Sally Beauty Holdings, Inc. - Quarter Report: 2013 March (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: MARCH 31, 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 April 26, 2013, there were 169,778,170 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	33
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	58
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 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 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;

·             the costs and effects of litigation; and

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

 

Additional factors that could cause actual events or results to differ materially from the events or results described in the forward-looking statements can be found in our Annual Report on Form 10-K for the fiscal year ended September 30, 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 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, 2013 and September 30, 2012, the consolidated statements of earnings and consolidated statements of comprehensive income for the three and six months ended March 31, 2013 and 2012, and the consolidated statements of cash flows for the six months ended March 31, 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						Six Months Ended
		March 31,						March 31,
		2013			2012			2013			2012
Net sales		$	898,239		$	889,281		$	1,803,680		$	1,754,096
Cost of products sold and distribution expenses		453,785			452,495			914,858			895,453
Gross profit		444,454			436,786			888,822			858,643
Selling, general and administrative expenses		299,370			289,189			605,059			582,203
Depreciation and amortization		17,247			15,940			34,055			31,493
Operating earnings		127,837			131,657			249,708			244,947
Interest expense		26,779			22,355			53,503			86,316
Earnings before provision for income taxes		101,058			109,302			196,205			158,631
Provision for income taxes		36,169			41,489			72,332			60,684
Net earnings		$	64,889		$	67,813		$	123,873		$	97,947
Earnings per share:
Basic		$	0.37		$	0.36		$	0.70		$	0.53
Diluted		$	0.36		$	0.35		$	0.69		$	0.51
Weighted average shares:
Basic		173,461			186,335			175,930			185,514
Diluted		178,389			191,684			180,743			190,662

 

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						Six Months Ended
		March 31,						March 31,
		2013			2012			2013			2012
Net earnings		$	64,889		$	67,813		$	123,873		$	97,947
Other comprehensive income (loss):
Foreign currency translation adjustments		(11,794		)	10,975			(9,136		)	9,095
Deferred gain on interest rate swaps		—			2,328			—			4,771
Total other comprehensive income, before tax		(11,794		)	13,303			(9,136		)	13,866
Income taxes related to other comprehensive income		—			(903		)	—			(1,851		)
Other comprehensive income (loss), net of tax		(11,794		)	12,400			(9,136		)	12,015
Total comprehensive income		$	53,095		$	80,213		$	114,737		$	109,962

 

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)

 

		March 31, 2013			September 30, 2012
		(Unaudited)
Assets
Current assets:
Cash and cash equivalents		$	62,256		$	240,220
Trade accounts receivable, less allowance for doubtful accounts of $2,532 at March 31, 2013 and $2,583 at September 30, 2012		56,859			59,496
Accounts receivable, other		40,560			42,260
Income taxes receivable		15,782			23,734
Inventory		752,741			735,356
Prepaid expenses		26,900			29,376
Deferred income tax assets, net		33,515			33,465
Total current assets		988,613			1,163,907
Property and equipment, net of accumulated depreciation of $360,712 at March 31, 2013 and $352,164 at September 30, 2012		216,903			202,661
Goodwill		529,137			532,331
Intangible assets, excluding goodwill, net of accumulated amortization of $65,291 at March 31, 2013 and $59,192 at September 30, 2012		121,076			128,437
Other assets		36,340			38,464
Total assets		$	1,892,069		$	2,065,800
Liabilities and Stockholders’ Deficit
Current liabilities:
Current maturities of long-term debt		$	24,475		$	1,908
Accounts payable		254,286			262,209
Accrued liabilities		175,864			200,267
Income taxes payable		10,587			13,004
Total current liabilities		465,212			477,388
Long-term debt		1,613,893			1,615,322
Other liabilities		23,680			24,232
Deferred income tax liabilities, net		69,793			63,943
Total liabilities		2,172,578			2,180,885
Stockholders’ deficit:
Common stock, $0.01 par value. Authorized 500,000 shares; 170,253 and 180,548 shares issued and 169,921 and 180,241 shares outstanding at March 31, 2013 and September 30, 2012, respectively		1,699			1,802
Preferred stock, $0.01 par value. Authorized 50,000 shares; none issued		—			—
Additional paid-in capital		259,949			540,007
Accumulated deficit		(522,368		)	(646,241		)
Accumulated other comprehensive loss, net of tax		(19,789		)	(10,653		)
Total stockholders’ deficit		(280,509		)	(115,085		)
Total liabilities and stockholders’ deficit		$	1,892,069		$	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)

