Greetings, and welcome to the ULTA Beauty Second Quarter 2015 Earnings 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. Thank you. You may begin. .

Thank you. Good afternoon, and thank you for joining us for ULTA Beauty's Second Quarter 2015 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 fact 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 may make references during this call to the metric free cash flow, a non-GAAP financial measure defined as cash provided by operating activities minus purchases of property and equipment..

[Operator Instructions] I'll now turn it over to Mary. .

Thank you, Laurel. Good afternoon, everyone. I'm pleased to report excellent second quarter results for ULTA Beauty, with strong sales momentum and better-than-expected earnings growth. To recap the headlines, sales grew 19.4%, and we achieved a 10.1% total company comp on top of the 9.6% comp in the second quarter of 2014.

Transaction growth accounted for about 2/3 of our comp, with average ticket growth contributing about 1/3. We continue to gain market share across all of our categories, with both prestige and mass color cosmetics achieving the strongest growth..

an 8.8% comp in retail; a 10.1% comp in salon; and 43.4% growth in e-commerce. Earnings per share increased 22% to $1.15 compared to $0.94 in the second quarter of last year..

Scott will share the details of our second quarter results in a few minutes. But first, I'd like to provide our quarterly business update through the lens of our 6 strategic imperatives, the framework we're using to drive sustainable sales and earnings growth and long term shareholder value..

The first imperative is to acquire new guests and deepen loyalty with existing guests. Our loyalty team is driving great performance through the critical ULTAmate Rewards platform, which drives well over 80% of our sales. We now have 16.1 million active members, up 18% over the prior 12-month period.

Our store associates are doing a fantastic job converting guests to loyalty members, and they achieved a significant increase in conversion, leading to an acceleration in new member growth. Member retention rate increased, and we continue to see higher frequency of purchases, higher average ticket and higher average sales per member.

As part of our effort to increase awareness of and clarity about the ULTA Beauty brand, we've relaunched our brand communications across all touch points to create an integrated message and consistent visual look and feel that positions ULTA Beauty as delivering the fun side of beauty.

We believe this work sharpens and differentiates ULTA Beauty in the marketplace and shapes our brand equity through a coordinated approach across all of our marketing vehicles, including advertising, e-mail, ULTAmate Rewards materials, website and mobile apps, digital ads, store signage, social media and customer magazines..

Based on our successful 2014 test market, our plan is to include national television advertising to support our upcoming 21 Days of Beauty next month as well as again for the important holiday season.

This national television advertising campaign marks the first in ULTA Beauty's history, an important step towards driving a strong and sustainable brand position while increasing awareness among beauty enthusiasts and driving new guest acquisition..

The second strategic imperative is to differentiate by delivering a distinctive and personalized guest experience across all channels. We continue to make progress here with in-store technology, associate training and evolving the labor model to increase guest facing time.

We've also had some nice wins enhancing personalization through our marketing tools. Let me give you a few examples. As we continue to improve our ability to personalize our e-mails and make them more relevant to our guests, we're seeing very positive results.

By leveraging insights about customer preferences and behaviors, we're able to tailor our communication to be more targeted and more motivating to our guests. During the second quarter, sales per e-mail delivered increased significantly year-over-year as a result of this approach..

We launched personalized display ads in the second quarter to better target ads that are relevant to customer attributes and shopping behavior, moving away from predominantly static ad formats towards more dynamic ad formats. In addition, we're leveraging offline and online customer insights to make our online advertising more effective..

Now turning to ULTAmate Rewards loyalty program. We continue to reward our best guest with a differentiated experience, driving increased engagement and satisfaction.

In the second quarter, our Platinum members, our guests who spend more than $400 with ULTA Beauty during the year, received many perks, including Platinum-only beauty steals, Platinum bonus points offers, early access to new products, Platinum social contest, free shipping offers and targeted surprise and delight gifts..

Now moving to the third strategic imperative, which is to offer relevant, innovative and often exclusive products that excite our guests. News and innovation were strong in the second quarter and prestige color cosmetics remained our best comping category.

Sales growth was driven by newness across the board, including innovative foundations from Too Faced and Smashbox, Urban Decay's matte lipsticks and the excited Naked Smoking Palette as well as continued rapid growth in IT Cosmetics and IT Brushes for ULTA.

The contouring trend is still growing strong, and the newer trend for strobing or highlighting drove comps in contouring kits and highlighters, with newness from Anastasia, LORAC, Laura Geller and Tarte among the best performers..

We continue to roll out Clinique, Lancôme and Benefit boutiques, and all these brands executed very strong product launches such as Benefit's Roller Lash Mascara, Clinique's Pop Lip Colour + Primer and Lancôme's cushion compact foundation.

In addition, we're planning on expanding our Lancôme presence by launching 5 of their best-selling items into every store, not just those with Lancôme boutiques, starting next week. This full chain expansion is a further demonstration that our business model is successfully driving incremental growth for key brand partners..

Mass cosmetics continues to grow as well, performing well above industry growth rates. NYX, Maybelline and L'Oreal were growth standouts driven by newness and innovation. We also introduced 2 popular indie brands from the U.K., Makeup Revolution and Catrice, into our mass cosmetics assortments on ulta.com and in a limited number of stores..

The mass category was also helped by solid growth in private label. We reset the ULTA Beauty collection in more than 300 stores at the end of the quarter, with enhanced presentation as well as new formulations.

The wall presentation is updated with colored shelf strips and tester tile graphics, making it easier to shop as well as more efficient for our associates to stock the fixtures. We also introduced a fresh series of ULTA Beauty kits offering great value and products that leverage current trends, including contouring, primers and brows.

