Sally Beauty Holdings, Inc. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations This section discusses management’s view of the financial condition, results of operations and cash flows of Sally Beauty. This section should be read in conjunction with the information contained in our Annual Report on Form 10-K for the fiscal year ended September 30, 2020, and our other filings with the Securities and Exchange Commission, including the Risk Factors sections therein, and information contained elsewhere in this Quarterly Report, including the condensed consolidated interim financial statements and notes to those financial statements. The results of operations for any interim period may not necessarily be indicative of the results that may be expected for any future interim period or the entire fiscal year, in particular as a result of the uncertainty of the continued effects of the COVID-19 pandemic on future periods. Highlights for the Three Months Ended December 31, 2020 • During the three months ended December 31, 2020, we experienced further disruption to sales from COVID-19, including temporary store closures in international markets, government-mandated store capacity restrictions and salon shut-downs in California and parts of Canada for part of the quarter; • Consolidated net sales for the three months ended December 31, 2020, decreased $44.2 million, or 4.5%, to $936.0 million, compared to the three months ended December 31, 2019; • Consolidated same store sales decreased 3.7% for the three months ended December 31, 2020, while our global e-commerce sales increased 48.0%, compared to the three months ended December 31, 2019; • Consolidated gross profit for the three months ended December 31, 2020, decreased $4.1 million, or 0.9%, to $470.7 million, compared to the three months ended December 31, 2019. Gross margin increased 190 basis points to 50.3% for the three months ended December 31, 2020, compared to the three months ended December 31, 2019; • Consolidated operating earnings for the three months ended December 31, 2020, increased $9.9 million, or 10.5%, to $104.3 million, compared to the three months ended December 31, 2019. Operating margin increased 150 basis points to 11.1% for the three months ended December 31, 2020, compared to the three months ended December 31, 2019; • Consolidated net earnings for the three months ended December 31, 2020 increased $4.0 million, or 7.5%, to $57.2 million, compared to the three months ended December 31, 2019; • For the three months ended December 31, 2020, we had diluted earnings per share of $0.50, compared to $0.45 for the three months ended December 31, 2019; and • Cash provided by operations was $37.4 million for the three months ended December 31, 2020, compared to $62.3 million for the three months ended December 31, 2019. Impact of COVID-19 on Our Business and Business Strategy Update As mentioned above, we continued to see the impact of COVID-19 on our sales into our first fiscal quarter as we had temporary store closures in international markets, restricted store capacity in certain markets and salon shut-downs in California and parts of Canada for part of the quarter. However, we continued to make progress against our key business initiatives, which include leveraging and optimizing our elevated digital capabilities, growing customer engagement and loyalty, and completing the final steps in our successful transformation journey. The effects of the COVID-19 pandemic and related responses had a noticeable impact on our first quarter fiscal year 2021 results of operations and cash flows. Furthermore, 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. 17 Overview Key Operating Metrics The following table sets forth, for the periods indicated, information concerning key measures we rely on to evaluate our operating performance (dollars in thousands): Three Months Ended December 31, 2020 2019 Increase (Decrease) Net sales: SBS $ 547,670 $ 569,147 $ (21,477 ) (3.8 )% BSG 388,352 411,061 (22,709 ) (5.5 )% Consolidated $ 936,022 $ 980,208 $ (44,186 ) (4.5 )% Gross profit: SBS $ 315,811 $ 308,989 $ 6,822 2.2 % BSG 154,913 165,859 (10,946 ) (6.6 )% Consolidated $ 470,724 $ 474,848 $ (4,124 ) (0.9 )% Segment gross margin: SBS 57.7 % 54.3 % 340 bps BSG 39.9 % 40.3 % (40) bps Consolidated 50.3 % 48.4 % 190 bps Net earnings: Segment operating earnings: SBS $ 95,128 $ 74,225 $ 20,903 28.2 % BSG 48,572 62,434 (13,862 ) (22.2 )% Segment operating earnings 143,700 136,659 7,041 5.2 % Unallocated expenses and restructuring (a) 39,378 42,272 (2,894 ) (6.8 )% Consolidated operating earnings 104,322 94,387 9,935 10.5 % Interest expense 25,978 21,541 4,437 20.6 % Earnings before provision for income taxes 78,344 72,846 5,498 7.5 % Provision