Ulta Beauty, Inc. (ULTA) Q2 2014 Earnings Report, Transcript and Summary

Greetings, and welcome to the Ulta Beauty Second Quarter 2014 Earnings Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Ms. Laurel Lefebvre, Vice President, Investor Relations. Thank you. You may begin.

Thank you. Good afternoon, and thanks for joining us for Ulta Beauty's Second Quarter 2014 Conference Call. Hosting our call are Mary Dillon, Chief Executive Officer; and Scott Settersten, Chief Financial Officer. Also joining us are Janet Taake, Chief Merchandising Officer; and Dave Kimbell, Chief Marketing Officer. Before we begin, I'd like to remind you of our 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. During this call we make references to the metric free cash flow, a non-GAAP financial measure defined as cash provided by operating activities, minus purchases of property and equipment. I'll now turn the call over to Mary.

Thank you, Laurel. Good afternoon, everyone. We're delighted to announce very strong second quarter results and to share the outcome of our updated strategic plan and financial targets. I'll talk about our long-term vision, 5-year financial targets and strategic imperatives today, then following up with more detail at Analyst Day in Chicago next month. First, a quick review of the second quarter headlines. We grew the top line 22% and drove the best comp we've achieved since the second quarter of 2012. Total company comparable sales were 9.6% on top of an 8.4% comp in the second quarter of 2013, both including the impact of ulta.com. Strength in prestige and mass cosmetics, boosted by some very successful new products and brands, as well as rapid growth in e-commerce, drove these exceptional results. We were pleased to see transaction growth contribute more than ticket growth to our same-store sales. Solid gross margin performance reflected strong sales of prestige and professional haircare categories, coupled with fewer discounts compared to a year ago. Earnings per share grew 34%, with strong flow-through from better-than-expected sales, healthy product margins and some benefit from the timing of marketing expenses. Scott will discuss the second quarter in more detail and the outlook for the rest of 2014 in just a few moments. Now I'd like to walk you through a review of our strategic planning process and our new 5-year financial targets. As a reminder, we set out several months ago to refresh our strategic plan. This process was led by me and my full senior team. We formed a fact-based, guest-centric and total enterprise view of the guest experience that we want to deliver in the future and determine what is required to do so. We feel confident about the opportunity to continue to drive growth in guest satisfaction in the years ahead. Our approach was to understand Ulta's current strengths and opportunities and then project guest needs, the potential competitive set and the omnichannel landscape of the future. We define Ulta's path from the perspectives of brand positioning, guest experience, products and services portfolio and store and e-commerce expansion plans. We also projected the IT and supply chain requirements to achieve our strategy, then considered the financial impact of all those factors to establish a 5-year plan that delivers sustainable growth and strong shareholder returns. To summarize the primary outcomes of this work, we've identified 6 strategic imperatives as the foundation of continued strong growth. We've identified areas of focus and investment that give us confidence that we can maintain strong top and bottom line growth rates. We developed a 5-year financial model to support the strategic framework. And finally, we developed a capital allocation strategy. We think about this strategic plan as evolutionary, not revolutionary. At the outset, we recognized that our core business model is strong. The original insight of our founders that women want a shopping experience that reflects the entire range of her beauty purchases is still very relevant today, almost 25 years after the first store opened. So the core of what Ulta is all about is not changing. This was about sharpening our view and getting even more focused on delivering a relevant and differentiated business model that drives sustainable profitable growth. In fact, we believe many of the key drivers of our past results still have plenty of runway and will continue to deliver, namely, new store growth; expansion of our prestige assortment; a strong, compelling loyalty program; a clear guest target, a woman we refer to as the beauty enthusiast, she represents about half of the spend in the beauty category, she's highly engaged in newness and discovery; a highly differentiated offering with an unmatched breadth of assortment across categories, brands and services; and rapid e-commerce growth. We also agreed on key opportunities we want to focus on to ensure long-term sustainable growth. And those include increasing Ulta's brand awareness and acquiring more new customers; becoming less reliant on discounting over time in a careful and measured way; and developing the omnichannel capabilities our guests expect us to offer to keep pace with the marketplace. Examples of these capabilities will include ordering in-store and delivery to home and checking availability of inventory online, as well as others. We established our vision for the future of Ulta to be the unmatched beauty authority by providing women a compelling, unique and on-trend array of products and experiences. We aspire to become the favorite beauty destination, the most loved and admired by our guests, associates, communities, partners and investors. Supporting this vision, we articulated 6 strategic imperatives that we believe will drive sustainable growth for Ulta: One, acquire new guests and deepen loyalty with existing guests; two, differentiate by delivering a distinctive and personalized guest experience across all channels; three, offer relevant, innovative and often exclusive products that excite our guests; four, deliver exceptional services in 3 core areas, hair, skin health and brows; five, grow stores and e-commerce to reach and serve more guests; and six, invest in infrastructure to support our guest experience and growth and capture scale efficiencies. At the upcoming Analyst Day, we plan to give you more color on each of these 6 strategic imperatives and show you how we'll bring the Ulta brand experience to life for our guests. The main components of our new 5-year financial targets are as follows. We expect to maintain comparable sales growth in the 5% to 7% range. We plan to open approximately 100 stores per year. For the next couple of years, these are expected to be almost entirely our 10,000 square foot prototype, pending findings from our upcoming small-store test. We anticipate that e-commerce will grow to represent about 10% of our sales. This model is expected to deliver earnings per share growth in the low 20% range over the next 5 years, excluding the impact of the supply chain investment. As you know, we're making significant investments in systems and supply chain, including a multiyear supply chain transformation designed to improve our inventory productivity, in-stocks and to free up labor in stores to be more customer facing. This supply chain work will also enable omnichannel capabilities to position us to keep up with changing consumers' expectations in the years ahead. This investment is expected to reduce our earnings per share growth rate by percentage points in the mid-single digits in 2015 and '16. After which, we anticipate EPS growth will return to the low 20% range. And these targets exclude any benefit from share repurchases. Despite these investments, operating margin is expected to remain stable for the next couple of years before heading up towards our long-term mid-teens target. These targeted range are not meant to represent specific guidance for 2015. We'll provide guidance for 2015 at the time we normally announce annual guidance, which will be on our March 2015 earnings call. Now turning to our capital allocation strategy. We recognize that we have more cash than we need on the balance sheet today, and this cash is expected to grow significantly over time as our business grows and our CapEx needs moderate. We plan to maintain our strong balance sheet and maintain enough cash to invest in organic growth, as well as to keep some dry powder for potential acquisitions or partnerships in the future. And we do plan to buy back shares going forward. We expect to offset dilution and, beyond that, give ourselves a flexibility to buy back more aggressively based on market conditions. Today, we announced a new share repurchase authorization for $300 million, which replaces our existing program. We announced our intention to implement a 10b5-1 plan to give us that flexibility. I believe our plan represents a strong set of strategic imperatives and initiatives and that our results will place Ulta in the top tier of high-performing retailers. We'll continue to drive market share gains and deliver strong sustainable sales and earnings growth, making our company a very attractive investment. I also know that we have the best associates in the industry who love what they do and are excited to bring more beauty into the lives of our guests. So let me turn over now to Scott to cover the quarter and updates to our 2014 guidance.

