Sally Beauty Holdings, Inc. - Quarter Report: 2012 June (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

x                QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

FOR THE QUARTERLY PERIOD ENDED: JUNE 30, 2012

 

-OR-

 

¨                   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

Commission File No. 1-33145

 

 

SALLY BEAUTY HOLDINGS, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Registrant’s telephone number, including area code: (940) 898-7500

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  YES  x  NO  o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  x  No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.)  YES  o  NO  x

 

As of July 26, 2012, there were 180,077,985 shares of the issuer’s common stock outstanding.

 

 

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TABLE OF CONTENTS

 

		Page
PART I – FINANCIAL INFORMATION
ITEM 1.  FINANCIAL STATEMENTS		6
ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS		36
ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK		58
ITEM 4.  CONTROLS AND PROCEDURES		59
PART II – OTHER INFORMATION
ITEM 1.  LEGAL PROCEEDINGS		60
ITEM 1A.  RISK FACTORS		60
ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS		60
ITEM 3.  DEFAULTS UPON SENIOR SECURITIES		60
ITEM 4.  MINE SAFETY DISCLOSURES		60
ITEM 5.  OTHER INFORMATION		60
ITEM 6.  EXHIBITS		61

 

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In this Quarterly Report, references to “the Company,” “Sally Beauty,” “our company,” “we,” “our,” “ours” and “us” refer to Sally Beauty Holdings, Inc. and its consolidated subsidiaries unless otherwise indicated or the context otherwise requires.

 

Cautionary Notice Regarding Forward-Looking Statements

 

Statements in this Quarterly Report on Form 10-Q and in the documents incorporated by reference herein which are not purely historical facts or which depend upon future events may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which we refer to as the Exchange Act. Words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan,” “project,” “target,” “can,” “could,” “may,” “should,” “will,” “would” or similar expressions may also identify such forward-looking statements.

 

Readers are cautioned not to place undue reliance on forward-looking statements as such statements speak only as of the date they were made. Any forward-looking statements involve risks and uncertainties that could cause actual events or results to differ materially from the events or results described in the forward-looking statements, including, but not limited to, risks and uncertainties related to:

 

·             the highly competitive nature of, and the increasing consolidation of, the beauty products distribution industry;

·             anticipating changes in consumer preferences and buying trends and managing our product lines and inventory;

·             potential fluctuation in our same store sales and quarterly financial performance;

·             our dependence upon manufacturers who may be unwilling or unable to continue to supply products to us;

·             the possibility of material interruptions in the supply of products by our manufacturers or third-party distributors;

·             products sold by us being found to be defective in labeling or content;

·             compliance with laws and regulations or becoming subject to additional or more stringent laws and regulations;

·             product diversion to mass retailers or other unauthorized resellers;

·             the operational and financial performance of our Armstrong McCall, L.P. (“Armstrong McCall”) franchise-based business;

·             the success of our internet-based businesses;

·             successfully identifying acquisition candidates and successfully completing desirable acquisitions;

·             integrating businesses acquired in the future;

·             opening and operating new stores profitably;

·             the impact of the health of the economy upon our business;

·             the success of our cost control plans;

·             protecting our intellectual property rights, particularly our trademarks;

·             conducting business outside the United States;

·             disruption in our information technology systems;

·             severe weather, natural disasters or acts of violence or terrorism;

·             the preparedness of our accounting and other management systems to meet financial reporting and other requirements and the upgrade of our existing financial reporting system;

·             being a holding company, with no operations of our own, and depending on our subsidiaries for cash;

·             our substantial indebtedness;

·             the possibility that we may incur substantial additional debt in the future;

·             restrictions and limitations in the agreements and instruments governing our debt;

·             generating the significant amount of cash needed to service all of our debt and refinancing all or a portion of our indebtedness or obtaining additional financing;

·             changes in interest rates increasing the cost of servicing our debt;

·             the potential impact on us if the financial institutions we deal with become impaired;

·             the costs and effects of litigation; and

·             the representativeness of our historical consolidated financial information with respect to our future financial position, results of operations or cash flows.

 

Additional factors that could cause actual events or results to differ materially from the events or results described in the forward-looking statements can be found in our Annual Report on Form 10-K for the fiscal year ended September 30, 2011, as filed with the Securities and Exchange Commission. The events described in the forward-looking statements might not occur or

 

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might occur to a different extent or at a different time than we have described. As a result, our actual results may differ materially from the results contemplated by these forward-looking statements. We assume no obligation to publicly update or revise any forward-looking statements.

 

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WHERE YOU CAN FIND MORE INFORMATION

 

Sally Beauty’s quarterly financial results and other important information are available by calling the Investor Relations Department at (940) 297-3877.

 

Sally Beauty maintains a website at www.sallybeautyholdings.com where investors and other interested parties may obtain, free of charge, press releases and other information as well as gain access to our periodic filings with the SEC. The information contained on this website does not constitute part of this Quarterly Report on Form 10-Q.

 

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PART I – FINANCIAL INFORMATION

 

Item 1. Financial Statements.

 

The following consolidated balance sheets as of June 30, 2012 and September 30, 2011, the consolidated statements of earnings for the three and nine months ended June 30, 2012 and 2011, and the consolidated statements of cash flows for the nine months ended June 30, 2012 and 2011 are those of Sally Beauty Holdings, Inc. and its consolidated subsidiaries.

 

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SALLY BEAUTY HOLDINGS, INC. AND SUBSIDIARIES
Consolidated Statements of Earnings
(In thousands, except per share data)

(Unaudited)

 

		Three Months Ended June 30,						Nine Months Ended June 30,
		2012			2011			2012			2011
Net sales		$	886,991		$	836,576		$	2,641,087		$	2,431,945
Cost of products sold and distribution expenses		442,612			426,045			1,338,065			1,250,208
Gross profit		444,379			410,531			1,303,022			1,181,737
Selling, general and administrative expenses		291,533			259,007			873,736			803,296
Depreciation and amortization		16,299			15,273			47,792			44,161
Operating earnings		136,547			136,251			381,494			334,280
Interest expense		26,925			27,741			113,240			85,058
Earnings before provision for income taxes		109,622			108,510			268,254			249,222
Provision for income taxes		40,135			39,367			100,820			89,852
Net earnings		$	69,487		$	69,143		$	167,434		$	159,370
Net earnings per share:
Basic		$	0.38		$	0.38		$	0.91		$	0.87
Diluted		$	0.37		$	0.37		$	0.88		$	0.85
Weighted average shares:
Basic		182,756			183,164			184,598			182,817
Diluted		188,496			188,592			189,901			187,783

 

The accompanying condensed notes, together with the Notes to Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2011, are an integral part of these financial statements.

