1. Business and basis of presentation

Ulta Salon, Cosmetics & Fragrance, Inc. (Company or Ulta) was incorporated in the state of Delaware on January 9, 1990, to operate specialty retail stores selling cosmetics, fragrance, haircare and skincare products, and related accessories and services. The stores also feature full-service salons. As of July 30, 2011, the Company operated 415 stores in 42 states, as shown in the table below:

		Number of						Number of
State		stores				State		stores
Alabama			7			Mississippi			3
Arizona			23			Missouri			4
Arkansas			3			Nebraska			2
California			36			Nevada			6
Colorado			11			New Hampshire			1
Connecticut			3			New Jersey			12
Delaware			1			New Mexico			1
Florida			30			New York			13
Georgia			18			North Carolina			16
Idaho			1			Ohio			12
Illinois			35			Oklahoma			7
Indiana			8			Oregon			5
Iowa			4			Pennsylvania			18
Kansas			3			Rhode Island			1
Kentucky			4			South Carolina			6
Louisiana			3			Tennessee			5
Maine			2			Texas			54
Maryland			6			Utah			3
Massachusetts			5			Virginia			11
Michigan			12			Washington			6
Minnesota			9			Wisconsin			5
						Total			415

The accompanying unaudited financial statements and related notes have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q and the U.S. Securities and Exchange Commission’s Article 10, Regulation S-X. In the opinion of management, the accompanying financial statements reflect all adjustments, which are of a normal recurring nature, necessary to fairly state the financial position and results of operations and cash flows for the interim periods presented.

The Company’s business is subject to seasonal fluctuation. Significant portions of the Company’s net sales and net income are realized during the fourth quarter of the fiscal year due to the holiday selling season. The results for the three and six months ended July 30, 2011 are not necessarily indicative of the results to be expected for the fiscal year ending January 28, 2012, or for any other future interim period or for any future year.

These interim financial statements and the related notes should be read in conjunction with the financial statements and notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended January 29, 2011. All amounts are stated in thousands, with the exception of per share amounts and number of stores.

2. Summary of significant accounting policies

Information regarding the Company’s significant accounting policies is contained in Note 2, “Summary of significant accounting policies,” to the financial statements in the Company’s Annual Report on Form 10-K for the fiscal year ended January 29, 2011. Presented below in this and the following notes is supplemental information that should be read in conjunction with “Notes to Financial Statements” in the Annual Report.

Fiscal quarter

The Company’s quarterly periods are the 13 weeks ending on the Saturday closest to April 30, July 31, October 31, and January 31. The Company’s second quarters in fiscal 2011 and 2010 ended on July 30, 2011 and July 31, 2010, respectively.

Share-based compensation

The Company measures share-based compensation cost on the grant date, based on the fair value of the award, and recognizes the expense over the requisite service period for awards expected to vest. The Company estimated the grant date fair value of stock options using a Black-Scholes valuation model using the following assumptions for the periods indicated:

		Six months ended
		July 30, 2011				July 31, 2010
Volatility rate			54.2	%			58.8	%
Average risk-free interest rate			2.4	%			2.2	%
Average expected life (in years)			6.3				4.8
Dividend yield		None				None

The Company granted 124 and 745 stock options during the six months ended July 30, 2011 and July 31, 2010, respectively. The weighted-average grant date fair value of these options was $28.62 and $11.38, respectively.

The Company recorded stock compensation expense of $2,388 and $2,487 for the three months ended July 30, 2011 and July 31, 2010, respectively. The Company recorded stock compensation expense of $5,196 and $4,222 for the six months ended July 30, 2011 and July 31, 2010, respectively. At July 30, 2011, there was approximately $21,290 of unrecognized compensation expense related to unvested options and restricted stock.

3. Commitments and contingencies

Leases — The Company leases stores, distribution and office facilities, and certain equipment. Original non-cancelable lease terms range from three to ten years, and store leases generally contain renewal options for additional years. A number of the Company’s store leases provide for contingent rentals based upon sales. Contingent rent amounts were insignificant in the three and six months ended July 30, 2011 and July 31, 2010. Total rent expense under operating leases was $23,127 and $20,135 for the three months ended July 30, 2011 and July 31, 2010, respectively. Total rent expense under operating leases was $44,984 and $39,594 for the six months ended July 30, 2011 and July 31, 2010, respectively.