The haircare category was also a big focus for us in the second quarter. We kicked off the quarter with our Love Your Hair event in May, featuring daily beauty steals, in-store events and live chats. July was headlined by our leader event, featuring great deals on jumbo sizes of haircare products across all categories and brands.

We also executed an extensive reflow of our pro-hair planogram at the end of the first quarter, which refreshed our assortment and introduced clear solutions-based signage to improve the guest experience. We believe this helps us set the stage for the most successful leader event in our history.

Our merchants, inventory and store operations teams worked closely together to ensure strong execution and in-stock levels throughout the event. And this drove significant acceleration in the growth of core brands like Redken.

This is a great example of how we can optimize growth on existing brands through a combination of guest insights, brand partnering and strong internal collaboration..

Other second quarter brand launches included several fragrance introductions, Sam Villa haircare appliances and Pacifica skincare products..

hair, skin health and brows. Our salon business continued to grow nicely, achieving total sales growth of 19.7% and comp growth of 10.1%, as we continue to improve our offerings and sharpen our messages to our guests..

Top growth categories were haircuts and color, blowouts and makeup services. Our comp was driven by about 2/3 guest count growth and about 1/3 by average ticket. Particular strength in new guest acquisition was driven by online booking and CRM campaigns, with targeted offers for first-time guests.

We continue to attract new guests by offering services like blowouts and quick skin services. Promotions included offers to get the perfect blowout, special events featuring Living Proof's Perfect Hair Day products and 25% off our 20-minute Dermalogica Microfoliant skin treatments for first-time salon guests, all very successful..

Now during the second quarter, we also trained all of our salon associates on the new fall and winter trends, which were developed in partnership with Redken and renowned stylist, Rodney Cutler, and supported by high-quality training materials, which integrate new styles for haircuts and colors with makeup trends for the very first time.

This included product recommendations and technical instruction for how to get the various styles. And I'm sure you might be wondering about some of those might be, so couple of examples. A tortoise shell hair with a suede eye and a rose blonde look with a petrol eye. Now these enhanced training sessions were very well received by our salon associates.

We're now presenting these looks and trends in our integrated marketing plans across all associate and guest touch points..

Turning to our fifth strategic imperative, to grow stores and e-commerce to reach and serve more guests. We opened 20 stores during the quarter, ending the second quarter with 18 -- 817 stores. New store productivity continues to be very strong for the class of 2015 new stores, which are comfortably exceeding their sales plan.

We remain on track to open approximately 100 net new stores this year, with plans to open 44 stores in the third quarter and about 15 in the fourth. The real estate pipeline for 2016 looks very good as well, and we've already approved a significant number of sites for next year's store growth plan..

The two 5,000-square-foot rural stores which we opened last fall continue to perform very well. We're encouraged by the results, and we're still gaining insights on operating a smaller box efficiently. We intend to open more of these small stores when we have the systems in place to make this format more scalable.

Meanwhile, we've opened several stores in smaller-than-average markets with our 10,000 square-foot format that are exceeding expectations like our new store in Pikeville, Kentucky..

So we're very confident that rural markets represent a significant and incremental opportunity for our store opening program. Insights from operating smaller-format stores will also benefit us as we look ahead to urban and other market opportunities..

On e-commerce side, ulta.com continues its rapid growth, with sales up 43.4%, contributing 120 basis points of the total company comp of 10.1%.

The ulta.com and loyalty teams continue to see excellent results from implementing more targeted digital marketing strategies to drive traffic to the site and guest insights to drive trial offers and incremental purchases..

Sampling is a key driver of growth in ulta.com. Along with our brand partners, we've had strong success with our signature online offers such as our monthly beauty bags with deluxe-sized samples and limited time beauty steals that drive awareness and trial. Our beauty enthusiast guests love these offers.

And brand partners also enjoy working with us through our CRM platform to get their samples to the right targeted segments of our customer base. We continue to explore other areas to drive trial and discovery as well..

The website has been rebranded to incorporate the new elements of the brand personality and color palette and guests have responded very positively to these changes to the online experience. We also continue to benefit from new brands that we've added to our website, including Lancôme, Redken, Matrix, Pureology and It's a 10..

And finally, we have much to report on our sixth strategic imperative, to invest in infrastructure to support our guest experience and growth and capture scale efficiencies..

We celebrated the grand opening of our Greenwood, Indiana distribution center on August 3. We started to fulfill a small number of stores and e-commerce orders.

We launched with 6 stores, and we're now gradually ramping up this facility, which is operating on a completely different model from our existing DCs and includes all new systems and material handling equipment.

While it's still early, we're delighted that the DC is off to a smooth start, the culmination of 2 years of hard work and collaboration across supply chain, IT, stores and the e-commerce teams. Now this DC will ultimately ramp to service 400 stores and 45,000 e-commerce orders when it reaches its full capacity over the next few years.

In addition to a more efficient operating model within the distribution centers, our stores will receive fewer, fuller and more stable cartons. Shipments will feature greater categorization, which makes it easier for our store associates to get product from carton to shelf, freeing up labor hours for customer-facing activities rather than tasking.

And we're also implementing a number of core merchandising systems and tools to drive productivity as part of the overall supply chain initiative.

For example, this fall, we'll launch a product information management system that integrates vendor information into ULTA Beauty systems and aligns product information across all channels to improve data governance.

We also plan to roll out a vendor scorecard to collaborate with our brand partners to drive improvements in performance, such as improved inbound lead time consistency, leading to better in-stock levels and an improved guest experience..