 

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SALLY BEAUTY HOLDINGS, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
(In thousands, except par value data)

 

		June 30, 2012			September 30, 2011
		(Unaudited)
Assets
Current assets:
Cash and cash equivalents		$	53,974		$	63,481
Trade accounts receivable, less allowance for doubtful accounts of $2,386 at June 30, 2012 and $2,086 at September 30, 2011		58,715			61,996
Accounts receivable, other		42,186			33,530
Inventory		718,995			665,246
Prepaid expenses		26,938			26,360
Deferred income tax assets, net		28,577			28,535
Total current assets		929,385			879,148
Property and equipment, net of accumulated depreciation of $339,457 at June 30, 2012 and $317,677 at September 30, 2011		189,746			182,489
Goodwill		528,564			505,873
Intangible assets, excluding goodwill, net of accumulated amortization of $55,782 at June 30, 2012 and $45,467 at September 30, 2011		130,797			129,658
Other assets		35,009			31,432
Total assets		$	1,813,501		$	1,728,600
Liabilities and Stockholders’ Deficit
Current liabilities:
Current maturities of long-term debt		$	54,966		$	3,004
Accounts payable		266,752			262,114
Accrued liabilities		157,499			185,509
Income taxes payable		644			9,379
Total current liabilities		479,861			460,006
Long-term debt		1,456,382			1,410,111
Other liabilities		22,932			26,154
Deferred income tax liabilities, net		56,287			51,311
Total liabilities		2,015,462			1,947,582
Stockholders’ deficit:
Common stock, $0.01 par value. Authorized 500,000 shares; 179,940 and 184,502 shares issued and 179,607 and 184,057 shares outstanding at June 30, 2012 and September 30, 2011, respectively		1,796			1,841
Preferred stock, $0.01 par value. Authorized 50,000 shares; none issued		—			—
Additional paid-in capital		528,321			681,256
Accumulated deficit		(711,871		)	(879,305		)
Treasury stock, 15 shares at September 30, 2011, at cost		—			(103		)
Accumulated other comprehensive loss, net of tax		(20,207		)	(22,671		)
Total stockholders’ deficit		(201,961		)	(218,982		)
Total liabilities and stockholders’ deficit		$	1,813,501		$	1,728,600

 

The accompanying condensed notes, together with the Notes to Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2011, are an integral part of these financial statements.

 

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SALLY BEAUTY HOLDINGS, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(In thousands)

(Unaudited)

 

		Nine Months Ended June 30,
		2012			2011
Cash Flows from Operating Activities:
Net earnings		$	167,434		$	159,370
Adjustments to reconcile net earnings to net cash provided by operating activities:
Depreciation and amortization		47,792			44,161
Share-based compensation expense		13,801			12,737
Amortization of deferred financing costs		4,164			5,196
Excess tax benefit from share-based compensation		(10,647		)	(1,954		)
Net loss on disposal of property and equipment		14			205
Net loss on extinguishment of debt		38,376			2,245
Deferred income taxes		(154		)	1,192
Changes in (exclusive of effects of acquisitions):
Trade accounts receivable		4,457			(3,111		)
Accounts receivable, other		(8,143		)	(2,617		)
Inventory		(44,329		)	(38,723		)
Prepaid expenses		(465		)	(2,490		)
Other assets		5,147			2,767
Accounts payable and accrued liabilities		(19,063		)	9,878
Income taxes payable		1,437			5,752
Other liabilities		(3,260		)	529
Net cash provided by operating activities		196,561			195,137
Cash Flows from Investing Activities:
Capital expenditures		(44,253		)	(43,117		)
Proceeds from sale of property and equipment		93			148
Acquisitions, net of cash acquired		(43,154		)	(83,922		)
Net cash used by investing activities		(87,314		)	(126,891		)
Cash Flows from Financing Activities:
Proceeds from issuance of long-term debt		1,876,300			379,505
Repayments of long-term debt		(1,801,933		)	(458,250		)
Debt issuance costs		(26,858		)	(5,386		)
Repurchase of common stock		(200,000		)	—
Proceeds from exercises of stock options		23,080			6,681
Excess tax benefit from share-based compensation		10,647			1,954
Net cash used by financing activities		(118,764		)	(75,496		)
Effect of foreign exchange rate changes on cash and cash equivalents		10			473
Net decrease in cash and cash equivalents		(9,507		)	(6,777		)
Cash and cash equivalents, beginning of period		63,481			59,494
Cash and cash equivalents, end of period		$	53,974		$	52,717
Supplemental Cash Flow Information:
Interest paid (a)		$	109,094		$	94,074
Income taxes paid		$	102,689		$	85,426

 

(a)  For the nine months ended June 30, 2012, interest paid includes $24.4 million in call premiums paid upon the redemption of certain notes.

 

The accompanying condensed notes, together with the Notes to Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2011, are an integral part of these financial statements.

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

1.   Description of Business and Basis of Presentation

 

Description of Business

 

Sally Beauty Holdings, Inc. and its consolidated subsidiaries (“Sally Beauty” or “the Company”) sell professional beauty supplies through its Sally Beauty Supply retail stores primarily in the U.S., Puerto Rico, Canada, Mexico, Chile, the United Kingdom, Ireland, Belgium, France, Germany, the Netherlands and Spain. Additionally, the Company distributes professional beauty products to salons and salon professionals through its Beauty Systems Group (“BSG”) store operations and a commissioned, direct sales force that calls on salons primarily in the U.S., Puerto Rico, Canada, the United Kingdom and certain other countries in Europe, and to franchises in the southern and southwestern regions of the U.S., and in Mexico through the operations of its subsidiary Armstrong McCall. Certain beauty products sold by BSG and Armstrong McCall are sold under exclusive territory agreements with the manufacturers of the products.

 

In November 2006, CDRS Acquisition LLC (or “CDRS”) and CD&R Parallel Fund VII, L.P. (together with CDRS, the “CDR Investors”) invested an aggregate of $575.0 million in cash equity in Sally Beauty in exchange for approximately 48% of our common stock on an undiluted basis. On May 10, 2012, we disclosed in a Current Report on Form 8-K that the Company had entered into an agreement pursuant to which the Company repurchased (and retired) 7,551,444 shares of its common stock from the CDR Investors, in a private transaction, at $26.485 per share. The Company funded this transaction (approximately $200.0 million) primarily with borrowings in the amount of $160.0 million under its revolving credit facility (the “ABL facility”) and with cash from operations. As of June 30, 2012, the CDR Investors owned approximately 12.8% of the outstanding shares of our common stock on an undiluted basis. On July 23, 2012, the CDR Investors disposed of all of the outstanding shares of our common stock held by them.

 

Basis of Presentation

 

The consolidated interim financial statements include the accounts of the Company and its subsidiaries. All significant inter-company accounts and transactions have been eliminated in consolidation. In the opinion of management, these consolidated financial statements reflect all adjustments which are of a normal recurring nature and which are necessary to present fairly the Company’s consolidated financial position as of June 30, 2012 and September 30, 2011, its consolidated results of operations for the three and nine months ended June 30, 2012 and 2011, and its consolidated cash flows for the nine months ended June 30, 2012 and 2011.

 

All references in these notes to “management” are to the management of Sally Beauty.

