Greetings, and welcome to the Ulta Beauty Third Quarter 2013 Earnings Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Ms. Laurel Lefebvre, Vice President of Investor Relations. Thank you. You may begin.

Thank you. Good afternoon, and thank you for joining us for Ulta Beauty's Third Quarter 2013 Conference Call. Hosting our call are Mary Dillon, Chief Executive Officer; and Scott Settersten, Chief Financial Officer. Also joining us are Janet Taake, Senior Vice President of Merchandising; and Jeff Severts, Senior Vice President of Marketing. Before we begin, I'd like to remind you of the company's Safe Harbor language. The statements contained in this conference call, which are not historical facts, may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual future results may differ materially from those projected in such statements due to a number of risks and uncertainties, all of which are described in the company's filings with the SEC. We 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. I'll now turn the call over to Mary.

Thank you, Laurel, and good afternoon, everyone. I'm pleased to report solid top line performance in the third quarter and, in particular, rapid growth in our e-commerce business despite a tougher-than-expected sales environment. After seeing good momentum in the second quarter and early in the third quarter, our sales trends in retail customer transactions softened somewhat in late September and October. We adjusted our promotional strategy to drive transactions and deliver healthy top line growth but gave up a bit of margin in the process. We nonetheless delivered solid earnings growth in line with sales growth, excluding severance charges, and made good progress in each of our key strategies. To recap the headlines, we grew sales 22.4% and delivered a 6.8% total company comp, following an 8.9% comp in the third quarter of 2012, both including the impact of online sales growth. E-commerce built on a strong momentum with 74% growth, contributing 170 basis points to the comp. Prestige Cosmetics and skincare continue to be the strongest categories while we experienced some softness in the nail and fragrance categories, consistent with industry-wide trends. Our comp was driven entirely by ticket, evenly split between units per transaction and average selling price, while transactions were slightly negative. Part of this transaction decline was driven by this year's strategy of reducing and better targeting our coupons and price promotions intended to reduce reliance on such discounts over time. We also believe we experienced a wider weakness in traffic that many retailers felt in the third quarter. In light of this change in trend, we elected late in the quarter to increase our promotions in order to protect our market share gains in an incrementally tougher retail landscape. GAAP earnings per share were $0.70, up 18%. Earnings per share, excluding severance charges and retention…

Thanks, Mary. Good afternoon, everyone. We recorded total sales of $618.8 million compared to $505.6 million last year, an increase of 22.4%, with a comp store sales increase of 6.8%. The retail comp was 5.1%, and e-commerce growth of 74% added 170 basis points to the comp. Gross profit dollars increased 24.9% to $231.7 million, and gross profit margin rose 70 basis points to 37.4% from 36.7% in Q3 of last year, driven by strength in our prestige categories and better-than-expected leverage of fixed costs. While strong, this margin expansion was a bit less than our guidance due to an uptick in promotional activity later in the quarter to drive sales amid weaker-than-expected consumer traffic. SG&A expenses, excluding the impact of the severance charges Mary mentioned, rose 26.7% to $149.5 million, up 90 basis points as a percentage of sales to 24.2%. This was driven by the planned investments on our new website, supply chain project, store labor and brand awareness that we've discussed previously, in line with our expectations. Preopening expense increased to $7.5 million compared to $6.3 million last year, driven by 55 store openings during the quarter compared to 49 new stores opened during Q3 of last year. Operating margin, including the severance charges, decreased 30 basis points to 11.8% versus 12.1% last year. Net income increased 19.1% to $45.4 million, or $0.70 per diluted share, versus $38.2 million, or $0.59 per diluted share, last year. Excluding the severance charges, EPS was $0.72, or 22% growth. Turning to the balance sheet. Inventories were $582.3 million at the end of the quarter compared to $462.8 million at the end of Q3 2012, up 1.7% on a per-store basis. This is consistent with our plan for the year where, after making permanent investments in inventory at the end of…

[Operator Instructions] Our first question is from Oliver Chen of Citigroup.

