Sally Beauty Holdings, Inc.: Form 10-Q for the period ended Jun 30, 2023

This section discusses management’s view of the financial condition, results of operations and cash flows of Sally Beauty for the periods covered by this Quarterly Report. This section should be read in conjunction with the information contained in our Annual Report on Form 10-K for the fiscal year ended September 30, 2022, including the Risk Factors sections therein, and information contained elsewhere in this Quarterly Report, including the condensed consolidated interim financial statements and notes to those financial statements.

Executive Overview

For fiscal 2023, we are focusing on three key strategic initiatives to drive growth and profitability:

• Enhancing our customer centricity;
• Growing high margin owned brands at Sally Beauty and amplifying innovation; and
• Increasing the efficiency of our operations and optimizing our capabilities.

We believe focusing in these areas will position our company for future growth and further enhance our ability to meet our customers where they are.

Enhancing our customer centricity

During the fiscal year, SBS launched its first Studio by Sally pilot store in Denton, Texas and is expected to open additional pilot stores in our next fiscal quarter. Our Studio by Sally pilot store program has a digital-first focus, from digital check-in to digital education throughout the store and beyond, including personalized appointments at our in-store salons where licensed stylists will train and educate customers, empowering them to personally achieve their desired results. If the pilot stores are successful, we project that we will be able to expand the Studio by Sally concept to 100 locations throughout the U.S. over the next three to four years.

At the end of the quarter, we announced the launch of Happy Beauty Co., a unique new retail store concept that brings to market an engaging beauty experience at a value offering. Happy Beauty Co. offers quality beauty at great prices in an accessible, fun and expressive environment. All of the merchandise is priced under $10 with product offerings encompassing four key categories: Cosmetics & Facial Care, Bath & Body, Nails and Hair, featuring both third-party brands and the Company’s owned brands. The initial pilot store was opened in the Dallas/Ft. Worth market in late June.

Furthermore, earlier this fiscal year, BSG launched a new strategic partnership with Salon HQ to help its professional stylist customers grow their business. The platform is a customizable digital storefront platform that gives stylists the ability to curate a product selection from thousands of BSG merchandise choices, and enables their clients to purchase directly from their shops without the stylists having to finance and carry inventory. As our pilot of Salon HQ enters its next phase of maturation, we made the strategic decision to brand the platform as “Cosmo Prof Direct.” During the quarter, we expanded the platform to an additional seven states, ending the quarter with more than 1,700 digital storefronts spread over nine states. Our stylists are embracing this new tool and gaining a deeper understanding of how they can leverage this resource to profitably grow their business.

Growing high margin owned brands at Sally Beauty and amplifying innovation

We believe growing our SBS owned brands, through innovation and marketing, will provide improved margins, strengthen our long-term relationships with existing customers and help attract new customers. During the fiscal year, we have invested more into marketing of our owned brands and launched our new owned branded vegan product line – bondbar – that’s SLS/SLES-free, paraben-free, phthalate-free and cruelty-free. These initiatives have helped deliver an increase in our owned brands sales penetration, resulting in increased SBS profit margins.

For BSG, vendors have launched new and exciting product lines during the fiscal year, including new bright hues from Paul Mitchell, greys and silver tones from Matrix, and a continued focus on blonding, which is a consistent traffic driver. During the quarter, we saw strong performance from new product launches, including Amika, Wella’s Ultimate Repair, and Danger Jones, as well as expanded distribution with Color Wow.

Increasing the efficiency of our operations and optimizing our capabilities

At the end of fiscal year 2022, we announced our plan to optimize our store base and distribution network to improve overall profitability by closing 330 SBS stores, 35 BSG stores and two BSG distribution centers. During the first half of our fiscal year, we completed the majority of our planned closures. Additionally, we have further optimized our store supply chain network based on our new store fleet. As of June 30, 2023, we have closed 329 SBS stores and 32 BSG stores and the two BSG distribution centers as part of the Plan, while meeting our sales recapture expectations.

See Note 11, Restructuring, in Item 1 of this quarterly report for more information on the Plan.