 

2.   Significant Accounting Policies

 

The consolidated interim financial statements included herein are unaudited and have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and note disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) have been condensed or omitted pursuant to those rules and regulations, although the Company believes that the disclosures made are adequate to make the information not misleading. These consolidated interim financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2011. The Company adheres to the same accounting policies in the preparation of its interim financial statements. As permitted under GAAP, interim accounting for certain expenses, including income taxes, is based on full year assumptions. Such amounts are expensed in full in the year incurred. For interim financial reporting purposes, income taxes are recorded based upon estimated annual effective income tax rates.

 

The results of operations for these interim periods are not necessarily indicative of the results that may be expected for any future interim period or the entire fiscal year.

 

3.   Recent Accounting Pronouncements and Accounting Changes

 

Recent Accounting Pronouncements

 

In December 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2010-28 which amended Accounting Standards Codification (“ASC”) Topic 350, Intangibles-Goodwill and Other (“ASC 350”). This amendment modified the goodwill impairment test for reporting units with a zero or negative carrying amount, by requiring that Step 2 of the goodwill impairment test be performed for such reporting units if it is more likely than not that an impairment of goodwill exists. The Company adopted this amendment during the first quarter of its fiscal year 2012 and its adoption did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

 

In December 2010, the FASB issued ASU No. 2010-29 which amended ASC Topic 805, Business Combinations. This amendment requires that a public company that enters into business combinations that are material on an individual or aggregate

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

basis disclose certain pro-forma information for the current and the immediately preceding fiscal year. This amendment also expands the supplemental pro-forma disclosures to include a description of the nature and amount of material, non-recurring pro-forma adjustments directly attributable to such business combination or business combinations. The Company adopted this amendment during the first quarter of its fiscal year 2012 and its adoption did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

 

In May 2011, the FASB issued ASU No. 2011-04 which amended ASC Topic 820, Fair Value Measurements and Disclosures (“ASC 820”). This amendment changed the title of ASC 820 to “Fair Value Measurement” and adopted fair value measurement and disclosure guidance that is generally consistent with the corresponding International Financial Reporting Standards (“IFRS”) guidance. More specifically, this amendment changed certain requirements for measuring fair value or for disclosing information about fair value measurements or, alternatively, clarified the FASB’s intent about the application of existing fair value measurement and disclosure guidance. The Company adopted this amendment during the second quarter of its fiscal year 2012 and its adoption did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

 

In September 2011, the FASB issued ASU No. 2011-08 which amended ASC 350. This amendment allows an entity to first assess relevant qualitative factors in order to determine whether it is necessary to perform the two-step quantitative goodwill impairment test otherwise required under ASC 350. In effect, the amendment eliminates the need to calculate the fair value of a reporting unit in connection with the goodwill impairment test unless the entity determines, based on the qualitative assessment, that it is more likely than not that the reporting unit’s fair value is less than its carrying amount. As permitted, the Company adopted this amendment during the second quarter of its fiscal year 2012 and its adoption did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

 

We have not yet adopted and are currently assessing any potential effect of the following pronouncement on our consolidated financial statements:

 

In June 2011, the FASB issued ASU No. 2011-05 which amended ASC Topic 220, Comprehensive Income (“ASC 220”). This amendment, which must be applied retrospectively, will allow an entity the option to present the components of net income, as well as total comprehensive income and the components of other comprehensive income, either in a single continuous statement of comprehensive income or in two separate consecutive statements. This amendment also eliminates the option to present the components of other comprehensive income in the statement of stockholders’ equity but does not change the items that must be reported. In addition, in December 2011, the FASB issued ASU No. 2011-12 which further amended ASC 220. More specifically, this amendment provided for deferral, until further action by the FASB, of the effective date for changes to the presentation of reclassifications of items out of accumulated other comprehensive income required by ASU No. 2011-05. For public companies, these amendments are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011. Early application is permitted.

 

Accounting Changes

 

The Company made no accounting changes during the nine months ended June 30, 2012.

 

4.   Fair Value Measurements

 

At June 30, 2012, the Company’s financial instruments consist of cash and cash equivalents, trade and other accounts receivable, accounts payable, foreign currency collar and forward agreements and debt. The carrying amounts of cash and cash equivalents, trade and other accounts receivable, and accounts payable approximate fair value due to the short-term nature of these financial instruments.

 

The Company measures on a recurring basis and discloses its financial instruments under the provisions of ASC 820, as amended. The Company defines “fair value” as the price that would be received to sell an asset or paid to transfer a liability (i.e., the exit price) in an orderly transaction between market participants at the measurement date. ASC 820 establishes a three-level hierarchy for measuring fair value and requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. This valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability on the measurement date. The three levels of that hierarchy are defined as follows:

 

Level 1 - Unadjusted quoted prices in active markets for identical assets or liabilities;

 

Level 2 - Unadjusted quoted prices in active markets for similar assets or liabilities; or unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active; or inputs other than quoted prices that are observable for the asset or liability; or inputs that are derived principally from or corroborated by observable market data; and

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

Level 3 - Unobservable inputs for the asset or liability.

 

Consistent with this hierarchy, the Company categorized certain of its financial assets and liabilities as follows at June 30, 2012 (in thousands):

 

		As of June 30, 2012
		Total			Level 1			Level 2			Level 3
Assets
Foreign currency forwards (a)		$	39		—			$	39		—
Foreign currency collars (a)		331			—			331			—
Total assets		$	370		—			$	370		—
Liabilities
Long-term debt (b)(c)		$	1,604,848		$	1,543,500		$	61,348		—
Foreign currency forwards (a)		603			—			603			—
Total liabilities		$	1,605,451		$	1,543,500		$	61,951		—

 

Consistent with this hierarchy, the Company categorized certain of its financial assets and liabilities as follows at September 30, 2011 (in thousands):

 

		As of September 30, 2011
		Total			Level 1			Level 2			Level 3
Assets
Foreign currency forwards (a)		$	424		—			$	424		—
Foreign currency collars (a)		680			—			680			—
Total assets		$	1,104		—			$	1,104		—
Liabilities
Long-term debt (b)(c)		$	1,420,337		$	725,288		$	695,049		—
Hedged interest rate swaps (a)		6,450			—			6,450			—
Foreign currency forwards (a)		528			—			528			—
Total liabilities		$	1,427,315		$	725,288		$	702,027		—

 

(a)          Foreign currency options, collars and forwards, and interest rate swaps are valued for purposes of this disclosure using widely accepted valuation techniques, such as discounted cash flow analyses, and reasonable estimates, such as projected market interest rates and projected foreign currency exchange rates, as appropriate. Please see Note 10 for more information about the Company’s foreign currency options, collars and forwards, and interest rate swaps.

