Sally Beauty Holdings Inc (SBH) 2007 Q1 法說會逐字稿

Good morning, ladies and gentlemen, welcome to the Sally Beauty Holdings conference call to discuss the Company's first-quarter fiscal 2007 results. All participants have been placed in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. Now, I would like to turn the call over to Sandy Martin, Vice President of Investor Relations for the Company. Ms. Martin, you may begin.

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 21E of the Securities Exchange Act of 1934. Many of these forward-looking statements can be identified by the use of the words such as may, will, expect, anticipate, estimate, assume, continue, project, plan, 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 recently filed annual report on Form 10-K. The Company does not undertake any obligation to publicly update or revise its forward-looking statements.

The Company has provided a detailed explanation and reconciliations of its adjusting items and non-GAAP financial measures in its earnings press release and on its website.

On the call with me today are Gary Winterhalter, President and Chief Executive Officer; David Rea, Chief Financial Officer; and [Mark Faulkner], Controller. Now I would like to turn the call over to Gary Winterhalter.

Thank you, Sandy, and good morning, everyone. Thank you for joining us for our earnings conference call. This is Sally Beauty Holdings' first investors call, and we are pleased to report solid first-quarter 2007 results.

Net sales for $630 million, an increase of 7%. Comp store sales grew by 5% compared to the year-ago quarter. As reported in our press release this morning, Sally Beauty Supply stores had positive comp store sales of 3% for the first quarter, and Beauty Systems Group comps increased 10%.

In a few minutes, David will provide a more detailed discussion of our financial results, but first I thought it would be appropriate to provide our new shareholders with a broader overview of our business. As most of you know, we were spun out from Alberto-Culver on November 16 of last year. On November 17, we began trading as Sally Beauty Holdings. Clayton Dubilier & Rice and affiliates, the private equity firm that made the spinoff possible, holds 48% of our outstanding shares.

Looking quickly at a description of our business, Sally Beauty Holdings is the largest distributor of professional beauty supplies in North America. Our two entities combined operate 3,367 Company-owned stores worldwide and 171 franchised stores. We also employed at the end of the December quarter approximately 1,200 distributor sales consultants. Our combined entities operate in the U.S., the UK, Canada, Puerto Rico, Mexico, Japan, Ireland, Germany, Spain, and the Netherlands.

Looking specifically at our two divisions, Sally Beauty Supply is the largest specialty retailer of professional beauty products in North America. Our store count is 2,531, with 90% of those being located in the United States. The average store size of a Sally store is 1,700 square feet. Sally's customer base is made up of retail consumers and salon professionals.

The Beauty Systems Group side of our business, or BSG as we refer to it, is the largest full-service distributor of professional exclusive line beauty products in North America. Here we operate 665 Company-owned stores and 171 franchises. This is also the division that employs the sales consultants. BSG is approximately twice the size of the next-largest full-service competitor. Many of the products sold within the BSG network are sold under exclusive distribution agreements. BSG stores average about 2,800 square feet in size. The BSG customer base, unlike Sally, is exclusively to licensed cosmetologists and salons.

For the first quarter, Sally revenues represented 59% of total, while Sally operating profits were 77% of our total. BSG's revenues were 41% and operating earnings were 23%.

We are very fortunate to operate in a wonderful industry. It is a very stable and consistent industry, as many of you have heard me say in the past. Over the last 15 years, the professional beauty industry has grown at a compound annual growth rate of 4.9%, never having a down year.

Our two divisions combined have an exceptionally strong leading market position. Sally and BSG in combination represent 36% of the $6.3 billion professional beauty industry.

Also playing well to our business model is a very fragmented customer base in the professional salon industry. Of the 240,000 beauty salons in the United States, 76% of those employee four or less stylists. This plays very well for distribution as well as the store component of both of our businesses.

We expect to continue growing the revenues and profitability of both sides of our business. Specifically on the Sally side, we will be expanding our store base. We will continue to drive our gross margins through increased control label sales, as well as a continued shift toward more retail customers in the Sally stores. We will be driving customer traffic primarily through our loyalty programs and CRM marketing programs. We always look at acquisitions on the Sally side and will continue to do so where it is appropriate in the U.S. and internationally.

On the BSG side of our business, we will also continue to expand our store base, further penetrating existing geographies, as well as entering new geographies with BSG stores. We will be bringing on new brands to be sold in BSG stores as well as through the sales consultants. On the BSG side, we will be improving profitability by optimizing our distribution network and consolidating procurement. We will have an aggressive acquisition strategy on the BSG side of our business, both domestically and internationally.

While I am very excited about the long-term prospects for Sally Beauty, we do face some challenges during fiscal '07. In late December, we announced certain changes in our agreements with L'Oreal. After months of negotiation last year regarding our BSG East geography, our negotiations took a direction that we did not expect. I talked with many of you following the announcement, and today I want to provide an update.

