Sally Beauty Holdings, Inc. 10-Q

Item 1. Financial Statements. The following condensed consolidated balance sheets as of December 31, 2020, and September 30, 2020, the condensed consolidated statements of earnings, condensed consolidated statements of comprehensive income, the condensed consolidated statements of stockholders’ equity and the condensed consolidated statements of cash flows for the three months ended December 31, 2020 and 2019, are those of Sally Beauty Holdings, Inc. and its subsidiaries. 5 SALLY BEAUTY HOLDINGS, INC. AND SUBSIDIARIES Condensed Consolidated Balance Sheets (In thousands, except par value data) December 31, 2020 September 30, 2020 (Unaudited) Assets Current assets: Cash and cash equivalents $ 537,644 $ 514,151 Trade accounts receivable, net 40,046 35,590 Accounts receivable, other 27,904 20,839 Inventory 895,984 814,503 Other current assets 44,300 48,014 Total current assets 1,545,878 1,433,097 Property and equipment, net of accumulated depreciation of $ 725,437 at December 31, 2020, and $ 694,709 at September 30, 2020 305,225 315,029 Operating lease assets 519,985 525,634 Goodwill 546,027 540,038 Intangible assets, excluding goodwill, net of accumulated amortization of $ 68,590 at December 31, 2020, and $ 63,491 at September 30, 2020 58,819 58,283 Other assets 23,714 23,066 Total assets $ 2,999,648 $ 2,895,147 Liabilities and Stockholders’ Equity Current liabilities: Current maturities of long-term debt $ 186 $ 180 Accounts payable 285,636 236,333 Accrued liabilities 133,328 170,665 Current operating lease liabilities 154,090 153,267 Income taxes payable 17,096 2,917 Total current liabilities 590,336 563,362 Long-term debt 1,798,154 1,796,897 Long-term operating lease liabilities 390,873 394,375 Other liabilities 29,406 32,976 Deferred income tax liabilities, net 92,013 92,094 Total liabilities 2,900,782 2,879,704 Stockholders’ equity: Common stock, $ 0.01 par value. Authorized 500,000 shares; 112,814 and 112,824 shares issued and 112,538 and 112,405 shares outstanding at December 31, 2020, and September 30, 2020, respectively 1,125 1,124 Preferred stock, $ 0.01 par value. Authorized 50,000 shares; none issued — — Additional paid-in capital 4,556 1,913 Accumulated earnings 174,300 117,109 Accumulated other comprehensive loss, net of tax ( 81,115 ) ( 104,703 ) Total stockholders’ equity 98,866 15,443 Total liabilities and stockholders’ equity $ 2,999,648 $ 2,895,147 The accompanying notes are an integral part of these condensed consolidated financial statements. 6 SALLY BEAUTY HOLDINGS, INC. AND SUBSIDIARIES Condensed Consolidated Statements of Earnings (In thousands, except per share data) (Unaudited) Three Months Ended December 31, 2020 2019 Net sales $ 936,022 $ 980,208 Cost of goods sold 465,298 505,360 Gross profit 470,724 474,848 Selling, general and administrative expenses 366,170 377,930 Restructuring 232 2,531 Operating earnings 104,322 94,387 Interest expense 25,978 21,541 Earnings before provision for income taxes 78,344 72,846 Provision for income taxes 21,153 19,631 Net earnings $ 57,191 $ 53,215 Earnings per share: Basic $ 0.51 $ 0.46 Diluted $ 0.50 $ 0.45 Weighted-average shares: Basic 112,475 116,125 Diluted 113,828 117,154 The accompanying notes are an integral part of these condensed consolidated financial statements. 7 SALLY BEAUTY HOLDINGS, INC. AND SUBSIDIARIES Condensed Consolidated Statements of Comprehensive Income (In thousands) (Unaudited) Three Months Ended December 31, 2020 2019 Net earnings $ 57,191 $ 53,215 Other comprehensive income: Foreign currency translation adjustments 25,007 14,961 Interest rate caps, net of tax 175 109 Foreign exchange contracts, net of tax ( 1,594 ) ( 200 ) Other comprehensive income, net of tax 23,588 14,870 Total comprehensive income $ 80,779 $ 68,085 The accompanying notes are an integral part of these condensed consolidated financial statements. 