We'll also start to roll out our demand forecasting and inventory optimization tool, which provides forecasting and replenishment models to improve supply chain capabilities. This tool will help us drive higher sales and less clearance and improve vendor fill rates as well as lead to better in-store presentation and higher in-stock levels.

We plan to launch one category this fall, then rollout the system to all categories next year..

And finally, we're on track to open up our fifth distribution center in Dallas next summer and all the core merchandising systems and tools that we're in the process of implementing will work together to support our growth plan and improve the guest and the associate experience.

In the aggregate, these new distribution centers, projects and systems are expected to drive significant long-term efficiencies to optimize our supply chain from product source to guests and help us deliver the financial results we've committed to in our 5-year plan..

That wraps up my update on the strategic imperatives. So now I'll hand it over to Scott. .

Thanks, Mary. Good afternoon, everyone. Second quarter sales were $877 million compared to $734 million last year, an increase of 19.4%. Comparable sales increased 10.1%. The retail comp was 8.8%. The salon-only comp was 10.1% and e-commerce growth was 43.4%..

The total company comp was driven primarily by traffic strength, with transactions up 7% and ticket up 3.1%. Similar to the trend we've seen for the past few quarters, ticket was driven by higher average selling price as a result of strong sales in prestige categories and less reliance on broad discounting..

Retail-only comparable transactions were very healthy, up 6.3%, even stronger than what we achieved in the first quarter. E-commerce growth was driven primarily by traffic but average ticket also increased..

Gross profit dollars were up 18.2% to $306.5 million, but gross profit margin deleveraged 40 basis points to 34.9% from 35.3% last year. Gross profit benefited from improvement in product margins due to higher mix of prestige products, offering a more complete assortment on ulta.com and less discounting overall.

These benefits, however, were offset by planned supply chain investments, including the startup of our new distribution center in Greenwood, Indiana..

SG&A expense increased 16.6% to $183.9 million, down 50 basis points as a percentage of sales to 21% versus 21.5% last year. The key driver of this improvement was marketing expense leverage, partly due to stronger-than-expected sales, but also as a result of concentrating more of our marketing expense later in the year.

We still plan to keep marketing as a percentage of sales flat for the full year since we will be ramping up our marketing spend in the second half to drive brand awareness through national television and radio campaign..

Preopening expense was $4.1 million compared to $3.6 million last year, driven by 20 store openings, 1 relocation and 2 remodels during the quarter compared to 19 new stores opened and 4 remodels completed during Q2 2014..

Operating income increased 20.9% to $118.5 million. Operating margin was up 20 basis points versus last year to 13.5%. Our tax rate was 37.5% versus 38.1% last year, driven primarily by the impact of accounting for equity compensation transactions..

Net income increased 22% to $74.2 million or $1.15 per diluted share versus $60.8 million or $0.94 per diluted share last year..

Turning to the balance sheet and cash flow. Inventories were $705.7 million at the end of the quarter compared to $541.5 million at the end of Q2 2014, up 14% on a per-store basis. Excluding the investment in inventory to stock the new DC in Greenwood, inventory per door was up 10.9%, roughly in line with our comp growth.

This increase was related to maintaining strong in-stock levels for our fastest-turning SKUs to support our rapid sales growth, the addition of new brands and the rollout of Clinique and Lancôme boutiques..

Capital expenditures were $80.6 million for the quarter, driven by our new store opening program, merchandise fixtures and supply chain and system investments. We are on track to spend about $300 million in CapEx this year.

Depreciation and amortization for the second quarter were $39 million and are expected to be about $170 million for the full year. We ended Q2 with $475 million of cash and short-term investments..

The company repurchased approximately 291,000 shares at a cost of $46 million during the quarter under our 10b5-1 plan as part of our program to return cash to shareholders. As of the end of the quarter, $286 million remained available under the $400 million share repurchase program.

We expect to continue to offset dilution with our 10b5-1 plan and still have the flexibility to repurchase opportunistically beyond that..

Turning now to guidance for 2015. In terms of our outlook for the full year, based on our strong performance in the first half, we are raising our sales and earnings expectations for the year. We expect to open approximately 100 stores in 2015 and remodel 4 stores. We plan to grow e-commerce sales in the 40% range.

We expect to drive comparable sales in the 8% to 10% range. We expect to deliver earnings per share growth in the high teens from the $3.96 of adjusted EPS we delivered in 2014, which excludes the $0.02 nonrecurring tax benefit in Q4 of last year.

This guidance includes planned supply chain and systems investments and assumes we continue to repurchase shares to offset dilution. We expect a deleverage on the gross profit line and modest leverage on the SG&A line and operating margin is expected to be about flat..

As a reminder, much of the investment related to our supply chain project will hit gross profit, including higher depreciation expense, which we'll really begin to see in the third quarter..

We expect our tax rate to be approximately 38%. We expect to spend capital on a $300 million range and to generate free cash flow similar to last year's performance..

We are very pleased to raise our annual comp guidance and earnings outlook to deliver high teens earnings growth while making significant investments in the business to drive sustainable, long-term market share gains and shareholder value..

Moving on to specific guidance for the third quarter. We expect sales to be in the range of $869 million to $883 million compared to $745.7 million last year. We anticipate achieving comparable sales in the range of 8% to 10% versus 9.5% last year. We expect to open 44 stores in the third quarter versus 50 stores opened in Q3 last year.

So preopening expense should -- expected to be down slightly. Earnings per share are expected to be in the range of $1 to $1.05 versus $0.91 for Q3 last year. We anticipate a tax rate of 36.9% and a fully diluted share count of approximately 64.2 million..

