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Sally Beauty Holdings

Q3 2008 Earnings Call

August 7, 2008, 11:00 a.m. ET

Executives

Karen Fugate – Vice President of Investor Relations

Gary Winterhalter, President and Chief Executive Officer

Mark Flaherty – Senior Vice President and Chief Financial Officer

John Golliher – President of SBG

Analysts

Karru Martinson – Deutsche Bank

Joseph Altobello – Oppenheimer & Co.

Todd Harkrider – Goldman Sachs

Mike Schultz – Wachovia

Linda Bolton-Weiser – Caris & Company

David Cumberland – Robert W. Baird

Peter Grandon – OSS Capital

Laura Richardson – BB&T

Jill Caruthers – Johnson Rice

Justin Hott - Chilton

Operator

Good morning ladies and gentleman and welcome to the Sally Beauty Holdings Conference Call to discuss the Company’s third quarter and fiscal year 2008 financial results. (Operator instructions) Now I would like to turn the call over to Karen Fugate, Vice President of Investor Relations for the Company.

Karen Fugate

Thank you, Michael. Before we begin, I would like to remind you that certain comments, including comments on matters such as forecasted financial information, contracts or business and trend information made during this call may contain forward-looking statements within the meaning of Section 21-e of the Securities Exchange Act of 1934. Many of these forward-looking statements can be identified by the use of words such as “may,” “will,” “should,” “expect,” “anticipate,” “estimate,” “assume,” “continue,” “project,” “plan,” and “believe” and similar words or phrases.

These matters are subject to a number of factors that could cause actual results to differ materially from expectations. Those factors are described in Sally Beauty Holdings SEC filings, including its most recent Annual Report on Form 10-K. The Company does not undertake any obligation to publicly update or revise its forward-looking statement. The Company has provided a detailed explanation and reconciliations of its adjusting items in non-GAAP financial measures in its earnings press release and on its website. With me on the call today are Gary Winterhalter, President and Chief Executive Officer and Mark Flaherty, Senior Vice President and Chief Financial Officer. Now I’d like to turn the call over to Gary.

Gary Winterhalter

Thank you, Karen, and good morning everyone. Thank you for joining us for our Fiscal 2008 Third Quarter Earnings Call. Before I get started, I’d like to congratulate Mark Flaherty for his promotion to Senior Vice President and Chief Financial Officer. Mark has served as our acting CFO since April, and our Board elected him Senior Vice President and CFO in June. He brings significant financial and operational experience to us and is a great addition to our management team. Congratulations Mark!

I’ll begin today’s discussion with a high-level review of our financial results following by an update on our business initiatives. Mark will then cover the financials in more detail. As demonstrated by our strong financial performance, we continue to execute on the initiatives set forth at the beginning of the fiscal year and delivered strong results. We reported an increase in consolidated net sales of 6.6% compared to our fiscal 2007 third quarter and a same store sales increase of 3.4%, making this our third quarter of sequential improvement.

Net earnings more than doubled over last years third quarter to $29 million or $0.16 per diluted share. Adjusted earnings, a non-GAAP measure, were $25 million or $0.13 per diluted share. We reported record adjusted EBITDA of $90 million, an increase of 23% over third quarter 2007. We believe that these operating results are further evidence that our business is fairly recession resistant and does not fluctuate greatly with the economy. As you know, our industry has never had a down year in the last 20.

Turning to the segments, Sally Beauty Supply had strong year-over-year results with revenue growth of 6%, gross margin expansion of 80 basis points, and operating profit growth of 10%. Same store sales at Sally Beauty Supply grew 2.1%, making this our third quarter of sequential improvement. We believe this growth is attributed to favorable product mix and the marketing initiatives we launched earlier this year. As you may recall, in May we announced our agreement with Paris Hilton to sell her line of hair extensions exclusively in our U.S. and Canadian Sally stores.

The publicity Sally Beauty received since this product launch has been outstanding, and we believe contributed to an increase in same store traffic and website traffic. The impressions from print, television, and online media reached more than 185 million, and we expect similar results as we role out more Paris Hilton products. Our customer acquisition effort uses analytics to identify the highest potential prospects by store segment, region, and demographics. This data is used to reach high potential customers and introduce them to Sally. Although it is a relatively new initiative, the test results to date are promising, and we look forward to expanding the program to other stores.

