Tuesday, August 14, 2007

Sally Beauty: The Good, the Bad and the Ugly

Last week Sally Beauty released its 3rd Quarter results. There isn't really much news here except that L'Oreal has hurt Sally by pulling products from Beauty Systems Group's (BSG). In the spring L'Oreal bought Beauty Alliance, a BSG competitor, so it no longer made sense for them to continue selling through another company. The bad news is that this has cost Sally some sales and dropped the price of Sally shares to their when-issued price.

The ugly news, which isn't really news to anyone, is Sally's rather massive debt load. On the conference call, there were some questions about how quickly the debt can be retired. Unsurprisingly, the covenants for the senior notes limit the speed Sally can pay off higher interest junior notes. So the debt may be with us for many years. Remember that the debt lowers net earnings, but also lowers taxes. Enterprise value is about $10 a share higher than the current stock price because of the debt load. A company representative on the call said something like, "We are in the beauty supply distribution business, not the bond trading business." At the moment, cash flow more than covers debt service, so the result is ugly not outright bad.

Now for the good news. I think the L'Oreal moves are a net positive for Sally Beauty in the long run. When Alberto-Culver spun off Sally, one of the primary reasons was that the association hurt the BSG business. Companies such as L'Oreal and Proctor&Gamble weren't happy about using a competitor's subsidiary to distribute their products. Since the split, it appears more brands are interested in being distributed by Sally Beauty, with the obvious exception of L'Oreal. Since L'Oreal has entered the distribution business, its competitors will have a vested interest in keeping other channels, such as BSG, open so that their products can be sold in salons.

I don't know if L'Oreal's gamble to go into the distribution business will work out, but it seems like a pretty good risk for them. Conversely, the gamble ought to be good for Sally because although they have lost a major supplier, L'Oreal has essentially taken out a major competitor. Only if fashion continues to focus on L'Oreal professional products in the next few years will Sally be in serious trouble.

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