Earlier this fiscal year, we started testing a new shipping frequency from our distribution centers to a limited population of SBS and BSG stores by leveraging investments within our supply chain systems. We believe we will be able to improve labor productivity, reduce our freight costs and lower our carbon emissions, while maintaining healthy in-stock levels. We have seen positive results from the test and will be expanding to the remaining SBS and BSG store fleet throughout the U.S. and Canada.

Financial Summary for the Three Months Ended June 30, 2023

• Consolidated net sales for the three months ended June 30, 2023, decreased $30.5 million, or 3.2%, to $931.0 million, compared to the three months ended June 30, 2022. Consolidated net sales included a net positive impact from changes in foreign currency exchange rates of $1.9 million;
• Consolidated comparable sales increased 0.6% for the three months ended June 30, 2023;
• Consolidated gross profit for the three months ended June 30, 2023, decreased $15.5 million, or 3.2%, to $474.7 million, compared to the three months ended June 30, 2022. Consolidated gross margin was unchanged at 51.0% for the three months ended June 30, 2023, compared to the three months ended June 30, 2022;
• Consolidated operating earnings for the three months ended June 30, 2023, decreased $9.1 million, or 9.2%, to $90.1 million, compared to the three months ended June 30, 2022. Operating margin decreased 60 bps to 9.7% for the three months ended June 30, 2023, compared to the three months ended June 30, 2022;
• For the three months ended June 30, 2023, our consolidated net earnings increased $4.3 million, or 9.1%, to $50.8 million, compared to the three months ended June 30, 2022;
• For the three months ended June 30, 2023, our diluted earnings per share was $0.46 compared to $0.43 for the three months ended June 30, 2022; and
• Cash provided by operations was $53.1 million for the three months ended June 30, 2023, compared to $52.0 million for the three months ended June 30, 2022.

Trends Impacting Our Business

Global inflationary pressures continued to influence consumer and stylist shopping behavior along with the cost for products and services. In the U.S. and Canada, we are seeing our SBS retail customers color their hair less frequently and reduced the size of their basket when they shop with us, while at BSG we are seeing a continuation of stylist demand trends we’ve seen over the last several quarters. These inflationary pressures have also impacted wages, especially among retail and hourly employees, as we have experienced an increase in our labor costs in order to attract and retain associates.

During the current year, these headwinds have resulted in lower traffic and conversion in our business and increases in certain operating costs. We continue to monitor these challenges and implement measures to help mitigate their impacts, including managing our inventory levels to reduce out-of-stock items, adjusting our promotional activities, optimizing our store base and expanding our partnerships with delivery service providers. Although these initiatives have helped mitigate ongoing macro-headwinds, we cannot reasonably predict the long-term effects of inflation. Furthermore, in a measure to curb inflation, the U.S. Federal Reserve has increased the federal funds effective rate. In turn, these increases have raised the cost of debt borrowings.

Comparable Sales

We believe that comparable sales is an appropriate performance indicator to measure our sales growth compared to the prior period. Our comparable sales include sales from stores that have been operating for 14 months or longer as of the last day of a month and e-commerce revenue. Additionally, comparable sales include sales to franchisees and full service sales. Our comparable sales excludes the effect of changes in foreign exchange rates and sales from stores relocated until 14 months after the relocation. Revenue from acquisitions are excluded from our comparable sales calculation until 14 months after the acquisition. Our calculation of comparable sales might not be the same as other retailers as the calculation varies across the retail industry.

Overview

Key Operating Metrics

The following table sets forth, for the periods indicated, information concerning key measures we rely on to evaluate our operating performance (dollars in thousands):

(a) Unallocated expenses consist of corporate and shared costs and are included in selling, general and administrative expenses in our condensed consolidated statements of earnings.

(b) Our June 30, 2023, store count was impacted by store closure in connection with the Plan. See Note 11, Restructuring, in Item 1 of this quarterly report for more information on the Plan.

