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**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-K**

 

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**x****      ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**FOR THE FISCAL YEAR ENDED: SEPTEMBER 30, 2010**

** **

**-OR-**

** **

**o****         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

** **

**For the transition period from                   to                   **

** **

**Commission File No. 333-144427**

 

**SALLY HOLDINGS LLC**

(Exact name of registrant as specified in itscharter)

 

| **Delaware**                                      | ** ** | **36-4472381**                        |
|---------------------------------------------------|------------|---------------------------------------|
| (State  or other jurisdiction of incorporation or |       | (I.R.S.  Employer Identification No.) |
| organization)                                     |       |                                  |

 

| **3001 Colorado Boulevard**               | ** ** |        |
|-------------------------------------------|------------|-------------|
| **Denton, Texas**                         |       | **76210**   |
| (Address  of principal executive offices) |       | (Zip  Code) |

 

Registrant’s telephone number, including area code:**(940) 898-7500**

 

Securities registered pursuant to Section 12(b) ofthe Act: **None**

** **

Securities registered pursuant to Section 12(g) ofthe Act:**None**

 

THEREGISTRANT, AN INDIRECT WHOLLY-OWNED SUBSIDIARY OF SALLY BEAUTYHOLDINGS, INC., MEETS THE CONDITIONS SET FORTH IN GENERALINSTRUCTION I(1) (a) and (b) OF FORM 10-K AND ISTHEREFORE FILING THIS FORM WITH THE REDUCED DISCLOSURE FORMAT PURSUANT TOGENERAL INSTRUCTION I(2).

 

Indicateby check mark if the registrant is a well-known seasoned issuer, as definedunder Rule 405 of the Securities Act. YES **o**  NO **x**

 

Indicateby check mark if the registrant is not required to file reports pursuant toSection 13 or Section 15(d) of the Act. YES **o**  NO **x**

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. YES **x**  NO **o**

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Website, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T during thepreceding 12 months (or for such shorter period that the registrant wasrequired to submit and post such files. YES **o**  NO **o**

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to thebest of registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K.  **x**

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reporting company.(See the definitions of “accelerated filer,” “large accelerated filer” and “smallerreporting company” in Rule 12b-2 of the Exchange Act).

 

| Large  accelerated filer **o**            | ** ** | Accelerated  filer **o**   |
|------------------------------------------------|------------|---------------------------------|
| ** **                                     | ** ** | ** **                      |
| Non-accelerated  filer **x**              |       | Smaller reporting company **o** |
| (Do  not check if a smaller reporting company) |       |                            |

 

Indicateby check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Exchange Act.)  YES **o**  NO **x**

 

Novoting or non-voting common equity of the registrant was held by non-affiliatesof the registrant as of March 31, 2010. As of November 17, 2010, allmember units were owned by Sally Investment Holdings LLC, a wholly-ownedsubsidiary of Sally Beauty Holdings, Inc.

 

DOCUMENTSINCORPORATED BY REFERENCE:**NONE**

 

 

 

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**TABLE OF CONTENTS**

 
| ** **    | ** ** | ** **                                                                                       | ** ** | **Page** |
|---------------|------------|--------------------------------------------------------------------------------------------------|------------|----------|
|          | ** ** | **PART I**                                                                                  |       |     |
| ITEM 1.  |       | BUSINESS                                                                                         |       | 1        |
| ITEM 1A. |       | RISK FACTORS                                                                                     |       | 12       |
| ITEM 1B. |       | UNRESOLVED STAFF  COMMENTS                                                                       |       | 26       |
| ITEM 2.  |       | PROPERTIES                                                                                       |       | 26       |
| ITEM 3.  |       | LEGAL PROCEEDINGS                                                                                |       | 27       |
| ITEM 4.  |       | REMOVED AND RESERVED                                                                             |       | 28       |
|          |       |                                                                                             |       |     |
|          | ** ** | **PART II**                                                                                 |       |     |
| ITEM 5.  |       | MARKET FOR  REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS                      |       | 28       |
| ITEM 6.  |       | SELECTED  FINANCIAL DATA                                                                         |       | 28       |
| ITEM 7.  |       | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS      |       | 30       |
| ITEM 7A. |       | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                      |       | 54       |
| ITEM 8.  |       | FINANCIAL  STATEMENTS AND SUPPLEMENTARY DATA                                                     |       | 56       |
| ITEM 9.  |       | CHANGES IN  AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE            |       | 56       |
| ITEM 9A. |       | CONTROLS AND  PROCEDURES                                                                         |       | 56       |
| ITEM 9B. |       | OTHER INFORMATION                                                                                |       | 57       |
|          |       |                                                                                             |       |     |
|          | ** ** | **PART III**                                                                                |       |     |
| ITEM 10. |       | DIRECTORS,  EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE                                          |       | 58       |
| ITEM 11. |       | EXECUTIVE  COMPENSATION                                                                          |       | 58       |
| ITEM 12. |       | SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER  MATTERS |       | 58       |
| ITEM 13. |       | CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE                       |       | 58       |
| ITEM 14. |       | PRINCIPAL  ACCOUNTANT FEES AND SERVICES                                                          |       | 58       |
|          |       |                                                                                             |       |     |
|          | ** ** | **PART IV**                                                                                 |       |     |
| ITEM 15. |       | EXHIBITS AND  FINANCIAL STATEMENT SCHEDULES                                                 |       | 59       |

 

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SallyHoldings LLC, or Sally Holdings, a limited liability company organized underthe laws of the State of Delaware, has been a wholly-owned subsidiary of SallyInvestment Holdings LLC, or Sally Investment, a wholly-owned subsidiary ofSally Beauty Holdings, Inc., or Sally Beauty, since November 16,2006. All of the interests of Sally Holdings are beneficially owned by SallyInvestment, and all of the interests of Sally Investment are beneficially ownedby Sally Beauty.  Prior to November 16,2006, Sally Holdings was a Delaware corporation named “Sally Holdings, Inc.”and was a wholly-owned subsidiary of Alberto-Culver Company, or Alberto-Culver.In November 2006, Sally Holdings, Inc. was converted to a Delawarelimited liability company, was renamed “Sally Holdings LLC” and became awholly-owned subsidiary of Sally Investment and an indirect subsidiary of SallyBeauty in connection with the separation of Sally Holdings’ business fromAlberto-Culver. All operations of Sally Investment and Sally Beauty areconducted through Sally Holdings and its consolidated subsidiaries.  Sally Capital Inc., a Delaware corporation,or Sally Capital, is a wholly-owned subsidiary of Sally Holdings and does nothave any assets or operations of any kind.

 

Inthis Annual Report, references to “Sally Holdings,” “the Company,” “ourcompany,” “we,” “our,” “ours” and “us” refer to Sally Holdings LLC, and itsconsolidated subsidiaries for periods after the separation from Alberto-Culver,and to Sally Holdings, Inc. and its consolidated subsidiaries for periodsprior to the separation from Alberto-Culver unless otherwise indicated or thecontext otherwise requires.

 

**CAUTIONARYNOTICE REGARDING FORWARD-LOOKING STATEMENTS**

 

Statementsin this Annual Report on Form 10-K and the documents incorporated byreference herein which are not purely historical facts or which depend uponfuture events may be forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities Exchange Act of 1934, as amended, which we refer to as the ExchangeAct.  Words such as “anticipate,” “believe,”“estimate,” “expect,” “intend,” “plan,” “project,” “target,” “can,” “could,” “may,”“should,” “will,” “would” or similar expressions may also identify suchforward-looking statements.

