Ulta Beauty Inc (ULTA) 2009 Q2 法說會逐字稿

Greetings and welcome to the Ulta second quarter 2009 results conference call.

At this time, all participants are in a listen-only mode.

A brief question-and-answer session will follow the formal presentation.

(Operator instructions).

As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Allison Malkin of ICR.

You may begin.

Thank you.

Good afternoon.

Before we get started I would like to remind you of the Company's Safe Harbor language, which I'm sure you're all all familiar with.

The statements contained in this conference call which are not historical facts, 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 will make references during this call to the metric free cash flow, a non-GAAP financial measure.

Free cash flow is defined as net cash provided by operating activities, less purchases of property and equipment.

A reconciliation of free cash flow to its US GAAP equivalent has been provided in exhibit 5 of our earnings release, which is also available on our website and has been filed with the SEC on Form 8-K.

And now, I'd like to turn the call over to Ulta's President and CEO, Lyn Kirby.

Thanks, Allison.

Good afternoon, everyone.

Thank you for joining us to discuss our second quarter fiscal 2009 results.

On the call with me today is our Chief Financial Officer, Gregg Bodnar.

Following my opening remarks, Gregg will review our second quarter financial highlights and outlook, then I will provide some closing comments and turn the call over to the operator so that we can answer the questions that you have for us today.

We are pleased to deliver second quarter sales and earnings that exceeded our expectations, reflecting a sequential improvement in comp store sales and earnings performance as compared to the first quarter.

For the second quarter, net sales increased 9.8%, to $273.5 million.

Comp store sales declined 1.7%, slightly exceeding our guidance and following a 3.7% increase last year.

So on a two-year basis, comp store sales are up 2%.

Comp customer traffic increased 2.2%.

And earnings per diluted share increased to $0.10 as compared to $0.06 last year.

The economic environment stabilized somewhat in second quarter, and while our performance, given the environment was good, we are certainly not satisfied and we would expect to deliver stronger results in a more robust economy.

That said, we attribute our strength in this difficult consumer spending environment to the successful execution of the key strategies we outlined at the beginning of the year, which included the development of exciting new customer propositions to entice consumers to make a trip to Ulta, the introduction of new brands and products, a reduction in expenses that will permanently impact our cost structure, and cash flow management strategies, including our planned reduction in new stores.

During the quarter, we successfully reached existing and new customers and drove a 2.2% increase in comp store traffic through exciting events such as our back-to-school hair care liter sale, the introduction of new brands including Benefit Cosmetics, Cargo cosmetics, Phyto hair care and [Dr.

Pearlkin] skin care.

Products exclusive to Ulta, such as the $15 Bare Minerals Discovery Kit.

We also increased traffic, by continuing to drive our fragrance business through gift with purchases such as our spa wrap at Mother's Day, and our cooler at Father's Day.

And new introductions such as Ed Hardy's Love and Luck, DKNY's Fresh Blossom and for men, fragrances such as Only the Brave which we introduced and performed very well at Father's Day.

Finally, we continued to utilize our private label to offer compelling value propositions and to introduce new products such as Ulta's professional nail color, and our Ulta 52 piece block buster with $150 value for $17.99.

As a result of these initiatives, we drove a 2.2% increase in comp store traffic during the second quarter without making any incremental investments in marketing.

However, as we saw in the first quarter, we experienced a great response to our marketing coupons which had a 30 basis points impact on gross profit margin versus last year.

We have appropriately planned our merchandising strategies to offset the modest margin impact from increased coupon redemption during the third quarter, and we believe we will deliver an increase in merchandising margin for the third quarter.

Despite positive traffic, we experienced a 3.9% decline in average ticket as compared to the second quarter last year, resulting in a 1.7% decline in comp store sales.

As I have said many times in the past, we have categories such as hair care and skincare that are consumable and therefore prompt repeat purchase and others such as higher priced styling tools, fragrance and salon service that's are more discretionary and continue to be impacted by this economic downturn, which in turn impacts average ticket.