Our e-commerce site now includes over 1,000 professional products. Our plans are to carry the entire Sally Beauty assortment of over 5,000 products by the holiday season. The new CRM Program we piloted in March was successful. In the stores we tested, Beauty Club card membership increased and sales and traffic also were up. We plan to rollout this program to the entire Sally store base in August.

Our initiative to drive unit growth in Sally continues; and during the third quarter, we grew the domestic store base by 22 and expanded our international footprint by 40 stores through the acquisition of Pro-Duo with locations in Belgium, France, and Spain. The BSG segment had very strong year-over-year results on the top and bottom line. Revenue grew 7.6%, representing the third quarter of sequential improvement.

The success of our vendor diversification through the introduction of new product lines is reflected in our same store sales growth of 7.2%. Operating margin reached 8.8% in the third quarter. We expect to drive the BSG operating margin back to historical levels of 9% to 10% by year-end, setting aside the expenses associated with the warehouse optimization project. Margin improvement initiatives remain a strategic focus for BSG. The warehouse optimization project, back office consolidation, and process improvements are just a few of our opportunities to reduce the cost and complexity of this business.

Marketing initiatives at BSG include our CRM campaign to augment the existing Pro-club customer demographics. This data is used to customize direct mail and email promotions to Pro-club professional customers. In areas where we’ve targeted these promotions, the results are encouraging. We saw a positive shift in shopping activity and improvement in average purchase size. Our Armstrong McCall franchise business, which has reported to me, now reports to John Golliher, President of BSG, and continues to be consolidated in the BSG segment results. Under John’s leadership, we will apply some of the BSG cost and complexity reduction initiatives to Armstrong McACall’s operations.

In fact, our warehouse optimization project includes relocating Armstrong McCall’s distribution function based in Austin to our existing Denton facility. The overall warehouse optimization project is making headway. We’ve closed three distribution facilities in Salt Lake, Fargo, and Chatsworth. We anticipate the closure of our Austin facility will be complete by the end of fiscal 2008.

Our Fresno warehouse operation is expected to be in full production by early this fall. Completion of the overall optimization project is anticipated in the first half of fiscal 2009. We anticipate savings realized in fiscal ’09 to be in the range of $8- to $10 million and expected annualized savings of $10 million in fiscal year 2010 and beyond. As I mentioned earlier, we continue to execute on the initiatives set forth at the beginning of the year, positioning us well to achieve our growth and profitability goals. We intend to capitalize on growth opportunities, as well as pay down debt, taking a balanced approach to our use of cash.

Given our proven ability to generate strong free cash flow, we believe we have the capacity to do both in the short and long-term. Now Mark will provide more financial details for the third quarter. Mark.

Mark Flaherty

Thanks, Gary. Before I begin, I’d like to welcome Karen Fugate, our new Vice President of Investor Relations. Karen brings 20 years of finance investor relations experience, and we’re pleased to have her on the team. Welcome, Karen.

In looking at our third quarter results, consolidated net sales for the third quarter were $676.8 million, an increase of 6.6% over the year ago period. This growth is attributed to an increase in same store sales of 3.4%, the addition of new stores, and the acquisition of Pro-Duo during the third quarter. Third quarter’s consolidated gross profit was $315 million or 46.6% of sales, an 80 basis point improvement compared to 45.8% of sales in the fiscal 2007 third quarter. This increase is due to improved gross margins of both operating segments.

Consolidated and SG&A expenses were $227 million or 33.5% of sales, an improvement from 34.9% in the year-ago quarter. SG&A expenses increased approximately $5 million over last year primarily due to incremental expenses related to new store openings and acquisitions, partially offset by lower sales commissions in the BSG segment. Unallocated corporate overhead costs are included as a component of SG&A and were $18.2 million for the third quarter, which was $4.4 million below last year primarily due to lower share-based compensation and employee-related costs.

In fiscal 2008, we continue to expect unallocated corporate overhead expenses to be approximately $80- to $85 million, including estimated share-based compensation expense of approximately $10 million. Consolidated operating earnings increased $18 million to $76.6 million or 30.7% higher than the year-ago quarter. Consolidated operating margins were 11.3%, a 210 basis point improvement over the third quarter last year.

The improvement was primarily due to the favorable product mix, store growth, and expense reductions. Third quarter interest expense net of interest income was $29.9 million and included $7.6 million non-cash credit due to the market-to-market changes in the fair value for interest rate swap transactions. As a reminder, these market-to-market adjustments are the proper GAAP accounting treatment for a swap but does not meet hedge counting requirements.

