Sally Beauty Holdings, Inc. - Quarter Report: 2013 June (Form 10-Q)

Table of Contents

 

 

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, 2013

 

-OR-

 

o         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, 2013, there were 167,737,109 shares of the issuer’s common stock outstanding.

 

 

Table of Contents

 

TABLE OF CONTENTS

 

			Page
PART I — FINANCIAL INFORMATION
ITEM 1.	FINANCIAL STATEMENTS		5
ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS		34
ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK		55
ITEM 4.	CONTROLS AND PROCEDURES		56
PART II — OTHER INFORMATION
ITEM 1.	LEGAL PROCEEDINGS		57
ITEM 1A.	RISK FACTORS		57
ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS		57
ITEM 3.	DEFAULTS UPON SENIOR SECURITIES		57
ITEM 4.	MINE SAFETY DISCLOSURES		57
ITEM 5.	OTHER INFORMATION		58
ITEM 6.	EXHIBITS		58

 

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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;

·             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 and catalogue-based businesses;

·             successfully identifying acquisition candidates and successfully completing desirable acquisitions;

·             integrating acquired businesses;

·             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 our debt and refinancing all or a portion of our indebtedness or obtaining additional financing on favorable terms, if at all;

·             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; and

·             the costs and effects of litigation.

 

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, 2012, 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 Securities and Exchange Commission (“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 statements of earnings and consolidated statements of comprehensive income for the three and nine months ended June 30, 2013 and 2012, consolidated balance sheets as of June 30, 2013 and September 30, 2012, and consolidated statements of cash flows for the nine months ended June 30, 2013 and 2012 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						Nine Months Ended
		June 30,						June 30,
		2013			2012			2013			2012
Net sales		$	912,101		$	886,991		$	2,715,781		$	2,641,087
Cost of products sold and distribution expenses		455,018			442,612			1,369,876			1,338,065
Gross profit		457,083			444,379			1,345,905			1,303,022
Selling, general and administrative expenses		295,719			291,533			900,778			873,736
Depreciation and amortization		18,798			16,299			52,853			47,792
Operating earnings		142,566			136,547			392,274			381,494
Interest expense		27,006			26,925			80,510			113,240
Earnings before provision for income taxes		115,560			109,622			311,764			268,254
Provision for income taxes		43,094			40,135			115,426			100,820
Net earnings		$	72,466		$	69,487		$	196,338		$	167,434
Earnings per share:
Basic		$	0.43		$	0.38		$	1.13		$	0.91
Diluted		$	0.42		$	0.37		$	1.10		$	0.88
Weighted average shares:
Basic		168,725			182,756			173,528			184,598
Diluted		173,762			188,496			178,278			189,901

 

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, 2012, are an integral part of these financial statements.

 

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SALLY BEAUTY HOLDINGS, INC. AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income
(In thousands)

(Unaudited)

 

		Three Months Ended						Nine Months Ended
		June 30,						June 30,
		2013			2012			2013			2012
Net earnings		$	72,466		$	69,487		$	196,338		$	167,434
Other comprehensive income (loss):
Foreign currency translation adjustments		(4,157		)	(10,778		)	(13,292		)	(1,683		)
Deferred gain on interest rate swaps		—			1,679			—			6,450
Total other comprehensive income (loss), before tax		(4,157		)	(9,099		)	(13,292		)	4,767
Income taxes related to other comprehensive income (loss)		—			(452		)	—			(2,303		)
Other comprehensive income (loss), net of tax		(4,157		)	(9,551		)	(13,292		)	2,464
Total comprehensive income		$	68,309		$	59,936		$	183,046		$	169,898

 

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, 2012, 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, 2013			September 30, 2012
		(Unaudited)
Assets
Current assets:
Cash and cash equivalents		$	53,444		$	240,220
Trade accounts receivable, less allowance for doubtful accounts of $2,945 at June 30, 2013 and $2,583 at September 30, 2012		59,912			59,496
Accounts receivable, other		39,580			42,260
Income taxes receivable		13,118			23,734
Inventory		780,200			735,356
Prepaid expenses		29,768			29,376
Deferred income tax assets, net		33,592			33,465
Total current assets		1,009,614			1,163,907
Property and equipment, net of accumulated depreciation of $366,139 at June 30, 2013 and $352,164 at September 30, 2012		222,355			202,661
Goodwill		531,380			532,331
Intangible assets, excluding goodwill, net of accumulated amortization of $68,364 at June 30, 2013 and $59,192 at September 30, 2012		127,376			128,437
Other assets		35,122			38,464
Total assets		$	1,925,847		$	2,065,800
Liabilities and Stockholders’ Deficit
Current liabilities:
Current maturities of long-term debt		$	77,513		$	1,908
Accounts payable		272,411			262,209
Accrued liabilities		150,397			200,267
Income taxes payable		5,838			13,004
Total current liabilities		506,159			477,388
Long-term debt		1,613,248			1,615,322
Other liabilities		24,759			24,232
Deferred income tax liabilities, net		76,064			63,943
Total liabilities		2,220,230			2,180,885
Stockholders’ deficit:
Common stock, $0.01 par value. Authorized 500,000 shares; 167,756 and 180,548 shares issued and 167,424 and 180,241 shares outstanding at June 30, 2013 and September 30, 2012, respectively		1,674			1,802
Preferred stock, $0.01 par value. Authorized 50,000 shares; none issued		—			—
Additional paid-in capital		177,791			540,007
Accumulated deficit		(449,903		)	(646,241		)
Accumulated other comprehensive loss, net of tax		(23,945		)	(10,653		)
Total stockholders’ deficit		(294,383		)	(115,085		)
Total liabilities and stockholders’ deficit		$	1,925,847		$	2,065,800

