filings.toolsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and related notes included elsewhere in this Annual Report on Form 10-K.
Overview
We were founded in 1990 as a beauty retailer at a time when prestige, mass and salon products were sold through distinct channels – department stores for prestige products, drug stores and mass merchandisers for mass products and salons and authorized retail outlets for professional hair care products. We developed a unique specialty retail concept that offers All Things Beauty, All in One PlaceTM, a compelling value proposition and a convenient and welcoming shopping environment. We believe our strategy provides us with the competitive advantages that have contributed to our financial performance.
We are currently the largest beauty retailer in the United States and the premier beauty destination for cosmetics, fragrance, skin care products, hair care products and salon services. We focus on providing affordable indulgence to our guests by combining unmatched product breadth, value and convenience with a distinctive specialty retail environment and experience. Key aspects of our business include: our ability to offer our guests a unique combination of more than 20,000 beauty products across the categories of prestige and mass cosmetics, fragrance, haircare, skincare, bath and body products and salon styling tools, as well as a full-service salon in every store featuring hair, skin and brow services; our focus on delivering a compelling value proposition to our guests across all of our product categories; and convenience, as our stores are predominantly located in convenient, high-traffic locations such as power centers.
The continued growth of our business and any future increases in net sales, net income and cash flows is dependent on our ability to execute our strategic imperatives: 1) acquire new guests and deepen loyalty with existing guests, 2) differentiate by delivering a distinctive and personalized guest experience across all channels, 3) offer relevant, innovative and often exclusive products that excite our guests, 4) deliver exceptional services in three core areas: hair, skin health and brows, 5) grow stores and e-commerce to reach and serve more guests, 6) invest in infrastructure to support our guest experience and growth, and capture scale efficiencies and 7) attract
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and retain talent that drives a winning culture. We believe that the expanding U.S. beauty products and salon services industry, the shift in distribution channel of prestige beauty products from department stores to specialty retail stores, coupled with Ulta Beauty’s competitive strengths, positions us to capture additional market share in the industry.
Comparable sales is a key metric that is monitored closely within the retail industry. Our comparable sales have fluctuated in the past and we expect them to continue to fluctuate in the future. A variety of factors affect our comparable sales, including general U.S. economic conditions, changes in merchandise strategy or mix and timing and effectiveness of our marketing activities, among others.
Over the long-term, our growth strategy is to increase total net sales through increases in our comparable sales, by opening new stores and by increasing sales in our e-commerce channel. Operating profit is expected to increase as a result of our ability to expand merchandise margin and leverage our fixed store costs with comparable sales increases and operating efficiencies offset by incremental investments in people, systems and supply chain required to support a 1,400 to 1,700 store chain with a successful e-commerce business and competitive omni-channel capabilities.
Basis of presentation
We have determined the operating segments on the same basis that we use to internally evaluate performance. We have combined our three operating segments: retail stores, salon services and e-commerce, into one reportable segment because they have a similar class of consumers, economic characteristics, nature of products and distribution methods.
Net sales include store and e-commerce merchandise sales as well as salon service revenue. We recognize merchandise revenue at the point of sale in our retail stores and e-commerce sales are recorded based on delivery of merchandise to the guest. Stores and e-commerce merchandise sales are recorded net of estimated returns. Salon service revenue is recognized at the time the service is provided. Gift card sales revenue is deferred until the guest redeems the gift card. Company coupons and other incentives are recorded as a reduction of net sales.
Comparable sales reflect sales for stores beginning on the first day of the 14th month of operation. Therefore, a store is included in our comparable store base on the first day of the period after one year of operations plus the initial one month grand opening period. Non-comparable store sales include sales from new stores that have not yet completed their 13th month of operation and stores that were closed for part or all of the period in either year as a result of remodel activity. Remodeled stores are included in comparable sales unless the store was closed for a portion of the current or prior period. Comparable sales include the Company’s e-commerce business. There may be variations in the way in which some of our competitors and other retailers calculate comparable or same store sales.