Although still negative, we did experience a strengthening in our comp store sales performance versus the first quarter, and this was driven entirely by our retail business.

Importantly, on a comp store basis, we grew market share during the quarter across each major category.

We grew share in prestige color and skin, fragrance, professional hair care, and mass.

Our market share gains of course are further enhanced with a continued expansion of our store base.

In addition to our solid topline performance, we made progress on our core financial strategies during the quarter.

We continue to make great progress on our cost savings initiatives.

We have raised our full year target by $3 million to approximately $18 million in savings this year.

We achieved a 9.8% reduction in inventory per store, positioning us to decrease inventory per door by 9% at year end, which is ahead of our initial target of down 5% to 7%.

And we delivered $40 million of free cash flow through the first six months of the year, driven by improved working capital management, reduced new store programs and lower new store investments.

As we look ahead, we expect the economic environment to remain challenging and consumers to continue spending cautiously for the remainder of this year.

However, we believe we remain well positioned as we begin the second half of the year.

We will continue to focus on profitable market share gains, while carefully managing expenses.

We will accomplish this by continuing to invest judiciously to balance topline growth with bottom line profitability, by executing our core strategies, by expanding our square footage by 11% this year, and continuing to carefully manage our costs.

In third quarter, we will continue to drive traffic and market share in our retail business.

Through new brand introductions including Philosophy Fragrance and Bath which has just been evidence in 246 stores, through the introduction of new products and existing brands such as Mineral Foundation from Bare Essentials, to the continued launch of new fragrances such as DKNY's Delicious Art and the Dolce & Gabbana collection of fragrances, and Lola for Mark Jacobs.

We will offer 16 in store events with Urban Decay's international makeup artist who will tour stores during the third quarter.

We will continue the excitement in our private label with a 15 piece gift with purchase across our cosmetics lines and new private label bath products such as Bodywhip for back to school.

And of course we will continue to drive exciting value propositions through our marketing campaigns.

This motivation in new and existing brands will anniversary a strong third quarter launch calendar last year.

Because of the exciting merchandise and brand opportunities, we will not invest in additional marketing in third quarter.

In fact, based on our ability to achieve greater efficiencies as we leverage our growth, we expect our third quarter advertising rate to be below last year's rate, even as we deliver more impressions versus last year.

In addition to our traditional traffic driving events, we have a new event in third quarter that I would like to share with you.

At Ulta you've heard me speak to our four Es, Esthetics, Escape, Education and Entertainment.

This year, we added a fifth E for Empowerment.

In keeping with our commitment to empower women, we have planned an in store event in October for breast cancer awareness month.

During a three week period, we will invite women to share their stories about their battle with breast cancer and their unsung heros who have supported them.

These stories will be displayed on Six Miles in our store front windows across our 330 plus stores.

And in so doing, we hope to encourage those who are fighting breast cancer and honor those who support them.

This campaign will be accompanied by an online campaign that we expect to create quite a buzz.

During this time period we will also be asking customers for donations to the Breast Cancer Research Foundation with an appropriate gifts of thanks for their donations.

We believe this event is a way to empower women, to strengthen the emotional connection with our brand, while giving to an important cause.

Within salon, we have aggressively pursued new initiatives to gain market share as we expect consumers to continue to defer services in this economy.

As we mentioned during our first quarter call, we have tested a new salon service with encouraging results which will launch in the third quarter.

The new salon service is a keratin treatment, which eliminates up to 95% of the frizz and curl from hair.

We will offer this service at a special introductory value compared to the suggested retail price of $250 a service.

While consumers are cutting back on their spending, our test of this service indicates that consumers are willing to spend for something new if it offers compelling features and value.

In addition, we are also very excited about our new marketing strategy for salon that gives us the potential to solidify Ulta's position as a leading authority in the salon business.

The strategy is called One Way, Your Way.

We have created a partnership with stylist Rodney Cutler, who styles for runway shows for fashion houses such as Marc Jacobs, Miu Miu and Cynthia Rowley.

Rodney has developed three unique hair cuts for Ulta for the fall season, adopted from the runway so that the styles are wearable for every woman.