And with that, I'll turn the call over to our conference call host to begin the Q&A session.

Operator?.

[Operator Instructions] First question comes from the line of Stephanie Wissink from Piper Jaffray. .

I have 2 questions for you. Mary, if you could just start with some of the new brand initiatives. We've seen some of the rollouts in-store as well as some of your digital communication.

Can you talk about some successes there and how you're thinking about strategically deploying those across some new initiatives for the back half? And then just a question on the DC.

Can you remind us, once that DC is fully up and running, what the total store capacity will be of your existing infrastructure and when you may need to invest again to support the next rollout of some of the smaller-format stores?.

Well, let me just say that the newness that you asked about, I think it's really -- we constantly know that our guests are interested in newness and innovation. And as I mentioned, there's several things that were quite successful in the quarter.

So brands like Benefit and Urban Decay with the Smoky Palette, brands like Anastasia, across all categories, Redken Frizz Dismiss. Mass, NYX was a hot brand. So there was really a lot of newness as well as existing brand newness, new brands and just core brand growth.

And how that works in terms of our platform, in terms of marketing, is just that's really where we bring it altogether is just making sure that our guests get to understand what we have that's new and exciting. And I think our marketing tactics are breaking through to her at even better ways all the time.

So that's going to be a core part of what we do, and I think we're getting better at it all the time, more efficient and more effective. In terms of distribution centers, so this new DC will serve the 400 stores, 45,000 e-commerce orders.

We're planning another distribution center that's in development and construction right now in Dallas that will open next year. And that will be sufficient for the capacity that we need for some period of time. We'll continue to evaluate that. Whether it's small or large stores, we would anticipate that to be covered in the network that we're defining.

But certainly, that's fluid as we continue to grow and look out to the future, we'll continue to evolve that strategy and our needs. .

Our next question comes from the line of Oliver Chen from Cowen and Company. .

Regarding the holiday plans and inventory optimization, which categories are most ripe for that process? And will that impact holiday? And some retailers are potentially -- in different categories -- are potentially over-inventoried in the marketplace.

So how should we think about the main catalyst for you and holiday at large and what might be most different on a year-over-year basis?.

Well, thank you, Oliver. I'd say broadly speaking, of course, holiday, we've been focused on it for months. We're excited about it. It's clearly something that is important to us and to our guests as well.

I guess what I would say is that, we just try to be clear about making sure that we've got adequate inventory for what we expect to be our top volume items, and we think we're in a good position to do that.

So I would say that, that's -- we look at that as a core part of how we do business given our growth trends, and I think our ability to really understand what's going to move. We don't have big concerns about things that don't work during holiday.

I think historically, we've been able to manage that really well and have a low amount of products that don't work well but -- so I think we're in good shape there. Is there anything... .

No, I would just add that we really, we don't have any concerns about our inventory position. Again, very little in the way of seasonality and what we carry in our stores.

I think we probably are one of the best-in-class in retail as far as the ability to work through discontinued product or clearance things and partnering with our brand vendors to do that in the most profitable way possible. .

Okay. And just a quick follow-up on the mobile front.

Is there any -- where are you in the innings of like innovation there and what are the next chapters for us to look forward to as customers seems really engaged on the mobile frontier as well?.

Well, I'll let Dave take it. .

Yes, that's great, Oliver. Yes, mobile, obviously, is continuing to grow for us and for -- it's increasingly the way consumers want to engage with brands and shop. For us, in the second quarter, about 60% of our traffic came through our mobile applications, mobile website and about 25% of our sales.

So it is -- we're well past the early innings on the impact that it's having in the marketplace. And we're continuing to optimize the experience in our total digital footprint, which mobile is a critical one. We're improving our app pretty significantly and trying to make that shopping experience easier.

When she's on our mobile website, all of the changes that we're making around trying to increase conversion and increase average order that we're doing both on the desktop service as well as mobile are having an impact.

So we're trying to sharpen how -- the offers that we're highlighting, the way we can personalize e-mails that then drive her to the mobile website. So a lot that we're doing. We think -- again, it will increase -- continue to increase is clearly the way that she wants to shop, and it's a big area of focus for us going forward. .

The next question comes from the line of Daniel Hofkin from William Blair. .

I'll echo the terrific results. Just a little more color, if I could, and a general trend within retail and omni-channel retailers, obviously, e-commerce sales and sometimes coming at the expense of the in-store business. Clearly, that does not seem to be happening with you guys seeing actually an uptick.

Just curious, what you feel like -- you talked about marketing. Are there any -- a couple of things that you feel like are incrementally resonating even a little bit more with the consumer? And then lastly, I'll just editorialize, I'm assuming that the Donald Trump look is not one of the fall and winter looks that you guys are considering. .

We put that one off the table. Oh, it's funny. On the e-commerce omni-channel, let me just start broadly, and then maybe I'll ask Dave to add some specifics. But I think a couple of things. One is that we're clear that for us, 2 things. One is that the multichannel shopper is our best shopper. She's driving a lot.

It's really pretty incremental business for us. The core insight is that the experience to go shop for beauty is one that largely women want to have happen in the physical bricks-and-mortar space.

And our play -- what we're trying to do is make the store experience just so inviting with the right products at the right level of service across the board, and we think that's working for us and is very sustainable. She likes to come and explore, to try and to spend time there with services as well.

Obviously, that's something you can't get done online. So for us, we see that as the core part of our business. E-commerce is working in a way that's kind of neat because it's pretty incremental. So the shoppers that we have that are shopping both online and in-store are by far our best shoppers.