Measuring comparable sales allows us to evaluate the performance of our store base as well as several other aspects of our overall strategy. Several factors could positively or negatively impact our comparable sales results:
| • | the general national, regional and local economic conditions and corresponding impact on customer spending levels; |
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| • | the introduction of new products or brands; |
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| • | the location of new stores in existing store markets; |
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| • | competition; |
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| • | our ability to respond on a timely basis to changes in consumer preferences; |
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| • | the effectiveness of our various marketing activities; and |
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| • | the number of new stores opened and the impact on the average age of all of our comparable stores. |
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Cost of sales includes:
| • | the cost of merchandise sold (retail and e-commerce), including substantially all vendor allowances, which are treated as a reduction of merchandise costs; |
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| • | warehousing and distribution costs including labor and related benefits, freight, rent, depreciation and amortization, real estate taxes, utilities and insurance; |
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| • | shipping and handling costs; |
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| • | store occupancy costs including rent, depreciation and amortization, real estate taxes, utilities, repairs and maintenance, insurance, licenses and cleaning expenses; |
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| • | salon payroll and benefits; |
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| • | customer loyalty program expense; and |
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| • | shrink and inventory valuation reserves. |
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Our cost of sales may be negatively impacted as we open an increasing number of stores. Changes in our merchandise mix may also have an impact on cost of sales. This presentation of items included in cost of sales may not be comparable to the way in which our competitors or other retailers compute their cost of sales.
Selling, general and administrative expenses include:
| • | payroll, bonus and benefit costs for retail and corporate employees; |
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| • | advertising and marketing costs; |
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| • | credit card program incentives; |
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| • | occupancy costs related to our corporate office facilities; |
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| • | stock-based compensation expense; |
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| • | depreciation and amortization for all assets, except those related to our retail and warehouse operations, which are included in cost of sales; and |
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| • | legal, finance, information systems and other corporate overhead costs. |
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This presentation of items in selling, general and administrative expenses may not be comparable to the way in which our competitors or other retailers compute their selling, general and administrative expenses.
Pre-opening expenses include non-capital expenditures during the period prior to store opening for new, remodeled and relocated stores including rent during the construction period for new and relocated stores, store set-up labor, management and employee training and grand opening advertising.
Interest income, net includes both interest income and expense. Interest income represents interest from short-term investments with maturities of twelve months or less from the date of purchase. Interest expense includes interest costs and unused facility fees associated with our credit facility, which is structured as an asset-based lending instrument. Our credit facility interest is based on a variable interest rate structure which can result in increased cost in periods of rising interest rates.
Income tax expense reflects the federal statutory tax rate and the weighted average state statutory tax rate for the states in which we operate stores.
Results of operations
Our fiscal years are the 52 or 53 week periods ending on the Saturday closest to January 31. The Company’s fiscal years ended January 28, 2017, January 30, 2016 and January 31, 2015 were 52 week years and are hereafter referred to as fiscal 2016, fiscal 2015 and fiscal 2014.
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As of January 28, 2017, we operated 974 stores across 48 states and the District of Columbia. The following tables present the components of our consolidated results of operations for the periods indicated:
| Fiscal year ended | ||||||||||||
| (Dollars in thousands) | January 28, 2017 | January 30, 2016 | January 31, 2015 | |||||||||
| Net sales | $ | 4,854,737 | $ | 3,924,116 | $ | 3,241,369 | ||||||
| Cost of sales | 3,107,508 | 2,539,783 | 2,104,582 | |||||||||
| Gross profit | 1,747,229 | 1,384,333 | 1,136,787 | |||||||||
| Selling, general and administrative expenses | 1,073,834 | 863,354 | 712,006 | |||||||||
| Pre-opening expenses | 18,571 | 14,682 | 14,366 | |||||||||
| Operating income | 654,824 | 506,297 | 410,415 | |||||||||
| Interest income, net | (890 | ) | (1,143 | ) | (894 | ) | ||||||
| Income before income taxes | 655,714 | 507,440 | 411,309 | |||||||||
| Income tax expense | 245,954 | 187,432 | 154,174 | |||||||||