 

Readersare cautioned not to place undue reliance on forward-looking statements as suchstatements speak only as of the date they were made. Any forward-lookingstatements involve risks and uncertainties that could cause actual events orresults to differ materially from the events or results described in theforward-looking statements, including, but not limited to, risks anduncertainties related to:

 

·             the highly competitivenature of, and the increasing consolidation of, the beauty productsdistribution industry;

·             anticipating changes inconsumer preferences and buying trends and managing our product lines andinventory;

·             potential fluctuation in oursame store sales and quarterly financial performance;

·             our dependence uponmanufacturers who may be unwilling or unable to continue to supply products tous;

·             the possibility of materialinterruptions in the supply of beauty supply products by our manufacturers;

·             products sold by us beingfound to be defective in labeling or content;

·             compliance with laws andregulations or becoming subject to additional or more stringent laws andregulations;

·             product diversion to massretailers;

·             the operational andfinancial performance of our Armstrong McCall, L.P. (“Armstrong McCall”)franchised-based business;

·             the success of ourinternet-based business;

·             successfully identifyingacquisition candidates or successfully completing desirable acquisitions;

·             integrating businesses acquiredin the future;

·             opening and operating newstores profitably;

·             the impact of a downturn inthe economy upon our business;

·             the success of our costcontrol plans;

·             protecting our intellectualproperty rights, particularly our trademarks;

·             conducting business outsidethe United States;

·             disruption in ourinformation technology systems;

·             natural disasters or acts ofterrorism;

·             the preparedness of ouraccounting and other management systems to meet financial reporting and otherrequirements and the upgrade of our existing financial reporting system;

·             we are a holding company,with no operations of our own, and we depend on our subsidiaries for cash;

 

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| · | our substantial indebtedness;                                                                                                                                         |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| · | the possibility that we may incur substantial additional debt in the  future;                                                                                         |
| · | restrictions and limitations in the agreements and instruments  governing our debt;                                                                                   |
| · | generating the significant amount of cash needed to service all of  our debt and refinancing all or a portion of our indebtedness or obtaining  additional financing; |
| · | changes in interest rates increasing the cost of servicing our debt  or increasing our interest expense due to our interest rate swap agreements;                     |
| · | the potential impact on us if the financial institutions we deal with  become impaired;                                                                               |
| · | the representativeness of our historical consolidated financial  information with respect to our future financial position, results of  operations or cash flows;     |
| · | our reliance upon Alberto-Culver for the accuracy of certain  historical services and information;                                                                    |
| · | the share distribution of Alberto-Culver common stock in our  separation from Alberto-Culver not constituting a tax-free distribution;                                |
| · | actions taken by certain large stockholders of Sally Beauty adversely  affecting the tax-free nature of the share distribution of Alberto-Culver  common stock;       |
| · | the voting power of Sally Beauty’s largest stockholder discouraging  third party acquisitions of Sally Beauty at a premium; and                                  |
| · | the interests of Sally Beauty’s largest stockholder differing from  the interests of other holders of Sally Beauty’s common stock.                          |

 

Theevents described in the forward-looking statements might not occur or mightoccur to a different extent or at a different time than we have described. As aresult, our actual results may differ materially from the results contemplatedby these forward-looking statements. We assume no obligation to publicly updateor revise any forward-looking statements.

 

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**PART I**

 

**ITEM 1. BUSINESS**

 

**Introduction**

 

Weare the largest distributor of professional beauty supplies in the U.S. basedon store count. We operate primarily through two business units, Sally BeautySupply and Beauty Systems Group, or BSG. Through Sally Beauty Supply and BSG(which operates stores under the CosmoProf service mark), we operated amulti-channel platform of 3,874 stores and supplied 185 franchised storesprimarily in North America, South America and selected European countries, asof September 30, 2010. Within BSG, we also have one of the largestnetworks of professional distributor sales consultants in North America, withapproximately 1,051 professional distributor sales consultants who selldirectly to salons and salon professionals. As of September 30, 2010,Sally Beauty Supply had 3,006 company-operated retail stores and supplied 26franchised stores located outside the U.S. and BSG had 868 company-operatedstores and supplied 159 franchised stores. We provide our customers with a widevariety of leading third-party branded and exclusive-label professional beautysupplies, including hair care and hair color products, styling appliances, skinand nail care products and other beauty items. Sally Beauty Supply storestarget retail consumers and salon professionals, while BSG exclusively targetssalons and salon professionals. Approximately 82%, 84% and 82% of ourconsolidated net sales for the fiscal years ended September 30, 2010, 2009and 2008, respectively, were in the U.S. For the fiscal year endedSeptember 30, 2010, our consolidated net sales were $2,916.1 million.

 

SallyBeauty Supply began operations with a single store in New Orleans in 1964 andwas acquired in 1969 by our former parent company, Alberto-Culver. BSG became asubsidiary of Alberto-Culver in 1995. In November 2006, we separated fromAlberto-Culver and became an indirect wholly-owned subsidiary of Sally Beauty.We refer to our separation from Alberto-Culver and its consumerproducts-focused business as the Separation Transactions. Sally Beauty is aDelaware corporation formed in June 2006 and became the accountingsuccessor company to Sally Holdings upon the completion of the SeparationTransactions. When we refer to Alberto-Culver, we mean Alberto-Culver Companyprior to the Separation Transactions or the company from which we separated.

 

Inconnection with the Separation Transactions, CDRS Acquisition LLC, or CDRS andCD&R Parallel Fund VII, L.P., or the Parallel Fund, and which we referto together with CDRS as the CDR Investors, invested an aggregate of$575.0 million in cash equity, representing ownership currently ofapproximately 47.0% of the outstanding shares of Sally Beauty’s common stock onan undiluted basis. CDRS, which owns approximately 47.0% of the outstandingshares of Sally Beauty’s common stock on an undiluted basis as of September 30,2010, is a Delaware limited liability company organized by Clayton,Dubilier & Rice Fund VII, L.P., a private investment fund managedby Clayton, Dubilier & Rice, Inc. Also in connection with theSeparation Transactions, certain of our subsidiaries incurred approximately$1,850.0 million of indebtedness, as more fully described below. Pleasesee “Risk Factors — Risks Relating toOur Substantial Indebtedness” in Item 1A below.

 

SallyHoldings is a Delaware limited liability company. Sally Capital, a Delawarecorporation, is a wholly-owned subsidiary of Sally Holdings and does not haveany assets or operations of any kind.

 

**ProfessionalBeauty Supply Industry Distribution Channels**

 

Theprofessional beauty supply industry serves end-users through four distributionchannels: full-service/exclusive distribution, open-line distribution, directand mega-salon stores.

 

***Full-Service/Exclusive***

 

Thischannel exclusively serves salons and salon professionals and distributes “professional-only”products for use and resale to consumers in salons. Many brands are distributedthrough arrangements with suppliers by geographic territory. BSG is a leadingfull-service distributor in the U.S.

 

***Open-Line***

 

Thischannel serves retail consumers and salon professionals through retail storesand the internet. This channel is served by a large number of localized retailersand distributors, with only a few having a regional presence and significantchannel share. We believe that Sally Beauty Supply is the only open-linedistributor in the U.S. with a national network of retail stores. Inaddition, Sally Beauty Supply’s website (*www.sallybeauty.com*)and e-commerce platform provides access to product offerings and informationbeyond our retail stores.

 

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***Direct***

 

Thischannel focuses on direct sales to salons and salon professionals by largemanufacturers. This is the dominant form of distribution in Europe, butrepresents a small channel in the U.S. due to the highly fragmented natureof the U.S. marketplace, which makes direct distribution cost prohibitivefor many manufacturers.

 

***Mega-Salon Stores***

 

Inthis channel, large-format salons are supplied directly by manufacturers due totheir large scale.

 

**KeyIndustry and Business Trends**

 

Weoperate within the large and growing U.S. professional beauty supplyindustry. Potential growth in the industry is expected to be driven byincreases in consumer demand for hair color, hair loss prevention and hairstyling products. We believe the following key industry and business trends andcharacteristics will influence our business and our financial results goingforward:

 

·             *High levelof marketplace fragmentation.*  TheU.S. salon channel is highly fragmented with over 250,000salons. Given the fragmented and small-scale nature of the salon industry,we believe that salon operators will continue to depend onfull-service/exclusive distributors and open-line channels for a majority oftheir beauty supply purchases.

