Greetings, and welcome to Ulta Beauty's Third Quarter 2019 Earnings Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Ms. Kiley Rawlins, Vice President, Investor Relations. Thank you. You may proceed.

Thank you, Devin. Good afternoon, and thank you for joining us today for Ulta Beauty's Third Quarter Earnings Conference Call. Hosting today's call are Mary Dillon, Chief Executive Officer; and Scott Settersten, Chief Financial Officer. Dave Kimbell, President and Chief Merchandising and Marketing Officer, is also with us today. This afternoon, we released our financial results for the third quarter of fiscal 2019. A copy of the press release is available in the Investor Relations section of our website at www.ulta.com. Before we begin, I'd like to remind you of the company's safe harbor language. The statements contained in today's 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 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 caution you not to place undue reliance on these forward-looking statements, which speak only as of today, December 5, 2019. We have no obligation to update or revise our forward-looking statements, except as required by law, and you should not expect us to do so. We'll begin this afternoon with prepared remarks from Mary and Scott. Following our prepared comments, we will open the call for questions. [Operator Instructions] Now I'll turn the call over to Mary. Mary?

Thank you, Kiley, and good afternoon, everyone. The Ulta Beauty team delivered another quarter of solid top line performance, gross margin expansion and EPS growth despite the current challenges facing the U.S. beauty category. Our differentiated model is winning in the marketplace. We continue to gain market share across all major beauty categories, and we're extending our leadership position by creating stronger connections with our guests and engaging them in better and more exciting ways. Our financial performance for the quarter was generally in line with our internal expectations. To recap, total sales grew 7.9%. Comp store sales increased 3.2% on top of 7.8% growth in the third quarter of last year. Gross margin expanded by about 40 basis points, and diluted earnings per share increased 3.2%. As we discussed on the last earnings call, we believe the makeup category in the U.S. is experiencing a down cycle. Like other consumer categories, makeup has experienced a number of up and down cycles. The most recent growth cycle began in 2014, driven by new application techniques in looks like contouring, highlighting and brow styling and new products, such as palettes, minis and travel sizes. The rise of social media influencers, video tutorials and selfies also contributed to strong growth in the category. After several years of robust growth, the category began to decelerate in 2017 and turned negative in late 2018, resulting from a lack of engaging newness and incremental innovation. This negative trend has continued through 2019 with further deceleration in the most recent quarter. Now makeup looks and trends are constantly evolving, driven by industry innovation, fashion and pop culture. And while we've seen sales decline in the U.S. makeup category this year, consumers are still buying and wearing makeup. For example, we're seeing interest in a more natural…

Thank you, Mary, and good afternoon, everyone. As Mary said earlier, today, we reported results for the third quarter that were generally in line with our internal expectation. Starting with the income statement. Top line growth of 7.9% was driven by a 3.2% comp, strong new-store productivity and robust growth in other income primarily driven by continued growth of our credit card program. The total company comp of 3.2% was composed of 2.3% transaction growth and 0.9% average ticket growth. Despite softness in the cosmetics category, we were pleased to see a modest increase in store traffic during the quarter. From a category standpoint, cosmetics was 51% of sales, down about 200 basis points from last year while the skincare, bath and fragrance category increased 200 basis points to 21% of sales. As a percent of sales, haircare products and styling tools decreased about 100 basis point to 18% of sales, while the services category was flat at about 6% of sale. Although we no longer break out e-commerce growth specifically, ulta.com growth was at the low end of our expected range of 20% to 30% growth, driven by traffic. Gross profit margin of 37.1% improved 40 basis points year-over-year from 36.7%, driven by stronger merchandise margin and leverage of rent and occupancy expense. This was partially offset by investments in our services business, while our supply chain operations were roughly flat as a percent of sales. Merchandise margins were higher year-over-year, reflecting ongoing benefit from our efficiencies for growth, or EFG, cost-optimization program and lower promotional activity as compared to last year, which more than offset headwinds from category and channel. While promotional activity was lower as compared to last year, largely because we anniversaried the impact of last year's clearance event, promotional activity in Q3 this year was…

[Operator Instructions] Our first question comes from the line of Michael Binetti with Credit Suisse.

