Description
I am recommending the purchase of Sally Beauty Holdings’
(NYSE: SBH) 10.5% semi-annual senior subordinated notes ($280mm issue) due November 15, 2016, which are
currently trading at par. With the U.S.
10-year bond currently offering 4.12% these high yield bonds present a spread
of 638 bps over the risk-free rate of return. I believe by investing in these
high yield bonds at par, one is getting a very good risk-adjusted
return—equity-like returns with much less risk than the equity markets.
SBH is one of the best businesses I have ever come across.
It dominates a highly fragmented industry. The industry in which it operates is
largely recession proof based on the past 20 years of industry and company data.
At 6.5x net debt to TTM EBIT, 5.7x run-rate EBIT and 5.5x 2008E EBIT the
valuation is extremely compelling. The management team is very experienced and
exceptionally good. The company continues to grow the business with minimal
capital investments (at 20-60% pre-tax ROIC), cut costs, further realize distribution
efficiencies and consistently pay down debt. Management has delivered on
everything they said they would do over the past year since being spun out of
Alberto Culver (NYSE: ACV).
Business Description: Sally Beauty Holdings, Inc. engages in
the distribution and retail of professional beauty supplies in the United
States and internationally. It operates in
two segments, Sally Beauty Supply and Beauty Systems Group. The Sally Beauty
Supply segment offers third-party branded and private label beauty products,
including hair care, nail care, beauty sundries, and appliances to retail
consumers and salon professionals. The Beauty Systems Group segment operates as
a beauty supply distributor offering professional brands directly to salons and
salon professionals through its sales force and professional-only stores. As of
September 30, 2007, the
company operated 2,694 Sally Beauty Supply stores, 699 Beauty Systems Group
stores and employed 1,067 professional distribution sales consultants. It had
175 Beauty Systems franchised stores in North America,
as well as in selected European countries and Japan.
SBH has exclusive regional distribution agreements on many of the beauty
products it sells and as a result many SKUs are not available in the mass
channel. Product suppliers like to sell through SBH because they gain national
distribution while maintaining a premium brand image that allows them to charge
premium pricing.
Sustainable Competitive Advantage: SBH is the largest
retailer (read distributor) of professional beauty supplies in the U.S.
based on store count by a factor of OVER 20x! It has the ONLY NATIONAL
DISTRIBUTION NETWORK. Its Sally Beauty Supply division at ~$1.6 billion in
sales represents 22.5% of the almost $7.0 billion professional beauty supply channel.
This segment of the market is extremely fragmented. There is not another
national competitor in this specific part of the market that exists. This
division represents 84% of SBH’s operating profit. Its less profitable Beauty
Systems Group represents 14% of the total market in terms of sales and is over
twice as large as its next closest competitor, Beauty Alliance. Its store count
is 5x (counting franchisees; 4x without) as large as Beauty Alliance, which was
bought this past year by L’Oreal in order to gain greater control of its
distribution to salon professionals. As a result, L’Oreal pulled product from
SBH’s BSG segment and did not renew its prior exclusive agreement with SBH.
Beauty Alliance only has a bricks
and mortar presence in 14 states and 35% of its store base is in Florida—a
real plus! It has no presence in California,
the rest of the west coast, northeast and upper mid-west. Over 60% of the
professional beauty supply market is supplied by local “mom and pop” owned
businesses.
Recession Resistant Industry: According to the Professional Consultants & Resources 2006 study (based on manufacturer sales of professional beauty supplies), the U.S. Beauty Supply Industry has experienced steady growth at a 5.0% CAGR with NO SINGLE YEAR BELOW 3.0%! In the last consumer-led recession back in 1991 the industry grew 5.5% and in 2001 it grew 3.0%. We dug up the 1990-1994 annual reports from Alberto Culver, which broke out the Sally Beauty Supply segment. The Sally Beauty Supply division grew its top and bottom line every year. More recently, while many retailers have struggled due to a weakening consumer, SBH’s comps for the quarter were solid. At Sally Beauty Stores they were up 2.4% (off a 3.1% comp from a year ago). At BSG they were up 10.1% (off a 7.4% comp from a year ago). The consolidated comp for the quarter was 4.3% (off of a 4.1% comp from last year's quarter). For the TTM, comps were up 2.7% at the Sally Beauty stores and 10.1% for the BSG stores and averaged out for the chain at 4.5% versus a 2.8% comp from a year ago.