To briefly recap, contractual changes with L'Oreal resulted in a long-term, non-exclusive agreement to sell their products in many of our BSG stores. In addition, our distributor sales consultants at BSG no longer sell L'Oreal products. Our Armstrong McCall franchises continue to sell Matrix on an exclusive basis, but they no longer distribute Redken products. Armstrong McCall represents approximately 17% of BSG, with stores ranging from the Panhandle of Florida, West through San Diego, including Mexico.

BSG has grown to revenues of almost $1 billion, mainly through acquisition, organic growth, and by adding brands. Also, we have built strong relationships through negotiations with many different manufacturers. Prior to these changes, L'Oreal represented the largest vendor concentration of our BSG sales. All other individual suppliers represent 10% or less of our BSG business.

While the L'Oreal decision does represent some short-term challenges, I thought it would be helpful to provide you with some perspective on this decision. BSG has experienced other changes in its vendor relationships in the past. As a point of comparison, a few years ago, P&G made changes to their Wella and Sebastian distribution. During that time frame, we worked to expand the BSG business with new product lines and continued with our longer-term business plan.

Today, we believe that BSG remains the largest full-service distributor of professional beauty supplies in the U.S. and is unmatched in our ability to cover the marketplace. That distribution capability remains a key competitive advantage to us, and continues to attract the best suppliers in the business.

That is one of the reasons we are delighted to once again be expanding our relationship with P&G Professional Care, which will broaden our U.S. distribution of brands including Wella, Sebastian, and Graham Webb. This includes exclusive distribution for stores and sales consultants in the Southeastern United States. These brands will receive increased presence and marketing support throughout our BSG stores.

To capitalize on changing distribution opportunities in North America, BSG and P&G Professional Care will have a targeted approach for jointly distributing Wella, Sebastian, and Graham Webb products to salons. Salons in current P&G coverage areas will remain exclusive to P&G's sales consultants. BSG will service a targeted number of salons not in the P&G coverage, as BSG offers the broad reach, scale, and expertise to best service these salons.

These collaborative distributions approach will allow P&G and BSG to create joint programs and drive customer conversions to grow sales for both companies. We look forward to further building upon this relationship in the future.

While the P&G agreement is not expected to have a large financial impact to us in fiscal '07, and therefore will not by any means offset the impact of the lost L'Oreal business, our expanding relationship with P&G is one example of the type of discussions we are having with suppliers to add additional lines of product to our BSG business to further offset December's developments.

In addition to these new initiatives, we're looking at other ways to minimize the lost revenue impact. These efforts include shifting L'Oreal business to our stores where practical; adding more product offerings to our stores; expanding existing product lines into new territories; and carefully managing cost, with plans to reduce variable expenses and reduced fixed overhead cost over the longer term. As an example, we have already made targeted reductions in our sales force, as well as changes to other administrative areas, and are actively working with our stores to position them to capture additional L'Oreal revenue.

Changes between L'Oreal and BSG should have no impact on Sally Beauty Supply stores. We believe that the combination of Sally Beauty Supply stores and the BSG store and full-service network provides strength through a diversified business strategy targeted for long-term growth.

Now David will provide you with a financial overview of the business. We're pleased to welcome David as the newest number of our management team. David brings many years of financial and operational expertise to our Company and understands multiunit businesses and leveraged public companies. David?

Thanks, Gary. I'm delighted to be part of the Sally Beauty team. As many of you know, Sally Beauty was separated from the Alberto-Culver Company on November 16, 2006. As part of the transaction, Sally Beauty Holdings issued approximately 180 million shares of common stock, of which approximately 86 million shares were acquired directly and indirectly by affiliates of the private equity firm Clayton Dubilier & Rice, through a capital contribution of $575 million. This contribution, along with the issuance of $1.85 billion of debt, funded the special cash dividend of $2.3 billion to Alberto-Culver shareholders as part of the separation agreement.

As a result, the historical financial results of Sally Beauty do not reflect the substantial change in capital structure that took place midway through the first quarter. That said, let me walk you through some of the numbers.

As Gary mentioned, the Company grew first-quarter sales by 7% to $630 million during the three months ended December 31, 2006. First-quarter gross profit was $284 million or 45.2%, compared to last year's first-quarter gross profit percentage of 45.5%.

Selling, general, and administrative expenses increased 9% to $213 million in the quarter, which represented 34% of sales. SG&A expenses included $5.7 million of share based compensation, compared to $2.1 million in last year's first quarter.

Of the $5.7 million this year, $5.3 million related to early vesting of existing options as a result of the separation transaction. In addition, SG&A costs include direct allocated overhead costs from Alberto of $1 million during the first quarter, compared to almost $4 million of direct overhead costs from Alberto from last year's first quarter.

Following our separation from Alberto-Culver, we began to incur the incremental cost for the stand-alone expenses of being a public company, related to items such as tax, legal, insurance, listing fees, and other costs. These costs replace the services that Alberto-Culver previously provided as part of the direct allocated overhead charges I just referenced.

In addition to the direct overhead charges, Alberto-Culver has historically charged the Company a sales-based service fee. This fee was $4 million during the first quarter of fiscal 2007, compared to $7 million in the year-ago quarter.