Congrats on a nice quarter. I want to ask about, I guess, on the gross margin, you mentioned third quarter were -- was lower. The promotions were a little lower on the clearance but a little above your expectations. I'd love any help you could offer us on how to connect that to the fourth quarter. Do you still think the fourth quarter gross margin will be positive? I think the fourth quarter embeds EPS growth of about 1.5% to 4%, so maybe a little bit below the mid-single digits you were talking about previously. I'm just trying to see if you could help us on whether that's a little bit more conservatism on the gross margin or on the SG&A line?

Sure, Michael. So looking back at the third quarter, I would say, overall, we're happy with the results. I would -- as we said in our prepared remarks, we were lapping that large clearance event last year, so we got some natural leverage there year-over-year. And we were slightly more promotional in the end than we had anticipated back in August when we last spoke to you. And as we look out here towards the fourth quarter. We're guiding now to gross margin overall being flattish versus what we said back in late August, which we thought we could be a little better than flat, even at the low end of the guidance, and really, the biggest change there is just looking at the overall retail universe, so to speak. I mean we expected it to be more promotional in the beauty space. And I think we communicated that to a lot of folks we've talked to over the last few months. But what we've seen with the ratcheting up really in the overall retail environment right now with the kind of the compressed shopping season. We're starting earlier. We've got deeper discounts across the board. And I'd just remind everyone that, in holiday season, unlike in the rest of the 3 quarters of the year, we compete with everyone in retail for wallet share, right, in the gift-giving period. So this is a critical time for us. We're driving a lot of new guests to our stores. We've got roughly 80 new stores versus last year and a much larger e-commerce business with engagement there. So it's critical for us to make sure we keep healthy traffic driven to both -- through both of those channels, and we're not going to be deterred on that. We'll spend some margin right there if we need to, and we're being prudent, I would say, with our outlook here based on all the facts and circumstances here as we speak today. So again, merchandise margin, a little weaker in the fourth quarter than we anticipated. And that's really the only change with the gross margin flat outlook year as we look ahead.

Okay. Could I just follow that with a quick follow-up? I think, a year ago, you had us out for an Analyst Day. You gave us the rough framework of how you were thinking about the next few years. You just mentioned to us they pushed out some spending on Jacksonville. Does that -- do the expected efficiencies that you we baking into the multiyear plan on the margin change at all as we think multiyear out through our model because of that -- does that change at all on Jacksonville?

So our EFG program, again, efficiencies for growth, we're seeing benefits. You're seeing benefits in the P&L right now. We're seeing them in the merch margin line item, we're also seeing them in fixed store costs there around real estate. That's helping drive some of the leverage that we're seeing there year-over-year. So we're still confident in that 150 to 200 range that we shared last year. We're still confident there. We're in the early innings there. We explained then that it's a multiyear kind of program, and it starts out slow, and there's lots of different levers there. Some delivers faster, some delivers slower. So we still feel confident with what we've got in front of us and that we can execute against that.

Our next question comes from the line of Christopher Horvers with JPMorgan.

Mary, you mentioned that the industry growth slowed in 3Q relative to 2Q. Curious how you would characterize the growth since the falloff in August that you described to us last quarter. Has the industry growth been relatively flat since August, down in that, I think it was like low double digits. And have you seen any variation in cosmetics versus skincare? And all related to that, how's your market share capture evolved against the changing industry trends?

Yes sure. Well, first of all, I'd say within the category, the issue about lack of growth is really about makeup, right? So other categories, skincare, fragrance, hair, all positive, and we've seen really strong comps in all of those categories. Makeup has been -- it was a little bit sort of bumpy around August, I'd say, big picture, Q2 was negative, and then Q3 was slightly more negative than that. So not as bad as the double digits that we're seeing at the time that we have the call, so we were anticipating it will continue to be pressured. And basically, we're right, the data supports that. And it's -- again, I'll just reiterate. I -- it's tough to be in a cycle, but the cycle in the U.S. feels very much about innovation. Not just being as incremental to categories that has been in prior years. And you can imagine, we're working very closely with our brand partners, big and small, and this should really bring back strong growth, and we believe the category will return to growth. There's always shifting preferences, but demographic trends really continue to be favorable for us, and our brand partners are very laser-focused on white space innovation, category growing opportunities. So tough to predict when that'll turn, but we feel confident it will. Our market share capture continues to be, I think, one of the strongest parts of our story. So -- and it's a little easy to get distracted by the short term. Our long-term view is that we have the winning model, and we are, I think proven by the fact that we're driving market share growth, new guest to our loyalty program. And for us to continue to do that in this time is really important. It sets us up, we think, really well for the future.

