Description

Thesis:

Sally Beauty Holdings (SBH) is a long-term structurally challenged company facing increasing demographic and competitive headwinds along with intensifying margin pressures in both its consumer-facing stores and its distribution business.  The market expects recent self-help initiatives (e.g. marketing mix shifts, new CRM / IT system implementations, store refreshes) to drive an acceleration in comps along with margin leverage as investments roll off.  I disagree – I think management is failing to achieve a turnaround in the brand / store base and expect comps to slow and margins to contract in coming quarters/years.  My base case offers mid-20s % return to the short (1.5x up/down) from the current ~$26/sh level under the assumption of LSD (and slowing) SSS and margin contraction over the next few years.

Business Overview:

Sally Beauty Holdings (SBH) is an international, multi-channel specialty retailer and distributor of professional beauty products.  The company started as one store in 1964, was acquired by Alberto-Culver in 1969, built up via acquisition and organic store growth, and was spun from Culver as an independent, publicly traded company in 2006.  SBH has ~5,070 stores globally in 13 countries, along with ~950 distributor sales consultants (DSCs).  Sales are roughly 82% domestic / 18% international.

SBH participates in two channels – full-service/exclusive distribution to the professional customer (salons) via CosmoProf stores and what are called distributor sales consultants (DSCs); and the open-line channel with Sally Beauty stores. The distribution business is called Beauty Systems Group (BSG); 39% of sales; 41.3% gross margin; 15.4% operating margin) and the open-line retail business is called Sally Beauty Supply (SBS; 61% of sales; 54.8% gross margin; 17.7% operating margin).

• SBS: There are ~2.9K Sally Beauty Supply stores in the US and ~850 internationally; each store features an average of 8K SKUs. US stores are 1.7K sq ft on average and primarily located in strip shopping centers. 47% of the product sold at Sally Beauty is private label. Sally also has the Beauty Club Card (BCC), where card members pay an annual fee and get discounted prices on almost every item; similarly, professional Sally shoppers have the ProCard.

• BSG: BSG has ~1.2K company owned stores and ~160 franchised stores under the Armstrong-McCall banner. BSG stores operate under the CosmoProf banner, are an average of 2.6K sq ft, carry 9K SKUs, and are located in secondary strip mall locations. BSG sales are 66% company-owned stores, 25% sales consultants, and 9% franchise stores. SBH operates various websites as well, including LoxaBeauty. SBH stores cost $70-75K to open, excluding inventory ($70K at Sally, $130K at BSG), and have cash payback periods of two years.

After a period of outsized growth (5-6% SSS, 30%+ EPS growth) in 2010-12 subsequent to the economic downturn, SBH’s growth has been normalizing to 2-3% SSS and single-digit EPS growth.

Short Thesis:

• Sally Beauty Supply stores are facing demographic and competitive headwinds, likely to pressure SSS over the medium term

• Sally attracts an older customer, and is struggling to attract millennials

• Food/drug/mass and Ulta are offering a nicer shopping experience and similar products to Sally

• The store refreshes are not enough to change SBH’s course, as they are simply making up for underinvestment in the fleet and advertising

• The strong SSS trajectory in the BSG business is decelerating as competitive advantages are coming to an end

• Ulta’s in-store salon allows it to carry professional products, at promotional prices similar to BSG (with the exception of hair color)

• BSG benefitted from exclusive product after L’Oréal’s acquisition of SalonCentric, but that tailwind is coming to an end and SalonCentric is poised to regain share

• Margin tailwinds have run their course and incremental margin gains from here will be difficult to come by (private label is near full penetration, foreign sourcing of product is complete, and wage inflation will put pressure on the business)

Consensus View / Bull Case:

The bull case on SBH is as follows:

• The industry is highly fragmented with 300K salons and the booth-renting trend has led to salon professionals purchasing their own supplies

• SBH has strong private label offerings (~47% of SBS sales) which have 5-10% higher gross margins and thus should add 10-15bps to consolidated GM each year

• Baby-boomers aging will led to an increasing use of hair color and hair loss products

• SBH has international growth potential

• Sally Beauty stores are undergoing a refresh – with half of the US fleet expected to be completed by end of 2016

• SBH is seen as a cash flow machine with ~$200M in FCF annually (5% yield on a $3.7bn mkt cap) and is underway with a $1B share repurchase program

Going forward, the Street expects 2-3% SSS growth (1-2% SBH, 4-5% BSG, 2-3% square footage growth, and 0-20bps annual EBIT margin expansion.  Combined with consensus expectations of 2-4% ongoing share buybacks, this should translate into HSD EPS growth.