8 SALLY BEAUTY HOLDINGS, INC. AND SUBSIDIARIES Condensed Consolidated Statements of Stockholders’ Equity (In thousands) (Unaudited) Accumulated Additional Other Total Common Stock Paid-in Accumulated Comprehensive Stockholders’ Shares Amount Capital Earnings Loss Equity Balance at September 30, 2020 112,405 $ 1,124 $ 1,913 $ 117,109 $ ( 104,703 ) $ 15,443 Net earnings — — — 57,191 — 57,191 Other comprehensive income — — — — 23,588 23,588 Share-based compensation — — 2,893 — — 2,893 Stock issued for equity awards 133 1 ( 250 ) — — ( 249 ) Balance at December 31, 2020 112,538 $ 1,125 $ 4,556 $ 174,300 $ ( 81,115 ) $ 98,866 Accumulated Additional Accumulated Other Total Common Stock Paid-in (Deficit) Comprehensive Stockholders’ Shares Amount Capital Earnings Loss Equity (Deficit) Balance at September 30, 2019 116,725 $ 1,167 $ — $ 55,797 $ ( 117,287 ) $ ( 60,323 ) Cumulative effect of ASC 842 adoption — — — ( 445 ) — ( 445 ) Net earnings — — — 53,215 — 53,215 Other comprehensive income — — — — 14,870 14,870 Repurchases and cancellations of common stock ( 766 ) ( 7 ) ( 6,237 ) ( 5,113 ) — ( 11,357 ) Share-based compensation — — 3,473 — — 3,473 Stock issued for equity awards 206 2 2,764 — — 2,766 Balance at December 31, 2019 116,165 $ 1,162 $ — $ 103,454 $ ( 102,417 ) $ 2,199 The accompanying notes are an integral part of these condensed consolidated financial statements. 9 SALLY BEAUTY HOLDINGS, INC. AND SUBSIDIARIES Condensed Consolidated Statements of Cash Flows (In thousands) (Unaudited) Three Months Ended December 31, 2020 2019 Cash Flows from Operating Activities: Net earnings $ 57,191 $ 53,215 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization 26,386 27,076 Share-based compensation expense 2,893 3,473 Amortization of deferred financing costs 1,496 887 Gain on early extinguishment of debt — ( 223 ) Loss on disposal of equipment and other property 1,589 — Deferred income taxes 229 555 Changes in (exclusive of effects of acquisitions): Trade accounts receivable ( 3,502 ) 2,457 Accounts receivable, other ( 8,643 ) 8,793 Inventory ( 67,764 ) ( 30,138 ) Other current assets 3,220 ( 482 ) Other assets ( 240 ) ( 2,480 ) Operating leases, net 2,996 — Accounts payable and accrued liabilities 12,401 ( 11,930 ) Income taxes payable 14,307 10,352 Other liabilities ( 3,573 ) 770 Net cash provided by operating activities 38,986 62,325 Cash Flows from Investing Activities: Payments for property and equipment, net of proceeds ( 15,483 ) ( 40,875 ) Acquisitions, net of cash acquired ( 2,025 ) ( 1,944 ) Net cash used by investing activities ( 17,508 ) ( 42,819 ) Cash Flows from Financing Activities: Proceeds from issuance of long-term debt — 232,000 Repayments of long-term debt ( 63 ) ( 247,830 ) Payments for common stock repurchased — ( 11,357 ) Proceeds from equity awards — 2,766 Employee withholding taxes paid related to net share settlement of equity awards ( 249 ) — Net cash used by financing activities ( 312 ) ( 24,421 ) Effect of foreign exchange rate changes on cash and cash equivalents 2,327 682 Net increase (decrease) in cash and cash equivalents 23,493 ( 4,233 ) Cash and cash equivalents, beginning of period 514,151 71,495 Cash and cash equivalents, end of period $ 537,644 $ 67,262 Supplemental Cash Flow Information: Interest paid $ 43,439 $ 33,297 Income taxes paid $ 2,609 $ 9,216 Capital expenditures incurred but not paid $ 6,707 $ 3,491 The accompanying notes are an integral part of these condensed consolidated financial statements. 10 Sally Beauty Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) 1. Basis of Presentation The condensed consolidated interim financial statements included herein have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) and pursuant to the rules and regulations of the SEC. Accordingly, certain information and note disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to the rules and regulations of the SEC, although we believe that the disclosures are adequate to make the information not misleading. These condensed consolidated interim financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended September 30, 2020. In the opinion of management, these condensed consolidated interim financial statements reflect all adjustments that are of a normal recurring nature and which are necessary to present fairly our consolidated financial position as of December 31, 2020 and September 30, 2020, and our consolidated results of operations, consolidated comprehensive income, and consolidated statements of stockholders’ equity and our consolidated cash flows for the three months ended December 31, 2020 and 2019. Our operating results for the three months ended December 31, 2020, may not be indicative of the results that may be expected for the full fiscal year ending September 30, 2021, in particular as a result of the uncertainty around the continuing effects of the COVID-19 pandemic on future periods. Due to the uncertainty over the duration and severity of the economic and operational impacts of COVID-19, the adverse impact of the pandemic may continue further into our fiscal year 2021 and possibly beyond, and it may be material. 