The improvement in Sally Beauty Holdings’ (SBH) business fundamentals does not match the current market valuation of the company. The company ended its fiscal year (FY end in September) on a strong note, reporting same-store sales growth on a consolidated basis of 1.3% and gross margins of 51%, a 150-basis-point expansion and the highest in the past 8 years. Consolidated revenues were slightly down during Q4, but taking into consideration a retail footprint of 23 fewer stores compared to the prior-year period, and the state of California shutting down salons during the quarter, we believe SBH showed strength in its results.
The company continues to trade at depressed multiples. At 5.6x forward earnings, SBH is a “show me” stock with very low expectations embedded in the share price. If the company can keep the momentum showed in its fourth-quarter going, we might be up for a surprise. With 20% of the outstanding shares been short, just a slight positive outcome could send the stock price higher as the market adjusts its expectations. At just 10x earnings, SBH could trade at approximately $18 per share based on $1.8 in EPS. We continue to believe SBH is an attractive value pick.
Solid year-end results
Considering the still lingering effects and unpredictability of the pandemic on the business, we believe SBH ended the year on solid ground. Total consolidated fourth-quarter sales were down 80 basis points compared to the prior-year period to $957 million, not bad taking into consideration 23 fewer stores and the fact that salons were ordered to close down once again in California during the months of July and August, having an unfavorable impact of 90 basis points to segment same-store sales in the Beauty Systems Group (which caters to the licensed professional) and having approximately 180 stores out of 450 stores in Europe completely closed due to COVID-19.
While the company didn’t beat the 3% consolidated same-store sales growth analysts were expecting and thus disappointed the market, it managed to report fourth-quarter positive consolidated SSS growth of 1.3%. We feel good about the positive SSS growth, however, which, coupled with an increase of 63% in e-commerce sales compared to last year, shows that customers are responding positively to SBH’s omnichannel strategy. The company has completed the rollout of ship-from-store and same-day delivery; and it was finishing the launch of Buy Online/Pick-up in-store and curbside pickup within its U.S. store network, both programs key to offset delivery charges, while offering the customer the convenience of online shopping. Another program that should help SSS growth is the rollout of the company’s private-label rewards credit card, which, as noted by management, has higher retention rates and higher spend per transaction. In the first month, the company signed 80,000 new card members, with a slight weight towards the professional stylist.
The highlight for the quarter was the 150-basis-point improvement in consolidated gross margins on a year-over-year basis to 51.1%, the highest in 8 years. The gross margin improvement was led by better coordination and execution of fewer promotions across all businesses and an intentional positive mix towards higher-margin categories like hair color in the quarter.
The company is doubling down on its efforts to increase penetration in the hair color category. We believe it is a smart strategy, as it is a higher-margin product, the company leads the industry in professional color for home use, it is aligned with the increasing DIY trend, and for some people it becomes a non-discretionary expenditure, whether in good or bad economies.
In that regard, SBH is changing its go-to-market strategy by decreasing the level of promotions and instead focusing on providing more content on its websites with “how-to” tutorials, starting with beginners to more complex application techniques. It is a good way to build rapport with potential customers and increase cross-selling opportunities. The strategy might be gaining momentum, as the company reported an increase of hair color sales in Q4 of over 22% compared to the prior year on Sally Beauty’s U.S and Canadian retail stores, driven by unit growth and AUR. The company believes it continues to gain market share in this core category:
We saw continued strength in our core category of hair color, where we continue to gain share in the retail and pro channels. – Q4 sales
Last quarter, management mentioned some “competitor disruptions” on the pro channel, which led to 40,000 new hair color customers. This quarter, the company saw 50% of repeat purchases from that group.
SBH completed a small acquisition in Canada, which added 10 stores, 17 direct sales consultants and, more importantly, exclusive distribution rights to professional hair color and hair care brands such as Wella Professional and Goldwell, strengthening its position in the hair color category:
And so on balance, as I think about the portfolio, we’re winning where we’re focused, and we have work to do in the basket fill categories that are around the core. And I would be a bad CFO if I did not point out, Rupesh, that the areas where we are seeing our growth are our higher-margin categories.
Bottom Line
SBH gave soft guidance for fiscal ’21. The company expects sales in 2021 to be higher than in 2019, assuming the current business environment stays relatively stable. If that is the case, then revenues should be approximately $3.9 billion. Gross margins are expected to show strength, and management believes current levels are sustainable.
From a liquidity point of view, the company is taking the necessary steps to reduce its debt load. SBH completed an amendment to its asset-based revolving line of credit that suspended certain anti-cash hoarding restrictions when its outstanding balance fell below a certain level, giving the company more flexibility in its use of cash. As a result, SBH repaid in full the $376 million balance in its revolving line of credit, a $20 million term loan facility and a $50 million portion of its 4.5% term loan. The company ended its fiscal year with $514 million in cash and full availability of $600 million in its credit line.
SBH continues to generate significant amounts of free cash flow. For example, the company generated $426 million in operating cash while deploying $110 million in CAPEX, ending the year with $316 million in free cash flow.
With no restrictions to the use of cash after the credit amendment and repayment of the credit line, there were some hints about the future capital allocation, which consists of lowering the leverage ratio to 2.5x from 3.8x and the possibility of share repurchases:
That all being said, as we look at the stock price versus our underlying business fundamentals, we may smartly consider share repurchases from time to time.
Source: Company Q4 earnings conference call
If the macro environment stays relatively stable, then we believe share repurchases would be highly accretive to shareholders, as the company would be repurchasing its shares at 6x earnings, or an earnings yield of 16% – a nice return considering the business climate.
The repayment of the debt would be a huge boost to EPS, as interest expense accounts for approximately 38% of operating income. Debt repayment would lead to less interest expense, with the savings dropping straight to the bottom line, adjusting for taxes.
At 6x forward earnings, the company offers compelling value. There are many levers the company can use to boost EPS in the next few years. A combination of strong margins, debt repayment, share buybacks and the heavily short position of market participants can lead to a strong rebound in the share price. At just 10x earnings, we could be looking at a price target of $18 per share – a significant upside.
That said, the investment is highly risky as well. Let’s not forget that SBH still depends on its retail stores to generate most of its sales, as e-commerce contributes approximately 3% to total sales, so still an immaterial contribution. Much of the uncertainty still relies on what will happen in the winter months if there is no vaccine available and COVID cases start increasing. Many states are now implementing restrictions that could lead to full lockdowns in the worst-case scenario. If that were to happen, SBH would just hoard its cash to weather the second storm, and its top line would remain pressured. Investors should position-size accordingly.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SBH over the next 72 hours. 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.