| Net income | $ | 409,760 | $ | 320,008 | $ | 257,135 | ||||||
| Other operating data: | ||||||||||||
| Number of stores end of period | 974 | 874 | 774 | |||||||||
| Comparable sales increase: | ||||||||||||
| Retail and salon comparable sales | 13.4 | % | 10.0 | % | 8.1 | % | ||||||
| E-commerce comparable sales | 56.2 | % | 47.5 | % | 56.4 | % | ||||||
| Total comparable sales increase | 15.8 | % | 11.8 | % | 9.9 | % |
| Fiscal year ended | ||||||||||||
| (Percentage of net sales) | January 28, 2017 | January 30, 2016 | January 31, 2015 | |||||||||
| Net sales | 100.0 | % | 100.0 | % | 100.0 | % | ||||||
| Cost of sales | 64.0 | % | 64.7 | % | 64.9 | % | ||||||
| Gross profit | 36.0 | % | 35.3 | % | 35.1 | % | ||||||
| Selling, general and administrative expenses | 22.1 | % | 22.0 | % | 22.0 | % | ||||||
| Pre-opening expenses | 0.4 | % | 0.4 | % | 0.4 | % | ||||||
| Operating income | 13.5 | % | 12.9 | % | 12.7 | % | ||||||
| Interest income, net | 0.0 | % | 0.0 | % | 0.0 | % | ||||||
| Income before income taxes | 13.5 | % | 12.9 | % | 12.7 | % | ||||||
| Income tax expense | 5.1 | % | 4.8 | % | 4.8 | % | ||||||
| Net income | 8.4 | % | 8.2 | % | 7.9 | % | ||||||
Fiscal year 2016 versus fiscal year 2015
Net sales
Net sales increased $930.6 million, or 23.7%, to $4,854.7 million in fiscal 2016 compared to $3,924.1 million in fiscal 2015. Salon service sales increased $31.9 million, or 15.2% to $241.1 million compared to $209.2 million in fiscal 2015. E-commerce sales increased $124.2 million, or 56.2%, to $345.3 million compared to $221.1 million in fiscal 2015. The net sales increases are due to the opening of 100 net new stores in 2016 and a 15.8% increase in comparable sales. Non-comparable stores, which include stores opened in fiscal 2016 as well
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as stores opened in fiscal 2015, which have not yet turned comparable, contributed $320.9 million of the net sales increase, while comparable stores contributed $609.8 million of the total net sales increase.
The 15.8% comparable sales increase consisted of a 13.4% increase at the Company’s retail and salon stores and a 56.2% increase in the Company’s e-commerce business. The inclusion of the e-commerce business resulted in an increase of approximately 240 basis points to the Company’s consolidated same store sales calculation for fiscal 2016 compared to 180 basis points for fiscal 2015. The total comparable sales increase included a 5.1% increase in average ticket and a 10.7% increase in transactions. We attribute the increase in comparable sales to our successful marketing and merchandising strategies.
Gross profit
Gross profit increased $362.9 million, or 26.2%, to $1,747.2 million in fiscal 2016, compared to $1,384.3 million, in fiscal 2015. Gross profit as a percentage of net sales increased 70 basis points to 36.0% in fiscal 2016 compared to 35.3% in fiscal 2015. The increase in gross profit margin was primarily due to:
| • | 30 basis points improvement in merchandise margins driven by our marketing and merchandising strategies, including a reduction in year-over-year promotional levels; |
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| • | 70 basis points of leverage in fixed store costs attributed to the impact of higher sales volume, partly offset by; |
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| • | 30 basis points of planned deleverage related to supply chain investments. |
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Selling, general and administrative expenses
Selling, general and administrative (SG&A) expenses increased $210.5 million, or 24.4%, to $1,073.8 million in fiscal 2016 compared to $863.4 million in fiscal 2015. As a percentage of net sales, SG&A expense increased 10 basis points to 22.1% in fiscal 2016 compared to 22.0% in fiscal 2015. The deleverage in SG&A was primarily due to:
| • | 30 basis points deleverage primarily due to investments in store labor to support our growth initiatives; |
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| • | 20 basis points deleverage in corporate overhead due to higher variable compensation, depreciation expense and impairment charges related to the closure of stores in Chicago, Illinois and Denham Springs, Louisiana, partly offset by; |
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| • | 40 basis points of leverage in marketing expense attributed to strong sales growth. |
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Pre-opening expenses
Pre-opening expenses increased $3.9 million, or 26.5%, to $18.6 million in fiscal 2016 compared to $14.7 million in fiscal 2015. During fiscal 2016, we opened 104 new stores, remodeled 12 stores and relocated two stores. During fiscal 2015, we opened 103 new stores, remodeled four stores and relocated five stores.
Interest income, net
Interest income, net was $0.9 million in fiscal 2016, compared to $1.1 million in fiscal 2015. Interest income results from short-term investments with maturities of twelve months or less from the date of purchase. Interest expense represents various fees related to the credit facility. We did not utilize our credit facility during fiscal 2016 or 2015.
Income tax expense
Income tax expense of $246.0 million in fiscal 2016 represents an effective tax rate of 37.5%, compared to fiscal 2015 tax expense of $187.4 million and an effective tax rate of 36.9%. The fiscal 2015 tax rate included benefits from lower state taxes that did not recur in fiscal 2016.
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Net income
Net income increased $89.8 million, or 28.0%, to $409.8 million in fiscal 2016 compared to $320.0 million in fiscal 2015. The increase in net income was primarily due to an increase in gross profit of $362.9 million, which was offset by a $210.5 million increase in SG&A expenses and a $58.5 million increase in income tax expense.