All Ulta stylists have been trained on these cuts, which will be launched at the end of September to our customers.

Our intention will be to update the collection with Rodney for each spring and fall season.

Regarding our web business, we expect to continue the positive momentum of Ulta.com.

While still a relatively small part of our business overall, second quarter sales grew at double-digit rates and we expect this trend to continue through 2009.

In second quarter, we expanded our assortment and continued to improve the shopping experience with increased functionality, including automated cross-selling and product recommendations.

In third quarter, in addition to the ongoing development of our online shopping experience, we expect to improve delivery times for our customers, while also reducing shipping expenses through more efficient shipping processes.

Regarding our store expansion, we continue to plan to open 35 new stores in fiscal 2009.

Increasing square footage by 11%.

In the second quarter, we are pleased with the performance of new stores.

We opened 13 stores and added two new states, Connecticut and Mississippi, ending the quarter with 333 locations.

For the third quarter, we expect to open 12 stores.

As we look forward, we are seeing real estate opportunities in existing centers as new center development has slowed, and continue to be opportunistic with regard to new site selection.

As we said in our last call, we believe there is an opportunity to accelerate our square footage growth in 2010, depending on the availability of quality site that's meet our investment model.

We remain confident in our 1,000 store opportunity long-term.

And now I'd like to turn the call over to Gregg to review our financials in more detail.

Thanks, Lyn.

Our second quarter results were driven by better than expected sales performance due to the successful execution of our marketing and new brand introduction strategies, combined with our continued focus on expense management and cash flow initiatives.

Improved retail sales performance as compared to the first quarter and prudent expense management, together have enabled us to exceed our second quarter targets in a challenging consumer environment, resulting in earnings above our guidance range.

Now beginning with a review of the income statement.

Net sales increased 9.8%, to $273.5 million, from $249.1 million in the second quarter last year.

Sales growth was driven by the addition of 50 new stores, since the second quarter last year.

Comp store sales decreased 1.7%, which follows an increase of 3.7% last year, resulting in a two year comp store sales gain of 2%.

Comparable store sales included a 2.2% increase in comp store traffic, offset by a 3.9% decline in average ticket.

Our customer shopping trends remain consistent with what we saw in the first quarter.

She is visiting our store more frequently, but spending less per visit as she's cut back on more discretionary items.

During the second quarter, we opened 13 new stores, ending the second quarter with 333 stores and expanding square footage by 18% from last year's second quarter.

We continue to be pleased with the early performance of our 2009 class of new stores.

Gross profit dollars in the second quarter increased 7.3% to $78.5 million, from $73.1 million last year.

Gross profit margin was 28.7%, a decline of 70 basis points to last year.

This decline was primarily driven by 130 130 basis points of fixed store deleverage, resulting primarily from our expanded new store program.

The fixed store deleverage is net of 30 basis points of temporary rent relief we received in a dozen stores where co-tenant vacancies triggered temporary rent reductions.

We also experienced a 30 basis point decrease in gross profit margin due to higher customer redemption rates for our marketing coupons which was expected and consistent with the first quarter.

The decreases in gross profit margin were offset by an 80 basis point improvement in our supply chain due to cost reductions and operating efficiencies.

The 70 basis point decrease in gross profit for the quarter was better than expected and better than what was reflected in our guidance.

The improved performance is primarily attributed to less deleverage of fixed store cost due to stronger sales, higher efficiency and lower operating costs in our supply chain, slightly higher merchandise margins, and the temporary rent relief I just mentioned.

SG&A expenses were $66.3 million, or 24.2% of net sales, compared to $61.9 million or 24.8% of net sales last year.

The 60 basis point improvement in SG&A primarily represents improved leverage in the store and corporate overhead expenses as a result of our focused expense management.

We currently expect to achieve annual cost savings of approximately $18 million, which as Lyn mentioned earlier represents and improvement of $3 million from our initial plan.

Preopening expense totaled $2 million in the quarter, which compares to $4.1 million in the second quarter of fiscal 2008.