2. Significant Accounting Policies We adhere to the same accounting policies in the preparation of our condensed consolidated interim financial statements as we do in the preparation of our full-year consolidated financial statements. As permitted under GAAP, interim accounting for certain expenses, including income taxes, is based on full-year assumptions. For interim financial reporting purposes, income taxes are recorded based upon estimated annual effective income tax rates. 3. Recent Accounting Pronouncements In December 2019, the FASB issued ASU No. 2019-12 which simplifies the accounting for income taxes by removing an exception related to the approach for intraperiod tax allocation, the methodology for calculating income taxes in an interim period with year to date losses and the recognition of deferred tax liabilities for outside basis differences. Additionally, the update clarifies and simplifies other areas of ASC 740, Income Taxes . For public companies, the amendments in the update are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. Early adoption is permitted, but all amendments must be adopted at once. The amendments in this update have different adoption methods including prospective basis, retrospective basis, and a modified retrospective basis dependent on the specific change. We are currently evaluating the impact of this update, but based on our preliminary assessment we do not believe this will have a material impact to our results of operations or financial position. 4. Revenue Recognition Substantially all of our revenue is derived through the sale of merchandise at the point-of-sale. Revenue is recognized net of estimated sales returns and sales taxes. We estimate sales returns based on historical data. Changes to our contract liabilities for the period were as follows (in thousands): September 30, 2020 $ 13,947 Loyalty points and gift cards issued but not redeemed, net of estimated breakage 5,709 Revenue recognized from beginning liability ( 3,476 ) December 31, 2020 $ 16,180 See Note 11, Business Segments , for additional information regarding the disaggregation of our sales revenue. 11 5. Fair Value Measurements Fair value on recurring basis Consistent with the three-level hierarchy defined in ASC Topic 820, Fair Value Measurement , as amended, we categorize our financial assets and liabilities as follows (in thousands): Classification Fair Value Hierarchy Level December 31, 2020 September 30, 2020 Financial Assets: Cash equivalents Cash and cash equivalents Level 1 $ — $ 194,612 Interest rate caps Other assets Level 2 18 27 Total assets $ 18 $ 194,639 . Financial Liabilities: Foreign exchange contracts Accrued liabilities Level 2 $ 1,587 $ — Other fair value disclosures December 31, 2020 September 30, 2020 Fair Value Hierarchy Level Carrying Value Fair Value Carrying Value Fair Value Long-term debt, excluding capital leases Senior notes Level 1 $ 1,177,380 $ 1,234,206 $ 1,177,380 $ 1,217,707 Term loan B Level 2 635,788 632,623 635,788 619,397 Total long-term debt $ 1,813,168 $ 1,866,829 $ 1,813,168 $ 1,837,104 The table above excludes amounts, if any, related to our ABL facility as the balance approximates fair value due to the short-term nature of our borrowings. 6. Stockholders’ Equity Share Repurchases In August 2017, our Board of Directors approved a share repurchase program authorizing the Company to repurchase up to $ 1.0 billion of its common stock, subject to certain limitations governed by our debt agreements, over an approximate four-year period expiring on September 30, 2021 . Information related to our shares repurchased and subsequently retired were as follows (in thousands): Three Months Ended December 31, 2020 2019 Number of shares repurchased — 766 Total cost of share repurchased $ — $ 11,357 Accumulated Other Comprehensive Loss The change in accumulated other comprehensive loss (“AOCL”) was as follows (in thousands): Foreign Currency Translation Adjustments Interest Rate Caps Foreign Exchange Contracts Total Balance at September 30, 2020 $ ( 102,111 ) $ ( 3,003 ) $ 411 $ ( 104,703 ) Other comprehensive income (loss) before reclassification, net of tax 25,007 ( 69 ) ( 1,224 ) 23,714 Reclassification to net earnings, net of tax — 244 ( 370 ) ( 126 ) Balance at December 31, 2020 $ ( 77,104 ) $ ( 2,828 ) $ ( 1,183 ) $ ( 81,115 ) The tax impact for the changes in other comprehensive loss and the reclassifications to net earnings were not material. 