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

Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

FOR THE QUARTERLY PERIOD ENDED: MARCH 31, 2012

 

-OR-

 

 

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 April 26, 2012, there were 187,209,678 shares of the issuer’s common stock outstanding.

 

 

Table of Contents

 

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	56
ITEM 4.	CONTROLS AND PROCEDURES	57
PART II — OTHER INFORMATION
ITEM 1.	LEGAL PROCEEDINGS	58
ITEM 1A.	RISK FACTORS	58
ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	58
ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	58
ITEM 4.	MINE SAFETY DISCLOSURES	58
ITEM 5.	OTHER INFORMATION	58
ITEM 6.	EXHIBITS	59

 

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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 or increasing our interest expense due to our interest rate swap agreements;

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

·             the costs and effects of litigation;

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

·             the voting power of our largest stockholder discouraging third party acquisitions of us at a premium; and

·             the interests of our largest stockholder differing from the interests of other holders of our common stock.

 

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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 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 March 31, 2012 and September 30, 2011, the consolidated statements of earnings for the three and six months ended March 31, 2012 and 2011, and the consolidated statements of cash flows for the six months ended March 31, 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						Six Months Ended
		March 31,						March 31,
		2012			2011			2012			2011
Net sales		$	889,281		$	801,805		$	1,754,096		$	1,595,369
Cost of products sold and distribution expenses		452,495			409,991			895,453			824,164
Gross profit		436,786			391,814			858,643			771,205
Selling, general and administrative expenses		289,189			271,381			582,203			544,289
Depreciation and amortization		15,940			14,777			31,493			28,888
Operating earnings		131,657			105,656			244,947			198,028
Interest expense		22,355			27,793			86,316			57,316
Earnings before provision for income taxes		109,302			77,863			158,631			140,712
Provision for income taxes		41,489			28,585			60,684			50,485
Net earnings		$	67,813		$	49,278		$	97,947		$	90,227
Net earnings per share:
Basic		$	0.36		$	0.27		$	0.53		$	0.49
Diluted		$	0.35		$	0.26		$	0.51		$	0.48
Weighted average shares:
Basic		186,335			182,831			185,514			182,644
Diluted		191,684			187,724			190,662			187,431

 

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)

 

		March 31,			September 30,
		2012			2011
		(Unaudited)
Assets
Current assets:
Cash and cash equivalents		$	64,810		$	63,481
Trade accounts receivable, less allowance for doubtful accounts of $2,374 at March 31, 2012 and $2,086 at September 30, 2011		56,000			61,996
Accounts receivable, other		37,073			33,530
Inventory		689,367			665,246
Prepaid expenses		25,492			26,360
Deferred income tax assets, net		28,588			28,535
Total current assets		901,330			879,148
Property and equipment, net of accumulated depreciation of $336,530 at March 31, 2012 and $317,677 at September 30, 2011		187,393			182,489
Goodwill		532,833			505,873
Intangible assets, excluding goodwill, net of accumulated amortization of $52,210 at March 31, 2012 and $45,467 at September 30, 2011		135,981			129,658
Other assets		32,395			31,432
Total assets		$	1,789,932		$	1,728,600
Liabilities and Stockholders’ Deficit
Current liabilities:
Current maturities of long-term debt		$	2,096		$	3,004
Accounts payable		250,265			262,114
Accrued liabilities		167,264			185,509
Income taxes payable		2,865			9,379
Total current liabilities		422,490			460,006
Long-term debt		1,354,068			1,410,111
Other liabilities		26,530			26,154
Deferred income tax liabilities, net		56,057			51,311
Total liabilities		1,859,145			1,947,582
Stockholders’ deficit:
Common stock, $0.01 par value. Authorized 500,000 shares; 187,040 and 184,502 shares issued and 186,707 and 184,057 shares outstanding at March 31, 2012 and September 30, 2011, respectively		1,867			1,841
Preferred stock, $0.01 par value. Authorized 50,000 shares; none issued		—			—
Additional paid-in capital		721,037			681,256
Accumulated deficit		(781,358		)	(879,305		)
Treasury stock, 15 shares at March 31, 2012 and September 30, 2011, at cost		(103		)	(103)
Accumulated other comprehensive loss, net of tax		(10,656		)	(22,671		)
Total stockholders’ deficit		(69,213		)	(218,982		)
Total liabilities and stockholders’ deficit		$	1,789,932		$	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)