(b)         In November 2011, the Company, through certain of its domestic subsidiaries, issued $750.0 million aggregate principal amount of the Company’s 6.875% senior notes due 2019 (the “senior notes due 2019”) and, in December 2011, it redeemed its senior notes due 2014 and its senior subordinated notes due 2016 with the net proceeds from such debt issuance. In May 2012, the Company through certain of its domestic subsidiaries, issued $700.0 million aggregate principal amount of the Company’s 5.75% senior notes due 2022 (the “senior notes due 2022”) and repaid in full its borrowings under the senior term loan B facility. Please see Note 9 for more information about the Company’s debt.

(c)          Long-term debt (including borrowings under the ABL facility), which is carried at amortized cost in the Company’s consolidated financial statements, is generally valued for purposes of this disclosure using widely accepted valuation techniques, such as discounted cash flow analyses, and observable inputs, such as market interest rates, except for the senior and senior subordinated notes (prior to their December 2011 redemption), the senior notes due 2019 and the senior notes due 2022. The senior and senior subordinated notes (prior to their December 2011 redemption) were, and the senior notes due 2019 and senior notes due 2022 are, valued using unadjusted quoted market prices for such debt securities. Please see Note 9 for more information about the Company’s debt.

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

5.  Net Earnings Per Share

 

Basic net earnings per share, is calculated by dividing net earnings by the weighted average number of shares of common stock outstanding during the period. Diluted net earnings per share, is calculated similarly but includes the potential dilution from the exercise of all outstanding stock options and stock awards, except when the effect would be anti-dilutive.

 

The following table sets forth the computations of basic and diluted earnings per share (in thousands, except per share data):

 

		Three Months Ended June 30,						Nine Months Ended June 30,
		2012			2011			2012			2011
Net earnings		$	69,487		$	69,143		$	167,434		$	159,370
Total weighted average basic shares		182,756			183,164			184,598			182,817
Dilutive securities:
Stock option and stock award programs		5,740			5,428			5,303			4,966
Total weighted average diluted shares		188,496			188,592			189,901			187,783
Net earnings per share:
Basic		$	0.38		$	0.38		$	0.91		$	0.87
Diluted		$	0.37		$	0.37		$	0.88		$	0.85

 

At June 30, 2012, options to purchase 44,340 shares of the Company’s common stock were outstanding but not included in the computation of diluted earnings per share for the nine months ended June 30, 2012 since these options were anti-dilutive. Anti-dilutive options are: (a) out-of-the-money options (options the exercise price of which is greater than the average price per share of the Company’s common stock during the period), and (b) in-the-money options (options the exercise price of which is less than the average price per share of the Company’s common stock during the period) for which the sum of assumed proceeds, including unrecognized compensation expense, exceeds the average price per share for the period. At June 30, 2011, all outstanding options to purchase shares of the Company’s common stock were dilutive.

 

6.   Comprehensive Income and Accumulated Other Comprehensive (Loss) Income

 

Comprehensive income consists of net earnings, foreign currency translation adjustments and deferred gain on interest rate swaps as follows (in thousands):

 

		Three Months Ended June 30,						Nine Months Ended June 30,
		2012			2011			2012			2011
Net earnings		$	69,487		$	69,143		$	167,434		$	159,370
Other comprehensive income adjustments:
Foreign currency translation adjustments (a)		(10,578		)	3,018			(1,483		)	15,033
Deferred gain on interest rate swaps (b)		1,027			1,160			3,947			3,997
Comprehensive income		$	59,936		$	73,321		$	169,898		$	178,400

 

(a)          Amounts are net of income tax of $0.2 million for the three and nine months ended June 30, 2012. There were no income tax amounts related to foreign currency translation adjustments recorded in other comprehensive income for the three and nine months ended June 30, 2011.

 

(b)         Amounts are net of income tax of $0.7 million for each of the three months ended June 30, 2012 and 2011; and net of income tax of $2.5 million for each of the nine months ended June 30, 2012 and 2011.

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

The components of accumulated other comprehensive loss, net of tax, as of June 30, 2012 and September 30, 2011 are as follows (in thousands):

 

		June 30, 2012			September 30, 2011
Cumulative foreign currency translation adjustments (a)		$	(20,207	)	$	(18,724	)
Deferred (losses) on interest rate swaps, net of tax (b)		—			(3,947		)
Total accumulated other comprehensive loss, net of tax		$	(20,207	)	$	(22,671	)

 

(a)          Amount is net of income tax of $0.2 million at June 30, 2012.

(b)         Amount is net of income tax of $2.5 million at September 30, 2011. Please see Note 10 for more information about the Company’s interest rate swaps.

 

7.   Share-Based Payments

 

The Company measures the cost of services received from employees, directors and consultants in exchange for an award of equity instruments based on the fair value of the award on the date of grant, and recognizes compensation expense on a straight-line basis over the vesting period or over the period ending on the date a participant becomes eligible for retirement, if earlier.

 

The Company granted approximately 2.0 million and 3.0 million stock options and approximately 32,000 and 199,000 restricted share awards to its employees and consultants during the nine months ended June 30, 2012 and 2011, respectively. Upon issuance of such grants, the Company recognized accelerated share-based compensation expense of $5.3 million and $5.0 million in the nine months ended June 30, 2012 and 2011, respectively, in connection with certain retirement eligible employees who are eligible to continue vesting awards upon retirement under the provisions of the Sally Beauty Holdings, Inc. 2010 Omnibus Incentive Plan (the “2010 Plan”) and certain predecessor share-based compensation plans such as the Sally Beauty Holdings, Inc. 2007 Omnibus Incentive Plan (the “2007 Plan”). In addition, the Company granted approximately 26,000 and 43,000 restricted stock units to its non-employee directors during the nine months ended June 30, 2012 and 2011, respectively.

 

The following table presents the total compensation cost charged against income and included in selling, general and administrative expenses for the periods presented for all share-based compensation arrangements and the related tax benefits recognized in our consolidated statements of earnings (in thousands):

 

		Three Months Ended June 30,					Nine Months Ended June 30,
		2012			2011		2012			2011
Share-based compensation expense		$	2,825		2,462		$	13,801		$	12,737
Income tax benefit related to share-based compensation expense		$	674		955		$	4,933		$	4,942

 

Stock Options

 

Each option has an exercise price that equals the closing market price of the Company’s common stock on the date of grant and generally has a maximum term of 10 years. Options generally vest ratably over a four-year period and are generally subject to forfeiture until the vesting period is complete, subject to certain retirement provisions contained in the 2010 Plan and certain predecessor share-based compensation plans such as the 2007 Plan.