Thanks, Mary. Good afternoon, everyone. Second quarter sales were $734.2 million compared to $601 million last year, an increase of 22.2%. Comparable sales increased 9.6%. The retail-only comp was 8.3% with the salon business comping slightly higher at 8.4%. E-commerce growth of 54.9% added 130 basis points to the comp. We were very pleased with the balance between transaction and ticket increases, with transactions up 5.8% and ticket up 3.8%. The ticket increase was driven by a modest increase in units per transaction, but mostly by higher average selling price due to strength in prestige categories and less discounting overall. Retail-only comparable transactions increased 5%, a significant acceleration compared to the first quarter. Since we're spending quite a bit of time on this call discussing the strategic plan and long-term financial targets, we thought we would share a condensed version of our usual discussion of our business drivers. From a real estate perspective, we opened 19 stores during Q2 ending the quarter with 715 stores. We also completed 4 remodels. New store productivity remains strong, and we're also seeing solid comps in our more mature stores as all classes of stores are benefiting from the momentum in new brand and product launches. On the merchandising front, newness continues to be a major driver of our business. After rolling out IT Cosmetics and Mally to every store during first quarter, these new brands were solid contributors to our growth. We are also pleased with the success of our chain-wide expansion of Urban Decay and excellent results in our Clinique, Lancôme and Benefit boutiques. Exciting new product launches during the quarter included an innovative liquid foundation from bareMinerals, a highly anticipated eyeliner to complement Benefit's best-selling They're Real Mascara, as well as new fragrances like Armani Sì and Marc Jacobs Daisy Dream. To update you on our loyalty program and CRM. We now have 14 million active members and are very pleased with the performance of the markets that were converted to the ULTAmate Rewards point-based program in February. Having all customers on one platform allows us to communicate the benefits of the loyalty program more efficiently and deliver CRM campaigns across the entire loyalty customer base compared to just half our customers before the conversion. On the marketing side. Second quarter highlights included our Love Your Hair event, which we enhanced with content more focused on education and benefits versus just price promotions. We also saw excellent results from our semiannual event promoting jumbo sizes of haircare products at great prices. Finally, turning to ulta.com. We continue to see strong performance from our e-commerce business. In July, we released exciting new features and functionalities to the site, designed to enhance the discovery and browse experience with the addition of rich editorial content. New pages for Get Inspired, Beauty Consultation and Share & Play focus on trends, new arrivals, best-kept secrets, advice and social content. We added online booking capability for our salon appointments for all stores. We also began to host live chats on ulta.com featuring some of our vendor partners like the founders of the brand Carol's Daughter and Tarte, which were very well received by our guests. Finally, we released our first iPad app in July, designed to provide our guests with a unique opportunity to browse, discover and share our products. Turning back to the P&L. Gross profit dollars increased 22.3% to $259.3 million. Gross profit margin was flat year-over-year at 35.3%, primarily driven by stronger-than-expected sales of prestige cosmetics and professional haircare products, as well as a modest rent and occupancy leverage on higher-than-expected same-store sales. This was offset by a slight deleverage in supply chain expense due to costs associated with the expansion of e-commerce fulfillment capabilities in our Chambersburg distribution center. SG&A expenses rose 17.4% to $157.8 million, down 90 basis points as a percentage of sales at 21.5% versus 22.4% last year, primarily due to leverage on strong sales as well as timing of marketing spend. We also pushed some of the planned expenses related to test-and-learn initiatives later in the year. About half of our earnings outperformance in the quarter was due to the impact of SG&A expenses moved later in the year. Preopening expense was $3.6 million compared to $4.8 million in Q2 of 2013, driven by 19 store openings during the quarter compared to 33 new stores opened last year. Operating margin increased 120 basis points to 13.3% versus 12.1% in Q2 of last year. Net income increased 35.4% to $60.8 million or $0.94 per diluted share versus $44.9 million or $0.70 per diluted share last year. Earnings per share grew 34.3%. Turning to the balance sheet. Inventories were $541.5 million at the end of the quarter compared to $461.2 million at the end of Q2 2013, driven by 106 net new stores opened since August last year. Inventories were flat on a per-store basis as our supply chain and store teams continued to keep inventory very clean. Capital expenditures were $55 million for the quarter, driven primarily by our new store opening program, as well as supply chain and IT investments. And depreciation and amortization for the quarter were $31.9 million. We moved $100 million of the cash on our balance sheet to short-term investments with a maturity of less than 12 months and, as a result, ended the quarter with $363 million in cash. Our free cash flow year-to-date is about $39 million, and we're well on track to generate more than $100 million in free cash flow this year. With a very strong first half of the year under our belt, we are raising our view of our full year performance. We anticipate comparable sales to increase in the 7% to 8% range and total sales to increase in the 20% range for the year. We expect that earnings per share will be in the 20% range this year, excluding any impact related to share repurchase activity. We expect to invest about $265 million in capital in 2014. Turning now more specifically to the third quarter of 2014. We expect sales to increase in the range of $724 million to $736 million versus $618.8 million last year. We expect comparable sales to increase in the range of 6% to 8%. Preopening expense is expected to come in around $7.1 million, with 50 stores planned to open in the third quarter. We expect to achieve earnings per share in the range of $0.79 to $0.84 compared to $0.70 in Q3 of last year. Our tax rate is expected to be approximately 38.2% and our fully diluted share count will be approximately 64.8 million, excluding any potential share repurchase activity. With that, I'll turn the call over to our conference call host to begin the Q&A session. Operator?