So do you think then as you sort of -- given that the category growth has been relatively consistent, albeit bumpy, do you think that, as you look ahead, it's just going to be a function of, get us to July, August next year and things will sort of flatten out from a market growth perspective?

I wish I could give you that exact timing. It's pretty [indiscernible] today. So nice try, though. But I mean we feel good about that it will turn. And I don't want to give a specific time frame. But you can imagine everybody in the industry in makeup would like to see this get improved, and it will.

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

As you think about the marketing that you're doing this year as compared to last year in the holiday season, especially given that Kylie launched last holiday season, how is it different this year? And as you head to 2020 with the issues with Colour Cosmetics, how are you thinking about the marketing game plan and what you allocate to it relative to sales?

Yes. We were very positive about our total impact in the marketplace through marketing and the innovation that we're bringing into the marketplace, new brands. In marketing, specifically, we are continuing the campaign that we launched last year, Possibilities Are Beautiful. It's had a very strong reaction in the marketplace. Consumers have seen it very positively. As Mary mentioned in her remarks, our awareness continues to grow, and we're confident that we'll continue to see that success through the fourth quarter and into 2020. We did have some big launches last year. You mentioned, Kylie, but we continue to bring new brands across the store this year. Mary mentioned a few of those in haircare, brands like Pattern with Tracee Ellis Ross, IGK in skincare, many of the brands that are coming in and driving growth and in makeup as well. So we're working hard to continue to evolve the assortment to drive growth and reach our guests in new and compelling ways behind our Possibilities Are Beautiful campaign. So we're optimistic with that, are seeing the results, and we'll continue to drive that through 2020.

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

So just wanted to ask about the updated comp guidance. I mean it doesn't still imply a strengthening in Q4 despite the tougher compare. Maybe update us on the drivers you see there to the strengthening sequentially. And then, just given the backdrop you're expecting the makeup category to remain under pressure. I mean to the extent that you're able to deliver those -- that level of comp in Q4 despite the backdrop, I guess, what changes as we get into next year, just as we think about the comp growth algorithm?

Well, we're not guiding for next year right now, so I understand the question. I'd say, as we think about the fourth quarter, I guess, the guidance that we gave at the midpoint is moderately better than Q3. But you're right, we have a lot left that we're lapping. But I think as Dave just described, we feel like we've got a really good array of tools from the offerings, the marketing, the promotions, et cetera. And we feel like we're off to a good start. And so as I said also in my call -- I mean, in my comments, there's quite a few things we have this quarter or this year that we didn't have last holiday. I think BOPUS might be one example of that. The buy online, pick-up store capability is something that we did not have last year, and it's off to a strong start for us this year. Stronger, I'd say our Ulta Beauty app is even better than before in terms of the ease of execution -- the ease of understanding what your points are and how they add up. Afterpay is another one that we have this year that we didn't have last year. Our service optimization has been rolled out now across every store, and a lot of newness in the box. And again, there's Millie Bobby Brown, Tracee Ellis Ross, Thrive, KKW Beauty. There's a lot of things that are incremental to a year ago. So we look at it and feel confident that the way we're guiding is as accurate as we can make it. And coming up against a big quarter last year, I think is -- we're in a good place to do that.

And then just maybe quickly following up, I mean, I understand that we don't want to get into specifics for next year, but to the extent that we remain in a slower-growth mode, maybe speak to some of the areas in SG&A that you have the ability to pull back and you're comfortable pulling back on? I know you mentioned that the DC -- that any other kind of bigger buckets we should think about as we try to triangulate that leverage point.

