Sally Beauty Holdings Inc (SBH) 2007 Q3 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the Sally Beauty Holdings conference call to discuss the Company's third quarter fiscal 2007 results. (OPERATOR INSTRUCTIONS). Now I would like to turn the call over to Sandy Martin, Vice President of Investor Relations for the Company.

Thank you. 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 words such as may, will, should, 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 and its last two quarterly reports on Form 10-Q. The Company does not undertake any obligation to publicly update or revise its forward-looking statements.

The Company has provided a detailed explanation and reconciliation of its adjusting items and non-GAAP financial measures in its earnings press release and on its Web site today.

With me on the call today are Gary Winterhalter, President and Chief Executive Officer, David Rea, Senior Vice President and Chief Financial Officer, and Greg Coffey, Vice President and Treasurer.

Now I would like to turn the call over to Gary.

Thank you, Sandy. Good morning, everyone. Thank you for joining us for our third-quarter earnings call.

Today we reported an increase in consolidated revenues of almost 6% and comparable store sales growth of 4.8% for the third quarter. We were pleased to see a return to normal sales levels at Sally Beauty stores after challenges with weather earlier this year.

For our segments, Sally Beauty Supply recorded comp store sales increases of 3.4%, and Beauty Systems Group store comps grew 9.2%, very solid comps for both operating segments. Comparisons to last year's third quarter include a number of non-comparable items that David and I will detail in the discussion of our third-quarter operating and financial results.

Turning to the segment operating results, Sally Beauty Supply sales increased 12.9% over last year's third quarter, including 26 million in revenue from Salon Services, our UK-based business that we acquired in February. Excluding this acquisition, total sales for Sally Beauty Supply during the third quarter increased 5.6%. Revenue growth was primarily the result of expanding our store base and growth in comp store sales of 3.4%.

We continued to work on developing our Sally loyalty program and testing different advertising to drive traffic and build increased brand awareness. Sally Beauty Supply's segment operating margins remained solid at 16.6%, even with the year-ago quarter. In the short-term, our continued margin improvements for the U.S. Sally Beauty segment may be somewhat obscured by the growth in our international Sally business, especially until we anniversary the Salon Services acquisition in February of '08.

The revenue mix of retail versus professional sales in our Sally international business is currently more heavily weighted to the professional customer, especially in Europe. We expect to continue to make progress on growing our Sally international retail customer base, and we believe there is an opportunity for Sally international to enhance gross profit margins overtime by increasing the retail customer mix. We are also expecting significant synergies and margin enhancement from the integration of Salon Services into Sally UK.

As we mentioned last quarter, we are also working on a Sally Beauty Supply e-commerce site, which we expect to pilot this month. Initially, we plan to offer customers the ability to purchase professional electrical appliances like hair dryers and styling irons on the e-commerce site.

On the BSG side, the third quarter represented a full three-month impact of the lost L'Oreal revenue in our full-service channel for BSG's East and West territories. BSG recovered 14 million of this revenue shortfall through sales growth of non-L'Oreal products, as well as an additional 5 million of incremental revenues from the Salon Success acquisition that anniversaried in June.

Consolidation in the beauty industry continued, and in July, L'Oreal announced the acquisition of Maly's West. This furthers L'Oreal's salon products distribution strategy in the U.S. as they vertically integrate manufacturing and distribution. Maly's West is based in Southern California, with an estimated 187 million of annual revenues. BSG stores and sales consultants geographically overlap with all Maly's locations and sales consultants.

Since our second-quarter earnings call update, we have continued to add brands to BSG's distribution network, especially since L'Oreal's acquisition announcement last month. We believe that BSG will continue to attract new suppliers, gain additional brands, and expand its territories, in part based on L'Oreal's decision to distribute through two manufacturer-owned distributors.

Revenue and cost initiatives for BSG continue to make progress. As we commented earlier this year, and continue to see, our non-L'Oreal sales have exceeded prior-year levels in the DSC channel, and we also continue to see strong sales growth in our stores. We no longer expect a significant portion of L'Oreal products sales to shift to BSG stores. In fact, L'Oreal products sales sold through our BSG stores are about even with prior-year levels, and the margin pressure from those sales is expected to continue due to our lack of exclusivity. Since our DSC business generally operates at a lower profit margin than stores, BSG's gross margin pressure from L'Oreal has been, and is expected to continue to be, somewhat mitigated by the strength and growth of the store business.

I want to update you on BSG supplier changes. As expected, we continue to add brands to our distribution network, especially following the announcement from L'Oreal regarding Maly's West. We believe a number of key manufacturers have strong feelings about not wanting to distribute products through a competitor's network. Following the L'Oreal announcement, BSG was informed that it will be distributing Paul Mitchell products in Southern California. We believe that this development should have some modestly positive financial impact to fourth-quarter results, and will be even more significant to our fiscal 2008 revenues. We were successful in hiring the entire Paul Mitchell sales force from Maly's, which should ensure a smooth transition of this business to BSG.

During the third quarter, BSG entered into an agreement with KPSS to distribute the Goldwell and KMS brands in 28 states for stores and DSC. BSG and KPSS have been strategic partners in the past, and this agreement expands that relationship.