 

		Six Months Ended March 31,
		2012			2011
Cash Flows from Operating Activities:
Net earnings		$	97,947		$	90,227
Adjustments to reconcile net earnings to net cash provided by operating activities:
Depreciation and amortization		31,493			28,888
Share-based compensation expense		10,976			10,275
Amortization of deferred financing costs		2,992			3,495
Excess tax benefit from share-based compensation		(9,124		)	(776		)
Net loss (gain) on disposal of property and equipment		5			(1,504		)
Net loss on extinguishment of debt		35,145			1,741
Deferred income taxes		(285		)	509
Changes in (exclusive of effects of acquisitions):
Trade accounts receivable		8,076			1,288
Accounts receivable, other		(2,805		)	(9,462		)
Inventory		(10,631		)	(12,671		)
Prepaid expenses		1,463			(670		)
Other assets		1,121			44
Accounts payable and accrued liabilities		(30,440		)	9,632
Income taxes payable		1,838			1,886
Other liabilities		319			2,723
Net cash provided by operating activities		138,090			125,625
Cash Flows from Investing Activities:
Capital expenditures		(27,047		)	(29,370		)
Proceeds from sale of property and equipment		91			145
Acquisitions, net of cash acquired		(43,154		)	(81,170		)
Net cash used by investing activities		(70,110		)	(110,395		)
Cash Flows from Financing Activities:
Change in book cash overdraft		—			2,516
Proceeds from issuance of long-term debt		929,200			379,505
Repayments of long-term debt		(1,010,474		)	(397,221		)
Debt issuance costs		(15,191		)	(5,284		)
Proceeds from exercises of stock options		20,111			3,807
Excess tax benefit from share-based compensation		9,124			776
Net cash used by financing activities		(67,230		)	(15,901		)
Effect of foreign exchange rate changes on cash and cash equivalents		579			279
Net increase (decrease) in cash and cash equivalents		1,329			(392		)
Cash and cash equivalents, beginning of period		63,481			59,494
Cash and cash equivalents, end of period		$	64,810		$	59,102
Supplemental Cash Flow Information:
Interest paid (a)		$	77,819		$	51,311
Income taxes paid		$	60,746		$	50,249

 

(a) For the six months ended March 31, 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 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.

 

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 March 31, 2012 and September 30, 2011, its consolidated results of operations for the three and six months ended March 31, 2012 and 2011, and its consolidated cash flows for the six months ended March 31, 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 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

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

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 six months ended March 31, 2012.

 

4.   Fair Value Measurements

 

The Company’s financial instruments consist of cash and cash equivalents, trade and other accounts receivable, accounts payable, interest rate swap agreements, foreign currency option, 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

 

Level 3 - Unobservable inputs for the asset or liability.

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

Consistent with this hierarchy, the Company categorized certain of its financial assets and liabilities as follows at March 31, 2012 (in thousands):

 

		As of March 31, 2012
		Total			Level 1			Level 2			Level 3
Assets
Foreign currency forwards (a)		$	7		—			$	7		—
Foreign currency collars (a)		327			—			327			—
Total assets		$	334		—			$	334		—
Liabilities
Long-term debt (b)(c)		$	1,404,914		$	798,750		$	606,164		—
Hedged interest rate swaps (a)		1,678			—			1,678			—
Foreign currency forwards (a)		86			—			86			—
Total liabilities		$	1,406,678		$	798,750		$	607,928		—

 

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)         Long-term debt, 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) and the 6.875% senior notes due 2019 (the “new senior notes”). The senior and senior subordinated notes (prior to their December 2011 redemption) were, and the new senior notes are, valued using unadjusted quoted market prices for such debt securities. Please see Note 9 for more information about the Company’s debt.