Effective as of the date of the separation transaction, all Alberto-Culver overhead charges to the Company ceased. The details of all of these (indiscernible) are included in the supplemental tables schedules that are part of the press release.

During the quarter, we recognized a total of $128 million in transaction cost, including debt and equity issuance cost, as a result of the separation. Of that total, $5 million of share-based compensation was included in SG&A, and $22 million was recorded as transaction expenses on the face of the income statement, which included payments made to Alberto-Culver, professional fees, and executive severance amounts.

In addition, $42 million was recorded as a reduction in shareholders equity for a portion of the transaction fees paid to CDR, the investment banking advisers, and other legal and accounting costs that were related to the raising of the CDR equity. Finally, $59 million of the $128 million was recorded as the Company's original debt issuance costs on the balance sheet and will be amortized over the life of the debt, which averages about 7.5 years.

Turning to the operating segment results, first-quarter segment operating earnings for Sally Beauty Supply stores were $66 million, a 12% increase over the prior-year period. The improvements were due to an increase in average purchase size driven by changes in product mix, and by increases in private or control label sales during the quarter.

On the BSG side, operating earnings were $19 million, down 15% due to some margin pressure, professional consulting charges of $1 million, and $600,000 of warehouse closing cost during the quarter. Our gross margins at BSG softened in the first quarter due to higher-than-expected volumes of traditionally low-margin business as well as the margin pressures on certain products.

When analyzing our segment operating profit, we chose to exclude certain corporate and shared costs so that the operating segments would not be distorted by overhead charges from home office expenses and other infrastructure costs. We intend to apply this approach going forward. These unallocated general and administrative expenses include, in addition to general overhead cost, direct allocation of Alberto-Culver costs up to the time of the separation, as well as share-based compensation expenses, both of which I discussed earlier as part of SG&A.

We currently expect our unallocated general and administrative expenses to be approximately $85 million for fiscal-year 2007, including the $1 million of Alberto direct allocated overhead charges incurred in the first quarter, and share-based compensation expense, which includes the $5.3 million of option expense recognized in the first quarter related to the separation.

Interest expense, net of interest income, amounted to $19 million for the first quarter of fiscal 2007, compared to $471,000 in the year-ago period. For the three months ended December 31, 2006, our interest expense only included debt service costs on the $1.8 million of debt since the separation transaction on November 16, 2006.

As part of the separation-related debt financing, the Company entered into two interest rate swaps for a total of $500 million on the Term A and Term B loans over the next two to three years. Because the interest rate swaps did not qualify for hedge accounting treatment under GAAP, the Company records mark-to-market adjustments for fair value changes each quarter through the interest expense line on its consolidated statement of earnings.

Interest expense for the first quarter included a $993,000 reduction in expense for a mark-to-market increase in fair value of interest rate swaps during the period. Although this is the proper accounting treatment for reporting purposes for a swap that does not meet to the hedge accounting requirement, it is still relevant to remember that the swap does take $500 million of our floating-rate debt and fixes the cash interest expense for the life of the respective swaps.

Our pretax earnings for the first quarter amounted to $17 million and reflect a charge of $21 million related to the separation. Our provision for income taxes for the first quarter was $14 million. This tax provision may look a bid odd, given our pretax earnings of $17 million, but the first-quarter tax provision reflects the nondeductibility of the majority of the separation transaction expenses recognized during the quarter. Excluding the impact of these amounts, the Company currently expects to have a 39% effective tax rate for fiscal-year 2007.

Net earnings for the quarter were $3 million or $0.02 per diluted share. As I previously mentioned, this net earnings number includes the impact of the separation from Alberto as well as a partial quarter of interest expense.

In an effort to provide you with other metrics that management believes are useful in understanding our results, we have included in the press release a supplemental schedule that provides certain non-GAAP disclosures to reconcile these numbers back to the GAAP financial measure.

We have provided an adjusted EBITDA number which begins with net earnings, based on GAAP; adds back depreciation and amortization, share-based compensation, transaction expenses, net interest expense, and the provision for income taxes. We have also provided an adjusted net earnings number which begins with adjusted EBITDA; and then deducts D&A as well as pro forma share-based compensation, pro forma interest expense assuming the current capital structure was in place at the beginning of the first quarter, and pro forma income taxes assuming an effective tax rate of 39%.

We have provided this adjusted net earnings calculation for this quarter in an effort to give you an estimate of what the results might have looked like had the transaction taken place just prior to the beginning of the first quarter.

We have also provided you with a schedule of our new debt, and I thought would be helpful to give some details on this, as some of you are calling us with questions regarding our new capital structure.

The Term A and B loans have no prepayment penalties. The Term B loan carries a contractual amortization schedule of 1% per year, while the Term A loan carries a scaled amortization schedule. The Senior Notes and Senior Sub Notes do not carry any amortization; otherwise contain customary high-yield bond provisions such as debt incurrence limitations and restrictions on certain payments such as dividends. We provided a table on the supplemental schedules which detail our debt maturity payments over the next five fiscal years.

Of our $1.8 million of debt, we currently have approximately $1.2 billion fixed, or just over 65% of the total, after considering the $500 million of interest rate swaps. As a result, our current blended cash interest expense rate is about 8.5%.