Results of Operations

The Three Months Ended June 30, 2023, compared to the Three Months Ended June 30, 2022

Net Sales

SBS. The decrease in net sales for SBS was primarily driven by the following (in thousands):

(a) Includes closed stores, including stores closed under the Plan, net of stores opened for less than 14 months

The increase in SBS’s comparable sales was a result of a growth in our average unit retail, primarily from inflationary impacts and pricing leverage. Comparable sales were also positively impacted by recapturing approximately half of the sales from stores closed in connection with the Plan.

BSG. The decrease in net sales for BSG was primarily driven by the following (in thousands):

(a) Includes closed stores, including stores closed under the Plan, net of stores opened for less than 14 months

BSG’s comparable sales faced headwinds from the from the continuation of stylist demand trends seen over the last several quarters, which resulted in fewer units per transaction, partially offset by an increase in our average unit retail.

Gross Profit

SBS. SBS’s gross profit decreased for the three months ended June 30, 2023, as a result of a decrease in net sales, partially offset by a higher gross margin. SBS’s gross margin grew as a result of pricing leverage and increased penetration of our owned brand products.

BSG. BSG’s gross profit decreased for the three months ended June 30, 2023, as a result of a decrease in net sales and a lower gross margin. BSG’s gross margin decline was driven by lower product margin resulting from an unfavorable sales channel mix between stores and lower-margin Regis e-commerce sales, and a shift in some distribution center costs from selling, general and administrative expenses into gross margin.

Selling, General and Administrative Expenses

SBS. SBS’s selling, general and administrative expenses decreased $8.2 million, or 3.5%, for the three months ended June 30, 2023, and included an unfavorable impact from foreign exchange rates of $1.4 million. As a percentage of SBS net sales, selling, general and administrative expense for the three months ended June 30, 2023, was 42.2% compared to 42.4% for the three months ended June 30, 2022. The decrease was due to cost savings resulting from the Plan as well as lower advertising expenses, partially offset by higher labor and accrued bonus expenses.

BSG. BSG’s selling, general and administrative expenses increased $0.2 million, or 0.2%, for the three months ended June 30, 2023. As a percentage of BSG net sales, selling, general and administrative expense for the three months ended June 30, 2023, was 28.2% compared to 27.2% for the three months ended June 30, 2022. The increase as a percentage of sales was driven primarily by higher labor and accrued bonus expenses, partially offset by a shift in some distribution center costs from selling, general and administrative expenses into gross margin.

Unallocated. Unallocated selling, general and administrative expenses, which represent certain corporate costs that have not been charged to our reporting segments, increased $1.2 million, or 2.7%, for the three months ended June 30, 2023, primarily due to higher labor and accrued bonus expenses and information technology expense. These increases were partially offset by prudent cost control and the lapping of disposal costs for obsolete personal-protective equipment inventory in the prior year.

Interest Expense

The decrease in interest expense is primarily due to the lapping of debt extinguishment costs in the prior year related to the repayment of our 8.75% Senior Notes due 2025 and from fewer debt borrowings outstanding, partially offset by higher interest rates on our variable rate debt. Additionally, our interest rate swap has helped mitigate some of the additional interest costs resulting from higher interest rates.

Provision for Income Taxes

The effective tax rates were 28.9% and 26.3%, for the three months ended June 30, 2023, and 2022, respectively. The increase in the effective tax rate was primarily due to additional taxes and interest for the one-time transition tax on unrepatriated foreign earnings ("Repatriation Tax") related to the fiscal year ended September 30, 2018, which is currently under IRS audit.

The Nine Months Ended June 30, 2023, compared to the Nine Months Ended June 30, 2022

Net Sales

SBS. The decrease in net sales for SBS was primarily driven by the following (in thousands):

(a) Includes closed stores, including stores closed under the Plan, net of stores opened for less than 14 months

SBS’s comparable sales increase was driven by a growth in our average unit retail, primarily from inflationary impacts and pricing leverage and the lapping of Omicron and supply chain challenges. Comparable sales were also positively impacted by recapturing approximately half of the sales from stores closed in connection with the Plan.