This is Nancy Hilliker filling in for Oliver Chen. I -- my first question is related really to the promotional strategy. Have you guys seen a difference in promotion, different ideas that you have been testing over the past quarter and the past month? And then is there any approach to maybe competitors offering prestige beauty online? Are you seeing any approach -- a different approach to strategy in terms of that as well?

Well, let me take a start at this, which is in terms of promotions, I would say that over the course of the year, we have been, I think, smartly experimenting with different ways to drive consumer retention and value with less discounting. So through the use of our CRM capabilities and some tweaks to some of our other tactics, we've been learning and experimenting with what our parameters are around how we can sort of drive long-term growth with little bit less reliance on promotion. And as we said, as we saw the environment start to change towards the end of the third quarter, the great thing is that we were able to nimbly, I would say, adjust and adapt to that because we have tools that we can turn very quickly. So we're going to continue to look for ways for the long haul. We can reduce some reliance on promotion and price discounts. But also, as we said in the call, we want to play to win, and we're going to continue to be aggressive in the fourth quarter, as we expect it to be very promotional.

And then any -- just as a follow-up, any thoughts as to the online competitors? Are there any other promotional strategies maybe that you can use to continue to gain market share?

Well, first of all, it's a -- there's a lot of activity in this category, that's for sure, and we are certainly aggressive. Our e-commerce performance in the quarter, we're very proud about that, and particularly the change for our new website, which is performing extremely well with even stronger conversion. So we're constantly watching the competitive environment certainly. And I don't think there's anything that we've seen that surprised us, but we know we should be in a stance to continue to be aggressive. And again, with our tools being more nimble and facile, and I think more consumer-friendly on our website, it gives us the opportunity to continue to play very strong.

The next question is from Brian Tunick of JPMorgan.

I guess just looking ahead for a second first, Scott, does it make sense, broadly speaking, that if you're guiding us for 15% square footage growth and for earnings growth next year to be similar to this year, that, that would embed a 50-, 60-basis-point operating margin expansion? And just wondering, if that's true, what buckets or what areas would be gross or SG&A that you would expect operating margin expansion? And then does your view that the earnings -- or your guidance is under a view going forward, does that take away the midteen operating margin that the previous management team had offered to the Street before, given how you guys are now looking at the business model with slowing category growth?

Thanks, Brian. I guess the first thing I would say is we're not giving any specific guidance for 2014 at this point in time. But being mindful of your question, I think directionally, we would think 2014 would shape up much in the way that 2013 did, with the emphasis and the strategy being on trying to lever back on the promotional environment overall and continuing to develop the guest experience in the store to drive the business, long-term profitable growth of the guest experience in our stores. So big picture, I would say it's more in the merchandise margin and gross profit line, directionally speaking, for 2014. Again, much like it was in 2013. As with respect to the midteens operating margin target, again, I would say that we're suspending that initially by what we're seeing here for the near term on 2014 and what we think the guidance targets are for 2014.

The next question is from Aram Rubinson of Wolfe Research.

You guys have a very high dollars per square foot level, around $415, and it seems like you are trying to figure out the balance between how much of that is kind of sticky customers and how much of that might be cherry pickers, because you're struggling maybe to balance the promotional cadence. If you were to kind of look at your customer base and say, hey, that $415, if we had kind of the right customers in the store for the brand, where do you think that sales per square foot number would actually be? I'm just trying to figure out how much of there might be at risk. And then if you can also just tell us how you're fiddling with the promotional cadence, just to kind of make sure that, that drop-off, if there is one, doesn't happen too quick?

Well, let me just start in a couple of ways. One is that we -- as we described in terms of the full year expectations, this is -- we are still performing at a strong level in terms of top line growth and really, one of the top in the industry. So we're not troubled by what we're seeing in terms of our customer trends. What we are doing is reacting to an environment that looks to be more promotional and also being mindful of future investments that we believe need to be made to continue to support our growing business. So our base of customers right now is strong. I mean, we've got a really strong loyalty membership group of customers who are very responsive, and we're learning as we're tweaking some of our tactics about how to really personalize and customize offers to them in a way that we believe will drive, as it is, more units per transaction. And that's a good thing. So the way that we're thinking about our promotional tactics right now, I would say, is really not dramatic. These are small changes around the edges to learn about the sensitivity, and we're doing them at the time that the marketplace is maybe a little bit volatile and consumer sentiment is a little bit unpredictable. The good news is that we can ratchet back, which is what we've done, to our more traditional cadence. But I believe we've got the best tools that we've ever had to continue to test and learn. And we know that there's a lot of guests who -- there's a lot for them to discover at Ulta and a lot of products that, when we bring it to their attention via some of our e-mails and Beauty Breaks! and whatnot, we're seeing great response. So we'll continue to play with that and drive our growth.

And just to follow up and recap this quarter, as far as I can tell, you did kind of hit your earnings target and you did hit your sales target, and you did have gross margins up with merchandise margins from the 10-Q saying that, that was kind of up 60 basis points. And your inventories weren't too out of whack. So I guess I'm just wondering as well, if you're doing any kind of bar setting as a new CEO coming in or -- because the numbers look good overall, at least for Ulta, to what you had issued in terms of guidance.

Well, that's an accurate reflection of our performance relative to guidance. And really, what we're doing today is just what we think is our best view of what to expect in the fourth quarter, given the environment as well as our preliminary view of 2014. Ulta is and will still continue to be a high-growth company, and the 2014 look that we're giving, which isn't guidance, but the early view, is still a very high-growth company. But it is different than what was stated before. I would say this isn't about bar setting, but it is about -- as Scott said and I said in my comments, this is also a great time for us just to take a step back and really create a 10-year view of Ulta. It's been a very successful company for many years, but like any business, the environment changes, whether it's the consumer environment, the categories we compete in, the competitive environment. So we really want to take a very thoughtful and deep view of our strategic planning. There's going to be plenty of choices we believe we have for future growth. We want to prioritize those and then come back with guidance based on that work.

The next question is from Gary Balter of Credit Suisse.

Mary, the tone that we're hearing is different than on your last quarter. So is it -- could you walk us through kind of -- in the last 3 months or maybe it's longer than that, what are the elements within the company that you felt aren't executing, that require the investments that you're talking about that kind of say, let's slow the growth, let's reinvest, let's pull out with a better company? Where is the focus right now for where you need to make those investments?

Well, I guess I would say a couple of things. One is we're also in an environment that's changing and fluid in the marketplace. So as we said in the third quarter, we did see a change in our trend towards the end of the quarter, and we're reacting to that. So I feel very optimistic and upbeat about our prospects. And again, we're going to come out of this year with a very top performance in terms of top and bottom line. But it's somewhat different than what we would have guided, even really just coming in -- out of the -- in the middle of the second quarter. So that's different, and that would give us a reason to say let's look at our preliminary view of 2014 and provide the best transparency to that, that we can. Beyond that, I feel very optimistic about our future growth prospects. I'd say the only thing that's different is, as I learned about our business, I continue to be very optimistic. But I think we're going to have to be choiceful in terms of how we pick our spots for future growth. There's investments that will continue to be required as we look at a competitive environment that's increasingly omni-channel. Consumer views are changing, categories are evolving. So it's really not anything more than -- regardless of how this quarter performed, we would have been doing the strategic planning, frankly, and really want to come out in the future with our best view of what that future growth looks like. And I continue -- we very much expect Ulta to continue to be a high-growth, high-performance company. That stance has not changed.

Okay. And just following up and then I'll get off, the -- you mentioned a few times, including in this answer, competitive environment is changing and got tougher. What -- could you be a little more specific on what's changed from expectations? Because everybody kind of expected a difficult Christmas period.

