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, 2022, 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. Executive Overview For fiscal 2023, we are focusing on three key strategic initiatives to drive growth and profitability: • Enhancing our customer centricity; • Growing high margin owned brands at Sally Beauty and amplifying innovation; and • Increasing the efficiency of our operations and optimizing our capabilities. We believe focusing in these areas will position our company for future growth and further enhance our ability to meet our customers where they are. Enhancing our customer centricity During the quarter, BSG launched a new strategic partnership with Salon HQ. Salon HQ is a customizable digital storefront platform that gives stylists the ability to curate a product selection from thousands of BSG merchandise choices and enables their clients to purchase directly from their shops without the stylists having to finance and carry inventory. In addition, SBS has identified the locations for its initial Studio by Sally pilot stores that we expect to open this fiscal year. The Studio by Sally pilot store program will have a digital-first focus, from digital check-in to digital education throughout the store and beyond, including personalized appointments at our in-store salons with licensed stylists who will train and educate consumers on how to color their own hair and achieve their desired results. We believe that we will be able to expand the Studio by Sally concept to 100 locations throughout the U.S. over the next three to four fiscal years if successful. Growing high margin owned brands at Sally Beauty and amplifying innovation We believe growing our SBS owned-brands, through innovation and marketing, will provide improved margins, strengthen our long-term relationships with existing customers and help attract new customers. During the quarter, we invested more into marketing of our owned-brands and launched the first phase of our new owned-branded hair repair product line – bondbar. These initiatives delivered an increase in our owned-brands sales penetration, resulting in increased SBS profit margins. Furthermore, we look forward to providing salons and stylists with new innovations from our BSG vendors as they are launched over the next two fiscal quarters. Increasing the efficiency of our operations and optimizing our capabilities In the fourth quarter of fiscal year 2022, we announced our plan to close 330 SBS stores, 35 BSG stores and two BSG distribution centers. Based on our strategic evaluation, we believe that we will able to recapture demand of closed stores in other nearby store locations and improve overall profitability. During the quarter, we completed the closure of our two BSG distributions centers and the majority of our planned store closures. Additionally, we re-optimized our store supply chain network based on our new store fleet. As of December 31, 2022, we have closed 327 SBS stores and 14 BSG stores as part of the Plan and are currently meeting our sales recapture expectations. See Note 11, Restructuring , in Item 1 of this quarterly report for more information on the Plan. Financial Summary for the Three Months Ended December 31, 2022 • Consolidated net sales for the three months ended December 31, 2022, decreased $23.2 million, or 2.4%, to $957.1 million, compared to the three months ended December 31, 2021. Consolidated net sales included a negative impact from changes in foreign currency exchange rates of $14.4 million; • Consolidated comparable sales increased 1.1% for the three months ended December 31, 2022, compared to the three months ended December 31, 2021; • Consolidated gross profit for the three months ended December 31, 2022, decreased $11.6 million, or 2.3%, to $488.6 million, compared to the three months ended December 31, 2021. Gross margin was unchanged at 51.0% for the three months ended December 31, 2022, compared to the three months ended December 31, 2021; 16 • Consolidated operating earnings for the three months ended December 31, 2022 , decreased $26.2 million , or 23.2% , to $ 86.6 million , compared to the three months ended December 31, 2021 . Operating margin decreased 250 bps to 9.0% for the three months ended December 31, 2022 , compared to the three months ended December 31, 2021 ; • For the three months ended December 31, 2022, our consolidated net earnings decreased $18.5 million, or 26.9%, to $50.3 million, compared to the three months ended December 31, 2021; • For the three months ended December 31, 2022, our diluted earnings per share was $0.46 compared to $0.60 for the three months ended December 31, 2021; and • Cash provided by operations was $55.0 million for the three months ended December 31, 2022, compared to cash used by operations of $5.7 million for the three months ended December 31, 2021. Trends Impacting Our Business Global inflationary pressures continue to influence consumer and stylist behavior along