Sally Beauty Loses its Moat

Sally Beauty Holdings (SBH) delivered some bad news last night. The company announced that its Sally Beauty Group LLC [BSG] subsidiary will no longer have exclusive rights to distribute products of the L’Oreal Professional Products Division through its distributor sales consultants or in its stores. BSG’s Armstrong McCall division will not retain the rights to distribute Redken professional products through distributor sales consultants or its stores, but will retain exclusive distribution rights for the Matrix line of products. On a positive note, L’Oreal professional products will remain available in BSG stores that currently carry these products and Sally Beauty Supply stores, which carry a different selection of L’Oreal products from those carried in BSG stores, are not impacted by these developments.

Sally Beauty Holdings (SBH) expects these changes to reduce revenue by $110 million during the last nine months of 2007. This estimate includes additional impact on revenue from other products that may be indirectly affected by these developments.

It appears that Sally Beauty Holdings relationship with L’Oreal has been deteriorating. There was an earlier mention by CEO Winterhalter concerning a loss of sales for BSG East consultants during recent negotiations with L’Oreal that was considered immaterial. This recent news however is material and this loss of business seems to have come as a surprise to Sally Beauty. The cause of this weakening relationship is not apparent to me, especially given that this spin-off from Alberto-Culver (ACV) was done to improve relationships with product manufacturers by eliminating the potential conflict of interest associated with distributing Alberto-Culver products when Sally Beauty was still part of that company.

It will be interesting to see how L’Oreal plans on distributing their products under this new arrangement. I’m trying to find out whether L’Oreal will be adding new distribution partners or whether they plan on doing direct sales to salons. This small leak in Sally Beauty Holdings’ moat will hopefully be quickly patched. However, if further competitive threats attack Sally Beauty, we will have to watch carefully how well the company staves off the threats.

It will also be worth watching what the private investor Clayton, Dubilier & Rice does in light of this new information. Clayton, Dubilier & Rice owns almost half of the equity in this spin-off. I would not be surprised if they add to their position given today’s over 17% drop in SBH stock. This could turn out similar to the way Realogy (H) was recently offered a buyout by private equity firm, Apollo Group.

The potential loss of $110 million in sales is approximately a 5 percent reduction in next years sales given the past twelve month revenue of $2.4 billion. I’m reducing my intrinsic value estimate for Sally Beauty Holdings from $10 to $9 per share given this new information. This 10 percent reduction in my value estimate should more than compensate for the loss of L’Oreal sales if Sally Beauty’s continues to have a sustainable competitive advantage.

Given Mr. Market’s overreaction to yesterday’s bad news, I am debating whether to add Sally Beauty Holdings to the Fat Pitch Financials Portfolio. SBH is already in the Special Situations Real Money Portfolio, but I am considering increasing my position in this stock. What are your thoughts?

SBH 1-yr chart: