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You Still Have to Look Pretty in a Recession

Many companies are deemed recession resistant if they survived a prior economic downturn without revenue falling significantly. Sally Beauty Holdings (NYSE: SBH  ) , specialty retailer and distributor of professional beauty supplies, has upped the ante with its remarkable financial track record. It has increased its revenues in almost every single year for more than two decades from 1990 to 2012.

Recession resistant business
First, the prices of the professional beauty supplies that Sally sells are not really comparable to those of big-ticket items such as cars, furniture and electronic appliances. Simply speaking, a consumer can save more money by holding off on a purchase of the latest iPhone 5S than by reducing the budget for beauty supplies.

Second, at the expense of being branded as superficial, I have to admit that looks matter and first impressions count. Even if you are not holding a sales job, maintaining a professional image is the least that is demanded of any working professional. Reducing your budget on beauty supplies and ending up looking unkempt is hardly the wisest career move.

Pricing power over customers
Sally increased its gross margin by about 530 basis points from 44.2% in 2003 to 49.5% in 2012, which is a strong indicator of its pricing power.

Sally's customers include both retail consumers and salon professionals. Many salon professionals own small private businesses; there are an estimated 280,000 salons and barbershops in the U.S. Most of Sally's customers do not have the scale to source their supplies directly from manufacturers. 

Looking ahead
In the third quarter of fiscal 2013, Sally's revenue growth was less than impressive at 2.8%. Same store sales increased by a mere 0.7% compared with a growth of 5.2% in the corresponding quarter a year ago, with lower non-Beauty Club Card traffic in U.S. stores being a key issue. Sally currently has about 7.2 million Sally Beauty Club Card members, who contribute approximately half of its retail sales. Given that Sally was able to double the number of members in a span of four years, I am optimistic that Sally will add more members in the near future to increase customer stickiness and bring greater stability to its revenue streams.

Going forward, Sally sees room to double the number of its non-U.S. stores to approximately 1,500. In particular, Sally views Europe and Canada as key growth markets, with the potential to triple its current store count in these regions.

Peer comparison
Sally's peers include Regis Corporation (NYSE: RGS  ) and Ulta Beauty (NASDAQ: ULTA  ) .

Ulta is a retailer of prestige, mass and salon products and salon services in the U.S. Although Ulta has been a stock market darling for its impressive five year revenue and net income compound annual growth rates of 19.5% and 46.8%, respectively, its profitability is inferior to that of Sally. Sally delivered a trailing twelve month operating margin of 14.2%, compared with an operating margin of 12.5% for Ulta.

I think that store economics is the key contributor to the difference between Sally and Ulta's margins. The average store size for Sally Beauty Supply stores is approximately 1,700 square feet, while the average Ulta store is about 10,000 square feet. I believe that the smaller store model for Sally results in lower rental costs, staff expenses, and capital expenditures, which contribute to a higher operating margin.

Notwithstanding, Ulta maintained its growth momentum for the second quarter of fiscal 2013. Quarterly sales and diluted earnings per share increased by 24.8% and 29.6%, respectively. On the back of this strong financial performance, Ulta has reiterated its full year guidance of diluted EPS growth of about 25%, driven by new stores, e-commerce and cost efficiencies from a new distribution center in 2014.

Regis is a leading owner, operator and franchisor of hair salons in close to 10,000 locations globally. Since its top line peaked in fiscal 2008 at $2.7 billion, Regis' revenues have fallen by 35% to register $2.0 billion for fiscal 2013. Regis also incurred losses in fiscal 2011 and 2012. 

To arrest this severe deterioration in sales and earnings, Regis has several initiatives in place. First, it introduced the SuperSalon point-of-sale system which will provide insights into customer retention and staff productivity. Second, Regis standardized Plan‐O‐Grams, a visual merchandising strategy, in its stores to improve the looks of its salons. Lastly, it has aligned its management and organizational structure with geographies to focus managerial attention and cut down on unnecessary travel.

Despite all the plans, I am not optimistic about Regis' future. My view is that hair salons are local businesses with no significant advantages to be extracted from scale or national branding. There are low switching costs associated with giving the new hair salon round the block a try.

Sally' strong financial track record speaks for itself. I like Sally for its recession-resistant revenue and its strong pricing power over customers. Moreover, with only slightly more than a fifth of its revenues generated outside the U.S., I am optimistic about Sally's growth prospects, particularly in the area of international expansion. Also, Sally is almost half as cheap as its closest competitor, Ulta. Sally trades at 15 times its forward P/E, compared with a forward P/E of 28 for Ulta. This makes my investment case for Sally even stronger.

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