After Farouk Systems terminated its agreement with BSG during the second quarter, BSG stores and DSCs once again began distributing Farouk products in July, with an expanded distribution area that initially includes 30 states.

Also during the third quarter, BSG began the distribution of TIGI brands in BSG stores in 20 states, Nioxin in BSG stores in eight states and DSCs in one state, Rusk in 11 states and the DSC channel in six states, and the Kenra brand in BSG stores and DSCs in three states.

Recent discussions with both Paul Mitchell and Farouk management confirmed that they pulled out of Beauty Alliance and Maly's West because they are not comfortable having their products distributed by L'Oreal. We continue to pay retention incentives to certain DSCs most impacted by the L'Oreal changes, which cost us about 2.3 million during the third quarter. BSG also incurred right-sizing expenses for the quarter of 400,000.

BSG stores are expected to complete their CosmoProf sign change throughout the U.S. by the end of this fiscal year.

Finally, we are moving ahead on the two-year program to consolidate warehouses and reduce administrative expenses. We believe that the savings after implementation could be approximately $10 million annually.

Now I would like to turn the call over to David to further discuss third-quarter results.

Thanks, Gary. On a number of fronts, third-quarter results were a continuation of trends we discussed in the second quarter. Sally Beauty Supply continued its solid performance, while BSG continues to adapt to changes in the beauty products industry.

As Gary mentioned, the third quarter was the first full fiscal quarter of L'Oreal revenue losses, which had an estimated negative sales impact of approximately 30 million for this year's third quarter. Through a combination of strong comp store sales, coupled with acquisition-related revenue, BSG sales are only down 10.6 million for the third quarter versus the year-ago period. Total net sales for the third quarter were 635 million, an increase of 35 million. The third quarter's consolidated gross profit was 291 million, or 45.8% of sales, down 30 basis points from last year's 46.1% of sales.

Selling, general and administrative expenses increased 9.4% to 221 million in the quarter, which represented 34.9% of sales. SG&A expenses for the third quarter included 2.7 million in expenses related to BSG's retention incentive costs and right-sizing expenses. Also, the Company incurred additional SG&A expenses for legal, audit and professional fees in the third quarter, primarily related to the cost of being a new public company.

SG&A expenses also included 3.8 million of share-based compensation, compared to 1 million in last year's third quarter. Of the 3.8 million in share-based compensation in Q3, approximately 2.3 million represented the accelerated recognition of option expenses for certain retirement-eligible employees. This accounting (inaudible) will be necessary for all future equity grants to these employees. All other equity grants to employees will be expensed over the normal vesting period. The Company expects to issue equity awards to employees on an annual basis, which is currently anticipated to occur during the first fiscal quarter of each year beginning in 2008. And similar to this quarter, accelerated expenses for these retirement-eligible employees will be recognized at that time.

Year-to-date share-based compensation costs also include 5.3 million for the onetime early vesting of equity awards from the separation transaction from Alberto-Culver. Last year's third quarter SG&A included non-recurring expenses for a direct allocated overhead charge of 3.4 million, representing expense from Alberto-Culver that ceased after the separation transaction.

Turning to the segment operating earnings, third-quarter earnings for Sally Beauty Supply stores were 67 million, an increase of 13.4% over the year-ago quarter, and operating earnings as a percentage of sales were 16.6%, even with the year-ago quarter. The third-quarter operating earnings for Sally North America stores improved due to enhanced gross profit margins from selling and mix of higher-margin products, and also from carefully managed expenses, which leveraged costs versus the year-ago quarter.

For the international Sally Beauty Supply business, Q3 represented our first full quarter of results for Salon Services, our UK acquisition within the Sally operating segment.

For BSG, revenues were down almost 11 million for the quarter versus last year, and segment operating earnings were 15 million, down 38% from the year-ago quarter. BSG's segment operating margins were 6.6% of sales for the quarter versus 10.3 in the prior-year quarter. BSG's operating earnings were primarily impacted during the third quarter by lost L'Oreal sales, retention incentives paid to DSCs, as well as some additional right-sizing expenses that totaled 2.7 million, a decline in the profitability in the BSG franchise business, and continued pressure on gross margins.

We expect BSG to continue to experience margin pressures as we work through the loss of the L'Oreal revenues. We expect DSC retention incentives to decline over time. These incentives are currently structured as commission, subsidies and guarantees that will terminate completely by February 2008.

While sales of non-L'Oreal products have continued to perform well, DSC sales of L'Oreal products do not appear to have shifted to the BSG stores, as originally expected. With that said, third-quarter comp store sales for BSG were strong, and we are clearly driving additional non-L'Oreal business through stores with new brands.

We continue to be very focused on both short and long-term revenue and cost initiatives for BSG that we expect could lessen some of the negative impact for the remaining fiscal year and into fiscal 2008.

Our primary driver for minimizing the revenue loss from L'Oreal is to replace the sales. Given the recent acquisitions by L'Oreal of Beauty Alliance and Maly's West, we expect more opportunities for BSG to add new brands into stores in its DSC channel. We will continue to update you on our progress concerning BSG's revenue and cost initiatives during our fourth-quarter call in November.