Fiscal year 2015 versus fiscal year 2014
Net sales
Net sales increased $682.7 million, or 21.1%, to $3,924.1 million in fiscal 2015 compared to $3,241.4 million in fiscal 2014. Salon service sales increased $33.7 million, or 19.2% to $209.2 million compared to $175.5 million in fiscal 2014. E-commerce sales increased $71.2 million, or 47.5%, to $221.1 million compared to $149.9 million in fiscal 2014. The net sales increases are due to the opening of 100 net new stores in 2015 and an 11.8% increase in comparable sales. Non-comparable stores, which include stores opened in fiscal 2015 as well as stores opened in fiscal 2014, which have not yet turned comparable, contributed $306.5 million of the net sales increase, while comparable stores contributed $376.2 million of the total net sales increase.
The 11.8% comparable sales increase consisted of a 10.0% increase at the Company’s retail and salon stores and a 47.5% increase in the Company’s e-commerce business. The inclusion of the e-commerce business resulted in an increase of approximately 180 basis points to the Company’s consolidated same store sales calculation for fiscal 2015 and 2014. The total comparable sales increase included a 3.4% increase in average ticket and an 8.4% increase in transactions. We attribute the increase in comparable sales to our successful marketing and merchandising strategies.
Gross profit
Gross profit increased $247.5 million, or 21.8%, to $1,384.3 million in fiscal 2015, compared to $1,136.8 million, in fiscal 2014. Gross profit as a percentage of net sales increased 20 basis points to 35.3% in fiscal 2015 compared to 35.1% in fiscal 2014. The increase in gross profit margin was primarily due:
| • | 20 basis points improvement in merchandise margins driven by our marketing and merchandising strategies, including improvement in e-commerce profit contribution; |
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| • | 30 basis points of leverage in fixed store costs attributed to the impact of higher sales volume, offset by; |
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| • | 30 basis points of supply chain deleverage related to the addition of our new Greenwood, Indiana distribution center. |
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Selling, general and administrative expenses
SG&A expenses increased $151.3 million, or 21.3%, to $863.4 million in fiscal 2015 compared to $712.0 million in fiscal 2014. As a percentage of net sales, SG&A expense was 22.0% in fiscal 2015 and fiscal 2014. Compared to fiscal 2014’s SG&A expense, fiscal 2015 had 10 basis points of leverage in marketing expense attributed to strong sales growth, offset by 10 basis points of deleverage in corporate overhead expense primarily driven by higher consulting expense.
Pre-opening expenses
Pre-opening expenses increased $0.3 million, or 2.2%, to $14.7 million in fiscal 2015 compared to $14.4 million in fiscal 2014. During fiscal 2015, we opened 103 new stores, remodeled four stores and relocated five stores. During fiscal 2014, we opened 100 new stores and remodeled nine stores and relocated two stores.
Interest income, net
Interest income, net was $1.1 million in fiscal 2015, compared to $0.9 million in fiscal 2014. Interest income results from short-term investments with maturities of twelve months or less from the date of purchase. Interest expense represents various fees related to the credit facility. We did not utilize our credit facility during fiscal 2015 or 2014.
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Income tax expense
Income tax expense of $187.4 million in fiscal 2015 represents an effective tax rate of 36.9%, compared to fiscal 2014 tax expense of $154.2 million and an effective tax rate of 37.5%. The lower tax rate in fiscal 2015 is primarily due to a decrease in state taxes and increase in federal income tax credits compared to fiscal 2014.
Net income
Net income increased $62.9 million, or 24.5%, to $320.0 million in fiscal 2015 compared to $257.1 million in fiscal 2014. The increase in net income was primarily due to an increase in gross profit of $247.5 million, which was offset by a $151.3 million increase in SG&A expenses and a $33.3 million increase in income tax expense.
Liquidity and capital resources
Our primary cash needs are for capital expenditures for new, relocated and remodeled stores, increased merchandise inventories related to store expansion and new brand additions, in-store boutiques (sets of custom designed fixtures configured to prominently display certain prestige brands within our stores), supply chain improvements, share repurchases and for continued improvement in our information technology systems.
Our primary sources of liquidity are cash on hand, short-term investments and cash flows from operations, including changes in working capital, and borrowings under our credit facility. The most significant component of our working capital is merchandise inventories reduced by related accounts payable and accrued expenses.