 

·             *Growth inbooth renting and frequent stocking needs.*  Salonprofessionals primarily rely on just-in-time inventory due to capitalconstraints and a lack of warehouse and shelf space at salons. In addition,booth renters, who comprise a significant percentage of total U.S. salonprofessionals, are often responsible for purchasing their own supplies.Historically, booth renters have significantly increased as a percentage oftotal salon professionals, and we expect this trend to continue. Given theirsmaller individual purchases and relative lack of financial resources, boothrenters are likely to be dependent on frequent trips to professional beautysupply stores, like BSG and Sally Beauty Supply. We expect that these factorswill continue to drive demand for conveniently located professional beautysupply stores.

 

·             *Increasinguse of exclusive-label products.*  We offer a broadrange of private label and controlled label products, which we generally referto collectively as “exclusive-label products.” Private label products arebrands for which we own or license the trademark and, in some instances, theformula. Controlled label products are brands that are owned by themanufacturer, but for which we have been granted sole distribution rights.Generally, our exclusive-label products have higher gross margins than the leadingthird-party branded products, and we believe this area offers potential forgrowth. Please see “Risk Factors—We depend upon manufacturers who may be unableto provide products of adequate quality or who may be unwilling to continue tosupply products to us.”

 

·             *Favorabledemographic and consumer trends.*  We expect theaging baby-boomer population to drive future growth in professional beautysupply sales through an increase in the usage of hair color and hair lossproducts. Additionally, continuously changing fashion-related trends that drivenew hair styles are expected to result in continued demand for hair stylingproducts. Changes in consumer tastes and fashion trends can have an impact onour financial performance. Our continued success depends in large part on ourability to anticipate, gauge and react in a timely and effective manner tochanges in consumer spending patterns and preferences for beauty products. Wecontinuously adapt our marketing and merchandising initiatives for Sally BeautySupply in an effort to expand our market reach or to respond to changingconsumer preferences.  If we are unableto anticipate and respond to trends in the marketplace for beauty products andchanging consumer demands, our business could suffer.

 

·             *International growthstrategies. *A key elementof our growth strategy depends on our ability to capitalize on growth in theinternational marketplace and to grow our current level of non-U.S. operations.For example, on December 16, 2009, we acquired Sinelco Group NV (“Sinelco”),a wholesale distributor of professional beauty products located in Belgium withsales throughout Europe. In addition, on September 4, 2009, we acquiredDistribuidora Intersalon Limitada (“Intersalon”), a leading distributor ofpremier beauty supply products with 16 stores located in Chile. Theseacquisitions furthered our expansion plans in Europe and Latin America, keytargets of the Company’s international growth initiative. We intend to continueto identify and evaluate non-U.S. acquisition and/or organic growth targets.Our ability to grow our non-U.S. operations, integrate our new non-U.S.acquisitions and successfully pursue additional non-U.S. acquisitions and/ororganic growth may be affected by business, legal, regulatory and economicrisks. Please see “Risk Factors*—*Wemay not be able to successfully identify acquisition candidates and completedesirable acquisitions,” “If we acquire any businesses in the future, theycould prove difficult to integrate, disrupt our business or have an adverseeffect on our results of operations” and “Our ability to conduct business ininternational marketplaces may be affected by legal, regulatory and economicrisks.”

 

·             *Continuingconsolidation.*  There is continuing consolidation amongprofessional beauty product distributors and professional beauty productmanufacturers. We plan to continue to examine ways in which we can benefit fromthis trend, including reviewing opportunities to shift business within theprofessional beauty products channel from competitive distributors to the BSGnetwork as well as seeking opportunistic, value-added acquisitions whichcomplement our long-term growth strategy. We believe that suppliers areincreasingly likely to focus on larger distributors and retailers with abroader scale and retail 

 

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footprint. We also believethat we are well positioned to capitalize on this trend as well as participatein the ongoing consolidation at the distributor/retail level. However, changesoften occur in our relationships with suppliers that may materially affect thenet sales and operating earnings of our business segments. Consolidation amongsuppliers could exacerbate the effects of these relationship changes and couldincrease pricing pressures. For example, as we announced in December 2006,our largest supplier, L’Oreal, moved a material amount of revenue out of theBSG nationwide distribution network and into competitive regional distributionnetworks. More recently, L’Oreal acquired distributors competing with BSG inthe southeastern and west coast of the U.S. and, as a result, directly competeswith BSG in certain geographic areas. If L’Oreal acquired other distributors orsuppliers that conduct significant business with BSG, we could lose relatedrevenue. There can be no assurance that there will not be further loss ofrevenue over time by BSG (including within its franchise-based business) due topotential losses of additional products (both from L’Oreal and from othersuppliers) as well as from the increased competition from L’Oreal-affiliateddistribution networks. Please see “Risk Factors*—*The beauty products distribution industry is highly competitive andis consolidating” and “We depend upon manufacturers who may be unable toprovide products of adequate quality or who may be unwilling to continue to supplyproducts to us.”

 

·             *Relationshipswith suppliers.*   Sally Beauty Supply/BSG and theirsuppliers are dependent on each other for the distribution of beauty products.We do not manufacture the brand name or exclusive-label products we sell. Wepurchase our products from a limited number of manufacturers. As is typical indistribution businesses, these relationships are subject to change from time totime (including the expansion or loss of distribution rights in variousgeographies and the addition or loss of product lines). Since we purchaseproducts from many manufacturers on an at-will basis, under contracts which cangenerally be terminated without cause upon 90 days’ notice or less orwhich expire without express rights of renewal, such manufacturers coulddiscontinue sales to us at any time or upon the expiration of the distributionperiod. Some of our contracts with manufacturers may be terminated by suchmanufacturers if we fail to meet specified minimum purchase requirements. Insuch cases, we do not have contractual assurances of continued supply, pricingor access to new products and vendors may change the terms upon which theysell. Infrequently, a supplier will seek to terminate a distributionrelationship through legal action. For example, in 2007 Farouk Systems, Inc.filed an action seeking a declaratory judgment that it was entitled toterminate a long-term distribution agreement with Armstrong McCall. In 2010that matter was settled and BSG now sells Farouk products in some territories.Changes in our relationships with suppliers occur often and could positively ornegatively impact our net sales and operating profits. Although we focus ondeveloping new revenue and cost management initiatives to mitigate the negativeeffects resulting from unfavorable changes in our supplier relationships, therecan be no assurance that our efforts will continue to completely offset theloss of these or other distribution rights. Please see “Risk Factors*—*We depend upon manufacturers who may beunable to provide products of adequate quality or who may be unwilling tocontinue to supply products to us.”

 

We expect to continue to expand our product lineofferings and to gain additional distribution rights over time through eitherfurther negotiation with suppliers or by strategic acquisitions of existingdistributors. Although we are focused on developing new revenue and costmanagement initiatives, there can be no assurance that our efforts willpartially or completely offset any potential loss of distribution rights in thefuture. Please see “Risk Factors—We depend upon manufacturers who may be unableto provide products of adequate quality or who may be unwilling to continue tosupply products to us.”

 

·            *High levelof competition.*  Sally Beauty Supply competes with otherdomestic and international beauty product wholesale and retail outlets,including local and regional open-line beauty supply stores, professional-onlybeauty supply stores, salons, mass merchandisers, drug stores and supermarkets,as well as sellers on the internet and salons retailing hair care items. BSGcompetes with other domestic and international beauty product wholesale andretail suppliers and manufacturers selling professional beauty productsdirectly to salons and individual salon professionals. We also face competitionfrom authorized and unauthorized retailers and internet sites offeringprofessional salon-only products. The increasing availability of unauthorizedprofessional salon products in large format retail stores such as drug stores,grocery stores and others could also have a negative impact on our business.Please see “Risk Factors*—*Thebeauty products distribution industry is highly competitive and isconsolidating.”

