-commerce approximately 40%. We anticipate top line growth in the low-teens, including the impact of the 53rd-week last year.

Total company comps are expected to be in the 7% to 8% range. We expect to grow diluted earnings per share in the low-20s percentage range, including the extra week in 2017. We anticipate capital expenditures of approximately $375 million, depreciation is forecasted at approximately $290 million, we expect to repurchase shares in the $500 million range for the year and the annual tax rate for the remainder of the year is expected to be 24%.

As you know, we provided a long-term look at our Analyst Day last month, targeting mid to high-teens earnings per share growth, 5% to 7% comparable sales for the next three years and modest margin improvement each year. We plan to provide specific annual guidance for 2019 on our Q4 call in March as we normally do.

And with that, I’ll turn it over to our conference call host for Q&A.

Question-and-Answer Session

Operator

Great. Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Our first question here is from Ike Boruchow from Wells Fargo. Please go ahead.

Lauren Frasch

Hi, everyone. This is Lauren for Ike. Scott, could you maybe provide a bit more color around Q3 gross margins, maybe help us understand the dynamics between fixed costs, the merchandise margin and how the clearance event play into that? Also, anything that may have surprised you in the quarter and how that helps you think about Q4 gross margins as well? Thank you very much.

Scott Settersten

Yes. Thanks for the question. I know this is a little complicated, so let’s give you a couple of points of reference. So versus last year, what you guys may have been expecting or looking for your models. So benefits versus last year included lapping the hurricanes. Of course, we had to promote a lot last year to capture lost sales, right?

We said, I think, it was about 100 basis points of comp of impact last year and then stronger rent in occupancy leverage versus last year, so we’re lapping over a number of, what I call, higher-cost stores, Manhattan and Michigan Avenue, and a number of others that we installed last year. Those benefits were offset by salon optimization investments that we’ve been talking about.

All year, the Fresno DC, again, new in the second quarter, that’s caused a bit of deleverage year-over-year and then the mix things we’ve been talking about in the business, the prestige brand mix and an e-commerce mix, all right, so that’s versus last year.

Versus our expectations, we call our transportation of 10 to 15 basis points at Analyst Day, so there has been some upward pressure there all year for us. On the sales mix side, Marry called our fragrance and mass doing really well in the third quarter. So again, fantastic market share gains, but those two categories do have slightly lower margins overall than the house. And then it was primarily, we called out the clearance event, was really the bigger surprise for us versus our plan.

So like I said, we had to go longer and deeper to move those items out of the store. But it was the right thing for us to do, and we feel really good where we are prepared for holiday.

Lauren Frasch

Great. Thank you so much for the color, Scott.

Operator

Our next question is from Simeon Gutman from Morgan Stanley. Please go ahead.

Simeon Gutman

Hey, thanks. Good afternoon. So one question and just a couple of parts. Scott, can you quantify to us how much more did the extra clearance or the extending of the clearance hurt your gross margin? And I guess, I would have presumed that by the time you gave your second quarter call, you had some idea of this at the time. And then I just want to reconcile this, Sephora called out a more promotional environment, you didn’t really, you didn’t say that, I mean, it was all sounds like this clearance event. But just if you can talk about the posture of the industry and if it feels more competitive? Thanks.

Scott Settersten

Yes. So maybe I can start with the promotional environment. So again, we feel like it’s relatively stable year-over-year as we look at things. So again, it seems like overall there has been a bit more buzz about things. In the competitive environment, this is a tough space it always has been and we expected to continue to be. So as we’re looking ahead now, specifically to the fourth quarter, we feel like we’re in a pretty stable place overall.

As far as the clearance event goes, not quantify it for you, but directionally I would tell you it’s primarily – it’s the biggest driver by far of the surprise versus where we thought we were headed for the third quarter. So, we talk a lot about the boutique strategy and the remodeling efforts that have been underway here over the last 18 months really in an accelerated phase.