 

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, 2012, 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,
		2013			2012
Cash Flows from Operating Activities:
Net earnings		$	196,338		$	167,434
Adjustments to reconcile net earnings to net cash provided by operating activities:
Depreciation and amortization		52,853			47,792
Share-based compensation expense		15,503			13,801
Amortization of deferred financing costs		2,719			4,164
Excess tax benefit from share-based compensation		(11,316		)	(10,647		)
Net loss on extinguishment of debt		—			38,376
Deferred income taxes		12,071			(154		)
Changes in (exclusive of effects of acquisitions):
Trade accounts receivable		(659		)	4,457
Accounts receivable, other		2,432			(8,143		)
Income taxes receivable		10,616			—
Inventory		(49,165		)	(44,329		)
Prepaid expenses		(792		)	(465		)
Other assets		(35		)	5,161
Accounts payable and accrued liabilities		(38,385		)	(19,063		)
Income taxes payable		4,312			1,437
Other liabilities		635			(3,260		)
Net cash provided by operating activities		197,127			196,561
Cash Flows from Investing Activities:
Capital expenditures		(64,551		)	(44,160		)
Acquisitions, net of cash acquired		(16,070		)	(43,154		)
Net cash used by investing activities		(80,621		)	(87,314		)
Cash Flows from Financing Activities:
Proceeds from issuance of long-term debt		222,500			1,876,300
Repayments of long-term debt		(148,424		)	(1,801,933		)
Repurchases of common stock		(407,197		)	(200,000		)
Debt issuance costs		—			(26,858		)
Proceeds from exercises of stock options		18,722			23,080
Excess tax benefit from share-based compensation		11,316			10,647
Net cash used by financing activities		(303,083		)	(118,764		)
Effect of foreign exchange rate changes on cash and cash equivalents		(199		)	10
Net decrease in cash and cash equivalents		(186,776		)	(9,507		)
Cash and cash equivalents, beginning of period		240,220			63,481
Cash and cash equivalents, end of period		$	53,444		$	53,974
Supplemental Cash Flow Information:
Interest paid (a)		$	104,366		$	109,094
Income taxes paid		$	84,735		$	102,689

 

(a)         For the nine months ended June 30, 2012, interest paid includes $24.4 million in call premiums paid upon the redemption of outstanding 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, 2012, 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, L.P. (“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 accompanying 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, 2013 and September 30, 2012, its consolidated results of operations for the three and nine months ended June 30, 2013 and 2012, and its consolidated cash flows for the nine months ended June 30, 2013 and 2012.

 

Certain amounts for prior fiscal periods have been reclassified to conform to the current fiscal period’s presentation.

 

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 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, 2012. 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.              Comprehensive Income and Accumulated Other Comprehensive (Loss) Income

 

In June 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-05 which amended Accounting Standards Codification (“ASC”) Topic 220, Comprehensive Income. The Company adopted the provisions of ASU No. 2011-05, as amended, effective October 1, 2012. Accordingly, the components of the Company’s other comprehensive income are reported in the accompanying consolidated statements of comprehensive income. The Company’s other comprehensive (loss) income has historically consisted of foreign currency translation adjustments, as well as deferred gains (losses) on certain interest rate swaps until the expiration of such swaps in May 2012 (Please see Note 11 for more information about the Company’s interest rate swaps).

 

For the three and nine months ended June 30, 2013, other comprehensive loss consists exclusively of foreign currency translation adjustments of $4.2 million and $13.3 million, respectively. For the three months ended June 30, 2012, other comprehensive income consists of foreign currency translation adjustments of $10.8 million (before income taxes of $0.2 million) and deferred gains on certain interest rate swaps of $1.7 million (before income taxes of $0.7 million). For the nine months ended June 30, 2012, other comprehensive income consists of foreign currency translation adjustments of $1.7 million (before income taxes of $0.2 million) and deferred gains on certain interest rate swaps of $6.5 million (before income taxes of $2.5 million).

 

At June 30, 2013 and September 30, 2012, accumulated other comprehensive loss (“AOCI”) consists of cumulative foreign currency translation adjustments of $23.9 million and $10.7 million, respectively, and is net of income taxes of $2.9 million at

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

each date. Any amounts previously reported in AOCI which were related to the interest rate swaps discussed above were reclassified into interest expense, as a yield adjustment, in the same period in which interest on the hedged variable-rate debt obligations affected earnings.