Actually, before -- maybe, Scott, you can take that, but I'll add because I forgot you had a second part -- a tricky 2-part question. But when you ask about that, well a little color on 2020. As I said, we would expect that the makeup category headwinds are with us for a while. That said, we are in a great position because we operate, I think everybody knows this, but across so many categories of beauty, and we have the ability to flex, and we are flexing. We had talked a lot about skincare as a category in our comments, more brands, more space, more activation. So we think that, while even with the headwinds of beauty, of makeup, and that will create some tough top line environment for us in 2020, we have other categories that we're going to continue to grow well in.

And as far as 2020 is concerned, I guess, I would just add that we've talked to a lot of investors here over the last couple months, and our communication, I think, has been consistent that we're not taking this lying down. I mean we're -- it's all hand on deck here looking at the business now in a new -- what we expect to be a lower-growth environment here for the foreseeable future. So we're looking at any and all levers on the business to see what we can do to control cost in a new kind of operating environment. So we're being realistic about the current operating environment and competitive threats, but we continue to strongly to believe in our ability to drive long-term profitable growth. So as we are building our 2020 plans, we've got an eye towards balancing short-term top line pressure with the need to reduce cost in our business while also ensuring that we position Ulta Beauty to continue to win in the long term. Jacksonville is just one example of something that came up that we made a decision here on recently, and there's many more of those in the queue right now that we're talking with our Board about and thinking through all the pluses and minuses, weighing the strategic benefits and the cost implications. And we'll have more to say about that in our March call.

Our next question comes from the line of Ike Boruchow with Wells Fargo.

A question for Scott. I was actually surprised and pleasantly surprised that you guys were able to get leverage in the fixed cost component of your cost of goods sold. Could you kind of tell us what's going on there? I know there's been a lot of investment and some deleverage. But on a 3% comp to get some leverage, can you just explain this to us, Scott, what exactly is going on within the fixed costs? And then is that kind of -- like, is that sustainable? Should we think that way going forward that, if you can comp a 3, you can get leverage within COGS?

Ike, there's a lot of variables that roll through any one quarter through that line. So the number, quality and timing of store openings, lease renewals, depreciation. Things we've been talking around, the EFG initiatives that we have. So the team's making great progress on that, and we're seeing some of that roll through 2019. So we're very happy with what we were able to deliver on the third quarter. We're going to stay focused on EFG and optimization, and all those things are working. Our real estate team is doing a great job working with our landlord partners to make sure we got fair economic deals as we look across a 1,200-plus store fleet. So we still think there's good progress to be made there. And I just want to -- just to remind people, again, as we continue to look at how we can manage our business in a lower top line environment, this is a good example of things that we can do. Again, it's not necessarily going to be a straight line or a hockey stick up and to the right, Ike, but it shows that we're flexible, and we can manage the business.

Got it. And this is a quick one for Mary. I'm going to give this a shot. So you guys said you expect the makeup headwinds to stay there for a while, lower-growth environment for the foreseeable future. I guess, what I'm asking -- I'm not asking for guidance, but Mary, would you expect this 3% comp to kind of be the trough of the business? Or is it just impossible to tell at this point? I just figured I'd ask you that.

A second nice try. I like that. Yes. I guess, I just want to be clear though, I mean, I hope this comes through, that we feel very strongly that our business model is working, and we're no less confident in the long-term attractiveness of our business model at all. We're outperforming the rest of the market in terms of gaining market share. I feel very good about our capabilities, our brand awareness, our omnichannel capabilities, which are so important right now, right? Our digital capabilities, we're the destination preferred for teens. That's really important as we think about the future of the business. And so, everything from services to how we operate in store, I think, are just really exceptionally well-executed right now. So being a little patient and taking a long view on the category is an important stance for us and not getting ahead of our skis on this. And so if we could call it better, we would. We don't have control of everything that happens in this industry, obviously, but we've got great partners that are working hard with us to make sure that we continue to bring this back to growth. So -- but I think, as Scott said, we were, I think, taking a realistic and cautious look or view of the current operating environment and planning for that. I think that's the most pragmatic thing for us to do as we plan for 2020. But I don't -- so in terms of what that number looks like, we'll talk more about that when we get to March. But that's how we're viewing this.

Our next question comes from the line of Michael Goldsmith with UBS.

