Special Situation Investing

Sunday, November 26, 2006

Sally Beauty Holdings (SBH) - Spinoff Analysis

Sally Beuty Holdings (SBH) was spun-off from Alberto-Culver (ACV) last week. The stock had a great run in it's opening week, rising from an initial $7.35 to $8.65. However, after having a look at the sec filings, I am going to stay clear of this one.

My problem with this one is that SBH has a massive amount of debt to the tune of $1.85 billion. This compares with $2.25 billion in sales and operating income of $192 million at the company last year. I do now know what interest rate SBH will be paying on the debt but in general, junk rated debt goes for ~10%. It is possible that SBH has better interest rate terms but if so probably only by 1 or 2%. What it comes down to is that the interest payments alone will eat up most of the operating profits. After taxes you are not going to be looking at very much booty.

Now there are several ways for a company to deal with large debt-loads. You can pay it off, you can grow and thereby reduce it's relative size or you can simply wait and inflationa will gradually reduce the debt's relative size. Obviously the last item is only an option for governments. SBH is likely planning some combination of the first and second options but it seems that this is going to require considerable time. If my analysis is correct, SBH has very little funds left after paying the debt and so paying off a debt of this size will take a very long time. Start thinking in terms of years. SBH has no choice but to grow their way out of the debt load, hopefully reducing it as they go.

When you look at the company from the perspective of growth you are just not getting that much of a bargain relative to the risks associated with the debt. From 2001 to 2005 SBH grew at an average rate of just over 11%. For the past 9 months, the rate has fallen to ~5%. This represents a fairly average growth rate and as such an average P/E, perhaps in the 14-17 range given the lack of a moat. At current prices, SBH has a market cap of ~$1.53 billion, against net income for the first 9 months of the year (prior to the debt-load coming into the picture) of $108 million excluding special charges. Extrapolating the results out for the full year (past results indicate there is little seasonal effects so I just multiply by 1.33) provides a P/E of ~10.7. So excluding all of the interest payments the company might be worth 30-60% more. Including all of the debt the earnings drop closer to nothing and the P/E is ridiculous.

Let's look at a quick scenario to see just how much growth can improve the situation. If the company can continue to grow revenue and profits at 11% (historically the profit growth has considerably lagged revenue growth so this is questionable) then in 6.5 years time earnings will have doubled. Let's say that the company has reduced the debt from $1.85 billion to $1.5 billion. This assumes they are putting a considerable sum of the growing earnings towards debt repayment. Let's also assume, very optimistically, that the company's debt load is only 8%. Even in this fantasy model, the company would have earnings of $170 million and might warrant a market cap of $3 billion (P/E 17.5). In that case you would have doubled your money after 6.5 years. However, if the company takes out more debt, issues new equity, grows slower than expected, if interest rates spike, if anything goes wrong at all I can't see this turning out well. Where is the margin of safety?

Another item that caught my attention is the external investments that were made into the spinoff. Independant investors contributed $575 million to SBH allowing it to pay out a special dividend. In return they recevied 47.5% of the company. The remaining ownership of the company went to ACV shareholders via the spinoff. At present prices, their $575 million investment has already grown ~26% to ~$725 million. One of the few positive points I might have drawn was these assumedly institutional investors willingness to invest such a large sum. However, the fact that current prices considerably exceed their entry point makes me question the validity of that argument.

To any investors who got in on the ground floor of this one, I salute you. You have made a good and quick profit. However, the debt-load and earnings on this one just don't seem weighted in my favour. Not at these prices. Much as it pains me to do so, I will sit out another spinoff.


I do now own shares in ACV or SBH nor do I plan to buy any.

Do your own research on this and all stocks mentioned on this blog.


  • I think the way to look at SBH is EV/EBITDA and EV/Sales. The EV or enterprise value is the sum of the equity plus the debt minus any cash that is not needed for operations. You can take these metrics and compare them to similar specialty retail companies to get a sense of it's valuation. I haven't done this recently. I looked at ACV back in July and decided to buy SBH after it was spun off.

    I assumed the private equity investors would buy the whole company in the near future at a premium to the spin-off price and the spin-off was just a way to get around ACV paying capital gains taxes.

    Unfortunately, the transaction slipped my mind and when I looked at SBH had spun-off and already popped considerably. Maybe it is still worth investing in, but I haven't done the work. If I do end up looking with it again I will share my work with you.

    By Anonymous Bayard, at 12:53 PM  

  • Sally beauty holdings seems like a good company.


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