In terms of our capital requirements, we are focused on managing our inventory and other working capital, in an effort to make this a source of cash without adversely impacting the business. Our intentions for cash are to grow the business, invest in new stores, make strategic acquisitions, and pay down debt.

We project that capital expenditures for fiscal 2007 will be between 35 and $40 million, and they will be used to open new stores and for other corporate needs. During the first quarter, we opened 20 net new Sally Beauty Supply stores and eight net new BSG stores. We plan to grow total square footage by approximately 4% to 5% this year. Projected capital expenditures do not include acquisitions.

Finally, I wanted to add to the comments Gary made regarding the L'Oreal situation. In the Company's Form 8-K filed in December, we reported that we expect the impact of the changes in the L'Oreal contracts would negatively impact the Company's revenue during the last three fiscal quarters of 2007 by approximately $110 million. This included the expected loss of approximately $90 million of sales from our distributor sales consultants for L'Oreal product, as well as an estimated $20 million of ancillary sales of non-L'Oreal products.

As Gary mentioned earlier, the Company is very focused on the action items that could potentially mitigate some of the impact of the lost revenues. Having said that, it is still uncertain to what degree these efforts will be able to offset the lost revenues during the remainder of the fiscal year.

For planning purposes, we have modeled a number of different scenarios; and we're providing what we term as a range of flowthrough projections. The sensitivity around our flowthrough analysis is a function of the mitigating actions.

For purposes of taking our detailed internal models and distilling it into a highly simplified format in order to illustrate the potential flowthrough impact, we made the following assumptions. One, that the L'Oreal revenue loss is $110 million for the next three quarters. Secondly, that gross margins are 45%. Third, that the variable selling and delivery costs total about 17% of revenues.

Using these assumptions, for illustrative purposes only, we would expect that the lost gross margin would be $50 million or 45% of the assumed $110 million revenue loss; while selling and delivery cost would decline by $19 million, or 17% of the assumed $110 million revenue loss; for a net estimated impact of $31 million, or an estimated flowthrough rate of 28% of the assumed $110 million revenue loss.

While this flowthrough illustration is highly simplified and ignores, among other factors, any onetime costs that the Company may incur to rationalize the cost structure of the BSG business, it does represent the basic framework of how the estimated or the assumed $110 million of lost L'Oreal and ancillary revenue could impact our results during fiscal 2007, unaffected by any other actions.

Obviously, we are working to mitigate our revenue loss to the extent possible. To the degree that the Company is successful in some of its mitigating actions, such as shifting some of the L'Oreal revenue to our stores, finding replacement revenue with new suppliers, and enacting further cost-savings measures, then the net impact should decline. Over the short term, we believe the primary driver for minimizing the revenue loss is in finding replacement revenue or shifting revenue to the stores, as demonstrated by the flowthrough illustration I just gave.

Over a longer-term perspective, we believe both revenue initiatives as well as changes in BSG's cost structure will be important factors. In fact, the Company is currently working on both revenue and cost initiatives which we believe could reduce the pretax impact of the assumed $110 million of lost revenues for fiscal 2007 from approximately 28% of that revenue loss to approximately 18% of that revenue loss. The new P&G agreement is just one example of an initiative that could begin to help us drive the flowthrough loss toward the 18% level.

Given the uncertainties surrounding this situation, of course there are no guarantees of what the actual impacts will be. But we feel very good about the game plan that we have put together to address this issue. We expect to update you on our progress during our second-quarter conference call in early May, and we look forward to speaking with you then.

Thank you for your interest in our Company, and we would now like to open the call up for questions.

(OPERATOR INSTRUCTIONS) [Reede Kim] with Merrill Lynch.

Could you go through that last point you just made about the P&G business? It sounds like as you are modeling that in the base case, the simplified base case you are giving us, that the earnings impact would push you more to the low end of that earnings hit, as opposed to really getting us much along the way to replacing the lost L'Oreal business this year.

Yes, and Gary, you can comment on this as well. But obviously when we gave our flowthrough analysis, we were aware of the new P&G agreement. So in looking at that, as Gary said, it does not by any means solve a $110 million revenue issue, but it is the type of thing and the types of actions that we are looking at to begin to mitigate that $110 million revenue loss.

Okay. Do margins on the brands differ greatly?

Not greatly.

Okay. So just so I understand, on the L'Oreal agreement you're now going to be non-exclusive in the stores. Will the new agreement allow another company to have exclusive sales territories while you operate the stores? Or will L'Oreal be opening it up further?

What I am getting at is I think there is a fear out there that maybe the industry is going through more of a fundamental change; and the vendors may be thinking -- maybe open it up a little bit more than before.

Well, the store business will be non-exclusive, so if they award the exclusive street business to another distributor in that geography, he would also be able to sell it in the stores. So there will be some competition in the store business.

In the geographies that we have operated in, we have an awful lot of stores. Most of the distributors that they have chosen to represent them on the street do not have much of a store presence in those geographies.