So, when we’re updating those stores, one of the biggest changes is our fragrance fixtures. And we’ve really pared back the assortment there as we upgrade the fixturing and presentation in the store. It was a lot of excess fragrance that had built up in the system overall and we’ve been trying to, I’d say, at the margins, kind of sell our way through that in clearance sections in our store just got to the point, where we thought we needed to be more aggressive and that’s what we did.

So we wanted to know – it can – it was playing its way through and in the third quarter we just needed to put our foot on the accelerator to get it out of the store. So again, overall was a little more expensive than we were hoping, but it was the right tactic for the business.

Operator

Our next question is from Joe Altobello from Raymond James. Please go ahead.

Joseph Altobello

Thanks. Hey, guys, good afternoon. I guess, the first question is on the comp guide for the fourth quarter of 7% to 8%. It sounds like it’s kind of consistent what you saw in the third quarter. I’m curious, your base period gets easier by about 150 basis points. You got the introduction of Kylie this quarter. So why would we see a comp acceleration sequentially quarter-over-quarter?

Mary Dillon

Yes. I mean, Joe, it’s Mary. I would say that, we guided the best we can with the information that we have. I feel really good about what we have in place for holiday, whether it’s like you mentioned the brand launch is off to a strong start, our holiday marketing, our exclusives, our gift with purchase, they’re all – we’re lined up really well, I’d say, to be competitive and have a strong quarter. But really this is just our best estimate at this point.

Scott Settersten

And I would just add, not to forget, fourth quarter is a different animal for us, right? This is a place where we compete with all the retail, not just the beauty competitors. So, we go into the quarter, we think in a – with prudent guidance, right, recognizing and feeling good about where our plan is for just making sure that we don’t get too far ahead of ourselves.

Joseph Altobello

Okay. Thank you, guys. I appreciate it.

Operator

Our next question is from Anthony Chukumba from Loop Capital Markets. Please go ahead.

Anthony Chukumba

Good afternoon, and thanks for taking my question. You talked a little bit about the fact that your unaided awareness and your aided awareness both continue to increase. Give me a sense for what’s been driving that? I mean, is that just increasing your store presence at some of the shifts that you’ve made in terms of your marketing? Is it the loyalty program? I’m just – I guess, I’m just wondering what do you think is driving that and where do you expect those numbers to trend going forward? Thanks.

Mary Dillon

Sure, Anthony, and I will say, this is Mary, because I thought you guess is this Mary. But anyway, I’m going to start. I’ll let – ask Dave to add more color. I’ll say, this is something we’ve been at now for multiple years, right, just the opportunity that with a brand at Ulta Beauty on the map literally and figuratively. And that’s triggered by a whole lot of factors and we’ve been measuring it. It’s not even just about people know us, but is there a meaningful understanding of what we are about.

And I do believe that this next level of creative that we’ve just launched is going to deepen, not just to people know about Ulta Beauty, but the way they understand what we stand for. But maybe Dave could add some color in terms of the tactics that in terms of…

David Kimbell

Yes, absolutely. We have, Anthony, dramatically adjusted our marketing approach, really revamped it in a significant way to make it more current and relevant and motivating to our consumers. And that’s driven a much greater connection really as we’ve done that over the last three years or so, we’ve seen this dramatic increase in awareness. So marketing, for sure.

But you mentioned some of the other things. Certainly, we’ve been opening new stores and that’s been helpful as we’ve entered into some new markets. Our loyalty program, as we combine that to one program about four years ago, that gave us the opportunity to market that and make the a deeper connection. And that helped us drive greater connection with our guests, but more word of mouth.

Our assortment has improved dramatically over the last several years. So those things have come together. And you asked about what come – where we think it’s going from here? We’re really pleased with the growth we had and awareness is just a critical – it was a critical opportunity, but we see more to come.