[Operator Instructions] Our first question is coming from the line of Mr. Brian Tunick with JPMorgan Chase.

Two questions. One, maybe just some more color on the SG&A timing shift, how that's changed and what we should be thinking there. And then maybe on the -- Mary, can you talk about the 1,200-store target? I know in the guidance, you talked about around 100 stores a year. But just ahead of the Analyst Day, I guess, can you talk about sort of, is at least 1,200 stores in the big format and then small markets can add to that? And does that change as you think about e-commerce becoming 10% of sales? Just curious about what you think long term about the 1,200-store target.

Sure, Brian, thank you. And let me start with the store question. So as I said, we're reiterating that our target has been and continues to be at least 1,200 stores and that, we think about that as really our current 10,000 square foot format and our suburban-type market. And we'll talk more about this at Analyst Day, but one of the things that we're learning about right now is the small-store format that we're opening up 2 of this year. We're going to learn a lot about that. So given how our stores are performing, we think that's a pretty good target, possibly conservative target. If we find a small-format city of interest, those would largely be incremental to our 10,000 square foot format. We're starting those in some more rural markets and in the future potentially urban markets. That would be down the road. New stores continue to be a great investment and they continue to perform. And we think about, relative to our strategic plan, getting more stores is a great way for us to get more guests. Beauty is a business that really is contingent on new experience that involves the physical experience. And as we see our guest experience in the future being able to really delight our guests, obviously, stores and e-commerce can work really well together, we think, to deliver on that. Our store expansion's always going to be contingent on finding high-quality sites. We have a very robust and rigorous process, but we continue to see plenty of excellent real estate opportunities in the years to come.

And as far as the SG&A question is concerned, as we mentioned in our prepared remarks, roughly half of the beat for the quarter is SG&A-related kind of expenses, so call it $0.05. Roughly half of that is marketing; the other half is test-and-learn. So the test-and-learn program was delayed a little bit, more than what we expected when we gave second quarter guidance. So we thought it was better to wait until we have those projects properly scoped and metrics aligned so we knew how to measure success at the completion of the test period. And on the advertising or marketing side, those were efficiencies that were identified by our marketing teams in the first half of the year or second quarter that we expect to redeploy in fourth quarter to drive more new customer acquisition kind of activities.

Our next question is coming from the line of Daniel Hofkin with William Blair & Co.

Just wanted to -- first, with regard to the comp and obviously, a very strong performance, where are you seeing kind of the most upside across the age of stores? Is it pretty balanced or is it more newer comping stores? Just that would be my first question.

Dan, I would say the general rule of thumb is when you have strong performance being driven by these new brand launches and exciting new things that merchants are bringing into the business, it really -- rising tides lift all boats in this business. I know I've said that before to many of our investors. I mean, it's not a single class of store or a vintage of stores or older stores versus newer stores. It really helps drive productivity in the whole fleet.

Okay. Great. And then with regard to the long-term plan, particularly impressed about on the comp sales outlook. Obviously, some of that is that the new plan includes e-commerce, whereas I think the old one, 3 to 5, did not. But could you comment on what are some of the things that -- what are some of the components of that or what are the things that you expect to kind of help drive a stronger underlying comp?