 

·             *Economic conditions.*  We appeal to a wide demographic consumerprofile and offer a broad selection of beauty products sold directly to retailconsumers and salons and salon professionals. Historically, these factors haveprovided us with reduced exposure to downturns in economic conditions in thecountries in which we operate. However, a downturn in the economy, especiallyfor an extended period of time, could adversely impact consumer demand ofdiscretionary items such as beauty products and salon services, particularlyaffecting our electrical products category and our full-service sales business.In addition, higher freight costs resulting from increases in the cost of fuel,especially for an extended period of time, may impact our expenses at levels thatwe cannot pass through to our customers. These factors could have a materialadverse effect on our business, financial condition and results of operations.Please see “Risk Factors*—*The health of theeconomy in the channels we serve may affect consumer purchases of discretionaryitems such as beauty products and salon services, which could have a materialadverse effect on our business, financial condition and results of operations.”

 

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·             *Controlling expenses*.  Another important aspect of our business isour ability to control costs, especially in our BSG business segment, byright-sizing the business and maximizing the efficiency of our structure. In2009, we completed implementation of an approximately $22.0 million capitalspending program to consolidate warehouses and reduce administrative expensesrelated to BSG’s distribution network resulting in annualized cost savings**ofapproximately $14.0 million for the 2010 fiscal year. Please see “RiskFactors*—*We are not certain thatour ongoing cost control plans will continue to be successful.”

 

·             *Opening new stores*.  Our future growth strategy depends in part onour ability to open and profitably operate new stores in existing andadditional geographic areas. The capital requirements to open a U.S.-basedSally Beauty Supply or BSG store, excluding inventory, average approximately$70,000 and $80,000, respectively, with the capital requirements forinternational stores costing less or substantially more depending upon themarketplace. We may not be able to open all of the new stores we plan to openand any new stores we open may not be profitable, any of which could have amaterial adverse impact on our financial condition or results of operations.Please see “Risk Factors*—*If weare unable to profitably open and operate new stores, our business, financialcondition and results of operations may be adversely affected.”

 

·             *Changes to our informationtechnology systems*. As our operations grow in both size and scope, wewill continuously need to improve and upgrade our information systems andinfrastructure while maintaining the reliability and integrity of our systemsand infrastructure. The expansion of our systems and infrastructure willrequire us to commit substantial financial, operational and technical resourcesin advance of any increase in the volume of our business, with no assurancethat the volume of business will increase. For example, we have recently upgraded our financial reporting systemsin the U.S. and are in the process of designing and implementing a standardizedenterprise resource planning (“ERP”) system internationally over the next fewyears. In addition, we are currently implementing a three-year point-of-salesystem upgrade program in a number of our divisions (including our Sally BeautySupply operations in the U.S.), which we anticipate will provide significantbenefits, including enhanced tracking of customer sales and store inventoryactivity. These and any other required upgrades to our information systems andinformation technology (or new technology), now or in the future, will requirethat our management and resources be diverted from our core business to assistin completion of these projects. There can be no assurance that the time andresources our management will need to devote to these upgrades, service outagesor delays due to the installation of any new or upgraded technology (andcustomer issues therewith), or the impact on the reliability of our data fromany new or upgraded technology will not have a material adverse effect on ourfinancial reporting, business, financial condition or results of operations.Please see “Risk Factors*—*We maybe adversely affected by any disruption in our information technology systems.”

 

**BusinessSegments, Geographic Area Information and Seasonality**

 

Weoperate two business segments: (i) Sally Beauty Supply, an open-line andexclusive-label distributor of professional beauty supplies offeringprofessional beauty supplies to both retail consumers and salon professionalsprimarily in North America, Europe, Puerto Rico and South America, and(ii) BSG, a full-service beauty supply distributor offering professionalbrands directly to salons and salon professionals through our own sales forceand professional-only stores, many in exclusive geographical territories inNorth America. BSG operates stores under the CosmoProf service mark. BSG alsofranchises beauty supply outlets in the southwest portion of the U.S. andMexico, and supplies sub-distributors in Europe. Sales of Sally Beauty Supplyaccounted for approximately 63%, 64% and 63%; and BSG accounted forapproximately 37%, 36% and 37% of the company’s consolidated net sales for theyears ended September 30, 2010, 2009 and 2008, respectively.

 

Financialinformation about business segments and geographic area information isincorporated herein by reference to the “Business Segments and Geographic AreaInformation,” Note 18 of the “Notes to Consolidated Financial Statements”in “Item 8—Financial Statements and Supplementary Data” of this AnnualReport.

 

Neitherthe sales nor the product assortment for Sally Beauty Supply or BSG aregenerally seasonal in nature.

 

***Sally BeautySupply***

 

Webelieve Sally Beauty Supply is the largest open-line distributor ofprofessional beauty supplies in the U.S. based on store count. As of September 30,2010, Sally Beauty Supply operated 3,006 company-operated retail stores, 2,429of which are located in the U.S. (with the remainder in the United Kingdom,Belgium and certain other countries in Europe, and in Canada, Puerto Rico,Mexico and Chile), and supplied 26 franchised stores located outside the U.S.Its stores carry an extensive selection of professional beauty products,ranging between 4,000 and 8,000 stock keeping units (or SKUs) of beautyproducts, and includes products for hair care, nail care, beauty sundries andsmall electrical appliances targeting retail consumers and salon professionals.Sally Beauty Supply stores carry leading third-party brands such as Clairol,Revlon and Conair, as well as an extensive selection of exclusive-labelmerchandise. We believe that Sally Beauty Supply has differentiated itself fromits competitors through its customer value proposition, attractive pricing,extensive selection of leading third-party branded and exclusive-labelproducts, a broad ethnic product selection, the product knowledge of its salesassociates and convenient store locations.

 

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*StoreDesign and Operations*

 

SallyBeauty Supply stores are designed to create an appealing shopping environmentthat embraces the retail consumer and salon professional and highlights itsextensive product offering. Sally Beauty Supply stores average between 1,500square feet and 1,700 square feet in size and are located primarily instrip shopping centers in the U.S. and Canada. Generally, Sally Beauty Supplystores in the U.S. and Canada follow a consistent format, allowing customersfamiliarity between Sally Beauty Supply locations. Store formats for SallyBeauty Supply outside the U.S. and Canada vary by marketplace.

 

SallyBeauty Supply stores are segmented into distinctive areas arranged by producttype with signs allowing its customers to easily navigate through its stores.Sally Beauty Supply seeks to stimulate cross-selling and impulse buying throughstrategic product placement and use of displays to highlight new products andkey promotional items.

 

*Merchandise*

 

SallyBeauty Supply stores carry a broad selection of branded and exclusive-labelbeauty supplies. Sally Beauty Supply manages each category by product and bySKU and uses centrally developed planoguides to maintain a consistentmerchandise presentation across its store base (primarily in the U.S. andCanada). Through its information systems, Sally Beauty Supply actively monitorseach store’s performance by category, allowing it to maintain consistently highlevels of in-stock merchandise. We believe Sally Beauty Supply’s tailoredmerchandise strategy enables it to meet local demands and helps drive trafficin its stores. Additionally, its information systems enable it to track andautomatically replenish inventory levels, generally on a weekly basis,primarily in the U.S.

 

SallyBeauty Supply offers a comprehensive ethnic product selection with specificappeal to African-American and Hispanic customers. Its ethnic product offeringsare tailored by store based on market demographics and category performance.For example, sales of products targeted for the African-American customersaveraged approximately 8.6% of net sales in Sally Beauty Supply’sU.S. stores during the past three years. We believe the breadth ofselection of ethnic products available in Sally Beauty Supply stores is uniqueand differentiates its stores from its competition. Sally Beauty Supply alsoaims to position itself to be competitive in price, but not a discount leader.