We’re one of the leading unaided awareness retailers, number two in the market right now, where we think we’re on a path to becoming the number one unaided retailer in beauty, the campaign that Mary described in her comments, is the next step of that to make a more purposeful effort to connect with our guest in a more meaningful way. And so far, we’re off to a good start with that.

Anthony Chukumba

Our next question is from Rupesh Parikh from Oppenheimer & Company. Please go ahead.

Rupesh Parikh

Good afternoon. Thanks for taking my questions. So on the Kylie Cosmetics launch, it sounds like the comment – the launch so far is off to a strong start. So I’m just curious how it’s trending versus your expectations. If there’s any surprises in terms of the customers bring into your stores?

David Kimbell

Yes, great question. Yes, we’d say, first, it’s early. It’s been less than a month just a couple of weeks, but we’re really pleased with the results, certainly has generated a lot of excitement. It is – our existing guests have responded very favorably to it, but also it’s done a nice job driving in some new guests, in particular, younger and diverse consumers. So we’re really pleased with the effort overall.

Kylie and the Kylie Cosmetic team has done a really nice job helping communicate this launch, but their fans excited about it. So overall, we’re pleased with it. I think, as far as the assortment, we’re seeing strength across line. It’s relatively narrow assortment, but we’ve been really happy with the performance we just launched a – an exclusive holiday kit, and that’s been received very well and that’s available only on Ulta and not on kyliecosmetics.com. Our teams are working really hard to keep the stores replenish. We have anticipated through Q4 of – kind of being tighter on inventory through the quarter.

So it’s possible as we move into holiday that we’ll sell out in some cases, but we’re working hard to continue to replenish and evolve the assortment going forward. So overall pleased, but a long road ahead of us as well.

Rupesh Parikh

Great. thank you.

Operator

Our next question is from Oliver Chen from Cowen and Company. Please go ahead.

Oliver Chen

Hi, good evening. The QM Scientific deal is great and awesome. We’re curious about the AI-powered customer engagement in terms of how you see that manifesting across different opportunities within the ecosystem? And also in the context of AI, how do you juxtapose that with the beauty enthusiast to often, likes new product versus driving an optimized personalized recommendation system and would love your thoughts?

The QM Scientific team has a lot of experience with robotics and we’re seeing a lot more retail robotics, as well as conversational commerce. How do you see that manifesting and what you’re building over time? Thank you.

David Kimbell

Yes. Oliver, great question. We too – we share your excitement about having QM joined Ulta Beauty and we’re just really optimistic about what that team has already brought and we’ll be bringing us going forward. You hit some of the highlights, but I’d say, of the things that we’re looking forward to drive with them. But I’d say, overall, as Mary mentioned in the comments, this is first and foremost about personalization, leveraging their capabilities to understand our guest in a better way and manage our connection to them.

The first phase with them is really getting them engaged and onboard, which they are, we’ve been doing that over the last month or so and getting them fully up to speed and connected to our business as we look forward over 2019. I’d say, it’s a mix of some foundational elements that they’re bringing to, say, helped us assess our capabilities.

We’ll be looking across kind of our personalization platform, our data foundation and make sure that that’s as strong as it can be, I shared some of that at the Analyst Day ad they’re going to play a key role in strengthening our foundational capabilities.

The first area is that, we’re going to be tackling things we’ve already been doing. But we’ll see that we think we can move faster in a bigger way around elements like recommendations, as you mentioned, dynamic content, personalized on page. Computer vision is a capability that they have that we see that integrating in as we get further in with them over the next several months that allow us to have product and image recognition, that will also connect to our GlamStreet acquisition to integrate virtual try on data with our personalization platform.

So those are the big areas that we’re focused on. And we see – we’re really just – we’re off to a great start with them. The team is really strong and we’re really pleased to have them on board.

Oliver Chen

Okay. And just a follow-up. With the store of the future, what do you really envision in terms of making sure that you link a lot of the innovation you’re conducting digitally and with AI into shopping – the physical experiential shopping experience? And as you use this incubation innovation lab to look at ideas, how should we think about how Ulta thinks about M&A versus organic innovation?