Sure. Well, first of all, we're in a growing industry, right. Especially the prestige side of beauty has been showing good growth and we participate heavily in that. As we look at our guests and look at her needs in the future, we believe that there's more market share that we can gain with the beauty enthusiasts and that our insights about how to meet our needs continue to deepen every day. So in that sense, we think there's plenty of opportunity for growth. We also know that, we've talked about this, the majority of our current growth is coming from our current loyalty members, which is great, and they love what Ulta has to offer. But an area of opportunity for us, as a big part of our test-and-learn this summer or this fall now, is about how do we get new guests to become aware of and try or either retry, perhaps, Ulta. So we think about it almost as a relaunch of the Ulta proposition. And again, there's plenty of women that are in this consumer segment that we believe would be very attracted to our proposition. So new guest acquisition, e-commerce growth, as you said, store growth, all those 6 strategic imperatives are largely around driving -- are different ways to drive growth.

Our next question is coming from the line of Aram Rubinson with Wolfe Research.

I wanted to ask you a bit about your current capabilities. We hear a lot about investments, a little bit last year, this year and obviously, for the next 2. Can you just give us a sense as to what you're capable of today and what you'd like to be capable of, whether it's warehouse management systems or merchandise systems or financial systems or distribution? Just can you give us a little bit of a lay of the land of where you are now with all of these capabilities and what you think you're missing and where you'll be in those couple of years that you can do that you can't do now?

Yes, well, first of all, Aram, our business is obviously running pretty darn well today, right. So we obviously have some core capabilities that we're using every day to execute the business. What we have identified is a couple of things. One is, as everybody knows, retail is changing rapidly in terms of guest expectations. So the omnichannel aspect of our capability is one we need to invest and to grow. We anticipate that the guest in the future is going to want a seamless experience and one that we don't necessarily offer today. It's not a big barrier to our growth, I'd say, as you see the performance that we're having. But we know that that's going to be something that she's going to need to have in the future. So a more seamless ability to buy something, bring it back to the store, order in store, have it shipped at home, be able to know in advance what we have in inventory in our stores. All those kind of basic shopping and retail capabilities are part of what we'll be investing in. Also, just as a part of this investment is really just around growth. As we continue to go down this growth path, which is a strong growth path, and we continue to drive a number of our stores, we need more capacity in the system. And so that's part of the investment, too, which are just pretty straightforward. And also, we just think overall end-to-end, we could have a more efficient system than we have today. So whether it's how we receive our orders and work with our vendors, how our stores are stocked as the product comes into the stores, there's plenty -- and how we forecast and replenish, we know that there's ways that we can be smoother, I guess faster, have less out of stocks. All those things that we know will just help our business be more -- a better experience for our guests and drive some efficiencies in the long run.

So if I can just drill down into that just a little bit. So I mean, are we on an automated replenishment? Do we have kind of store scheduling for labor? Just trying to figure out. Do we have a space optimization program? Do we have price optimization? Are all these things kind of totally new or are they -- I'm just trying to understand whether you have these capabilities or not.

Yes, I don't know if we want to go through a specific laundry list of what's in and what's out, Aram. But I will say, what you described predominantly, we don't operate in that kind of environment today. So we've got good systems in our stores. Over the last couple of years, we've made some investments in store laboring, and we're working on task management in the stores. We're just about ready to finalize our rollout with a new POS system, which we think will be best-in-class kind of checkout experience for our guests, so again, early stages of that. On the supply chain and the merchandise organization, I think you've heard and I think many of our long-term investors have heard us say that we still do things kind of the hard way. We muscle through a lot of things that we know factually that there's better, more efficient ways to do that, whether it's forecast and replenishment, which Mary mentioned, and helping our vendors help us forecast the business and get it to our DCs more effectively and getting it to our stores, right, in the right kind of what I would say, delivery mode, boxes so it's shelf ready, ready to -- so that we can take time out of the backroom and get it into more guest-facing time.

Our next question is coming from the line of Oliver Chen with Citigroup.

Regarding the outlook for the gross margin. Your inventories are under really good control at this point. The gross margin comparison, as we look at it, is a little bit harder than easier in the fourth quarter. Is the expectation that you'll be able to keep promotions under control versus last year? And how are you seeing kind of the promotional environment unfold as we approach holiday?

Okay. Oliver, thank you. The promotional environment, right, that's -- we expect that as we get into the holiday, it will continue to be a competitive promotional holiday. I don't think there's any reason to think that, that will -- it's always going to be like that, right. Now the overall sentiment right now, consumer sentiment, is strong. And I think we hear retailers feeling pretty optimistic about their inventory situation going into holiday. But nonetheless, we know that's a competitive time. We're also seeing some success. And again, I would say we're walking before we run. But we're, I think, every day getting better at how we can use some of our tools like our CRM capabilities to be more targeted with our offers and drive value in ways that are less about price discounting. So would we need to be more promotional than last year? I doubt it. Will it be a promotional holiday? We'd expect that. But we feel, as you can see in our guidance, optimistic about the rest of the year.

And, Oliver, I would just add, as far as rate goes, again, gross profit margin rate overall was flat year-to-year in the quarter. And you may recall last quarterly call, we mentioned loyalty program, right, is still going to be a headwind for us for the rest of the year. There's still some product mix challenges that we have. We did a good job this quarter overcoming some of that, and we have more of that planned for the rest of the year. So we'll do our -- do the best we can to make sure we keep that all in balance.

Okay. And, Mary, on the product side, one of the strategic highlights is the focus on hair, skincare -- skin health and brows. Is that consistent with how you have been? Or are there categories that you may deemphasize as you focus on these 3? And…

Yes, those -- I'm sorry, go ahead.