 

SallyBeauty Supply’s pricing strategy is differentiated by customer segment.Professional salon customers are generally entitled to a price lower than thatreceived by retail customers. However, Sally Beauty Supply does offer discountsto retail customers through its customer loyalty program.

 

*LeadingThird-Party Branded Products*

 

SallyBeauty Supply offers an extensive selection of hair care products, nail careproducts, beauty sundries and appliances from leading third-party brands suchas Clairol, Revlon and Conair, as well as an extensive selection ofexclusive-label merchandise. We believe that carrying a broad selection of thelatest premier branded merchandise is critical to maintaining long-termrelationships with our customers. The merchandise Sally Beauty Supply carriesincludes products from one or more of the leading manufacturers in eachcategory. Sally Beauty Supply’s objective is not only to carry leading brands,but also to carry a full range of branded and exclusive-label products withineach category. As hair trends continue to evolve, we expect to offer thechanging professional beauty product assortment necessary to meet the needs ofretail consumers and salon professionals.

 

*Exclusive-LabelProducts*

 

SallyBeauty Supply offers a broad range of exclusive-label products. We believeexclusive-label products provide customers with an attractive alternative tohigher-priced leading third-party brands. Exclusive-label products accountedfor approximately 42% of Sally Beauty Supply’s product sales in the U.S. duringthe 2010 fiscal year. Generally, the exclusive-label brands have higher grossmargins than the leading third-party branded products, and we believe this areaoffers continued potential growth. Sally Beauty Supply maintainsexclusive-label products in a number of categories including hair care, smallelectrical appliances and salon products. Sally Beauty Supply actively promotesits exclusive-label brands through in-store promotions and monthly shoppingguides. We believe our customers perceive these exclusive-label products to becomparable in quality and name recognition to leading third-party brandedproducts.

 

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Thefollowing table sets forth the approximate percentage of Sally Beauty Supply’ssales by merchandise category:

 

| ** **                       | ** ** | **Fiscal Year Ended September 30,** | ** ** |
|----------------------------------|------------|---------------------------------------------------------|------------|
| ** **                       | ** ** | **2010**                                                | ** ** | **2009** | ** ** | **2008** | ** ** |
| Hair color                       |       | 22.7                                                    | %          | 22.8 | % | 21.7 | % |
| Hair care                        |       | 20.7                                                    | %          | 19.7 | % | 18.5 | % |
| Brushes, cutlery and accessories |       | 15.1                                                    | %          | 15.6 | % | 16.8 | % |
| Skin and nail care               |       | 14.2                                                    | %          | 13.0 | % | 12.4 | % |
| Electrical appliances            |       | 11.8                                                    | %          | 11.9 | % | 13.2 | % |
| Ethnic products                  |       | 8.1                                                     | %          | 8.7 | % | 9.1 | % |
| Other beauty items               |       | 7.4                                                     | %          | 8.3 | % | 8.3 | % |
| Total                            |       | 100.0                                                   | %          | 100.0 | % | 100.0 | % |

 

*Marketingand Advertising*

 

SallyBeauty Supply’s marketing program is designed to promote its extensiveselection of brand name products at competitive prices. The program iscurrently centered on multi-page, color flyers highlighting promotionalproducts. Separate flyers are created and tailored to Sally Beauty Supply’sretail customers and salon professionals. These flyers, which are available inSally Beauty Supply stores, are also mailed to loyalty program customers andsalon professionals on a monthly basis and are supplemented by e-mailnewsletters.

 

Wecontinuously adapt our marketing and merchandising initiatives for Sally BeautySupply in an effort to expand our market reach or to respond to changingconsumer preferences.

 

SallyBeauty Supply’s customer loyalty and marketing programs, primarily in the U.S.and Canada, allow Sally Beauty Supply to collect point-of-sale customer dataand increase our understanding of customers’ needs. The Sally “Beauty Club” isa loyalty program for customers who are not salon professionals. Beauty Clubmembers, after paying a nominal annual fee, receive a special, discounted priceon almost every non-sale item. Members are also eligible for a special BeautyClub e-mail newsletter that contains additional savings, beauty tips, newproduct information and coupons. In addition, the “ProCard” is a marketingprogram for licensed salon professionals. ProCard members receive discounts onall beauty products sold at Sally Beauty Supply stores. We believe theseprograms are effective in developing and maintaining customer relationships.Outside the U.S. and Canada, our customer loyalty and marketing programs varyby marketplace.

 

*StoreLocations*

 

SallyBeauty Supply selects geographic areas and store sites on the basis ofdemographic information, quality and nature of neighboring tenants, storevisibility and location accessibility. Sally Beauty Supply seeks to locate storesprimarily in strip malls, which are occupied by other high traffic retailersincluding grocery stores, mass merchants and home centers.

 

SallyBeauty Supply balances its store expansion between new and existingmarketplaces. In its existing marketplaces, Sally Beauty Supply adds stores asnecessary to provide additional coverage. In new marketplaces, Sally BeautySupply generally seeks to expand in geographically contiguous areas to leverageits experience. We believe that Sally Beauty Supply’s knowledge of localmarketplaces is an important part of its success.

 

Thefollowing table provides a history of Sally Beauty Supply’s store count duringthe last five fiscal years:

 

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| ** **                          | ** ** | **Fiscal Year Ended September 30,** | ** ** |
|-------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                          | ** ** | **2010**                                                | ** ** | **2009** | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
| Stores  open at beginning of period |       | 2,923                                                   |       | 2,844 |   | 2,694 |   | 2,511 |   | 2,419 |   |
| Net  store openings during period   |       | 108                                                     |       | 60 |   | 110 |   | 83 |   | 92 |   |
| Stores  acquired during period      |       | 1                                                       |       | 19 |   | 40 |   | 100 |   | — |   |
| Stores  open at end of period       |       | 3,032                                                   |       | 2,923 |   | 2,844 |   | 2,694 |   | 2,511 |   |

 

***Beauty SystemsGroup***

 

Webelieve that BSG is the largest full-service distributor of professional beautysupplies in the U.S. As of September 30, 2010, BSG had868 company-operated stores, supplied 159 franchised stores and had asales force of approximately 1,051 professional distributor sales consultantsselling exclusively to salons and salon professionals in substantially everystate in the U.S., in Puerto Rico and in portions of Canada, Mexico and certainEuropean countries.

 

*StoreDesign and Operations*

 

BSGstores are designed to create a professional shopping environment that embracesthe salon professional and highlights its extensive product offering.Company-operated BSG stores average approximately 2,700 square feetand are located primarily in secondary strip shopping centers. BSG storelayouts are designed to provide optimal variety and options to the salon professional.Stores are segmented into distinctive areas arranged by product type withcertain areas dedicated to leading third-party brands; such as Paul Mitchell,Wella, Sebastian, Goldwell and TIGI. The selection of these brands varies byterritory.

 

*ProfessionalDistributor Sales Consultants*

 

BSGhas a network of approximately 1,051 professional distributor sales consultants(“DSC” or “DSCs”), which exclusively serve salons and salon professionals. Thefollowing table sets forth the number of consultants in the BSG network duringthe last five fiscal years:

 
| ** **                                     | ** ** | **Fiscal Year Ended September 30,** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                     | ** ** | **2010**                                                | ** ** | **2009** | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
| Professional  distributor sales consultants(a) |       | 1,051                                                   |       | 1,022 |   | 984 |   | 1,002 |   | 1,163 |   |

 

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(a)          Includes 395, 300, 328, 317 and 348 distributorsales consultants of our Armstrong McCall franchisees at September 30,2010, 2009, 2008, 2007 and 2006, respectively.