Okay, and as far as the flowthrough analysis you gave us, does that incorporate an estimate about changes in the compensation structure for the sales force? Because I assume you will be reducing it in size in regions of the country, increasing it probably in the Southeast, and you may be looking at paying some of your best performers more to retain them.

Yes, that is all in the plan.

Yes, just to be clear, in the illustration I gave, that is sort of an unaffected flowthrough analysis. So to the extent that we take other actions -- such as reducing headcount and have costs associated with that, or restructuring our distribution assets and costs associated with that -- that sort of changes that. But we didn't put either the cost or the benefit of those types of things in the sort of 28% illustration that I gave you.

Okay. Then just a couple more of the acquisitions. It sounds like it is full speed ahead on the BSG side. Any product acquisitions in the pipeline? I know you had talked about that a couple months ago.

You mean any brand acquisitions in the pipeline?

Right.

We are reviewing a few; nothing is imminent.

Okay. Just finally, what is -- you gave us your adjusted EBITDA calculation. Is that the same that you're using for the banks? And if you could share with us the LTM adjusted EBITDA calculation.

Then just finally, is the $7.5 million run rate on the corporate overhead, is that still a good number to use? I would assume yes. Thanks.

I guess, a couple quick there. On the public company cost I think that you just referenced, the $7.5 million that you just said?

Right.

Yes, that is embedded in the number I gave for our unallocated corporate overhead costs. So on an annual basis, all of that is subsumed into that number for the year. So we are not separately tracking or taking the public company cost. It is embedded in that number of $85 million.

With respect to the credit EBITDA, obviously, as you probably know, there's a number of different terms as part of those agreements that would need to be looked at for adjustments from what we put in our press release. So that is really a separate calculation that we will provide to those lenders in those agreements.

Thanks a lot.

Justin Hott with Bear Stearns.

Thanks, I am just going to ask a couple and then try to jump back in the queue. I want to start with the changes with P&G and L'Oreal. The biggest question, I guess, I would love to hear right now is -- when you lose the biggest supplier in the industry from your consultancy business, how do you replace them? Now, you have a great supplier in P&G. Can you walk us through how you think about the business, and how you think about losing such a large supplier here, and replacing them with someone else?

Sure, Justin. This is Gary. First of all, they were the largest supplier for our sales consultant business. But when you look at individual sales consultants, it can vary anywhere from 10% of their business to 70% of their business.

The sales consultants that we lost were the ones that were 60 or 70% of their business. The other ones view all the other brands that the sell as an opportunity to replace that business. They know if they leave, yes, they may be able to maintain the 20% or the 30% or the 35% of that business; but they won't be taking the remainder of the business with them.

To be honest with you, these sales consultants have been a bit frustrated over the last few years in trying to grow particularly the Matrix brand, which is a 30-year-old brand now that as you are well aware has significant issues with diversion. It has become more and more difficult to get salons to inventory and use the brand.

So I think our ability to maintain a much higher percentage of our sales consultants than I thought we would be able to is driven by exactly that. Their customers and they are looking to get onto the next brand.

When you look at the history of the industry, 30 years ago when Matrix got started, Redken was the king of the hill and had many of the same issues that I believe Matrix has today, in the age of the brand and the industry looking for the next latest and greatest. That is one of the beauties of our business, that our stylists, our professional customers are always looking for what is new. Their customers, they expect that when they go into a salon. I think you understand that from going to the beauty shows and probably from listening to your wife.

Now all the investors know that too. Thanks, Gary. Can you give us an idea on the headcount at BSG consultants at the end of the quarter versus start of the quarter?

Well, at the end of the quarter, they were pretty much the same. The reductions we made were primarily in January. What we did, in the affected areas we reduced our headcount by about 20%. Now that is not 20% of the 1,200, because a lot of those areas were not affected, such as Armstrong McCall and Canada and some of the other geographies.

So bottom line is, we reduced our headcount by about 160 people that we chose to eliminate. Of the balance, we right now are maintaining over 88% of the ones that we wanted to keep. Which as I mentioned before, I'm so proud of those people, that they have made the decision that this is the right thing for their career and their future. That it is far beyond what my expectations were, to be honest with you.

As a reference point, can you tell us how that 88% would compare to when Procter went direct a couple of years ago?

Yes, actually we -- well, it is difficult to do that on a percentage basis, because we did not carry the Wella and Sebastian brands in nearly as wide a geography as we did the L'Oreal brands. So I would have to take a look at that, to be honest with you. I can't really do that off the top of my head.

I can tell you that we lost between 60 and 70 sales consultants in a much smaller geography, with a brand that only represented 6% of our business. So if you look at all that, it has been a much better situation for us. I attribute that all to John Golliher, who is the President of BSG, and him going around and just explaining what this means to the Company, to the industry, and where we expect to go in the future, and that we want these people to stay with us.

Gary, I want to just ask one more, and then I will jump back in the queue. Staying on L'Oreal, there can still be more changes. Obviously, it was a big surprise when they pulled out of the East Coast. But two of the changes we hear about that could be coming is, one, what if they buy a brand that could be in your distribution? Obviously, I'm not going to name names here.