They're, for example, maybe coming 9 times a year versus store-only, which is like 4 times a year. And that's only a small percentage of our guests that are actually doing that. So we like that. We think growth in e-commerce obviously is going to be incremental and profitable for us and fits with the consumer insight and the model that we're building. .

Yes, and I'd just add to that. Certainly, we look at the total omni-channel customer as the one that we're most focused on continuing to grow. And so most of the marketing efforts that we're doing are driving both online and in-store activity.

So the -- Mary mentioned some of the advertising programs in the second quarter, a fair amount of radio advertising, enhanced digital advertising, both of which through our analysis said drives both in-store and online activities. Certainly, within the digital space itself, our social media activity has increased quite a bit. Our PR is much stronger.

We're doing more with social influencers to drive greater engagement. And then as we roll, as Mary mentioned, roll into the third quarter beyond into other tactics that we historically haven't used like TV. We think all of those will contribute to drive, integrate a more loyal guest. She is very attracted to our loyalty program.

And that behavior then gets her to shop in both channels. And that's the behavior that we want to continue to drive, and we've had some success doing that so far. .

Our next question comes from the line of Simeon Siegel from Nomura. .

Sorry if I missed it.

Within the traffic increase, can you share the breakdown between new customers versus increased frequency of existing shoppers and then maybe can you talk about where you're still sourcing those customers from? And then just, Scott, given the moving pieces, can you help with the magnitude of the gross margin impacts over the next several quarters?.

Yes, I guess, I'll start. We don't really break out new customers versus existing. I mean, we bifurcate the comp. We've talked about the fact that the majority of the comp, 2/3 of it was transactional traffic-based with the remainder being average ticket. And that was primarily driven by average selling price.

So units were relatively flat year-over-year, more prestige, again, less promotion, which is driving the basket increase overall. .

I'd tell you, we are excited here. We're really pleased with both though, our new traffic, our new guest acquisition rate. Mary in her comments mentioned that our membership grew to 16 million guests or about 18%, and that was driven by healthy increases in new guests as well as the strong retention, increase in retention of existing guests.

So we feel like we're both attracting new and then keeping -- getting even more of our existing guests engaged in our proposition. .

And a little color specific to 2Q as far as margin goes. We're very happy to see core product margins in our retail business, which again as more than 90% of our total sales continue to expand, prestige mix helped, less promotion overall helped. We did have a little bit of headwinds.

We didn't have as much fixed store leverage in the second quarter as what we saw earlier in the year or what we saw in a year-ago period. We also had a litany of other smaller items that affected the quarter. Again, we normally don't get into this level of detail.

But salon, for example, we mentioned in the script, Mary did, about some training for our salon associates for the fall trend look. We pulled forward some expenses there. So that was a bit more of a headwind than what we expected. And we also had the startup of the DC, which negatively affected gross profit in the quarter. .

Our next question comes from the line of Rupesh Parikh from Oppenheimer. .

This is Erica Eiler on for Rupesh. So I just want to get back to e-commerce here. I mean, it sounds like you've clearly done a lot of to enhance the customer experience online.

I was hoping maybe you could talk a little bit more about what you're seeing from consumer purchases online, specifically maybe what the mass/prestige mix of products looks like online versus in stores? And then also just wondering if perhaps consumers are buying more staple-like products, maybe there are foundations or go-to mascaras versus maybe shaded goods or skincare products that consumers may want to experiment with in stores.

That would be great. .

Yes. Great questions. Again, we're very pleased with our overall e-commerce success, and we see a lot of runway going forward.

Specifically, some of the questions -- we don't really break down between categories, but what I -- your question about the mass versus prestige, what I would say is that the -- a key part of our total proposition, e-commerce, anywhere, in our brick-and-mortar and e-commerce stores is all things beauty all in one place, the breadth of assortment, the breadth of price points, the breadth of categories.

That certainly is what drives our business and differentiates us and we see that within the e-commerce space. So largely, I'd say the assortment and the engagement that we have in our brick-and-mortar stores is largely reflected on e-commerce.

There were some categories in e-commerce that we've talked about in the past that we didn't have as full of an assortment, but much of that gap has been closed largely in our professional haircare. So we see that really reflecting what we see in the in-store environment. For staples versus trying new things, I'd say it's a bit of both.

We certainly don't see only staple or replenishment-type items being bought online. There's -- that is happening. But what we find, particularly with those guests that are -- that we talked about that are our omni-channel guest that are really our best guest. She's shopping more frequently in total across both our retail stores and our e-commerce site.

And she finds items that, yes, she can -- maybe that are replenishment, but she's also indulging in things that she hasn't tried, that are new items. She wants to get it first. She wants to go online right when new offers are up and available. So she's doing a bit of both, and that's absolutely the type of things that we're encouraging.

We'll find it -- make it easier for her going forward to replenish those favored items, but also continuing to highlight new and exclusive and first-to-market items that get her excited when they come out. .

Yes, and I'll just add, and I mentioned this in the script. Our CRM capability gives us the ability to really get -- to experiment a lot with how to get more personalized and more customized on what we e-mail to whom and really allow her to try things, whether it's Beauty Breaks! or just e-mail to introduce her to new products.

So it's really a nice way for our guests to learn about new products and try new categories that they wouldn't have before. .

Our next question comes from the line of Simeon Gutman from Morgan Stanley. .

Mary, you mentioned evolving labor model in your prepared remarks. Can you update us on your thoughts there? I think at Analyst Day, you suggested you might experiment in some areas in the labor model. And then connected to it, you're being very successful with CRM and marketing.