 

(c)          In November 2011, the Company, through certain of its domestic subsidiaries, issued $750.0 million aggregate principal amount of the Company’s new senior notes. In December 2011, the Company redeemed its senior notes due 2014 and its senior subordinated notes due 2016 with the net proceeds from the new senior notes. 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 March 31,						Six Months Ended March 31,
		2012			2011			2012			2011
Net earnings		$	67,813		$	49,278		$	97,947		$	90,227
Total weighted average basic shares		186,335			182,831			185,514			182,644
Dilutive securities:
Stock option and stock award programs		5,349			4,893			5,148			4,787
Total weighted average diluted shares		191,684			187,724			190,662			187,431
Net earnings per share:
Basic		$	0.36		$	0.27		$	0.53		$	0.49
Diluted		$	0.35		$	0.26		$	0.51		$	0.48

 

At March 31, 2012, options to purchase 44,340 and 1,964,831 shares of the Company’s common stock were outstanding but not included in the computation of diluted earnings per share for the three and six months ended March 31, 2012, respectively, 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 March 31, 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 March 31,						Six Months Ended March 31,
		2012			2011			2012			2011
Net earnings		$	67,813		$	49,278		$	97,947		$	90,227
Other comprehensive income adjustments:
Foreign currency translation adjustments (a)		10,975			11,324			9,095			12,015
Deferred gain on interest rate swaps (b)		1,425			1,308			2,920			2,837
Comprehensive income		$	80,213		$	61,910		$	109,962		$	105,079

 

(a)         There were no income tax amounts related to foreign currency translation adjustments recorded in other comprehensive income for the three and six months ended March 31, 2012 and 2011.

 

(b)         Amounts are net of income tax of $0.9 million and $0.8 million for the three months ended March 31, 2012 and 2011; and net of income tax of $1.9 million and $1.8 million for the six months ended March 31, 2012 and 2011, respectively.

 

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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 March 31, 2012 and September 30, 2011 are as follows (in thousands):

 

		March 31, 2012			September 30, 2011
Cumulative foreign currency translation adjustments (a)		$	(9,629	)	$	(18,724	)
Deferred (losses) on interest rate swaps, net of tax (b)		(1,027		)	(3,947		)
Total accumulated other comprehensive loss, net of tax		$	(10,656	)	$	(22,671	)

 

(a)         There were no income tax amounts related to foreign currency translation adjustments at March 31, 2012 and September 30, 2011.

(b)         Amounts are net of income tax of $0.7 million and $2.5 million at March 31, 2012 and September 30, 2011, respectively. 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 six months ended March 31, 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 six months ended March 31, 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 six months ended March 31, 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 March 31,					Six Months Ended March 31,
		2012			2011		2012			2011
Share-based compensation expense		$	2,945		2,437		$	10,976		$	10,275
Income tax benefit related to share-based compensation expense		$	1,143		946		$	4,259		$	3,987

 

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 six months ended March 31, 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		(2,528	)	7.96
Forfeited or expired		(113	)	10.48
Outstanding at March 31, 2012		13,116		$	10.21		6.9		$	191,413
Exercisable at March 31, 2012		7,023		$	8.29		5.7		$	115,978

 

The following table summarizes information about stock options under the Company’s share-based compensation plans at March 31, 2012:

 

		Options Outstanding							Options Exercisable
Range of Exercise Prices		Number Outstanding at March 31, 2012 (in Thousands)		Weighted Average Remaining Contractual Term (in Years)		Weighted Average Exercise Price			Number Exercisable at March 31, 2012 (in Thousands)		Weighted Average Exercise Price
$ 2.00 — 5.24		2,007		5.7		$	4.72		1,402		$	4.49
$ 7.42 — 19.21		11,109		7.1		11.20			5,621		9.23
Total		13,116		6.9		$	10.21		7,023		$	8.29

 

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:

 

		Six Months Ended March 31,
		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 six months ended March 31, 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 six months ended March 31, 2012 and 2011 was $9.60 and $5.74 per option, respectively. The total intrinsic value of options exercised during the six months ended March 31, 2012 was $31.7 million. Cash proceeds from these option exercises were $20.1 million and the income tax benefit realized from these option exercises was $12.3 million.