The reduced new preopening expense was slightly ahead of our expectations, and was driven by lower labor costs.

Strong sales growth combined with solid SG&A leverage and our planned lower store opening program led to a 42% increase in operating income to $10.2 million or 3.7% of net sales, from $7.2 million or 2.9% of net sales last year.

Interest expense decreased to $0.6 million, from $1 million last year reflecting lower borrowings and interest rates.

The effective tax rate for the quarter was 40%, compared to 40.4% in the prior year.

Net income for the quarter increased 55.9% to $5.8 million or $0.10 per diluted share, from $3.7 million or $0.06 per diluted share last year.

Now turning to the balance sheet and cash flow results.

Merchandise inventories at the end of the quarter were $209.2 million, compared to $197 million at the end of the second quarter last year.

Average inventory per store decreased 9.8% from the prior year quarter.

The per store inventory decrease is the result of specific inventory management initiatives put in place in fiscal 2009.

The $12.2 million increase in inventory was due to 50 new stores opened over the last 12 months.

We remain comfortable with both the level and composition of our inventories as we enter the third quarter.

Regarding debt, during the quarter we were able to pay down roughly $35 million on our credit facility balance.

This was driven by our focus on aggressively managing working capital levels, specifically in inventory and receivables and lower capital expenditures on fewer planned new stores.

Outstanding borrowings as of August 1st, 2009, were $65.5 million.

And our debt-to-equity ratio was a very modest 0.2 times.

As of quarter end, we had $120.8 million of availability on our credit facility.

As a reminder, our credit facility provides borrowing capacity of up to $200 million.

We achieved free cash flow of $34.5 million for the quarter, and $40.1 million for the six month period, and based on our progress and the aforementioned initiatives, we now expect to generate approximately $50 million of free cash flow this year.

Capital expenditures for the quarter were $17.5 million, and depreciation and amortization for the quarter was $16 million.

Regarding our outlook, we are pleased to see a continuation of the signs of stabilization in our comp store sales.

We have also experienced a slight improvement in our comp store sales trends quarter-to-quarter, driven entirely by our retail business.

Having said that, consumers remain cautious and there continues to be limited visibility into future consumer spending trends.

For the third quarter of fiscal 2009, we currently estimate net sales in the range of 270 to $278 million, compared to actual third quarter net sales of $254.8 million in fiscal 2008.

This assumes comparable store sales decrease 1 to 4%, compared to an increase of 2% in the third quarter of last year.

As previously noted, we've seen a stabilization and slight improvement in our sales trends, driven by the impact of our marketing strategies and new brand introductions.

The wider comp sales range continues to reflect the uncertainty regarding any potential unexpected impacts to current consumer trends.

Income per diluted share for the third quarter of fiscal 2009 is estimated to be in the range of $0.08 to $0.11.

This compares to income per diluted share of $0.09 for the third quarter last year.

Our third quarter EPS guidance at the midpoint of our range reflects a gross margin decline of approximately 20 to 30 basis points, and deleverage in SG&A of approximately 70 to 80 basis points.

This SG&A deleverage is driven by 100 basis point increase in bonus compensation expense, versus the third quarter of 2008.

With regard to our new stores, we continue to plan to open approximately 35 new stores in 2009.

As we look forward, we are seeing real estate opportunities in existing centers as new center development has slowed, and continue to be opportunistic with regard to new site selection.

As we said on our last call, we believe there is an opportunity to accelerate our square footage growth in 2010, depending on the availability of quality sites that meet our investment model.

With the strength of our balance sheet, we remain well positioned to capitalize on these opportunities and our fiscal 2010 program.

We also remain confident in our ability to attain 1,000 store long-term potential.

With respect to capital expenditures, we continue to expect capital expenditures to be in the range of 72 to $74 million.

Now in closing, we continue to believe the consumer spending environment will remain difficult and uncertain.

We have and will continue to take the necessary actions to control what we can control.

We will continue to manage the business to drive earnings and generate free cash flow and reinforce our already strong balance sheet and liquidity position.