 

4.              Recent Accounting Pronouncements and Accounting Changes

 

Recent Accounting Pronouncements

 

In February 2013, the FASB issued ASU No. 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income, to improve the reporting of reclassifications out of AOCI. This amendment requires an entity to present the changes in each component of AOCI for the periods presented, to separately report significant amounts reclassified from each component of AOCI and to disclose among other things the components, if any, of net income affected by such reclassifications. The disclosures about such reclassifications must be presented either parenthetically on the face of the financial statements or disclosed in the notes to the financial statements. As permitted, the Company adopted the provisions of ASU No. 2013-02 effective January 1, 2013 and its adoption did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

 

In July 2012, the FASB issued ASU No. 2012-02, Testing Indefinite-Lived Intangible Assets for Impairment, which amended ASC Topic 350, Intangibles-Goodwill and Other (“ASC 350”). This amendment allows an entity to first assess relevant qualitative factors in order to determine whether it is necessary to perform the quantitative impairment test for indefinite-lived intangible assets otherwise required under ASC 350. In effect, the amendment eliminates the need to calculate the fair value of an indefinite-lived intangible asset in connection with the impairment test unless the entity determines, based on the qualitative assessment, that it is more likely than not that the asset is impaired. As permitted, the Company adopted the provisions of ASU No. 2012-02 effective January 1, 2013 and its adoption did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

 

Accounting Changes

 

The Company made no accounting changes during the nine months ended June 30, 2013.

 

5.              Fair Value Measurements

 

The Company’s financial instruments consist of cash equivalents, trade and other accounts receivable, accounts payable, foreign currency derivative instruments and debt. The carrying amounts of 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 the fair value of its financial instruments under the provisions of ASC Topic 820, Fair Value Measurement, as amended (“ASC 820”). 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 June 30, 2013 (in thousands):

 

		Total			Level 1			Level 2			Level 3
Assets
Cash equivalents (a)		$	—		$	—		$	—		—
Foreign currency forwards (b)		98			—			98			—
Total assets		$	98		$	—		$	98		—
Liabilities
Long-term debt (c)		$	1,745,273		$	1,663,125		$	82,148		—
Foreign currency forwards (b)		248			—			248			—
Total liabilities		$	1,745,521		$	1,663,125		$	82,396		—

 

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

 

		Total			Level 1			Level 2			Level 3
Assets
Cash equivalents (a)		$	155,000		$	155,000		$	—		—
Foreign currency forwards (b)		4			—			4			—
Total assets		$	155,004		$	155,000		$	4		—
Liabilities
Long-term debt (c)		$	1,739,547		$	1,731,625		$	7,922		—
Foreign currency forwards (b)		132			—			132			—
Total liabilities		$	1,739,679		$	1,731,625		$	8,054		—

 

(a)         Cash equivalents, at September 30, 2012, consist of highly liquid investments which have no maturity and are valued using unadjusted quoted market prices for such securities. The Company may from time to time invest in securities with maturities of three months or less (consisting primarily of investment-grade corporate or government bonds), with the primary investment objective of minimizing the potential risk of loss of principal.

(b)         Foreign currency forwards are valued for purposes of this disclosure using widely accepted valuation techniques, such as discounted cash flow analyses, and reasonable estimates, such as projected foreign currency exchange rates. Please see Note 11 for more information about the Company’s foreign exchange contracts (including foreign currency forwards).

(c)          Long-term debt (including current maturities and borrowings under the ABL facility) is carried in the Company’s consolidated financial statements at amortized cost of $1,690.8 million at June 30, 2013 and $1,617.2 million at September 30, 2012. The senior notes due 2019 and senior notes due 2022 are valued for purposes of this disclosure using unadjusted quoted market prices for such debt securities. Other long-term debt (consisting primarily of borrowings under the ABL facility and capital lease obligations), 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. Please see Note 10 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)

 

6.              Accumulated Stockholders’ Equity (Deficit)

 

In August 2012, the Company announced that its Board of Directors approved a share repurchase program authorizing the Company to repurchase up to $300.0 million of its common stock (the “2012 Share Repurchase Program”). In addition, on March 5, 2013, the Company announced that its Board of Directors approved a new share repurchase program authorizing the Company to repurchase up to $700.0 million of its common stock over the eight quarters commencing on such date (the “2013 Share Repurchase Program”). In connection with the authorization of the 2013 Share Repurchase Program, the Company’s Board of Directors terminated the 2012 Share Repurchase Program.

 

Prior to such termination, the Company had repurchased approximately 10.4 million shares at a cost of $266.4 million under the 2012 Share Repurchase Program. In addition, during the period from March 5, 2013 through June 30, 2013, the Company repurchased approximately 4.7 million shares at a cost of $140.8 million under the 2013 Share Repurchase Program.