 

		Six Months Ended March 31,
		2013			2012
Cash Flows from Operating Activities:
Net earnings		$	123,873		$	97,947
Adjustments to reconcile net earnings to net cash provided by operating activities:
Depreciation and amortization		34,055			31,493
Share-based compensation expense		12,313			10,976
Amortization of deferred financing costs		1,810			2,992
Excess tax benefit from share-based compensation		(8,294		)	(9,124		)
Net loss on extinguishment of debt		—			35,145
Deferred income tax expense		6,082			(285		)
Changes in (exclusive of effects of acquisitions):
Trade accounts receivable		2,489			8,076
Accounts receivable, other		1,510			(2,805		)
Income taxes receivable		7,952			—
Inventory		(22,343		)	(10,631		)
Prepaid expenses		2,130			1,463
Other assets		(33		)	1,126
Accounts payable and accrued liabilities		(30,970		)	(30,440		)
Income taxes payable		6,057			1,838
Other liabilities		(464		)	319
Net cash provided by operating activities		136,167			138,090
Cash Flows from Investing Activities:
Capital expenditures		(43,112		)	(26,956		)
Acquisitions, net of cash acquired		(670		)	(43,154		)
Net cash used by investing activities		(43,782		)	(70,110		)
Cash Flows from Financing Activities:
Proceeds from issuance of long-term debt		58,500			929,200
Repayments of long-term debt		(36,947		)	(1,010,474		)
Repurchases of common stock		(313,349		)	—
Debt issuance costs		—			(15,191		)
Proceeds from exercises of stock options		13,256			20,111
Excess tax benefit from share-based compensation		8,294			9,124
Net cash used by financing activities		(270,246		)	(67,230		)
Effect of foreign exchange rate changes on cash and cash equivalents		(103		)	579
Net (decrease) increase in cash and cash equivalents		(177,964		)	1,329
Cash and cash equivalents, beginning of period		240,220			63,481
Cash and cash equivalents, end of period		$	62,256		$	64,810
Supplemental Cash Flow Information:
Interest paid (a)		$	53,373		$	77,819
Income taxes paid		$	52,998		$	60,746

 

(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, 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 March 31, 2013 and September 30, 2012, its consolidated results of operations for the three and six months ended March 31, 2013 and 2012, and its consolidated cash flows for the six months ended March 31, 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 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, 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 six months ended March 31, 2013, other comprehensive loss consists exclusively of foreign currency translation adjustments of $11.8 million and $9.1 million, respectively. For the three months ended March 31, 2012, other comprehensive income consists of foreign currency translation adjustments of $11.0 million and deferred gains on certain interest rate swaps of $2.3 million (before income taxes of $0.9 million). For the six months ended March 31, 2012, other comprehensive income consists of foreign currency translation adjustments of $9.1 million and deferred gains on certain interest rate swaps of $4.8 million (before income taxes of $1.9 million).

 

At March 31, 2013 and September 30, 2012, accumulated other comprehensive loss (“AOCI”) consists of cumulative foreign currency translation adjustments of $19.8 million and $10.7 million and is net of income taxes of $2.9 million and $2.9 million, respectively. Any amounts previously reported in AOCI which were related to the interest rate swaps discussed above were

 

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Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

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 six months ended March 31, 2013.

