Sally Beauty returned 25% since we first recommended it less than 6 months ago. SBH also gave our readers another time to buy when it dropped after the L'Oreal scare. We further expect the company to continue creating shareholder value over the long term at above average rates.

Our coverage of Sally Beauty will cease as we focus more energy on uncovering more lucrative opportunities. One thing that we believe is holding SBH back is the speed at which it is executing on its growth strategy. Smaller companies can execute strategy faster, which is why we are shifting our focus to uncovering more companies like Peace Arch Entertainment (PAE) and Premier Exhibitions (PRXI), each of which has more than doubled since October.

Since our last report, in which we stated that the 13% sell-off was overdone, SBH is up 18% from $7.75 to $9.15. There was a conference call on February 8th where Management outlined growth plans but the call contained no information that was terribly surprising. What follows are highlights from the conference call and an update since our last report. If you are unfamiliar with SBH, our initial report is worth reading.

Comments by CEO
Winterhalter, CEO, admitted that the change in the L'Oreal distribution agreement (which caused the sell-off) was unexpected. Although we are concerned that Winterhalter did not anticipate the change, we do appreciate his candor. He went on to describe how the company will minimize the lost revenue. SBH will increase the number of products it offers and expand existing product lines into new territories where they are not currently offered. Targeted sales force reductions will also be implemented in order to reduce costs.

More importantly, SBH's distribution agreement with P&G was broadened to include more brands. BSG will also be permitted to target salons that are outside of P&G's target geographies. Winterhalter revealed that BSG will receive some exclusive distribution rights and said that although this agreement will not have a meaningful impact on earnings, it is an example of how agreements are continually being revised, which helps put the L’Oreal problem into perspective.

Winterhalter praised the President of BSG for his ability to retain sales consultants despite the revised L'Oreal agreement. We always like to see CEO's give credit when credit is due. Although this may seem petty, comments like these are revealing of the management team. Sometimes the CEOs like to take all the credit, which we find concerning.

Growth Plans
Management intends to grow the company by acquiring new products and brands and by acquiring distributors to expand and optimize the distribution network. Within a few days SBH issued a press release saying they would acquire Chapleton, a European beauty products distributor. These acquisitions not only benefit SBH in the short term but any improvement in the distribution network increases its competitive advantage.

Compete with L'Oreal?
One analyst suggested that SBH may find itself competing with L'Oreal for acquisitions. After all, L'Oreal does have a stake in Beauty Alliance, an SBH competitor. However, SBH is looking to diversify its suppliers so we should expect them to avoid acquiring distributors that carry a large percentage of L'Oreal products. As a result, Winterhalter does not expect to compete with L'Oreal for acquisitions, as L'Oreal will be looking to acquire distributors that already carry their products.

No Spin-off of BSG
Another analyst suggested a spin-off of BSG, which has lower margins and occupies a lot of Management's time. The CEO said that BSG along with Sally are what makes SBH an attractive distributor to suppliers. The value proposition would be diminished if BSG were no longer part of SBH.

Conclusion
Not much has changed since we initiated coverage. We like that the debt is not hindering the acquisition strategy and that Management is looking to diversify its suppliers. Concentration of suppliers and debt continue to be the biggest risks facing SBH. We think that Management will continue to create value and manage the risks facing the company.

Note: Our initial report better explains why we like this company. This article is meant as an update.

Disclosure: Author is long SBH

Sally Beauty Holdings (SBH) (view initial report) announced on Tuesday that they are no longer the exclusive distributors of L'Oreal USA professional products and the Armstrong McCall division of BSG would no longer distribute Redken professional products. (See the press release for details) On the news the stock fell 13%. Was the sell-off overdone? We needed to determine the immediate implications for SBH and whether this agreement is a precursor to further problems at SBH in particular or with the industry as a whole.

Short-term Implications
The short term implications were stated in the press release: a $110M (or 5%) negative impact on sales for the last nine months in FY07. This number includes negative indirect impacts on other products. We would like to be able to verify this number but must instead rely on management's best judgment because they have access to much more detailed information. The effect on net income is tough to determine because margins on L'Oreal products aren't as high as private label but any incremental revenue leverages fixed costs. These factors may cancel one another out or result in a net decline in margins. We just can't know without SBH providing guidance.