 

During the three months ended June 30, 2013, the Company repurchased and retired approximately 3.1 million shares of its common stock (under the 2013 Share Repurchase Program) at a cost of $93.8 million. During the nine months ended June 30, 2013, the Company repurchased and retired approximately 15.1 million shares of its common stock (under the 2012 Share Repurchase Program and the 2013 Share Repurchase Program) at a cost of $407.2 million. The Company reduced common stock and additional paid-in capital, in the aggregate, by these amounts.

 

7.              Earnings Per Share

 

Basic earnings per share, is calculated by dividing net earnings by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is calculated similarly but reflects 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,
		2013			2012			2013			2012
Net earnings		$	72,466		$	69,487		$	196,338		$	167,434
Total weighted average basic shares		168,725			182,756			173,528			184,598
Dilutive securities:
Stock options and stock award programs		5,037			5,740			4,750			5,303
Total weighted average diluted shares		173,762			188,496			178,278			189,901
Earnings per share:
Basic		$	0.43		$	0.38		$	1.13		$	0.91
Diluted		$	0.42		$	0.37		$	1.10		$	0.88

 

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 any unrecognized compensation expense related to such options, exceeds the average price per share for the period. At June 30, 2013, all outstanding options to purchase shares of the Company’s common stock were dilutive.

 

8.              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 1.6 million and 2.0 million stock options and approximately 128,000 and 32,000 restricted share awards to its employees and consultants during the nine months ended June 30, 2013 and 2012, respectively. Upon issuance of such grants, the Company recognized accelerated share-based compensation expense of $5.9 million and $5.3 million in the nine months ended June 30, 2013 and 2012, respectively, in connection with certain retirement eligible employees

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

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. In addition, the Company granted approximately 36,000 and 26,000 restricted stock units to its non-employee directors during the nine months ended June 30, 2013 and 2012, 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,
		2013			2012			2013			2012
Share-based compensation expense		$	3,190		$	2,825		$	15,503		$	13,801
Income tax benefit related to share-based compensation expense		$	1,161		$	674		$	5,731		$	4,933

 

Stock Options

 

Each option has an exercise price equal to 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.

 

The following table presents a summary of the activity for the Company’s stock option awards for the nine months ended June 30, 2013:

 

		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, 2012		11,861		$	10.45		6.5		$	173,601
Granted		1,578		23.49
Exercised		(2,224	)	8.42
Forfeited or expired		(72	)	17.97
Outstanding at June 30, 2013		11,143		$	12.66		6.4		$	205,514
Exercisable at June 30, 2013		6,137		$	9.24		5.1		$	134,131

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

The following table summarizes additional information about stock options outstanding under the Company’s share-based compensation plans:

 

		Options Outstanding							Options Exercisable
Range of Exercise Prices		Number Outstanding at June 30, 2013 (in Thousands)		Weighted Average Remaining Contractual Term (in Years)		Weighted Average Exercise Price			Number Exercisable at June 30, 2013 (in Thousands)		Weighted Average Exercise Price
$2.00 — 9.66		5,439		4.7		$	7.92		4,782		$	7.98
$11.39 — 23.49		5,704		7.9		17.17			1,355		13.69
Total		11,143		6.4		$	12.66		6,137		$	9.24

 

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,
		2013		2012
Expected life (in years)		5.0		5.0
Expected volatility for the Company’s stock		56.3	%	58.4	%
Risk-free interest rate		0.8	%	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 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%.

 

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, 2013 and 2012 was $11.29 and $9.60 per option, respectively. The total intrinsic value of options exercised during the nine months ended June 30, 2013 was $42.3 million. The cash proceeds from these option exercises were $18.7 million and the tax benefit realized from these option exercises was $13.8 million.

 

At June 30, 2013, approximately $17.8 million of total unrecognized compensation costs related to unvested stock option awards are expected to be recognized over the weighted average period of 2.4 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 the restrictions lapsing, subject to certain retirement provisions of the 2010 Plan and certain predecessor share-based compensation plans.

 

The fair value of the Company’s restricted stock awards is expensed on a straight-line basis over the period (generally five years) 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.

 

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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 restricted stock awards for the nine months ended June 30, 2013:

 

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, 2012		307		$	10.42		2.5
Granted		128		23.49
Vested		(103	)	9.48
Forfeited		—		—
Unvested at June 30, 2013		332		$	15.77		2.9

 

At June 30, 2013, approximately $2.5 million of total unrecognized compensation costs related to unvested restricted stock awards are expected to be recognized over the weighted average period of 2.9 years.

 

Restricted Stock Units

 

The Company currently grants Restricted Stock Unit (“RSU” or “RSUs”) awards, 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, RSUs are generally retained by the Company as deferred stock units that are not distributed until nine months after the independent director’s service as a director terminates. With respect to awards made by the Company after September 30, 2012, an independent director who receives an RSU award may elect, upon receipt of such award, to defer until a later date delivery of the shares of common stock of the Company that would otherwise be issued to such director on the vesting date. 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.