Two, what do you do on acquisitions if L'Oreal now owns a stake in one of their -- in Beauty Alliance; and they might take equity stakes in other companies. Aren't you going to have to compete with L'Oreal on acquisitions of other distributors and other stores that might carry a big portion of L'Oreal brands there? How do you think about these changes?

Okay, let me take the second one first. First of all, it is probably not likely that we would target a distribution company that is heavily into the L'Oreal brands as an acquisition. That kind of goes counter to the strategy of wanting to diversify our business and wanting to get involved with some of the newer up-and-coming brands that are typically not in the L'Oreal distributors. That is number one.

And the first question, sure, they could go out and buy other brands that could have an impact on us. I am not sure that the brands that we represent, when I look at that, that there's any or certainly not many that would make a whole lot of sense for them to buy, just looking at their brand portfolio, and understanding that they are a heavily color-driven company. All three of their brands, Matrix, Redken, and L'Oreal, are very, very heavy in the color business.

So that could happen. They bought [R-tek] four or five years ago, we were a distributor of that. Unfortunately, the brand went significantly south after they bought it, so it really didn't have much of an impact on us. But it is a possibility.

I guess tying with that, that is just one general salon-related question. As you try to recover from L'Oreal -- maybe that is not the right choice of words, I apologize. Salons don't like to change their color. You're obviously going to obviously be working on getting your sales force to get new color lines, I would assume, into salons. How do we think about the replacement of brands, and how do you go about fixing that?

You're absolutely right. The most difficult category to replace in a salon is hair color. But you do what you have to with it. We are with the number-two color brand worldwide, which is Wella, and they have some pretty effective programs going in, and swapping out the business.

Keeping in mind that a very large part of our business goes through our stores. That is really a very small color user. Our store people are actually pretty effective at changing out that business, because they develop such a strong relationship with these booth runners that come in two or three times a week.

If they are not being serviced by a sales consultant and there is not a store in that geography, it is going to be difficult. Sure, they can come in and continue buying the L'Oreal brands, and we are certainly going to represent those brands and do everything that we can to further that business in our stores. But as they get exposed to other brands, they may change on their own. So it is a challenge. There is no question about it.

Okay, thanks, Gary.

Linda Bolton Weiser with Oppenheimer.

Gary, a lot of talk here about a business, BSG, that really represents a small part of your overall Company.

You're right; we sometimes lose focus of that.

Right. So it kind of occurs to me that -- why don't you just kind of discontinue it? It strikes me as a very independent business from the BSG store business, which you could certainly continue. You have just pointed out how high the fixed costs are. I think the operating margin of the BSG direct selling piece is extremely low relative to the stores. So you know, you could discontinue the business, cut the fixed costs, and it won't even dilute your earnings that much.

Well, that would be true. However, Linda, the brands that we represent, they want coverage in the salons. Truthfully, for that business to be healthy long-term, it is really the street business that drives the store business, particularly on new brands.

Keep in mind that the sales consultants are generally the ones that introduce new products. They sell education, and they sell promotions. So it really would not make sense strategically for us to do that.

Plus, if we did it, most of the manufacturers that we represent -- in particular, someone like Paul Mitchell -- really do not want us just as a store partner. They want us out there selling their brands as well. They have gotten heavily into the school business. You talk about a brand that is really exploding in the color category, Paul Mitchell is. They need that salon representation by the sales consultant to effect that plan properly.

So sure if you looked at just the numbers, what you said would be doable. But it is not something that would work in our industry. I believe that long-term, that this business will be fine.

If you look at the history of the business and take out the impact of our acquisitions, which we were making almost one every year, there is no reason that this business cannot be close to the Sally business on a margin standpoint. I don't believe that it will necessarily all ever get to where Sally is, but I believe it can be a double-digit earner.

Okay, thanks, that's helpful. Also can you just tell us a little more color on when this happened with Procter, when you lost some business two years ago, I think then you also tried to make up for it by getting other business and cutting costs, et cetera. Yet we really saw a very contracted operating margin for BSG for like three quarters. It was pretty significant. And this is even more business, so I guess I am just kind of wondering.

Keep in mind something, Linda, that only about half of the margin hit we took in that year, those three quarters you are talking about, had anything to do with Wella. We were also going through a significant integration of a major acquisition, that we had a lot of conversion costs that year. So it wasn't by any means all due to the Wella situation.

Also keep in mind that when we lost the Wella distribution rights, we lost it for the stores as well. So here that is not the case, and as I think you know from listening to us in the past, and you just mentioned yourself, that the store business is a slightly more profitable model.

We expect that a lot of people that are looking for these L'Oreal brands that can't buy them through the sales consultant, but yet don't have access either to another sales consultant or to a competitor's store in the geography, are going to come into the store. We expect the store business to actually improve. As you know, it is a better margin.

So I think all of that having been said that it is difficult to compare this to the Wella impact. But there is no question that this is going to be a difficult year for us.