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

The following table presents a summary of the activity for the Company’s stock option awards for the nine months ended June 30, 2012:

 

		Number of Outstanding Options (in Thousands)		Weighted Average Exercise Price			Weighted Average Remaining Contractual Term (in Years)		Aggregate Intrinsic Value (in Thousands)
Outstanding at September 30, 2011		13,778		$	8.50		6.8		$	111,571
Granted		1,979		19.21
Exercised		(2,995	)	7.71
Forfeited or expired		(166	)	11.15
Outstanding at June 30, 2012		12,596		$	10.34		6.7		$	193,992
Exercisable at June 30, 2012		6,556		$	8.42		5.5		$	113,524

 

The following table summarizes information about stock options under the Company’s share-based compensation plans at June 30, 2012:

 

		Options Outstanding							Options Exercisable
Range of Exercise Prices		Number Outstanding at June 30, 2012 (in Thousands)		Weighted Average Remaining Contractual Term (in Years)		Weighted Average Exercise Price			Number Exercisable at June 30, 2012 (in Thousands)		Weighted Average Exercise Price
$2.00 – 5.24		1,786		5.6		$	4.81		1,184		$	4.59
$7.42 – 19.21		10,810		6.9		11.25			5,372		9.27
Total		12,596		6.7		$	10.34		6,556		$	8.42

 

The Company uses the Black-Scholes option pricing model to value the Company’s stock options for each stock option award. Using this option pricing model, the fair value of each stock option award is estimated on the date of grant. The fair value of the Company’s stock option awards is expensed on a straight-line basis over the vesting period (generally four years) of the stock options or to the date a participant becomes eligible for retirement, if earlier.

 

The weighted average assumptions relating to the valuation of the Company’s stock options are as follows:

 

		Nine Months Ended June 30,
		2012		2011
Expected life (in years)		5.0		5.0
Expected volatility		58.4	%	59.0	%
Risk-free interest rate		1.1	%	1.1	%
Dividend yield		0.0	%	0.0	%

 

The expected life of options represents the period of time that the options granted are expected to be outstanding and is based on historical experience of employees of the Company who have been granted stock options. The expected volatility used for awards made during the nine months ended June 30, 2012, reflects the average volatility for the Company’s common stock. For awards made prior to the fiscal year 2012, the expected volatility used was derived using the average volatility of both the Company and similar companies (based on industry sector) since it was not practicable to estimate the Company’s expected volatility on a stand-alone basis due to a lack of sufficient trading history. The risk-free interest rate is based on the five-year zero-coupon U.S. Treasury notes as of the date of the grant. Since the Company does not currently expect to pay dividends, the dividend yield used is 0%.

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

The weighted average fair value of the stock options issued to the Company’s grantees at the date of grant in the nine months ended June 30, 2012 and 2011 was $9.60 and $5.74 per option, respectively. The total intrinsic value of options exercised during the nine months ended June 30, 2012 was $41.0 million. Cash proceeds from these option exercises were $23.1 million and the income tax benefit realized from these option exercises was $14.3 million.

 

At June 30, 2012, approximately $17.1 million of total unrecognized compensation costs related to unvested stock option awards are expected to be recognized over the weighted average period of 2.5 years.

 

Stock Awards

 

Restricted Stock Awards

 

The Company from time to time grants restricted stock awards to employees and consultants under the 2010 Plan. A restricted stock award is an award of shares of the Company’s common stock (which have full voting and dividend rights but are restricted with regard to sale or transfer) the restrictions over which lapse ratably over a specified period of time (generally five years). Restricted stock awards are independent of stock option grants and are generally subject to forfeiture if employment terminates prior to these restrictions lapsing, subject to certain retirement provisions of the 2010 Plan and certain predecessor share-based compensation plans such as the 2007 Plan.

 

The Company expenses the cost of the restricted stock awards, which is determined to equal the fair value of the restricted stock award at the date of grant, on a straight-line basis over the period (the “vesting period”) in which the restrictions on these stock awards lapse (“vesting”) or over the period ending on the date a participant becomes eligible for retirement, if earlier. For these purposes, the fair value of the restricted stock award is determined based on the closing market price of the Company’s common stock on the date of grant.

 

The following table presents a summary of the activity for the Company’s restricted stock awards for the nine months ended June 30, 2012:

 

Restricted Stock Awards		Number of Shares (in Thousands)		Weighted Average Fair Value Per Share			Weighted Average Remaining Vesting Term (in Years)
Unvested at September 30, 2011		445		$	9.12		3.1
Granted		32		19.21
Vested		(144	)	8.70
Forfeited		—		—
Unvested at June 30, 2012		333		$	10.27		2.6

 

At June 30, 2012, approximately $1.9 million of total unrecognized compensation costs related to unvested restricted stock awards are expected to be recognized over the weighted average period of 2.6 years.

 

Restricted Stock Units

 

The Company currently grants Restricted Stock Unit awards (“RSU” or “RSUs”), which generally vest less than one year from the date of grant, pursuant to the 2010 Plan. To date, the Company has only granted RSU awards to its non-employee directors. RSUs represent an unsecured promise of the Company to issue shares of common stock of the Company. Upon vesting, such RSUs are generally retained by the Company as deferred stock units that are not distributed until six months after the independent director’s service as a director terminates. RSUs are independent of stock option grants and are generally subject to forfeiture if service terminates prior to the vesting of the units. Participants have no voting rights with respect to unvested RSUs. Under the 2010 Plan, the Company may settle the vested deferred stock units with shares of the Company’s common stock or in cash.

 

The Company expenses the cost of the RSUs, which is determined to be the fair value of the RSUs at the date of grant, on a straight-line basis over the vesting period (generally one year). For these purposes, the fair value of the RSU is determined based on the closing market price of the Company’s common stock on the date of grant.

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

The following table presents a summary of the activity for the Company’s RSUs for the nine months ended June 30, 2012:

 

Restricted Stock Units		Number of Shares (in Thousands)		Weighted Average Fair Value Per Share			Weighted Average Remaining Vesting Term (in Years)
Unvested at September 30, 2011		—		$	—		—
Granted		26		19.21
Vested		—		—
Forfeited		—		—
Unvested at June 30, 2012		26		$	19.21		0.3

 

At June 30, 2012, approximately $0.1 million of total unrecognized compensation costs related to unvested RSUs are expected to be recognized over the weighted average period of 0.3 years.

 

8.   Goodwill and Intangible Assets

 

The change in the carrying amounts of goodwill by operating segment for the nine months ended June 30, 2012 is as follows (in thousands):

 

		Sally Beauty Supply			Beauty Systems Group			Total
Balance at September 30, 2011		$	75,536		$	430,337		$	505,873
Additions and purchase price adjustments (a)		14,982			9,189			24,171
Foreign currency translation		(2,683		)	1,203			(1,480		)
Balance at June 30, 2012		$	87,835		$	440,729		$	528,564

 

(a)          Please see Note 12 for additional information about businesses acquired.

 

The Company performs its goodwill impairment test during the second quarter of its fiscal year. As permitted, the Company adopted the provisions of ASU 2011-08 in connection with its goodwill impairment test for the fiscal year 2012. There were no goodwill impairment losses recognized in the current or prior periods presented.