On May 27th, we entered into two new interest rate swap agreements that do qualify for hedge accounting treatment, which I will talk about in a moment. As a reminder, we are providing adjusted net earnings and adjusted EPS solely for the purpose of adjusting your non-cash interest expense from the market-to-market changes in the fair value of our interest rate swaps. We believe that excluding this non-cash market-to-market adjustment provides investors with a better depiction of the Company’s core operating results and provides a more important baseline for modeling future earnings expectations.

For the fiscal 2008 third quarter, adjusted [inaudible] earnings doubled year-over-year to reach $25 million or $0.13 per diluted share after adjusting for non-cash interest credit from our interest rate swaps of approximately $5 million net of tax or $0.3 per diluted share. On a GAAP basis, net earnings for fiscal 2008 third quarter were $29 million or $0.16 per diluted share. We recognize adjusted EBITDA of $90 million, a 23% increase compared to the prior year quarter.

Turning to the segment starting with Sally Beauty, the third quarter net sales were $428 million, an increase of 6.1% versus the year-ago period. This increase is attributable to the same store sales growth of 2.1%, new stores, and acquisition revenue of $7 million. Same store sales strengthened for the third quarter in a row principally due to the improved product mix and incremental marketing efforts launched earlier this year.

Gross profit increased $15.6 million or 7.7% over the year-ago quarter and gross margin 51% compared to 50.2% last year. Gross margin improved 80 basis points due to the favorable product mix and improvement in international business margins. Sales at Sally International remain soft; however, the infrastructure consolidation and cost reduction efforts in Europe are anticipated to keep us on track to reach a 10% operating margin by year-end.

The Sally segment reported operating earnings of $72.9 million, an increase of 10%. Operating margins in the third quarter were 17% of sales, up from the year-ago quarter of 16.4%. The operating margin improvement was due to an increase in the number of stores and favorable product mix. Turning to the BSG business, third quarter net sales were $248.9 million, up $17.5 million or approximately 7.6% from the prior year, making this the third quarter of sequential improvements. Same store sales increased 7.2%.

This growth in same store sales is attributable to our vendor diversification through the introduction of new product lines. Gross profit for BSG increased approximately $8.6 million or 9.8% compared to the year-ago quarter. Gross margin was 39%, an increase of 80 basis points. Gross margin [inaudible] due to the shift in revenue to our store sales which carry higher gross margins. Segment operating profit for BSG increased 46% year-over-year to $21.8 million. Operating earnings were positively impacted by improved gross margins and BSG’s initiative to broaden its product mix and reduce expenses.

Operating margins strengthened to 8.8%, a sequential improvement from 7.6% last quarter and 6.5% in the year-ago quarter. Expenses for the BSG warehouse optimization project were $1.6 million in the quarter. We expect approximately $1 million of related expenses in the fourth quarter. Total project expenses for fiscal 2008 are expected to be approximately $4.5 million. Project completion date is expected to occur during the first half of fiscal 2009. We anticipate savings in fiscal 2009 to be in the range of $8- to $10 million and annualized savings of $10 million in fiscal 2010 and beyond.

Turning to the balance sheet, I’d like to begin with two interest rate swap agreements that we entered into in May. These interest rate swap agreements expire at the end of May 2012 and are valued at the aggregate negotiable amount of $300 million. These agreements allow us to convert a portion of our variable interest rate obligations to a fixed rate obligation with interest rates ranging from 5.6% to 6.1%. These agreements are designated as effective hedges consistent with FAS 133. The changes in the fair value of the swap are reporting no tax in accumulated other comprehensive income until the hedge obligation is settled or the swap agreements expire.

The fair value of these hedge swap agreements was an asset of approximately $3.6 million at the end of June, with the offset recorded as comprehensive income. Looking at the balance sheet, the outstanding loan balance of our ABL facility increased $18.2 million during the third quarter. Keep in mind our Pro-Duo acquisition was funded through $29.8 million in cash and borrowings on our ABL facility.

As we explained earlier this year, our working capital improvements will be constrained by the introduction of new brands in Sally and BSG, as well as the [inaudible] of a new warehouse as we consolidate a number of facilities this year. We ended the third quarter with approximately $307 million of borrowing capacity on our ABL facility. We also paid down approximately $4 million of our long-term debt, which including capital leases, was approximately $1.8 billion at the end of the quarter.

