Is Sally Beauty a Value Trap?

The company is exceptionally cheap, but lack of top-line growth is pushing down multiples

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May 20, 2022
Summary
  • The beauty product distributor is a cash-generating machine.
  • It has a strong niche in hair care and color.
  • The company has been unable to generate top-line growth, resulting in massive deflation in price multiples.
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Distributer and Retailer Sally Beauty Holdings Inc. (

SBH, Financial) is not getting any respect from the market despite a low price-earnings ratio. The company is also making bucket loads of cash.

There is at least one guru who likes the stock, however. In his first-quarter 2022 commentary,

Bernard Horn (Trades, Portfolio) of the Polaris Global Value Fund discussed the company. He said:

"Sally Beauty, the U.S. based retailer and distributor of professional beauty supplies, captured significant market share in both the wholesale and retail categories, with substantial profits in stable beauty lines like hair color, hair care and nail/salon supplies. These more defensive investments may minimize downside risk in the event of more economic volatility if the RussianUkraine conflict and higher interest rates weigh on economic activity."

Similarly to Horn, I am long the stock and have written about it many times. So far, I can say that the company has been good for a few singles, but has not been a home run. The fact is the stock screens well on value, but the share price is volatile. Currently, the GF Value Line is showing it as modestly undervalued.

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Sally Beauty is a global distributor and retailer of professional beauty products with revenue of $3.9 billion annually. Through the Sally Beauty Supply division and Beauty Systems Group division, the company sells and distributes through over 5,000 stores, including approximately 180 franchised units, throughout the U.S. and Puerto Rico, the U.K., Belgium, Chile, France, Canada, Mexico, Peru, Ireland, the Netherlands, Spain and Germany.

The company has over 3,700 Sally Beauty Supply stores that offer more than 8,000 products for hair color, hair care, skin and nails through proprietary brands such as Ion, Generic Value Products, Beyond the Zone and Silk Elements, as well as professional lines like Wella, Clairol, OPI, Conair and Hot Shot Tools.

The Beauty Systems Group business has over 1,300 stores, including 164 franchised locations. It also has one of the largest networks of professional distributor sales consultants in North America, with approximately 820 consultants. The BSG stores and sales consultants sell up to 10,500 professionally branded hair, skin and nail beauty products exclusively to professional stylists and salons for use and resale to their customers. Hair care and hair color constitute the majority of the company's sales.

The company is highly profitable with strong margins and cash flow generation.

Profitability Rank

Rank: 8 /10

Current

Industry Median

Historical Median

Operating Margin %

11.34

3.83

12.67

Net Margin %

6.66

2.62

6.37

ROE %

109.18

6.84

161.97

ROA %

9.20

2.80

11.88

ROC (

Joel Greenblatt (Trades, Portfolio)) %

32.17

11.69

57.26

Sally Beauty's growth, however, is mediocre, with revenue and net income declining over the past five years. The company has used its copious cash flow to purchase a lot of shares. As illustrated below, shares outstanding has plummeted over the past decade.

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A lack of overall growth has led to a compression of ratios. For example, the price-earnings ratio has been in continuous decline. Currently, the price-earnings ratio is just six, meaning the market is attributing no growth or negative growth to earnings as earnings multiple of 8.5 is a rule of thumb for a no-growth stock.

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Similarly, an examination of Sally Beauty's cash flow reveals a strong cash generating capacity, but overall little growth of cash flow. However, it does produce a lot of cash. As the diagram below shows, the company produced core free cash flow (orange line) of $272 million on a market cap of $1.46 billion. That equates to a free cash flow yield of 18.6%.

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Conclusion

Given the company's inability to generate organic top-line growth, it has been reduced to buying back its own stock to financially engineer growth by reducing the number of shares outstanding. However, the stock buyback is not translating to share price gains because the multiples keep compressing. As shown in the chart below, price multiples have tumbled more than 70% over the past decade. This means each dollar of Sally's earnings in 2012 is only worth 30 cents now. This is massive deflation.

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Moreover, the company does not pay dividends, so it is neither a growth stock nor an income stock. While Sally Beauty may be an excellent value stock, the lack of growth or income or share appreciation makes it seem like a value trap.

The company is undeniably cheap on a fundamental basis as well as in regard to historical metrics. The overall GF Score is not bad at 80 out of 100.

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So there is a case for continuing to hold Sally Beauty. I think most often good things happen to cheap stocks, as long as they don't go out of business. Chances of the latter happening are low since the Altman Z-Score and Piotroski F-Score are both quite good and common sense tells me women will keep coloring their hair, regardless of the market environment.

I hold a core position of Sally Beauty stock, but use options to trade around that by going long when I feel the stock is undervalued and selling some as the stock rises. Right now, the stock is undervalued, so I am selling puts.

The market has been besotted with profitless growth while value stocks, which make real profits, have been discounted. This appears to be changing. I agree with Horn that this could be a good place to be as we face a possible recession.

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Disclosures

I am/we currently own positions in the stocks mentioned, and have NO plans to sell some or all of the positions in the stocks mentioned over the next 72 hours. Click for the complete disclosure
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