Summary of ULTA SALON, COSMETICS & FRAGRANCE, INC.

Item 2. 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 quarterly report. This discussion contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, which reflect our current views with respect to, among other things, future events and financial performance. You can identify these forward-looking statements by the use of forward-looking words such as "outlook," "believes," "expects," "plans," "estimates," or other comparable words. Any forward-looking statements contained in this Form 10-Q are based upon our historical performance and on current plans, estimates and expectations. The inclusion of this forward-looking information should not be regarded as a representation by us or any other person that the future plans, estimates or expectations contemplated by us will be achieved. Such forward-looking statements are subject to various risks and uncertainties, which include, without limitation: the impact of weakness in the economy; changes in the overall level of consumer spending; changes in the wholesale cost of our products; the possibility that we may be unable to compete effectively in our highly competitive markets; the possibility that our continued opening of new stores could strain our resources and have a material adverse effect on our business and financial performance; the possibility that new store openings may be impacted by developer or co-tenant issues; the possibility that the capacity of our distribution and order fulfillment infrastructure may not be adequate to support our recent growth and expected future growth plans; the possibility of material disruptions to our information systems; weather conditions that could negatively impact sales and other risk factors detailed in our public filings with the Securities and Exchange Commission (the "SEC"), including risk factors contained in our Annual Report on Form 10-K for the year ended January 31, 2009. We assume no obligation to update any forward-looking statements as a result of new information, future events or developments. References in the following discussion to "we", "us", "our", "the Company", "Ulta" and similar references mean Ulta Salon, Cosmetics & Fragrance, Inc. unless otherwise expressly stated or the context otherwise requires.
Overview
We were founded in 1990 as a discount beauty retailer at a time when prestige, mass and salon products were sold through separate distribution channels. In 1999 we embarked on a multi-year strategy to understand and embrace what women want in a beauty retailer and transform Ulta into the shopping experience that it is today. We pioneered what we believe to be our unique combination of beauty superstore and specialty store attributes. We believe our strategy provides us with the competitive advantages that have contributed to our strong financial performance.
We are currently the largest beauty retailer that provides one-stop shopping for prestige, mass and salon products and salon services in the United States. We combine the unique elements of a beauty superstore with the distinctive environment and experience of a specialty retailer. Key aspects of our beauty superstore strategy include our ability to offer our customers a broad selection of over 21,000 beauty products across the categories of cosmetics, fragrance, haircare, skincare, bath and body products and salon styling tools, as well as salon haircare products. We focus on delivering a compelling value proposition to our customers across all of our product categories. Our stores are conveniently located in high-traffic, primarily off-mall locations such as power centers and lifestyle centers with other destination retailers. As of May 2, 2009, we operated 320 stores across 36 states. In addition to these fundamental elements of a beauty superstore, we strive to offer an uplifting shopping experience through what we now refer to as "The Five E's": Escape, Education, Entertainment, Esthetics and Empowerment.
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 growth strategy, including growing our store base, expanding our prestige brand offerings, driving incremental salon traffic, expanding our online business and continuing to enhance our brand awareness. We believe that the steadily expanding U.S. beauty products and services industry, the shift in distribution of prestige beauty products from department stores to specialty retail stores, coupled with Ulta's competitive strengths, positions us to capture additional market share in the industry through successful execution of our growth strategy.
Comparable store sales is a key metric that is monitored closely within the retail industry. We do not expect our future comparable store sales increases to reflect the levels experienced in prior periods. This is due in part to the difficulty in improving on such significant increases in subsequent periods and the current economic environment.
Over the long-term, our growth strategy is to increase total net sales through increases in our comparable store sales and by opening new stores. Gross profit as a percentage of net sales is expected to be relatively consistent with historical rates given our planned distribution infrastructure investments and the impact of the rate of new store growth. We plan to continue to improve our operating results by leveraging our fixed costs and decreasing our selling, general and administrative expenses, as a percentage of our net sales.