Our working capital needs are greatest from August through November each year as a result of our inventory build-up during this period for the approaching holiday season. This is also the time of year when we are at maximum investment levels in our new store class and may not have collected all of the landlord allowances due to us as part of our lease agreements. Based on past performance and current expectations, we believe that cash on hand, short-term investments, cash generated from operations and borrowings under the credit facility will satisfy the Company’s working capital needs, capital expenditure needs, commitments and other liquidity requirements through at least the next 12 months.
The following table presents a summary of our cash flows for fiscal years 2016, 2015 and 2014:
| Fiscal year ended | ||||||||||||
| (In thousands) | January 28, 2017 | January 30, 2016 | January 31, 2015 | |||||||||
| Net cash provided by operating activities | $ | 634,685 | $ | 375,874 | $ | 396,592 | ||||||
| Net cash used in investing activities | (273,747 | ) | (278,958 | ) | (399,276 | ) | ||||||
| Net cash used in financing activities | (321,768 | ) | (140,225 | ) | (27,643 | ) | ||||||
| Net increase (decrease) in cash and cash equivalents | $ | 39,170 | $ | (43,309 | ) | $ | (30,327 | ) | ||||
Operating activities
Operating activities consist of net income adjusted for certain non-cash items, including depreciation and amortization, non-cash stock-based compensation, realized gains or losses on disposal of property and equipment and the effect of working capital changes.
Merchandise inventories were $944.0 million at January 28, 2017, compared to $761.8 million at January 30, 2016, representing an increase of $182.2 million or 23.9%. Average inventory per store increased 11.2% compared to prior year. The increase in inventory is primarily due to the following:
| • | approximately $87 million due to the addition of 100 net new stores opened since January 30, 2016; |
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| • | approximately $82 million due to the opening of the Company’s fourth and fifth distribution centers in Greenwood, Indiana and Dallas, Texas; and |
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| • | approximately $13 million due to increased sales, new brand additions and incremental inventory for in-store prestige brand boutiques. |
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Deferred rent liabilities were $366.2 million at January 28, 2017, an increase of $44.4 million compared to $321.8 million at January 30, 2016. Deferred rent includes deferred construction allowances, future rental increases, free rent and rent holidays which are all recognized on a straight-line basis over their respective lease term. The increase is primarily due to the addition of 100 net new stores opened since January 30, 2016 and corporate and supply chain expansion.
Investing activities
We have historically used cash primarily for new and remodeled stores, supply chain investments, short-term investments and investments in information technology systems. Investment activities for capital expenditures were $373.7 million in fiscal 2016, compared to $299.2 million and $249.1 million in fiscal 2015 and 2014, respectively. Capital expenditures increased in fiscal 2016 compared to fiscal 2015 due to our new store program, the expansion of prestige boutiques and related in-store merchandising upgrades, and corporate office expansion. During fiscal 2016, we opened 104 new stores, remodeled 12 stores and relocated two stores, compared to 103 new stores, four remodels and five relocations during fiscal 2015 and 100 new stores, nine remodels and two relocations during fiscal 2014. During fiscal 2016, the average investment required to open a new Ulta store was approximately $1.4 million, which includes capital investment net of landlord contributions, pre-opening expenses and initial inventory net of payables. The average investment required to remodel an Ulta Beauty store was approximately $1.5 million. Purchases of short-term investments were $90 million during fiscal 2016 and consist of certificates of deposit with maturities of twelve months or less from the date of purchase.
Capital expenditures for fiscal 2016, 2015 and 2014 and planned fiscal 2017 by major category are as follows:
| (In millions) | 2017 Budget | Fiscal 2016 | Fiscal 2015 | Fiscal 2014 | ||||||||||||
| New, Remodeled, Relocated Stores | $ | 191 | $ | 154 | $ | 122 | $ | 125 | ||||||||
| Merchandising | 100 | 83 | 42 | 19 | ||||||||||||
| Information Systems | 82 | 56 | 63 | 45 | ||||||||||||
| Supply Chain | 49 | 41 | 49 | 46 | ||||||||||||
| Store Maintenance & Other | 41 | 40 | 23 | 14 | ||||||||||||
| $ | 463 | $ | 374 | $ | 299 | $ | 249 | |||||||||
Our future investments will depend primarily on the number of new, relocated and remodeled stores, supply chain investments and information technology systems that we undertake and the timing of these expenditures. Based on past performance and current expectations, we expect to self-fund future capital expenditures. We expect to spend approximately $463 million for capital expenditures in fiscal 2017. In 2017, new, remodeled and relocated stores and merchandising capital expenditure increases reflect the prestige brand expansions and the related in-store merchandising upgrades, as well as incremental spend related to non-prototypical store locations. We embarked on a multi-year supply chain project beginning in 2014, which included adding capacity, with fourth and fifth distribution centers opened in 2015 and 2016 and plans for a sixth distribution center in 2018, and system improvements to support expanded omni-channel capabilities.