with the cost for products and services. In the U.S. and Canada, we are seeing our SBS customers color their hair less frequently and reduce the size of their basket when they shop with us, while at BSG we are seeing stylists purchasing closer to the time they use products. Additionally, inflationary pressures have impacted wages, especially among retail and hourly employees, as we have experienced an increase in our labor costs in order to attract and retain associates. During the current quarter, these headwinds have resulted in lower traffic and conversion in our business and increases in certain operating costs. We continue to monitor these challenges and implement measures to help mitigate their impacts, including managing our inventory levels to reduce out-of-stock items, adjusting our promotional activities, optimizing our store base and expanding our partnerships with delivery service providers. Although these initiatives have helped mitigate ongoing macro-headwinds, we cannot reasonably predict the long-term effects of inflation. Furthermore, in a measure to curb inflation, the U.S. Federal Reserve has increased the federal funds effective rate. In turn, these increases have raised the cost of debt borrowings. We currently have $471.1 million in variable rate debt outstanding, of which $406.1 million is hedged with interest rate caps to help mitigate the impact of raising rates. Future increases in the federal funds effective rate could have a material adverse impact to our cost of borrowing, including any future changes in our debt structure. Impact of COVID-19 on Our Business While we have seen signs of stabilization from the impacts of the COVID-19 virus, we cannot reasonably predict the effects of new variants or expect improving trends to continue. Therefore, our future performance may partially depend on impacts of COVID-19, such as decreased customer in-store traffic, temporary store closures, and labor and supply chain disruptions. Refer to Item 1A. “Risk Factors” in our Form 10-K for the fiscal year ended September 30, 2022, for further discussion on the risks and uncertainties created by COVID-19. Comparable Sales We believe that comparable sales is an appropriate performance indicator to measure our sales growth compared to the prior period. O ur comparable sales include sales from stores that have been operating for 14 months or longer as of the last day of a month and e-commerce revenue. Additionally, comparable sales include sales to franchisees and full service sales. Our comparable sales excludes the effect of changes in foreign exchange rates and sales from stores relocated until 14 months after the relocation. Revenue from acquisitions are excluded from our comparable sales calculation until 14 months after the acquisition. Our calculation of comparable sales might not be the same as other retailers as the calculation varies across the retail industry. 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, 2022 2021 Increase (Decrease) Net sales: SBS $ 549,472 $ 561,530 $ (12,058 ) (2.1 )% BSG 407,583 418,721 (11,138 ) (2.7 )% Consolidated $ 957,055 $ 980,251 $ (23,196 ) (2.4 )% Gross profit: SBS $ 323,475 $ 328,172 $ (4,697 ) (1.4 )% BSG 165,099 171,957 (6,858 ) (4.0 )% Consolidated $ 488,574 $ 500,129 $ (11,555 ) (2.3 )% Segment gross margin: SBS 58.9 % 58.4 % 50 bps BSG 40.5 % 41.1 % (60) bps Consolidated 51.0 % 51.0 % — bps Net earnings: Segment operating earnings: SBS $ 99,174 $ 100,623 $ (1,449 ) (1.4 )% BSG 49,647 58,546 (8,899 ) (15.2 )% Segment operating earnings 148,821 159,169 (10,348 ) (6.5 )% Unallocated expenses and restructuring (a) 62,233 46,389 15,844 34.2 % Consolidated operating earnings 86,588 112,780 (26,192 ) (23.2 )% Interest expense 17,923 20,241 (2,318 ) (11.5 )% Earnings before provision for income taxes 68,665 92,539 (23,874 ) (25.8 )% Provision for income taxes 18,328 23,701 (5,373 ) (22.7 )% Net earnings $ 50,337 $ 68,838 $ (18,501 ) (26.9 )% . Number of stores at end-of-period (including franchises) (b) : SBS 3,146 3,529 (383 ) BSG 1,352 1,364 (12 ) Consolidated 4,498 4,893 (395 ) Comparable sales growth (decline): SBS 3.0 % 4.4 % (140) bps BSG (1.5 )% 8.6 % (1,010) bps Consolidated 1.1 % 6.1 % (500) bps (a) Unallocated expenses consist of corporate and shared costs and are included in selling, general and administrative expenses in our condensed consolidated statements of earnings. (b) Our December 31, 2022 store count was impacted by the closure of 327 SBS store and 14 BSG store from the Plan. See Note 11, Restructuring , in Item 1 of this quarterly report for more information on the Plan. 18 Results of Operations The Three Months Ended December 31, 2022, compared to the Three Months Ended December 31, 2021 Net Sales SBS . The decrease in net sales for SBS was primarily driven by the following (in thousands): Comparable sales $ 15,954 Sales outside comparable sales (a) (16,220 ) Foreign currency exchange (11,792 ) Total $ (12,058 ) (a) Includes