Sally Beauty's Stock Price Decline Is Unwarranted

Sally Beauty Holdings (SBH) (view initial report) announced on Tuesday that they are no longer the exclusive distributors of L'Oreal USA professional products, and that the Armstrong McCall division of SBH's Beauty Systems Group [BSG] would no longer distribute Redken professional products. (See the press release for details) On the news the stock fell 13%. Was the sell-off overdone? We needed to determine the immediate implications for SBH and whether this agreement is a precursor to further problems at SBH in particular or with the industry as a whole.

Short-term Implications

The short term implications were stated in the press release: a $110M (or 5%) negative impact on sales for the last nine months in FY07. This number includes negative indirect impacts on other products. We would like to be able to verify this number but must instead rely on management's best judgment because they have access to much more detailed information. The effect on net income is tough to determine because margins on L'Oreal products aren't as high as private label but any incremental revenue leverages fixed costs. These factors may cancel one another out or result in a net decline in margins. We just can't know without SBH providing guidance.

Affect On The Future

The next question we asked ourselves was "what does this mean for the future of SBH and other distributors?" To do this we must understand why L'Oreal pulled the exclusive distribution rights. We read through L'Oreal’s 2005 Annual Report and found some useful information. First, a new CEO has taken the helm and has a history of aggressively boosting growth of the L'Oreal brands. L'Oreal's products have experienced significant growth in North America and the newly introduced brands, including Redken and Matrix, are evolving. The new distribution agreement looks like it is just part of the ongoing evolution of L'Oreal's brands and not a result of a larger industry shift or as a result of SBH doing something "wrong."

No Longer Exclusive Distributor of L'Oreal USA Professional Products

L'Oreal is trying to boost growth of their professional products lines. They have not pulled the products from SBH stores, but have instead chosen to seek additional distribution channels. The BSG sales force will no longer be able to sell L'Oreal Professional Products.

We believe this is because L'Oreal wants to direct-sell to salons - not that they intend to switch distributors in the short term. L'Oreal is a large beauty supply manufacturer with great ambitions of North American growth. SBH has the largest North American footprint and is best able to help L'Oreal realize their goals.

L'Oreal owns a 30% stake in Beauty Alliance, an SBH competitor. BA has fewer stores and would take at least several years to become a formidable competitor. In this time we believe SBH will continue to grow and adapt to protect its competitive advantage. If L'Oreal eventually drops SBH, we anticipate SBH would have had enough time to reduce its reliance on L'Oreal and minimize the effect on earnings.

By preventing BSG's salesforce from selling L'Oreal Professional Products, L'Oreal is almost certainly going to distribute directly to salons. Our question is, with a smaller salesforce than BSG, how does L'Oreal expect to sell to mid-size and smaller salons? P&G pulled its products from SBH and experienced this exact problem. They since returned their products to SBH.

Replacing Redken with Matrix

In the last year, Redken has experienced "high penetration in ultra-fashionable hair salons." (L'Oreal 2005 Annual Report) Large ultra-fashionable salons are not SBH’s target market because they are less profitable. In the last conference call Winterhalter said, "[Big salons] all want huge discounts and they all want to be the only person on the block carrying that particular product line." SBH no longer distributes Redken but will distribute a L'Oreal newcomer, Matrix, which is "targeted at a wire range of salons offering affordable prices and services." Longer term, we believe it makes more sense (for L'Oreal and Sally Beauty) that SBH carry Maxim instead of Redken. Suddenly this product loss doesn't sound so bad; now we look at L'Oreal USA Professional Products.

Put it in Perspective

SBH has made a lot of people a lot of money since the spinoff. It rose quickly and traders didn't hesitate to lock in gains. To put the announcement in perspective, we must remember that Beauty Systems Group represents roughly half of SBH's revenue. Less than half of BSG revenue is from hair products. Of this, an even smaller portion is L'Oreal products and smaller still are the sales lost as a result of this new agreement. Additionally, BSG is shifting towards private label which has higher margins. We don't believe that this press release warrants a 13% stock drop. We have used the opportunity to increase our SBH position.

Note: SBH closed Thursday at $7.76, down 3% from Wednesday's 13% decline.

SBH 1-mo chart

Disclosure: Author is long SBH