Affect On The Future
The next question we asked ourselves was "what does this mean for the future of SBH and other distributors?" To do this we must understand why L'Oreal pulled the exclusive distribution rights. We read through L'Oreal’s 2005 Annual Report and found some useful information. First, a new CEO has taken the helm and has a history of aggressively boosting growth of the L'Oreal brands. L'Oreal's products have experienced significant growth in North America and the newly introduced brands, including Redken and Matrix, are evolving. The new distribution agreement looks like it is just part of the ongoing evolution of L'Oreal's brands and not a result of a larger industry shift or as a result of SBH doing something "wrong."

No Longer Exclusive Distributor of L'Oreal USA Professional Products
L'Oreal is trying to boost growth of their professional products lines. They have not pulled the products from SBH stores, but have instead chosen to seek additional distribution channels. The BSG sales force will no longer be able to sell L'Oreal Professional Products.

We believe this is because L'Oreal wants to direct-sell to salons - not that they intend to switch distributors in the short term. L'Oreal is a large beauty supply manufacturer with great ambitions of North American growth. SBH has the largest North American footprint and is best able to help L'Oreal realize their goals.

L'Oreal owns a 30% stake in Beauty Alliance, an SBH competitor. BA has fewer stores and would take at least several years to become a formidable competitor. In this time we believe SBH will continue to grow and adapt to protect its competitive advantage. If L'Oreal eventually drops SBH, we anticipate SBH would have had enough time to reduce its reliance on L'Oreal and minimize the effect on earnings.

By preventing BSG's salesforce from selling L'Oreal Professional Products, L'Oreal is almost certainly going to distribute directly to salons. Our question is, with a smaller salesforce than BSG, how does L'Oreal expect to sell to mid-size and smaller salons? P&G pulled its products from SBH and experienced this exact problem. They since returned their products to SBH.

Replacing Redken with Matrix
In the last year, Redken has experienced "high penetration in ultra-fashionable hair salons." (L'Oreal 2005 Annual Report) Large ultra-fashionable salons are not SBH’s target market because they are less profitable. In the last conference call Winterhalter said, "[Big salons] all want huge discounts and they all want to be the only person on the block carrying that particular product line." SBH no longer distributes Redken but will distribute a L'Oreal newcomer, Matrix, which is "targeted at a wire range of salons offering affordable prices and services." Longer term, we believe it makes more sense (for L'Oreal and Sally Beauty) that SBH carry Maxim instead of Redken. Suddenly this product loss doesn't sound so bad; now we look at L'Oreal USA Professional Products.

Put it in Perspective
SBH has made a lot of people a lot of money since the spinoff. It rose quickly and traders didn't hesitate to lock in gains. To put the announcement in perspective, we must remember that Beauty Systems Group represents roughly half of SBH's revenue. Less than half of BSG revenue is from hair products. Of this, an even smaller portion is L'Oreal products and smaller still are the sales lost as a result of this new agreement. Additionally, BSG is shifting towards private label which has higher margins. We don't believe that this press release warrants a 13% stock drop. We have used the opportunity to increase our SBH position.

Note: SBH closed today at $7.76 down 3% on top of yesterday's 13% decline.
Disclosure: Author is long SBH

Become a member and you can subscribe to updates about the companies we cover.

Garry Winterhalter (CEO) held an investor presentation for the first time since SBH was spunoff from Alberto-Culver. Key quotations include Winterhalter's thoughts on: the threats posed by direct marketing and product diversion, how SBH differentiates its products, and the opportunities for growth.

Editor's Note: SBH is up over 20% since we initiated coverage

One of the first things I noticed was how enthusiastic Gary Winterhalter is about the future of SBH. In his opening, he says that: the management team is "very passionate and very proud," "sally is a great company," and that the spinoff presents a "tremendous opportunity." It is always good to see this enthusiasm and entrepreneurial spirit as it is one of the factors that makes a good spinoff.