Curious, in places where you're testing increased labor if you're seeing a benefit above and beyond some of the success you're seeing with CRM and targeting. .

Thank you, Simeon. Just stepping back, let me just kind of big picture-wise, I guess, what I'd say is that, as we think about it, Kecia Steelman, who's our Head of Store Operations and her leadership team. We've got a very experienced set of store operators.

And we're really focused on continuous improvement and excellence in operations and guest service kind of across the board.

So while the payroll test is kind of a piece of it, just to give you a broader perspective, I mean, we're really kind of thinking about how do you put the guest and the associate serving the guest in the center of kind of everything we do and really a holistic approach to improvements, whether it's people, processes or tools.

So that's everything from identifying the right talent, training and development, store processes, best use of labor hours as we kind of talked about there, all to kind of just really improve that guest experience. So the payroll test is just a part of it. We're learning things. We've extended it to another 60 stores.

We've gotten some specific learnings. Things that we're trying that are differently. I don't want to get more specific on it than that because we're still learning. But certainly, we're measuring the impact on sales and units per transaction and whatnot. It's kind of a combination of art and science. It will be core to just what we do all the time.

So there's no big kind of aha and one specific thing coming out of it, but think about it as just a piece of a broader focus on how do we get better every day, what we do in-store to serve our guest. .

The next question comes from the line of Matt McGinley from Evercore ISI. .

My first one is on the inventory. When we look at that 30% inventory growth you had, I think, you said 16% of that was related to getting that DC in stock, and I assume some of that would be safety stock.

So I wonder what the -- of that 16%, how much is in-stock versus safety stock? And does that normalize over the year or do we really need to get past the DC that opens in 2016 to see those growth rates drop? And the second one is on advertising.

With the testing you were doing last year, I know you were happy with those tests and you expressed how good they were in the test markets you tried it in.

So my question is, as you didn't do as much advertising in the second quarter, did those markets where you did the test in continue to outperform the rest of the company or the company average?.

Yes, I'll start with that. I'm not -- I wouldn't want to comment about kind of all the specific learnings. Clearly, we feel good about what we've learned and it's been -- we've been, I guess, modifying our marketing mix for some period of time under Dave's leadership and his team.

So what I'm excited about is that our marketing is getting more efficient and effective every day. And that's really critical for us for the long term, to drive short-term results and to create a long term strong brand and brand equity.

So that I'd say in the last quarter, seeing we added radio advertising, we did a lot of PR, we did a lot of digital, we also continue the tactics that we've always done like tabs in magazines, all of those are getting more effective and efficient with less reliance on discounting.

In addition, now as I mentioned, this really starting next month, we're going to layer in national television advertising. We learned from the in-store test that, that was going to be effective for us and so we're going to add that to the mix.

So just -- I guess I feel confident in saying that we got a lot of good learnings out of the test and now we're moving forward to implementing all those learnings as we go. But again, it's art and science. So there's never actually one answer and it's never any one stopping point, right? We'll continue to evolve as we go. .

And with respect to the inventory, it was roughly $20 million at the end of the quarter, which I'd say is all safety stock because we weren't servicing any stores out of that DC at that point in time, right? We started subsequent to quarter end. So I would say we expect that to be kind of the high watermark on a per-door basis for fiscal 2015.

We expect to see some moderation now in the second half of the year and should stay roughly in that zone as we cycle through next year with another DC stacked on top.

So once we get through 2016, again, with all of the systems we're putting in place, the DC forecast and replenishment, other floor planning kinds of tools, we expect all of those to help contribute to improved inventory flows and improved turns. .

Our next question comes from the line of Chris Horvers from JPMorgan. .

So I wanted to follow-up on the gross margin question.

How significant was the DC startup cost in the 50 bps? And would you consider it onetime? And then on a related note, can you provide some color on the magnitude of the marketing shift out of 2Q and whether those dollars spread roughly equally in the back half?.

Yes, I guess with respect to the gross margin, I'm not going to quantify the basis points here. We try to steer away from specific P&L line guidance.

But it's going to be much more significant in the third quarter than it was in the second quarter, okay? So just directionally, second quarter a lot of payroll cost, right? We've got rent expense running through the P&L because we're in startup mode, but the depreciation doesn't really start, and that's really going to be the significant incremental cost running through the gross profit line starting in the third quarter, all right, for all the investment.

And again, we called that out in our investor communications, right, it's upwards of $60 million. So it is a significant step-up from what we've done historically. Marketing, kind of along the same lines. We're not trying to get too specific on what dollars moved where, but it's significant. I mean, we saw some in the first quarter. We called that out.

We saw more in the second quarter. And again, it's a result of us being smarter during the quarter. We're seeing sales trends. And if we see an opportunity to pull back, we will do that. And we'll keep the dry powder for when the ducks are flying, so to speak.

So fourth quarter, there's a lot of shopping, a lot of new guests coming into a lot of new stores that we're opening during the course of the year, and we're going to deploy the marketing where we think it makes the most sense. .

And then -- and just going back to the gross margin question, so understood, the depreciation steps up, but you don't necessarily have the other items sitting in there like the salon training, which would pressure gross margin.

I guess what I'm trying to understand is, could gross margin in the back half be down in similar magnitude as it was in the second quarter?.

I don't think I want to get to that level of detail. Again, I would just say though, there's always -- every quarter is kind of standalone. There's ins and there's outs. The salon we mentioned this time because that was a bit of an unusual item.

E-commerce was strong, right? That leader event and given that's another one-off, it was stronger than we thought it was going to be online, which was great. They were incremental sales. But we had additional freight cost, right? It's heavier product. It costs a little bit more to ship.