 

5.   Fair Value Measurements

 

The Company’s financial instruments consist of cash and cash equivalents, trade and other accounts receivable, accounts payable, foreign currency derivative instruments 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 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 March 31, 2013 (in thousands):

 

		Total			Level 1			Level 2			Level 3
Assets
Cash equivalents (a)		$	—		$	—		$	—		—
Foreign currency forwards (b)		113			—			113			—
Total assets		$	113		$	—		$	113		—
Liabilities
Long-term debt (c)		$	1,748,148		$	1,718,625		$	29,523		—
Foreign currency forwards (b)		176			—			176			—
Total liabilities		$	1,748,324		$	1,718,625		$	29,699		—

 

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 borrowings under the ABL facility) is carried in the Company’s consolidated financial statements at amortized cost of $1,638.4 million at March 31, 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 next eight quarters (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 March 31, 2013, the Company repurchased approximately 1.6 million shares at a cost of $46.9 million under the 2013 Share Repurchase Program.

 

During the six months ended March 31, 2013, the Company repurchased and subsequently retired, in the aggregate, approximately 12.0 million shares of its common stock under the 2012 Share Repurchase Program or the 2013 Share Repurchase Program at an aggregate cost of $313.3 million and reduced common stock and additional paid-in capital, in the aggregate, by an equal amount.

 

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 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,
		2013			2012			2013			2012
Net earnings		$	64,889		$	67,813		$	123,873		$	97,947
Total weighted average basic shares		173,461			186,335			175,930			185,514
Dilutive securities:
Stock options and stock award programs		4,928			5,349			4,813			5,148
Total weighted average diluted shares		178,389			191,684			180,743			190,662
Earnings per share:
Basic		$	0.37		$	0.36		$	0.70		$	0.53
Diluted		$	0.36		$	0.35		$	0.69		$	0.51

 

At March 31, 2013, options to purchase 1,577,766 shares of the Company’s common stock were outstanding but not included in the computation of diluted earnings per share for both the three and six months ended March 31, 2013 since these options were anti-dilutive. In addition, 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 any unrecognized compensation expense related to such options, exceeds the average price per share for the period.

 

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 six months ended March 31, 2013 and 2012, respectively. Upon

 

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Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

issuance of such grants, the Company recognized accelerated share-based compensation expense of $5.9 million and $5.3 million in the six months ended March 31, 2013 and 2012, 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. In addition, the Company granted approximately 34,000 and 26,000 restricted stock units to its non-employee directors during the six months ended March 31, 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 March 31,						Six Months Ended March 31,
		2013			2012			2013			2012
Share-based compensation expense		$	3,262		$	2,945		$	12,313		$	10,976
Income tax benefit related to share-based compensation expense		$	1,168		$	1,143		$	4,570		$	4,259

 

Stock Options

 

Each option has an exercise price that equals 100% of 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 six months ended March 31, 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		(1,623	)	8.18
Forfeited or expired		(40	)	18.54
Outstanding at March 31, 2013		11,776		$	12.49		6.6		$	198,941
Exercisable at March 31, 2013		6,738		$	9.23		5.4		$	135,784

 

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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 March 31, 2013 (in Thousands)		Weighted Average Remaining Contractual Term (in Years)		Weighted Average Exercise Price			Number Exercisable at March 31, 2013 (in Thousands)		Weighted Average Exercise Price
$2.00 – 9.66		5,846		5.0		$	7.87		5,185		$	7.92
$11.39 – 23.49		5,930		8.2		17.04			1,553		13.59
Total		11,776		6.6		$	12.49		6,738		$	9.23

 

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,
		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 six months ended March 31, 2013 and 2012 was $11.29 and $9.60 per option, respectively. The total intrinsic value of options exercised during the six months ended March 31, 2013 was $29.4 million. The cash proceeds from these option exercises were $13.3 million and the tax benefit realized from these option exercises was $9.9 million.