Growth Strategy

• Margins grow as customers shift to controlled label and as retail grows faster than professional. (This natural margin enhancement has already been going on for years)
• Better sourcing of products from Far-East – eliminate middlmen
• Increase customer loyalty – headed by Sally President Mike Spinozzi who lead similar initiatives at Borders Books
• Consolidate distribution centers, advertising, AR, management, etc.
• At Sally - Increase new store growth in US, Canada, and Mexico

On product differentiation:
"Our desire is to carry nothing that's available in the retail channel because it doesn't fit our umbrella of being a purveyor of professional beauty supplies"

"High in-stock position is extremely important"
"When [professionals] come to us for a product that they only use once or twice a year, it's a very low turning product for us, but we have to have it in stock because that's their expectation of us."
Downside: don't turn inventory as much as some retailers.
Upside: higher margins than most retailers.

On the threat of direct sales:
"[Manufacturers direct sell to] very large salons … and that's actually fine with us because we don’t do real well in those big salons anyway."
"[Big salons] all want huge discounts and they all want to be the only person on the block carrying that particular product line."
He says it is only economical for manufacturers to go after 8% of salons, which represent only about 20% of the money.

On product diversion:
How product diversion affects SBH: Half of products in salons are resold to individuals.
When those individuals can buy the same product (at a discount) in their pharmacy this hurts SBH’s business.
"[Manufacturers] need numbers and they kind of turn their head"
"You will see us being very active along with Regis in fighting this problem"

On debt repayment and free cash flow:
"We think we have a lot of free cash flow on top of the debt service to further pay down debt"
He later stated that debt is relatively inexpensive in the current environment and there's no need to go to extreme measures to pay it down. (This was in response to an analyst who suggested franchising stores to generate cash)

Additional Resources
A recording of the investor presentation can be found here
You may also want to read our ongoing analysis of SBH or our initial research report on SBH.

Disclosure: Author is long SBH

Five trading days have passed since SBH was spunoff from ACV. The stock has opened higher every day, advancing up to 18% within the first few days but has remained relatively unchanged today. Current price is $8.65.

We don't base our decisions on the following, but we think there were people who wanted to own SBH and/or ACV and have waited until the spinoff and dividend - for tax reasons. We're thinking that capital appreciation mutual funds wouldn't have wanted the dividend. Additionally, investors who are outside of the US would have come out ahead if they held off their purchase until after the spinoff to avoid the 30% withholding tax on the $25 dividend. These investors would have come out ahead even if they missed the 7% advance last Friday.

Also, because 47.5% of the shares are owned by CD&R, investors should be prepared for volatile movements in the stock price due to the smaller float.

In hindsight, we believe these factors may have contributed to the fairly rapid price appreciation.

We look at this stock as a long term holding; if our theory about volatility proves correct then there may be a chance to buy more shares in the coming days/weeks.

Disclosure: Author is long SBH

SBH gained about 7% on Friday (the day of the spinoff) and is up about 7% today. We took the weekend to analyze the company so missed out on Friday's gains. Today it opened higher so we haven't realized all of today's gains either. However, at $8.41, we like the company's prospects just as much as we liked them at Friday's opening price.

More analysts are covering ACV than SBH and we hope this will lead to some irrational pricing in the coming days. We would take advantage of a decline to increase our position. But we can't be sure we will see this.

Disclosure: Author is long SBH

A Very Unique Spinoff
On November 17, 2006, Alberto-Culver (ACV) completed its spinoff of Sally Beauty Holdings (SBH) and paid a $25 special dividend. Shareholders of ACV (pre-spinoff) received 1 share of SBH for every share of ACV. This spinoff was atypical, because Clayton, Dubilier & Rice (CD&R), a private equity firm, purchased 47.5% of SBH as part of the spinoff agreement (the largest percentage while preserving tax-free treatment). Also, SBH funded the $25/share dividend and incurred $1.8 billion of debt. This sets up a situation where you and I can participate in a leveraged buyout. Sound interesting?

Business Description
SBH is a distributor of higher-end hair care, skin care, and related products. The company has two divisions, one distributes to retail and professional customers (Sally Beauty) while the other solely supplies professional salons (Beauty Systems Group, or BSG). See end of report for an in-depth business description.

Industry Outlook
The industry is growing as demographic shifts occur. The most significant of these shifts is the aging of baby boomers. People will always pay to look good, and the older customers are less fickle and, better yet, have money.