So it's not -- and we don't think it's productive to get into reconciling the basis points every quarter. The one thing I would point out is, if you're looking at next year, we got a new distribution center coming online next year, right, where we can have a lot of these startup costs and the same.

So I wouldn't expect it to create the same level of headwinds just because you're kind of lapping a big event like we had this year, but it will be additional headwind next year. .

Our next question comes from the line of Joe Altobello from Raymond James. .

Just first question, I just want to go back to the inventory line for a second. I think, Scott, you mentioned earlier, obviously, that, that's going to remain a bit elevated here with the new DC coming online.

When do you expect the year-over-year increase in improved door inventories to migrate back to basically same-store sales growth? Is that next year?.

Well, I'd say we're going to be in the neighborhood this year. I mean, look at the comp that we're posting, it's an 11 comp. So you're looking at -- x that $20 million of startup inventory, I'd call it, we're at the comp level. So it's not -- I wouldn't view the inventory as being out of control in any way, shape or form.

I mean, we feel very comfortable with the inventory that we have. Again, there's little seasonal or fashion risk to the inventory. I mean, to be frank, we spend most of our time trying to figure out how to stay ahead of the trend usually when we're chasing inventory.

So we're -- with the cash and the balance sheet strength we have, we're not going to be shy about making some bets going into the fourth quarter, right, on hot products. So we're -- I would say generally speaking, there's nothing to see here, right? We're very comfortable with our inventory position. .

Okay. That's good to hear. And then secondly, in terms of your decision to go into national TV advertising for the first time.

Why now? Is there something that you view as a natural extension of your marketing strategy? Was it something that was sort of debated internally or was it just an obvious move on your part?.

Yes. It's really been part of our thinking all along and really part of our 5-year plan. The first strategic imperative that we described is driving new guest acquisition and more sales from our current guest.

We know that we have a gap in awareness of our brand relative to our competitors, whether it's aided or unaided, and that television advertising is one of the tools, one of the fastest tools to drive awareness. And we've been 2 years into it now. So this wasn't like we're just going to go and jump and do that overnight.

We carefully developed brand positioning, creative, tested it, tested the media plan. So I feel confident that the time is right. Also, I would say, we all know has been very competitive marketplace. It's always been and probably always will be.

So striking while the iron is hot, I guess, we're in a position to build a long-term sustainable business model here. And we think this is a key part of it, is to really keep pressing ahead with the marketing tools to drive both short-term and long-term results, and we feel it's the right time to do it. We're ready to do it. .

Next question comes from the line of Kelly Halsor from Buckingham Research. .

I was wondering if you could talk a little bit more about the prestige skincare category. It's been a few quarters since you guys have called it out as a top-performing category.

So what are you seeing in terms of trends in newness of products and brands beyond the rollout of the branded boutiques? Are there any opportunities to add new brands, especially in light of some of the well-known brands recently announcing plans again to the specialty multichannel in a bigger way? And then secondly, could you provide any more color around the cadence of the DC and the store ramp-up? How many stores do you need to get to start to see some leverage on costs associated with that facility? And just any timing around that would be helpful as well.

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I'll start with prestige skincare. Prestige skincare, I think, as you're probably aware is not -- has been a little slower than historical the last few years. It has slowed down as a category, although we see it as a critical central category to our overall proposition. And we're excited about the potential.

I think it's a mix of great partners that we have in place today, some of our biggest, strongest brands like Philosophy, Dermalogica, Clarisonic. Dermalogica with our partnership with skin services is a key strategic platform for us. We continue to engage our guest and not only have them engaged in products, but have them engaged in services.

So we see those largest brands continue to grow and provide opportunity, both today and some of the innovation in the pipeline that we know that they're going to drive going forward. There are additional brands in our box that are relatively new or newer or up and coming.

A brand like Juice Beauty is a nice brand that we're excited about, and that's performing quite well. There are, to your question, there are certainly additional brands that we don't carry today.

I'm not going to talk about any of them specifically, but there's certainly other brands that we're continuing to explore, with a whole team dedicated to exploring and figuring out which ones would make the most sense in our proposition and our box going forward. So we'll continue to add innovation in the skincare category. We see it as a mix.

You're right that there's been some -- a fair amount of, I guess, consolidation, Unilever playing a bigger role in the prestige skincare. We think that's probably only good to get greater emphasis on the category, some new resources, and we think it will drive growth going forward. .

And Kelly, the short answer on the leverage question on fixed cost there, we would expect -- we expect to see benefits from the Greenwood facility. We expect to see some benefits next year. Of course, those will be masked somewhat by adding another new DC in the Dallas area.

Meaningfully, 2017, I think, is where you would -- we'd be able to see more presence of leverage on the P&L overall. .

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

Kind of a bigger-picture question. Mary, we've seen growth in popularity of these beauty subscription services. I think one of your competitors actually recently announced a launch in that area.

Can you just give us your thoughts on the merits of that model? Is it something ULTA loyalty guests are asking for? Something you could see ULTA doing in the foreseeable future? And maybe any comment on where your capabilities lie there given the new DC investment. .

Yes, I'll take that, Mark. We see the real benefit of that whole space as fundamentally driving trial and discovery of products for our guest, and that' something that we've been focused on for a while. We do a lot in that space. We do not currently offer a exact subscription-based model similar to some of the other ones that are out there.

And we'll explore all options going forward. Although I'd say what we're really focused on is finding what we think are probably the better ways to drive that discovery and trial. We do a lot with our guests to provide products. We do programs through our e-commerce platform.