 

At March 31, 2013, approximately $20.7 million of total unrecognized compensation costs related to unvested stock option awards are expected to be recognized over the weighted average period of 2.6 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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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 six months ended March 31, 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 March 31, 2013		332		$	15.77		3.0

 

At March 31, 2013, approximately $2.8 million of total unrecognized compensation costs related to unvested restricted stock awards are expected to be recognized over the weighted average period of 3.0 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 six 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 six months ended March 31, 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		34		23.49
Vested		—		—
Forfeited		(4	)	23.49
Unvested at March 31, 2013		30		$	23.49		0.5

 

At March 31, 2013, approximately $0.4 million of total unrecognized compensation costs related to unvested RSUs are expected to be recognized over the weighted average period of 0.5 years.

 

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

 

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Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

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, 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.

 

10.   Short-term Borrowings and Long-term Debt

 

Details of long-term debt as of March 31, 2013 are as follows (in thousands):

 

		Amount			Maturity Dates		Interest Rates
ABL facility		$	22,500		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)		858,845			Jun. 2022		5.750% (b)
Other (c)		1,886			2014-2015		4.93% to 5.79%
Total		$	1,633,231
Capital leases and other		$	5,137
Less: current portion		(24,475		)
Total long-term debt		$	1,613,893

 

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

(b)         Includes unamortized premium of $8.8 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 Separation Transactions, 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 March 31, 2013, the Company had $355.9 million available for borrowing under the ABL facility, including the Canadian sub-facility.

 

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 14 for certain condensed financial statement data pertaining to Sally Beauty, the Issuers, the guarantor subsidiaries and the non-guarantor subsidiaries.

 

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Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

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 March 31, 2013 (in thousands):

 

Twelve months ending March 31:
2014		$	23,713
2015		643
2016		30
2017		—
2018		—
Thereafter		1,608,845
		$	1,633,231
Capital lease obligations		5,137
Less: current portion		(24,475		)
Total		$	1,613,893

 

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 March 31, 2013, the Company’s Secured Leverage Ratio was approximately 0.1 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.

 

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 March 31, 2013, the Company’s Consolidated Coverage Ratio was approximately 6.2 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

 

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Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

 (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 March 31, 2013, the Company’s Consolidated Total Leverage Ratio was approximately 2.6 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, as amended, Sally Holdings may make Restricted Payments if availability under the ABL facility exceeds certain thresholds, and no default then exists under the facility. For Restricted Payments up to $30.0 million during each fiscal year, borrowing availability must exceed the lesser of $80.0 million or 20% of the borrowing base for 45 days prior to such Restricted Payment. For Restricted Payments in excess of that amount, the same borrowing availability must be maintained and the Consolidated Fixed Charge Coverage Ratio (as defined in the ABL facility) must equal or exceed 1.2 to 1.0. Consolidated Fixed Charge Coverage Ratio is defined as the ratio of (i) Consolidated EBITDA, as defined in the ABL facility, minus certain unfinanced capital expenditures and tax payments to (ii) fixed charges, as specified in the ABL facility. In addition, during any period that availability under the ABL facility is less than the greater of $40.0 million or 15% of the borrowing base, the level of the Consolidated Fixed Charge Coverage Ratio that the Company must satisfy is 1.1 to 1.0. As of March 31, 2013, the Consolidated Fixed Charge Coverage Ratio was approximately 4.5 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 March 31, 2013, all the net assets of our consolidated subsidiaries were unrestricted from transfer under our credit arrangements.

 

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 March 31, 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 March 31, 2013, the Company did not purchase or hold any derivative instruments for trading or speculative purposes.