And now I'd like to turn the call back over to Lyn.

In summary, we are pleased with our second quarter results.

Although we still believe that in a better economy our results would be stronger, we are optimistic regarding our opportunities to drive market share gains, solid profitability, and free cash flow during the second half of 2009.

Longer term, we expect the strategies and programs we are implementing this year, as well as the significant opportunities we see for expansion in our store base and brands to enable us to increase our long-term profitability.

We continue to believe we are doing well navigating this difficult economy while simultaneously positioning our Company for stronger performance when the economy improves.

And now I'd like to turn the call back over to the operator to begin the question-and-answer portion of the call.

Thank you.

We will now be conducting a question-and-answer session.

(Operator Instructions).

One moment, please, while we poll for questions.

The first questions is from Brian Tunick with JPMorgan.

Please go ahead with your question.

Hi.

Thanks.

Good afternoon and congrats.

Hey, Brian.

Hey, Gregg.

So I guess a question for each of you.

Maybe Lyn, maybe talk about -- I know fragrance was a weak category last holiday.

Can you talk about are there any big fragrance launches that you see happening in Q4 this year and have you changed your marketing or gift with purchase plans, given what you think or see the department stores starting to do?

And then maybe Gregg, if you can talk about the number of leases you've already signed for next year and what are the lead times to be able to sign and open a store so we can just get some idea if 45 or 55 or 60 could be the number of new stores next year.

Thank you.

Hey, Brian.

It's Lyn.

Let me take the first part first.

As it relates to the fragrance business, we do have some exciting new fragrances for fourth quarter.

We expect to be anniversarying the newness from last year as well as the continued flow-through of some really exciting fragrances from third quarter this year going into fourth quarter.

So we feel great about the newness availability, and on the gift with purchase strategy, we continue to see traction with that strategy for our customers.

We continue to develop fresh, new, exciting gifts with purchases, to continue to stay motivational to our customer base, and have appropriately planned that in our fourth quarter.

And Brian, on real estate, we continue to see lots of opportunities.

They keep coming to us as we continue to diligently review those through the process and as you would expect, we're being certainly much more careful as we go through and evaluate each one of these.

As we typically think of it in terms of the number of deals that we have approved at this point in time, we have about 26 deals approved at this point in time.

We have a significant number that we are going through as we speak.

And we also have a meaningful number that the deal makers are continuing to work on to get them ready to present to us.

As far as the lead time goes, we usually have until early part of next year to get something finished and documented to still get it open in 2010.

And if I could just ask, Lyn, do you see the department stores being at all any more rational as we've come into the back half?

When you say rational, are we talking about the beauty business?

The apparel business?

Just what aspect are we talking about?

More about the beauty and fragrance business.

We have -- as you may recall, we did see some discounting in the fourth quarter around the holiday season last year from department stores, first time we had ever seen that, as well as the specialty competitors.

We continue to see that run through first quarter, but it has absolutely diminished in second quarter.

So if that -- I'm not sure if that's your definition of rationality but we have certainly seen less of that straight across the board discounting, Brian.

Thank you very much and good luck.

Thank you.

(Operator Instructions).

Please limit your questions to one and one follow-up.

The next question is from Tamminga Neely with Piper Jaffray.

Please go ahead.

Neely Tamminga.

Hey, Neely.

Hey.

At least you said it right.

Just in the wrong order.

Okay.

So just two questions, actually one real question and then a housekeeping one.

The boutique, in store boutique strategy I think is a big picture longer term strategy for Ulta, if you go way back to the road show from the IPO to where you guys are today to where you'll be in the next couple years, it's not just the stores that you're growing, it's the productivity improvement within those stores.

Could we take a moment to kind of review where you guys are this year versus maybe last year in terms of how you look at the store base, ranging from the one, maybe brand in store boutique to the in some cases up to four in store brand boutiques, how you're sizing up the store base that way and then maybe next year, if you're willing, what that might look like and to the CapEx plan, et cetera for next year.