 

The following table presents a summary of the activity for the Company’s RSUs for the nine months ended June 30, 2013:

 

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, 2012		—		$	—		—
Granted		36		23.84
Vested		—		—
Forfeited		(4	)	23.49
Unvested at June 30, 2013		32		$	23.89		0.3

 

At June 30, 2013, approximately $0.2 million of total unrecognized compensation costs related to unvested RSUs are expected to be recognized over the weighted average period of 0.3 years.

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

9.              Goodwill and Intangible Assets

 

The Company completed its annual assessment of goodwill for impairment during the quarter ended March 31, 2013. No impairment losses were recognized in the current or prior periods presented in connection with the Company’s goodwill.

 

In July 2012, the FASB issued ASU No. 2012-02, Testing Indefinite-Lived Intangible Assets for Impairment, 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 quantitative impairment test for indefinite-lived intangible assets otherwise required under ASC 350. In effect, the amendment eliminates the need to calculate the fair value of an indefinite-lived intangible asset in connection with the impairment test unless the entity determines, based on the qualitative assessment, that it is more likely than not that the asset is impaired. As permitted, the Company adopted the provisions of ASU No. 2012-02 effective January 1, 2013.

 

The Company completed its annual assessment of intangible assets, other than goodwill and including indefinite-lived intangible assets, for impairment during the quarter ended March 31, 2013. No impairment losses were recognized in the current or prior periods presented in connection with the Company’s intangible assets.

 

Amortization expense was $3.1 million and $3.6 million for the three months ended June 30, 2013 and 2012; and $9.4 million and $10.3 million for the nine months ended June 30, 2013 and 2012, respectively.

 

10.       Short-term Borrowings and Long-term Debt

 

Details of long-term debt as of June 30, 2013 are as follows (in thousands):

 

		Amount			Maturity Dates		Interest Rates
ABL facility		$	75,500		Nov. 2015		(i)    Prime plus (1.25% to 1.75%) or;
							(ii)   LIBOR (a) plus (2.25% to 2.75%)
Senior notes due 2019		750,000			Nov. 2019		6.875%
Senior notes due 2022 (b)		858,613			Jun. 2022		5.750% (b)
Other (c)		1,627			2014-2015		4.93% to 5.79%
Total		$	1,685,740
Capital leases and other		$	5,021
Less: current portion		(77,513		)
Total long-term debt		$	1,613,248

 

(a)         London Interbank Offered Rate (“LIBOR”).

(b)         Includes unamortized premium of $8.6 million related to notes issued in September 2012 with an aggregate principal amount of $150.0 million. The 5.75% interest rate relates to notes in the aggregate principal amount of $850.0 million.

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

 

In connection with the Company’s separation from its former parent company, Alberto-Culver Company, in November 2006, the Company, through its subsidiaries (Sally Investment Holdings LLC and Sally Holdings LLC) incurred $1,850.0 million of indebtedness by: (i) borrowing $70.0 million under a $400.0 million revolving (asset-based lending (“ABL”)) credit facility; (ii) entering into two senior term loan facilities (term loans A and B) in an aggregate amount of $1,070.0 million; and (iii) issuing 9.25% senior notes due 2014 in an aggregate amount of $430.0 million and 10.50% senior subordinated notes due 2016 in an aggregate amount of $280.0 million.

 

Borrowings under the term loan A facility were paid in full in the fiscal year ended September 30, 2010.

 

In the fiscal year ended September 30, 2011, Sally Holdings LLC (“Sally Holdings”) entered into a new $400 million, five-year asset-based senior secured loan facility (the “ABL facility”) and terminated its prior ABL credit facility. The availability of funds under the ABL facility is subject to a customary borrowing base comprised of a percentage of our credit card and trade receivables, and of our inventory (minus certain customary reserves) and reduced by certain outstanding letters of credit. The ABL facility includes a $25.0 million Canadian sub-facility for our Canadian operations. At June 30, 2013, the Company had $302.2 million available for borrowing under the ABL facility, including the Canadian sub-facility.

 

On July 26, 2013, the Company, Sally Holdings and other parties to the ABL facility entered into a second amendment (hereafter, the “Second Amendment”) to the ABL facility which, among other things, increased the maximum availability to $500.0 million (subject to borrowing base limitations), reduced pricing, relaxed the restrictions regarding the making of Restricted Payments, extended the maturity to July 26, 2018 and improved certain other covenant terms. The remaining terms of the amended ABL facility are substantially the same as those of the ABL facility prior to the Second Amendment.

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

In the fiscal year ended September 30, 2012, the Company redeemed in full the 9.25% senior notes due 2014 and 10.50% senior subordinated notes due 2016 and repaid in full its borrowings under the term loan B facility with the net proceeds from the Company’s issuance of $750.0 million aggregate principal amount of its 6.875% Senior Notes due 2019 (the “senior notes due 2019”) and $700.0 million aggregate principal amount of its 5.75% Senior Notes due 2022 (the “senior notes due 2022”). Please see Note 14 of the “Notes to Consolidated Financial Statements” in “Item 8 - Financial Statements and Supplementary Data” contained in our Annual Report on Form 10-K for the fiscal year ended September 30, 2012 for additional information about the Company’s long-term debt.