In response to the deceleration in cosmetic, how have your conversations with suppliers evolved? Have they been more willing to provide more support than they have in the past? Are they taking a more collaborative view on innovation? Are they talking about their product pipeline and introductions any differently? And then also, are you seeing any signs of stabilization from the prestige business?

Yes. I would say our brand partners across the board are very engaged and very focused as we are in both understanding and turning around the challenges in the makeup category. And so their level of engagement has always been high. What I'd say is different now than what we've been experiencing over the period of growth over the last few years is much deeper effort to understand consumer behavior, a much more robust focus on driving new forms of innovation that'll really be incremental to really uncover new habits and behaviors for consumers. So we're seeing that across the board with our end partners, and we're very -- feeling very positive about the engagement that we're getting, the level of focus that they have because they're obviously very incented to drive return to growth in this category. So we feel good about it. I think as both Mary and Scott has said, it's hard to predict exactly when the category is going to turn around, but we're working hard every day. And we have a lot of bright spots that, while the category is challenged, the work we're doing to bring in new brands to bring in exclusive brands, brands like Morphe, Juvia's Place, new launches like Thrive, KKW. So even in a tough market, we're gaining share because our strategy is working by both partnering with new brands and then returning to growth with existing brands. So everybody is working hard on this, and we feel confident that the category will return to growth. And we're working to make sure that's as soon as possible.

And just following up on that point, it seems like outside the deceleration in cosmetics, other categories were generally steady, maybe fragrance accelerated a bit here -- decelerated a little, but is there any risk in the reduced interest in cosmetics could bleed into other categories and start to drag them down?

Well, we do feel -- continue to see strength across the nonmakeup parts of our business, and that's a great part of our overall model because we do have all things beauty all in one place. So strength in hair and skin and bath and sun and fragrance. And as we mentioned, traffic was modestly positive. So consumers are absolutely still coming into store. We're gaining new members. So we had strong new member growth because they're attracted to the whole portfolio. So we're not anticipating a big impact on the other parts of the business. If anything, as consumers are maybe slowing in their engagement and makeup to a moderate extent, we're certainly seeing greater growth and focus on skincare and the merging of those categories in some ways as brands are looking for ways to drive new growth. So no, we don't think that will have a long-term impact. And as I said, we're optimistic that makeup will stabilize and get back to a growth spot over time.

Our next question comes from the line of Adrienne Yih with Barclays.

Mary, I was wondering if you could talk about the purchase -- Coty purchased a majority share of Kylie Cosmetics. How does that impact your exclusive relationship? And then if you could also talk maybe, David, about the KKW launch in the third quarter? When did it launch? And then in terms of SKU count, was it same, larger than the Kylie launch last year? And really, really quick one. Scott, can you give us any color on areas where you could cut SG&A or in the EFG program for next year.

So yes, let me start with your question about Coty and Kylie. So Kylie -- we've had a fantastic relationship with the Kylie business and the Kylie team. It has certainly contributed to our comp growth. We're pleased with the brand. It's been driving excitement and new guest, and so we're really happy with the overall performance. And the Kylie-Coty partnership is new and still being finalized, but we have a great relationship with Coty, and we anticipate a lot of positive opportunity to continue to grow those brands together going forward. So we're really positive about that. KKW has been a nice addition to our business. We launched it in all stores on a customized end cap late in the third quarter, and we're very pleased with the results, and again, the partnership we've had with that brand. It's a different assortment. Kylie, if you remember, when we launched, was a limited assortment, predominantly lip kits and some individual lip that's expanded over time. KKW has a broader assortment across different segments of makeup. And so it is a different assortment and a different approach, reflective of the different strengths of each of those brands. So again, glad to have KKW in our portfolio and feeling good about the early results of that business.

Yes. So with respect to 2020 in SG&A. I know that's at the top of everyone's list, is what does 2020 look like? And we -- it's still a little just -- it's too early for us to give too much detail on that. But when we think about SG&A, the types of costs that are in there and roll through our SG&A line are store labor, variable store expenses, corporate overhead people costs, and then innovation investments, right, that roll through there that are long term in nature that are going to help us grow our business. So when we think about EFG, EFG sprinkles all through the P&L. So there's a lot of work underway there to try to optimize the business, whether it's in the gross margin line through some of the merchandise margin things we've talked about with transitions and even the clearance event that we mentioned that we're getting a benefit of this year. I mean that's part of EFG as well. I mean we're doing a lot of work on how the transitions work in our stores so that we have less clearance items at the end of the day that we have to take markdowns on. So it's going to be a balanced view. I would tell you that EFG applies equally on the margin -- gross margin line as it does on SG&A, and we're just going to be very thoughtful as we think about what the right balance is for 2020 and beyond.