And then if I could get it up front, just the housekeeping question, Gregg, just so I understand, your bonus accrual practices that you were indicating for Q3, was that for just Q3's performance or is that actually the full back half?

Thanks.

Do you want to take the second one?

I'll take the second one first, Neely.

As you remember last year, this is the point in time where the economy really fell apart, the consumer went into paralysis and at that particular point in time, we would have adjusted our bonus expense last year, reflecting where we thought we would have finished the year.

It covers the full back half?

Yes.

Okay.

Thank you.

And then Neely, on the boutiques, middle of the year last year we had about 130 doors with boutiques and at the same time this year, we've got about 190 or so doors with one boutique.

And we've got roughly about 80 stores with two boutiques and that of course is primarily the combination of Benefit and Bare, by and large.

We've got a very small handful of stores, some of our largest stores, maybe roughly around 10 or so with multiple boutiques.

So with three or four boutiques.

As we look forward to next year, we certainly will continue to roll Benefit across the majority of our chain, with that boutique strategy.

And depending on the availability of other prestige brands, we certainly have a game plan developed on how we would do multiple boutiques and more stores, if that opportunity was available to us.

The next question is from Liz Dunn with Thomas Weisel Partners.

Please go ahead with your question.

Hi.

Good afternoon.

Congratulations on a great quarter.

Thanks, Liz.

I was wondering if you could update us on competition.

We've seen from some of the drugstore channels, just from the drugstore competitors, excuse me, some real interest in prestige as a category.

How are you thinking about those?

And also competition from Sephora inside JCPenney.

In terms of the drugstores, let me just go to the heart of the drugstore competition right now which is on the mass business.

We continue to see ourselves remaining extremely competitive on the mass business, and we are watching with interest in tests that Walgreens has been particularly public on as they reduce selection in their drugstores.

At the very heart of our competition there we continue to watch that very closely.

As it relates to a couple of tests that are going on, in terms of expansion into prestige from the drugstores, we are going to watch it very closely, as I'm sure you are.

It's at a very modest number at this point.

Extremely modest.

And I am not seeing too much indication that it's going to be a rapid expansion.

As I take a look at the brand expansion that the drugstores have in those test stores, it is more of what I would call specialty brand selection and not at all department store brands at this point.

So again, we will of course watch that really closely.

But are not seeing it as a significant threat at this point in time, given the magnitude of what that test is.

Sephora inside of JCPenney's we of course watch very closely and continue to keep our eye on that as you would know, if you've done -- as I'm sure you have, your store checks, the selection of brand availability of brands inside the Sephoras inside of JCPenney's is not consistent with what they have in their free-standing stores.

We certainly watch it.

We are obviously very familiar with JCPenney's real estate expansion strategy so that one we watch extremely closely.

So right now it is a different brand selection in those stores.

The next question is from Erika Maschmeyer with Robert W.

Baird.

Please go ahead with your question.

I was wondering if you could comment on comp trends quarter to date, and then also maybe comment on whether you're still seeing prestige brands comping above the Company average?

Erika, in terms of the prestige brands, prestige as I think we have mentioned before absolutely remains one of our highest growth categories, and continues to remain that, both as we expand brand selection as well as penetration with the customer base, so that does remain an above average trend for us.

In terms of the quarter to date trend, we are not going to speak to quarter to date, but are certainly happy with our business quarter to date, but we really feel that it is appropriate for us to pull back from offering quarter to date trends on these calls.

What I would suggest is what's very indicative of how we feel our business is, is to take a look at the guidance ranges that Gregg gave and they certainly indicate a positive shift in the comp numbers versus the prior quarter's guidance and that is the best indication of how we feel about the business quarter to date.

Gregg, would you have anything -- ?

If you look back over the last couple of quarters, we tried to provide that information to give folks further insights into the trends.

We've seen two quarters of consistent trends.

We've seen stabilization in our business and we've seen some slight quarter-to-quarter improvement and that's reflected in the comp guidance we provided for the third quarter.

That is fair enough.

And then if you could just comment on your private brands, that sounded optimistic on them and sounds like you're adding an additional categories.