Key Drivers of Short Thesis:

1. Sally faces a number of challenges in its core SBS business

Core loyalty customer growth is slowing:

A key component of the SBS business is the Beauty Club Card “BCC” program which rewards customers for purchases, provides insights into customer habits, and allows the company to target communication based on customers’ shopping behavior.  BCC currently has 9.5mm members who represent ~60% of SBS sales (and ~80% of SBS U.S. retail sales).  BCC members shop more frequently and spend more per visit than non-BCC customers, so they are an important focus for the company and investors.

In 2Q16, BCC revenue growth decelerated from 7-8% in the prior five quarters to 3%.  It decelerated again in 3Q16 to 2.5%.  Management said the deceleration was due to Sally Beauty store refreshes driving confusion in the consumer base and argued that easy fixes, such as changing the placement of items, could address the problem in future quarters.  However, the BCC sales growth slowdown was due to both traffic and basket size.  Disruption inside the store should not theoretically affect traffic levels, so I am skeptical of this claim.

While the BCC sales growth deceleration was pronounced in 2Q16, sales per avg BCC member has been trending down for many quarters, suggesting that incremental BCC members are less attractive or that BCC members overall are spending less with SBH, both of which are negative.

Only ~20% of SBS’s U.S. retail customers (and shrinking) are not Beauty Club Card holders (a paid-loyalty club program), suggesting that while SBH has a loyal base, they are not garnering new interest and traffic in the stores.  I believe intensifying competition is one of the culprits responsible for SBH’s slowing loyalty-driven sales growth.

Competitive environment is heating up for both divisions

In the SBS segment, SBH’s main competitors are the food/drug stores (e.g. CVS, Walgreens) and mass merchandisers (e.g. Walmart, Target).  These two sets of competitors continue to emphasize beauty categories as a key strategic focus.  Examples include CVS front of store growth in beauty (and margin benefits from it), as well as Walgreens rolling out a new beauty format in stores, benefitting from Alliance Boots’ exclusive beauty product in both Walgreens stores and Rite-Aid stores to come.

In the BSG segment, SBH competes primarily with L’Oreal’s SalonCentric and Ulta (ULTA).  Essentially all of Ulta’s stores have a full-service salon, and recently Ulta announced they would start carrying professional products in addition to the existing consumer products.  This will make Ulta the first retailer to carry open-line and closed-line products in the same location.  Ulta’s SSS have outperformed SBH’s and industry growth, implying Ulta is gaining share – and I expect these share gains to continue and possibly accelerate going forward at the expense of BSG.

In addition, SalonCentric has recently undergone some management changes, and a more competitive response from SalonCentric could be coming driven by their recent struggles.  SalonCentric’s performance has started improving of late, suggesting the once weaker competitor to BSG is poised to regain some lost market share.  

They have underinvested in advertising/marketing and have low brand awareness:

SBH has meaningfully underinvested in advertising and marketing, leading to mediocre brand awareness, particularly amongst the all-important millennial demographic.  SBH spends 2.5% of sales on advertising, compared to 4.8% at Ulta.

The store base is outdated and cannot be fixed without material investment

I believe SBH’s store remodel strategy is structurally flawed because its marketing budget remains far too small in dollar terms.  Management has been trying to “refresh” the Sally retail stores to drive higher traffic and improve the customer shopping experience.  Elements of this strategy include changing the logo/store imagery, using new packaging, adding LED lights to stores, re-doing the floors, and other in-store fixes.  Sally Beauty’s store refresh is costing $20K/store, or an average of $12/sq ft.  This compares to $1.2M on an Ulta refresh, or an average of $114/sq ft.  Ulta is considered the beauty industry bellwether in terms of in-store quality and customer experience.

“The Sally marketing team didn't have the money they needed to do the job they wanted when I was there.  When I joined them, they were burning money on direct mail marketing without knowing who they're actually spending it on.  It's been a little better since they've changed the CRM platform, but still sub-par.  Improving their consumer brand without increasing the gross marketing dollars is impossible… the CEO is wrong on this."

Former VP Marketing at Sally Beauty (Jan-Sept 2015)

Sally may be fully penetrated in the core U.S. market

In terms of the store base, I believe management’s expectations for Sally’s ultimate store TAM are far too optimistic.  SBH expects to grow store count 3% annually; however, my contacts believe that 3,000 is the supper limit for U.S. Sally Beauty Supply stores.  As of 3QFY16, Sally Beauty Supply had 2,902 stores in the U.S., suggesting near-saturation.

“There isn’t enough greenfield territory left for them to add another Sally Beauty Store without seeing cannibalization.  You might see them add another store in the U.S., but if they do, they will see comps fall at an existing store.  I think they’ve pretty much saturated the market in the U.S.”

Former VP Marketing at Sally Beauty (Jan-Sept 2015)

As further evidence of likely market saturation, new store productivity growth has been declining and is now negative.  New store productivity, defined as (revenue growth – SSS growth) / (store growth), fell below 100% in 2011 and turned negative in 2015 for SBS.  This suggests that adding new SBS stores has become considerably less attractive over time.

