Ulta Beauty, Inc. (ULTA) Q3 2018 Earnings Report, Transcript and Summary

Greetings, and welcome to the Ulta Beauty Third Quarter 2018 Earnings Results Conference Call. [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.

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 the lower tax rate and onetime 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.

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 effort to drive loyalty and to take our brand to the next level. We grew 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 2 tiers combined. These guests are over 3x more likely than our average guests to be omnichannel 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 in driving higher sales per member, and personalization is the next major tool for growing share of wallet. Our vision is to make every guest touch point 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 lift in sales for our guests who hold the Ulta Beauty credit card. Sales of gift cards grew 35% in the quarter, driven by expanding distribution in 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 improvement 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's 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 the partnership with NBC Universal'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 and leadership of young women 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 the Ulta Beauty as the destination for both glamming 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 skincare, 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 positioned 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, but we believe there's significant opportunity to grow with each of these groups in multiple expressions and formats. In fact, we've recently launched an emerging brands team focused on identifying new and [ offering ] digitally native brands. This team has developed customized processes to onboard and incubate smaller or emergent brands with 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 influencers' celebrity-driven brands. Kylie Cosmetics is off to a strong start, with 28 SKUs launched in-store on November 17 and a more curated assortment online. We also announced the introduction of 4 Kim Kardashian-West fragrances for holidays, which launched in-store only. Both brands have been very supportive of these launches with the series of social media posts by Kylie and Kim, who each have 120 million Instagram followers. Kylie also made a personal appearance at one of our Houston stores the weekend of the launch. Other examples of influencer-led brands are the launch of the Beauty Bakerie, Juvia's Place and the expansion of Morphe. Morphe is now in 10 feet with an elevated presentation at all stores, and we launched an exclusive collaboration on November 16 with James Charles, an influencer with over 10 million Instagram followers. Our holiday plans have been well executed by the teams with many exclusive products and kits, elevated gift with purchase offerings for fragrance and a strong Black Friday, Cyber Monday offer as well as our early December Beauty Blitz program. Combined with the new holiday television and radio creative and in-store marketing, we're confident that we have implemented a comprehensive merchandising and 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 comped 3.5%, driven by average ticket increases and benefiting from increased traffic in our stores. To update you on the rollout of our service optimization program. Our new services model is now in over 30% of the chain. We continue to see encouraging results and will continue to roll it out to additional markets in early 2019. This program was built to attract and retain top stylists who provide exceptional services. The components of services optimization are: compensation designed to retain top talent; industry-leading internal training 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 at Ulta Beauty, and now has this format at 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 startup, Spruce. 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 3, ending the quarter with 1,163 stores. New stores continued 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 1 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've narrowed our U.S. store target range of 1,500 to 1,700 and will 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 the greater focus on portfolio repositioning as a 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 11% of total company revenue. E-commerce contributed 340 basis points to 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 our store-to-door or save-the-sale program, and we're now testing buy online, pick up in-store in 47 locations. Now 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 multiyear 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 and Colorado as well as share knowledge across industries. Iterate tracks trends, provides research and curates technology partnership opportunities. And for Ulta Beauty, it enables rapid prototyping and gives us access to startups that would 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 2 small tech startups, GlamST and QM Scientific, to support our digital experience roadmap and develop an innovation pipeline. We welcome these entrepreneur founders and their teams to the Ulta Beauty family. We're excited to work together with these teams to unlock personalization in a differentiated way. GlamST has been our partner for the past few years behind the development of GLAM LAB, 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 combine 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 GlamST 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, work 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 in Fresno is ramping quickly, now serving 173 stores and 21% of e-commerce orders. In concert with the continued ramp of our 3 newer buildings, we are reducing activity in our Phoenix DC 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 the goal of 50 basis points of improvement over the next 5 years. So with that, I will 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.

Thanks, Mary. Good afternoon, everyone. I will begin with the income statement. Top line growth of 16.2% was driven by a 7.8% comp in strong new store productivity. The revenue recognition accounting standard adopted at the beginning of the year added $10.5 million of 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 and 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 3 weeks of our postcard 20% offer this year compared to 4 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 of that, 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 backrooms to get our stores ready for all the great new launches ahead of holiday. While the clearance event did pressure margin rate more than planned, we're happy with the end result 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 on 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 are 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 through the first few weeks early in the third quarter. Capital expenditures were $115 million for the quarter, driven by new stores, investments in systems, prestige brand rollouts, merchandise fixtures and supply chain investments. We ended the third quarter with $296.9 million in cash. We repurchased 451,000 shares through 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 the 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 a $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 onetime 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 outlook at our Analyst Day last month, targeting mid-to high-teens earnings per share growth, 5% to 7% comparable sales for the next 3 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.