Beauty Breaks! which are kind of weekly limited-time offers that give hot prices and samples associated with it. You have beauty bags that are extremely popular that give premium-sized samples to our guests and we feel they're more targeted and more relevant, we often partner those with buy-ins on certain products.

So there's a -- our customers are more engaged in it. They're expecting these products to come along with it. So their usage, we think, is really good. We're also experimenting in another -- a variety of different ways to again drive this trial and discovery.

For example, recently, we had a program with a very popular YouTube blogger, created a sample bag with her favorite items that was exclusively sold through or made available to her followers with a buy-in on our website. So we think it not only drove business, it drove engagement, it sampled products and discovery.

So the whole space around trial and discovery is the one that we think we're very active and we've reached hundreds of thousands of guests with those kind of programs, and we'll continue to drive that kind of program going forward because it excites our guests and get them engaged in more and more of our products going forward. .

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

As you think about the new guests that are coming in, whether going to the salon or even in the store with prestige, do you think these salon guests, how many of them are coming from loyalty programs? How many of them are coming from the marketing efforts that you're putting into place? And what does this mean for conversion into loyalty members going forward?.

Yes, I'm glad you asked that because it's an exciting area for us in terms of growth, future growth, because really, a small percentage of our loyalty guests today are using the salon. We're doing a lot. I'd say, it's coming from a lot of things.

One is, we've offered a new online booking service that we know is driving largely incremental new guests, thousands of them, in fact. And then also our marketing programs right now are getting more and more focused on integrating makeup and hair and trend. And they're very exciting.

And I think we're actually bringing to our store associates this kind of trend training that we talked about, bringing it to life inside the store.

And certainly, every guest that comes into an ULTA store who's a potential new loyalty member, our associates in-store are doing a great job of converting them into the loyalty program because they understand that, that's important for the business.

So all those items will work together, we think going to continue to be a key part of our growth story. .

Our next question comes from the line of Mike Baker from Deutsche Bank. .

You guys talked about in your prepared remarks a metric of sales per e-mail sent out which is an interesting metric.

How long have you -- can you give us some more color on that? How long have you measured that? Has the growth accelerated at all or what does that look like in the past?.

Yes, we won't get the real -- the specific numbers on it, but it is something that we measured for a while, and we're seeing really, really healthy growth. And that growth in effectiveness of our e-mail campaigns is really fundamentally coming from, I'd say, 2 places. One is better targeting.

So we're understanding our consumers' desires, we think, a little bit better and personalizing the e-mails to them. And then the offers, the items and the creative that surrounds them, we think it's better as well. So the e-mails themselves are better, better items, better offers, better programs that are personalized in much sharper ways.

And those things have really worked well. So we're sending out more e-mails, but we're getting much more effective and efficient in doing it, and we think it will be a big growth driver for us going forward. .

Okay. That makes sense. If I could ask one other.

Just on the supply chain, I assume we're still in line for that, the hit this year to be 5 percentage points relative to your earnings growth and does that peak -- it seems like that's going to peak probably around the third quarter, is that right?.

That's correct. You got that. Yes, third quarter when we flipped the switch at the beginning of the third quarter. And that's when it was, right, just doing a store or 2. And now we're going to ramp it up and it will get more efficient over time. And as we get into the fourth quarter, it's going to service 130, 140 stores.

So at that point, it will be more productive and be contributing more or less drag overall, I guess, I should say. .

Our next question comes from the line of Aram Rubinson from Wolfe Research. .

A lot of retailers have struggled with trying to reduce promotions and still hold sales. You guys are one of the few where you've actually pulled back on promotions and sales have kind of held or accelerated. I know you're still using pretty blunt instruments when it comes to CRM and customer knowledge.

I'm just wondering, is there potentially another round of that as you look at kind of the response that your customers have had to it? Do you think that if we or you decided to kind of pull that lever again that you might be able to go another round, perhaps a bit more surgical, but kind of almost repeat that same exercise?.

I would say that I don't know that I envision another big change here. This is a gradual process that we've been working on really for some period of time, which is the kind of the careful experimentation, testing and learning, trying things differently and changing such that our marketing mix -- I wouldn't say it's blunt instrument so much anymore.

I mean, I understand your question, but I think we now have a really robust array of tools that are getting better and better as it relates to effectiveness and efficiency.

So I will just consider this a core part of how we're going to always do our business, which is constantly look for how can we be driving long-term brand equity, which is really important that people understand what ULTA is and they're aware of us. They understand that we are all things beauty all in one place.

And then lots of surgical tools to drive the short term day-to-day results that we need. So it's an ongoing piece of how we're going to do the business. Dave and his team are all over it. And that's how we look at it. .

Let me ask it another way.

If you were to look at your level of promotion today versus the brand equity, you think ULTA deserves or warrants, do you think those 2 are in balance now or are they still a little out of balance and which way?.

Well, we're really just starting the national television advertising as you know. So that's another kind of shift in the balance of the mix. I envision that we'll be able to hold our ADS [ph] ratio pretty consistent over time with the mix being -- getting more in balance. But I'd say it's getting there gradually. It's not wildly out of balance.

I think we're moving into a place that will be pretty sustainable for the long term. .

And it appears there's no further questions at this time.

Would you like to make any closing remarks?.

Yes. In closing, I'd just like to say I'm very proud of the excellent results that the associates across ULTA Beauty are delivering while making significant progress on all of our initiatives, marketing, merchandising and supply chain. I want to thank you for your interest in ULTA Beauty, and we look forward to speaking with you again soon. Thank you. .

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