Global economic conditions
Recent global market and economic conditions have been unprecedented and challenging with tighter credit conditions and recession in most major economies continuing in 2009. As a result of these market conditions, the cost and availability of credit has been and may continue to be adversely affected by illiquid credit markets and wider credit spreads. Concern about the stability of the markets generally and the strength of counterparties specifically has led many lenders and institutional investors to reduce, and in some cases, cease to provide credit to businesses and consumers. These factors have led to a decrease in spending by businesses and consumers alike, and a corresponding decrease in global infrastructure spending. Continued turbulence in the United States and international markets and economies and prolonged declines in business and consumer spending may adversely affect our liquidity and financial condition, and the liquidity and financial condition of our customers, including our ability to refinance maturing liabilities and access the capital markets to meet liquidity needs.
Basis of presentation
Net sales include store and e-commerce merchandise sales as well as salon service revenue. Salon service revenue represents less than 10% of our combined product sales and services revenues and therefore, these revenues are combined with product sales. We recognize merchandise revenue at the point of sale (POS) in our retail stores and the time of shipment in the case of Internet sales. 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 customer redeems the gift card. Company coupons and other incentives are recorded as a reduction of net sales.
Comparable store 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 store sales unless the store was closed for a portion of the current or prior period. There may be variations in the way in which some of our competitors and other retailers calculate comparable or same store sales. As a result, data herein regarding our comparable store sales may not be comparable to similar data made available by our competitors or other retailers.
Comparable store sales is a critical measure that 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 store sales results:
• the general national, regional and local economic conditions and corresponding impact on customer spending levels;

• the introduction of new products or brands;

• the location of new stores in existing store markets;

• competition;

• our ability to respond on a timely basis to changes in consumer preferences;

• the effectiveness of our various marketing activities; and

• the number of new stores opened and the impact on the average age of all of our comparable stores.

Cost of sales includes:
• the cost of merchandise sold, including all vendor allowances, which are treated as a reduction of merchandise costs;

• warehousing and distribution costs including labor and related benefits, freight, rent, depreciation and amortization, real estate taxes, utilities, and insurance;

• store occupancy costs including rent, depreciation and amortization, real estate taxes, utilities, repairs and maintenance, insurance, licenses, and cleaning expenses;

• salon payroll and benefits; and

• shrink and inventory valuation reserves.

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;

• advertising and marketing costs;

• occupancy costs related to our corporate office facilities;

• public company expense including Sarbanes-Oxley compliance expenses;

• stock-based compensation expense related to option grants which will result in increases in expense as we implemented a structured stock option compensation program in 2007;

• depreciation and amortization for all assets except those related to our retail and warehouse operations, which is included in cost of sales; and

• legal, finance, information systems and other corporate overhead costs.

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 expense includes non-capital expenditures during the period prior to store opening for new and remodeled stores including store set-up labor, management and employee training, and grand opening advertising. Pre-opening expenses also includes rent during the construction period related to new stores.
Interest expense includes interest costs associated with our credit facility, which is structured as an asset based lending instrument. Our interest expense will fluctuate based on the seasonal borrowing requirements associated with acquiring inventory in advance of key holiday selling periods and fluctuation in the variable interest rates we are charged on outstanding balances. Our credit facility is used to fund seasonal inventory needs and new and remodel store capital requirements in excess of our cash flow from operations. 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 quarterly periods are the 13 weeks ending on the Saturday closest to April 30, July 31, October 31, and January 31. The Company's first quarters in fiscal 2009 and 2008 ended on May 2, 2009 and May 3, 2008, respectively. 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.

The following tables present the components of our results of operations for the periods indicated:

                                                        Three months ended                     Three months ended
                                                     May 2,             May 3,              May 2,               May 3,
                                                      2009               2008                2009                 2008
                                                      (Dollars in thousands)               (Percentage of net sales)
Net sales                                         $    268,825         $ 239,298                 100.0 %           100.0 %
Cost of sales                                          189,482           165,377                  70.5 %            69.1 %

Gross profit                                            79,343            73,921                  29.5 %            30.9 %

Selling, general and administrative expenses            69,194            62,065                  25.7 %            25.9 %
Pre-opening expenses                                     1,195             3,772                   0.4 %             1.6 %

Operating income                                         8,954             8,084                   3.3 %             3.4 %
Interest expense                                           671               915                   0.2 %             0.4 %

Income before income taxes                               8,283             7,169                   3.1 %             3.0 %
Income tax expense                                       3,363             2,894                   1.3 %             1.2 %

Net income                                        $      4,920         $   4,275                   1.8 %             1.8 %


Other operating data:
Number stores end of period                                320               265
Comparable store sales (decrease) increase                (2.3 )%            3.9 %