BSG. The decrease in net sales for BSG was primarily driven by the following (in thousands):

(a) Includes closed stores, including stores closed under the Plan, net of stores opened for less than 14 months

BSG’s comparable sales faced headwinds from elevated demand in the prior year from the easing of COVID-19 restrictions and the continuation of stylist demand trends seen over the last several quarters, which resulted in fewer transactions and units per transaction, partially offset by an increase in our average unit retail.

Gross Profit

SBS. SBS’s gross profit decreased for the nine months ended June 30, 2023, as a result of fewer net sales, partially offset by a higher gross margin. SBS’s gross margin grew as a result of pricing leverage, increased penetration of our owned brand products and adjustments to our expected obsolescence reserve related to the Plan.

BSG. BSG’s gross profit decreased for the nine months ended June 30, 2023, as a result of fewer net sales and a lower gross margin. BSG’s gross margin decline was driven by lower product margin resulting from an unfavorable sales channel mix between stores and lower-margin Regis e-commerce sales, and a shift in some distribution center costs from selling, general and administrative expenses into gross margin, partially offset by adjustments to our expected obsolescence reserve related to the Plan.

Selling, General and Administrative Expenses

SBS. SBS’s selling, general and administrative expenses decreased $14.8 million, or 2.1%, for the nine months ended June 30, 2023, and included a favorable impact from foreign exchange rates of $5.4 million. As a percentage of SBS net sales, selling, general and administrative expense for the nine months ended June 30, 2023, was 41.8% compared to 42.1% for the nine months ended June 30, 2022. The decrease as a percentage of sales was primarily driven by cost savings from the closure of stores in connection with the Plan and lower advertising expenses, partially offset by higher labor and accrued bonus expenses.

BSG. BSG’s selling, general and administrative expenses increased $6.2 million, or 1.8%, for the nine months ended June 30, 2023, and included a favorable impact from foreign exchange rates of $2.2 million. As a percentage of BSG net sales, selling, general and administrative expense for the nine months ended June 30, 2023, was 28.6% compared to 27.6% for the nine months ended June 30, 2022. The increase was primarily driven by higher labor and accrued bonus expenses, partially offset by a shift in some distribution center costs from selling, general and administrative expense into gross margin.

Unallocated. Unallocated selling, general and administrative expenses, which represent certain corporate costs that have not been charged to our reporting segments, increased $18.0 million, or 13.7%, for the nine months ended June 30, 2023, primarily due to higher labor and accrued bonus expenses and information technology expenses. These increases were partially offset by prudent cost control and the lapping of disposal costs for obsolete personal-protective equipment inventory.

Restructuring

For the nine months ended June 30, 2023, we incurred $18.1 million in restructuring charges related to the Plan. For the nine months ended June 30, 2022, restructuring charges in connection with our prior transformation plan were immaterial. See Note 11, Restructuring, in Item 1 of this quarterly report for more information on the Plan.

Interest Expense

The decrease in interest expense was primarily due to the lapping of debt extinguishment costs related to the repayment of our 8.75% Senior Notes due 2025 in fiscal year 2022, partially offset by higher interest rates on our variable rate debt and an increase in our average borrowings outstanding under our ABL facility. Additionally, our interest rate derivatives have helped mitigate some of the impacts from higher interest rates on a portion of our variable rate debt.

Provision for Income Taxes

The effective tax rates were 27.1% and 27.0% for the nine months ended June 30, 2023 and 2022, respectively. The increase in the effective tax rate was primarily due to Repatriation Tax related to the fiscal year ended September 30, 2018, which is currently under IRS audit, offset by greater losses in the prior year quarter for which a tax benefit could not be recognized.

Liquidity and Capital Resources

Overview

Our principal sources of liquidity are cash from operations, cash and cash equivalents and borrowings under our ABL facility. A substantial portion of our liquidity needs arise from funding the costs of our operations, working capital, capital expenditures, debt interest and principal payment. Additionally, under our share repurchase program, see below for more details, we will from time-to-time repurchase shares of our common stock on the open market to return value to our shareholders. At June 30, 2023, we had $541.0 million in our liquidity pool, which includes $466.7 million available for borrowing under our ABL facility and cash and cash equivalents of $74.3 million.