I was talking about [ph] more of a long term view which was that as we know that there's more people competing in beauty and really the need to be able to really operate in a very omni-channel environment, which is part of what our investment in our supply chain and ITs are going to allow us to do. In terms of the short term, I would just say, as we saw some impacts on our traffic -- I mean, our transactions, is that -- towards the end of the second quarter relative to our promotional changes, we felt that it's probably a little bit more promotionally sensitive than we might have thought going into the fourth quarter. But not dramatically so.

The next question is from Evren Kopelman of Wells Fargo.

I wanted to ask in terms of the slowdown you saw at the end of the quarter, is it primarily a nail and fragrance category issue that you mentioned? Or did you see a slowdown in the growth rates of even the outperforming categories like the prestige skincare fragrance and salon?

Yes. Hey, Evren, a couple of data points again for people who follow the industry fairly closely. If you look back over the last couple of years, so 8 to 10 quarters, you would notice that both prestige and mass color cosmetic categories were really at the high-water mark at the end of fiscal 2011. So both of those categories were just into the double-digit year-over-year growth rates at that point in time, and they've both been on a slow deceleration over the course of the last 2 years so that we ended our Q3 -- I think mass color year-over-year was flat, and prestige color was low to mid-single-digits. So we're bucking those headwinds as well overall in our box besides the category -- the nail and the fragrance deceleration that has been talked about in the open marketplace here for the last couple of quarters. So there's a number of headwinds that we have category-wise that, to this point in time, we've been able to mitigate fairly well, even with the pullback on some of the promotional things that we're doing for the business. So people are curious as to the timing of things. Coming out of Q2, we felt really good about where we were. Our plans were working, we felt comfortable with where we were through the guidance phase of the last quarter's call. And really, this transaction trend went south on us late September and really heavily into October. So we're taking a really close look at that both from an internal view on what did we do that could have changed the guest perception or shopping patterns, or was it more macro kinds of things that have kind of stacked on top of each other here over time. So again, we're deep into the investigation process on all of those things, and you can -- rest assured, we're working hard to try to find the answer.

Great. That makes sense. The other question is your younger stores typically comp stronger than your older ones as the younger ones mature. Have you seen any changes to that historical trend? Or can we expect that to continue?

No. The comp stack for the third quarter is pretty similar to what we had back in the first quarter so you can remember back, we did a 6.7% all-in comp in the first quarter. We're doing a 6.80% or so. By and large, the stores look the same. Still the stores from 0 to 5 years, that comp ramp looks exactly the same as what's reflected in our model. When you get beyond year 5, years 6 through 15 is roughly in the -- it's in the solid low-single digit range. And then when you get beyond the 15-year range, it's more or less a net 0. So consistent with what we would expect at this kind of comp level. So again, we feel -- we're pleased with the 2013 slate of new stores and no change in the ramps.

The next question is from Ike Boruchow with Sterne Agee.

I guess my question is the last time we heard from you, you were guiding a 5% to 7% comp for both Q3 and the year, which I think essentially implied a 5% to 7% comp for Q4. So to guide it now a 7% to 9% comp for Q4 with sales that are so far below the Street is just a little confusing. So I guess can you just help us understand the Q4 top line outlook and how does that compare to your view of what the Q4 sales number was going to be 3 months ago?

Yes. We tried to give you a realistic view of the business. Again, I mentioned in my prepared comments that there's 200 basis points in that 7% to 9%, Ike, that's really just a basic measurement, the arithmetic measure versus last year. So it's not really reflective of the core of the business. The core business is still operating at a 5% to 7%.

But when we think about the outlook for Q4 coming down, is that a function -- I mean, you said more promotional environment. So obviously, margins lower than you had planned. But are the sales -- the total sales dollars, are those also -- where you're putting them now, are they lower than where you thought 3 months ago? Or is that not -- is that somewhat unchanged?

They are somewhat lower. I mean, we did see a dropoff in retail sales late in the third quarter, which we mentioned here, driven by transaction deceleration. So we have taken down our internal view of what we expect retail sales to be in the fourth quarter. So yes, that has been taken down somewhat.