 

In addition, in September 2012, the Company issued an additional $150.0 million aggregate principal amount of the senior notes due 2022. The proceeds from this issuance were used for general corporate purposes. The senior notes due 2022 in this subsequent offering were issued at par plus a premium, which is being amortized over the term of the notes using the effective interest method.

 

The senior notes due 2019 and the senior notes due 2022 (together, the “senior notes due 2019 and 2022”) are unsecured obligations of Sally Holdings and Sally Capital Inc. (together, 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. Please see Note 15 for certain condensed financial statement data pertaining to Sally Beauty, the Issuers, the guarantor subsidiaries and the non-guarantor subsidiaries.

 

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, 2013 (in thousands):

 

Twelve months ending June 30:
2014		$	76,734
2015		393
2016		—
2017		—
2018		—
Thereafter		1,608,613
		$	1,685,740
Capital lease obligations		5,021
Less: current portion		(77,513		)
Total		$	1,613,248

 

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 ABL facility does not contain any restriction against the incurrence of unsecured indebtedness. However, the ABL facility restricts the incurrence of secured indebtedness if, after giving effect to the incurrence of such secured indebtedness, the Company’s Secured Leverage Ratio exceeds 4.0 to 1.0. At June 30, 2013, the Company’s Secured Leverage Ratio was approximately 0.2 to 1.0. Secured Leverage Ratio is defined as the ratio of (i) Secured Funded Indebtedness (as defined in the ABL facility) to (ii) Consolidated EBITDA (as defined in the ABL facility).

 

18

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

The ABL facility is pre-payable and the commitments thereunder may be terminated, in whole or in part, at any time without penalty or premium.

 

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, 2013, 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: (i) 50% of Sally Holdings’ and its subsidiaries’ cumulative consolidated net earnings since July 1, 2006, plus (ii) 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 (iii) the net reduction in investments in unrestricted subsidiaries since the issue date of the applicable senior notes plus (iv) 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, 2013, the Company’s Consolidated Total Leverage Ratio was approximately 2.7 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 end 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.

 

The ABL facility also restricts the making of Restricted Payments. More specifically, under the ABL facility, Sally Holdings may make Restricted Payments if availability under the ABL facility equals or exceeds certain thresholds, and no default then exists under the facility. As stated above, the Second Amendment relaxes the restrictions against the making of Restricted Payments.

 

For Restricted Payments up to $30.0 million during each fiscal year, borrowing availability must equal or exceed the lesser of $75.0 million or 15% of the borrowing base for 45 days prior to such Restricted Payment (down from $80.0 million or 20% of the borrowing base prior to the Second Amendment). For Restricted Payments in excess of that amount, borrowing availability must equal or exceed the lesser of $100.0 million (up from $80.0 million prior to the Second Amendment due to the increase in the facility size from $400.0 million to $500.0 million) or 20% of the borrowing base (unchanged by the Second Amendment) for 45 days prior to such Restricted Payment and the Consolidated Fixed Charge Coverage Ratio (as defined below) must equal or exceed 1.1 to 1.0 (down from 1.2 to 1.0 prior to the Second Amendment). Further, if borrowing availability equals or exceeds the lesser of $150.0 million or 30% of the borrowing base, Restricted Payments are not limited by the Consolidated Fixed Charge Coverage Ratio test. The Consolidated Fixed Charge Coverage Ratio is defined as the ratio of (i) Consolidated EBITDA (as defined in the ABL facility) during the trailing twelve-month period preceding such proposed Restricted Payment minus certain unfinanced capital expenditures made during such period and income tax payments paid in cash during such period to (ii) fixed charges (as defined in the ABL facility). In addition, during any period that borrowing availability under the ABL facility is less than the greater of $40.0 million or 10% of the borrowing base (down from $40.0 million or 15% of the borrowing base prior to the Second Amendment), the level of the Consolidated Fixed Charge Coverage Ratio that the Company must satisfy is 1.0 to 1.0 (down from 1.1 to 1.0 prior to the Second Amendment). As of June 30, 2013, the Consolidated Fixed Charge Coverage Ratio was approximately 3.8 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 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, total comprehensive income, 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, 2013, all the net assets of our consolidated subsidiaries were unrestricted from transfer under our credit arrangements.

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

11.       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 foreign currency exchange rates and in interest 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 foreign exchange contracts and interest rate swaps) by Sally Holdings.

 

The Company from time to time uses foreign exchange contracts, 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 relative to the functional currency of certain of its consolidated subsidiaries, 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, sometimes providing a natural hedge against its foreign currency risk. In connection with the remaining foreign currency risk, the Company uses foreign exchange contracts 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.

 

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. At June 30, 2013, our exposure to interest rate fluctuations relates to interest payments under the ABL facility, if any, and the Company held no derivatives instruments in connection therewith.