Financing activities
Financing activities in fiscal 2016, 2015 and 2014 consist principally of capital stock transactions and the related income tax effects and our stock repurchase program. Purchase of treasury shares in fiscal 2016, 2015 and 2014 represents the fair value of common shares repurchased from plan participants in connection with shares withheld to satisfy minimum statutory tax obligations upon the vesting of restricted stock.
We had no borrowings outstanding under our credit facility at the end of fiscal 2016, 2015 and 2014. The zero outstanding borrowings position is due to a combination of factors including strong sales growth, overall performance of management initiatives including expense control as well as inventory and other working capital reductions. We may require borrowings under the facility from time to time in future periods to support our new store program and seasonal inventory needs.
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Share repurchase plan
On September 11, 2014, we announced that our Board of Directors authorized a share repurchase program (the 2014 Share Repurchase Program) pursuant to which the Company could repurchase up to $300 million of the Company’s common stock. The 2014 Share Repurchase Program authorization revoked the previously authorized, but unused amounts of $112.7 million from the share repurchase program adopted in 2013. On March 12, 2015, we announced that our Board of Directors authorized an increase of $100 million to the 2014 Share Repurchase Program effective March 17, 2015. The 2014 Share Repurchase Program did not have an expiration date, but provided for suspension or discontinuation at any time.
On March 10, 2016, we announced that our Board of Directors authorized a new share repurchase program (the 2016 Share Repurchase Program) pursuant to which the Company may repurchase up to $425 million of the Company’s common stock. The 2016 Share Repurchase Program authorization revoked the previously authorized, but unused amounts of $172.4 million from the 2014 Share Repurchase Program. The 2016 Share Repurchase Program does not have an expiration date and may be suspended or discontinued at any time.
As part of the 2016 Share Repurchase Program, we entered into an Accelerated Share Repurchase (ASR) agreement with Goldman, Sachs & Co. to repurchase $200 million of the Company’s common stock. Under the ASR agreement, the Company paid $200 million to Goldman, Sachs & Co. and received an initial delivery of 851,653 shares in the first quarter of 2016, which were retired and represented 80% of the total shares the Company expected to receive based on the market price at the time of the initial delivery. In May 2016, the ASR settled and an additional 153,418 shares were delivered to the Company and retired. The final number of shares delivered upon settlement was determined with reference to the average price of the Company’s common stock over the term of the agreement. The transaction was accounted for as an equity transaction. The par value of shares received was recorded as a reduction to common stock with the remainder recorded as a reduction to additional paid-in capital and retained earnings. Upon receipt of the shares, there was an immediate reduction in the weighted average common shares calculation for basic and diluted earnings per share.
During fiscal year 2014, we purchased 321,113 shares of common stock for $39.9 million at an average price of $124.31. During fiscal 2015, we purchased 1,034,418 shares of common stock for $167.4 million at an average price of $161.81. During fiscal 2016, excluding the shares repurchased under the ASR, we purchased 634,155 shares of common stock for $144.3 million at an average price of $227.49.
On March 9, 2017, we announced that the Board of Directors authorized a new share repurchase program (the 2017 Share Repurchase Program) pursuant to which the Company may repurchase up to $425 million of the Company’s common stock. The 2017 Share Repurchase Program authorization revokes the previously authorized but unused amounts from the 2016 Share Repurchase Program. The 2017 Share Repurchase Program does not have an expiration date and may be suspended or discontinued at any time.
Credit facility
In 2011, we entered into an Amended and Restated Loan and Security Agreement with Wells Fargo Bank, National Association, as Administrative Agent, Collateral Agent and a Lender thereunder, Wells Fargo Capital Finance LLC as a Lender, J.P. Morgan Securities LLC as a Lender, JP Morgan Chase Bank, N.A. as a Lender and PNC Bank, National Association, as a Lender, which has been amended multiple times since 2011 (as amended, the Loan Agreement). The Loan Agreement currently matures in December 2018, provides maximum revolving loans equal to the lesser of $200 million or a percentage of eligible owned inventory, contains a $10 million subfacility for letters of credit and allows the Company to increase the revolving facility by an additional $50 million, subject to consent by each lender and other conditions. The Loan Agreement contains a requirement to maintain a minimum amount of excess borrowing availability at all times. Substantially all of the Company’s assets are pledged as collateral for outstanding borrowings under the facility. Outstanding borrowings will bear interest at the prime rate or LIBOR plus 1.50% and the unused line fee is 0.20%.
