Description

I recommend a long position in Sally Beauty Holdings (SBH.) While not the typical special situation I typically favor for VIC writeups, I believe SBH is an attractive investment at current prices. The stock was driven down somewhat by a sloppy exit by its private equity backer this summer. Additionally, sentiment is overly negative surrounding their upcoming quarterly results, resulting in an opportunity to purchase shares in a great franchise at a good price. While this writeup should not be construed as a call on the quarter, I do believe the risk/reward going into earnings on 11/15/2012 is favorably balanced.

Investment Thesis:

Sally Beauty Holdings (SBH) is a high quality, recession resistant business, with dollar store-like economics in its retail stores and a fantastic competitive position in professional/wholesale business. Through a combination of door growth, comps, margin expansion, and market share gains, SBH should be a reliable HSD topline and high-teens to low-20s bottom line growth for the next several years.

Business Overview:

SBH operates two segments: Sally Beauty Supply (SBS) and Beauty Systems Group (BSG). SBS is the largest beauty supply retail chain in the US with 2,500 domestic and 3,200 total stores, and represents 62% of total revenues. BSG is the largest distributor of professional beauty supplies in North America through 1,100 stores and over 1,000 sales consultants (38% of revenues.)

Sally Beauty Supply (62% of revenues):

SBS holds a 50% market share in the US, and is remarkably stable. Quarterly comps have been positive every quarter since 2004. The average store is 15 year old and still consistently comps mid-single-digits. SBS stores are typically located in strip malls – the ones I have visited wereadjacent to grocery stores, Family Dollars, Dollar Trees, etc.  The boxes average 1,700 square feet in size and carry ~6,500 SKUs across product categories including hair color (22% of revenues), hair care (20%), skin and nail care (13%), accessories (16%), electrical appliances (12%), and ethnic products (9%.) Brands include Clairol, Revlon, and Conair in addition to professional and private label products. The strategy for the SBS retail concept is very similar to that of TSCO:

-        Inexpensive real estate leads to attractive store economics (50% returns on capital)

-        Know the core customer well and serve her with attractive product offerings

-        Two prong organic growth strategy: Open new doors (5% annually) and take share from single location beauty supply stores or small local chains (2-4% annually)

-        Steady rollout of private label brands carrying 65% GM vs. 45% for branded products

Beauty Supply Group (38% of revenues):

BSG holds a 45% share in the US market, which is essentially a duopoly. The other national player is SalonCentric, which holds a 30% share, and was acquired in 2010 by L’Oreal. The remaining 25% of the market is held by a large number of independent regional distributors. Most brands in the professional channel are exclusive to a single distributor (and that distributor accounts for the majority of most of the vendors volumes.) BSG has significant growth and margin potential due to both the industry structure and ongoing trends:

-        Share gains from brands defecting to BSG from SalonCentric14575951 (many do not want to be dependent on a competitors, L’Oreal, for distribution)

-        Share gains from sub-scale regional distributors as brands seek a national platform

-        In the salon industry, stylists are increasingly independent contractors (“booth renters”) instead of employees. These independent contractors shop BSG stores weekly on their own, eliminating the costs of a sales force and discount for bulk orders.

Earnings and Free Cash Flow:

SBH was owned by Albert-Culver until a management buyout (with Clayton Dubilier & Rice) and IPO in 2006. Since 2006, SBH has consistently used approximately half of FCF to paydown debt (other half goes to new stores and small acquisitions, where SBH achieves 50% ROIC.) Last summer, CDR sold their final shares of stock, removing a ~10% overhang. Additionally, the company recently reached its target level of 2.5x debt-to-ebitda (from 6.1x in 2007), which should allow them to return capital to shareholders in the near future (consensus earnings estimates do not contemplate share buybacks.)

SBH will achieve HSD revenue growth for each of the next several years on a combination of comps, door growth and tuck-in M&A. Topline growth combined with margin expansion operating (margins have grown on average 100bps per year since 2004, evenly split b/t gross margin expansion and operating leverage) and share buybacks in turn lead to 20% annual earnings growth. This type of growth profile is all the more remarkable for a business that is very stable/recession resistant – revenues grew 2% in 2009 (in a flat US beauty supply industry) and comps have never gone negative in the 34 quarters of available data.

Risk/Reward:

The reward case is 20x calendar 2013E EPS of $1.75 = $35, while I think risk can reasonably be viewed as 15x calendar 2012E EPS of $1.50 = $22.50. With 2012 annual FCF of ~$275MM, SBH has a FCF yield of 6.1%. 

Catalyst