Our next question comes from the line of Omar Saad with Evercore ISI.

I wanted to follow up on some of the commentary around color, makeup and cosmetics. I know you guys are focused on it. You're working with your brand partners, all different levels. It sounds like the whole industry is really focused on this issue. Is there anything that you can see in your, obviously, robust data stream that gives some insight into the behavior around this category? Are there certain types of customers where you're seeing that spend and that category slow, whether it's age or regional or demographic? Or is it pretty much across the board? And I guess, I'm ultimately asking the question, is there any change in behavior as new generations come of age and enter the category in terms of how they're consuming the category?

Yes. I'm happy to take that. First of all, let me step back and say, we're all showing a heck a lot of makeup still. It's not like people aren't wearing makeup. I think that's really important that this is about growth versus year ago, really, at that most macro level. It's really about -- our main thesis is that there just isn't as many items that people are adding to their basket that are creating -- that are new rituals like things like contouring or doing your brows. So people are buying lots of makeup, and we'd say, engagement in the category is still quite high but just not at the level it was with the kind of newness that we'd seen for a few years. That's all solvable. That's around finding new consumer insights around white spaces and whatnot. So I think that that's kind of at a macro, what we think is happening. The -- when we think about it, there's also, I think, some misnomers about Gen Z. I mean all of our data on Gen Z show that they're very engaged in the category. And in fact, the good news, too, is that they're also getting engaged in skin at a younger age than people did with older consumers when they were at that age. That means they'll carry that habit forward. As they get into the workforce, they start wearing and using more makeup. So that, we think, is a positive factor. And as we also said, just looking at other demographic trends, we feel very positive about the ability that we don't see people turning away from makeup. In fact, we see them turning more to it. The other thing I'd say is that there's always been a segment of women in the U.S. that don't wear makeup and aren't engaged in the category. That's not new. We've never counted on that segment. It's a small segment. We never counted on that segment for growth for our business model. We focus on the beauty enthusiast, which represent 77% of sales in the U.S. in terms of beauty, and that's -- and we still only have 1/3 of them in our Ultimate Rewards program. So we've got lots of potential. We think it's 77% of spend, beauty enthusiasts out there for us to continue to grow with. So we think that, as the category and the industry gets back to more incremental type category growth, we'll see this begin to change.

Is there anything that you can read into this natural trend that's informative for the color trend, Mary?

Yes. And I've mentioned this in the script, too. Certainly, a more -- we see -- I'd say it's almost like a bifurcation of things. We see a natural -- more natural look, for sure, but anybody who wears makeup knows that, that requires, sometimes, quite a few products to achieve that. It's not a bare face. You might look tomorrow and see celebrities out there taking barefaced selfies. If everybody looked like that, we'd be having a different conversation, but that's not -- so even a barefaced more natural look is really about using products that create that look, a dewy look, a more neutral eye, et cetera? Conversely, if you look at what's happening in the Paris fashion shows in the spring, there was some very cool extreme eye makeup looks, too. So it all kind of -- not everybody does one thing, I guess, is the best way to think about it. And even a more natural look presents plenty of opportunity for product innovation.

And ladies and gentlemen, we have reached the end of our question-and-answer session. I would now like to turn the call back over to Mary Dillon for any closing remarks.

Thank you. I'd just like to close by thanking all of the Ulta Beauty associates across our stores, distribution centers, and our headquarters for delivering another quarter of solid financial results, at the same time, executing against our longer-term strategic imperatives and working really hard to get our stores, website and DCs ready for this busy holiday season. So we look forward to speaking with all of you again in March, and we'll be reporting our fourth quarter results then and hope you all have a happy holiday.

This concludes today's teleconference. You may now disconnect your lines at this time. Thank you for your participation, and have a wonderful day.