 

The following table provides the carrying value for intangible assets with indefinite lives, excluding goodwill, and the gross carrying value and accumulated amortization for intangible assets subject to amortization by operating segment at June 30, 2012 (in thousands):

 

		Sally Beauty Supply			Beauty Systems Group			Total
Balance at June 30, 2012:
Intangible assets with indefinite lives:
Trade names		$	26,636		$	27,341		$	53,977
Total		26,636			27,341			53,977
Intangible assets subject to amortization:
Gross carrying amount		26,120			106,482			132,602
Accumulated amortization		(9,032		)	(46,750		)	(55,782		)
Net value		17,088			59,732			76,820
Total intangible assets, excluding goodwill, net		$	43,724		$	87,073		$	130,797

 

As described in Note 12, during the nine months ended June 30, 2012, intangible assets subject to amortization in the amount of $11.8 million were recorded in connection with the Company’s November 2011 acquisition of Kappersservice Floral B.V. and two related companies (together, the “Floral Group”) based on their estimated fair values.

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

Amortization expense was $3.6 million and $3.1 million for the three months ended June 30, 2012 and 2011, respectively; and $10.3 million and $9.2 million for the nine months ended June 30, 2012 and 2011, respectively. As of June 30, 2012, future amortization expense related to intangible assets subject to amortization is estimated to be as follows (in thousands):

 

Fiscal Year:
2012		$	3,430
2013		12,253
2014		11,847
2015		11,318
2016		10,168
Thereafter		27,804
		$	76,820

 

9.   Short-term Borrowings and Long-term Debt

 

Details of long-term debt are as follows (in thousands):

 

		As of June 30, 2012			Maturity Dates		Interest Rates
ABL facility		$	53,000		Nov. 2015		(i)      Prime plus (1.25% to 1.75%) or;
							(ii)     LIBOR plus (2.25% to 2.75%)
Senior notes due 2019		750,000			Nov. 2019		6.875%
Senior notes due 2022		700,000			June 2022		5.750%
Other (a)		2,746			2012-2015		4.05% to 5.79%
Total		$	1,505,746
Capital leases and other		$	5,602
Less: current portion		(54,966		)
Total long-term debt		$	1,456,382

 

(a)     Represents pre-acquisition debt of Pro-Duo NV and Sinelco Group BVBA (“Sinelco”).

 

The Company, through its subsidiaries (Sally Investment Holdings LLC (“Sally Investment”) and Sally Holdings LLC (“Sally Holdings”)), incurred $1,850.0 million of indebtedness in connection with the Company’s separation from its former parent, Alberto-Culver Company, in November 2006. These borrowings included: (i) drawing on a revolving (asset-based lending (“ABL”)) credit facility in the amount of $70.0 million, (ii) entering into two senior term loan facilities (term loans A and B) in an aggregate amount of $1,070.0 million and (iii) together (jointly and severally) with another of the Company’s indirect subsidiaries, Sally Capital Inc., issuing senior notes in an aggregate amount of $430.0 million and senior subordinated notes in an aggregate amount of $280.0 million. Borrowings under the senior term loan A facility were repaid in full in the fiscal year 2010.

 

In November 2010, Sally Holdings entered into a new $400 million, five-year ABL facility and terminated its prior ABL credit facility (the “prior ABL facility”). The terms of the ABL facility contain a commitment fee of 0.50% on the unused portion of the facility. Borrowings under the ABL facility are secured by substantially all of our assets, those of Sally Investment, a wholly-owned subsidiary of Sally Beauty and the direct parent of Sally Holdings, those of our domestic subsidiaries, those of our Canadian subsidiaries and a pledge of certain intercompany notes. Such borrowings bear interest at Prime plus 1.25% to 1.75% or LIBOR plus 2.25% to 2.75%. In connection with our termination of the prior ABL facility we expensed approximately $1.6 million in unamortized deferred financing costs. This amount is included in interest expense in the Company’s consolidated statements of earnings.

 

In November 2011, Sally Holdings and Sally Capital Inc. (collectively, the “Issuers”), both wholly-owned subsidiaries of the Company, the Company and certain of its domestic subsidiaries entered into an agreement pursuant to which the Issuers sold in a private placement $750.0 million aggregate principal amount of the Issuers’ 6.875% Senior Notes due 2019 (the “senior notes due 2019”). The senior notes due 2019 bear interest at an annual rate of 6.875% and were issued at par. In connection with the issuance of such notes the Company incurred and capitalized financing costs of approximately $15.2 million. These deferred financing costs are included in other assets on our consolidated balance sheets and are being amortized over the term of the senior notes due 2019 using the effective interest method. In June 2012, the Company exchanged the senior notes due 2019 for

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

notes that are registered pursuant to a registration statement, which was effective May 2012, and otherwise are identical to the senior notes due 2019.

 

In December 2011, the Issuers used the net proceeds from the issuance of the senior notes due 2019: (i) to redeem $430.0 million aggregate principal amount outstanding of the Issuers’ 9.25% senior notes due 2014, (ii) to redeem $275.0 million aggregate principal amount outstanding of the Issuers’ 10.50% senior subordinated notes due 2016 (together with the senior notes due 2014, the “Old Notes”), pursuant to the terms of the indentures governing the Old Notes, and (iii) to pay accrued and unpaid interest on the Old Notes, and fees and expenses incurred in connection with issuance of the senior notes due 2019 and redemption of the Old Notes. In connection with our redemption of the Old Notes we recorded a charge to earnings in the amount of approximately $34.6 million, including approximately $24.4 million in call premiums paid and approximately $10.2 million in unamortized deferred financing costs expensed. This amount is included in interest expense in the Company’s consolidated statements of earnings.

 

In May 2012, the Issuers, the Company and certain of the Company’s domestic subsidiaries entered into an agreement pursuant to which the Issuers sold $700.0 million aggregate principal amount of the Issuers’ 5.75% Senior Notes due 2022 (the “senior notes due 2022”). The senior notes due 2022 bear interest at an annual rate of 5.75%, were issued at par, and are registered securities pursuant to a registration statement filed with the SEC in May 2012. In connection with the issuance of such notes, the Company incurred and capitalized financing costs of approximately $13.0 million. These deferred financing costs are included in other assets on our consolidated balance sheets and are being amortized over the term of the senior notes due 2022 using the effective interest method.

 

Sally Holdings used the net proceeds from the debt offering: (i) to repay in full the aggregate principal amount outstanding (approximately $596.9 million) under its senior term loan B facility due 2013, plus accrued and unpaid interest thereon, (ii) to pay approximately $90.0 million of borrowings outstanding under the ABL facility, and (iii) to pay fees and expenses incurred in connection with the offering. In connection with our repayment of the senior term loan B facility, we expensed approximately $3.2 million in unamortized deferred financing costs. This amount is included in interest expense in the Company’s consolidated statements of earnings.

 

During the first half of its fiscal year 2012 prior to its repayment and termination, the Company had made optional prepayments in the aggregate amount of $100.0 million on the senior term loan B facility. In connection with such prepayments the Company expensed approximately $0.6 million in unamortized deferred financing costs. This amount is included in interest expense in the Company’s consolidated statements of earnings.