for income taxes 21,153 19,631 1,522 7.8 % Net earnings $ 57,191 $ 53,215 $ 3,976 7.5 % . Number of stores at end-of-period (including franchises): SBS 3,645 3,703 (58 ) (1.6 )% BSG 1,384 1,369 15 1.1 % Consolidated 5,029 5,072 (43 ) (0.8 )% Same store sales growth (decline) (b) : SBS (3.3 )% (1.1 )% (220) bps BSG (4.6 )% 1.2 % (580) bps Consolidated (3.7 )% (0.3 )% (340) bps (a) Unallocated expenses consist of corporate and shared costs and are included in selling, general and administrative expenses in our consolidated statements of earnings. See Note 12, Restructuring , of the Notes to Condensed Consolidated Financial Statements for details on our restructuring charges. (b) For the purpose of calculating our same store sales metrics, we compare the current period sales for stores open for 14 months or longer as of the last day of a month with the sales for these stores for the comparable period in the prior fiscal year. Our same store sales are calculated in constant dollars and include e-commerce sales from certain digital platforms, but do not generally include the sales from stores relocated until 14 months after the relocation. The sales from stores acquired are excluded from our same store sales calculation until 14 months after the acquisition. 18 Results of Operations The Three Months Ended December 31, 2020, compared to the Three Months Ended December 31, 2019 Net Sales Consolidated . Consolidated net sales include a positive impact from changes in foreign currency exchange rates of $3.5 million, or 0.4% of consolidated net sales. SBS . The decrease in net sales for SBS was primarily driven by the following (in thousands): Same store sales $ (17,525 ) Other (a) (7,033 ) Foreign currency exchange 3,081 Total $ (21,477 ) (a) Other consists of non-store sales, which include catalog and internet sales of our Sinelco Group subsidiaries. SBS experienced lower unit volume caused primarily by the impact of the temporary closure of certain customer-facing store operations in various markets globally due to the effects of COVID-19 and fewer company-operated stores. The challenges faced by lower unit volume were partially offset by an increase in average unit prices, resulting from a change in product mix to higher-priced products and the cancellation of most promotional activity. BSG . The decrease in net sales for BSG was primarily driven by the following (in thousands): Distributor sales consultants $ (12,838 ) Same store sales (12,795 ) Other (a) 2,502 Foreign currency exchange 422 Total $ (22,709 ) (a) Other consists of stores outside same store sales, included recently acquired businesses, and sales to our franchisees. BSG experienced lower unit volume primarily as a result of the temporary closure and restricted capacity of certain customer-facing store operations in various markets in the U.S. and Canada as well as salon closures in parts of California and Canada due to the effects of COVID-19. These negative impacts were partially offset by an increase in average unit prices resulting primarily from lower promotional activity. Gross Profit Consolidated . Consolidated gross profit decreased for the three months ended December 31, 2020, due to lower net sales in both segments and a lower gross margin in BSG, partially offset by a higher gross margin in SBS. SBS . SBS’s gross profit increased for the three months ended December 31, 2020, as a result of a higher gross margin, partially offset by lower net sales. SBS’s gross margin increased primarily as a result of fewer promotions. BSG . BSG’s gross profit decreased for the three months ended December 31, 2020, as a result of lower net sales and a lower gross margin. BSG’s gross margin decreased primarily as a result of higher capitalized inventory costs from lower inventory purchases. Selling, General and Administrative Expenses Consolidated . Consolidated selling, general and administrative expenses decreased primarily as a result of cost saving initiatives in response to COVID-19, including savings associated with lower compensation and compensation-related expenses and advertising expenses, and the suspension or elimination of all non-critical projects and non-essential spend. These decreases were partially offset by increased shipping costs resulting from increased e-commerce volume and incremental costs from businesses acquired in the past 12 months. Consolidated selling, general and administrative expenses, as a percentage of net sales, increased 50 basis points to 39.1% for the three months ended December 31, 2020, due to the decrease in sales. SBS . SBS’s selling, general and administrative expenses decreased $14.1 million, or 6.0%, for the three months ended December 31, 2020, primarily due to our response to