And I was also just curious about articulating your thoughts on your competitive advantage versus department stores.

Sure, okay. Well, first of all, that strategic imperative, actually, I was talking about services. And actually, one of the earlier questions was about levers for growth. And I should have mentioned we do see that our services are absolutely one of the areas that strategically are important to us, to your point, one of our points of differentiation, and we believe an area that we can focus on to drive future growth. Our salon guest -- salon's a small part of our business today as you know. That's our best guest, though. She comes more frequently, she spends more and she loves the experience. And we've kind of carved about 3 pillars that we think we excel in today and can excel in even more in the future. And it's about the hair, basically cut and color, and also hair services that involve trend like braids, things like that. On the skin side, as you know, we have a partnership with Dermalogica, and we have trained aestheticians at our stores; a small part of our business today in terms of that service. We know that could be an -- it will be an area of growth. And then lastly, brows, particularly through our partnership with Benefit and the Brow Bars. So we look at those 3 pillars of service as areas that we will focus on and drive. We're experimenting already today with how to drive more new guests to try our salon and come back. And those often, not as much as I'd like, but often have products attached to them. So you can imagine that's a great flywheel for us. So that's an area, and it really dovetails, I guess, with your second question, which is part of the work we do in the strategic plan is to just really step back and say, what is our competitive advantage today and what would it be in the future? And it's a competitive industry. Everybody's interested in beauty. It's a growth industry, but we've got advantages that we think we can really push and accelerate. And it is about this total guest experience that we think will get even better as we allow our associates in store to have even more guest-facing time, as perhaps our systems get more efficient in some of the ways that Scott described. And at Ulta, she'll be able to get an experience that's very different and unique. It's different than the department stores, different than mass outlets and different than other specialty stores and that -- and we plan that, that will be kind of our cores. We differentiate and we'll lead with that.

Our next question is coming from the line of Gary Balter with Crédit Suisse. [Technical Difficulty]

It appears there's a connection issue with Mr. Balter's line. We'll move on to the next question, coming from the line of Matthew Fassler with Goldman Sachs.

My first question relates to capital. Obviously, you talked about the SG&A impact of some of the investments you're going to make. Can you talk about, as the store growth, I guess, flattens out, whether the investments that you're making contemplate any kind of bump in CapEx? And then also related to capital, you talked about buying back stock at least at the level you would need to offset dilution. What is the typical dilution you would see in a given year from options issuance?

As far as the CapEx question is concerned, we're projecting $265 million for 2014. Directionally, that might be at a slightly more elevated rate over the next couple of years as we get through the supply chain cycle year event. But it would -- we expect it to moderate once we get past 2016, generally speaking. And as far as dilution or dilution is concerned we'd expect that to be roughly maybe 1 percentage point, Matt, you could estimate is what the buyback dilutive offset would be.

Got it. One other quick financial question and a strategic one. As we think about the $0.05 or so that you deferred from the second quarter to the remainder of the year, should we think about it as being roughly half and half Q3, Q4 based on the comments you made earlier?

Yes, I think that's a good approximation.

Great. And then finally, I know you'll have an extensive strategic discussion in Chicago in a few weeks, but very briefly on mobile. And my interest and you talked about having the iPad app, which, on the one hand, I guess you're not the first retailer; on the other hand, it's because of the opportunity. Can you talk about how you think your customer and your category deploys mobile differently than for other retail categories? And what you think its potential is relative to the online business that you've been doing already?

Sure. Well, obviously, mobile is a growing part of our business as it is for everybody, and we know that that's increasingly a way that our guests engage with our brand as well as others. Probably one of the biggest opportunities for us with mobile is the ability for her to be learning about content, about brands and products and services, whether she's in our store or not in our store or outside of our store. As well as for our associates; a part of our technology plan is to allow them to have more access to mobile technology in the stores so that she can be an even bigger expert on every brand that we offer than she is today. Frankly, our associates, it's hard to be able to do that all the time. Having more access to mobile information helps get us to the same position that our guests are in. Mobile transactions are continuing to grow as a percentage of our transactions, and we'll expect that to continue to happen.

Our next question is coming from the line of Ike Boruchow with Sterne Agee.

Mary, I wanted to know, can we dive in a little bit on the new marketing -- new customer acquisition side and things that you've been doing and tests you've been doing regionally with some new marketing and your CRM capabilities? Then to take that a step further, could you comment on the traffic increase you saw in the quarter and maybe how much of that was new customer traffic and how that compares with the prior couple of quarters?

Well, you know what? Really, at the Analyst Day, we'll have more color on some of the test-and-learns and the experiments that we're doing. There's a couple of different things going on. One is we have an end market advertising test that just started in several markets to see just sort of in a general way can we drive new customer acquisition through basically driving awareness through a more mass media and digital media kind of approach? So that's something that's just started, and we'll know a lot more about that soon. And that's one way. We know that basically top of mind awareness for Ulta is not as high as it can be. And we believe that by driving that awareness and positioning the brand in a way that we know we represent, which is this great place for women to discover and have fun with beauty, that we think there's upside there. So we'll learn more about that. And certainly, Dave Kimbell and his team are also using our CRM capability to run, I guess, several small-scale experiments right now around how can we either get guests who are coming as often as we'd like, to see what could incent her to come more often, or using multiple forms of either social marketing to see if we can target new prospective guests to try Ulta. So a lot of that is in process, and we feel optimistic that that'll be part of our growth strategy going forward.

