Sally Beauty Spinoff Should Unlock Value

Includes: ACV-OLD, SBH
by: Think Intrinsic

Since our initial report on the Sally Beauty Holdings spinoff just a few days ago, SBH has climbed over 11% (and about 17% since the spinoff on Friday). We believe there are more gains to come, as this spinoff has many favourable characteristics which are still relevant. Most significantly, SBH is 47.5% owned by a private equity firm and has a debt to EV ratio of 60%, providing a leveraged buyout-like situation in which you can invest. Our complete research report is below.

A Very Unique Spinoff
On November 17, 2006, Alberto-Culver (NYSE:ACV-OLD) completed its spinoff of Sally Beauty Holdings (NYSE:SBH) and paid a $25 special dividend. Shareholders of ACV (pre-spinoff) received 1 share of SBH for every share of ACV. This spinoff was atypical, because Clayton, Dubilier & Rice (CD&R), a private equity firm, purchased 47.5% of SBH as part of the spinoff agreement (the largest percentage while preserving tax-free treatment). Also, SBH funded the $25/share dividend and incurred $1.8 billion of debt. This sets up a situation where you and I can participate in a leveraged buyout. Sound interesting?

Business Description
SBH is a distributor of higher-end hair care, skin care, and related products. The company has two divisions, one distributes to retail and professional customers (Sally Beauty) while the other solely supplies professional salons (Beauty Systems Group, or BSG). See end of report for an in-depth business description.

Industry Outlook
The industry is growing as demographic shifts occur. The most significant of these shifts is the aging of baby boomers. People will always pay to look good, and the older customers are less fickle and, better yet, have money.

Competitive Advantage
We believe SBH has a sustainable economic moat. SBH is the largest distributor in a fragmented industry, which should allow SBH to use its large distribution network as a bargaining chip when negotiating with manufacturers. The company has expanded geographically over many years and the distribution network cannot be easily or quickly replicated by competitors. Its largest competitor, Regis Corporation, was originally going to buy SBH before ACV cancelled the agreement due to Regis's declining share price. This is when CD&R stepped in and spinoff talks began.

Growth Prospects
From the most recent investor conference call, we heard that SBH expects to grow the top line (geographical expansion), operating margins (cost controls), and profit margins (reduction of interest expense). Growing sales, margins, and potentially accelerating EPS growth (CEO foresees double digit EPS growth) could lead to P/E expansion.

Cash Flows and Return on Capital
SBH has impressive cash flow generating abilities which was probably the reason CD&R consented to loading the company with debt. Additionally, the return on tangible capital employed is around 15-17%. This number changes depending on assumptions but is clearly in excess of the cost of capital. It appears high and demonstrates SBH’s ability to leverage its distribution network.

An Attractive Spinoff
Now that we’ve seen why the company and industry are attractive, let’s look at the factors that make this a particularly promising spinoff. CD&R has experience with owning and managing distribution companies. CD&R has a $575 million stake in SBH and cannot sell their stock for 2 years. They control 6 of the 12 Directors. Additionally, they probably lobbied for a lower spinoff valuation of SBH which could have reduced the price for us individual investors.

Debt to enterprise value is roughly 60%. As this debt is paid down we will see "deleveraging" contribute to EPS growth.

ACV and SBH have conflicting interests. Although owning SBH gave ACV control over its distribution network, ACV was looking for growth, and wanted to expand into other channels which directly competed with SBH. Simultaneously, SBH was looking to grow and wanted to carry products that competed with ACV's. Both companies identified this problem well over a year ago and ACV has been trying to sell or spinoff SBH for over a year.

As with all spinoffs, management's incentives will now be tied directly to the share price of the new company which provides incentive to grow shareholder value. CD&R’s expertise and determination to make their investment profitable increase the chances of individual shareholders benefiting because management's goals are aligned with ours.

Product divergence is when middle-men want to move manufacturers’ products and significantly cut the price. This is why a Walgreens or CVS may offer the same products as SBH for less. Regis is currently working very diligently to pressure manufacturers not to support this practice. It poses a risk to the industry, not to SBH in particular. I don't believe it is a sustainable trend (in the very long term) because it dilutes manufacturers' brands. However, in the short term, manufacturers appreciate the increased volume. The future of product divergence isn’t clear. However, as industry leaders, SBH and Regis are best positioned to pressure manufacturers to dissuade retailers from this activity.

We didn't see (nor did we expect to see) forced selling after this spinoff. This is when mutual funds, index funds, and other institutions are forced to sell their holdings, which depresses the stock price. We did not expect to see this with SBH because CD&R holds 47.5% of the common stock and is unable to sell for 2 years. SBH was also a large part of ACV, so it wasn't indiscriminately sold; institutions likely weighed their options.

The S-4 contains many valuation measures as calculated by Goldman Sachs. All of these are right around the current stock price, but I consider most to be conservative. These valuations do not take into account many of the factors discussed above. How do you quantify an economic moat, entrepreneurial spirit, better alignment of incentives, or a board of directors from an experienced private equity firm? You can’t, so we do not attempt to. We know, through sound logic, that the valuations that currently exist do not take these qualitative attributes into account.

SBH will continue to create shareholder value. It is the leader in a growing industry with an extremely talented and experienced management team and board of directors. This is not a deep-discount stock. It is, however, a company that will unlock value, now that it no longer has a conflict of interest with its parent company, and now that it has the support of the experienced CD&R.

Disclosure: Author is long SBH

SBH since IPO:

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