 

As of June 30, 2013, 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 which enabled it to convert a portion of its then variable-interest rate obligations under the term loan B facility, to fixed-interest rate obligations. These agreements 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 (“AOCI”) until the swap agreements expired in May 2012. Amounts previously reported in AOCI which were related to such interest rate swaps were reclassified into interest expense, as a yield adjustment, in the same period in which interest on the hedged variable-rate debt obligations affected earnings. As such, for the three and nine months ended June 30, 2012, the Company’s other comprehensive income included deferred gains on these interest swaps of $1.0 million and $3.9 million, respectively, net of income tax of $0.7 million and $2.5 million, respectively.

 

Non-designated Cash Flow Hedges

 

The Company may use from time to time derivative instruments (such as foreign exchange contracts and interest rate swaps) not designated as hedges or that do not meet the requirements for hedge accounting to manage its exposure to interest rate or foreign currency exchange rate movements, as appropriate.

 

The Company uses foreign exchange contracts including, at June 30, 2013, foreign currency forwards with an aggregate notional amount of $3.0 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. These foreign currency forwards enable Sinelco to buy U.S. dollars at a contractual exchange rate of 1.2772, are with a single counterparty and expire ratably through September 2013.

 

The Company also uses foreign exchange contracts to mitigate its exposure to changes in foreign currency exchange rates in connection with certain intercompany balances not permanently invested. As such, at June 30, 2013, we held: (a) a foreign currency forward which enables us to sell approximately €26.0 million ($33.8 million, at the June 30, 2013 exchange rate) at the contractual exchange rate of approximately 1.3019, (b) a foreign currency forward which enables us to sell approximately $2.3 million Canadian dollars ($2.2 million, at the June 30, 2013 exchange rate) at the contractual exchange rate of 1.0519, (c) a foreign currency forward which enables us to buy approximately $26.2 million Canadian dollars ($24.9 million, at the June 30, 2013 exchange rate) at the contractual exchange rate of 1.0488, (d) a foreign currency forward which enables us to sell approximately 18.7 million Mexican pesos ($1.4 million, at the June 30, 2013 exchange rate) at the contractual exchange rate of 13.0095 and (e) a foreign currency forward which enables us to sell approximately £9.0 million ($13.7 million, at the June 30, 2013 exchange rate) at the contractual exchange rate of approximately 1.5310. The foreign currency forwards discussed in this

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

paragraph are with a single counterparty, not the same party as the counterparties on the other forwards held at June 30, 2013, and expire on or before September 30, 2013.

 

In addition, the Company uses foreign exchange contracts including, at June 30, 2013, foreign currency forwards with an aggregate notional amount of €0.9 million ($1.2 million, at the June 30, 2013 exchange rate) to mitigate the exposure to the British pound sterling resulting from the sale of products and services among certain European subsidiaries of the Company. The foreign currency forwards discussed in this paragraph enable the Company to buy British pound sterling in exchange for Euro currency at the weighted average contractual exchange rate of 0.8154, are with a single counterparty, not the same party as the counterparties on the other forwards held at June 30, 2013, and expire ratably through September 2013.

 

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 $1.2 million and net gains of $2.2 million for the three months ended June 30, 2013 and 2012, respectively; and net losses of $0.9 million and net gains of $2.6 million for the nine months ended June 30, 2013 and 2012, 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, 2013 and September 30, 2012 (in thousands):

 

		Asset Derivatives								Liability Derivatives
		Classification		June 30, 2013			September 30, 2012			Classification		June 30, 2013			September 30, 2012
Derivatives designated as hedging instruments:
None
Derivatives not designated as hedging instruments:
Foreign Exchange Contracts		Prepaid expenses		$	98		$	4		Accrued liabilities		$	248		$	132
				$	98		$	4				$	248		$	132

 

The table below presents the effect of the Company’s derivative financial instruments on the statements of earnings for the three months ended June 30, 2013 and 2012 (in thousands):

 

Derivatives		Amount of Gain or (Loss) Recognized in OCI on Derivative (Effective Portion), net of tax						Amount of Gain or (Loss) Reclassified from Accumulated OCI into Income (Effective Portion)
Designated as		Three Months Ended June 30,								Three Months Ended June 30,
Hedging Instruments		2013			2012			Classification		2013			2012
Interest Rate Swaps		$	—		$	1,027		Interest expense		$	—		$	(1,670	)

 

				Amount of Gain or (Loss) Recognized in Income on
		Classification of Gain or		Derivatives
Derivatives Not Designated as		(Loss) Recognized into		Three Months Ended June 30,
Hedging Instruments		Income		2013			2012
Foreign Exchange Contracts		Selling, general and administrative expenses		$	(1,163	)	$	2,239

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

The table below presents the effect of the Company’s derivative financial instruments on the statements of earnings for the nine months ended June 30, 2013 and 2012 (in thousands):

 

Derivatives		Amount of Gain or (Loss) Recognized in OCI on Derivative (Effective Portion), net of tax						Amount of Gain or (Loss) Reclassified from Accumulated OCI into Income (Effective Portion)
Designated as		Nine Months Ended June 30,								Nine Months Ended June 30,
Hedging Instruments		2013			2012			Classification		2013			2012
Interest Rate Swaps		$	—		$	3,947		Interest expense		$	—		$	(6,731	)

 

				Amount of Gain or (Loss) Recognized in Income on
		Classification of Gain or		Derivatives
Derivatives Not Designated as		(Loss) Recognized into		Nine Months Ended June 30,
Hedging Instruments		Income		2013			2012
Foreign Exchange Contracts		Selling, general and administrative expenses		$	(878	)	$	2,611

 

Credit-risk-related Contingent Features

 

At June 30, 2013, the aggregate fair value of all foreign exchange contracts held which consisted of derivative instruments in a liability position was $0.2 million. The Company was under no obligation to post and had not posted any collateral related to the agreements in a liability position.