Are you increasing penetration there?

Is that still around 5% of your revenue?

Right now the 5% is a good number to be using.

It continues to be a strategy for us longer term to continue to add to that and you can hear some of the additions that we have been making, but given the growth factor of some of the other big categories in the business, the penetration is harder to shift than the actual growth rate so you know that math.

But the -- private label in the short term for us continues to be a great lever for us to pull to be driving profitable traffic to our store.

It is part of our ongoing strategy to use that category, to drive both traffic and unit penetration on the business.

The next question is from Sam Panella with Raymond James.

Please go ahead.

Okay.

Good afternoon.

I'll add my congratulations as well.

Just to follow up on the comp guidance, looking at even the high end of our guidance, it does appear that the two year trend would worsen from the second quarter.

Any reason to think that, other than conservatism, being conservative?

What I would say, Sam, is we continue to evaluate the trends on our business.

I think in this particular environment, particularly given what we're cycling that started the volatility from last year, we believe it's more relevant to look at the current year trends.

And to the stabilization that we've experienced there.

We recognize we're juggling over slightly lower comps than last year but the comp guidance is reflective of what the current trends are, which I think is more relevant to look at as we go throughout the course of this year, up until the fourth quarter.

Okay.

And then with respect to the temporary rent relief, how many stores did you receive that and how long should that last?

It's about a dozen.

And a lot of those, about half of those have been cured or about to be cured, so it will have a small impact on the third quarter.

Okay.

Great.

Thank you and good luck.

Thanks, Sam.

The next question is from Daniel Hofkin with William Blair.

Please go ahead with your question.

Good afternoon.

Great job on the quarter.

A question about the launch of Benefit, obviously that looks to have been very successful so far.

Just curious if you could maybe help quantify a little bit what type of a lift do you think you saw?

I think that came out around mid-quarter, as I recall, or at least it started to, just curious what sort of a lift you might have seen.

And I know you guys did not do incremental marketing year to year.

And then I guess the second question would be looking at the free cash flow performance in the second quarter or in your new full year expectation, what's the main one or two sources of upside there?

Thank you.

Dan, I'll take the first part.

We're not going to comment on individual brand in terms of numbers or specific growth rates, but we are certainly pleased with the Benefit launch so let me say that first of all.

But secondly, I would remind you that we also continue to see really good strength in the current existing business.

So in the quarter, we did for example have a back-to-school liter event around our professional hair care lines.

We had a very exciting private label event which was a buy two, get two free, which led into some other brands, and we have some of our existing brands like Bare Essentials where we offered a $15 Discovery Kit.

So we are pleased with Benefit but there is much more to our business than just an individual brand and new products.

One of the great strengths we have as a business is multiple levers to pull, depending on the trends of the business, the environment we see and it is one of our core competitive advantages.

And Dan, on the improvement in free cash flow, I think as we've mentioned the last couple of calls, we had a number of initiatives that we've been working on that haven't materialized in priority order versus our last guidance on free cash flow, the drivers are really improvement in net inventory.

You've seen it, we've moved up -- or moved down in this particular case our improvement versus last year on a per store basis from five to seven to nine.

We've also seen some benefits in net inventory, over and above that gross reduction.

Tax planning is another key driver that's going to benefit us both -- it did in the second quarter and the rest of the year.

Earnings improvement versus our prior expectations as we've experienced in the second quarter and are now guiding to in the third quarter and the last is really just fundamental working capital management and accounts receivable.

Those are the four drivers.

The next question is from Jill Caruthers with Johnson Rice.

Please state your question.

Yes.

Could you talk about the for the third quarter, you're looking for gross margin pressure of 20 to 30 basis points, if you could talk about what's driving that given you're not expecting as much rent relief and whatnot.

If you look at it versus the second quarter and we've talked about this before, part of the pressure we get on gross margin is the deleverage from our new store program and the fixed store expenses.

As we have slowed down our square footage growth this year, we're starting to diminish that amount.

So in the third quarter, I'm expecting about 100 basis points of deleverage.