 

At March 31, 2012, approximately $19.8 million of total unrecognized compensation costs related to unvested stock option awards are expected to be recognized over the weighted average period of 2.7 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 six months ended March 31, 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 March 31, 2012		333		$	10.27		2.7

 

At March 31, 2012, approximately $2.2 million of total unrecognized compensation costs related to unvested restricted stock awards are expected to be recognized over the weighted average period of 2.7 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 six months ended March 31, 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 March 31, 2012		26		$	19.21		0.5

 

At March 31, 2012, approximately $0.2 million of total unrecognized compensation costs related to unvested RSUs are expected to be recognized over the weighted average period of 0.5 years.

 

8.   Goodwill and Intangible Assets

 

The change in the carrying amounts of goodwill by operating segment for the six months ended March 31, 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		510			2,279			2,789
Balance at March 31, 2012		$	91,028		$	441,805		$	532,833

 

(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 our financial statement 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 March 31, 2012 (in thousands):

 

		Sally Beauty Supply			Beauty Systems Group			Total
Balance at March 31, 2012:
Intangible assets with indefinite lives:
Trade names		$	27,666		$	27,421		$	55,087
Total		27,666			27,421			55,087
Intangible assets subject to amortization:
Gross carrying amount		27,028			106,076			133,104
Accumulated amortization		(8,172		)	(44,038		)	(52,210		)
Net value		18,856			62,038			80,894
Total intangible assets, excluding goodwill, net		$	46,522		$	89,459		$	135,981

 

As described in Note 12, during the six months ended March 31, 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 $3.0 million for the three months ended March 31, 2012 and 2011, respectively; and $6.7 million and $6.1 million for the six months ended March 31, 2012 and 2011, respectively. As of March 31, 2012, future amortization expense related to intangible assets subject to amortization is estimated to be as follows (in thousands):

 

Fiscal Year:
2012		$	6,935
2013		12,311
2014		11,914
2015		11,392
2016		10,244
Thereafter		28,098
		$	80,894

 

9.   Short-term Borrowings and Long-term Debt

 

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

 

		As of March 31, 2012			Maturity Dates		Interest Rates
ABL facility		$	—		Nov. 2015		(i) Prime plus (1.25% to 1.75%) or; (ii) LIBOR plus (2.25% to 2.75%)
Term loan B		596,856			Nov. 2013		(i) Prime plus (1.25% to 1.50%) or; (ii) LIBOR plus (2.25% to 2.50%) (a)
Senior notes		750,000			Nov. 2019		6.875%
Other (b)		3,214			2012-2015		4.05% to 5.79%
Total		$	1,350,070
Capital leases and other		$	6,094
Less: current portion		(2,096		)
Total long-term debt		$	1,354,068

 

(a)                           At March 31, 2012, the contractual interest rate for the term loan B is 2.49%. The interest rate on $300.0 million of principal outstanding under this loan is fixed by interest rate swaps which expire in May 2012.

(b)                           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 term loan A facility were paid in full in the fiscal year 2010.

 

In November 2010, Sally Holdings entered into a new $400 million, five-year revolving credit facility (the “new ABL facility” or the “ABL facility”) and terminated its prior ABL credit facility (the “prior ABL facility”). The terms of the new ABL facility contain a commitment fee of 0.50% on the unused portion of the facility. Borrowings under the senior term loan facilities and 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 and, in the case of the ABL facility, those of our Canadian subsidiaries and a pledge of certain intercompany notes. Borrowings under the ABL facility 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

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

Notes”). The Senior Notes bear interest at an annual rate of 6.875% and were issued at par. In connection with the issuance of the Senior 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 using the effective interest method. The Company intends to exchange the Senior Notes for notes that will be registered pursuant to a registration statement filed with the SEC in February 2012 and will otherwise be identical to the Senior Notes. The Company expects to complete such exchange during the third quarter of its fiscal year 2012.