Could you comment if you -- are you already beginning to see some of the fruits of your labor on the new customer acquisition front?

Yes. Most of our sales right now are really being driven by our current guests. And she's coming more often and spending more, which is great. So it's really, I'd say, early stages. Now our e-commerce business is one of the ways that we are seeing some new customer acquisition, and that, again, will be an area for growth for us as well.

Our next question is again coming from the line of Gary Balter.

Following up on Ike's question a little bit. Mary, when you first came and met with a lot of the sales side people, one of your concerns was that Ulta isn't as well-known as people like Sephora, and you were trying to figure out how do we improve that. Obviously, you've had great traffic drivers this quarter. As you -- without giving all the answers to the October 15 meeting, what's your perception now of Ulta? Do you feel that you've made some nice progress in terms of the customer understanding who you are and have you closed the gap a lot? And have you changed your perception of it?

Okay. Thank you, Gary. I would characterize that less of a concern that I saw and more of an opportunity, and I still see it today because I think we're really in the early stages of driving that new customer acquisition. So most of what we're doing right now, we're refining the tactics that we've used previously, and I think getting even better at them. But they're largely targeted at our current loyalty members and that's largely where our growth is coming from, which is great. It says that our current guests love us, they're coming more often and spending more, and we're getting growth on e-commerce, and some of that is new guests. But we believe, again, why we're confident about the long-term targets that we're providing is that there's still that opportunity. So I would say really, Gary, I wouldn't feel -- I don't think it's very different today in terms of the awareness and sharpness of the perception of Ulta. But we have done the work to identify more insights about our current guests, prospective guests and how to position and really drive awareness to the brand. And we'll know more as these tests run, so I don't want to overpromise. We don't know yet what the response will be, but that work is still in process and we'll know a lot soon.

Our next question is coming from the line of Neely Tamminga with Piper Jaffray.

Just 2 quick questions, hyper-specific here. On the new POS system, what are some of the key functionalities that are making you guys feel excited about launching this new POS system, number one? And number two, what sort of kind of key metrics or problems or KPIs, however you want to look at it, on the e-commerce business are you looking to address over the next couple of years? I mean, is it really kind of about bounce rate through the e-mail campaigns? Is it about cart abandonment? Like give us some sense of what you're going to improve on the e-commerce side, too.

Okay. Thank you. So the POS front, I'd say a couple of key categories would benefit us. One is speed of transaction, which we know there's always a little bit of a learning curve, but our associates, or the ones who are using it, love it. And they are seeing the benefits of it. So we know that that'll help speed the transaction, as well as going to give us the ability to have more information about our guest when she comes in. So over time, we believe that that's going to help us to even be more personalized in terms of what we offer her. And also, one of the capabilities is going to be to be able to order in the store and have it delivered to your home. So we think about, for example, on our small-store tests, those are smaller stores, not going to carry every single SKU. So the ability for our guests to be able to still have access to everything that we sell will be a benefit as well. Those are just a few of them. Dave, do you want to comment on the e-com metrics?

Yes, absolutely. As we look at e-commerce, first of all, we're really pleased with the results that we've had so far. We're really just about a year into the relaunch of our site and really happy with that. And because we're really still relatively new and that there's a lot of foundational pieces, that we're really still very much focused on driving traffic. We continue to have success in getting new customers and potential customers to come to our site. We saw traffic increase pretty significantly in the second quarter last year through -- this year through sharper, more sophisticated customer acquisition efforts. So we'll continue to do that. Our conversion rate, through optimization of our site experience, we really significantly improved a year ago. And we're continuing to fine-tune that experience, things through the check-out process, the way the cart works. We're making improvements through that site experience to make sure we're, as you mentioned, limiting cart abandonment and maximizing conversion. And our AOB, as we get -- as we improve our merchandising approach, get learnings about what's working in the e-commerce environment, maximize the understanding of our best guest and how she's experiencing both our brick-and-mortar retail and our online and personalize and to customize our marketing to her, we think we're making progress on AOB through our merchandise, and we'll continue to do that. So a lot of it is really foundational and we're going to continue to focus on those efforts going forward.

Our next question is coming from the line of Evren Kopelman with Wells Fargo.

Two questions. First is on the comp growth, the strong comp growth in the quarter. Do you have a sense of how much that conversion of the half the people to the new loyalty program in the first quarter, how much that is helping traffic this year as people are getting more e-mails about their points and things like that? And then the second question is on the e-commerce. Can you discuss how you expect the product mix and the margin to evolve over your long-term horizon?

As far as the comp drivers for the quarter, I guess I will tell you, we're not going to be able to just aggregate the comp loyalty versus non or new versus old customer, existing customer. We can say with certainty that typically, historically what we saw when we implemented the loyalty programs is that it took a while for the customers to kind of come back. The sales performance was a little weaker on conversion. And then we kind of cycled back through the course of like a full 1-year period, we kind of get the comp back. This time, again hopefully, we learned some lessons on our last conversion cycle. This time we've seen sales kind of maintain, so we haven't seen any degradation or any weakness in sales with those people that have been converted. So that was a really great sign for us that the conversion has gone very well. As far as product margin mix is concerned, I think we're talking about 2014, Evren. We talked overall on margin rate that we still have this loyalty headwind. We will expect to have that for the remainder of 2014. We're still seeing one of our more important categories, professional male, has been a bit weaker than what we are expecting this year, so that's a headwind on our margin rate as well. Again, the merchant team is working hard to try to mitigate that. We saw some of that in the second quarter with better performance than we were expecting, and we'll continue to do that in the back half of the year.

