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 March 31, 2021 • During the three months ended March 31, 2021, we experienced further disruption to sales from COVID-19, including mandated store closures in international markets and salon closures in California in January; • Consolidated net sales for the three months ended March 31, 2021, increased $55.3 million, or 6.3%, to $926.3 million, compared to the three months ended March 31, 2020; • Consolidated same store sales increased 6.5% for the three months ended March 31, 2021, while our global e-commerce sales increased 56%, compared to the three months ended March 31, 2020; • Consolidated gross profit for the three months ended March 31, 2021, increased $37.5 million, or 8.7%, to $467.2 million, compared to the three months ended March 31, 2020. Gross margin increased 110 basis points to 50.4% for the three months ended March 31, 2021, compared to the three months ended March 31, 2020; • Consolidated operating earnings for the three months ended March 31, 2021, increased $32.2 million, or 74.5%, to $75.5 million, compared to the three months ended March 31, 2020. Operating margin increased 320 basis points to 8.2% for the three months ended March 31, 2021, compared to the three months ended March 31, 2020; • Consolidated net earnings for the three months ended March 31, 2021, increased $24.9 million, or 186.6%, to $38.3 million, compared to the three months ended March 31, 2020; • For the three months ended March 31, 2021, we had diluted earnings per share of $0.34, compared to $0.12 for the three months ended March 31, 2020; and • Cash provided by operations was $92.6 million for the three months ended March 31, 2021, compared to $13.8 million for the three months ended March 31, 2020. Impact of COVID-19 on Our Business and Business Strategy Update As mentioned above, we continued to see disruption resulting from COVID-19 due to mandated store closures in parts of our international markets and salon closures in California in January. However, we did experience an increase in sales driven primarily by the favorable impact in the U.S. from improving consumer confidence, government stimulus payments and the easing of COVID-19 restrictions in the U.S. salons. The effects of the COVID-19 pandemic and related responses continued to impact our first two quarters of fiscal year 2021 results of operations and cash flows. Additionally, due to the continued 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. Furthermore, we continue to make progress against our key business initiatives, which includes leveraging and optimizing our elevated digital capabilities, growing our customer engagement and loyalty, and implementing the final steps in our successful transformation journey, which is remains on track to be substantially completed by the end of the year. 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 March 31, Six Months Ended March 31, 2021 2020 Increase (Decrease) 2021 2020 Increase (Decrease) Net sales: SBS $ 542,664 $ 519,509 $ 23,155 4.5 % $ 1,090,334 $ 1,088,657 $ 1,677 0.2 % BSG 383,664 351,514 32,150 9.1 % 772,016 762,574 9,442 1.2 % Consolidated $ 926,328 $ 871,023 $ 55,305 6.3 % $ 1,862,350 $ 1,851,231 $ 11,119 0.6 % Gross profit: SBS $ 317,161 $ 289,067 $ 28,094 9.7 % $ 632,973 $ 598,057 $ 34,916 5.8 % BSG 150,068 140,690 9,378 6.7 % 304,980 306,548 (1,568 ) (0.5 )% Consolidated $ 467,229 $ 429,757 $ 37,472 8.7 % $ 937,953 $ 904,605 $ 33,348 3.7 % Segment gross margin: SBS 58.4 % 55.6 % 280 bps 58.1 % 54.9 % 320 bps BSG 39.1 % 40.0 % (90) bps 39.5 % 40.2 % (70) bps Consolidated 50.4 % 49.3 % 110 bps 50.4 % 48.9 % 150 bps Net earnings: Segment operating earnings: SBS $ 100,063 $ 56,373 $ 43,690 77.5 % $ 195,191 $ 130,598 $ 64,593 49.5 % BSG 47,843 41,039 6,804 16.6 % 96,415 103,473 (7,058 ) (6.8 )% Segment operating earnings 147,906 97,412 50,494 51.8 % 291,606 234,071 57,535 24.6 % Unallocated expenses and restructuring (a) 72,395 54,147 18,248 33.7 % 111,773 96,419 15,354 15.9 % Consolidated operating earnings 75,511 43,265 32,246 74.5 % 179,833 137,652 42,181 30.6 % Interest expense 23,883 21,644 2,239 10.3 % 49,861 43,185 6,676 15.5 % Earnings before provision for income taxes 51,628 21,621 30,007 138.8 % 129,972 94,467 35,505 37.6 % Provision for income taxes 13,316 8,253 5,063 61.3 % 34,469 27,884 6,585 23.6 % Net earnings $ 38,312 $ 13,368 $ 24,944 186.6 % $ 95,503 $ 66,583 $ 28,920 43.4 % . Number of stores at end-of-period (including franchises): SBS 3,625 3,701 (76 ) (2.1 )% BSG 1,379 1,374 5 0.4 % Consolidated 5,004 5,075 (71 ) (1.4 )% Same store sales growth (decline) (b) : SBS 4.9 % (7.0 )% 1,190 bps 0.7 % (4.0 )% 470 bps BSG 9.9 % (7.4 )% 1,730 bps 2.1 % (3.0 )% 510 bps Consolidated 6.5 % (7.1 )% 1,360 bps 1.2 % (3.6 )% 480 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. (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 March 31, 2021, compared to the Three Months Ended March 31, 2020 Net Sales Consolidated . Consolidated net sales include a positive impact from changes in foreign currency exchange rates of $7.5 million, or 0.9% of consolidated net sales. SBS . The increase in net sales for SBS was primarily driven by the following (in thousands): Same store sales $ 24,295 Other (a) (6,758 ) Foreign currency exchange 5,618 Total $ 23,155 (a) Other consists of non-store sales, which include catalog and internet sales of our Sinelco Group subsidiaries. SBS experienced higher unit volume primarily due to temporary closure of all of our customer-facing store operations in the U.S. and Canada due to the effects of COVID-19 in the prior year, the expansion of our digital commerce capabilities and the favorable impact in the U.S. from improving consumer confidence. For the three months ended March 31, 2021, there was minimal impact from temporary closures of certain customer-facing store operations as a result of COVID-19. Additionally, SBS experienced an increase in average unit prices, resulting from a change in product mix to higher-priced products. BSG . The increase in net sales for BSG was primarily driven by the following (in thousands): Same store sales $ 23,845 Distributor sales consultants 3,309 Other (a) 3,163 Foreign currency exchange 1,833 Total $ 32,150 (a) Other consists of stores outside same store sales, included recently acquired businesses, and sales to our franchisees. BSG experienced an increase in average unit prices and higher unit volume. The increase in average unit price was driven primarily from a decrease in promotional activity. The higher unit volume was primarily due to temporary closure of all of our customer-facing store operations in the U.S. and Canada due to the effects of COVID-19 in the prior year and higher operating capacities in salons. During the three months ended March 31, 2021, we experienced minimal temporary store closures and restricted capacity of certain customer-facing store operations in various markets in the U.S. and Canada due to the effects of COVID-19. Gross Profit Consolidated . Consolidated gross profit increased for the three months ended March 31, 2021, due to higher net sales in both segments and a higher gross margin in SBS, partially offset by a lower gross margin in BSG. SBS . SBS’s gross profit increased for the three months ended March 31, 2021, as a result of an increase in net sales and a higher gross margin. SBS’s gross margin increased primarily as a result of fewer promotions, partially offset by the write-down of personal-protective equipment inventory. BSG . BSG’s gross profit increased for the three months ended March 31, 2021, as a result of an increase in net sales, partially offset by a lower gross margin. BSG’s gross margin decreased primarily as a result of the write-down of personal-protective equipment inventory. Selling, General and Administrative Expenses Consolidated . Consolidated selling, general and administrative expenses increased primarily as a result of donation expense related to personal-protective equipment inventory and incremental costs from businesses acquired in the past 12 months. These increases were partially offset by a decrease in advertising and field labor expenses. Consolidated selling, general and administrative expenses, as a percentage of net sales, decreased 180 basis points to 42.2% for the three months ended March 31, 2021, due to the increase in sales. SBS . SBS’s selling, general and administrative expenses decreased $15.6 million, or 6.7%, for the three months ended March 31, 2021. The decrease was driven by lower compensation and compensation-related expenses of $8.4 million and lower advertising expenses of $8.3 million. BSG . BSG’s selling, general and administrative expenses increased $2.6 million, or 2.6%, for the three months ended March 31, 2021. The increase was driven primarily by an increase in shipping costs of $1.8 million, resulting primarily from increased e-commerce 19 volume, and incremental expenses from recently acquired businesses in the past twelve months. These increases were partially offset by lower compensation and compensation-related expenses of $1.3 million. Unallocated. Unallocated selling, general and administrative expenses, which represent certain corporate costs that have not been charged to our reporting segments, increased $20.8 million, or 40.8%, for the three months ended March 31, 2021, primarily due to higher COVID-19 expense in the current period mainly from the donation expense related to personal-protective equipment inventory of $31.2 million, compared to COVID-19 expense of $14.7 million last year, and higher compensation and compensation-related expenses of $7.9 million as a result of employees furloughed in the prior year. Restructuring For the three months ended March 31, 2021, we incurred restructuring charges of $0.6 million primarily in connection with our previously communicated Project Surge and the Transformation Plan. For the three months ended March 31, 2020, we recognized charges of $3.2 million in connection with our previously communicated Project Surge and the Transformation Plan. 