Previously I explained how we excluded certain corporate and shared service costs from the operating segments. These unallocated general and administrative expenses include, in addition to general overhead costs, direct allocations from Alberto-Culver up to the time of the separation, as well as share-based compensation expenses, both of which were discussed as part of SG&A.

We currently expect unallocated G&A expenses to be approximately 92 million for fiscal year 2007. This increase to the G&A guidance previously provided is due to additional share-based compensation expenses this quarter, as well as increased staffing and outside professional costs during our first year as a public company. While we have had some negative leverage on corporate overhead expenses during this year, we believe we will stabilize the base of corporate costs and share-based compensation, and hope to begin leveraging corporate overhead costs in fiscal 2008.

Our unallocated G&A expense projection of 92 million for fiscal 2007 includes 1 million of Alberto-Culver allocated overhead charges incurred in the first quarter, and all share-based compensation expenses, including 5.3 million of option expense recognized in the first quarter related to the separation.

Interest expense net of interest income was 37 million, versus 43 million recognized in Q2 2007. For the three months ended June 30, 2007, the Company recognized 4 million of non-cash interest income based on changes in the fair value of our interest rate swaps. This is the proper GAAP accounting treatment for swaps that does not meet the hedge accounting requirements, and the swaps take 500 million of our floating rate debt and fixes the cash interest expense for the life of the swaps.

Our pre-tax earnings for the third quarter were approximately 22 million, and the provision for income taxes for the third quarter was about 8 million. The year-to-date tax provision of 29 million looks unusual given our pre-tax earnings for the first nine months of almost 57 million, but the first-quarter tax provision reflects the non-deductibility of a majority of the separation transaction expenses recognized in that quarter. Excluding the impact of these amounts, the Company currently expects to have a 36.7% effective tax rate for fiscal 2007.

Net earnings for the quarter were 13.4 million, or $0.07 per diluted share. In an effort to provide you with other metrics that we believe are useful in understanding results, we have included in the press release a supplemental schedule that provides certain non-GAAP disclosures and reconciles these numbers back to the equivalent GAAP financial measures.

We have provided an adjusted EBITDA number, which begins with net earnings based on GAAP, adds back depreciation and amortization, share-based compensation expenses, Alberto-Culver transaction fees or expenses, and interest expense and a provision for income taxes discussed above. Adjusted EBITDA for the third quarter was 73.2 million, a $1.7 million decline compared to the prior-year quarter, due to decreases, primarily decreases in BSG's profitability this year, as previously discussed. Our reconciliation of GAAP net earnings to adjusted EBITDA is included in the schedule that is part of today's release.

Turning to the capital liquidity area, we paid down 22 million of debt during the quarter. We continue to be focused on managing inventory and other working capital in an effort to produce a source of cash without adversely impacting the business. The Company's current goal for the full fiscal year is to reduce consolidated inventories by over 40 million, excluding acquisition-related inventory.

As we mentioned last quarter, our intentions for cash are to grow the business, invest in new stores, make strategic acquisitions and pay down debt. We continue to project that net capital expenditures for fiscal 2007 will be between 45 and 50 million. Projected net capital expenditures do not include any potential acquisitions and are net of proceeds from the sale of property and equipment.

During the third quarter we increased the Sally Beauty Supply store base by 34 stores and 13 net new BSG stores. In Florida, looking at the combination of owned and franchise locations, we project a total of 15 stores in operation by the end of fiscal 2007, and 35 total [floor] stores by January 2008.

Last quarter we ended with borrowings on the revolving ABL facility of 58 million. By the end of Q3 we paid down the ABL facility to $40 million with approximately 303 million of available capacity on the revolver. In addition we paid down 2 million on each of the senior term loan A and senior term loan B loans during the third quarter. We ended the third quarter with long-term debt, including capital leases, of about 1.81 billion.

Based upon recent capital market trends, it appears that there has been a downturn in the credit margins that has caused general concerns about liquidity and short-term refinancing for leveraged companies. Let me walk you through our current financial position.

Debt maturities for fiscal 2008 are 17 million, and fiscal years '09 and '10 are 24 million each, respectively, excluding any potential repayments related to our excess cash flow test under the term A and B loans. Schedule E from our Q3 press release has the table of debt maturities excluding capital leases.

During the first nine months of our current fiscal year, the business generated almost 128 million of cash from operating activities, while we currently expect to only spend approximately 115 to 120 on the combination of capital expenditures and acquisitions for the entire fiscal year, assuming 70 million of acquisitions so far this year. As a result, we currently expect to pay down additional debt in the fourth quarter.

As you know, we're always looking for the most appropriate ways to utilize our cash resources. Based on recent volatility in the capital markets, some investors have inquired about our ability or intention to repurchase the Company's debt securities. In general, we are not prohibited from repurchasing the Company's debt securities on the open market through private negotiations, transactions, or otherwise. However, our credit agreements and indentures set quantitative limits or baskets on payments to junior creditors. These quantitative limits are subject to change, but the most restrictive of these currently caps us at about 100 million for any such payments. In addition, any use of the baskets for purposes of buying notes would limit the Company's flexibility on uses of cash for other activities.

