My pick for the Seeking Alpha Retail contest, Sally Beauty Holdings (NYSE:SBH), has been performing remarkably well as of late. As a quick recap, I was drawn to the company due to its solid free cash flow generation, minimal capex, and fairly protected retail business model. Almost immediately after this publication, JANA Partners picked up a solid 4M share/$100M USD position, citing the same similar deep intrinsic values that I found as reasons for investing. After a steady run, and what the market interpreted as blistering fiscal Q1 2016 results, both of us appear to have been on the right track with this pickup. The equity is now up 27.5% in my own portfolio, and is actually rapidly accelerating towards my 2018 price target nearly three years ahead of schedule.
Is it time for me to take my profits and look for value elsewhere, or has something materially changed to change my outlook to be even more positive? Finding the right stock to buy is hard enough, but it is only half the battle. Opportunity cost should always be on an investors' mind, and it is worth looking to see if the story has changed and I should shift capital elsewhere.
My Assumptions and Q1 2016 Results
Retail is a tough market to predict, as predicting trends and consumer spending habits is at best difficult and at worst nearly impossible. Trends come and go, and even those that reach the top are often quick to fall. Polo Ralph Lauren (NYSE:RL) and Kohl's (NYSE:KSS) are examples of companies that attracted Contributor interest in that contest that have since performed poorly due to abrupt same store sales growth shifts. When I invest in retail, I am extremely careful when modeling both future revenue growth and margins.
With Sally Beauty, I assumed a continuation of prior trends through 2018. This entailed revenue growth of 3.8%, with only slight margin expansion (49.6% gross margin, 12.88% GAAP operating margin). Sally Beauty met, and slightly beat, many of my expectations going into fiscal Q1 of 2016. Same store sales grew 3.9%, and operating margin expanded to 49.5%. With so many duds reporting weak results in Retail, Sally Beauty has drawn in plenty of new investors attracted to a retail store that actually is posting improving metrics.
What was a key driver of the significant earnings beat, however, was falling SG&A expenses. SG&A as a % of GAAP revenue came in a hair above 34%, more than 200bps above what I believed the company would produce for full year fiscal 2016. SG&A efficiency is the one area you could point out as a weakness for the company. The company focuses on small footprint stores in non-prime real estate. While I won't call it a quality versus quantity model, the company does have over 5,000 stores. As a result, keeping all those stores staffed and properly advertised does cost a significant amount of money compared to other retail companies.
Now, 34.2% remains the SG&A guidance that the company is giving for the full fiscal year:
"Overall, when you look at the guidance that we put out there for the street in terms of the 34.2%, we're still maintaining that guidance for the year. We still have a considerable amount of investments that we're making in our business development, the $16 million that we put in the guidance that we gave for next year. That is a bit of a timing issue from one quarter to the next. That is the way I would look at the outlook of our SG&A structure for the remainder of the year."
- Mark Flaherty, Sally Beauty Q1 2016 Earnings Call
So it remains to be seen if management is being cautious and we're seeing true long-term SG&A improvement, or if fiscal Q1 is just an anomaly. Q2 may not give us much insight, given all stores are given a reorganization and moving of products, and Sally Beauty management wants to take the time to run more advertisements in print, television, and radio to both promote the company, while also informing customers already familiar with the product moves.
While Q1 results were definitely good, they weren't terribly ahead of expectations, and we haven't seen any bumps to guidance. While management might be playing coy and being cautious, it is worth being cautious as well. I'll be taking down my position on Monday, February 7 to a half position, taking a little profit off the table for the time being. If I see a better risk/reward opportunity, the remainder of my position will likely be the first on the chopping block for a shift in capital towards what I believe to be greener pastures.
Disclosure: I am/we are long SBH.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.