 

The counterparties to all our derivative instruments are deemed by the Company to be of substantial resources and strong creditworthiness. However, these transactions result in exposure to credit risk in the event of default by a counterparty. The financial crisis that has affected the banking systems and financial markets in recent years resulted in many well-known financial institutions becoming less creditworthy or having diminished liquidity which could expose us to an increased level of counterparty credit risk. In the event that a counterparty defaults in its obligation under our derivative instruments, we could incur substantial financial losses. However, at the present time, no such losses are deemed probable.

 

12.       Income Taxes

 

In January 2012, the IRS concluded the field work associated with its examination of the Company’s consolidated federal income tax returns for the fiscal years ended September 30, 2007 and 2008 and issued its examination report. The Company is appealing certain disputed items and it does not anticipate the ultimate resolution of these items to have a material impact on the Company’s financial statements.

 

The IRS is currently conducting an examination of the Company’s consolidated federal income tax returns for the fiscal years ended September 30, 2009, 2010 and 2011. The IRS had previously audited the Company’s consolidated federal income tax returns through the tax year ended September 30, 2006, thus our statute remains open from the year ended September 30, 2007 forward. Our foreign subsidiaries are impacted by various statutes of limitations, which are generally open from 2007 forward. Generally, states’ statutes in the United States are open for tax reviews from 2006 forward.

 

13.       Acquisitions

 

On May 31, 2013, the Company acquired certain assets and business operations of Essential Salon Products, Inc., a professional-only distributor of beauty products operating in the northeastern region of the United States, for approximately $15.7 million, subject to certain adjustments. The assets acquired and liabilities assumed, including intangible assets subject to amortization of $9.1 million, were recorded based on their preliminary estimated fair values at the acquisition date. In addition, goodwill of $3.2 million (which is expected to be deductible for tax purposes) was recorded as a result of this acquisition. The final valuation of the assets acquired and liabilities assumed will be completed within twelve months from the acquisition date. We funded this acquisition with cash from operations and with borrowings under our ABL facility.

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

14.       Business Segments

 

The Company’s business is organized into two separate segments: (i) Sally Beauty Supply, a domestic and international chain of cash and carry retail stores which offers professional beauty supplies to both salon professionals and retail customers primarily in North America, Puerto Rico, and parts of South America and Europe and (ii) BSG, including its franchise-based business Armstrong McCall, a full service beauty supply distributor which offers professional brands of beauty products directly to salons and salon professionals through its own sales force and professional-only stores (including franchise stores) in partially exclusive geographical territories in North America, Puerto Rico and parts of Europe.

 

The accounting policies of both of our business segments are the same as described in the summary of significant accounting policies contained in Note 2 of the “Notes to Consolidated Financial Statements” in “Item 8 - Financial Statements and Supplementary Data” contained in our Annual Report on Form 10-K for the fiscal year ended September 30, 2012.

 

Sales between segments, which were eliminated in consolidation, were not material during the three and nine months ended June 30, 2013 and 2012. Segment data for the three and nine months ended June 30, 2013 and 2012 is as follows (in thousands):

 

		Three Months Ended June 30,						Nine Months Ended June 30,
		2013			2012			2013			2012
Net sales:
Sally Beauty Supply		$	559,150		$	553,419		$	1,673,942		$	1,643,749
BSG		352,951			333,572			1,041,839			997,338
Total		$	912,101		$	886,991		$	2,715,781		$	2,641,087
Earnings before provision for income taxes:
Segment operating profit:
Sally Beauty Supply		$	117,672		$	117,622		$	329,715		$	330,023
BSG		52,734			46,667			151,307			135,590
Segment operating profit		170,406			164,289			481,022			465,613
Unallocated expenses (a)		(24,650		)	(24,917		)	(73,245		)	(70,318		)
Share-based compensation expense		(3,190		)	(2,825		)	(15,503		)	(13,801		)
Interest expense (b)		(27,006		)	(26,925		)	(80,510		)	(113,240		)
Earnings before provision for income taxes		$	115,560		$	109,622		$	311,764		$	268,254

 

(a)  Unallocated expenses consist of corporate and shared costs.

(b)       For the three and nine months ended June 30, 2012, interest expense includes losses on extinguishment of debt in the aggregate amount of $3.2 million and $37.8 million, respectively, in connection with the Company’s redemption of outstanding notes and repayment of the term loan B loan.

 

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