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Sally Beauty Holdings, Inc. (SBH) sells and distributes beauty products through 4,128 company-owned stores, 181 franchised stores, and 1,116 professional distributor sales consultants. It operates primarily in North America, South America, and Europe. While the stock is already up over 85% in the past year, there are many catalysts that will continue driving the stock higher to my price target of $32. As the consumer sector continues to outperform the market, specialty retailers like Sally Beauty Holdings may help diversify and increase returns for your portfolio.

Investment Thesis

Sally Beauty Holdings, Inc. is growing top-line, increasing margins, and being favored by improving industry demand, accelerating market share gains, and favorable product mixes. Greater awareness of the brand and CRM initiatives have led to higher margin retail consumers (versus professional) in US stores. Sally Beauty is also well positioned to expand in the European business, which currently has no multi-country beauty product retailers. Greater purchasing scale along with new acquisitions will help the top- and bottom-line. As Sally Beauty continues to pay back debt with tremendous cash flows, stock buybacks or dividends are highly likely in the future, attracting new potential investors. I am setting the price target to $32.

Top-line and Margin Growth

The recent quarter was one of Sally's strongest as a public company. It has done a great job marketing and gaining a presence with not only professionals, but also retail customers. Its marketing mix, which used to be more professional focused, is now 70% retail and 30% professional. The greater number of retail customers is good as they result in higher margins compared to professionals looking for wholesale pricing. As this mix continues to increase on the retail side, which is what the trends are suggesting, margins will only continue to increase from the current 48% operating margins to over 52% in the four-five years.

On top of this, the nail business has been on fire as new products such as the Shellac No-Chip nail polish leads to higher margin nail polish sales and the sales of necessary equipment, including the UV lamps that are necessary to cure this nail polish. No-Chip nail polish has become very popular in salons and beauty parlors.

European growth opportunity

Sally Beauty has an opportunity to become the first professional beauty retailer to cross country lines in Europe. I think it can build a successful integrated European model that benefits from purchasing scale and growth through acquisitions. On top of that, I believe that Sally will try to switch its current 80/20% professional to retail customer mix to look more like that of America, where the majority of sales are in the higher margin retail segment.

Paying off debt and improving CCC

While Sally is still piled with debt, with a leverage ratio of around 2.5x, it is a huge improvement from its ratio of 6.0x back in 2006. Management has done a great job paying down debt with free cash flow, and I believe this will only continue. It is expected to generate about $300 million in free cash flow this year, which will be used to continue paying off debt, make more acquisitions, and potentially start paying a dividend.

Conclusion

Many of Sally's peers are trading much higher relatively. Look at ULTA (ULTA) which is trading at over 23x EV/EBITDA and 50x trailing P/E. If Sally continues to pay off debt and operate successfully, it can reach the level of Ulta's valuation.

The future looks bright for Sally. Below is a screenshot from my DCF model, showing a glimpse of my valuation.

Click to enlargeSBH financials

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Polish Your Portfolio With Sally Beauty