Our next question is coming from the line of Joe Altobello with Oppenheimer.

I just want to start with the e-commerce target you guys talked about earlier, the 10% of sales. How does that benchmark against some of your peers in what they're doing today, for example? And then secondly, in terms of the required investment to get there, are we talking a step function or is it more incremental investment on the infrastructure side to allow for that 10% of sales from e-commerce?

Yes. I think competitively, we feel there's a wide range of our competitors and we're actually probably not as much focused on where our competitors are. We think 10% is a really both attainable and smart place for us to be. Our focus within e-commerce, as we've talked before, is to make sure we're serving our customer where she needs to be, where she wants to be served, but also finding ways to get her to experience our full breadth of offerings, including our in-store products and services. And we think 10% is the right guide path to get us -- target to get us to that. As far as the investments?

Yes. We saw most of it, the step-up in investments, back in 2012 and 2013, and I think we've talked about that and called those numbers out. That was really the step function, I think, as you use that term. Future investments are embedded in the supply chain numbers that we've given today and built into the overall CapEx that we'll talk about in more detail as we get to the future. So again, I wouldn't expect there to be any kind of an extraordinary step-up in the investment call for that business.

Okay, Scott. And then secondly, in terms of acquisitions, you referenced that earlier. Are you talking more square footage acquisitions or could you guys, in fact, purchase brands or partner with companies on brands?

Yes. We haven't defined all that yet. But generally speaking, I'd say we would have more of an interest in things that we could -- that would strengthen what we offer to our guests. We think we're pretty darn good at what we do, but we know there's opportunities out there to bring her news and innovation and exclusiveness. So that would be more likely the area we'd focus on, but we don't have anything planned right now.

Our next question is coming from the line of Simeon Gutman with Morgan Stanley.

Stepping back a little bit with regard to investments, next couple of years, they'll be a little heavier. When they go away, when they subside and earnings growth reaccelerates, does that reflect the cost of them just being lifted? Or does it factor in that the business itself becomes more efficient? So in other words, are you baking in anything, any benefits in those out years?

Yes. There's definitely benefits from our supply chain investments from some of the other, what I'd call, just pure P&L kind of charges that we're thinking about, like marketing, incremental marketing efforts, whether or not we tweak the store payroll model at all, which is yet to be determined. We're still testing that. But anything that we would contemplate along those lines, we would fully expect to see top line comp benefits come out of those.

Okay. And then switching gears to product. I think Mary mentioned expand prestige, which I think has been a focus for a long time. Does the prestige mix just grow simply by the natural mix shift in the business; you're adding brands, you're introducing new products? Or does it contemplate some type of some space increase or even reallocation over time?

Well, I'd say it's a little of both. I mean, what we're seeing is that our guest is really responding to prestige brands right now. Certainly not only that, but that certainly is a strong area of growth for us. And some of the brands that we've launched or new products that have been introduced in some of our brands have done quite well this year. And in fact, we've expanded space for some of those brands. So we imagine it'll be a pipeline of new products and expansion of existing brands. And what that mix exactly is going to be will be determined as we look -- as we march forward over time.

Our next question is coming from the line of Mark Altschwager with Robert W. Baird.

Just a couple of quick follow-ups. First, on the gross margin side. I think the comments in the Q and you mentioned earlier that merchandise margin was about flat. But I was hoping you could parse that out a bit because it sounds like you benefited from both mix and fewer discounts. So I'm just trying to understand where you saw the offset there.

Yes. We're not going to be able to quantify everything for you, Mark. But as I think I mentioned earlier here, we still have -- the loyalty conversion is still going to be a headwind for us throughout the course of the year. Product mix, again every quarter has a little bit different levers that we pull as a merchant team. So we try to plan ahead to make sure we have a good balance of ticket drivers and traffic drivers embedded in our marketing materials. We've been able to offset some of the drag that we've seen from some deceleration in pro-nail. We've been able to offset that luckily with strength in the prestige line here over the first half of the year. E-commerce, I know we've mentioned that in the past. I mean, e-commerce rate is dilutive to us overall. But that's a business that we're going to continue to compete in very well, I believe, and we'll continue to expand merchandising opportunities there as well, which should help mitigate some of that over the long term, as well as continuing to scale up that business will help as well, so.

And then just following up on the services. As you look at the long-range plan, where do you see services as the optimal mix of overall sales? And how does that play into the longer-range margin expectation?

Well, we haven't set a specific target yet for the size of services. We know we're going to grow it. We think that, as I said, we have data that shows that our guests who are participating in our services right now are great guests because they come on a frequent basis, they love the experience and then she often buys other add-on products. So while services in general are lower margins than our retail product, that guest is a very valuable guest to us. And we'll continue to look for ways to drive awareness, not just of Ulta as a retailer but Ulta as a beauty authority, with our service as a critical component of that. And that's a very sticky part of the equation for us.

Our next question is coming from the line of John Kernan with Cowen.

Just on the outlook. With ticket and traffic both trending in the right direction, why would comps decelerate a bit in the back half of the year? And then, can you help us understand long term what your market share in beauty will look like in 5 years versus now, particularly in the prestige offering?