 

Theincrease in the number of DSCs in 2009 reflects approximately 90 distributorsales consultants previously employed by Schoeneman Beauty Supply, Inc (“Schoeneman”)prior to the Company’s acquisition of Schoeneman on September 30, 2009.The decrease in DSCs in the fiscal year 2007 was in response to the loss of L’Oreal-relatedsales resulting from changes to our contractual relationship with L’Oreal. BSG’sDSC sales force was reduced in the fiscal year 2007 and the remaining affectedsales consultants were offered certain compensation related incentives to staywith the Company, as BSG replaced lost L’Oreal sales. Please see “RiskFactors—The beauty products distribution industry is highly competitive and isconsolidating,” and “We depend upon manufacturers who may be unable to provideproducts of adequate quality or who may be unwilling to continue to supplyproducts to us.”

 

Inorder to provide a knowledgeable sales consultant team, BSG actively recruitsindividuals with industry knowledge or sales experience, as we believe that newsales consultants with either broad knowledge about the products or directsales experience will be more successful.

 

BSGprovides training to new sales consultants beginning with a two-week trainingprogram, followed by a continuing program of media-based training, deliveredthrough audio, video and web-based e-learning. The program is designed todevelop product knowledge as well as techniques on how best to serve salonprofessionals. In addition to selling professional beauty products, these salesconsultants offer in-salon training for professionals and owners in areas suchas new styles, techniques and business practices.

 

Animportant component of sales consultants’ compensation is sales commissions.BSG’s commission system is designed to drive sales and focus consultants onselling products that are best suited to individual salons and salonprofessionals. We believe our emphasis on recruitment, training, andsales-based compensation results in a sales force that distinguishes itselffrom other full-service/exclusive-channel distributors.

 

Thefollowing table sets forth the approximate percentage of BSG sales attributableby distribution channel:

 
| ** **                                                 | ** ** | **Fiscal Year Ended September 30,** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                 | ** ** | **2010**                                                | ** ** | **2009** | ** ** |
| Company-operated  retail stores                            |       | 65.1                                                    | %          | 60.0 | % |
| Professional  distributor sales consultants (full-service) |       | 24.2                                                    | %          | 27.9 | % |
| Franchise  stores                                          |       | 10.7                                                    | %          | 12.1 | % |
| Total                                                      |       | 100.0                                                   | %          | 100.0 | % |

 

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*Merchandise*

 

BSGstores carry a broad selection of third-party branded products, ranging between5,000 and 10,000 SKUs of beauty products, including hair care products, nailcare, small electrical appliances and other beauty items. Some products areavailable in bulk packaging for higher volume salon needs. Through BSG’sinformation systems, each store’s product performance is actively monitored,allowing maintenance of an optimal merchandise mix. Additionally, BSG’sinformation systems track and automatically replenish inventory levels on aweekly basis, enabling BSG to maintain high levels of product in stock.Although BSG positions itself to be competitive on price, its primary focus isto provide a comprehensive selection of branded products to the salonprofessional. Certain BSG products are sold under exclusive arrangements withsuppliers, whereby BSG is designated the sole distributor for a specific brandname within certain geographic territories. We believe that carrying a broadselection of branded merchandise is critical to maintaining relationships withour valued professional customers.

 

Thefollowing table sets forth the approximate percentage of BSG’s salesattributable by merchandise category:

 
| ** **            | ** ** | **Fiscal Year Ended September 30,** | ** ** |
|-----------------------|------------|---------------------------------------------------------|------------|
| ** **            | ** ** | **2010**                                                | ** ** | **2009** | ** ** | **2008** | ** ** |
| Hair care             |       | 37.1                                                    | %          | 38.5 | % | 38.1 | % |
| Hair color            |       | 29.6                                                    | %          | 28.4 | % | 26.3 | % |
| Promotional items(a)  |       | 13.2                                                    | %          | 12.5 | % | 12.4 | % |
| Skin and nail care    |       | 8.1                                                     | %          | 7.7 | % | 8.0 | % |
| Electrical appliances |       | 4.5                                                     | %          | 4.9 | % | 6.5 | % |
| Other beauty items    |       | 7.5                                                     | %          | 8.0 | % | 8.7 | % |
| Total                 |       | 100.0                                                   | %          | 100.0 | % | 100.0 | % |

 

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(a)          Promotional items consist ofsales from other categories that are sold on a value-priced basis.

 

*Marketingand Advertising*

 

BSG’smarketing program is designed primarily to promote its extensive selection ofbrand name products at competitive prices. BSG distributes at its stores andmails to its salon and salon professional customers, multi-page colorshopping guides that highlight promotional products. Some BSG stores also hostmonthly manufacturer-sponsored classes for customers. These classes are held atBSG stores and led by manufacturer-employed educators. Salon professionals,after paying a small fee to attend, are educated on new products and beautytrends. We believe these classes increase brand awareness and drive sales inBSG stores.

 

*StoreLocations*

 

BSGstores are primarily located in secondary strip shopping centers. Although BSGstores are located in visible and convenient locations, salon professionals areless sensitive about store location than Sally Beauty Supply customers.

 

Thefollowing table provides a history of BSG’s store count during the last fivefiscal years:

 
| ** **                            | ** ** | **Fiscal Year Ended September 30,** | ** ** |
|---------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                            | ** ** | **2010**                                                | ** ** | **2009** | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
| Stores  open at beginning of period   |       | 991                                                     |       | 929 |   | 874 |   | 828 |   | 822 |   |
| Net  store openings during period     |       | 36                                                      |       | 16 |   | 44 |   | 46 |   | 6 |   |
| Stores  acquired during period (a)(b) |       | —                                                  |       | 46 |   | 11 |   | — |   | — |   |
| Stores  open at end of period         |       | 1,027                                                   |       | 991 |   | 929 |   | 874 |   | 828 |   |

 

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(a)          Stores acquired in thefiscal year 2009, include 43 stores owned by Schoeneman prior to the Company’sacquisition of Schoeneman on September 30, 2009.

 

(b)         Stores acquired during andat the end of the fiscal periods presented herein do not include 82 storesowned by Aerial Company Inc. (“Aerial”) prior to the Company’s acquisition ofAerial on October 1, 2010.

 

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**OurStrategy**

 

Webelieve there are significant opportunities to increase our sales andprofitability through the further implementation of our operating strategy andby growing our store base in existing and contiguous marketplaces, bothorganically and through strategic acquisitions. Specific elements of our growthstrategy include the following:

 

***Increase SalesProductivity of Our Stores***

 

Weintend to grow same store sales by focusing on improving our merchandise mixand introducing new products. In addition, we plan to tailor our marketing,advertising and promotions to attract new customers and increase sales withexisting customers. We also plan to enhance our customer loyalty programs,which allow us to collect point-of-sale customer data and increase ourunderstanding of customers’ needs.

 

***Open New Storesand Exploring New Marketplaces***

 

Inthe fiscal year 2010, we opened or acquired 109 and 36 net new stores forSally Beauty Supply and BSG, respectively. Because of the limited initialcapital outlay, rapid payback, and attractive return on capital, we intend tocontinue to expand our Sally Beauty Supply and BSG store base. We believe thereare growth opportunities for additional stores in North America, Europe andCentral and South America. We expect new store openings and acquisitions inexisting and new areas to be an important aspect of our future growthopportunities. Please also see “Pursue Strategic Acquisitions.”

 

***Increase Sales ofExclusive-label Products***

 

Wecurrently intend to grow exclusive-label sales in Sally Beauty Supply. Webelieve our customers view our exclusive-label products as high-quality,recognizable brands, which are competitive with leading third-party brandedmerchandise. Exclusive-label products are currently sold through our SallyBeauty Supply stores with very limited exclusive-label offerings at BSG.Exclusive-label products account for a substantial amount of the Sally BeautySupply segment net sales and generate a gross margin greater than that of theleading third-party brands sold through our stores. Potential growth for suchproducts is believed to be significant. In addition, our broad exclusive-labelproduct offering minimizes our dependence on any one brand or supplier. Webelieve exclusive-label products present opportunities to grow profits andincrease store loyalty.