The next question is from Daniel Hofkin of William Blair.

Just to follow up on that question, I guess still not completely clear. Like, where -- if you have -- I totally get that last year's comparison was affected by Sandy. That ought to benefit your comp growth and your total sales growth, it would seem, this year. So we're just trying to understand what appears to be, and again, maybe it's just the calendar shift that you described, but what appears to be a mismatch between the comp that you're projecting and the total sales growth, which has a much smaller spread relative to the comp than we're used to seeing. That's the first question.

Dan, I don't think I really have anything more to share on that one other than the 200 -- we're calling it 200 basis points roughly of the year-over-year comparison. And we have taken down our retail estimates, our retail comp estimates for the fourth quarter that are really -- really, it's the competitive environment and the conservative view that we're taking on the fourth quarter and what the margin rate investment is going to be to maintain those sales levels.

So are you implying that you're expecting a moderation in new store performance or, let's say, non-comp store performance in the balance of the year that's maybe more significant?

No. I don't think so. I mean, our stores are continuing to perform at the levels that we expect them to. We may not see an overperformance kind of environment, like maybe that you've seen in the past or have been reflected in models just through the delivering of actual results. Historically, stores have -- our new store program has way overdelivered what our initial expectations were. So naturally, in an environment where comps are a bit more challenged, there's going to be some kind of headwinds on those new stores. I mean, they're not immune to what's going on with the macro consumer environment. So that might be a bit [indiscernible] if you're looking at it from a modeling perspective.

The next question is from Matthew Fassler of Goldman Sachs.

First question I would ask, you talked about severance and some changes that you're making in supply chain and HR. Could you give us any more details on the changes that you made there?

Yes, sure. That was related to 2 changes at the executive team level in terms of the HR and the supply chain functions and just my judgment about capabilities that we needed there for the future. So we've got a great strong team here, we made a couple of changes and we're moving forward.

So, Mary, did you replace the senior executives in those roles with internal people at this stage?

One was internal and one was external.

Okay. My second question relates to the real estate plans. So this year, obviously, you were in the -- you're going to end up in the low to mid-20s. You were pretty close to that last year. And I guess in '11 and prior to that, I guess you had peaked at 15%, but that was sort of coming out of a downturn. So I guess as I combine the move to 15% next year with your discussion of developing urban and smaller store prototypes, what's your sense of the blue sky footprint potential for the existing format as you have it? And would you say that's changed at all from perhaps what you guys have talked about prior to the time you came to the company?

No, Matt. Our view is on the 1,200-store potential for our 10,000 square foot box. Nothing's changed with respect to any of that. Again, what we're faced with here in the near term, we think, is just -- it's whatever, a pendulum swing that will come and it will go, and consumer and category itself will bounce back here. Again, over the long term, we feel really good about our model and about the category overall. As we look at next year, it's really a balance. I think we've said before that 125 stores this year was kind on the outer reaches of what we felt like we could do comfortably, both supporting it with operating disciplines and training and all the other things we have to do with our new store associates. As we look to next year, we want to do a few more remodels, so that's kind of -- again, those are more or less like a new store, so that kind adds in -- gets you to your total buildout. And then there's a few more things internally that we want to do, kind of in-store projects with planogram changes in the mass area and a few other things we want to do. So all in all, we feel really comfortable with where we are, and it's more of a balanced approach next year.

Got it. And one last quick one. So if you think about the promotional environment, I guess, last year in the fourth quarter, the gross margin had a bit of a setback. It almost seems like there are other seasonal entrants into the business or some of your competitors choose to turn up the juice at this time of year. It seems to be a recurring pattern. Is it the year-round players who you find aggravating the competitive backdrop? Or are there more seasonal players, be it general merchants or others, who tend to refocus on this around holiday, who seem to be gumming up the works a bit from a margin perspective?