 

In December 2011, the Issuers used the net proceeds from their issuance of the Senior Notes: (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 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.

 

Borrowings under the senior term loan facilities and the ABL facility are secured by substantially all of our assets, those of Sally Investment, those of our domestic subsidiaries and, in the case of the ABL facility, those of our Canadian subsidiaries and a pledge of certain intercompany notes. Borrowings under the senior term loan B facility may be prepaid at the option of Sally Holdings at any time without premium or penalty and are subject to mandatory prepayment in an amount equal to 50% of excess cash flows (as defined in the agreement governing the senior term loan facilities) for any fiscal year unless a specified leverage ratio is met. Amounts paid pursuant to said provision may be applied, at the option of the Company, against minimum loan repayments otherwise required of us over the twelve-month period following any such payment under the terms of the loan agreement. Additionally, borrowings under the senior term loan facilities would be subject to mandatory prepayment in an amount equal to 100% of the proceeds of specified asset sales that are not reinvested in the business or applied to repay borrowings under the ABL facility.

 

During the six months ended March 31, 2012, the Company 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.

 

The Senior Notes 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 who had guaranteed obligations under Sally Holdings’ senior credit facilities, existing notes and other indebtedness outstanding prior to issuance of the Senior Notes. Interest on the Senior Notes is payable semi-annually. The Senior Notes 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; and on or after November 15, 2015 at par plus a premium declining ratably to par, plus accrued and unpaid interest. 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. 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, 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 agreements underlying the Company’s credit facilities, including the indenture governing the Senior Notes, contain terms which significantly restrict the ability of Sally Beauty’s subsidiaries to pay dividends or otherwise transfer assets to Sally Beauty. Please see the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2011, for additional information about the Company’s credit facilities.

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

Maturities of the Company’s long-term debt are as follows as of March 31, 2012 (in thousands):

 

Twelve months ending March 31:
2013		$	1,328
2014		598,064
2015		678
2016		—
2017		—
Thereafter		750,000
		$	1,350,070
Capital leases and other		6,094
Less: current portion		(2,096		)
Total		$	1,354,068

 

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.

 

Under the credit agreement and/or indenture governing the senior term loans and the Senior Notes, Sally Holdings and its subsidiaries may not make certain restricted payments, including dividends and other restricted payments to us, if a default then exists under the credit agreement and/or the indenture or, in the case of the senior term loans, if Sally Holdings’ consolidated interest coverage ratio is less than 2.0 to 1.0 at the time of such restricted payment. As of March 31, 2012, Sally Holdings’ consolidated interest coverage ratio was approximately 5.7 to 1.0. In addition, Sally Holdings and its subsidiaries may not make certain restricted payments, including dividends and other restricted payments, to us if at the time of such restricted payment Sally Holdings’ indebtedness had reached certain limitations specified in the indenture governing the Senior Notes. Further, the aggregate amount of restricted payments Sally Holdings and its subsidiaries are able to make is limited pursuant to various baskets as calculated pursuant to the credit agreement and/or the indenture.

 

Under our ABL facility, Sally Holdings may pay dividends and make other equity distributions to us if availability under the facility exceeds certain thresholds and no default then exists under the facility. For dividends and distributions 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 dividend and distribution. For dividends in excess of that amount, it must maintain that same borrowing availability and its fixed-charge coverage ratio must exceed 1.1 to 1.0. As of March 31, 2012, its fixed-charge coverage ratio was approximately 3.4 to 1.0. As of March 31, 2012, the net assets of our consolidated subsidiaries that were unrestricted from transfer under our credit arrangements totaled $552.3 million, subject to certain adjustments. The ABL facility and the senior term loan facilities, as well as the Company’s Senior Notes indenture contain customary cross-default and/or cross-acceleration provisions.