Well, it'll be bigger. I'm just kidding. But I mean, we definitely expect to grow our market share, and that's part of our vision is that we're going to continue to really be a stronger player in this industry and we'll grow share. In terms of the outlook for the year, listen, we're really pleased with our second quarter results, and we've reflected that by raising guidance from a mid-teen to about 20% sales and earnings growth. Some of the upside that Scott talked about, some of it was new product launches, which is great. Some of it was expense timing shifts, which is fine. We expect to see positive sale and share trends as we complete the year.

Our next question is coming from the line of Dana Telsey with Telsey Advisory Group.

Can you talk a little bit about as you think about the longer-term investments beyond supply chain over the next 2 years, how do you see operating margin being impacted? Or is that when we should begin to see some leverage in the model?

Yes. We expect operating margin to remain rather flattish over the next couple of years, which we think is an excellent result considering the amount of investments that we're going to be making over the next 2 years, especially in the areas of supply chain. I alluded to earlier, maybe not as clearly as I should, but we believe that there are significant efficiencies that are going to come out of this supply chain implementation that are going to help drive top line and operating margin performance overall once we get through the 2016 time frame. At that point, we expect that our operating margin then will start making significant progress towards our mid-teens target, which we've talked about for some time.

And let me just add that we've talked a lot about the investments that we're making this year and what we're calling "test-and-learn." And those are some experiments around hypotheses that we have about how we can drive the business, investing in things like advertising, investing in things like more attention to salon, perhaps more guest-facing time in our stores. The reason we're testing it is that we hold ourselves to a standard of getting a return on that investment. So as we look at those "investments," the reason that our 5-year plan leads to improving that operating margin is that we will only choose the things to "invest in" that drive that kind of return that'll help us -- that will allow us deliver those results.

And as you think of the size of those investments over time, are they going to be bigger at the beginning of this time period? Or how do you think of the scale of them?

Yes, I mean directionally, they're more significant in the near term than they are, so they moderate. Again, once we get through -- 2015 and 2016 are the big step-up years, I would say, generally speaking. And then they moderate once we get past 2016.

Our next question is coming from the line of Jill Nelson with Johnson Rice.

You saw nice traffic gains, which exceeded ticket gains for the first time in quite a few quarters. Could you talk about kind of that variance going forward and how do you see ticket versus traffic playing out in your kind of long-term 5% to 7% comp growth?

Well, yes, we're very pleased that we saw the strong growth in retail transactions that we did in the second quarter. I would just say that long term, short term, every quarter, our goals really have a good balance between transaction and ticket, and we work together as a team to put plans in place that we believe will continue to do that. So it's not a science, right. So some quarters, it's going to play out a little differently. Some of our new products like Urban Decay, Benefit, some of the new products in those lines, launch of IT, Mally, they were significant contributors, as well as a strong pro-hair event, the leader event that Scott mentioned earlier. And our marketing and merchandising teams continue to work together to create, I'd say, even more compelling communications every quarter. So our goal here is to really just maintain a balance going forward.

Okay. And then, could you talk about kind of the role of prestige boutiques going forward; kind of your thought process of how many boutiques you're looking at adding in the 100 new stores per year kind of plan and just their role in the long-term goals?

Sure. Well, our guests love the prestige boutiques. We're very pleased with the business. Janet Taake and her team work closely with our vendor partners on those opportunities. And we hope and expect to continue to grow those.

Our next question is coming from the line of Janet Kloppenburg with JJK Research.

I just had a couple of quick questions. There's been some talk in the beauty industry over the last couple of weeks that the mass business, mass brands are being cannibalized by the prestige business, and Estée Lauder and L'Oréal have both talked about that. I was wondering if you could talk about that change and how that may affect your business going forward, or if you even agree with that trend that is being witnessed by some of the big suppliers. And also, I was wondering on the e-com being dilutive to margins, if we should expect it to be equally dilutive in fiscal '15 and fiscal '16, or it will start to get some scale from that channel as we go forward.

Sure. On the categories, I would say if you step back and just think about our business model, our guests, what she needs and expects, she is always looking for a balance; the ability to go across the store and to buy different types of products at different price points that meet her needs. So I can't comment on the trend that you're describing that people are talking about. What I would say in our business, we're seeing a good balance there. And so we expect to continue to be able to drive that kind of balance within Ulta. Second question?

As far as e-commerce contribution might be considered or scalability of that business, I mean, if we just carve that out as a stand-alone operating business, I think anyone would be happy to have it. I mean, it generates a lot of operating income for the business. We're improving our merchandise rates there. So gross margin -- gross profit margin, in general, is improving. And we continue to see scale in that business. So these growth rates do that kind of inherently, and we expect more of it in the future.

Ladies and gentlemen, at this time, I would like to turn the floor back over to Mary Dillon for any closing remarks.

In closing, I'd like to thank all of our Ulta Beauty associates in our stores and our distribution centers, our headquarters. They've all really worked hard to deliver excellent results this quarter, and they're working hard to implement the strategies that we've shared with you today to continue to drive strong top and bottom line growth. Go, team Ulta! I also want to thank all of you for your interest in Ulta Beauty, and I look forward to speaking with you soon. Thank you.

Thank you. Ladies and gentlemen, at this time, you may disconnect your lines. This does conclude today's teleconference. Have a wonderful day.