COVID-19. The decrease was driven by lower compensation and compensation-related expenses of $12.0 million and lower advertising expenses of $4.9 million. These decreases were partially offset by an increase in shipping costs of $3.0 million, resulting primarily from increased e-commerce volume, and incremental store expense for personal protective equipment and cleaning protocols related to COVID-19 safety procedures. BSG . BSG’s selling, general and administrative expenses increased $2.9 million, or 2.8%, for the three months ended December 31, 2020. The increase was driven primarily by an increase in shipping costs of $3.0 million, resulting primarily from increased e- 19 commerce volume, and incremental expenses from recently acquired businesses in the past 12 months. These increases were partially offset by lower compensation and compensation-related expenses of $1.5 million. Unallocated. Unallocated selling, general and administrative expenses, which represent certain corporate costs that have not been charged to our reporting segments, decreased $0.6 million, or 1.5%, for the three months ended December 31, 2020, primarily from lower costs associated with travel in response to COVID-19. Restructuring For the three months ended December 31, 2020, we incurred restructuring charges of $0.2 million primarily in connection with the Project Surge. For the three months ended December 31, 2019, we recognized charges of $2.5 million in connection with Project Surge and the Transformation Plan. See Note 12, Restructuring , of the Notes to Condensed Consolidated Financial Statements included in Item 1 of this Quarterly Report for more information about our restructuring plans. Interest Expense The increase in interest expense is primarily from incremental interest on the senior notes issued in April 2020 of $6.6 million, partially offset by the impact of lower interest rates on our term loan B variable tranche of $1.8 million and a lower outstanding balance on our term loan B fixed tranche of $0.9 million. See “Liquidity and Capital Resources” below for additional information. Provision for Income Taxes The effective tax rates were 27.0% and 26.9%, for the three months ended December 31, 2020, and 2019, respectively. Liquidity and Capital Resources We are highly leveraged and a substantial portion of our liquidity needs will arise from debt service on our outstanding indebtedness and from funding the costs of operations, working capital, capital expenditures, debt repayment and share repurchases. Working capital (current assets less current liabilities) increased $85.8 million, to $955.5 million at December 31, 2020, compared to $869.7 million at September 30, 2020, resulting primarily from an increase in inventory. The increase in inventory resulted from investments in key products to reach desired inventory levels. At December 31, 2020, cash and cash equivalents were $537.6 million. Based upon the current level of operations and anticipated growth, we anticipate that existing cash balances (excluding certain amounts permanently invested in connection with foreign operations), funds expected to be generated by operations and funds available under the ABL facility will be sufficient to fund working capital requirements, potential acquisitions, anticipated capital expenditures, including information technology upgrades and store remodels, and debt repayments over the next 12 months. Due to the impact of COVID-19, we have shifted our focus to being proactive in maintaining our financial flexibility. We utilize our ABL facility for the issuance of letters of credit, certain working capital and liquidity needs, and to manage normal fluctuations in our operational cash flow. In that regard, we may from time to time draw funds under the ABL facility for general corporate purposes including funding of capital expenditures, acquisitions, interest payments due on our indebtedness, paying down other debt and opportunistic share repurchases. During the three months ended December 31, 2020, we did not borrow on our ABL facility. As of December 31, 2020, we had $461.0 million available for borrowings under our ABL facility, subject to borrowing base limitations, as reduced by outstanding letters of credit. Amounts drawn on our ABL facility are generally paid down with cash provided by our operating activities. Share Repurchase Programs During the three months ended December 31, 2020, we did not repurchase any common stock. As of December 31, 2020, we had authorization of approximately $726.1 million of additional potential share repurchases remaining under the 2017 Share Repurchase Program. Historical Cash Flows Historically, our primary source of cash has been net funds provided by operating activities