 

***IncreaseOperating Efficiency and Profitability***

 

Webelieve there are opportunities to increase the profitability of operations,especially in our BSG business. During the last couple of fiscal years, we madecertain changes which included right-sizing the business (including sometargeted reductions-in-force) and maximizing the efficiency of our structure.We completed a re-branding project at BSG that repositioned all of our NorthAmerican company-operated stores under a common name and store identity,CosmoProf, which we believe has improved brand consistency, saved onadvertising and promotional costs and allowed for a more focused marketingstrategy. We also implemented a two-year, $22.0 million capital spendingprogram to consolidate warehouses and reduce administrative expenses related toBSG’s distribution network. Over the past few years, we have undertaken a fullreview of our procurement strategy. This initiative is intendedto identify lower-cost alternative sources of supply in certain productcategories from countries with lower manufacturing costs. We also offer between5,000 and 8,000 SKUs of our Sally Beauty Supply products for sale through SallyBeauty’s website (*www.sallybeauty.com*), which weexpect will increasingly lead to additional sales for that business segment.

 

***Pursue StrategicAcquisitions and New Territories for Organic Growth***

 

Wehave completed more than 30 acquisitions during the last 10 years. Webelieve our experience in identifying attractive acquisition targets; ourproven integration process; and our highly scalable infrastructure have createda strong platform for potential future acquisitions, subject to restrictions onour ability to finance acquisitions by incurring additional debt or issuingequity under our debt agreements. For example, (1) in March of 2010,we acquired certain assets and the business of a former exclusive distributorof John Paul Mitchell Systems beauty products with sales primarily in southFlorida and certain islands in the Caribbean; (2) in December of2009, we acquired Sinelco, a wholesale distributor of professional beautyproducts located in Belgium with sales throughout Europe; (3) on September 30,2009, we acquired Schoeneman, a 43-store beauty supply chain located in thecentral northeast United States; (4) in September of 2009, weacquired Intersalon, a leading distributor of premier beauty supply productswith 16 stores located in Chile; (5) in September of 2009, we alsoacquired the assets and business of Belleza Concept International, Inc., adistributor of beauty supply products operating in Puerto Rico; and (6) inMay of 2008, we acquired Pro-Duo NV (“Pro-Duo”), a cash and carry retailerof both professional and retail hair products with 40 stores located primarilyin Belgium, France and Spain. We intend to continue to identify and evaluateacquisition targets and organic growth targets both domestically andinternationally, with a focus on expanding our exclusive BSG territories andallowing Sally Beauty Supply to enter new geographic areas principally outsidethe U.S.

 

**Competition**

 

Althoughthere are a limited number of sizable direct competitors to our business, thebeauty industry is highly competitive. In each area in which we operate, weexperience competition from domestic and international businesses often withmore resources, including

 

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massmerchandisers, drug stores, supermarkets and other chains offering similar orsubstitute beauty products at comparable prices. Our business also facescompetition from department stores. In addition, our business competes withlocal and regional open-line beauty supply stores and full-service distributorsselling directly to salons and salon professionals through both professionaldistributor sales consultants and outlets open only to salons and salonprofessionals. Our business also faces increasing competition from certainmanufacturers that use their own sales forces to distribute their professionalbeauty products directly or align themselves with our competitors. Some ofthese manufacturers are vertically integrating through the acquisition ofdistributors and stores. In addition, these manufacturers may acquireadditional brands that we currently distribute and attempt to shift theseproducts to their own distribution channels. Our business also facescompetition from authorized and unauthorized retailers and internet sitesoffering professional salon-only products. Please see “Risk Factors—The beautyproducts distribution industry is highly competitive and is consolidating” foradditional information about our competition.

 

**CompetitiveStrengths**

 

Webelieve the following competitive strengths differentiate us from ourcompetitors and contribute to our success:

 

***The LargestProfessional Beauty Supply Distributor in the U.S. with Multi-ChannelPlatform***

 

SallyBeauty Supply and BSG together comprise the largest distributor of professionalbeauty products in the U.S. by store count. Our leading channel positionsand multi-channel platform afford us several advantages, including strongpositioning with suppliers, the ability to better service the highly fragmentedbeauty supply marketplace, economies of scale and the ability to capitalize onthe ongoing consolidation in our sector. Through our multi-channel platform, weare able to generate and grow revenues across broad, diversified geographies,and customer segments using varying product assortments. In the U.S. and PuertoRico, we offer up to 8,000 and 10,000 SKUs in Sally Beauty Supply (in ourstores and online) and BSG stores, respectively, to a potential customer basethat includes millions of retail consumers and more than 250,000 hair salons inthe U.S.

 

***DifferentiatedCustomer Value Proposition***

 

Webelieve that our stores are differentiated from their competitors throughconvenient location, broad selection of professional beauty products (includingleading third-party branded and exclusive-label merchandise), high levels ofin-stock merchandise, knowledgeable salespeople and competitive pricing. Ourmerchandise mix includes a comprehensive ethnic product selection, which istailored by store based on market demographics and category performance. Webelieve that the breadth of our selection of these products furtherdifferentiates Sally Beauty Supply from its competitors. In addition, asdiscussed above, Sally Beauty Supply also offers a customer loyalty program forSally Beauty Supply customers, the Beauty Club, whereby members receive aspecial, discounted price on products and are also eligible for a special BeautyClub e-mail newsletter with additional promotional offerings, beauty tips andnew product information for a nominal annual fee. We believe that ourdifferentiated customer value proposition and strong brands drive customerloyalty and high repeat traffic, contributing to our consistent historicalfinancial performance. Our BSG professional distributor sales consultantsbenefit from their customers having access to the BSG store systems ascustomers have the ability to pick up the products they need between salesvisits from professional distributor sales consultants.

 

***Attractive StoreEconomics***

 

Webelieve that our stores generate attractive returns on invested capital. Thecapital requirements to open a U.S.-based Sally Beauty Supply or BSG store, excludinginventory, average approximately $70,000 and $80,000, respectively, with thecapital requirements for international stores costing less or substantiallymore depending on the local economic conditions. Sally Beauty Supply storesaverage between 1,500 square feet and 1,700 square feet and BSG stores averageapproximately 2,700 square feet in size in the U.S. and Canada.Domestically, our stores are typically located within strip shopping centers.Strong average sales per square foot combined with minimal staffingrequirements, low rent expense and limited initial capital outlay typicallyresult in positive contribution margins within a few months, and cashpayback on investment within approximately two years. Due to such attractiveinvestment returns and relatively high operating profit contributions perstore, during the past five years Sally Beauty Supply and BSG have opened anaggregate of 453 and 148 net new stores, respectively, excluding theeffect of acquisitions. Store formats, including average size, for Sally BeautySupply outside the U.S. and Canada vary by marketplace.

 

***ConsistentFinancial Performance***

 

Wehave a proven track record of strong growth and consistent profitability due tosuperior operating performance, new store openings and strategic acquisitions.Over the past five fiscal years, our consolidated same store sales growth hasbeen positive in each year and has averaged 3.3%, as set forth in the followingtable:

 
| ** **                                          | ** ** | **Fiscal Year Ended September 30,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------------------|------------|
| **Same store sales growth (a)** | ** ** | **2010**                                                | ** ** | **2009** | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
| Sally  Beauty Supply                                |       | 4.1                                                     | %          | 2.1 | % | 1.2 | % | 2.7 | % | 2.4 | % |
| Beauty  Systems Group                               |       | 6.2                                                     | %          | 1.0 | % | 6.9 | % | 10.1 | % | 4.1 | % |
| Consolidated                                        |       | 4.6                                                     | %          | 1.8 | % | 2.6 | % | 4.5 | % | 2.8 | % |

 

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(a)     Same stores are defined ascompany-operated stores that have been open for at least 14 months as of thelast day of a month. Our same store sales calculation includes internet-basedsales (beginning in fiscal year 2009) and store expansions, if applicable, butdoes not generally include sales from stores relocated.

 

***ExperiencedManagement Team with a Proven Track Record***

 

Ourmanagement team, which includes the management team of Sally Beauty is, led byPresident and Chief Executive Officer Gary Winterhalter and has a strong recordof performance.