As we said on our second-quarter call, fiscal year 2007 looks to be a challenging year for BSG as it rebuilds its revenue base, but we also expect Sally Beauty Supply segment financial results to remain strong. We recently began our annual planning process for fiscal 2008, and we are optimistic about the momentum in our business going into fiscal 2008.

With that said, I'd like to open the call up for questions. Thank you for your interest in our company.

(OPERATOR INSTRUCTIONS). Karru Martinson, Deutsche Bank.

In terms of just housekeeping, as far as -- I thought I heard free cash flow before CapEx of 115 to roughly 120 before -- for the year, correct?

What we said was our total investing would be in the 115 to 120, including acquisitions.

Including acquisitions. It seemed like working capital was a source of cash for you this quarter. Is that just a timing issue compared with the year ago, or that's the inventory work-down that you're going through? Kind of give us some color on the drivers there.

Sure. Most of the -- with respect to the quarter, we continue to, obviously, try and reduce inventories. Much of it was more related to just overall working capital than the inventories. The bulk of the inventory reduction occurred earlier in the year.

And then, just in terms of the Farouk Systems returning and other professionals, since they just left, were you in discussions, or how did this all take place? It's about 30 million of revenue, correct?

That's correct. We had been in discussions since shortly after parting ways with them. I think they were a little disappointed in the L'Oreal purchase of Beauty Alliance shortly after we parted ways with them. And I think that drove their decision to come back. But we had -- we have and have always had a very strong relationship with Farouk through our Armstrong McCall division. It's a significant piece of Armstrong McCall sales throughout the southern third of the U.S. and Mexico. So it wasn't like there was an ugly situation to begin with; I think they made a decision based on some facts that turned out to be not necessarily accurate shortly after they made their decision.

Justin Hott, Bear Stearns.

First question, I'm a little confused on some of the comments on BSG. It sounds like sales are doing better; margins are doing worse. There was some previous guidance on how BSG would be affected by L'Oreal. Can you update us, I guess, looking toward '08, and really just give us a summary? Do you think you're doing better or worse than what you previously said?

I actually think we're doing better than we previously said, particularly on the revenue line, although a lot of the brands that we mentioned coming on board are just now happening, and will have some impact on Q4 and a significant impact on '08. Example of that is the Paul Mitchell situation in Southern California, this whole Farouk situation, the Goldwell situation. So, I think, even though I've been very pleased with the revenue that we've brought back into BSG, the major pieces of that are just now beginning.

On the margin line, if you take our quarter of almost $2.5 million in retention bonuses, as these -- not bonuses -- retention incentives, as these brands come on, we will be able to eliminate those, which will help our margins. A lot of the difference is being driven by the gross profit margin line, and we will anniversary that probably in January relative to the L'Oreal business. And a lot of the brands that are coming on now, as they kick in in the stores, with the store margins being significantly stronger than the street margins, I think we'll see the margins rebound nicely.

Gary, on the store part, on BSG, one of the things we're wondering is with what you've said now about L'Oreal about the shift, I guess, toward the stores maybe not being as strong as expected, is there any decrease in traffic because you don't have the L'Oreal brands in your stores anymore? And sort of as a follow-up, I guess, on that one -- well, let's just go there, and then I'll get back in the queue.

Our traffic is actually up significantly in the BSG stores. What's difficult to determine is was there a L'Oreal customer that was buying L'Oreal brands that is no longer coming in because a competitor has L'Oreal brands? I don't necessarily know the answer to that, but we still have the L'Oreal brands in the stores. What we're not seeing is some of the street business that we expected would migrate to the stores for the L'Oreal brands is not happening. As David and I both mentioned, our L'Oreal sales in the stores are exactly flat. Now, long-term, that's a good thing for us. And fortunately, short-term, we have been able to make up that plus more business that we anticipated would be coming into the stores. But the answer to your question is our traffic in the BSG stores is up.

Just one more thing here; I guess it's just a side part to this question. In previous times you've mentioned -- previous calls you've mentioned your retention of key salespeople, some sort of numbers, some percentage of what you've been able to retain. Can you give us an update on that?

Sure. I think last quarter we told you that of the sales consultants that we determined we wanted to keep, we were at 88% of those. We are still at 88 or 89%. And we've actually had a couple of sales consultants in the upper Midwest, good sales consultants, that had left us that have now come back.

Linda Bolton Weiser, Oppenheimer.

My first question just has to do with the Sally store side of it. It still seems to me that the square footage growth is still not ramped up to, I guess, what you were talking about. So maybe you could just indicate the timing of when that might ramp up more significantly. And also in the Sally stores, can you comment -- the percentage of sales who -- regular consumers that are nonprofessional, maybe this quarter versus in the quarter in the prior year?

Yes. I'll handle the second part of that, and then let David handle the first part of it. Our business in Sally continues to migrate more and more toward the consumer. And a year ago -- these are round numbers -- we were in the 69-or-so% consumer business with Sally, and now that's slightly over 70, which has been the history of about a 1 or 1.5% change on an annual basis. David, you want handle the store count?