 

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Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

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 six months ended March 31, 2012, the Company’s other comprehensive income included deferred gains on these interest swaps of $1.4 million and $2.9 million, respectively, net of income tax of $0.9 million and $1.9 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 March 31, 2013, foreign currency forwards with an aggregate notional amount of $6.0 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 March 31, 2013, we held: (a) a foreign currency forward which enables us to sell approximately €26.7 million ($34.3 million, at the March 31, 2013 exchange rate) at the contractual exchange rate of 1.2867, (b) a foreign currency forward which enables us to sell approximately $3.8 million Canadian dollars ($3.7 million, at the March 31, 2013 exchange rate) at the contractual exchange rate of 1.0187, (c) a foreign currency forward which enables us to buy approximately $15.9 million Canadian dollars ($15.6 million, at the March 31, 2013 exchange rate) at the contractual exchange rate of 1.0179, (d) a foreign currency forward which enables us to sell approximately 9.3 million Mexican pesos ($0.8 million, at the March 31, 2013 exchange rate) at the contractual exchange rate of 12.3495 and (e) a foreign currency forward which enables us to sell approximately £12.9 million ($19.7 million, at the March 31, 2013 exchange rate) at the contractual exchange rate of 1.5146. The foreign currency forwards discussed in this paragraph are with a single counterparty, not the same party as the counterparties on the other forwards held at March 31, 2013, and expire on or before June 30, 2013.

 

In addition, the Company uses foreign exchange contracts including, at March 31, 2013, foreign currency forwards with an aggregate notional amount of €1.8 million ($2.3 million, at the March 31, 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 0.8149, are with a single counterparty, not the same party as the counterparties on the other forwards held at March 31, 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 gains of $1.3 million and net losses of $1.3 million for the three months ended March 31, 2013 and 2012, respectively; and net gains of $0.3 million and $0.4 million for the six months ended March 31, 2013 and 2012, respectively, including marked-to-market adjustments, in connection with all of the Company’s foreign currency derivatives.

 

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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, 2013 and September 30, 2012 (in thousands):

 

		Asset Derivatives								Liability Derivatives
		Classification		March 31, 2013			September 30, 2012			Classification		March 31, 2013			September 30, 2012
Derivatives designated as hedging instruments:
None
Derivatives not designated as hedging instruments:
Foreign Exchange Contracts		Prepaid expenses		$	113		$	4		Accrued liabilities		$	176		$	132
				$	113		$	4				$	176		$	132

 

The table below presents the effect of the Company’s derivative financial instruments on the statements of earnings for the three months ended March 31, 2013 and 2012 (in thousands):

 

Derivatives Designated as Hedging Instruments		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)
		Three Months Ended March 31,								Three Months Ended March 31,
		2013			2012			Classification		2013			2012
Interest Rate Swaps		$	—		$	1,425		Interest expense		$	—		$	(2,508	)

 

Derivatives Not Designated as Hedging Instruments		Classification of Gain or (Loss) Recognized into Income		Amount of Gain or (Loss) Recognized in Income on Derivatives
				Three Months Ended March 31,
				2013			2012
Foreign Exchange Contracts		Selling, general and administrative expenses		$	1,305		$	(1,337	)

 

The table below presents the effect of the Company’s derivative financial instruments on the statements of earnings for the six months ended March 31, 2013 and 2012 (in thousands):

 

Derivatives Designated as Hedging Instruments		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)
		Six Months Ended March 31,								Six Months Ended March 31,
		2013			2012			Classification		2013			2012
Interest Rate Swaps		$	—		$	2,920		Interest expense		$	—		$	(5,061	)

 

Derivatives Not Designated as Hedging Instruments		Classification of Gain or (Loss) Recognized into Income		Amount of Gain or (Loss) Recognized in Income on Derivatives
				Six Months Ended March 31,
				2013			2012
Foreign Exchange Contracts		Selling, general and administrative expenses		$	285		$	372

 

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Table of Contents

 

Sally Beauty Holdings, Inc. and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

Credit-risk-related Contingent Features

 

At March 31, 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 their examination of the Company’s consolidated federal income tax returns for the fiscal years ended September 30, 2007 and 2008 and issued their 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.   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.

 

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