and, when necessary, borrowings under our ABL facility. While historically, the primary uses of cash have been for share repurchases, capital expenditures, repayments and servicing of long-term debt and acquisitions, we have shifted our focus in the short-term to reduce cash expenditures. Net Cash Provided by Operating Activities Net cash provided by operating activities during the three months ended December 31, 2020, decreased $23.3 million to $39.0 million, compared to the three months ended December 31, 2019, mainly due to increased inventory purchases, in connection with inventory investments to improve stock levels for key products, and the timing of our vendor receivables, partially offset by an increase in our accounts payable in connection with increased inventory purchases. 20 Net Cash Used by Investing Activities Net cash used by investing activities during the three months ended December 31, 2020, decreased $25.3 million to $17.5 million, compared to the three months ended December 31, 2019. This change was primarily a result of our focus on reduced capital expenditures. Net Cash Used by Financing Activities Net cash used by financing activities during the three months ended December 31, 2020, decreased $24.1 million to $0.3 million, compared to the three months ended December 31, 2019. The decrease was driven by the absence of debt borrowings and minimal repayments during the current quarter and not repurchasing our common stock under our share repurchase program. Long-Term Debt and Guarantor Financial Information At December 31, 2020, we had $1,813.2 million in debt, not including capital leases, unamortized debt issuance costs and debt discounts, in the aggregate, of $14.8 million. Our debt consisted of $1,177.4 million of senior notes outstanding and a term loan with an outstanding principal balance of $635.8 million. As of December 31, 2020, there were no outstanding principal borrowings under our ABL facility. We are currently in compliance with the agreements and instruments governing our debt, including our financial covenants. See Note 9, Short-term Borrowings and Long-term Debt , and Note 13, Subsequent Event , for more information on our debt. Guarantor Financial Information We are providing the following information in compliance with Rule 13-01 of Regulation S-X for guaranteed issued securities that have been registered under such regulation. Currently, our issued securities consist of the 5.625% Senior Notes due 2025 and the 5.50% Senior Notes due 2023. These debt instruments were issued by our wholly-owned subsidiaries, Sally Holdings LLC and Sally Capital Inc. (the “Issuers”), under a shelf registration statement. These notes are unsecured debt instruments guaranteed by us and certain of our wholly-owned domestic subsidiaries (together, the “Guarantors”) and have certain restrictions on the ability to pay restrictive payments to Sally Beauty. The guarantees are joint and several, and full and unconditional. Certain other subsidiaries, including our foreign subsidiaries, do not serve as guarantors. The following summarized consolidating financial information represents financial information for the Issuers and the Guarantors on a combined basis. All transactions and intercompany balances between these combined entities has been eliminated. The following table presents the summarized balance sheets information for the Issuers and the Guarantors as of December 31, 2020 and September 30, 2020 (in thousands): December 31, 2020 September 30, 2020 Inventory $ 681,568 $ 615,092 Intercompany receivable $ 77,499 $ 75,892 Current assets $ 1,244,851 $ 1,166,250 Total assets $ 2,344,371 $ 2,281,896 Current liabilities $ 343,132 $ 325,380 Total liabilities $ 2,667,543 $ 2,657,033 The following table presents the summarized statement of income information for three months ended December 31, 2020 (in thousands): Net sales $ 759,620 Gross profit $ 385,129 Earnings before provision for income taxes $ 62,595 Net earnings $ 45,830 Contractual Obligations There have been no material changes outside the ordinary course of our business in any of our contractual obligations since September 30, 2020. Off-Balance Sheet Financing Arrangements At December 31, 2020, and September 30, 2020, we had no off-balance sheet financing arrangements other than outstanding letters of credit related to inventory purchases and self-insurance programs. 21 Critical Accounting Estimates There have been no material changes to our critical accounting estimates or assumptions since September 30, 2020. Recent Accounting Pronouncements See Note 3, Recent Accounting Pronouncements , of the Notes to Condensed Consolidated Financial Statements in Item 1 – “Financial Statements” in Part I – Financial Information.