Sure. With respect to the store count, what we have previously been saying is we expected our square footage in total for the Company to grow at about 4 to 5%. And that's -- at the end of this year, that's for all of SBS; that's what we expect to be at the low-end of that admittedly. We do expect to be there excluding acquisition; obviously, the Salon Services acquisition adds a lot of stores net. But excluding that, we thought we'd be in the 4 to 5% range. We think we'll be at the bottom-end of that range this year. And we would hope to accelerate on that going into next year. We are in the fourth quarter probably going to have lower openings than we did in Q3; not a whole bunch lower. But going into next year, we expect to try and move that growth percentage up.

Linda, keep in mind also, on the Sally side, if you include the acquisition, our space grew 7%. And historically, when we make a fairly significant acquisition -- and in this case it was, I think, 99 stores -- we sometimes, just due to resource limitations, will slow down our organic growth just a little bit to enable us to incorporate the new stores into the system, and do that without disruption.

Thanks. Just for my second question, just on that topic of acquisitions, what are you seeing in terms of pricing for acquisitions for deals you're looking at, and has that changed recently? And how would there be a difference in valuations between retail chains like you bought in the UK versus BSG-type of acquisitions?

I don't -- on the Sally side, as I think we've said in the past, I don't really see a lot of acquisition activity, particularly in North America. We may see more opportunities outside North America. And I don't think that those valuations have really changed much. There's not much reason for them to. On the BSG side, obviously, it probably wouldn't make a lot of sense for us to be making acquisitions of distributors that are heavily into the L'Oreal brands, and there's, truthfully, not a lot of those out there anyway. So the other acquisitions that you would see us make of the non-L'Oreal distribution, there's really not a reason that those valuations would change a great deal. And I think you will see us be making several small acquisitions, as we've stated in the past, that will be extremely synergistic and accretive to the BSG business since we already have the national infrastructure in place.

Laura Richardson, BB&T.

Two questions. One is could you talk about the ad testing you're doing at Sally? And two is, could you talk about the cost expectations you have that are going to keep the income statement for all the distribution consolidation and other transitions in Beauty Systems? That's it. Thanks.

I'll take the first part of that question on the advertising. We've been testing, particularly in the Sally side, in just a few test markets some FSI advertising. We really don't have a lot of the results of that at this point; it just happened in early July and the latter part of June. And as I mentioned, we are firing up the tests on the Internet site here. And Mike Spinozzi, during -- I think during the first quarter of our fiscal '08, you'll see more of the retail advertising testing that he's planning. He's been working very hard on putting all that together, and we expect to be starting the tests on most of it here at the very end of the fiscal year, and then into the fall season. David, do you want to handle the rest?

Sure. If I understand your question on the distribution project, that's a two-year project. We are expecting to have about a $19 million total capital cost for that, which we're underway. So we'll see, hopefully, some of that cost come through here in fourth quarter from a capital perspective, and then more, the bulk of it, in fiscal '08. And we would hope that could produce annual savings after that completion of the project of $10 million. Between now and then, we would also, though, expect to have onetime realignment expenses associated with closing facilities and that type of thing, which will be recognized at the time that those are decided and communicated.

Any thought on what the magnitude of the onetime expenses are? Because I assume not everything you do is going to be capital; there's going to be a lot of moving product around, and personnel changes, and maybe systems integration that you can't capitalize.

That's correct. There will be those types of expenses. And we don't have an exact number on that, but it could be in the 3 to $5 million range, something like that.

In total, over --?

Yes. Because it will be -- this is, as I say, a two-year phased project. So, as we go place by place, piece by piece, then we'll be incurring -- much like we have in the right-sizing of BSG this year, as we've made those changes, then those costs have come through. And what we would anticipate doing is highlighting and extracting those costs, and identifying them for you as we incur them. So we'll let you know as we get those.

Can I follow-up also on Gary's commentary on the ad testing? I'm just wondering, Gary, is it -- how long do you anticipate you're going to be testing advertising before you make a decision of, hey, do we go national with this or not?

Until we determine if it works.

A couple quarters, at least, it sounds like?

I would say a couple quarters at least, sure. Because we want to make sure that we don't just get a onetime hit from an ad, and then we don't establish a new customer or continued visits from that customer. But we -- Mike Spinozzi is doing a lot of work also with our loyalty programs, which we still think will be the most efficient way to advertise to prospective new customers by data-mining the existing Beauty Club Card members, just to determine their demographics and psychographics, and then specifically go after those customers. So, a lot of what you'll see us do, you probably won't see in the way of TV or print or something like that, because it's more of the, I guess, guerrilla-type advertising. And with a customer base of almost 5 million Beauty Club Card members now, it's a pretty significant base to be drawing data from.

Reade Kem, Merrill Lynch.

This is actually [Kira Shay] in for Reade Kem. I know you went over this a little bit earlier, but I missed what you said. I was wondering if you could go over how much both traffic and transaction contributed to each of the segments in the quarter?

We have not -- in terms of transactions, specific transaction [fees]? I'm not quite sure what you're asking.

Just average number of transactions, and value of that, and (multiple speakers)

We have not previously gone in and disclosed that.

Okay. Following up to some of the acquisition comments made, following the recent consolidations in the industry, are you hearing anything from some of your smaller -- some of the smaller distributors out there expressing any interest in wanting to sell their business? And how has that changed any of your acquisition plans?