Mary Dillon

These are deep questions. I’ll start and just say a couple of things. Well, the store in the future, we talked a bit at the Analyst Day. It’s early in our thinking and we’re not going to show a lot of the direction. I’d say, high level the notion of the ability to be very experiential and meet our guests where they are. It’s going to be critical. We think an important in the beauty category, I think, Ulta Beauty will be able to do that, serve that needs really well.

But to your point, an underpinning of technology for everything we do. So these investments in these companies, we see as ways to drive a personalized experience across all touch points, and that would be an underpinning. And again, in the future, we would imagine not surprisingly that there’s less and less friction in the transaction happening in store right more time, less time tasking and checking out a lot more time spent consulting and just having fun with beauty.

So we see them all is working together. And frankly, the place that we can play the best is to play together ease and convenience with discovery and through human experience. That’s both physical and emotional and that – and it’s kind of in a big picture way is how we think about our – not just store, but experience in the future.

Oliver Chen

Thank you. Best regards. Happy holidays.

Mary Dillon

Thank you, Oliver.

Operator

Our next question is from Simeon Siegel from Nomura Instinet. Please go ahead.

Simeon Siegel

Thanks. Hi, guys, good afternoon and happy holidays. Mary, I’ll start with the labor, the clearance conversation. But just can you speak to the why you think it happened? Just was it internal buying planning, or is it more a function of the external environment? Just basically, can you speak your comfort around this not being go-forward necessity? And then, Scott, sorry, if I missed it. What are the gross margins embedded in the Q4 guide that you guys gave? Thank you.

Mary Dillon

So yes, on the clearance, I would say, it’s just a combination of factors that more about that fair number of remodels and expansions of brands that happened in the quarter and a lot of new brands coming in. That just – we make a call [indiscernible] I’m assuming it, we never do, this just happens periodically.

So in this instance, it was bigger with an opportunity, we thought to really clear out inventory and get a set up for the holiday. It’s not something that we expect to repeat at that scale this quarter – on the fourth quarter, for sure. But just one of those business calls that we made that we think we’re right for the business at the time.

Scott Settersten

And as far as margin for the fourth quarter, just a little bit of color on some of the levers there. So, Fresno, less of a headwind in the fourth quarter as that building continues to scale up and, of course, higher volumes overall. Rent and occupancy will – lever, will be stronger in the fourth quarter than it was in the third, again, where we had 42 new stores in the third quarter.

We’ve got a dozen, I think, in the fourth quarter, so that will be better overall. We will be lapping those stores again from last year that we’re in 2017 with higher cost stores. So we’ll see some nice benefits there.

I mentioned earlier, the promotional environment overall, we think is pretty stable right now. So again, it’s a competitive environment, make no mistake about that and holiday is more so than the rest of the year, so we’re prepared for that, but that’s baked into the plan.

When you get down to the SG&A line, labor, so we’ll see – get leverage there unlike earlier in the year. Again, you got higher volumes there that help with some of that. The mix assumptions are all baked in there now. Freight, we mentioned earlier today, that’s in there, although I will say there has been some upward surprises there as we kind of march through the course of the year, but again, that’s not a major driver overall. So feel good about where we are in the plan we have in place for the rest of the year.

Simeon Siegel

Great, thanks. And then just high level for a second. So you – congrats on the awareness obviously keeps getting better. Did you – would you expect the – to accelerate the store productivity curve as that happened? I mean, I guess as you open up new stores, should that ramp happen quicker?

Scott Settersten

Yes. I mean, we’re keeping an eye on that. I mean, we did up – update our store model here at Analyst Day just a few weeks ago. So we are seeing stronger productivity there. It’s a mix of things, as Dave alluded to it earlier, assortment is part of it, awareness is part of it, better guest experience in the store the payroll investments we’re making are part of it. So again, it’s kind of hard to break it down on an individual basis.