Well, one thing I do want to point out is that in the fourth quarter, even though we're guiding gross profits flat year-over-year, we are expecting merchandise margin to expand by roughly 50 basis points. So our plan of trying to balance the promotional environment here whilst continuing to drive a great value orientation for our customer is still in place. What we've seen here develop recently -- again, everybody sees this in the news, right? Our mailboxes are full every night, our e-mail accounts are full. We see the fashion and soft good guys out there with 50% off the whole store on the first week in a holiday. I mean, that -- nobody really expected that. I mean, we knew it was going to be competitive, but we didn't know it was going to be to this extent. So looking at it again objectively, in a balanced way, we said we need to compete here to maintain our gains. But when I think back -- and this is one of the benefits, I guess, for being around for a while, right? Thinking back, analogizing back to really -- the last time we saw discussions about inventory levels with these soft good players and the need to get through this stuff before the end of the holiday season was back in 2008, and that was a tough environment for everyone. And we'll take the same view this year as we did then, a balanced view between investing margin and chasing the comp number. So we'll be very mindful of that.

Yes. I just want to add one thing, which is that up until a recent shift in trend, these tweaks to our promotional strategy were encouraging to us. So in no way, shape or form did we step back from that as a longer-term way for us to continue to drive top line and bottom line, because we know we're getting smarter, we can test and learn. And yet, if the environment changed, we can respond to it. But we're going to continue to drive that over the long haul.

The next question is from David Wu of Telsey Advisory Group.

First, in terms of next year's square footage guidance of 15% growth, which obviously -- that's at the low end of your long-term target range of 15% to 20%, and I understand that you're planning to do more remodels next year. But can you talk about whether -- or why you're not opening up more stores next year and if you're perhaps seeing any real estate limitations out there, and if you're still sort of sticking to your long-term 15% to 20% square footage growth target range?

Well, let me just start by saying that 125 stores this year, we've said, is probably about the peak in terms of really just executing with excellence. Every time we open up new stores, we do a great job identifying real estate and constructing those stores. We also have to hire folks and staff them and train them and have them ready for our guests. So we feel good about that number and really believe that, coming down off of that, is really just a way for next year to make sure that we're striking that right balance. We're not concerned about our ability to find the right real estate and to build those stores, and we're not concerned about the productivity of our store model. We just think this is a better pace for us right now.

Great. And can you talk more about your strategy for the brand boutiques, including your initial plans for next year and what the longer-term opportunity could be?

Well, as you know, we are really thrilled with the fact that our assortment continues to evolve. Our team here has done a great job partnering with really great vendors and iconic brands, and that's been part of the magic of Ulta, frankly. And it's great. So as I said in my prepared comments, we've gone to 100 Clinique store boutiques and 105 Lancôme boutiques this year, which is great. Benefit boutique doing exceptionally well, and we're going to continue to build out that strategy. So I can't tell you specifics today, but you can imagine that, that's high on our hit list of things to continue to build on.

Great. In terms of the higher promotions, are you expecting this to impact your non-prestige business? Or are you becoming more promotional also on the prestige side?

No. By and large, again, when we talk about promotions and discounting, that is non-prestige kind of business. So prestige product, that category, by and large, there is no discounting allowed. It's an SRP out the door.

Got it. So in terms of then the slower traffic and sales that you saw towards the tail end of September and into October, did that mainly impact then sort of the non-prestige side? Or did you also see a little bit of a pullback on prestige as well?

No. The promotions itself, it's generally non-prestige-related. Again, from time to time, prestige becomes part of the mix with some of the offers that we give our guests. But by and large, in the third quarter, it was non-prestige-related categories.

Where you saw the pullback?

Yes.

The next question is from Mark Altschwager of Robert W. Baird.

I wanted to touch a bit more on the supply chain side. Mary, I was hoping you could talk about your long-term vision there. You made some changes, so what is your assessment of the supply chain today? And where does it need to go in order to support the type of growth that Ulta is capable of?