That's really been going on for several years, even before L'Oreal decided to get into distribution. And what's happening is a lot of these smaller distributors that don't have stores are under a lot of pressure from the manufacturers that they represent to, obviously, increase share and increase sales and purchases. And it's very difficult for these folks to do without a store base, because stores are well over half of the business today for all the distributors that have stores. So what that's done is put some pressure on some of these folks to either sell the business to someone like us who has the store network, or to at least partner with someone who can provide the store network for them, and then they keep the street sales, which we've done that with several small manufacturers. But I don't think that whole scenario has really been changed too much by the recent acquisitions that L'Oreal has made, or that we have made.

Can you allude to any acquisitions you might have in the pipeline for retail or wholesale, or just any plans in the near-term future?

We always have plans, and we're always working on numerous acquisitions. Obviously, we can't comment in any detail on any of that.

Lastly, on the BSG side, can you tell us how many sales consultants you had at the end of the quarter? And can you discuss any changes you've seen in the productivity of your consultants, 2Q versus 3Q?

Actually, our productivity continues to rise. We have put in a pretty sophisticated routing system that enables us to track exactly what sales consultants are doing on a daily and almost hourly basis. So the productivity is up. And the number of sales consultants we had at the end of the quarter was 1011.

[Greg Nathan], First Pacific Advisors.

I was just wondering if you could give me a little bit more detail on the - you talked about 100 million that you're able to potentially pay down on the senior and senior sub notes. Can you give me more detail on what the restrictions are, and how that will work in a given year?

The restrictions are pretty straightforward. They say that we're limited in the amount that we can do in debt repurchases to -- the restrictions come into play for our senior debt; they restrict the amounts that we can pay in buying back our public notes. And it's pretty straightforward; buyback of the debt does count toward a restricted payment basket under those term loans. So it's a pretty straightforward calculation.

So you basically have 100 million, up to 100 million per year that you can do?

At this time we have 100 million. It fluctuates over time. We've simplified. That 100 million is really two different baskets that work different ways, so it gets more complicated than that. And you'd just probably -- I hate to say it out, but you'd probably just have to read the documents to figure out all the nuances of it. But that's -- at this time, it's around 100 million that we can do.

The primary issue there is the -- on both the public notes and the term A, B have what's commonly known as a restricted payment basket, and the calculation related to that, which relates -- it builds up over time as you create earnings and get (inaudible) credit, if you will, for part of that. So that's the over-time piece of it, and then there are other baskets to utilize, or could be utilized on it as well. Obviously, given our overall capital structure and the waterfall effect, senior debtholders don't like cash leaving the box, if you will, paying off junior creditors ahead of their maturity. So it's not -- it's a pretty normal type of structure.

I guess I'm just trying to understand, did you have to pay the 22.3 million to -- some of it went to the term loans (inaudible). Did you have to pay that to those guys as (inaudible) pay those loans back, and not pay the senior and senior sub notes?

We have a repayment schedule that is required in the term loans. And so it's a maturity schedule, so to speak, that we -- those are mandatory payments. The term loans are the loans that contain the provisions that restrict us on how much we can buy back of the senior and subordinated notes.

Just to be clear, if you look on schedule -- supplemental schedule E, at the bottom of the page we provide a debt maturity schedule for you. So it's 16.7 million in '08, 24.2 million '09, '10 on. So those are our debt maturities. And then, I thought the question you were asking is --

Your excess cash flow (multiple speakers)

With respect to possible repurchases, so that would be at the Company's election, there are limitations in what we can buy. So that's a separate issue. And then, with respect to the excess cash flow, the term A and B have a repayment provision so that a portion of our excess cash flows defined in those documents is used to pay down that debt. So there are really kind of three separate things going on. You have debt maturities as shown in schedule E, you have an excess cash flow test which begins in fiscal '08, which may kick in, and then you have a question of whether the Company could go out in the open market and repurchase some of its debt securities, and there's limitations, as we described, on that.

So just think of generally max 100 million in a given year, and that anniversaries every fiscal year ending, so --

(multiple speakers)

(multiple speakers) given year. It's a total at any given time.

Peter Grondin, OSS Capital.

Quick question on the inventories; I just want to be clear. You had said that you're looking to take down inventories for about 40 million for the fiscal year ended '07. If I'm reading the press release right, you've done 39 through nine months? Is that correct?

Yes.

So basically we're kind of there for the year?

Honestly, we're always looking (multiple speakers)

I appreciate that.

The bulk -- as I said, the bulk of our inventory gain from a working capital perspective, I think, has already occurred this year.

Is there -- do you think there's something of that magnitude next year, or is it too early to tell?

It's probably going to be more difficult to get that type of change out of inventories without doing some other things that are more fundamentally different for the business. What we did this year, frankly, is just taking the inventories that were excess under sort of previous ownership, and taking that out. I think the next level is going to be more of a challenge without impacting the business, in taking those terms out, yet at the same time still having the right type of inventory at those stores when the customer wants it. But we are looking at some things that could produce some more savings. But those aren't kicking in yet, and we'll see if we can implement those or not.