We expect to see about 50 basis points of benefit from our supply chain initiatives.

And then the rest of it is improvement in merchandise margin.

Okay.

And if you could talk a little bit about inventory per store was down more than expected.

You lowered also year-end targets.

You quoted specific initiatives in place.

Could you add a little bit more detail around that?

Yes.

A couple of things that we've been focused on, and this isn't necessarily in priority order, but as we expanded our distribution network over a year ago now, we knew that there was a greater opportunity to take the safety stock levels down and move inventory through our DCs faster.

Along with our supply chain efficiency progress, we've made a lot more progress on managing distribution center inventory levels.

Okay?

So not in front of the customer.

We're very comfortable with the safety stock and the lead times and the team continues to fine-tune those to get some working capital benefit out of the Company.

The other benefit is really as we continue to fine-tune the inventory levels that we've put into our newer stores from a depth of -- not from a depth of assortment but from a safety stock level, the assortment is the same, but we fine-tuned the amount of inventory or depth per SKU that we put in versus a mature store and we're continuing to make better progress on that initiative versus what we expected.

So no impact on consumer experience and in fact slight benefit to in stock levels because we can move inventory through our DCs faster.

(Operator Instructions.) The next question is from Henry Cappellin with Oppenheimer.

Please go ahead with your question.

Hi, good afternoon, guys.

Just had a question about the sequential improvement in same store sales.

Wanted to know if that was also occurring in the salon business or was that -- or is that disproportionately weaker than the rest of the sequential improvement in same store sales?

Hey, Henry.

The answer is that the improvement was entirely from the retail business, from first quarter to second quarter and by and large the salon business has basically remained stable in its negative trend.

Okay.

Okay.

Great.

And then in terms of the average ticket decline, you said that that was 3.9% in the quarter.

Wanted to know if you could just talk about consumer tradedown.

I think previously you highlighted mineral based cosmetics as a particular category.

Wanted to see if that was still the case.

Yes, that continues to be one of the factors that we see in terms of the average ticket decline.

The other factors are also the fragrance category.

Still remains the most discretionary category and, therefore, our sales are still lower than prior year, although we are significantly out-pacing the industry and taking market share in that category.

And the other category that has certainly been hurt by this economy is our high priced styling tools, products.

Products that are north of $100 in terms of their price.

So that continues to run through the average ticket.

The next question is from Anthony Lebiedzinski from Sidoti & Company.

Please state your question.

Good afternoon.

I was wondering if you can talk about the expense savings that you're now guiding to, $18 million versus $15 million.

Where is the additional $3 million coming from?

I did have one other question as well.

Two-thirds of the improvement is coming out of our supply chain, Anthony, and the rest is coming out of our core store expense management strategies.

Okay.

And as far as the real estate is concerned over here, could you just talk about sort of for next year the openings that you're looking to do?

Are they mostly back-fills or new markets and also has there been any change to the length of your lease terms?

In terms of the first part of your question, there's very little change in the composition of the real estate program that we are expecting.

The new existing market ratio is about the same, although you may have heard us say before, we've had a very slight uptick in the number of stores that we are opening in single store markets.

So there's very modest uptick.

And we have had a modest uptick certainly in the last six months between new and existing centers and we have seen a little bit of an uptick in existing centers since the impact of the economy but not a significant uptick from first quarter to second quarter.

And Anthony, as we head into next year, as we've talked about, the opportunity really is in existing centers.

Because by the time we get to next year, any of the pipeline that was already built for new centers will have been opened so we don't expect a big mix of our portfolio, unlike the balance in past years, to be in new centers.

And as it relates to the lease term, we still continue to have a similar structure to what we've done in the past.

We typically do a 10 year initial lease term and multiples of two or three five year options that are our options for extension.

Okay.

Thank you.

There are no further questions in queue.

I would like to turn the call back over to Lyn Kirby for closing remarks.

Thanks, again, for joining us today.

We look forward to speaking with you on our third quarter call in December.

This concludes the teleconference.

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Thank you for your participation.