Simeon Siegel

Great. Thanks a lot, guys. Best of luck for the holiday.

Mary Dillon

Thank you.

Operator

Our next question is from just look at all the. Our next question is from Steph Wissink from Jefferies. Please go ahead.

Stephanie Wissink

Thanks. Good afternoon, everyone. I just have a follow-up question on your prior comments, Scott, on labor leverage. I’m wondering if you can break the deleverage you saw in Q3 in – for payroll into the boutique and skin bar investments relative to wage rate pressure overall. It sounds like your lever in the fourth quarter, does that imply that those boutiques in those skins bars hit a level of sales volume that allows you to lever there as well? Thank you.

Scott Settersten

Yes. I think big picture that that’s the answer. I mean, as you know, we install these fixtures throughout the course of the year, right, we’re kind of building to a crescendo here. And so you get maximum benefit from that in the fourth quarter when you’ve got much larger sales volumes overall.

So, again, I would just remind people when we’re talking about payroll deleverage it is largely around investments that we’re making for the guest experience, which a lot revolves around these boutique brands that we’re installing in our stores. So all good for the long-term exactly, the thing – the way we think we should be playing it.

Operator

Our next question is from Christopher Horvers from JPMorgan. Please go ahead.

Christopher Horvers

Thanks. Good evening. Correct me if I’m wrong, but did you say e-commerce would grow in the mid-30s in the fourth quarter, so that would be about a 100 basis points less on comp contribution. So you’re expecting to the store to accelerate in the fourth quarter? And can you talk about your thoughts around that, and how do you think the drivers of that are?

Scott Settersten

Yes. I guess, we’re trying to avoid a detailed breakdowns of the comp by business unit here, but yes, we did. So I can confirm we, did say mid-30s for e-commerce in the third quarter. So again, it’s just natural to kind of assume some moderation in that again when you do the adjustment for the 53rd-week last year as part of the math as well. So again, we are off – we feel good about the plan overall.

We think the guidance is strong. We feel like the business is well-positioned. And so we just want to be a little bit prudent with what we’re forecasting for the public at this point in time, because there’s a long way to go between now and Christmas, right? It’s the longest period, right, start to finish. I think 31 days between Thanksgiving and Christmas. So we’re just playing it wisely, we believe.

Christopher Horvers

Understood. And then just to clean up the questions on the gross margin front, questions that we’ve been getting. So earlier this week, there was a coupon. Some people thought it was an extra coupon. I want to get your thoughts on that. And then in terms of 4Q, the clearance which sounded like it lasted a few weeks into the fourth quarter, what sort of headwind are you expecting in 4Q gross margin around the clearance?

Scott Settersten

Well, let me start there first, to be clear. So that the clearance event is behind us now. So that was, Mary mentioned as well. We would call pretty extraordinary. So I think it was some catch up for us right to get through that and we accelerated it in the third quarter. So that we could clear out the back room, so we didn’t have to struggle with it in the fourth quarter. So that’s kind of off the table.

Christopher Horvers

Yes.

Scott Settersten

Again, there’s always a bit of clearance floating through the margin line right, but not not to the extent that what we just saw over the last two quarters.

Christopher Horvers

Got it.

Scott Settersten

And then as far as the coupon is concerned, again, I tried to do this earlier in the year to tell people not to try so hard trying to track individual coupons that hit their e-mail box, rights, because there’s a lot of factors that influence how many times we ping you and what you do with your open rates and redemption rates and all those kinds of thing. So again, I would just reassure investors that we’re pragmatic in our approach. We’re doing the best that we can to deliver the best overall result for the quarter and that includes promotion levels.

Christopher Horvers

Understood. Thank you.

Operator

Our next question is from Dana Telsey from Telsey Advisory Group. Please go ahead.