I'll add to that, though, that there are a couple of things that will be happening in '08 that will enable us to reduce some inventory, and that is we will -- one of them is the consolidation of BSG Western distribution centers into the one we have been talking about, which will start to have impact in '08. Another one is the consolidation of our two businesses in the UK, which will happen during '08. And we're also starting to ship some of our franchise business out of BSG warehouses, so we can eliminate some inventory duplication there. So I think those three things, as well as what David said, could help us in '08.

We also -- one of the -- counterbalancing that is, though, when we get new brands, we also have inventories related to those new brands, which tend to have a sort of opposite impact. So (inaudible) at this point we're not quite clear. So we've got some good things on that side, as Gary mentioned, and new inventory related to new brands, which we certainly want to do from a perspective of reselling the revenue, but they also do have some pressures on inventory.

That's correct.

One other question and I'll get back in the queue. There is -- if you look at -- by my math, BSG margins were about 6.6% for the quarter.

Yes.

And that's actually up a little bit from the second quarter; I think you were at 5.9%.

Yes.

So on a percentage basis, it's a reasonable increase. Is that a trajectory we can kind of think about going into the fourth quarter and the first few quarters of the next year, in terms of percentage improvement on the margin from the prior quarter?

For this quarter, you're absolutely right. We are at 6.6% for BSG earnings, versus the 10.3% same quarter last year. And this quarter was an improvement from prior quarter. Obviously, we disclosed, and Gary and I both talked about the $2.3 million of DSC retention incentives, 0.4 million for the right-sizing. So if you were to adjust, if you will, for those, the margins would be closer to 8% in this quarter without those in it. And therefore, the question really is what do you do after that? Can you get back to the 10%? Gary, if you want to talk a little about that.

As we've said before, it took us one year to rebound from an operating margin standpoint when we had the falling out with Wella two years ago. And the falling out with L'Oreal is much more significant, but I believe it still will take us about a year. I think by the second or third quarter of next year, BSG margins should be back to historical levels, or levels that were prior to this happening.

I think you said in the call that you sort of anniversary that kind of thing by February in terms of the retention bonuses, retention [comp] schemes. So, kind of Q2, Q3, theoretically -- I'm not putting you down, but just doing my math -- we should be at sort of 8, 9%, or something like that, just by the math that you're talking about.

The retention incentives should all be ending by February of '08. So to the extent revenues go up, then part of that calculation starts to go down. But they all should be -- both the subsidy and the guarantee should be complete by February of '08.

Justin Hott, Bear Stearns.

I want to ask a question on some of the brands you have in your BSG portfolio, but the overall theme on it is you now have a lot of brands, but they're not L'Oreal brands. And the L'Oreal brands might be the strongest in the industry. How do you go about going from having a bunch of different brands to building a couple into powerhouses? And with that in mind, let me jump to the individual brands, because I realize we're supposed to phrase this in the form of two questions, so I'm going to ramble on here. Matrix -- is this still -- now that you have it, and your relationship with L'Oreal is fractured, are you still getting the support you would have thought out in Armstrong McCall? Or just because you have it, it doesn't mean it might not get enough support? Also, status on Procter & Gamble, how large you think Paul Mitchell could be, and just what's incremental on Farouk? Last quarter we heard some commentary about how you would be replacing it with another brand. So you're getting back 3% of sales; I'm just wondering if this is a net neutral.

Let me make some broad statements to try and address that. First of all, what you're saying about the L'Oreal brands is correct as of 2007. I've been in this business almost 40 years, and the brands that they have today weren't even around 20 and 25 years ago. So the brands in our industry may be on top today, and not on top five years from now. The beauty industry is fickle. Stylists are fickle. As you know, you're married to one, right? But I think that what -- if L'Oreal doesn't get their arms around some of the diversion issues, particularly on Matrix, I think that the stylists are going to be soured on that brand. And keep in mind, the brands that we are bringing on board in many cases are large, multinational brands that are much larger outside the U.S. than they are in the U.S., And have been looking for a long time to find a way to increase their market share in the U.S., and prior to now have really been limited in their distribution options here in the U.S. because both of the major distributors, us and Beauty Alliance, were heavily into the L'Oreal brands.

So you look at a brand like Goldwell; you look at a brand like Shiseido's Joico and ISO; you look at the P&G brands -- these are brands that have significant market shares outside the U.S. that, I think, with the pockets that they have to increase these market share in the U.S. with these brands, you're going to see some significant growth. Most of those brands in the past have not been with distributors that had a store network.

Also, the independents that are still here in the U.S., specifically Paul Mitchell and TIGI and Farouk, are brands that are growing at a much faster percentage pace than the L'Oreal brands today. So, 20 years ago, when Redken was really the only exclusive full-service brand, they got very difficult to deal with. And Matrix came along and really knocked them off in the '80s. And I think that you will see a lot of that happening going forward. The playing field is much more level for a lot of the other brands that have been looking to get a foothold in the U.S.

Gary, what I'm wondering here is Sally -- if BSG is now, let's call it, the kingmaker; if you can either go to L'Oreal or you can go to BSG, and L'Oreal will be supporting mostly L'Oreal brands, and if BSG is the kingmaker in making brands because you have such distribution, have you changed any of your thinking about this? Is there a different strategic approach? Or is it just let's get all the brands in here and then see how they sort each other out and see who does the best job? I'm just trying to understand the strategy here.