I will tell you that when that happened with Wella, we were still very much -- I don't want to use the word handcuffed, but it is really the right word, by our L'Oreal contracts as far as going out and getting other brands to replace that Wella business with. We no longer have any of those constraints, and we will be actively pursuing other brands, like we just reached the agreement with P&G on, to bring more sales into BSG.

Okay, that's helpful. Just a question on the store side. I know you are expecting to ramp up the square footage growth. I was under the impression that ramp up would start fairly early in the fiscal year; and yet it wasn't quite as much as I had thought. So what is the schedule for ramping up that square footage growth, both for Sally stores and the BSG stores?

Well, the schedule is the same. We expect to increase our square footage 4% to 5%. Keep one thing in mind, in our first fiscal quarter is the month of December, obviously. You don't do a lot of store openings in December, partly because two weeks of that month we give to our set-up crews every year as their vacation time. But also, it is a very difficult time to be opening stores.

So our first quarter typically is lighter than the rest of the year. But we still expect to be opening the 4% to 5% new space.

So then fiscal second quarter, we should see like a bigger square footage growth percentage, kind of?

Yes, the second quarter and particularly the third quarter.

Okay. Okay, thanks very much.

Connie Maneaty with Prudential.

Could you put a dimension on what you think the sales potential of the new agreement with P&G would be, on an annual basis? Just to give us a sense of how much more revenue would need to be offset.

Connie, I would love to be able to do that, because a lot of this is new to us, I mean within the last week, the Southeastern portion of it, and we really don't know what to expect from that. The good news is, that piece of it should be positive to what we were expecting as short as two or three weeks ago.

But at this point, I really can't do that. I think we may be able to do that next quarter after we get a little bit under our belt of how things are going.

Also, as you noted earlier that Matrix is kind of a tired brand in salon distribution, and sales consultants are kind of frustrated with selling it, is there a sense or any scuttlebutt that Matrix could also just go direct to mass?

I don't think that would happen, Connie. L'Oreal is -- they have been in the professional industry a long time. That would send a terrible message to the professional customer. I would be very surprised if they went that route with any of their brands.

Okay, great, thank you.

Justin Lumiere with Oscar Gruss & Son.

I just have a pretty simple question, just one question, though. If I am a salon and I used to be serviced by a sales professional, how do I get product without having to go into the store, if it is inconvenient for me? Can you ship product?

No.

Okay. Can you only ship from the Sally stores, the Sally Beauty Supply stores?

Sally doesn't ship, period. Sally is a cash and carry store. But keep in mind, now, Sally doesn't represent these L'Oreal brands. That is BSG.

No, because on your website, actually, on the frequently asked questions, it says no phone or mail ordering is available, but some of our stores provide this service for their professional salon customers.

Well, yes, that is -- I shouldn't have said that no Sally store ships. There are a few that ship to some remote areas, but it is a very, very small piece of the business there. It is really not significant at all.

But to answer your question, if you are a salon, and you're using one of the L'Oreal brands, and you can no longer get it through your sales consultant, if you don't have another sales consultant calling on you right now, you really have to go to the store. I am sure that L'Oreal and their distributors have probably contacted these salons saying, hey, here is an 800 number you can call to another distributor that is outside this geography, who will ship it in; or something like that.

But it is part of the confusion that has been created by this, and part of our shock that they would do something like this, because it is creating a tremendous amount of disruption in the marketplace for the customer.

Why is it that you can't ship?

That is the agreement that we have.

Okay, and there is no changing that?

Well, I don't think so. They would have to suggest the change. We would be happy to do that, but I don't see that in the cards right now.

Okay, so your hands are tied right now on that issue. Okay, very good. Thank you.

Carla Casella with JPMorgan.

Hi, I am wondering if you're seeing any trends at either P&G or L'Oreal in terms of their own sales consultants? Have you seen them either add or subtract sales consultants? Or has P&G decided or agreed not to add in the territories where they are not -- where they cross over with you?

I think P&G's plan has been pretty clearly laid out, that they want to call or they want to be in the A and the B salons, so to speak, the large salons, with there own representation. I think they will adjust -- either add or delete --- their sales force as they see necessary to accomplish that goal.

And that we will be handling the majority of the salons; however, they are the smaller salons. Of course, we will be handling the store component of the business. In this Southeast arrangement that we have with them, we are handling the street and the store business for a pretty significant market. It includes six or seven states in the Southeast.

Okay, that's great.

As far as L'Oreal, I am not aware of them having a direct sales force other than for their Kerastase brand.

Okay. Then in your existing BSG stores that already carry P&G, what percentage of their sales are coming from the P&G product?

It is growing. When we parted ways with P&G a few years ago, it varied anywhere from 5% to 10%. It is not back at level yet, because of the disruption, but I fully expect that it will get back to that level over the next 12 to 24 months.

Okay, great. Then, is the store sales or the consultant piece of the P&G business going to be larger? Would the consultant piece be larger than the 500 store additions?

That is a good question. In the geographies that we are working with P&G, where they are also direct so to speak, I would expect that our business will be larger in the stores.

In the geographies, for example the Southeast that I just mentioned, I think that the business will be a little more slanted to the sales consultant. That is what historically we experienced when we used to carry it everywhere and they were not direct.