[Operator Instructions] Our first question here is from Ike Boruchow from Wells Fargo.

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

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 in 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 and occupancy leverage versus last year. So we're lapping over a number of what we'd 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 then the e-commerce mix, all right? So that's versus last year. Versus our expectations, we called out transportation being 10 to 15 basis points at Analyst Day, so there's been some upward pressure there all year for us. On the sales mix side, Mary called out fragrance and mass doing really well in the third quarter. So again, fantastic market share gains, but those 2 categories do have slightly lower margins overall than the house. And then it was primarily we called out the clearance event. It was really the bigger surprise for us versus our plans. 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.

Our next question is from Simeon Gutman from Morgan Stanley.

So one question and just a couple of parts. Scott, can you quantify to us how much more did to 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.

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's a bit more buzz about things. And the competitive environment, this is a tough space. It always has been, and we expect it 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 pace. 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 the presentation in the store. And it was -- there was a lot of excess fragrance that had built up in the system overall. And while we've been trying to, I'd say at the margins, kind of sell our way through that in clearance sections in our stores, it just got to the point where we thought we needed to be more aggressive and that's what we did. So we wanted -- it was playing its way through, and then in the third quarter, we just needed to put our foot on the accelerator to get it out of the stores. So again, overall, it was a little more expensive than we were hoping, but was the right tactic for the business.

Our next question is from Joe Altobello from Raymond James.

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

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 launches 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.

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, but just making sure that we don't get too far ahead of ourselves.

Our next question is from Anthony Chukumba from Loop Capital Markets.

We talked a little bit about the fact that your unaided awareness and your aided awareness still continue to increase. Do you have any sense for what's been driving that? I mean, is that just increasing your store presence and 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 you think is driving that and where do you expect those numbers to trend going forward?

Sure, Anthony. And I won't say this is Mary because I bet you could guess this is Mary. But anyways, I'm going to start. I'll let -- ask Dave to add more color. I'll tell you, this is something that we've been at now for multiple years, right, just the opportunity to put the brand of Ulta Beauty on the map literally and figuratively. And that's driven by a whole lot of factors, and we've been measuring it. It's not even just about, do 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 launched is going to deepen not just to people who know about Ulta Beauty, but do they understand what we stand for? But maybe you can add some color in terms of the tactics.

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 3 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 4 years ago, that gave us the opportunity market that and make that 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 comes -- where we think it's going from here, we're really pleased with the growth we've had in awareness. It's just been a critical -- it was a critical opportunity, but we see more to come. We're one of the leading unaided awareness retailers, #2 in the market right now. We think we're on path to become the #1 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 guests in a more meaningful way. And so far, we're off to a good start with that.

Our next question is from Rupesh Parikh from Oppenheimer & Co.

So on the Kylie cosmetics launch, it sounds the launch so far is off to a strong start. So was just curious how it's trending versus your expectations and if there's any surprises in terms of the customers bringing into your stores?

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 results. Certainly, it's generated a lot of excitement. It is -- our existing guests have responded very favorably to it. It 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 Cosmetics team has done a really nice job helping communicate this launch, get their fans excited about it. So overall, we're pleased with it. I think as far as the assortment, we're seeing strength across the line. It's a relatively narrow assortment, but we've been really happy with the performance. We just launched an exclusive holiday kit, and that's been received very well. And that's available only at Ulta, not on kyliecosmetics.com. Our teams are working really hard to keep the stores replenished. We have anticipated through Q4 kind of being tighter around inventory through the quarter. So it's possible as we move into holidays 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.

Our next questions from Oliver Chen from Cowen and Company.

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 who often likes new products versus driving an optimized, personalized recommendation system? And would love your thoughts -- and 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 in what you're building over time?