Capital expenditures totaled $10 million for the quarter and $36 million year-to-date. Net capital expenditures for fiscal 2008 are now projected at the range of approximately $55 to $60 million excluding potential acquisitions. Included in the capital expenditures is approximately $15 million for our BSG warehouse optimization project of which approximately $2.5 million is expected to occur during the fiscal fourth quarter. Now I’d like to turn the call back over to Gary.

Gary Winterhalter

Thanks, Mark. We are pleased with our strong top and bottom line results in the third quarter. We grew revenue by 6.6% and doubled our earnings, despite the challenging business environment. We continue to execute on our initiatives set forth at the beginning of the year. Our 2008 store growth for the combined Sally and BSG is 4% to 5%. Operating margin the Sally International business continues to improve and we remain optimistic that 10% operating margin is achievable by year-end.

BSG operating margin has expanded over the last six quarters; and in the fiscal 2008 third quarter, reached 8.8%, very close to our 2008 goal of returning to historical levels of 9% to 10% by year-end. We continue to look for margin expansion opportunities throughout our business, such as the warehouse restructuring and product mix improvements. Our top priority remains unchanged to grow the business organically and through acquisition. We will take a balanced approach to our use of cash by investing in the Company’s growth initiative while at the same time paying down debt. We believe we have the capacity to do both.

As always, thank you for your interest in Sally Beauty Holdings and now we will turn it back to the operator to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Karru Martinson with Deutsche Bank.

Karru Martinson – Deutsche Bank

With the growth that you’re seeing here in your comp store sales, where do you feel that that’s coming from? Is that the consumer trading down, the basket size continuing to grow? You have the new products available. What’s really kind of the drivers and sustainability of those drivers?

Gary Winterhalter

I think it’s several things, Karru. I think there is a little bit of trade down from some of the pricier salon brands into the same quality product that they can purchase at Sally Beauty. I think also that a lot of the growth that we’ve been experiencing in the recent months have been to the marketing initiatives that we talked about in the call.

Karru Martinson – Deutsche Bank

In terms of the 4% to 5% growth target in acquisitions, one, are you seeing an easing of rental rates and ability to pickup space; and then just also in terms of the acquisition environment of again similar type of concept with the difficult market, perhaps multiples coming down in the outlook there.

Gary Winterhalter

Addressing the rent question first: unfortunately, we’re not seeing a lot of that happening. It’s like the residential real estate market. The good properties are holding their price, and the centers that we’d really like to get into as Sally seem to be holding pretty well. They don’t have the vacancy levels that some of the weaker centers have. I do expect, if this continues too much longer, that we could see a little easing on the BSG side because we don’t look for a-type retail space. We look more for service centers and I think there could be some pressure there. As you might expect, it varies by geography. What was the second part of your question?

Karru Martinson – Deutsche Bank

Just in terms of what you’re seeing for acquisition environment, multiple…

Gary Winterhalter

Acquisition, well, keep in mind as we’ve said in the past and most of our acquisition activity will probably be outside the U.S. So we haven’t seen a whole lot of deterioration there because our industry throughout the world seems to fare pretty well in economic times so the owners of these businesses are not experiencing huge deterioration in their business, so the values are kind of upholding.

Operator

The next question comes from Joe Altobello with Oppenheimer.

Joseph Altobello – Oppenheimer & Co.

First question: just wanted to follow-up on Karru’s question regarding the [inaudible] sales growth here. Are you guys getting any sense that you’re gaining share whether it’s on the Sally Beauty side or on the BSG side?

Mark Flaherty

Well, I think obviously on the BSG side, we have to be gaining share because it’s a fairly finite market of professional customers only. On the Sally side, we are seeing consistent growth in our professional business, but it’s very low single-digit and has been for years. The growth we’re seeing is on the retail side of our business and we’re just scratching the surface there so obviously we’re taking share from somebody; but if it’s coming out of mass, I doubt that they’re feeling it yet.

Joseph Altobello – Oppenheimer & Co.

Exactly. Then in terms of the stimulus check impact, any sense that that helped to drive the sales growth?

Mark Flaherty

Joe, I don’t think that that had any impact on our business at all. I think, as we’ve said before, that most people use those checks on higher end items like electronics and things like that. Our price points and our average sale is so low that I just don’t think it had any impact with us at all.