General litigation — In May 2010, a putative employment class action lawsuit was filed against the Company and certain unnamed defendants in state court in California. The plaintiff and members of the proposed class are alleged to be (or have been) non-exempt hourly employees. The suit alleges that Ulta violated various provisions of the California labor laws and failed to provide plaintiff and members of the proposed class with full meal periods, paid rest breaks, certain wages, overtime compensation and premium pay. The suit seeks to recover damages and penalties as a result of these alleged practices. On June 21, 2010, the Company filed its answer to the lawsuit. On January 12, 2011, the Company and plaintiffs engaged in a voluntary mediation. Although the Company continues to deny plaintiffs’ allegations, in the interest of putting certain of the claims behind it, the Company agreed in principle to settle all claims of the putative class consisting of non-exempt hourly hair designers in the salon department within the California retail stores. The settlement, which is not an admission of liability, is subject to final documentation and Court approval. Counsel for the plaintiffs has agreed to dismiss without prejudice the claims of all other putative class members. The proposed settlement amount is not material.

The Company is also involved in various legal proceedings that are incidental to the conduct of its business. In the opinion of management, the amount of any liability with respect to these proceedings, either individually or in the aggregate, will not be material.

4. Notes payable

The Company’s credit facility is with Wells Fargo Bank, National Association, as Administrative Agent, Collateral Agent and a Lender thereunder, JPMorgan Chase Bank, N.A. as a Lender, and PNC Bank, National Association, as a Lender. The facility provides maximum credit of $200,000 through May 31, 2013 and is available for working capital and general corporate purposes. The facility provides maximum borrowings equal to the lesser of $200,000 or a percentage of eligible owned inventory, and contains a $10,000 subfacility for letters of credit. The credit facility agreement contains a restrictive financial covenant requiring the Company to maintain tangible net worth of not less than $200,000. The Company’s tangible net worth was $478,032 at July 30, 2011. 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 2.00% and the unused line fee is 0.25%.

As of July 30, 2011 and January 29, 2011, the Company had no borrowings outstanding under the credit facility.

5. Fair Value Measurements

The carrying value of cash and cash equivalents, accounts receivable, and accounts payable approximates their estimated fair values due to the short maturities of these instruments.

On February 3, 2008, the Company adopted the ASC rules for fair value measurements and disclosures. The adoption had no impact on the Company’s financial statements. The new rules established a three-tier hierarchy for fair value measurements, which prioritizes the inputs used in measuring fair value as follows:

	•		Level 1 — observable inputs such as quoted prices for identical instruments in active markets.
	•		Level 2 — inputs other than quoted prices in active markets that are observable either directly or indirectly through corroboration with observable market data.
	•		Level 3 — unobservable inputs in which there is little or no market data, which would require the Company to develop its own assumptions.

As of July 30, 2011, the Company held financial liabilities of $1,936 related to its non-qualified deferred compensation plan. The liabilities have been categorized as Level 2 as they are based on third-party reported net asset values which are based primarily on quoted market prices of underlying assets of the funds within the plan.

6. Net income per common share

The following is a reconciliation of net income and the number of shares of common stock used in the computation of net income per basic and diluted share:

		Three months ended								Six months ended
		July 30,				July 31,				July 30,				July 31,
		2011				2010				2011				2010
Net income		$	23,905			$	13,062			$	47,201			$	26,723
Denominator for basic net income per share — weighted-average common shares			61,126				58,727				60,840				58,517
Dilutive effect of stock options and non-vested stock			2,115				1,945				2,173				1,988
Denominator for diluted net income per share			63,241				60,672				63,013				60,505
Net income per common share:
Basic		$	0.39			$	0.22			$	0.78			$	0.46
Diluted		$	0.38			$	0.22			$	0.75			$	0.44

The denominators for diluted net income per common share for the three months ended July 30, 2011 and July 31, 2010 exclude 124 and 1,061 employee stock options, respectively, due to their anti-dilutive effects.

The denominators for diluted net income per common share for the six months ended July 30, 2011 and July 31, 2010 exclude 252 and 1,061 employee stock options, respectively, due to their anti-dilutive effects.