12 7. Weighted-Average Shares The following table sets forth the reconciliation of basic and diluted weighted-average shares (in thousands): Three Months Ended December 31, 2020 2019 Weighted-average basic shares 112,475 116,125 Dilutive securities: Stock option and stock award programs 1,353 1,029 Weighted-average diluted shares 113,828 117,154 Anti-dilutive options excluded from our computation of diluted shares 6,009 5,132 8. Goodwill and Intangible Assets Due to the uncertainty around COVID-19, our projected future cash flows may differ materially from actual results. We considered potential triggering events and determined there were none during the three months ended December 31, 2020. No material impairment losses were recognized in the current or prior periods presented in connection with our goodwill and other intangible assets. For the three months ended December 31, 2020 and 2019, amortization expense related to other intangible assets was $ 1.7 million and $ 2.4 million, respectively. Additionally, goodwill increased primarily from the effects of foreign currency exchange rates of $ 6.1 million during the three months ended December 31, 2020. 9. Short-term Borrowings and Long-term Debt At December 31, 2020, there were no outstanding borrowings and we had $ 461.0 million available for borrowing under our ABL facility, including the Canadian sub-facility, subject to the conditions contained therein. Our ABL facility matures on July 6, 2022 . Please see Note 13, Subsequent Event , for further information about our debt. Covenants The agreements governing our ABL facility, term loan B and the senior notes contain a customary covenant package that places restrictions on the disposition of assets, the granting of liens and security interests, the prepayment of certain indebtedness, and other matters with customary events of default, including customary cross-default and/or cross-acceleration provisions. As of December 31, 2020, we were in compliance with all debt covenants and all the net assets of our consolidated subsidiaries were unrestricted from transfer. 10. Derivative Instruments and Hedging Activities During the three months ended December 31, 2020, we did no t purchase or hold any derivative instruments for trading or speculative purposes. See Note 5, Fair Value Measurements , for the classification and fair value of our derivative instruments. Designated Cash Flow Hedges Foreign Currency Forwards We regularly enter into foreign currency forwards to mitigate our exposure to exchange rate changes on inventory purchases in U.S. dollars by our foreign subsidiaries. At December 31, 2020, the notional amount we held through these forwards, based upon exchange rates at December 31, 2020, was as follows (in thousands): Notional Currency Notional Amount Euro $ 13,916 Mexican Peso 10,932 Canadian Dollar 3,767 Total $ 28,615 We record quarterly, net of income tax, the changes in fair value related to the foreign currency forwards into AOCL. As the forwards are exercised, the realized value is recognized into cost of goods sold based on inventory turns. For the three months ended December 13 31, 2020, we recognized a $ 0.4 million gain into cost of goods sold on our condensed consolidated statements of earnings. Based on December 31, 2020 , valuations and exchange rates, we expect to reclassify losses of approximately $ 1.3 million into cost of goods sold over the next 12 months . Interest Rate Caps In July 2017, we purchased two interest rate caps with an initial aggregate notional amount of $ 550 million (the “interest rate caps”) to mitigate the exposure to higher interest rates in connection with our term loan B. The interest rate caps are comprised of individual caplets that expire ratably through June 30, 2023 , and are designated as cash flow hedges. Accordingly, changes in fair value of the interest rate caps are recorded quarterly, net of income tax, and are included in AOCL. Over the next 12 months, we expect to reclassify approximately $ 1.3 million into interest expense, which represents the original value of the expiring caplets. The effects of our interest rate caps on our condensed consolidated statements of earnings were not material for the three months ended December 31, 2020. 