SBH

Business Context and Reporting Period

This Form 10-Q covers the three-month period ended December 31, 2006, for Sally Beauty Holdings, Inc. The reporting period is defined by the company's separation from its former parent, Alberto-Culver Company, which was completed on November 16, 2006. Sally Beauty Holdings operates as a holding company with two primary segments: Sally Beauty Supply (retail stores) and Beauty Systems Group (BSG) (professional distribution). As of December 31, 2006, the company operated 3,196 stores globally.

Key Financial Metrics

Note: 2005 data reflects the company as a wholly-owned subsidiary of Alberto-Culver. 2006 data reflects the first quarter as a standalone public entity.

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 7.4% to $629.9 million, driven by 5.0% comparable store sales growth, the acquisition of Salon Success (UK), and the opening of 100 net new stores.
• Profitability Decline: Operating earnings decreased 33.8% to $36.3 million, and Net Earnings plummeted 90.7% to $3.1 million. This decline is primarily attributed to $21.5 million in transaction expenses related to the separation and a significant increase in interest expense.
• Debt Structure: In connection with the separation, the company incurred approximately $1.85 billion in new indebtedness, including term loans, senior notes, and senior subordinated notes. Interest expense rose from $0.5 million in 2005 to $19.1 million in 2006.
• Equity Position: Stockholders' equity turned negative to a deficit of $836.2 million due to a $2.34 billion special cash dividend paid to Alberto-Culver shareholders as part of the separation transaction.

Guidance, Outlook, and Risks

• Supplier Relationship Impact: The company announced the loss of exclusive distribution rights for L'Oréal professional products in BSG stores and via sales consultants. Management expects this to negatively impact consolidated revenue by approximately $110 million during the last nine months of fiscal 2007.
• Liquidity and Covenants: The company is highly leveraged. Liquidity depends on operating cash flows and a $400 million Asset-Based Lending (ABL) facility. Debt agreements contain restrictive covenants, including a maximum consolidated secured leverage ratio of 5.25 for the period ending March 31, 2007, and a fixed-charge coverage ratio of 1.0 to 1.0.
• Interest Rate Risk: The company entered into interest rate swaps on $500 million of variable-rate debt. A decrease in interest rates could increase interest expense due to the mark-to-market accounting of these swaps.
• Equity Restrictions: The company's ability to issue public or private equity is severely limited for at least two years to preserve the tax-free status of the separation.

Investor Verification Checklist

• Debt Service Capacity: Verify the company's ability to meet the 5.25x leverage ratio covenant and service $1.85 billion in debt given the reduced cash flow from transaction costs.
• L'Oréal Revenue Impact: Monitor the actual revenue decline in the BSG segment against the projected $110 million loss due to the loss of exclusive distribution rights.
• Working Capital Trends: Review the decline in working capital from $479.1 million to $363.3 million and the reduction in cash reserves to $31.4 million.
• Interest Rate Sensitivity: Assess the impact of potential interest rate fluctuations on the company's net interest expense, given the variable-rate nature of the term loans and the specific swap agreements.
• Comparable Store Sales: Confirm the sustainability of the 5.0% consolidated comparable store sales growth in a competitive retail environment.