Sure. Well, I -- we'll just answer that really at a macro level. But our supply chain today, I think, is performing very well for us, yet we know that we need to do more, especially because number one, we're a growing business. So we need more infrastructure to support our multi-year growth plans. We also know that we need to continually increase our ability to compete in an omni-channel way. So we're thrilled with our e-commerce performance, but we want to make sure that we have the capability at a minimum to be able to have our guests, for example, understand if they can order online and pick up in our stores. Whether or not we ship from stores is a different question, but we're really looking at the range of capabilities. And as I'm sure you imagine, that's not the -- you need to have the right systems in place to allow that kind of capability. And we also know that we have opportunities just in end-to-end efficiency in our supply chain. So we've taken some time to really build a robust view of that. We're -- the first stage of that is really building a new distribution center in 2015, which we're planning. But beyond that, there's also plans to invest in the right systems and in people and capability and capacity to support our long-term growth ambitions. We plan to get to 1,200 stores and continue to be a very high-growth retailer, so we need a supply chain that supports that.

Okay. And then on the services side, where do you see the biggest opportunities? And how do you think about allocating the space in the store? And then as the environment gets more competitive, how do services fit with the long-term vision of building brand awareness and customer engagement?

Right. I think it's a perfect example of -- we sit back and think about our 10-year view of Ulta and how we want to really differentiate Ulta. That's exactly the kind of question we're asking ourselves. Ultimately, we really have a differentiated proposition today because of the one-stop shop ability, the exciting assortment that we offer, but also the fact that you can get services in our stores, which I don't think anybody can get online yet and hopefully never. But anyway -- so we've got a really differentiated concept that we believe is going to really be the place that allows us to win for the long term. So we're going to examine what we think about trends, consumer trends, anti-aging -- an example might be skin health, right? So there's ways that we can think about. Is there more we can do there? But that's just one example. But we'll put all those under the, I guess, sort of the examination lens here as we think about places that we'll continue to invest to grow. So -- but for sure, services will continue to be part of our long-term proposition.

The next question is from Kayla Berg of Piper Jaffray.

First, if you would, could you share your thoughts about approaching holiday from a digital marketing perspective versus last year? And also, how do you guys feel positioned for holiday in fragrances here across the price points and newness?

Okay. Can I ask you guys to take those for us? Janet and Jeff, you want to take the marketing? We have our team here.

Sure. Well, Kayla, I would say that our digital marketing efforts will be pretty consistent with what you've seen from us for the balance of the year. So as we've talked through the first couple of quarters of the year, we're a lot more focused on the digital space than we have been traditionally, and you're just going to see that continue. Not going to give you much more detail than that because I'm sure the competition would love to hear it.

And in fragrance -- this is Janet. Basically, we have our exclusive gift with purchase that we started in November and continue through holiday, and that is exclusive to Ulta and something we have done for many, many years. And we're very excited. We've improved the quality of both of those. One has already been in the stores, and the second one hit this week actually. But we're also encouraged by some of the newness that we have seen at the end of third quarter. Just to comment on One Direction, out of the box was very strong, along with Honey from Mark Jacobs and a few other things. So gift sets are strong. And also, I think that we feel very good about some of the opening price points in purse sprays or roller balls, if you will. So from a fragrance perspective, we're ready for holiday.

Okay. And one last quick follow-up. Where do you guys expect to end the year in terms of inventory levels?

We expect to end the year in line -- similar to where we ended the third quarter. So it'll be well below what the comp increase is for the year. We feel very, very comfortable with our inventory position. Again, as many of you know, there's very little in the way of fashion risk in our inventory, so very low obsolescence risk. So again, very comfortable we're on plan and expecting to hit our targets at the end of the year.

The next question is from Krystyna Metcalf of Oppenheimer.

Most of my questions have already been asked, but I was just wondering if salon comps were still above product comps this quarter?

They were indeed. They were -- they added roughly...

10 basis points.

10 basis points to the comp for the quarter. So still performing very strong.