Yes, Oliver. Great question. We, too, we share your excitement about having QM join Ulta Beauty. We're just really optimistic about what that team has already brought and will 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 her 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, and 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, and they're going to play a key role in strengthening our foundational capabilities. The first areas that we we're going to be tackling, things that we've already been doing, but we'll see -- we think we can move faster and in a bigger way around elements like recommendations, as you've mentioned, dynamic content, personalized homepage. 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. They will also connect to our GlamST 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 -- we're off to a great start with them. The team is really strong, and we're really pleased to have them on board.

Okay, 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 the 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?

Well, these are deep questions. I'll start, and just say a couple of things. Well, the store of the future, we talked a bit at the Analyst Day. It's early. And our thinking, we're not going to share a lot of the direction. I'd say, high level the notion of the ability to be very experiential and lead our guest where they are is going to be critical, we think, and important in the beauty category. We think Ulta Beauty will be able to do that, serve that need really well. But to your point -- and underpinning technology through 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. I think, 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, and a lot more time spent consulting and just having fun with beauty. So we see them all as working together. And frankly, the place that we can play the best is to bring together ease and convenience with discovery and a true human experience that's both physical and emotional. And that -- and just kind of in a big picture ways how we think about our, not just store but experience in the future.

Our next question is from Simeon Siegel from Nomura Instinet.

Mary, sorry to belabor the clearance conversation, but just can you speak to why you think it happened? Just, was it internal buying, planning? Or was it more a function of the external environment? Just basically can you speak to your comfort around this not being a 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?

So yes, on the third, I would say, just a combination of factors, but more about the 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. Clearance is not something that's -- it's not like we never do this. This happens periodically. So in this instance, it was bigger, it was an opportunity, we thought, to really clear out inventory and get us set up for the holiday. It's not something that we expect to repeat at that scale in the fourth quarter for sure. But it's just one of those business calls that we made that we think were right for the business at the time.

Yes. 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, we had 42 new stores in the third quarter. We got half -- a dozen, I think, in the fourth quarter. So that will be better overall. We'll be lapping those stores again from last year that were in 2017, those 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's been some upward surprises there as we've kind of marched through the course of the year. But again, that's not a major driver overall. So feel good about where we are and the plan we have in place for the rest of the year.

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

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

Our next question is from Steph Wissink from Jefferies.

I just have a follow-up question on your prior comment, Scott, on labor leverage. I'm wondering if you can break the deleverage you saw in Q3 in store payroll into the boutique and skin bar investments relative to wage rate pressure overall? It sounds like you're levering the fourth quarter. Does that imply that those boutiques and those skin bars hit a level of sales volume that allows you to lever there as well?

Yes, I think big picture, that's the answer. I mean, as 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 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.

Our next question is from Christopher Horvers from JPMorgan.

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 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 you think of the drivers of that are?

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're 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.

Understood, understood. And then just 2 clean-up 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. Just wanted 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?

Well, let me start there first to be clear. So that 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 backroom so we didn't have to struggle with it in the fourth quarter. So that's kind of off the table. Again, there's always a bit of clearance floating through the margin line, right, but not to the extent of what we just saw over the last 2 quarters. 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, right, because there's a lot of factors that influence how many times do we ping you, what you do with your open rates and redemption rates and all those kinds of things. 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.

Our next question is from Dana Telsey from Telsey Advisory Group.

As you think about this fourth quarter, and obviously, a lot of the discussions points on gross margin coming up, what about 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?

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 scenes 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 [ schnooze, ] 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 5 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.

Our next question is from Mark Altschwager from Robert W. Baird.

It's encouraging to hear that prestige cosmetics saw some sequential improvement, and obviously, you have Kylie coming in Q4. But bigger picture, can you talk about your outlook for category growth. In the past years, we've seen the acceleration in skincare but a deceleration in cosmetics. Just based on the trends in the innovation pipeline you see, do you think we're beginning to see an inflection back in favor of the cosmetic category?

Yes. So this is a crystal ball moment, right? And Dave and I can tag team with [indiscernible]. What I would say in 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. It's big. It's very important to us. But it really is sort of like a tale of different brands. There are some brands that had huge 2015 and '16s that are still struggling a bit with kind of matching that kind of growth and others that are seeing stellar growth. So in total, that sort of mutes, 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 aren't -- the brands that aren't measured in our traditional channel. So there's a lot of growth and innovation for us to participate in that we feel good in. I 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 you'd add to that, that I missed on that, Dave, [indiscernible]?