stores opened for less than 14 months, net of stores closures, including stores closed under the Plan The decrease in SBS’s net sales was driven by the negative impact from foreign exchange rates and the impact of store closures in the prior twelve months, including stores closed under the Plan, partially offset by an increase in our comparable sales. SBS’s comparable sales increase was driven by a growth in average ticket, primarily from inflationary impacts and pricing leverage, and partially offset by fewer transactions. BSG . The decrease in net sales for BSG was primarily driven by the following (in thousands): Comparable sales $ (6,109 ) Sales outside comparable sales (a) (2,396 ) Foreign currency exchange (2,633 ) Total $ (11,138 ) (a) Includes stores opened for less than 14 months, net of stores closures, including from the Plan The decrease in BSG’s net sales was primarily due to lower comparable sales, the impact of closed stores and the negative impact from the Canadian foreign exchange rate. BSG’s comparable sales faced headwinds from elevated demand in the prior year from the easing of COVID-19 restrictions and the impacts of the current economic environment which resulted in fewer transactions, but was partially offset by growth in average ticket. Gross Profit SBS . SBS’s gross profit decreased for the three months ended December 31, 2022, as a result of lower net sales, partially offset by a higher gross margin. SBS’s gross margin grew as a result of pricing leverage and increased penetration of our owned-brand products. BSG . BSG’s gross profit decreased for the three months ended December 31, 2022, as a result of lower net sales and a lower gross margin. BSG’s gross margin decline was driven by lower product margin resulting from an unfavorable sales channel mix between stores and lower-margin Regis e-commerce sales, partially offset by adjustments to our expected obsolescence reserve related to the Plan. Selling, General and Administrative Expenses SBS . SBS’s selling, general and administrative expenses decreased $3.2 million, or 1.4%, for the three months ended December 31, 2022 and included a favorable impact from foreign exchange rates of $4.6 million. As a percentage of SBS net sales, SG&A for the three months ended December 31, 2022 was 40.8% compared to 40.5% for the three months ended December 31, 2021. The increase as a percentage of sales was driven by deleveraging as a result of lower net sales. BSG . BSG’s selling, general and administrative expenses increased $2.0 million, or 1.8%, for the three months ended December 31, 2022. As a percentage of BSG net sales, SG&A for the three months ended December 31, 2022 was 28.3% compared to 27.1% for the three months ended December 31, 2021. The increase as a percentage of sales was driven primarily by deleveraging as a result of lower net sales as well as increases in labor and personnel costs and depreciation expenses. Unallocated. Unallocated selling, general and administrative expenses, which represent certain corporate costs that have not been charged to our reporting segments, increased $6.5 million, or 14.4%, for the three months ended December 31, 2022, primarily due to increased labor and personnel costs of $4.6 million and information technology expense of $2.9 million . Restructuring For the three months ended December 31, 2022, we incurred $10.4 million in restructuring charges related to our Distribution Center Consolidation and Store Optimization Plan. For the three months ended December 31, 2021, restructuring charges in connection with our previously communicated Transformation Plan were immaterial . See Note 11, Restructuring , in Item 1 of this quarterly report for more information on the Plan. 19 Interest Expense The decrease in interest expense is due to the interest savings from the repayment of our 8.75% Senior Notes due 2025 during fiscal year 2022, partially offset by higher interest expense on our variable rate debt resulting from the increase in borrowing rates and outstanding amounts under our ABL facility . See Note 9, Derivatives , in Item 1 of this quarterly report for more information on our interest rate caps used to help mitigate raising interest rates. Provision for Income Taxes The effective tax rates were 26.7% and 25.6%, for the three months ended December 31, 2022, and 2021, respectively. The increase in the effective tax rate was primarily due to the tax impact of share-based compensation which was detrimental in the current year quarter, but beneficial in the prior year quarter. Liquidity and Capital Resources Overview Our principal sources of liquidity are from cash and cash equivalents, cash from operations and our ABL facility. A substantial portion of our liquidity needs arise from funding the costs of our operations, working capital, capital expenditures, debt interest and principal payment. Additionally, under our share repurchase program, see below for more details, we will repurchase