Our working capital (current assets less current liabilities) increased $169.3 million, to $633.8 million at June 30, 2023, compared to $464.5 million at September 30, 2022. The increase was driven by higher inventory balances, resulting from inflationary vendor cost increases and $24.6 million from foreign exchange rates, partially offset by optimization efforts to improve inventory stocking levels. The increase was further driven by fewer outstanding borrowings under our ABL facility, a reduction in our accounts payable, due to the timing of payments and impacts of optimization efforts around inventory purchases, and by fewer accrued liabilities, due to the timing of interest and payroll payments, partially offset by an increase in accrued bonuses.

We anticipate that existing cash balances (excluding certain amounts permanently invested in connection with foreign operations), cash expected to be generated by operations, and funds available under our ABL facility will be sufficient to fund our working capital and capital expenditure requirements over the next twelve months.

Cash Flows

(in thousands)

Net Cash Provided by Operating Activities

The increase in cash provided by operating activities was driven by the timing of inventory purchases, primarily from the impact of global supply chain issues in the prior year, partially offset by fewer net sales for the current year.

Net Cash Used by Investing Activities

The decrease in cash used by investing activities was driven by fewer capital expenditures related to store improvements and information technology.

Net Cash Used by Financing Activities

The decrease in cash used by financing activities was primarily due to no shares repurchased in the current year under our share repurchases program and from fewer net debt repayments in the current year.

Debt and Guarantor Financial Information

During the fiscal year, we entered into a seven-year term loan facility agreement in the aggregate principal amount of $400.0 million and used the proceeds to subsequently repay our previously existing term loan facility. See Note 8, Short-term Borrowings and Long-term Debt, in Item 1 of this quarterly report for more information.

At June 30, 2023, we had $1,095.0 million in outstanding debt, not including finance lease obligations, unamortized debt issuance costs and debt discounts, in the aggregate, of $9.9 million. Our debt consists of $680.0 million in 2025 Senior Notes outstanding, $399.0 million remaining on our term loan and $16.0 million in outstanding borrowings under our ABL facility.

We utilize our ABL facility for the issuance of letters of credit, certain working capital and liquidity needs, and to manage normal fluctuations in our operational cash flow. In that regard, we may from time to time draw funds under the ABL facility for general corporate purposes including funding of capital expenditures, acquisitions, paying down other debt and share repurchases. Amounts drawn on our ABL facility are generally paid down with cash provided by our operating activities. During the nine months ended June 30, 2023, the weighted average interest rate on our borrowings under the ABL facility was 5.9%.

We are currently in compliance with the agreements and instruments governing our debt, including our financial covenants.

Guarantor Financial Information

Our 2025 Senior Notes were issued by our wholly-owned subsidiaries, Sally Holdings LLC and Sally Capital Inc. (the “Issuers”). The notes are unsecured debt instruments guaranteed by us and certain of our wholly-owned domestic subsidiaries (together, the “Guarantors”) and have certain restrictions on the ability of our subsidiaries to make certain restrictive payments to Sally Beauty. The guarantees are joint and several, and full and unconditional. Certain other subsidiaries, including our foreign subsidiaries, do not serve as guarantors.

The following summarized consolidating financial information represents financial information for the Issuers and the Guarantors on a combined basis. All transactions and intercompany balances between these combined entities has been eliminated.

The following table presents the summarized balance sheets information for the Issuers and the Guarantors as of June 30, 2023, and September 30, 2022:

(in thousands)

The following table presents the summarized statement of earnings information for the Issuers and the Guarantors for nine months ended June 30, 2023 (in thousands):

Share Repurchase Programs

Under our current share repurchase program, we may from time-to-time repurchase our common stock on the open market. During the nine months ended June 30, 2023, no shares were repurchased in connection with our share repurchase program. During the nine months ended June 30, 2022, we repurchased 6.8 million shares of our common stock for $130.3 million under our share repurchase program. See Note 4, Stockholders’ Equity, for more information about our share repurchase program.