Okay. So overall, the additional P&G sales will probably net-net almost come 50% from stores and 50% from consultants, just depending on the area? I'm trying to get a sense for -- are those areas as big as the areas where you are adding stores?

Well, the area that we are sharing the street business with them is larger than the area where we have both the stores and the street. So looking at it in total, I would say that the store business could be a higher -- more than half of the total business.

Keep in mind that we have been their store partner for many years through an acquisition in California. That is a large state that we are well established with the store business and they are well established with their direct business. So that affects the percentages overall just because of the size of that market.

Okay, great. That's very helpful. Thanks a lot.

[Grant Jordan] with Wachovia Securities.

Most of my questions have been answered, but you talked a little bit about continuing to aggressively look at acquisitions on the BSG side. Maybe you could just remind us what you have historically paid for acquisitions, and maybe what that market looks like right now.

Well, what we have paid for acquisitions has been all over the board. If anything, it would be on the high side of what we would probably be paying going forward, simply because we in many cases paid a premium because we were getting into new geographies.

Now that we have a national footprint, two things will happen. The need to pay a premium just to get into the geography isn't there any longer. But probably more importantly than that, any acquisition that we make going forward would be highly synergistic, simply because we already have the infrastructure throughout the country now and we would not have to take any of the overhead with any acquired business going forward.

Okay. Then, just in terms of acquisitions, if there are potential acquisition target that has, say, an agreement with L'Oreal, am I thinking about it right that that probably would not be a good target for you now?

Yes, probably you're thinking about it right. That probably would not make a whole lot of sense.

Okay, great. Thank you.

We have time for one more question.

Susan Jansen with Lehman Brothers.

I just slipped in under the wire. A couple questions, First on what actually happened during the quarter. Secondly, a little bit of an observation question.

First of all, can you talk about the gross margin at BSG? Or the operating margin, it was down pretty materially and I think it was on product shift. So you can you tell us if you expect this to continue, really, going forward?

It is David. In the quarter, the BSG segment earnings margin, if you will, was impacted by a couple things. The margin percentage was impacted by the fact that of the roughly $22 million in BSG's revenue growth, about $10 million of that came in revenue that has traditionally carried very low margins with it, so that had the effect of overall depressing the margin percentage. It was a contribution towards segment operating earnings; but on a margin basis, it had a dilutive effect.

The other component there, or one of the other components, was general margin pressures among certain products. Then that had a negative impact overall.

So those are two of the big things that impacted the margin decline at the segment level from last year's first quarter of about 9.6% down to this year, about 7.5% or so.

What was it in that product category that drove sales so strongly?

I will give you one example. We do a huge business with a flatiron called the CHI iron, which is made by Farouk. Unfortunately, a lot of that product somehow or other was diverted into Target and other retailers at prices that were ridiculous relative to what we pay for the product and have to sell it for. So in order for the salons that we sell it to to be competitive, and particularly to our franchise operation that does a huge business with that product, they had to significantly reduce their margins just to be competitive. So that the salon could be competitive with a retailer who has no business carrying the product. So that is one example. It is a big example. But it was a significant example relative to the margin story.

Okay, and do you expect that to continue going forward?

You know, this diversion issue is a problem. We're doing everything that we can to not get behind the brands that don't seem to be able to control their division. But yes, I expect it to be a problem. I think that particular instance was just that, it was a particular instance, and I don't think that we will be experiencing that on a large scale.

But there is no question that diversion is creating some issues. I will say that there are several manufacturers -- and if any of you get the Nielsen report -- that actually are showing reduced sales of their brand through retail, which tells me that they are putting some effort into controlling diversion. But unfortunately, some of the larger ones don't seem to be making that same effort; and it is getting worse.

Okay. My second question is, how should we think about working capital going forward? Particularly with the changes to your business model this year, is it likely to be a source or a use of funds this year?

Well, you will see, actually, when we file the Q here tomorrow, if you look at the cash-flow statement, that within the quarter change in inventories was almost a $20 million source of cash. That is one of the items that we are focused on in terms of managing going forward, to use as a source of cash without overall having any type of adverse impact to the business.

If you look back on -- turns this year have been more around 2 times or so, and we're obviously trying to drive that number up going forward. So within the quarter when you look at our working capital changes, that was one of the items that positively impacted us, and is one of the things that we are looking at to help advantage the business and use those funds towards the uses that we said in terms of growing the business, paying down debt, etc.

A quick follow-up, David. Was that more a seasonal or is that more a onetime impact that happened in the quarter on inventories?

Overall, the Company has put in place a focus on more tightly managing the inventory. So that was the biggest piece of it, which is something that is a bit of a change from the days of being a subsidiary of Alberto-Culver.

Great, thank you.

I would like to thank everyone for joining us. We certainly appreciate your continued interest in our Company. Also I invite you if you have other questions to please give us a call. We will be happy to address those. And also invite any of you who would wish to come to Denton and learn more about Sally to do so. So thank you again.

Thank you.

This concludes today's conference call. You may now disconnect.