Competitive Advantage
We believe SBH has a sustainable economic moat. SBH is the largest distributor in a fragmented industry, which should allow SBH to use its large distribution network as a bargaining chip when negotiating with manufacturers. The company has expanded geographically over many years and the distribution network cannot be easily or quickly replicated by competitors. Its largest competitor, Regis Corporation, was originally going to buy SBH before ACV cancelled the agreement due to Regis's declining share price. This is when CD&R stepped in and spinoff talks began.

Growth Prospects
From the most recent investor conference call, we heard that SBH expects to grow the top line (geographical expansion), operating margins (cost controls), and profit margins (reduction of interest expense). Growing sales, margins, and potentially accelerating EPS growth (CEO foresees double digit EPS growth) could lead to P/E expansion.

Cash Flows and Return on Capital
SBH has impressive cash flow generating abilities which was probably the reason CD&R consented to loading the company with debt. Additionally, the return on tangible capital employed is around 15-17%. This number changes depending on assumptions but is clearly in excess of the cost of capital. It appears high and demonstrates SBH’s ability to leverage its distribution network.

An Attractive Spinoff
Now that we’ve seen why the company and industry are attractive, let’s look at the factors that make this a particularly promising spinoff. CD&R has experience with owning and managing distribution companies. CD&R has a $575 million stake in SBH and cannot sell their stock for 2 years. They control 6 of the 12 Directors. Additionally, they probably lobbied for a lower spinoff valuation of SBH which could have reduced the price for us individual investors.

Debt to enterprise value is roughly 60%. As this debt is paid down we will see "deleveraging" contribute to EPS growth.

ACV and SBH have conflicting interests. Although owning SBH gave ACV control over its distribution network, ACV was looking for growth, and wanted to expand into other channels which directly competed with SBH. Simultaneously, SBH was looking to grow and wanted to carry products that competed with ACV's. Both companies identified this problem well over a year ago and ACV has been trying to sell or spinoff SBH for over a year.

As with all spinoffs, management's incentives will now be tied directly to the share price of the new company which provides incentive to grow shareholder value. CD&R’s expertise and determination to make their investment profitable increase the chances of individual shareholders benefiting because management's goals are aligned with ours.

Risks
Product divergence is when middle-men want to move manufacturers’ products and significantly cut the price. This is why a Walgreens or CVS may offer the same products as SBH for less. Regis is currently working very diligently to pressure manufacturers not to support this practice. It poses a risk to the industry, not to SBH in particular. I don't believe it is a sustainable trend (in the very long term) because it dilutes manufacturers' brands. However, in the short term, manufacturers appreciate the increased volume. The future of product divergence isn’t clear. However, as industry leaders, SBH and Regis are best positioned to pressure manufacturers to dissuade retailers from this activity.

We didn't see (nor did we expect to see) forced selling after this spinoff. This is when mutual funds, index funds, and other institutions are forced to sell their holdings, which depresses the stock price. We did not expect to see this with SBH because CD&R holds 47.5% of the common stock and is unable to sell for 2 years. SBH was also a large part of ACV, so it wasn't indiscriminately sold; institutions likely weighed their options.

Conclusion
The S-4 contains many valuation measures as calculated by Goldman Sachs. All of these are right around the current stock price, but I consider most to be conservative. These valuations do not take into account many of the factors discussed above. How do you quantify an economic moat, entrepreneurial spirit, better alignment of incentives, or a board of directors from an experienced private equity firm? You can’t, so we do not attempt to. We know, through sound logic, that the valuations that currently exist do not take these qualitative attributes into account.

SBH will continue to create shareholder value. It is the leader in a growing industry with an extremely talented and experienced management team and board of directors. This is not a deep-discount stock. It is, however, a company that will unlock value, now that it no longer has a conflict of interest with its parent company, and now that it has the support of the experienced CD&R.

Additional Resources

• Selected pages from S-4 - In-depth description of the business, competitive environment, and strategic plan can be found here. I have taken the relevant pages of the Form S-4 and converted them to a PDF.
• Our article on Why Spinoffs are Goldmines
• How we identify good spinoffs
• Complete Form S-4 (on the SEC website)
• Over at Fat Pitch Financials, they agree that this spinoff is a "Fat Pitch" - to use a Warren Buffett analogy.

Disclosure: Author is long SBH