During fiscal 2008, we experienced a deceleration of our comparable store sales. Our comparable store increases for the first, second and third quarters of fiscal 2008 were 3.9%, 3.7%, and 2.0%, respectively, while our fourth quarter comparable store sales decreased 5.5% resulting in a full year comparable store sales increase of 0.2%. We believe that the deterioration of the U.S. economy was the primary contributing factor to our comparable store sales deceleration throughout fiscal 2008.
Comparison of three months ended May 2, 2009 to three months ended May 3, 2008 Net sales
Net sales increased $29.5 million, or 12.3%, to $268.8 million for the three months ended May 2, 2009, compared to $239.3 million for the three months ended May 3, 2008. The increase is primarily due to an additional 55 net new stores operating since first quarter 2008. Non-comparable stores contributed $34.7 million to net sales while comparable stores contributed negative $5.2 million to net sales.
Our comparable store sales decreased 2.3%, which included a 2.0% increase in traffic offset by a 4.3% decrease in average ticket. We attribute the decrease in comparable store sales primarily to the continuing difficult economic environment and its negative impact on consumer spending. Gross profit
Gross profit increased $5.4 million, or 7.3%, to $79.3 million for the three months ended May 2, 2009, compared to $73.9 million for the three months ended May 3, 2008. Gross profit as a percentage of net sales decreased 140 basis points to 29.5% for the three months ended May 2, 2009, compared to 30.9% for the three months ended May 3, 2008. The 140 basis point decrease in gross margin rate was primarily driven by expected de-leverage in fixed store occupancy costs resulting from the acceleration of our new store program over the last twelve months. We also planned a 50 basis point investment in margin rate during the quarter compared to the prior year to drive customer traffic and market share in a difficult retail environment. This incremental investment was offset by improved efficiencies in our distribution and transportation network including the opening of our Phoenix, Arizona distribution center.

Selling, general and administrative expenses Selling, general and administrative (SG&A) expenses increased $7.1 million, or 11.5%, to $69.2 million for the three months ended May 2, 2009, compared to $62.1 million for the three months ended May 3, 2008. As a percentage of net sales, SG&A expenses decreased 20 basis points to 25.7% for the three months ended May 2, 2009, compared to 25.9% for the three months ended May 3, 2008. A 70 basis point increase in advertising expense during the quarter was offset by improved leverage in corporate overhead and variable store expenses as compared to the prior year period.
Pre-opening expenses
Pre-opening expenses decreased $2.6 million, or 68.3%, to $1.2 million for the three months ended May 2, 2009, compared to $3.8 million for the three months ended May 3, 2008. During the three months ended May 2, 2009, we opened 9 new stores, compared to 17 new store openings and 1 remodeled store during the three months ended May 3, 2008.
Interest expense
Interest expense was $0.7 million for the three months ended May 2, 2009, compared to $0.9 million for the three months ended May 3, 2008. The increase in our average debt outstanding on our credit facility was offset by a decline in our weighted-average interest rate compared to the same period last year. Income tax expense
Income tax expense of $3.4 million for the three months ended May 2, 2009 represents an effective tax rate of 40.6%, compared to $2.9 million of tax expense representing an effective tax rate of 40.4% for the three months ended May 3, 2008.
Net income
Net income increased $0.6 million, or 15.1%, to $4.9 million for the three months ended May 2, 2009, compared to $4.3 million for the three months ended May 3, 2008. The increase is primarily related to the $5.4 million increase in gross profit and a $2.6 million decrease in pre-opening expenses, partially offset by a $7.1 million increase in SG&A expenses. 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 for continued improvement in our information technology systems. Our primary sources of liquidity are cash flows from operations, 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 position benefits from the fact that we generally collect cash from sales to customers the same day, or within several days of the related sale, while we typically have up to 30 days to pay our vendors.
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 have not yet collected landlord allowances due us as part of our lease agreements. Based on past performance and current expectations, we believe that 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 the three months ended May 2, 2009 and May 3, 2008:

                                                             Three months ended
                                                            May 2,        May 3,
    (In thousands)                                           2009          2008

    Net cash provided by (used in) operating activities   $  17,957     $  (1,417 )
    Net cash used in investing activities                   (12,320 )     (30,545 )
    Net cash (used in) provided by financing activities      (5,435 )      32,148

