Sally Beauty Holdings: Upside Shouldn’t Be Done Yet (NYSE:SBH)

One of the beautiful things about value investing, is that you can achieve attractive upside even by buying into a company that is showing deteriorating fundamentals. This is often possible because shares of the business in question are trading at levels that are already remarkably cheap and have a great deal of pain priced in. One firm that I could point to as an example of this is Sally Beauty Holdings (NYSE:SBH), an enterprise that’s focused on providing hairstyling services and products to its customers through its network of stores and salons, as well as directly to licensed beauty professionals. Even though sales and profits have shown some weakness as of late, and at a time when management is focused on closing a significant number of stores, shares of the company look quite affordable and probably offer some additional upside compared to what they have seen solely because of how cheap they are. Because of this, I’ve decided to keep the ‘buy’ rating I have on its stock to reflect my view that upside moving forward should outpace with the broader market can achieve.

Fundamentals could be better

Back near the end of July of 2022, I wrote an article discussing my bullish thesis regarding Sally Beauty. In that article, I talked about how cheap shares of the company had gotten over the prior several months. A combination of fundamental weakness and the fear from investors about the economy more broadly had a severe negative impact on the firm. But given how cheap shares were, I could not help pretty rate the business a ‘buy’. Since then, the company has delivered nicely. Even though the S&P 500 is up only 2.7%, shares of Sally Beauty have seen upside of 11.1%.

It’s really interesting that performance has been this great compared to what the broader market has achieved when you consider the fundamental data provided by management. Consider the final quarter of the company’s 2022 fiscal year. During this time, sales came in at $962.5 million. This is 2.8% lower than the $990.3 million reported the same time one year earlier. Actual comparable store sales for the company managed to be roughly flat. The firm also benefited from a 30% rise in sales associated with its e-commerce operations if you ignore foreign currency translation. The real pain for the company then came from a decline in store count, compared to the same time one year earlier, the company had 117 fewer locations in operation.

On the bottom line, we saw some additional pain for the company. Net income of $21.3 million was significantly lower than the $68.1 million reported the same time of the 2021 fiscal year. In addition, it saw a $19.4 million inventory write-down, plus it reported an increase in selling, general, and administrative costs of $11.3 million year over year thanks to higher labor costs. Other profitability metrics also came under pressure as a result. Operating cash flow fell from $164.2 million to $107.3 million. If we adjust for changes in working capital, it would have fallen from $90.8 million to $66.5 million. And finally, EBITDA for the business shrank from $143.4 million to $112.4 million.

The final quarter of 2022 was not the only quarter in which the company experienced some pressure. For 2022 as a whole, revenue came in at $3.82 billion. That’s down from the $3.88 billion reported the same time one year earlier. Net income dropped from $239.9 million to $183.6 million. We saw a decline in operating cash flow from $381.9 million to $156.5 million, while the adjusted figure for this fell from $355.1 million to $320.6 million. And finally, EBITDA for the company contracted from $575 million to $501.9 million.

Though it may seem odd, a great deal of this pain has been intentionally inflicted by the company. You see, Sally Beauty is an enterprise that’s undergoing an evolution of sorts. For the past several quarters, the company had been piloting the idea of closing stores strategically, with the idea of reducing costs and using other nearby stores, plus other shopping experiences like online, to recapture sales lost from said store closures. That’s why, when the company announced financial results for the final quarter of 2022 late last year, management claimed that they were going to be closing 350 of their locations. Most of these closures took place in the month of December. While this sounds like a lot, it’s important to note that, inclusive of franchised locations, the company ended its latest fiscal year with 3,439 Sally Beauty Supply locations and 1,355 Beauty Supply locations. As part of this initiative, the company also decided to optimize its supply chain by closing two small distribution centers and transferring the volumes from those to larger distribution centers. All combined, this optimization plan resulted in a $45.5 million charge for the company in the final quarter of 2022, including the aforementioned inventory write-down.

Management is expecting savings from this optimization plan to be $50 million, with adjusted operating earnings for 2023 realizing $10 million of this. Starting in 2023, management hopes to further evolve by focusing on three primary initiatives. The first is to enhance customer centricity by expanding its services ecosystem that supports professional stylists, and increased education and expertise to inspire and support its customers. It wants to grow high-margin brands that the company has under its belt. And finally, the company wants to increase the efficiency of its operations so as to cut costs. All combined, for 2023, management does think that comparable sales will rise at a low single-digit rate. But overall net sales will fall by the low single digits because of store closures and foreign currency translation. Unfortunately, though, the company has not provided any guidance for profitability.

For now, if we focus solely on 2022 data, we would see that the company is trading at a price-to-earnings multiple of 8.7. The price to adjusted operating cash flow multiple should be 5, while the EV to EBITDA multiple would come in at 5.3. By comparison, using the data from 2021, these multiples would be 6.7, 4.5, and 4.7, respectively. Probably the best company to compare Sally Beauty to would be Ulta Beauty (ULTA), despite the fact that it has grown at a more impressive rate than Sally Beauty has over the past few years. Naturally, such outperformance from a fundamental perspective would warrant some premium. But in my opinion, it’s difficult to justify such a divide between it and Sally Beauty right now. For instance, using trailing 12-month data, Ulta Beauty it’s trading at a price-to-earnings multiple of 22.4. The price to operating cash flow multiple is only marginally lower at 21.9, while the EV to EBITDA multiple stands at 14.

Company	Price / Earnings	Price / Operating Cash Flow	EV / EBITDA
Sally Beauty Holdings	8.7	5.0	5.3
Ulta Beauty	22.4	21.9	14.0

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Takeaway

In my opinion, Sally Beauty it’s not the kind of company that you buy and expect to own for the next 20 years. While it is entirely possible that the company’s restructuring efforts could pave the way for long-term upside, there’s nothing to indicate right now that such maneuvers will create tremendous long-term value that will allow the company to continue growing at a nice pace moving forward. Having said that, it is a fundamentally attractive company, even though top line and bottom line results are being affected by management strategy. Given how cheap the company is, both on an absolute basis and relative to a similar firm, I would say that further upside exists from here. Because of this, I believe a soft ‘buy’ rating is still appropriate at this time.