Operating Performance: In the 9/30/07 quarter sales grew 5.5% YoY and for the TTM sales grew 5.9% YoY. Operating margins increased at the Sally Beauty stores from 15.5% to 17.4% YoY. Gross margins for the quarter increased to 46.2% from 45.1% a year ago. This was largely due to an increase in sales of exclusive label products to Sally, margin increases on certain products and a favorable customer mix shift. SG&A as a % of sales for the quarter declined to 32.9% v. 33.5% a year ago.
Adjusted EBITDA for the
most recent September-ending quarter was $88.0mm for a run-rate of $352.0mm.
Adjusted EBITDA for the TTM was $309.5mm. Adjusted EBIT for the quarter was
$75.9mm for a run-rate of $303.7mm and for the TTM was at $266.9mm.
Adjusted EBITDA grew YoY 22.6% in the quarter and 5.4% for the TTM. The reason it grew more in the quarter was because it had more time to off-set the L'Oreal product loss with other companies’ products this quarter than in quarters past due to them finally ramping up.
Valuation: As of 9/30/07, SBH has $1,775.7mm of total debt and cash of $38.3mm or net debt of $1,737.5mm. Thus net debt to TTM EBIT is 6.5x. Net Debt to run-rate EBIT is 5.7x. SBH’s business is not seasonal so it makes sense to value the business using run-rate EBIT (D&A = maintenance capex) based on the 9/30/07 quarter. Based on my 2008 estimate, I believe SBH will do $318.5mm in EBIT, which puts net debt to 2008E EBIT at about 5.5x.
Net debt declined by $39.3mm sequentially, almost double the $20.8mm paid down in the June-ending quarter. Going forward SBH should be able to pay down at least $80mm of debt each year assuming some tuck-in acquisitions. It will be able to pay more debt down each year as its cost savings initiatives continue to kick-in coupled with its organic growth, tuck-in acquisitions continually being integrated and paying less interest expense.
The number of Sally Beauty Supply stores increased 7.3% YoY (4.0% from organic growth) and the number of BSG stores increased 5.6%. The number of BSG sales consultants was down 10.5% YoY (but up 5.5% sequentially) due to the L'Oreal account loss. As a result SBH looked to push more professional sales to the stores. Ultimately, SBH will look to continue ramp back up sales consultants to previous levels as its newly distributed brands take hold.
Inventory even declined by $5.6mm and if you exclude acquisition related inventory, it would have declined by $40mm. Most of this benefit is due to the on-going consolidation of its DCs.
SBH continued to pay down debt all while continuing to do tuck-in acquisitions just like they said they would. Management claims there are no major acquisitions in the world for them to acquire even if they wanted to. The last one available (Beauty Alliance) was acquired by L'Oreal in the past year.
Details on the Senior Subordinated Notes: They are unsecured obligations of Sally Holdings and its co-issuers and are guaranteed on a senior subordinated basis by each domestic subsidiary of Sally Holdings. The senior subordinated notes are carry optional redemption features whereby Sally Holdings has the option to redeem the notes on or before November 15, 2010 and November 15, 2011, respectively, at par plus a premium, plus accrued and unpaid interest, and on or after November 15, 2010 and November 15, 2011, respectively at par plus a premium declining ratably to par, plus accrued and unpaid interest.
Details on the Term Loans: The senior term loan facilities are secured by substantially all of the assets of Sally Holdings and its subsidiaries. The senior term loan facilities may be prepaid at Sally Holdings’ option at any time without premium or penalty and are subject to mandatory prepayment in an amount equal to 50% excess cash flow for any fiscal year unless a specified leverage ratio is met and 100% of the proceeds of specified asset sales that are not reinvested in the business or applied to repay borrowings under the asset-based lending credit facility.