 

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 (including interest rate swaps, and foreign currency options, collars and forwards) by Sally Holdings.

 

The Company uses interest rate swaps, as part of its overall economic risk management strategy, to add stability to the interest payments due in connection with its term loan obligations. Interest payments related to the senior term loans are impacted by changes in LIBOR. The Company’s interest rate swap agreements involve the periodic receipt by Sally Holdings of amounts based on a variable rate in exchange for Sally Holdings making payments based on a fixed rate over the term of the interest rate swap agreements, without exchange of the underlying notional amount.

 

The Company 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

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

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 March 31, 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 expire in May 2012 and are designated and qualify 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 are adjusted quarterly) are recorded, net of income tax, in accumulated other comprehensive (loss) income (“OCI”) until the hedged obligation is settled or the swap agreements expire, whichever is earlier. Any hedge ineffectiveness, as this term is used in ASC 815, is recognized in interest expense in our consolidated statements of earnings. No hedge ineffectiveness on cash flow hedges was recognized during the six months ended March 31, 2012 or 2011.

 

Amounts reported in OCI related to interest rate swaps are reclassified into interest expense, as a yield adjustment, in the same period in which interest on hedged variable-rate debt obligations affects earnings. Interest expense resulting from such reclassifications was $2.5 million during each of the three months ended March 31, 2012 and 2011; and $5.1 million and $5.0 million during the six months ended March 31, 2012 and 2011, respectively. The entire amount reported in OCI ($1.7 million, before income tax) as of March 31, 2012 will be reclassified into interest expense by May 2012.

 

Non-designated Cash Flow Hedges

 

The Company uses foreign currency options and collars including, at March 31, 2012, collars with an aggregate notional amount of $7.0 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 March 31, 2012, have contractual Euro to U.S. dollar exchange rates between 1.4000 and 1.4612 and expire in varying amounts monthly 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 March 31, 2012, we hold: (a) a foreign currency forward which enables us to sell approximately €26.2 million ($35.0 million, at the March 31, 2012 exchange rate) at the contractual exchange rate of 1.331, (b) a foreign currency forward which enables us to sell approximately $2.0 million Canadian dollars ($2.0 million, at the March 31, 2012 exchange rate) at the contractual exchange rate of 0.9989, (c) a foreign currency forward which enables us to buy approximately $2.7 million Canadian dollars ($2.7 million, at the March 31, 2012 exchange rate) at the contractual exchange rate of 0.9988, (d) a foreign currency forward which enables us to sell approximately 19.3 million Mexican pesos ($1.5 million, at the March 31, 2012 exchange rate) at the contractual exchange rate of 12.849 and (e) a foreign currency forward which enables us to buy approximately £0.6 million ($1.0 million, at the March 31, 2012 exchange rate) at the contractual exchange rate of 1.590. All foreign currency forwards held by the Company at March 31, 2012 expire on or before June 1, 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 losses of $1.3 million and $1.0 million for the three months ended March 31, 2012 and 2011, respectively; and net gains of $0.4 million and net losses of $0.4 million for the six months ended March 31, 2012 and 2011, respectively, including marked-to-market adjustments, in connection with all of the Company’s foreign currency derivatives.

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

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 March 31, 2012 (in thousands):

 

Tabular Disclosure of Fair Values of Derivative Instruments

 

		Asset Derivatives					Liability Derivatives
		As of March 31, 2012					As of March 31, 2012
		Balance Sheet Location		Fair Value			Balance Sheet Location		Fair Value
Derivatives designated as hedging instruments:
Interest Rate Swaps		Other assets		$	—		Accrued liabilities		$	1,678
Total derivatives designated as hedging instruments				$	—				$	1,678
Derivatives not designated as hedging instruments:
Foreign Currency Collars and Forwards		Prepaid expenses		$	334		Accrued liabilities		$	86
Total derivatives not designated as hedging instruments				$	334				$	86

 

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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