Just to reiterate. Yes, we really are optimistic about makeup. There certainly is a strengthening in skincare, but we feel that our consumers remain very engaged in makeup. All the demographic trends continue to be very positive. One of the -- that's one of the reasons, though, 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 big, established brands like Tarte and Benefit and Anastasia and L'Oreal and Maybelline on the mass side. So well-rounded, and we're positive about where -- the future of makeup.

And just a quick follow-up, it looks like the transaction component to the equation did reaccelerate this quarter even if it gets a tougher compare. Were there any callouts there, drivers on the marketing side this quarter, and learnings you can leverage for the holiday quarter?

I'd say, from a marketing, we were -- we felt really good about our marketing approach. Yes, we had some activity throughout the quarter as we made adjustments to make sure we were 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 of doing that. And all the other changes that we're making, we think, will continue to drive strong growth across all aspects of the business.

Our next mission from Erinn Murphy from Piper Jaffray.

I was hoping you guys could talk a little bit more about the mass category and the performance during the quarter. And then how are you thinking about that as you go into '19. 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 mass or prestige?

Go ahead, Dave.

Yes. So on the mass side, we're very pleased with the results this year, and we're really optimistic about the future. We'll share more as we get into it, 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. I mean Juvia's Place is a recent example of a brand we launched early but off to good start, and that's in our mass cosmetics space. So as much success as we had this year, we have a large share opportunity. It's 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.

Yes. And I would just add, Erinn. I think that with the emerging brands, it's really across the board that we'll see innovation, right? So across categories and price points, not just mass.

Okay. And then just the ticket growth was the lightest we've seen year to date. I'm just curious, is that just tied to the clearance event being extended? Or was there any other puts and takes for the ticket which came in a little bit lighter than we thought?

Actually, that's probably the primary driver there. So again, the clearance event wasn't much of a sales help overall for the quarter. So yes, that would be something that I would attribute a good piece of that, too, as well.

Our next question is from Michael Goldsmith from UBS.

It looks like your e-commerce and 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?

Yes. We -- well, a couple of things I'd say is we're continuing 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. 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 shopping either in-store or to find stores. So there's other reasons to use mobile than maybe you're not using a desktop. So conversion shifts a little bit there, but when we look across [ AOB ] conversion, traffic, all pointing in the right direction and contributing in a meaningful way to our e-commerce business. Then we think we continue to grow across all aspects of that business going forward.

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

I guess 2 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 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.

Sure. I'll start on the promotion question. I would reframe it. It's really not that any one tactic is about that. I'd say, if you step back, we have a wide variety of tools in our toolkit, I guess, I'd 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 for existing guests. And increasingly, I'm really proud about the fact that our teams have, over the past several quarters and years, really created a much more sophisticated set of tools that involve everything from the ability to invest in awareness to our loyalty program. And 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 guests, you're competitive, you drive a profitable growth and driving market share gains. And there's -- you'll continue to see a whole array of ways that we do that.

And as far as gross margins are concerned, I mean, Brian, you've been following us a long time. It's a very dynamic category. I mean, Dave described, I mean, a 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 -- that long-term algorithm that we laid out clearly at Analyst Day.

Our next question is from Michael Binetti from Crédit Suisse.

So I know you normally wouldn't comment on quarter-to-date trends, but given the -- both the excitement and the significant stock moves we've seen around the last few times you've made Kardashian announcements. Would it be safe to -- can we make an assumption that current trends are above the 7% to 8% guidance for the comp?

Yes, we're not going to comment on the current 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 good shape, but I'll leave it at that.

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

Our forecast, when we look at the business, when we lay out the days, when we look at what we're -- the events we're comping against and the newness that we have to drive our business, that's kind of -- to Mary's earlier point, we keep it current right up to the last minute here to make sure we get our best thinking when we put our guidance together.

All right. Fair enough. And Scott, as I think about the detailed guidance you gave at the Analyst Day and the algorithm for the next 3 years and I look at 2019 [ year ] model, you mentioned to us that some of the efficiency initiatives wouldn't be linear at the Analyst Day. One could assume that you'd be implying EPS growth rate then can maybe start at the low end of the mid- to high-teens range to start the 3-year plan? Is that the right way to orient ourselves as we think about the puts and takes of the multiyear plan?

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 '19. Again, I think I explained at the Analyst Day that we're in the midst of our planning process here, 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.

This concludes the question-and-answer session. I'd like to turn the floor back to Mary Dillon for any closing comments.

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

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