2.  BSG comps have enjoyed unsustainable benefits and will continue to slow

BSG appears to have been the beneficiary of missteps at its biggest competitor, SalonCentric (owned by L’Oreal).  SalonCentric, like BSG, is primarily a roll-up of regional distributors, and BSG benefitted from brands that defected during SalonCentric’s major rollup phase from 2008-12 (brands didn’t want to have a competitor, L’Oreal, distributing their products).  During the past year, it appears that a few additional remaining brands have left SalonCentric for BSG, propelling SSS growth for BSG above 7%.

This roll-up/consolidation of regional distributors began in 2002 and, per my consultant checks, ended in 2013-14.  Since distribution consolidation has been the catalyst for brand defections, I think the wave of brand defections to BSG is now complete.  As these brand defections from SalonCentric anniversary, I believe BSG will be unable to maintain recent high growth rates.  Management has guided BSG SSS to slow to 4-5% long-term rate (consensus expects ~4%), but expectations may surprise to the downside given the lack of large, non-L’Oreal owned brands that are left for BSG to acquire.

3.  Margins tailwinds have run their course and margin headwinds will soon take over

SBH’s margin initiatives are in late stages; wage inflation will be a headwind going forward.

Private Label Penetration:

SBS generates 47% of sales from private label / exclusive brands today (vs. 28% in 2000).  By working closely with suppliers, the company has continued to introduce new exclusive label items into its mix.  Ion represents the largest brand within SBH’s suite of private label products.  Historically, private label mix has provided a 10-15bps annual gross margin tailwind for SBS given private label’s 5-10% higher gross margins.  However, my sources suggest ~50-55% is an approximate upper limit to private label penetration and thus the margin tailwind of private label is fully reflected in the results today.

Sourcing:

The smallest of SBH’s gross margin drivers has been the direct sourcing of products from low-cost foreign suppliers.  While low cost country sourcing has been a 0-5bps margin tailwind historically, former President Mike Spinozzi notes only liquids are left to source internationally, and SBH is unlikely to do so because it is cost prohibitive.

Labor Inflation:

SBH employs ~28K workers, of which ~14K are part-time and ~6K hourly.  According to my sources, SBH is likely to face increased labor costs because of stricter overtime pay rules as well as tougher state minimum wage laws.

Valuation:

• On consensus estimates, SBH is currently trading at ~13.0x CY18 P/E and ~8.0x CY18 EV/EBITDA

• Consensus expects ~$2 EPS in CY18 based on ~3% consolidated SSS, 2-3% sq footage growth, continued gross margin & EBIT margin expansion, and 3-4% share buybacks, driving LDD EPS growth

• On my estimates, SBH is trading at ~14.1x CY18 P/E and ~8.6x CY18 EV/EBITDA

• I am roughly 15% below consensus with ~$1.70 CY18 EPS based on 1.5% consolidated SSS in CY17-18, ~2% sq footage growth, ~40-50bps margin deleverage (mostly on opex as the company will have to increase marketing/advertising spend to maintain even flat traffic growth and slight price increases), and LSD share buybacks

• I think SBH should trade at 12x CY18 P/E (in line with its last few year trough when comps slowed to LSD levels) as comps slow, competitive pressures in the food/drug/mass & discount channels intensify, and margins de-lever

• Upside price to the short is 12x CY18 EPS of $1.70 = ~$20/share (23% upside)

• Downside is 15x CY18 EPS of ~$2 (consensus) = ~$30/share (15% downside)

Management:

SBH announced a CEO succession plan in May 2014, whereby the then-CEO/Chairman of the Board, Gary Winterhalter, would eventually be replaced by Christian Brickman.  Winterhalter, 61 at the time of the announcement, had been SBH’s CEO since the company separated from Alberto-Culver in 2006.  Current senior management owns limited shares (~1.8mm shares assuming exercise of vested options, or ~$47mm), and has been selling.

CEO Christian Brickman began in early 2015.  He was COO and President from 2014 – Feb 2015 and prior was President of Kimberly-Clark.  Brickman owns ~$1.9mm of stock (assuming exercise of vested options).

Former CFO Mark Flaherty had been in his role since 2008 but resigned abruptly on 9/29/16 to “pursue other interests.”  CAO Janna Minton will serve as Interim CFO until a successor is appointed.

Risks

• If the consumer is indeed weak, SBH may benefit from a trade-down customer and Sally Beauty Supply comps could accelerate to +MSD

• Store refreshes could drive the sought-after millennial consumer into the store

• The addition of private label cosmetics can drive incremental, high margin sales

• SBH could bring Sally Beauty Supply margins back to peak levels of 20% (would be a ~200 bps increase from here)

• SBH could add leverage to the balance sheet and increase their stock buyback program

Catalyst

• Continued slowdown in SSS along with margin pressures
• 3Q16 earnings (reporting on Nov 10th) is potential catalyst event