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 $1.7 million and the repayment of our term loan B fixed tranche in January 2021 of $3.1 million. See “Liquidity and Capital Resources” below for additional information. Provision for Income Taxes The effective tax rates were 25.8% and 38.2%, for the three months ended March 31, 2021, and 2020, respectively. The higher effective tax rate in the prior year period was primarily driven by the establishment of a valuation allowance for a foreign subsidiary and increased foreign losses, as compared to the current period. The Six Months Ended March 31, 2021, compared to the Six Months Ended March 31, 2020 Net Sales Consolidated . Consolidated net sales include a positive impact from changes in foreign currency exchange rates of $11.0 million, or 0.6% of consolidated net sales. SBS . The increase in net sales for SBS was primarily driven by the following (in thousands): Same store sales $ 6,784 Other (a) (13,806 ) Foreign currency exchange 8,699 Total $ 1,677 (a) Other consists of non-store sales, which include catalog and internet sales of our Sinelco Group subsidiaries. SBS experienced an increase in average unit prices, resulting from a reduction in promotional activity and consumers selecting higher-priced products. The increase in average unit prices was partially offset by lower unit volume primarily due to the impact of the restrictions in the U.S. and Canada due to the effects of COVID-19 along with fewer company-operated stores. For the six months ended March 31, 2021, various markets globally where impacted by temporary closures of certain customer-facing store operations and reduced capacity. BSG . The increase in net sales for BSG was primarily driven by the following (in thousands): Same store sales $ 11,050 Distributor sales consultants (11,957 ) Other (a) 8,093 Foreign currency exchange 2,256 Total $ 9,442 (a) Other consists of stores outside same store sales, included recently acquired businesses, and sales to our franchisees. BSG experienced an increase in average unit prices and a higher unit volume. The increase in the average unit price was primarily driven by lower promotional activity. The higher unit volume was primarily due to the impact of the temporary closure of certain customer-facing store operations in the U.S. and Canada due to the effects of COVID-19 in the prior period. For the six months ended March 31, 2021, we experienced additional temporary closures 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. 20 Gross Profit Consolidated . Consolidated gross profit increased for the six months ended March 31, 2021, due to higher net sales in both segments and a higher gross margin in SBS, partially offset by a lower gross margin in BSG. SBS . SBS’s gross profit increased for the six months ended March 31, 2021, as a result of increased net sales and a higher gross margin. SBS’s gross margin increased primarily as a result of fewer promotions, partially offset by the write-down of personal-protective equipment inventory. BSG . BSG’s gross profit decreased for the six months ended March 31, 2021, as a result of a lower gross margin, partially offset by increased net sales. BSG’s gross margin decreased primarily as a result of the write-down of personal-protective equipment inventory during our second fiscal quarter, partially offset by fewer promotions. 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 donation expense related to personal-protective equipment inventory, 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 40 basis points to 40.7% for the six months ended March 31, 2021, due to the increase in sales. SBS . SBS’s selling, general and administrative expenses decreased $29.7 million, or 6.3%, for the six months ended March 31, 2021. The decrease was driven by lower compensation and compensation-related expenses of $19.2 million and lower advertising expenses of $13.2 million. These decreases were partially offset by an increase in shipping costs of $4.2 million, resulting primarily from increased e-commerce volume. BSG . BSG’s selling, general and administrative expenses increased $5.5 million, or 2.7%, for the six months ended March 31, 2021. The increase was driven primarily by an increase in shipping costs of $4.7 million, resulting primarily from increased e-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 $2.5 million. Unallocated. Unallocated selling, general and administrative expenses, which represent certain corporate costs that have not been charged to our reporting segments, increased $20.2 million, or 22.3%, for the six months ended March 31, 2021, primarily due to higher COVID-19 expense in the current period mainly from the donation expense related to personal-protective equipment inventory of $31.2 million, compared to COVID-19 expense of $14.7 million last year, and higher compensation and compensation-related expenses of $10.5 million as a result of employees furloughed in the prior year. Restructuring For the six months ended March 31, 2021, we incurred restructuring charges of $0.9 million primarily in connection with the Project Surge and Transformation Plan. For the six months ended March 31, 2020, we recognized charges of $5.7 million in connection with Project Surge and the Transformation Plan. Interest Expense The increase in interest expense is primarily from incremental interest on the senior notes issued in April 2020 of $13.1 million, partially offset by the impact of the repayment of our term loan B fixed tranche in January 2021 of $4.0 million and lower interest rates on our term loan B variable tranche of $3.5 million. See “Liquidity and Capital Resources” below for additional information. Provision for Income Taxes The effective tax rates were 26.5% and 29.5%, for the six months ended March 31, 2021, and 2020, respectively. The higher effective tax rate in the prior year period was primarily driven by the establishment of a valuation allowance for a foreign subsidiary and increased foreign losses, as compared to the current period, which cannot be tax benefitted. 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) decreased $278.3 million, to $591.4 million at March 31, 2021, compared to $869.7 million at September 30, 2020, resulting primarily from the reclassification of our 5.50% Senior Notes due 2023 (“2023 Senior Notes”) to current maturities of long-term debt. 21 At March 31, 2021 , cash and cash equivalents were $408.3 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 improving COVID-19 conditions, we have shifted our focus to reducing our debt levels while also 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 six months ended March 31, 2021, we did not borrow on our ABL facility. As of March 31, 2021, we had $496.9 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 six months ended March 31, 2021, we did not repurchase any common stock. As of March 31, 2021, 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 six months ended March 31, 2021, increased $55.4 million to $131.6 million, compared to the six months ended March 31, 2020, mainly due to increased net income and the timing of inventory purchases and payments as we restock to new levels of demand. Net Cash Used by Investing Activities Net cash used by investing activities during the six months ended March 31, 2021, decreased $44.6 million to $29.3 million, compared to the six months ended March 31, 2020. This change was primarily a result of our focus on reduced capital expenditures. Net Cash (Used) Provided by Financing Activities Net cash used by financing activities during the six months ended March 31, 2021 resulted from the paydown of our term loan B fixed tranche. During the six months ended March 31, 2020, we had a source of cash from financing activities primarily from the borrowings on our ABL and the issuance of senior notes as a response to COVID-19. Long-Term Debt and Guarantor Financial Information At March 31, 2021, we had $1,600.0 million in debt, not including capital leases, unamortized debt issuance costs and debt discounts, in the aggregate, of $13.0 million. Our debt consisted of $1,177.4 million of senior notes outstanding and a term loan with an outstanding principal balance of $422.6 million. As of March 31, 2021, there were no outstanding borrowings under our ABL facility. During the three months ended March 31, 2021, we paid the remaining $213.2 million of aggregate outstanding principal on our term loan B fixed tranche at par. 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 2023 Senior Notes. These debt instruments were issued by our wholly-owned subsidiaries, Sally Holdings LLC and Sally Capital Inc. (the “Issuers”), under a shelf registration statement. See and Note 13, Subsequent Event , for more information on our 2023 Senior Notes. 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. 22 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 March 31, 2021 and September 30, 2020 (in thousands): March 31, 2021 September 30, 2020 Inventory $ 736,497 $ 615,092 Intercompany receivable $ 72,845 $ 75,892 Current assets $ 1,177,328 $ 1,166,250 Total assets $ 2,272,374 $ 2,281,896 Current liabilities $ 438,933 $ 325,380 Total liabilities $ 2,550,861 $ 2,657,033 The following table presents the summarized statement of income information for six months ended March 31, 2021 (in thousands): Net sales $ 1,553,633 Gross profit $ 787,895 Earnings before provision for income taxes $ 114,872 Net earnings $ 85,546 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, other than the extinguishment of our term loan B fixed tranche, as discussed above. Off-Balance Sheet Financing Arrangements At March 31, 2021, 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. 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.