As of January 28, 2017 and January 30, 2016, we had no borrowings outstanding under the credit facility and the Company was in compliance with all terms and covenants of the agreement.
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Seasonality
Our business is subject to seasonal fluctuation. Significant portions of our net sales and profits are realized during the fourth quarter of the fiscal year due to the holiday selling season. To a lesser extent, our business is also affected by Mothers’ Day as well as the “Back to School” season and Valentine’s Day. Any decrease in sales during these higher sales volume periods could have an adverse effect on our business, financial condition or operating results for the entire fiscal year. Our quarterly results of operations have varied in the past and are likely to do so again in the future. As such, we believe that period-to-period comparisons of our results of operations should not be relied upon as an indication of our future performance.
Impact of inflation and changing prices
Although we do not believe that inflation has had a material impact on our financial position or results of operations to date, a high rate of inflation in the future may have an adverse effect on our ability to maintain current levels of gross margin and selling, general and administrative expenses as a percentage of net sales if the selling prices of our products do not increase with these increased costs. In addition, inflation could materially increase the interest rates on any future debt.
Off-balance sheet arrangements
As of January 28, 2017, we have not entered into any “off-balance sheet” arrangements, as that term is described by the SEC. We do, however, have off-balance sheet operating leases and purchases obligations incurred in the ordinary course of business as indicated within the contractual obligations table below.
Contractual obligations
The following table summarizes our contractual arrangements and the timing and effect that such commitments are expected to have on our liquidity and cash flows in future periods. The table below excludes variable expenses related to contingent rent, common area maintenance, insurance and real estate taxes. The table below includes obligations for executed agreements for which we do not yet have the right to control the use of the property as of January 28, 2017:
| (In thousands) | Total | Less Than 1 Year | 1 to 3 Years | 3 to 5 Years | More than 5 Years | |||||||||||||||
| Operating lease obligations(1) | $ | 2,006,041 | $ | 270,684 | $ | 534,500 | $ | 474,282 | $ | 726,575 | ||||||||||
| Purchase obligations | 47,463 | 40,518 | 6,945 | — | — | |||||||||||||||
| Total | $ | 2,053,504 | $ | 311,202 | $ | 541,445 | $ | 474,282 | $ | 726,575 | ||||||||||
| (1) | Variable operating lease obligations related to common area maintenance, insurance and real estate taxes are not included in the table above. Total expenses related to common area maintenance, insurance and real estate taxes for fiscal 2016 were approximately $59 million. |
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We lease retail stores, warehouses, corporate offices and certain equipment under operating leases with various expiration dates through fiscal 2032. Our store leases generally have initial lease terms of 10 years and include renewal options under substantially the same terms and conditions as the original leases. In addition to future minimum lease payments, most of our lease agreements include escalating rent provisions which we recognize straight-line over the term of the lease, including any lease renewal periods deemed to be probable. For certain locations, we receive cash tenant allowances and we report these amounts as deferred rent, which is amortized on a straight-line basis as a reduction of rent expense over the term of the lease, including any lease renewal periods deemed to be probable.
Purchase obligations reflect legally binding agreements entered into by the Company to purchase goods or services. Excluded from our purchase obligations are normal purchases and contracts entered into in the ordinary course of business. The amount of purchase obligations relates to commitments made to a third party for products and services for a future distribution center for which a lease has been signed, advertising and other goods and service contracts entered into as of January 28, 2017.
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As of January 28, 2017, the unrecognized tax benefit was $3.3 million, which is not included in the above table due to uncertainty regarding the realization and timing of the related future cash flows, if any.
Critical accounting policies and estimates
Management’s discussion and analysis of financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (GAAP). The preparation of these financial statements required the use of estimates and judgments that affect the reported amounts of our assets, liabilities, revenues and expenses. Management bases estimates on historical experience and other assumptions it believes to be reasonable under the circumstances and evaluates these estimates on an on-going basis. Actual results may differ from these estimates. A discussion of our more significant estimates follows. Management has discussed the development, selection and disclosure of these estimates and assumptions with the Audit Committee of the Board of Directors.