Other Important Details on the Debt: SBH is restricted from buying back stock and/or paying out dividends to shareholders. SBH must pay off the Revolving Credit Facility and Term Loan A and then substantially pay down the Term Loan B before it is able pay off any of the principal of the senior or senior subordinated notes. Also, there are restrictions from the debt that only allows SBH to make small, tuck-in acquisitions. Beauty Alliance was the last substantial acquisition opportunity that existed in the industry.
Recent Spin-off: Sally Beauty Holdings was spun out of
Alberto Culver just over a year ago. A $2.4 billion special cash dividend was
paid to ACV shareholders. SBH was spun out with $1.85 billion of indebtedness.
Clayton, Dubilier & Rice took a 47.7% equity ownership stake for $545mm,
net ($575mm minus a $30mm transaction fee)—paying about $6.35 per share.
Between now and November, 2008 CDR is able to sell 13% of its stake; after
November, 2008 CDR is free to do what it wants with the other 35%. The main
reason it was spun out of Alberto Culver was because the full potential of its
business was not able to be realized as a subsidiary of Alberto Culver. Since
third-party branded product suppliers perceived there to be a conflict of
interest at SBH given that it was selling products to a retailer/distributor
(Sally Beauty Holdings) that was owned by a product supplier competitor
(Alberto Culver) that had SBH sell Alberto Culver products. Due to this
conflict of interest at Sally Beauty Holdings, many product suppliers looked
for alternative ways to distribute its products. P&G’s Wella brand tried to
self-distribute (solely with sales consultants) away from the BSG side over the
past few years, but ultimately failed and recently came back to a newly
independent SBH. The same thing could ultimately happen to L’Oreal as it
realizes it is not worth (from a return on capital perspective) trying to go
more the route of self-distribution.
Attractive Growth Opportunities: SBH plans to continue to
take market share by opening up about 100 Sally Beauty stores per year (3.7%
growth). It believes it can increase its Sally Beauty store base by about 40%
to 3,750 locations—mainly by opening up stores in the south-eastern U.S.,
Mexico, Canada,
UK/Ireland and Latin America. At the same time it plans
to open up about 50 (7.2% increase) new BSG stores per year. Also, SBH will
continue to make tuck-in acquisitions, particularly abroad as it did most
recently in the U.K/Ireland and in Latin America, at very attractive pro forma
valuations of 5-6x TTM EBIT. It is able to make these acquisitions in the
non-BSG market because SBH is the only national company that has the millions of
dollars to buy companies. At the same time it already has the infrastructure so
it can eliminate much of the acquired overhead. Also, SBH has the ability to
buy at better prices than any one else in the industry. The same acquisition
related advantages can be said for the BSG side as well except that L’Oreal is
the only other company that has the deep pockets and a platform in Beauty
Alliance on which to make acquisitions.
High ROIC on New Stores: It takes a $66k capital investment and
$70k of inventory, net of accounts payable or a total of $136k to open a new
Sally Beauty Supply store. An average store generates $575k in sales and $76.6k
in 4-wall operating profit. For a new BSG store it takes a $68k capital
investment and $95k of net inventory. The average BSG store does $1.3mm in
sales and $92.3k in 4-wall operating profit. Thus the pre-tax ROIC on opening a
new store for both segments is about 50%.
Margin Improvement Opportunities: SBH will continue to
consolidate its distribution centers from 16 to 8 and realize more cost
savings. At the same time, it will look to increase private label penetration
at its Sally Beauty stores from 37% to 40%. SBH makes 1000 bps more selling
private label versus branded products. It is important to note that at the BSG
side less than 1% of its sales are private label. This is a huge opportunity
that SBH will attack in 2009 and beyond. The reason it is not going after it at
this point is because many suppliers are currently increasing their allocations
to BSG away from L’Oreal’s Beauty Alliance due to a perceived conflict of
interest there. Ironically, this is the main reason SBH was spun out of ACV in
the first place—got to love the French! Thus SBH does not want to give these
companies any reason to not make the switch away from Beauty Alliance to BSG.