Joseph Altobello – Oppenheimer & Co.

Lastly, in terms of modeling, the corporate overhead was a lot lower than I anticipated and it sounds like you still got into $80- $85 million for the year, which would imply a pretty big uptake in the fourth quarter. What am I missing?

Mark Flaherty

I think it’s still consistent for the year. I think a lot of it is just timing of expenses between one quarter to the next, particularly in certain departments in terms of when they were [inaudible], but there’s nothing unusual.

Operator

The next question comes from Todd Harkrider with Goldman Sachs.

Todd Harkrider – Goldman Sachs

I know you talked about a balanced approach on growth and paying down debt but since you’re spun off, you’ve upped your new store growth rate. You continue to make small acquisitions, but you still had the tiny problem generating a lot of cash. Can you talk about if we should see maybe a faster rate of debt pay down, the couple larger than average acquisition that are in Latin America or further expand into Europe or just use this for cash [inaudible]?

Gary Winterhalter

I would say that, as we’ve said in the past, Todd, that the acquisitions that we’re most likely to do are very small. There are not a lot of large acquisitions that we’re aware of in Western Europe or South America that we would be focusing on; so as we’ve said in the past, on the BSG side here in the U.S., our acquisitions have been a lot of little tuck-ins, which has helped BSG’s margins significantly. On the Sally side, they will most likely be outside the U.S.; but again, small acquisitions either to add to what we already have or to get a start in a new country, which we’ve historically done with very small acquisitions.

Todd Harkrider – Goldman Sachs

Then on the BSG side, and I think you’ve been able to replace the L’Oreal sales and bring profitability closer to the historical levels at a much faster rate than even a lot of the optimistic investors even expected. Can you talk about maybe the “what” now? Would you be open to selling it since it’s operating smoothly again or do you think it’s still good to own since you have a first lick into the hot products to actually supply Sally with private label at a quicker rate, first to market, or how should we look at BSG going forward?

Gary Winterhalter

Well, we don’t have any interest in selling BSG at this point. I think there’s still a lot of upside to BSG. There’s a lot of brands that we continue to add to BSG. I think that there’s a lot of synergies between the two companies, particularly in back office type functions, not so much on the distribution side; but the vendors and the manufacturers that we deal with, to a large extent, are the same companies with BSG and Sally, just different divisions of those companies. So there’s a lot to be said for keeping them together, not the least of which is what you said. We really get an insight into what’s really hot and popular in the salon industry by having BSG as part of our group.

Todd Harkrider – Goldman Sachs

Lastly, can you talk about what you might be seeing out of Regis? Are they blown out of the professional hair care products when they’re converting the Trade Secrets to Pure Beauty or is it too early to tell; and do you think the salon’s youth service will pickup share after the conversions or do you think the diverted channels will pick up most of it?

Gary Winterhalter

I’m not sure I got the first part of your question about whether they’re blowing out of what professional products?

Todd Harkrider – Goldman Sachs

When they’re converting the Trade Secrets to Pure Beauty, are you seeing they are discounting a lot of the professional hair care products since they’re reducing the footprint by their stores on hair care or is it too early to tell at this point?

Gary Winterhalter

I would say it’s too early to tell, but I think what they did makes sense. I don’t know that they’re discontinuing any professional products. I think they’re just scaling down the amount of space they devote to that and adding some categories that they weren’t previously in, which I think is smart.

Operator

Your next question comes from Grant Jordan with Wachovia.

Mike Schultz – Wachovia

Mike Schultz in for Grant. Were there any categories that exhibited particular strength or weakness in the quarter?

Gary Winterhalter

Not that haven’t been trending that way for the last several quarters. Our hair extension business continues to be extremely strong; and as we expected, our association with Paris Hilton not only on hair extensions but bringing in a younger group of customers has accelerated the growth in some of our other categories and specific product lines that are geared at that younger generation.

Mike Schultz – Wachovia

What was the private label penetration for SBS in the quarter?

Gary Winterhalter

For the quarter, I’m not sure we have that number handy. Oh yes, we do. It was 41%.

Mike Schultz – Wachovia

So pretty consistent.

Gary Winterhalter

Yes.

Operator

Your next question comes from Linda Bolton-Weiser with Caris.