Dana Telsey

Hi, good afternoon, everyone. As you think about this fourth quarter and obviously a lot of the discussion points on gross margin coming up, what about on inventory levels as you’re heading into the season? Flat per store, how do you see yourself positioned for the holiday with flat per store inventory levels? Thank you.

Scott Settersten

Well, we feel great about our inventory position. So again, we alluded to, Mary did in her comments about the tools and process improvements and things that we’re doing. Part of that is just improved capabilities in our distribution centers. Part of it is behind the team’s investments in tools for our merchants and support teams here at the home office to help us just manage inventories better overall.

So taking out excess weeks of supply in our supply chain network and reinvesting a lot of that into our best selling SKUs, the As and Bs and making sure we’re always in stock on the things that our guests are looking to us for. So again, overall, managing it and we’re guiding to again our long-term guidance 50 basis points of inventory productivity improvement here over the next five years.

So this is – we’ve been promising and talking about this for a long time now,. I know. But now you’re starting to see the fruits of our labor manifest themselves and we’re really happy about where we are and what we have in front of us.

Dana Telsey

Thank you.

Operator

Our next question is from Mark Altschwager from Robert W. Baird. Please go ahead.

Mark Altschwager

Good afternoon. Thanks. It’s encouraging to hear the prestige cosmetic saw some sequential improvement. Obviously, you have Kylie coming in Q4. But bigger picture, can you talk about your outlook for category growth? The past year we’ve seen the acceleration in skincare bit of deceleration in cosmetics. Based on the trends in the innovation pipeline, do you see – do you think we’re beginning to see an inflection back in favor of the cosmetic category?

Mary Dillon

Yes. It’s always – this is a crystal ball moment, right? And Dave and I [indiscernible]. What I would on the prestige, we’re encouraged as well that that’s an encouraging sign about stabilization of that side of the – that part of the business is big. It’s very important to us. But it really is sort of like a tale of different brands or some brands that have huge 2015 – 2015 and 2016s that are so struggling a bit with kind of matching that kind of growth and others that are seeing stellar growth.

So, in total, that sort of muted, I guess, a little bit, but it’s still a healthy segment. Use of cosmetics and innovation in all aspects of color is continuing to be huge out there. And, of course, there’s the channels that are – the brands that are aren’t measured in our traditional channel. So there are a lot of growth and innovation for us to participate and that we feel good. And I feel – we feel good about what’s happening with the other segments of the business with prestige skin, as you said, mass cosmetics, fragrance, all with double-digit comps for us. So anything if you can add to that [indiscernible] Dave?

David Kimbell

Just reiterate. Yes, we’re really optimistic about makeup. Yes, there certainly is a strengthening in skincare. But we feel that our consumers are – remained very engaged and in makeup all the demographic trends continue to be very positive. One of the – that’s one of the reason. So we’ve been focused on digitally-native brands and expanding that part of our portfolio.

So certainly, a brand like Kylie, but also Morphe and ColourPop, Juvia’s Place, so a number of brands that we think will play a role. At the same time, continuing to drive growth on some of our biggest stylish brands like Tarte and Benefit and Anastasia and L’Oreal and Maybeline on the mass side. So wellround and we are positive about where the future of makeup.

Mark Altschwager

Thanks. And just a quick follow-up. It looks like the transaction component to the equation did reaccelerate this quarter, even I guess a tougher compare. Were there any call outs there drivers on the marketing side this quarter and learnings you can leverage for the holiday quarter?

David Kimbell

I’d say from a marketing, we were – we felt really good about our marketing approach. Yes, the – we had some activities throughout the quarter as we made adjustments to make sure we’re driving traffic and transactions. And so the mix we felt was ended up in a solid place. But certainly, as we continue to look forward in the fourth quarter and into 2019, driving traffic is obviously critical and our new advertising campaign we think is front and center doing that and all the other changes that we’re making, I think, will continue to drive strong growth across all aspects of the business.

Mark Altschwager

Great. Best of luck. Thank you.

Operator

Our next question is from Erinn Murphy from Piper Jaffray. Please go ahead.