Once this transition is fully implemented throughout 2008, BSG will begin to
make a real private label push starting in 2009.
Solid Management: SBH has a seasoned management team with an average of 19 years of industry experience, 10 years of which has been spent at Sally. CEO Gary Winterhalter has been with Sally for 20 years and has another 16 years of beauty industry experience. The President of Sally Beauty came over from Borders in 2006 and has CRM expertise. He will be very helpful with the DC consolidation.
Conclusion: Even if the U.S. has a consumer led recession in 2008-2009 and the industry declines YoY for the first time in its history, how bad could SBH’s business get? I believe women in general will continue to use the beauty products they like during tough times. There are many other things that women will cut out and/or back on before making a move that they perceive would negatively impact their looks. However, even if the industry declines and thus SBH’s business declines, SBH will still be able to easily cover interest expense. I estimate that net interest expense in 2008 will be about $150mm. On a run-rate SBH is doing $303.7mm in EBIT, which equates to about 2x interest coverage. Even if we go back to 2002, SBH generated $178.8mm in EBIT. However, five years ago, SBH had 19.2% fewer Sally Beauty stores, 45.6% fewer BSG stores, 11.4% fewer franchisees and 12.8% fewer distribution sales consultants. The bottom line is a lot would have to happen for the senior subordinated notes to be impaired based on macroeconomic conditions. If these bonds were to be impaired then that would likely mean the U.S. would be in a severe depression.
The 9/30/07 quarter was a
good proxy to see how SBH’s business responded in the face of the
consumer starting to weaken. Clearly, the next quarter and year will be
even more telling. However, as of now it appears that the female
consumer (just as she did in 1990-1992 and in 2001) puts her beauty
product purchases at the very senior part of her capital structure.
Opinion on SBH Equity: The market is currently pricing SBH at $10.70 or a value of almost $2.0 billion—over $200mm more than net debt! I believe the equity is fully and fairly valued. I do not think it is a short or long at this price. However, the equity and debt markets seem to be disconnected at this time. Either the stock should come down or the bonds should trade up.
Risks: 1) Although I believe SBH's credit risk is minimal, there will likely be a fall-out should the high-yield market weaken further. The high-yield market continues to offer a spread to U.S. Treasuries that is less than 500 bps. In 1991 and 2002, the high-yield market saw spreads 2x that. General disaffection for high-yield bonds could easily cause this paper to decline in price over the short-term. In the middle of this year, the bonds traded down to the low 90s on no news. Importantly, we fail to see how this paper could be worth less than par at maturity; 2) Interest rate risk given there is still a nine year maturity to this paper. Should interest rates rise or fall by 1%, the corresponding loss or gain, would be just greater than 5%. Even if interest rates were to rise 100 bps in a given year, you would still do much better than treasuries since there is a cash yield of 10.5%. A rise in rates should be mitigated by an improved perception of credit quality as the company continues to pay down debt, not to mention should my expected increases in sales, operating margins and free cash flow materialize; 3) Poor returns on tuck-in acquisitions; 4) A U.S. consumer led recession hits and the U.S. Beauty Supply Industry turns out to be economically sensitive this time around; 5) Poor management execution; 6) L’Oreal’s Beauty Alliance takes market share from SBH’s BSG segment (16% of total EBIT).
Disclaimer: My firm and I may or may not own SBH bonds and/or equity. We may trade some or all of our position without notifying anyone. This is not a recommendation to buy or sell anything. Please do your own work and come to your own conclusions.
Catalyst
The company continues to open new stores at a measured pace, grow the top line, realize cost savings from cutting its DCs in half, integrate tuck-in acquisitions, which together allows SBH to continue to pay down more debt each year. The market ultimately realizes how good SBH's business is and thus re-rates these bonds to trade at a lower spread to treasuries given the cheap valuation.