Linda Bolton-Weiser – Caris & Company

I was just curious on the Sally Stores growth margin expansion, is there anyway to indicate to us how much was due to more private label product versus how much was the improvement in the international margins?

Gary Winterhalter

No, as we just said, our control label was 41%, which without looking at last year’s third quarter, I would tell you slightly higher; but as we’ve said all along, we pick up about a point a year in that. Last year, I think we finished just over 40; but other than that, we don’t disclose a lot of detail about margins between the U.S. and our international business.

Linda Bolton-Weiser – Caris & Company

Then did you say of the 22 organic new store openings for Sally, how many were international versus domestic?

Gary Winterhalter

Those were all domestic.

Linda Bolton-Weiser – Caris & Company

Then I’m just curious, you opened 22 stores this quarter, 13 last quarter, and yet the sales contribution from the new store openings seem to be about the same even though there were quite a few more stores opened. Is there anyway to explain that? Are they still performing well in terms of the new store openings?

Gary Winterhalter

The new store openings are performing the way they always have. You’re comparing that number to what number? I’m not sure I’m following you.

Linda Bolton-Weiser – Caris & Company

I think you just said that new stores openings contributed about 1.5 percentage points to the growth of Sally in the quarter; and I think that was about the same contribution last quarter, although there were many fewer stores opened.

Gary Winterhalter

But keep in mind that the growth of 1½% would be the stores that we opened last year in the same quarter that are not in the same store sales calculation yet.

Linda Bolton-Weiser – Caris & Company

Then, just so I understand the information you gave about the interest rate swap agreement, are you saying that that agreement lowers your underlying interest rate that we should assume is the underlying rate?

Gary Winterhalter

It will, certainly over the long term; it’s probably at par right now. This is given the interest rate environment right now to lock in, and I’ll give you a little bit more color on that too because when I talked about that there’s a range of 5.6 to 6.1, I’m also including the borrowing spread on our loans as well in there. The actual fixed to liable rate which is the rate that we fix to that, we fixed the 300 million at 3.579, so you’ve also got in that 5.6 to 6.1, the borrowing spread of 200 to 250 basis points.

Operator

Your next question comes from David Cumberland with Robert W. Baird.

David Cumberland – Robert W. Baird

First on the Sally’s stores, did traffic turn positive in the quarter?

Gary Winterhalter

Yes, it did.

David Cumberland – Robert W. Baird

Can you elaborate on the test you did both with analytics and CRM? How many stores roughly were involved?

Gary Winterhalter

The CRM test was about 115 stores; that’s the test we referred to in our last call that took place in March and April. That’s what’s rolling out in August. We’ve added about 500 more stores on August 1st and the balance of our stores will be in that by the end of August.

David Cumberland – Robert W. Baird

Then my last question on the warehouse optimization project, the $8- to $10 million in savings in fiscal ’09, does that have any costs that you might have related to that early next year?

Gary Winterhalter

We expect the majority of the cost to be incurred in this fiscal year, any carryover costs that may incur during the first part of fiscal ’09 would be pretty immaterial.

Operator

The next question comes from Peter Grandon with OSS Capital.

Peter Grandon – OSS Capital

Gary, can you, if at all possible, try to parse out for us the impact from the CRM initiative going forward on same store sales versus looking in the rearview mirror? Looking back over this quarter, obviously you had some benefits from that initiative, some benefits from Paris Hilton, some benefits from just, maybe a little bit from refund checks, sounds like not a lot; but going forward, how are you guys thinking about that? Is Paris Hilton the most important thing? Is the CRM initiative the most important thing, something else?

Gary Winterhalter

Well, I think long-term, the CRM initiative is the most important thing. I think, as I said a minute ago, the Paris Hilton Association’s been great for us, mostly from the standpoint of bringing a younger customer into our stores and we’re selling lots of hair extensions obviously; but we’re also selling some of the products, Beyond the Zone is an example, our younger generation brand. It’s been exploding since we’ve been getting the press from the Paris Hilton launch.

Peter Grandon - OSS Capital

Okay, because I guess stated another way, the, I mean you comp pretty well, especially in this environment, and it seems like a small portion of that comp was due to a CRM Initiative and if all of a sudden you’re at, August 1st, you’re at 500 stores by Labor Day, you’re basically system wide, I sort of draw the conclusion and say, “Well gees, unless things absolutely fall out of bed, it could be 2.4/2.5%.