No. We're not taking the approach of let's get all the brands in here. We want to put our distribution system behind international brands that we know are here that won't be acquired, and that we know are here to increase market share in the U.S. We also will be putting our efforts behind the Paul Mitchells of the world. They've been an excellent business partner. I think as we get back with Farouk, that will prove to be an excellent relationship as well.

So there's dozens of small brands out there, Justin, that if they're looking for store distribution, we will be happy to give them store distribution. But we're going to be very selective on where we put our emphasis going forward. And it will be with the brands that, number one, have the deep pockets to support their brand, and number two, we don't have to be concerned about the future of the brand and whose hands it will be in.

Any commentary on those individual brands, I guess, parts 20 through 35 of my question?

What now?

Matrix -- I'm wondering if it's getting -- just because L'Oreal has a contract with you, if they're supporting it? Proctor --

Matrix -- we're getting the same support at the Armstrong McCall business with Matrix that we've always received. And in Canada, we are continuing to get the support that we've always received. And keep in mind that I still would venture to say we're L'Oreal's largest customer just through our store purchases in the U.S. And they're supporting that business.

And the others were the Proctor brands, Farouk. And I was wondering -- the biggest one, I guess, would be just how large Paul Mitchell is on the West Coast.

Paul Mitchell being birthed on the West Coast and being a West Coast Company is extremely strong on the West Coast. We will be gaining a very nice piece of business in Southern California. We have been the Paul Mitchell distributor in the rest of California through our West Coast acquisition, and West Coast was the first Paul Mitchell distributor back in 1980 or '81. So it's a very strong brand, and they are doing just a wonderful job in cleaning up diversion. And I think this is a brand to be reckoned with going forward. It's not a new brand, but John Paul DeJoria is a great business partner. And he's very, very loyal and very passionate about the beauty industry.

Is there anything -- in terms of other brands, is there anything as exciting out there as Paul Mitchell and Wella? These are the two big ones, right?

I think that Goldwell is going to surprise everyone. It's an excellent brand of hair color. And like I said, they've been with very small distributors. But in spite of that, they have a nice share in the U.S., and a much greater share outside the U.S. To say the next exciting brand, I don't know what the next exciting brand is. But I believe that the future of the brands that we are involved with now is very bright. And I think a lot of people are looking at this as a huge opportunity and a huge window that L'Oreal has really opened up for them in their decision to part ways with us on the street.

Amanda, we want to take two more callers, if that's okay.

Grant Jordan, Wachovia.

You talked about margin pressure on certain other products at BSG. Can you just give us a little more detail on that?

Sure. As we've discussed here for the last couple quarters, part of what's happening at BSG is with the loss of the DSC distribution rights, we're having some margin pressures on our L'Oreal product, which is now on a non-exclusive basis within the BSG East and West territories. So that's part. And then what's happening is we've been re-filling the revenue bucket and doing a good job there, but some of that revenue has been coming in at a lower margin. So we've been replacing revenues at one margin with new revenues at a lower margin. So those are parts of that puzzle.

You talked about reducing inventory by 40 million this year. Is it in any specific category, or is it pretty much across the board?

It's been pretty much across the board. I would stay with that. It's been pretty much across the board.

My last question. Did you look at the Maly's West acquisition, or was that a pretty heavy L'Oreal distributor?

We can't comment on that.

Did it have a large proportion of L'Oreal business prior to the acquisition?

We don't know. But I suspect, given just what I know about the industry, that yes; it was significant.

Chip Allison, ING.

Just to go at it one more time -- with the credit agreement and your ability to buy back bonds, I forget the -- I guess there's an ability, a $100 million basket which grows with earnings. What is your willingness to do so? It would seem to make more sense than to buy back higher cost at a discount.

As we said, we've got both stated debt maturities, so that's one thing; we then have the excess cash flow piece of it. And then the last question which, I think, you're asking is just do we want to utilize that bucket for repurchase or not? And as we said now several times, our focus is on growing the business. Gary mentioned we have -- I talked about previously the possibility for acquisitions and use of capital to grow the business there. We are actively growing the business on the store side. So, in the interim, we are paying down debt. As we talked about, the revolver declined from the end of Q2, the end of Q3, and it's our current expectation that we'd show some reduction on the revolver in Q4 as well. That's something that we, obviously, always continually evaluate whether that makes sense or not. So that's always a question that we'll look at.

So you're just looking at, essentially, the IRRs of investing in a business or making an acquisition, versus the IRRs of buying back debt, and patching this together and doing the appropriate thing, right?

Our primary business is in the beauty products business, not as a bond trader. So our focus is first and foremost on the business. And then, to the extent that we can optimize our capital structure and manage our balance sheet, then certainly we want to do so. But as we said, we're looking at fundamental parts of our business from a store growth perspective and acquisition perspective. And yet at the same time, if we can deleverage and it makes sense, then that's something we're going to look at.

Thank you very much. We appreciate your interest in the Company, and we will be speaking to you soon. Bye.

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