Erinn Murphy

Great, thanks. Good afternoon. I was hoping you guys could talk a little bit more about the math category and the performance during the quarter? And then how are you thinking about that as you go into 2019? I know you’re lapping your major reset this year.

And then, I guess, Mary, if you think about the emerging brands team and just the opportunities that they can kind of now look through, is there more coming down the pipeline in math or prestige? Thanks.

Mary Dillon

Go ahead, Dave.

David Kimbell

Yes. So on the math side, we’re very pleased with the results this year and then we’re really optimistic about the future. We’ll share more as we get into, but we’re going to continue to expand and grow brands that have been doing well for us. So there’s still opportunity to make them bigger parts of our portfolio.

There’s some core foundational brands, including Ulta Beauty collection, but also L’Oreal and Maybelline and some of the bigger established brands that have been doing well. And we see, we’re positive and optimistic about the future there because of the innovation pipeline that’s ahead of us.

We’ll continue to find emerging brands, and Juvia’s Place is a recent example of a brand we launched early, but off to a good start and that’s in our mass cosmetic space. So as much success as we had this year, we have a large share opportunity. It’s a huge category, and we feel like we’ve got a lot of runway ahead of us to continue to try to drive growth in that space.

Mary Dillon

Yes, and I would just add, Erinn. I think that with the emerging brands that’s really across the Board that we’ll see innovation, right across categories and price points, not just math.

Erinn Murphy

Okay. And then just the ticket growth was the slightest we’ve seen year-to-date. I’m just curious, is that just part of the clearance events being extended or was there any other puts and takes for the ticket, which came in a little bit lighter than we thought? Thanks.

Scott Settersten

I’d say, that’s probably the primary driver there. So again, the clear of that wasn’t much of a sales help overall for the quarter. So yes, that, that would be something that I would attribute a good piece of that as well.

Erinn Murphy

Thanks, and happy holidays.

Operator

Our next question is from Michael Goldsmith from UBS. Please go ahead.

Michael Goldsmith

Good evening. Thanks a lot for taking my question. It looks like your e-commerce in your mobile traffic decelerated sequentially, but your e-commerce sales accelerated. So are you seeing an improvement in conversion online and what would be driving that? Thank you.

David Kimbell

Yes. We – well, a couple of things I’d say is, we’re – we continue to be pleased with traffic. You talked about mobile, that’s a big part of the business – a growing part of the business. And we’re pleased all around with all aspects of that – of the business traffic is strong and healthy.

What we see in mobile is conversion in mobile is a little bit less than desktop, because mobile is used often as an aid to shop in either in-store or on store, so there’s other reasons to use mobile to maybe you’re not using the desktop. So conversion shifts just a little bit there. But when we look across the conversion, traffic, all pointing in the right direction and contributing in a meaningful way to our e-commerce business. And we think we continue to grow all aspects of that business going forward.

Michael Goldsmith

Thank you very much.

Operator

Our next question is from Brian Tunick from Royal Bank of Canada. Please go ahead.

Brian Tunick

Thanks. Good afternoon, everyone. I guess, two questions. One just curious, on the 20% off coupons, maybe can you talk – are you still using them to acquire new guests, or has your philosophy around the returns that you’re seeing on those coupons changed?

And then maybe secondly, Scott, on merchandise margin expectations, as we look at next year or so, maybe talk about any mix shift within prestige growing versus mass growing again, maybe just give us some sense of how you think merchandise margins will play out going forward? Thank you very much.

Mary Dillon

Sure. I’ll start on the promotion question. I would reframe it, it’s really not that any one tactic is about that I think, you said that we have a wide variety of tools in our toolkit, I guess, I call it to drive traffic, to drive share gains, to make our guests very excited and happy, and the 20% off is just actually one of many tools that we do. Everything is designed to do, to get new guests and increase share of wallet of existing guest.