Gary Winterhalter

Well we sure hope you’re right.

Peter Grandon - OSS Capital

I mean, I know you’re not doing [inaudible] logically is my lawyers that make sense generically.

Gary Winterhalter

I don’t think your logic is flawed, but as you know, we don’t give guidance on that but we have a lot of confidence in what we’re doing and believe that the tests were very accurate and we tried to isolate any factors that could have impacted the tests to make sure that what we saw was real results and we’re comfortable with it.

Peter Grandon - OSS Capital

Okay. One other thing I wanted to get into is the margins, Sally Beauty, the margins in BSU* as you’ve articulated have sort of come up and seems like they’re on track to be where you’ve pointed us to by the end of the year. Sally’s side came up to 17%. I mean is that a trend that we can sort of continue to expect, especially given the CRM Initiative and so forth?

Gary Winterhalter

Well keep in mind that our international business on a percentage basis is growing much faster than our Sally U.S. business. So as that continues and as we make more acquisitions internationally, and our international businesses in a 9- to 10% operating margin area where Sally is closer to 18- to 18.5%, it is somewhat of a drag on a percentage basis to the Sally margin, so I would say to you that even if Sally continues the margin expansion that we’ve done historically, or even improved upon that, it will be somewhat offset by the growth of our international business at lower margins.

Peter Grandon - OSS Capital

But obviously on a dollar basis, it’s positive.

Operator

Your next question comes from Laura Richardson with BB&T.

Laura Richardson – BB&T

I want to ask a couple of questions related to what we might see in the margins in the fourth quarter because I thought I heard Mark saying SG&A, there were some accruals that were probably lighter in this third quarter that will come back in the fourth quarter, and then I thought I remembered something last year in the fourth quarter – there was a yearend accrual, maybe an international that helped the gross margin. Should we expect… Was I right about the SG&A comment from Mark, and then should we expect the gross margin to act like it did in the fourth quarter last year? Then I have another kind of point I wanted to address.

Mark Flaherty

As I said, we’re just reaffirming our guidance as far as where our SG&A structure is. The corporate expenses for the year, without giving guidance into the fourth quarter, Laura, we’re certainly not seeing any unusual trends one way or the other.

Laura Richardson – BB&T

Okay, and how about the gross margin last year in the fourth quarter?

Mark Flaherty

Again, it’s just that we’ve seen a pretty consistent pattern of what our gross margin has been for the last three quarters sequentially both in BSG as well as Sally, and again, without giving a lot of guidance...

Laura Richardson – BB&T

Right.

Mark Flaherty

…we’re not seeing anything in the marketplace that would make it not comparable.

Laura Richardson – BB&T

So you’re saying… Well, just kind of, without giving guidance of course, I understand, but just kind of assume margin trends continue what they’ve been doing and don’t expect any weird variance in gross margin in the fourth quarter like we had last year with a positive variance, and don’t expect any weird variance in SG&A that it sounded like it might have been a negative variance.

Mark Flaherty

Yeah, I think that’s a fair statement.

Laura Richardson – BB&T

Okay. Then the other thing I wanted to kind of poke into was on the warehouse consolidation. Now what, when you’re done with that, how many distribution centers are you going to have, and then what should the inventory levels go to, and what kind of working capital benefit should you get from that?

Mark Flaherty

Well, we will be ultimately putting four warehouses of which we – I talked about a minute ago, three of those are already gone and one of them will be, well actually moved up to an existing facility here in Denton by the end of September. Though on the BSG side, we will have two major, excuse me, three major distribution facilities in the U.S., a smaller one here in Denton, a very small one in Oregon, and a very small one in Connecticut.

Laura Richardson – BB&T

So BSG is going to have three DCs in the U.S. when this is all done?

Mark Flaherty

They’ll actually have six as I mentioned, three large ones and three small ones, and obviously the impact on inventory will be positive, it just takes a little while to sell through the inventory that you’re moving from these close facilities into the open one. You have to seed the new one before you can start shipping out of it and it’s something we’ve done many times in the past and the ultimate result of it will be much lower inventory for BSG, but at this point it’s hard to put a number on that as far as time.

Laura Richardson – BB&T

Yeah. Well is timing going to be about when you sell through, all that maybe late ’09, that we’ll start to see that inventory start to come down?

Mark Flaherty

Yeah, I would hope so on that piece of the business.

