Sally Beauty Holdings (NYSE:SBH) has been one of our more challenging portfolio positions over the last few years. The market has severely discounted the company’s earnings and free cash flows despite incremental progress in turning the underlying business. The likely reason – aside from ongoing competitive pressures and a general dislike of traditional retail – is the company’s high debt load and preference for share repurchases instead of deleveraging the balance sheet.
We’re sympathetic to the debt concerns to a degree. The company is overleveraged and would benefit from the flexibility of a lower debt balance and lower interest expense. However, our view is that the magnitude of the debt related discount is disproportionate to the actual risk – a view we’ve held for some time – though this clearly continues to be a minority viewpoint.
Unfortunately, the positive progress the company was making on its transformation, with comparable store sales running decently higher in the early months of the current calendar year, was rudely interrupted by coronavirus related store closures. Nonetheless, we remain optimistic and feel the present share price presents an appealing opportunity for long term shareholders. Our models and multiple analysis suggest a two year forward fair value closer to $15.00 within a range of $12.00 and $20.00. The $15.00 base valuation, achievable once revenues have stabilized in 2022 after coronavirus related store closures, incorporates only modest ongoing improvements in the business albeit starting from a notably lower base revenue threshold. In comparison, our low case valuation reflects a modest acceleration of revenue erosion experienced over the last few years (despite the improvement in the first part of the last quarter) while our high case reflects a more aggressive attitude towards debt reduction even with only modest operating gains. The valuations are all reasonably appealing, especially given the recent share price of $11.50, with expectations clearly biased towards the upside. The forward implied compound average annual return under our