    Net increase in cash and cash equivalents             $     202     $     186

Operating activities
Operating activities consist of net income adjusted for certain non-cash items, including depreciation and amortization, non-cash stock-based compensation, excess tax benefits from stock-based compensation, realized losses on disposal of property and equipment, and the effect of working capital changes. Merchandise inventories were $230.3 million at May 2, 2009, an increase of $17.7 million compared to May 3, 2008. The increase is primarily related to the addition of 55 net new stores opened since May 3, 2008. Average inventory per store at May 2, 2009 decreased approximately 4.8% compared to May 3, 2008 after adjusting for the inventory build in our Phoenix, Arizona distribution center which opened in April 2008.
Income taxes were prepaid by $5.9 million at May 2, 2009, compared to $8.6 million at January 31, 2009. The change of $2.7 million related to first quarter 2009 activity. In May 2009, we received an expected $8.0 million income tax refund related to certain tax planning changes adopted in fiscal 2008. Deferred rent liabilities were $104.2 million at May 2, 2009, an increase of $23.8 million compared to May 3, 2008. Deferred rent includes deferred construction allowances, future rental increases and rent holidays which are all recognized on a straight-line basis over their respective lease term. The increase is due to activity since May 3, 2008 which includes 55 net new stores. Investing activities
We have historically used cash primarily for new and remodeled stores as well as investments in information technology systems. Investment activities relate to capital expenditures and were $12.3 million during the three months ended May 2, 2009, compared to $30.5 million during the three months ended May 3, 2008. Capital expenditures were higher during the three months ended May 3, 2008 due to the addition of a second distribution center and the number of new store openings (9 new stores were opened during first quarter 2009, compared to 17 new stores during first quarter 2008).
Financing activities
Financing activities consist principally of draws and payments on our credit facility and capital stock transactions. The decrease in net cash provided by financing activities of $37.6 million in first quarter 2009 compared to first quarter 2008 is primarily the result of increased payments on long-term borrowings.
Credit facility
Our credit facility is with LaSalle Bank National Association as the administrative agent, Wachovia Capital Finance Corporation as collateral agent, and JP Morgan Chase Bank as documentation agent. This facility provides maximum credit of $200 million through May 31, 2011. The credit facility agreement contains a restrictive financial covenant requiring us to maintain tangible net worth of not less than $80 million. On May 2, 2009, our tangible net worth was approximately $251 million. Substantially all of our assets are pledged as collateral for outstanding borrowings under the facility. Outstanding borrowings bear interest at the prime rate or the Eurodollar rate plus 1.00% up to $100 million and 1.25% thereafter. The advance rates on owned inventory are 80% (85% from September 1 to January 31).
The interest rate on the outstanding balances under the facility as of May 2, 2009 and January 31, 2009 was 1.48% and 1.52%, respectively. At May 2, 2009, we had $100.6 million of outstanding borrowings under the facility. We have classified $88.0 million as

long-term as this is the minimum amount we believe will remain outstanding for an uninterrupted period over the next year. We had approximately $93.5 million and $86.8 million of availability as of May 2, 2009 and January 31, 2009, respectively. We also have an ongoing letter of credit that renews annually which had a balance of $0.3 million as of May 2, 2009 and January 31, 2009. Off-balance sheet arrangements
Our off-balance sheet arrangements consist of operating lease obligations and letters of credit. We do not have any non-cancelable purchase commitments as of May 2, 2009. Our letters of credit outstanding under our revolving credit facility were $0.3 million as of May 2, 2009. Contractual obligations
Our contractual obligations consist of operating lease obligations and our revolving line of credit. No material changes outside the ordinary course of business have occurred in our contractual obligations during the three months ended May 2, 2009.
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 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. There have been no significant changes to the critical accounting policies and estimates included in our Annual Report on Form 10-K for the year ended January 31, 2009. Share-based compensation
We account for share-based compensation in accordance with Statement of Financial Accounting Standards (SFAS) No. 123(R), Share-Based Payment. Pursuant to SFAS No. 123(R), share-based compensation cost is measured at grant date, based on the fair value of the award, and is recognized as expense 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 volatilities of a peer group of publicly-traded companies. 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. We have elected to use the shortcut approach in accordance with Staff Accounting Bulletin (SAB) No. 107, Share-Based Payment, and SAB No. 110, Simplified Method for Plain Vanilla Share Options, to develop the expected life. We recognize compensation cost related to the stock options on a straight-line method over the requisite service period. See notes to financial statements, "Summary of significant accounting policies - Share-based compensation," for disclosure related to the Company's stock compensation expense and related valuation model assumptions. Item 3. Quantitative and Qualitative Disclosures about Market Risk Market risk represents the risk of loss that may impact our financial position . . .