Operator

Your next question comes from Jill Caruthers from Johnson Rice

Jill Caruthers – Johnson Rice

Maybe you could talk about a certain market that you pointed out last quarter that we’re a little weaker in that you focused your additional promotional activity in marketing in such as California, Arizona, Florida. Maybe how those particular markets performed in third quarter in this and maybe just a little bit more on the promotional activity or marketing you did in those specific things.

Mark Flaherty

We saw some improvement in the third quarter in those markets specifically. The promotion we did there was basically just a little more of the promotion we typically do to the professional side of the business, and we did a little bit of retail advertising in a couple of those markets but it was not significant, so I think that just the weakness we were seeing was more on the professional side of the business in those three markets for some reason than the retail, but the retail was also a bit soft and as we said before, it’s probably not a coincidence that those three markets are having some difficulty in the macro in an economic sense.

Jill Caruthers – Johnson Rice

Okay, and then last question: Maybe if you could just talk about on the distribution side of the business with Beauty System, kind of how it’s changed given you’ve lost the L’Oreal business and if they’ve entered into the distribution side with Beauty Alliance and [Malleys], just kind of changes that you’ve seen recently as well as kind of the growing issue of diversion for the mass channel.

Mark Flaherty

We haven’t seen a great deal of change, but personally I think that the owners that had those businesses previously were probably a little tougher competition than L’Oreal is seeming to be and as you know, several of the brands that were distributed there prior to the L’Oreal ownership have come over to us, so it’s had a positive impact on us so far. Diversion, we’re expecting the second quarter numbers any day now. We haven’t seen them yet. It continues to be a problem, although I will say we’ve seen some very positive trends from Paul Mitchell which is a huge partner of ours as well as the Sebastian brand which is part of P&G. Several of the other key brands for us really have no diversion. Goldwell has been a stellar brand for us and they have no diversion, same thing with Joyco and many of the other brands that we’re involved with just don’t have that problem and we’re confident because of their background and just the nature of the management at those companies that they won’t, which is why we’re putting our effort behind them.

Operator

Your next question comes from Justin Hott with Chilton.

Justin Hott – Chilton

First, you suffered through the couple of years with the L’Oreal issue. Now we’ve had a terrible U.S. consumer environment yet you put up these results. You sound pretty positive, but would you want to send the message that the worst is probably behind you for Sally Beauty?

Gary Winterhalter

I think from the standpoint of the issue we had with L’Oreal, that’s definitely been behind us now for at least two quarters. On the Sally side, I think a lot of the things that we did two or three years ago in bringing in Mike Spinozzi, and I’ve talked about his background in the past, we realize that the future of our Sally business is going to be very heavily involved in CRM. We have to determine the consumer out there that is likely to be a Sally customer and focus on them. A lot of what Mike and our recent addition of Sue Davidson, her talents have done, is exactly that, and it’s showing results. So I don’t know that on the Sally side, I can say that the worst is behind us; but I would say that I don’t know that we had a worst. We had a couple quarters of a little softer than normal same store sales; however, we never had a negative quarter of same store sales. I think that the direction that we’re taking today is going to show long-term, positive results.

Justin Hott – Chilton

You just mentioned on a previous question about how the previous owners of [inaudible] and Beauty Alliance might have some commentary on how the competitive situation has changed. Can you elaborate or do you not want to reveal anything about that?

Gary Winterhalter

I mean that, Justin, more from the standpoint of I think anytime you’re competing with the founder and owner of a business and somebody that’s been in the industry for 20 or 30 or 40 years, they’ve got a lot of skin in the game; and they’re very good competitors. I think when companies get swallowed up by very large companies where distribution and certainly store operations is not their forte or their primary business, it’s just not run quite the way that it was previously.

Justin Hott – Chilton

The two-year lockups from the spin-off of Alberto-Culver I assume our rolling out, if I remember, in November. Any indication on what could happen with I guess some of the major stakeholders?

Gary Winterhalter

No, as I’ve said in the past, we have no reason to believe that CD&R, which is who you’re talking about, has any intention of doing anything other than they told us from the very beginning; and beyond that, you’d really have to ask them.

Operator

Once again, ladies and gentlemen, thank you for dialing in for today’s conference call. You may now disconnect.

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Source: Sally Beauty Holdings Q3 2008 (Qtr End 06/30/08) Earnings Call Transcript
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