Contractual Obligations

Other than our debt, as discussed above, there have been no material changes outside the ordinary course of our business to our contractual obligations since September 30, 2022.

Off-Balance Sheet Financing Arrangements

At June 30, 2023, and September 30, 2022, we had no off-balance sheet financing arrangements other than outstanding letters of credit related to inventory purchases and self-insurance programs.

Critical Accounting Estimates

There have been no material changes to our critical accounting estimates or assumptions since September 30, 2022.

Recent Accounting Pronouncements

There have been no recent accounting pronouncements issued that will have a material impact to our business.

As a multinational corporation, we are subject to certain market risks including foreign currency fluctuations, interest rates and government actions. See our disclosures about market risks contained in Item 7A. “Quantitative and Qualitative Disclosures about Market Risk” in Part II of our Annual Report on Form 10-K for the fiscal year ended September 30, 2022.

Since September 30, 2022, there have been changes to our debt structure, including amending debt terms to replace LIBOR with SOFR, and with our derivative instruments used to help mitigate the interest rate risks associated with variable-rate debt. See Note 8, Short-term Borrowings and Long-term Debt, and Note 9, Derivative Instruments and Hedging Activities, in Item 1 of this quarterly report for more information on these changes.

At June 30, 2023, we had $415.0 million in outstanding floating interest rate debt, with $200 million of SOFR denominated interest hedged under an interest rate swap agreement. As of June 30, 2023, a 1.0 percentage point interest rate increase would negatively impact our annual interest expense and cash flows by $2.2 million.

Controls Evaluation and Related CEO and CFO Certifications. Our management, with the participation of our principal executive officer (“CEO”) and principal financial officer (“CFO”), conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2023. The controls evaluation was conducted by our Disclosure Committee, comprised of senior representatives from our finance, accounting, internal audit, and legal departments under the supervision of our CEO and CFO.

Certifications of our CEO and our CFO, which are required in accordance with Rule 13a-14 of the Exchange Act, are attached as exhibits to this Quarterly Report. This “Controls and Procedures” section includes the information concerning the controls evaluation referred to in the certifications, and it should be read in conjunction with the certifications for a more complete understanding of the topics presented.

Limitations on the Effectiveness of Controls. We do not expect that our disclosure controls and procedures will prevent all errors and all fraud. A system of controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the system are met. Because of the limitations in all such systems, no evaluation can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. Furthermore, the design of any system of controls and procedures is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how unlikely. Because of these inherent limitations in a cost-effective system of controls and procedures, misstatements or omissions due to error or fraud may occur and not be detected.

Scope of the Controls Evaluation. The evaluation of our disclosure controls and procedures included a review of their objectives and design, our implementation of the controls and procedures and the effect of the controls and procedures on the information generated for use in this Quarterly Report. In the course of the evaluation, we sought to identify whether we had any data errors, control problems or acts of fraud and to confirm that appropriate corrective action, including process improvements, was being undertaken if needed. This type of evaluation is performed on a quarterly basis so that conclusions concerning the effectiveness of our disclosure controls and procedures can be reported in our Quarterly Reports on Form 10-Q and our Annual Reports on Form 10-K. Many of the components of our disclosure controls and procedures are also evaluated by our internal audit department, by our legal department and by personnel in our finance organization. The overall goals of these various evaluation activities are to monitor our disclosure controls and procedures on an ongoing basis and to maintain them as dynamic systems that change as conditions warrant.

Conclusions regarding Disclosure Controls. Based on the required evaluation of our disclosure controls and procedures, our CEO and CFO have concluded that, as of June 30, 2023, we maintain disclosure controls and procedures that are effective in providing reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting. During our most recent fiscal quarter, there have been no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

In addition to the other information set forth in this Quarterly Report, you should carefully consider the factors contained in Item 1A. “Risk Factors” in Part I of our Annual Report on Form 10-K for the fiscal year ended September 30, 2022, which could materially affect our business, financial condition or future results. There have been no material changes from the risk factors disclosed in such Annual Report. The risks described in such Annual Report and herein are not the only risks facing our company.