Great. And then I'm not sure if you answered this already, but I believe last quarter, you said that you were expecting e-commerce sales to go down just because of the new website rollout? And obviously, this quarter, they were pretty similar. So what are your expectations for 4Q?

Well, yes. We were very happy with that transition, and we were being cautious about that. So that's better than we expected. The first 3 quarters still, I would say, were benefiting from some pretty high-ticket products that we were selling that were hot products and -- I mean, supplements and some tools. We're excited about our continued growth, but the comps do get tougher going forward. So we're going to continue to grow. I'm not sure if we're citing a specific number, but it's -- we're going to continue to have tough comps, but we also feel more optimistic with the transition going better than it did, I might add.

And I would add, we picked up steam at the end of 2012 with our e-commerce site. They had a really good fourth quarter, so I wouldn't expect the 70% growth for the fourth quarter year-over-year.

We have time for one more question from Jill Nelson of Johnson Rice.

A quick one on fourth quarter gross margin. You did mention that merchandise margins are planned up. Could you talk about maybe the pressures in that line item you're expecting?

On the gross profit line?

Yes, because you had said, for overall, it'd be flat.

Right. So we are happily expecting to see merchandise margin expansion with product mix and the prestige mix being richer as part of the overall business. We do have headwinds with fixed store cost. That's really the primary offset there, Jill. So it's really the accelerated new store program, especially with 125 new stores now kind of entering into the chain here late in the third quarter. So that's the headwind that's offsetting the merchandise margin gains.

Okay. And then kind of big-picture question into 2014. Clearly, you need to put in more investments into the business. And could you maybe just talk about some of the big buckets? You've mentioned supply chain, but maybe if you could put them in order? Or just some type of magnitude of where you feel like the company has underinvested and what needs to help grow the business for -- into next year?

Yes. I wouldn't use the term underinvested, Jill. I mean, there is -- I think we've talked to many of you, at least I have, over the last year. Right? I mean, as a growing company, there's always things we'd like invest in, but you need to have the proper team in place and the proper third parties to help coach you along in some of these more complicated kinds of things. So I would just remind everyone, the biggest investment we're making is in the new store program. So big acceleration in 2012 and into 2013. And even next year, at 15%, 100 stores, do the arithmetic. That's no small feat for us. And that's still -- the best investment produces the best shareholder returns that we currently have. So in the current term though, that creates some headwinds for us on fixed store cost. Again, we don't get the leverage with all those stores going in place that we have in recent years, so that hurts us a bit. Some of the investments are more certain things. Mary talked about supply chain. We're going to get a lot of new capabilities there, which are going to be very helpful for us down the road. There's things in IT. Again, they're primarily customer-facing kinds of investments. So in-store POS systems that will allow us to do more mobile and all that kind of flashy iPad stuff, which everyone does now and we need to invest in as well. That's what the guests expects. There's other investments like brand awareness, marketing investments, training for store associates to make sure we give the right guest experience in places like skin category, which is high touch and high impact. So those things -- those are one of the things that we're talking about as part of the strategic planning process and how far do we need to go and to what extent do we need to do those kinds of things. So -- and then there are other things I'd call kind of compliance costs, non-investments, but will be a drag on earnings next year around health care. So some of that stuff is starting to kick in now. And I can tell you, generally speaking, it's more expensive than anybody really thought initially. So that's kind of the short bucket list for what we're looking at for 2014.

That is all the time we have for questions. I'd like to turn the floor back over to Ms. Dillon for any closing remarks.

In closing, I'd like to thank all of our Ulta Beauty associates who worked very hard to deliver solid results in a tough environment in the third quarter. I'm very proud of the team for driving strong store sales while delivering on elements of our longer-term initiatives to position the company for success over the long haul. While we're acknowledging some of the challenges we're facing in the near term, I know the long-term opportunities for Ulta still make it one of the most exciting growth stories in all of retail. Thank you for your interest in Ulta Beauty, and I look forward to speaking with you soon.

Thank you. Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time, and thank you for your participation.