Inventory valuation
Merchandise inventories are carried at the lower of average cost or market value. Cost is determined using the weighted-average cost method and includes costs incurred to purchase and distribute goods as well as related vendor allowances including co-op advertising, markdowns and volume discounts. We record valuation adjustments to our inventories if the cost of a specific product on hand exceeds the amount we expect to realize from the ultimate sale or disposal of the inventory. These estimates are based on management’s judgment regarding future demand, age of inventory and analysis of historical experience. If actual demand or market conditions are different than those projected by management, future merchandise margin rates may be unfavorably or favorably affected by adjustments to these estimates.
Inventories are adjusted for the results of periodic physical inventory counts at each of our locations. We record a shrink reserve representing management’s estimate of inventory losses by location that have occurred since the date of the last physical count. This estimate is based on management’s analysis of historical results and operating trends.
We do not believe that there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our lower of cost or market or shrink reserves. Adjustments to earnings resulting from revisions to management’s estimates of the lower of cost or market and shrink reserves have been insignificant during fiscal 2016, 2015 and 2014. An increase or decrease in the lower of cost or market reserve of 10% would have had no material impact on our pre-tax income for fiscal 2016. An increase or decrease in the shrink rate included in the shrink reserve calculation of 10% would have had no material impact on our pre-tax income for fiscal 2016.
Vendor allowances
The majority of cash consideration received from a supplier is considered to be a reduction of the cost of the related products and is reflected in cost of sales in our consolidated statements of income as the related products are sold unless it is in exchange for an asset or service or a reimbursement of a specific, incremental, identifiable cost incurred by the Company in selling the vendors’ products. We estimate the amount recorded as a reduction of inventory at the end of each period, based on a detailed analysis of inventory turns and management’s analysis of the facts and circumstances of the various contractual agreements with vendors. We record cash consideration expected to be received from vendors in net receivables at the amount we expect to collect. We do not believe that there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our reduction of inventory. An increase or decrease in inventory turns of five basis points would have affected pre-tax income by approximately $3.8 million in fiscal 2016.
Impairment of long-lived tangible assets
We review long-lived tangible assets whenever events or circumstances indicate these assets might not be recoverable based on undiscounted future cash flows. Assets are reviewed at the store level, which is the lowest level for which cash flows can be identified. Significant estimates are used in determining future operating
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results of each store over its remaining lease term. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. We do not believe that there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our impairment charges. In fiscal 2016, we recognized $3.1 million of fixed asset impairment charges related to store closures in Chicago, Illinois and Denham Springs, Louisiana. No significant impairment charges were recognized in fiscal 2015 or 2014.
Customer loyalty program
We maintain a customer loyalty program, Ultamate Rewards, in which program members earn points based on purchases. Points earned by members are valid for at least one year and may be redeemed on any product we sell. We accrue the cost of anticipated redemptions related to this program at the time of the initial purchase based on historical experience. We do not believe that there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our redemption rates. Adjustments to earnings resulting from revisions to management’s estimates of the redemption rates have been insignificant during fiscal 2016, 2015 and 2014. If our redemption rate were to increase or decrease by 5%, it would have affected pre-tax income by approximately $5.7 million in fiscal 2016.
Share-based compensation
We account for share-based compensation in accordance with the Accounting Standards Codification (ASC) rules for stock compensation. Share-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized on a straight-line method over the requisite service period for awards expected to vest.
We estimate the grant date fair value of stock options using a Black-Scholes valuation model. The expected volatility is based on the historical volatility of the Company’s common stock. The risk free interest rate is based on the United States Treasury yield curve in effect on the date of grant for the respective expected life of the option. The expected life represents the time the options granted are expected to be outstanding. The expected life of options granted is derived from historical data on Ulta Beauty stock option exercises. The historical exercise data is updated on an annual basis and the changes have not had a material impact on the calculation in any years presented.
Forfeitures of options are estimated at the grant date based on historical rates of the Company’s stock option activity and reduce the compensation expense recognized. The forfeiture rate is updated on an annual basis and the changes have not had a material impact on compensation expense recognized in any years presented. We do not believe that there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our grant date fair value of stock options or forfeiture rate.
See Note 2 to our consolidated financial statements, “Summary of significant accounting policies – Share-based compensation,” for disclosure related to the Company’s stock compensation expense. See Note 10 to our consolidated financial statements, “Share-based awards,” for disclosure related to our stock compensation expense and related valuation model assumptions.
Recent accounting pronouncements not yet adopted
See Note 2 to our consolidated financial statements, “Summary of significant accounting policies – Recent accounting pronouncements not yet adopted.”
Recently adopted accounting pronouncements
See Note 2 to our consolidated financial statements, “Summary of significant accounting policies – Recently adopted accounting pronouncements.”
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