And increasingly, I’m really proud about the fact that our teams have over the past several quarters and years really create a much more sophisticated set of tools that involve everything from an ability to invest and awareness to our loyalty program, as we just talked about the investment in these new capabilities that we have to really use that in a more personalized way.

So it’s all in a journey of how do you make sure that you’re excited for the guest, you’re competitive to driving profitable growth and driving market share gains. And there’s – you’ll continue to see a whole array of ways that we do that.

Scott Settersten

And as far as gross margins are concerned, I mean, Brian, we’ve been following us a long time. It’s a very dynamic category. I mean, they’ve described, I mean, the mix of products that come in and out of our box and now online to a great degree. Every year is kind of like a new story, right? What’s the hot product? What’s the hot SKU? What’s the newness look like?

So again, we’re not expecting. We never have, I guess, really to expand “merchandise margins” in any significant way in the foreseeable future. I mean, we just – we are looking for market share gains, profitable market share gains over the long-term and finding products that excite our guests that drive traffic in our stores and online and that’s what we’re focused on delivering. And then we’ve got, so we’ve talked about EFG during the course of the year a little bit and more explicitly at the Analyst Day.

So that’s a lever for us, again, a back around a lot of our core processes and other places in the business, where we feel like we’ve got good opportunities to find savings to mitigate some of those headwinds if they present themselves. So again, trying to balance all elements of the business to deliver those – the long-term algorithm that we laid out clearly at the Analyst Day.

Brian Tunick

All right. Super. Thanks for the color. Good lucks for holiday.

Scott Settersten

Thanks.

Operator

Our next question is from Michael Binetti from Credit Suisse. Please go ahead.

Michael Binetti

Hey, guys, thanks for taking our question here. So I know, you normally wouldn’t comment on quarter-to-date trends. But given the – of the excitement and the significant stock moves we’ve seen around the last two times, you made [indiscernible] announcements. Would it be safe to make an assumption that current trends are above the 70 guidance for the comp?

Mary Dillon

Yes. We’re not going to comment on the fourth quarter. I feel like, as I said earlier, really good about what our teams have put in place from a merchant side, the product offerings, the marketing, our store teams, our distribution teams are performing at exceptional levels. So, I think, we’re in a good shape, but I’ll leave it at that.

Michael Binetti

Okay. Is there – and then just one more cleanup on that. Is there anything so far that make you think the right e-comm growth rate is mid-30s in fourth quarter?

Scott Settersten

Our forecast – when we look at the business when we layout to be and we look at what were the events we’re comping against and newness that we have to drive our business. That’s kind of – to Mary’s earlier point, we keep it – rate up to the last minute here to make sure we got our best thinking when we put our guidance together.

Michael Binetti

All right. Fair enough. And as you guys think about the detailed guidance you gave at the Analyst Day and the algorithm for the next three years and I look at 2019, you model, you mentioned to us that some of the efficiency initiatives wouldn’t be linear at the Analyst Day. One could assume that you be implying the EPS growth rate than to maybe start at the low-end of the mid to high-teens range to start the three-year plan? Is that the right way to orient ourselves as we think about the puts and takes of multi-year plan?

Scott Settersten

I appreciate your question, Michael, but we’re not going to get into that today. So we’re going to – we’ll lay out our plan for 2019. Again, I think I explained at the Analyst Day that we’re in the in the midst of our planning process here and there’s still a long way for us to go and a lot of decisions to be made. So we’ll share more with you on that in March.

Michael Binetti

Okay. I just had a try. Thank you very much.

Operator

Great. Thank you. This concludes the question-and-answer session. I would like to turn the floor back to Mary Dillon for any closing comments.

Mary Dillon

Thank you. I’d just like to close by thanking our 40,000 associates for delivering another strong quarter, as they’re working hard to get the store’s website and DC is ready for the busy holiday season, all while continuing to elevate the guest experience. So I look forward to speaking with all of you again and happy holidays. Thank you.

Operator

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