shares of our common stock on the open market to return value to our shareholders. At December 31, 2022, we had $440.8 million in our liquidity pool, which includes $417.7 million available for borrowings under our ABL facility and cash and cash equivalents of $99.1 million. Working capital (current assets less current liabilities) increased $77.4 million, to $541.9 million at December 31, 2022, compared to $464.5 million at September 30, 2022. This increase was driven by higher inventory balances, resulting from inflationary cost increases and the impact of foreign exchange rates of $12.7 million, and an increase in cash and cash equivalents. We anticipate that existing cash balances (excluding certain amounts permanently invested in connection with foreign operations), cash expected to be generated by operations, and funds available under our ABL facility will be sufficient to fund our working capital and capital expenditure requirements over the next twelve months. Cash Flows Three Months Ended December 31, (in thousands) 2022 2021 Net cash provided (used) by operating activities 54,951 (5,685 ) Net cash used by investing activities (25,007 ) (26,709 ) Net cash used by financing activities (5,992 ) (70,185 ) Net Cash Provided (Used) by Operating Activities The change in net cash provided by operating activities for the three months ended December 31, 2022, compared to the net cash used by operating activities three months ended December 31, 2021, was driven by the timing of inventory purchases, primarily from the impact of global supply chain issues in the prior year. Additionally, it was driven by the timing of income taxes and a decrease in net sales. Net Cash Used by Investing Activities The decrease in net cash used by investing activities for the three months ended December 31, 2022, compared to the three months ended December 31, 2021, was driven by fewer capital expenditures related to store improvements and information technology. Net Cash Used by Financing Activities The decrease in net cash used by financing activities for the three months ended December 31, 2022, compared to the three months ended December 31, 2021, was a result of share repurchases in the prior year and lower cash proceeds from employees exercising equity awards. Debt and Guarantor Financial Information At December 31, 2022, we had $1,151.1 million in debt, not including capital leases, unamortized debt issuance costs and debt discounts, in the aggregate, of $3.7 million. Our debt consists of $680.0 million in 5.625% Senior Notes due 2025 (“2025 Senior Notes”) outstanding, $406.1 million remaining on our term loan and $65.0 million in outstanding borrowings under our ABL facility. 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, paying down other debt and share repurchases. Amounts 20 drawn on our ABL facility are generally paid down with cash provided by our operating activities. During the three months ended December 31, 2022 , the weighted average interest rate on our borrowings under the ABL facility was 5.2%. We are currently in compliance with the agreements and instruments governing our debt, including our financial covenants. Guarantor Financial Information Our 2025 Senior Notes were issued by our wholly-owned subsidiaries, Sally Holdings LLC and Sally Capital Inc. (the “Issuers”). The 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, 2022, and September 30, 2022: (in thousands) December 31, 2022 September 30, 2022 Inventory $ 742,642 $ 714,477 Intercompany receivable $ 394 $ — Current assets $ 882,858 $ 827,155 Total assets $ 2,032,279 $ 1,982,982 Current liabilities $ 550,883 $ 549,415 Intercompany payable $ — $ 4,431 Total liabilities $ 2,084,606 $ 2,085,169 The following table presents the summarized statement of earnings information for the Issuers and the Guarantors for three months ended December 31, 2022 (in thousands): Net sales $ 775,768 Gross profit $ 399,794 Earnings before provision for income taxes $ 52,383 Net Earnings $ 38,413 Share Repurchase Programs Under our current share repurchase program, we may from time-to-time repurchase our common stock on the open market. During the three months ended December 31, 2022, no shares were repurchased in connection with our share repurchase program. During three months ended December 31, 2021, we repurchased 3.7 million shares of our common stock for $75.0 million under our share repurchase program. See Note 5, Stockholders’ Equity , for more information about our share repurchase program. Contractual Obligations There have been no material changes outside the ordinary course of our business in any of our contractual obligations since September 30, 2022. Off-Balance Sheet Financing Arrangements At December 31, 2022 and September 30, 2022, 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, 2022. Recent Accounting Pronouncements There have been no recent accounting pronouncements issued that will have a material impact to our business. 21