 

Borrowings under the ABL facility are secured by substantially all of our assets, those of Sally Investment, those of our domestic subsidiaries, those of our Canadian subsidiaries and a pledge of certain intercompany notes.

 

The senior notes due 2019 and the senior notes due 2022 (hereafter, the “senior notes due 2019 and 2022”) are unsecured obligations of the Issuers and are jointly and severally guaranteed by the Company and Sally Investment, and by each material domestic subsidiary of the Company. Interest on the senior notes due 2019 and 2022 is payable semi-annually, during the Company’s first and third fiscal quarters.

 

The senior notes due 2019 carry optional redemption features whereby the Company has the option to redeem the notes, in whole or in part, on or after November 15, 2017 at par, plus accrued and unpaid interest, if any, and on or after November 15, 2015 at par plus a premium declining ratably to par, plus accrued and unpaid interest, if any. Prior to November 15, 2015, the notes may be redeemed, in whole or in part, at a redemption price equal to par plus a make-whole premium as provided in the indenture, plus accrued and unpaid interest, if any. In addition, on or prior to November 15, 2014, the Company has the right to redeem at par plus a specified premium, plus accrued and unpaid interest, if any, up to 35% of the aggregate principal amount of notes originally issued, subject to certain limitations, with the proceeds from certain kinds of equity offerings, as defined in the indenture.

 

The senior notes due 2022 carry optional redemption features whereby the Company has the option to redeem the notes, in whole or in part, on or after June 1, 2020 at par, plus accrued and unpaid interest, if any, and on or after June 1, 2017 at par plus a premium declining ratably to par, plus accrued and unpaid interest, if any. Prior to June 1, 2017, the notes may be redeemed, in whole or in part, at a redemption price equal to par plus a make-whole premium as provided in the indenture, plus accrued and unpaid interest, if any. In addition, on or prior to June 1, 2015, the Company has the right to redeem at par plus a specified premium, plus accrued and unpaid interest, if any, up to 35% of the aggregate principal amount of notes originally issued, subject to certain limitations, with the proceeds from certain kinds of equity offerings, as defined in the indenture.

 

Maturities of the Company’s long-term debt are as follows as of June 30, 2012 (in thousands):

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

Twelve months ending June 30:
2013		$	54,238
2014		962
2015		546
2016		—
2017		—
Thereafter		1,450,000
		$	1,505,746
Capital leases and other		5,602
Less: current portion		(54,966		)
Total		$	1,456,382

 

We are a holding company and do not have any material assets or operations other than ownership of equity interests of our subsidiaries. The agreements and instruments governing the debt of Sally Holdings and its subsidiaries contain material limitations on their ability to pay dividends and other restricted payments to us which, in turn, constitute material limitations on our ability to pay dividends and other payments to our stockholders.

 

The indentures governing the senior notes due 2019 and 2022 contain terms which restrict the ability of Sally Beauty’s subsidiaries to incur additional indebtedness. However, in addition to certain other material exceptions, the Company may incur additional indebtedness under the indentures if its Consolidated Coverage Ratio, after giving pro forma effect to the incurrence of such indebtedness, exceeds 2.0 to 1.0 (“Incurrence Test”). At June 30, 2012, the Company’s Consolidated Coverage Ratio was approximately 6.1 to 1.0. Consolidated Coverage Ratio is defined as the ratio of (i) Consolidated EBITDA, as defined in the indentures, for the period containing the most recent four consecutive fiscal quarters, to (ii) Consolidated Interest Expense, as defined in the indentures, for such period.

 

The indentures governing the senior notes due 2019 and 2022 restrict Sally Holdings and its subsidiaries from making certain dividends and distributions to equity holders and certain other restricted payments (hereafter, a “Restricted Payment” or “Restricted Payments”), to us. However, the indentures permit the making of such Restricted Payments if, at the time of the making of such Restricted Payment, the Company satisfies the Incurrence Test as described above and the cumulative amount of all Restricted Payments made since the issue date of the applicable senior notes does not exceed the sum of: (a) 50% of Sally Holdings’ and its subsidiaries’ cumulative consolidated net earnings since July 1, 2006, plus (b) the proceeds from the issuance of certain equity securities or conversions of indebtedness to equity, in each case, since the issue date of the applicable senior notes plus (c) the net reduction in investments in unrestricted subsidiaries since the issue date of the applicable senior notes plus (d) the return of capital with respect to any sales or dispositions of certain minority investments since the issue date of the applicable senior notes. Further, in addition to certain other baskets, the indentures permit the Company to make additional Restricted Payments in an unlimited amount if, after giving pro forma effect to the incurrence of any indebtedness to make such Restricted Payment, the Company’s Consolidated Total Leverage Ratio (as defined in the indentures) is less than 3.25 to 1.00. At June 30, 2012, the Company’s Consolidated Total Leverage Ratio was approximately 2.5 to 1.0. Consolidated Total Leverage Ratio is defined as the ratio of (i) Consolidated Total Indebtedness, as defined in the indentures, minus cash and cash equivalents on-hand up to $100.0 million, in each case, as of the most recently-ended fiscal quarter to (ii) Consolidated EBITDA, as defined in the indentures, for the period containing the most recent four consecutive fiscal quarters.

 

In June 2012, the Company, Sally Holdings and the other parties to the ABL facility entered into an amendment (hereafter, “the Amendment”) to the ABL facility which, among other things, relaxed the restrictions regarding the making of Restricted Payments. Under the ABL facility, as amended, Sally Holdings may make Restricted Payments to us if availability under the ABL facility exceeds certain thresholds, and no default then exists under the facility. For Restricted Payments up to $30.0 million during each fiscal year, borrowing availability must exceed the lesser of $80.0 million or 20% of the borrowing base for 45 days prior to such Restricted Payment. For Restricted Payments in excess of that amount, the same borrowing availability must be maintained and the Consolidated Fixed-Charge Coverage Ratio (as defined in the ABL facility) must equal or exceed 1.2 to 1.0 (up from 1.1 to 1.0 prior to the Amendment). Consolidated Fixed-Charge Coverage Ratio is defined as the ratio of (i) Consolidated EBITDA, as defined in the ABL facility, minus certain unfinanced capital expenditures and tax payments to (ii) fixed charges, as specified in the ABL facility. However, pursuant to the Amendment, the calculation of the Consolidated Fixed-Charge Coverage Ratio now excludes from fixed charges any Restricted Payments. Further, the Amendment increased the level of the Consolidated Fixed-Charge Coverage Ratio that the Company must satisfy to 1.1 to 1.0 (from 1.0 to 1.0) during any period that availability under the ABL facility is less than the greater of $40.0 million or 15% of the borrowing base. As of June 30, 2012, the Consolidated Fixed-Charge Coverage Ratio was approximately 3.2 to 1.0.

 

When used in this quarterly report, the phrase “Consolidated EBITDA” is intended to have the meaning ascribed to such phrase in the ABL facility or the indentures governing the senior notes due 2019 and 2022, as appropriate. EBITDA is not a recognized

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

measurement under GAAP and should not be considered a substitute for financial performance and liquidity measures determined in accordance with GAAP, such as net earnings, operating earnings and operating cash flows.