11. Business Segments Segment data for the three months ended December 31, 2020 and 2019, is as follows (in thousands): Three Months Ended December 31, 2020 2019 Net sales: Sally Beauty Supply ("SBS") $ 547,670 $ 569,147 Beauty Systems Group ("BSG") 388,352 411,061 Total $ 936,022 $ 980,208 Earnings before provision for income taxes: Segment operating earnings: SBS $ 95,128 $ 74,225 BSG 48,572 62,434 Segment operating earnings 143,700 136,659 Unallocated expenses 39,146 39,741 Restructuring 232 2,531 Consolidated operating earnings 104,322 94,387 Interest expense 25,978 21,541 Earnings before provision for income taxes $ 78,344 $ 72,846 Sales between segments, which are eliminated in consolidation, were not material during the three months ended December 31, 2020 and 2019. Disaggregation of net sales by segment Three Months Ended December 31, SBS 2020 2019 Hair color 35.4 % 29.4 % Hair care 18.6 % 19.4 % Skin and nail care 14.2 % 14.0 % Styling tools 12.8 % 14.9 % Salon supplies and accessories 7.9 % 7.7 % Textured hair products 5.5 % 6.1 % Other beauty items 5.6 % 8.5 % Total 100.0 % 100.0 % 14 Three Months Ended December 31, BSG 2020 2019 Hair color 40.8 % 37.5 % Hair care 35.0 % 34.5 % Skin and nail care 8.2 % 8.1 % Styling tools 7.1 % 3.6 % Other beauty items 2.6 % 5.8 % Promotional items 6.3 % 10.5 % Total 100.0 % 100.0 % The following tables disaggregate our segment revenue by sales channels: Three Months Ended December 31, SBS 2020 2019 Company-operated stores 93.9 % 95.8 % E-commerce 6.0 % 4.0 % Franchise stores 0.1 % 0.2 % Total 100.0 % 100.0 % Three Months Ended December 31, BSG 2020 2019 Company-operated stores 69.6 % 69.4 % Distributor sales consultants 14.3 % 17.9 % E-commerce 8.5 % 7.3 % Franchise stores 7.6 % 5.4 % Total 100.0 % 100.0 % 12. Restructuring Restructuring expense for the three months ended December 31, 2020 and 2019, are as follows (in thousands): Three Months Ended December 31, 2020 2019 Project Surge $ 190 $ 1,253 Transformation Plan 42 1,278 Total expense $ 232 $ 2,531 Project Surge In November 2019, we announced that we were launching Project Surge, which takes the successful elements of the North American Sally Beauty transformation and integrates them into our European operations, with the support and participation of several key leaders from the corporate headquarters. As part of this plan, we are focusing on several operating elements, including a review of our talent and operating structure. The liability related to Project Surge, which is included in accrued liabilities on our condensed consolidated balance sheets, is as follows (in thousands): Project Surge Liability at September 30, 2020 Expenses Expenses Paid or Otherwise Settled Adjustments Liability at December 31, 2020 Workforce reductions $ — $ 150 $ 150 $ — $ — Other — 40 40 — — Total $ — $ 190 $ 190 $ — $ — 15 Expenses incurred during the three months ended December 31, 2020, represent costs incurred by SBS of $ 0.2 million. Transformation Plan We previously disclosed a plan to focus on certain core business strategies. In addition to optimizing our supply chain network with changes to our transportation model and network of nodes, we are improving our marketing and digital commerce capabilities, and advancing our merchandising transformation efforts. In addition, we expanded our plan and announced a reduction in workforce within our field and headquarters. All these together, make up our Transformation Plan. The liability related to the Transformation Plan, which is included in accrued liabilities on our condensed consolidated balance sheets, is as follows (in thousands): Transformation Plan Liability at September 30, 2020 Expenses Expenses Paid or Otherwise Settled Adjustments Liability at December 31, 2020 Workforce reductions $ 65 $ 7 $ 72 $ — $ — Other — 35 35 — — Total $ 65 $ 42 $ 107 $ — $ — Expenses incurred during the three months ended December 31, 2020, represent costs incurred by SBS of $ 0.1 million. 13. Subsequent Event On January 5, 2021, we announced that we fully repaid the outstanding balance of $ 213.2 million on our term loan B fixed portion. The repayment was funded with excess cash and reflects our continued progress toward deleveraging the balance sheet. In connection with this repayment, we recognized an approximately $ 1 million loss on the extinguishment of debt from the write-off of unamortized deferred financing costs. 16