 

The ABL facility and the indentures governing the senior notes due 2019 and 2022 contain other covenants regarding restrictions on assets dispositions, granting of liens and security interests, prepayment of certain indebtedness and other matters and customary events of default, including customary cross-default and/or cross-acceleration provisions. As of June 30, 2012, all the net assets of our consolidated subsidiaries were unrestricted from transfer under our credit arrangements.

 

10.    Derivative Instruments and Hedging Activities

 

Risk Management Objectives of Using Derivative Instruments

 

The Company is exposed to a wide variety of risks, including risks arising from changing economic conditions. The Company manages its exposure to certain economic risks (including liquidity, credit risk, and changes in interest rates and in foreign currency exchange rates) primarily (a) by closely managing its cash flows from operating and investing activities and the amounts and sources of its debt obligations; (b) by assessing periodically the creditworthiness of its business partners; and (c) through the use of derivative instruments from time to time (including interest rate swaps, and foreign currency options, collars and forwards) by Sally Holdings.

 

The Company from time to time has used interest rate swaps, as part of its overall economic risk management strategy, to add stability to the interest payments due in connection with its debt obligations. Interest payments related to the senior term loans were impacted by changes in LIBOR.

 

The Company from time to time uses foreign currency options, collars and forwards, as part of its overall economic risk management strategy, to fix the amount of certain foreign assets and obligations relative to its functional and reporting currency (the U.S. dollar) or to add stability to cash flows resulting from its net investments (including intercompany notes not permanently invested) and earnings denominated in foreign currencies. The Company’s foreign currency exposures at times offset each other thus providing a natural hedge against its foreign currency risk. In connection with the remaining foreign currency risk, the Company uses foreign currency options, collars and forwards to effectively fix the foreign currency exchange rate applicable to specific anticipated foreign currency-denominated cash flows thus limiting the potential fluctuations in such cash flows as a result of foreign currency market movements.

 

As of June 30, 2012, the Company did not purchase or hold any derivative instruments for trading or speculative purposes.

 

Designated Cash Flow Hedges

 

In 2008, Sally Holdings entered into certain interest rate swap agreements with an aggregate notional amount of $300 million. These agreements expired in May 2012 and were designated and qualified as effective cash flow hedges, in accordance with ASC Topic 815, Derivatives and Hedging (“ASC 815”). Accordingly, changes in the fair value of these derivative instruments (which were adjusted quarterly) were recorded, net of income tax, in accumulated other comprehensive (loss) income (“OCI”) until the swap agreements expired. Amounts reported in OCI related to interest rate swaps were reclassified into interest expense, as a yield adjustment, in the same period in which interest on hedged variable-rate debt obligations affected earnings. Interest expense resulting from such reclassifications was $1.7 million and $2.6 million during the three months ended June 30, 2012 and 2011, respectively; and $6.7 million and $7.6 million during the nine months ended June 30, 2012 and 2011, respectively. There were no amounts remaining in OCI at June 30, 2012.

 

Non-designated Cash Flow Hedges

 

The Company uses foreign currency options and collars including, at June 30, 2012, collars with an aggregate notional amount of $3.6 million to manage the exposure to the U.S. dollar resulting from certain of our Sinelco Group subsidiaries’ purchases of merchandise from third-party suppliers. Sinelco’s functional currency is the Euro. The foreign currency collar agreements held by the Company at June 30, 2012, have contractual Euro to U.S. dollar exchange rates between 1.4000 and 1.4612, are with a single counterparty and expire in equal monthly amounts through September 2012.

 

In addition, the Company currently uses foreign currency forwards to mitigate its exposure to changes in foreign currency exchange rates in connection with certain intercompany balances not permanently invested. At June 30, 2012, we hold: (a) a foreign currency forward which enables us to sell approximately €30.4 million ($38.4 million, at the June 30, 2012 exchange rate) at the contractual exchange rate of 1.2469, (b) a foreign currency forward which enables us to sell approximately $2.3 million Canadian dollars ($2.2 million, at the June 30, 2012 exchange rate) at the contractual exchange rate of 1.0189, (c) a foreign currency forward which enables us to buy approximately $4.6 million Canadian dollars ($4.5 million, at the June 30, 2012 exchange rate) at the contractual exchange rate of 1.0278, (d) a foreign currency forward which enables us to sell approximately 28.8 million Mexican pesos ($2.2 million, at the June 30, 2012 exchange rate) at the contractual exchange rate of

 

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Table of Contents

 

Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

13.3941 and (e) a foreign currency forward which enables us to buy approximately £0.6 million ($0.9 million, at the June 30, 2012 exchange rate) at the contractual exchange rate of 1.5557. All foreign currency forwards held by the Company at June 30, 2012 are with a single counterparty other than the counterparty on the foreign currency collar agreements discussed above, and expire on or before September 30, 2012.

 

The Company’s foreign currency derivatives are not designated as hedges and do not currently meet the hedge accounting requirements of ASC 815. Accordingly, the changes in fair value of these derivative instruments, which are adjusted quarterly, are recorded in our consolidated statements of earnings. Selling, general and administrative expenses reflect net gains of $2.2 million and net losses of $0.3 million for the three months ended June 30, 2012 and 2011, respectively; and net gains of $2.6 million and net losses of $0.7 million for the nine months ended June 30, 2012 and 2011, respectively, including marked-to-market adjustments, in connection with all of the Company’s foreign currency derivatives.

 

The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the balance sheet as of June 30, 2012 (in thousands):

 

Tabular Disclosure of Fair Values of Derivative Instruments

 

		Asset Derivatives					Liability Derivatives
		As of June 30, 2012					As of June 30, 2012
		Balance Sheet Location		Fair Value			Balance Sheet Location		Fair Value
Derivatives designated as hedging instruments:
Interest Rate Swaps		Other assets		$	—		Accrued liabilities		$	—
Total derivatives designated as hedging instruments				$	—				$	—
Derivatives not designated as hedging instruments:
Foreign Currency Collars and Forwards		Prepaid expenses		$	370		Accrued liabilities		$	603
Total derivatives not designated as hedging instruments				$	370				$	603

 

The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the balance sheet as of September 30, 2011 (in thousands):

 

Tabular Disclosure of Fair Values of Derivative Instruments

 

		Asset Derivatives					Liability Derivatives
		As of September 30, 2011					As of September 30, 2011
		Balance Sheet Location		Fair Value			Balance Sheet Location		Fair Value
Derivatives designated as hedging instruments:
Interest Rate Swaps		Other assets		$	—		Accrued liabilities		$	6,450
Total derivatives designated as hedging instruments				$	—				$	6,450
Derivatives not designated as hedging instruments:
Foreign Currency Collars and Forwards		Prepaid expenses		$	1,104		Accrued liabilities		$	528
Total derivatives not designated as hedging instruments				$	1,104				$	528

 

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