 

**CustomerService**

 

Westrive to complement our extensive merchandise selection and innovative storedesign with superior customer service. We actively recruit individuals withcosmetology experience because we believe that such individuals are moreknowledgeable about the products they sell. Additionally, Sally Beauty Supplyrecruits individuals with retail experience because we believe their generalretail knowledge can be leveraged in the beauty supply industry. We believethat employees’ knowledge of the products and ability to demonstrate andexplain the advantages of the products increases sales and that their prompt,knowledgeable service fosters the confidence and loyalty of customers anddifferentiates our business from other professional beauty supply distributors.

 

Weemphasize product knowledge during initial training as well as during ongoingtraining sessions, with programs intended to provide new associates andmanagers with significant training. The training programs encompass operationaland product training and are designed to increase employee and storeproductivity. Store employees are also required to participate in training onan ongoing basis to keep up-to-date on products and operational practices.

 

Mostof our stores are staffed with a store manager, and two or three full-time orpart-time associates. BSG stores are generally also staffed with an assistantmanager. The operations of each store are supervised by a district manager, whoreports to a territory manager. A significant number of our store managers andassistant managers are licensed in the cosmetology field. Additionally, incertain geographic areas in the U.S., a significant number of our storepersonnel, including store managers and assistant managers, speak Spanish as asecond language. We believe that these skills enhance our store personnel’sability to serve our customers.

 

**Relationshipswith Suppliers**

 

Wepurchase our merchandise directly from manufacturers through supply contractsand by purchase orders. For the fiscal year 2010, our five largest suppliers,The Procter & Gamble Company, or P&G, Shiseido Cosmetics (America)Limited, Conair Corporation, the Professional Products Division of L’Oreal USAS/D, Inc., or L’Oreal, and John Paul Mitchell Systems, accounted forapproximately 39% of our consolidated merchandise purchases. Products arepurchased from these and many manufacturers on an at-will basis or undercontracts which can be terminated without cause upon 90 days notice orless or expire without express rights of renewal. Such manufacturers coulddiscontinue sales to us at any time or upon short notice. If any of thesesuppliers discontinued selling or were unable to continue selling to us, therecould be a material adverse effect on our consolidated results of operations.

 

Asis typical in the distribution businesses, relationships with suppliers aresubject to change from time to time (including the expansion or loss ofdistribution rights in various geographies and the addition or loss of productslines). Changes in our relationships with suppliers occur often, and couldpositively or negatively impact our net sales and operating profits. Please see“Risk Factors— We depend upon manufacturers who may be unable to provideproducts of adequate quality or who may be unwilling to continue to supplyproducts to us.” However, we believe that we can be successful in mitigatingnegative effects resulting from unfavorable changes in the relationshipsbetween us and our suppliers through, among other things, the development ofnew or expanded supplier relationships.

 

**Distribution**

 

Asof September 30, 2010, we operated mainly through 17 distribution centers,nine of which serviced Sally Beauty Supply and eight of which serviced BSG.During the 2009 fiscal year, we completed implementation of a comprehensiveoptimization program to consolidate warehouses and reduce administrativeexpenses related to BSG’s distribution network. Total capital expenditures forthis program were approximately $22.0 million and certain related expenses wereapproximately $5.0 million. We believe that annual savings from this programare approximately $14.0 million for the 2010 fiscal year.

 

Ourpurchasing and distribution system is designed to minimize the delivered costof merchandise and maximize the level of merchandise in-stock in stores. Thisdistribution system also allows for monitoring of delivery times andmaintenance of appropriate inventory levels. Product deliveries are typicallymade to our stores on a weekly basis. Each distribution center has a qualitycontrol department that monitors products received from suppliers. We utilizeproprietary software systems to provide computerized warehouse locator andinventory support.  Please see “Risk Factors—We arenot certain that our ongoing cost control plans will continue to be successful.”

 

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**ManagementInformation Systems**

 

Ourmanagement information systems provide order processing, accounting andmanagement information for the marketing, distribution and store operationsfunctions of our business. A significant portion of these systems have beendeveloped internally. The information gathered by the management informationsystems supports automatic replenishment of in-store inventory and providessupport for product purchase decisions. Please see “Risk Factors—We may be adverselyaffected by any disruption in our information technology systems.”

 

**Employees**

 

Inour domestic and foreign operations, we had approximately 22,900 employeesas of September 30, 2010; consisting of approximately 6,730 salaried,4,670 hourly and 11,500 part-time employees. We had approximately22,410 employees as of September 30, 2009; consisting ofapproximately 6,480 salaried, 4,930 hourly and 11,000 part-time employees.Part-time employees are used to supplement schedules, particularly in NorthAmerica.

 

Certainsubsidiaries in Mexico have collective bargaining agreements covering warehouseand store personnel which expire at various times over the next several years.We believe that we have good relationships with our employees worldwide.

 

**Regulation**

 

Weare subject to a wide variety of laws and regulations, which historically havenot had a material effect on our business. For example, in the U.S., most ofthe products sold and the content and methods of advertising and marketingutilized are regulated by a host of federal agencies, including, in each case,one or more of the following: the Food and Drug Administration, or FDA, theFederal Trade Commission, or FTC, and the Consumer Products Safety Commission.The transportation and disposal of many of our products are also subject tofederal regulation. State and local agencies regulate many aspects of ourbusiness. In marketplaces outside of the U.S., regulation is also comprehensiveand focused upon labeling and safety issues.

 

Asof September 30, 2010, Sally Beauty Supply supplied 26 and BSG supplied159 franchised stores located in the U.S., Mexico and certain countries inEurope. As a result of these franchisor-franchisee relationships, we aresubject to regulation when offering and selling franchises in the applicablecountries. The applicable laws and regulations affect our business practices,as franchisor, in a number of ways, including restrictions placed upon theoffering, renewal, termination and disapproval of assignment of franchises. Todate, these laws and regulations have not had a material effect uponoperations.

 

**Trademarksand Other Intellectual Property Rights**

 

Ourtrademarks, certain of which are material to our business, are registered orlegally protected in the U.S., Canada and other countries throughout the worldin which we operate. Together with our subsidiaries, we own over 250 trademarkregistrations in the U.S., and over 900 trademark registrations outside theU.S. We also rely upon trade secrets and know-how to develop and maintain ourcompetitive position. We protect intellectual property rights through a varietyof methods, including reliance upon trademark, patent and trade secret laws andconfidentiality agreements with many vendors, employees, consultants and otherswho have access to our proprietary information. The duration of our trademarkregistrations is generally 10 or 15 years, depending on the countryin which a mark is registered, and generally the registrations can be renewed.The scope and duration of intellectual property protection varies byjurisdiction and by individual product.

 

**Accessto Public Filings**

 

OurAnnual Report on Form 10-K, our Quarterly Reports on Form 10-Q andour Current Reports on Form 8-K, and amendments to such reports areavailable, without charge, on Sally Beauty’s website, *www.sallybeautyholdings.com*,as soon as reasonably possible after they are filed electronically with theSecurities and Exchange Commission, or SEC, under the Exchange Act. We will providecopies of such reports to any person, without charge, upon written request toour Investor Relations Department at 3001 Colorado Blvd, Denton, TX 76210. Theinformation found on Sally Beauty’s website shall not be considered to be partof this or any other report filed with or furnished to the SEC.

 

Inaddition to Sally Beauty’s website, you may read and copy public reports wefile with or furnish to the SEC at the SEC’s Public Reference Room at 100F Street, NE, Washington, DC 20549. You may obtain information on the operationof the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SECmaintains an internet site that contains our reports, proxy and informationstatements, and other information that we file electronically with the SEC at *www.sec.gov*.

 

**ITEM 1A. RISK FACTORS**

 

Thefollowing describes risks that we believe to be material to our business. Ifany of the following risks or uncertainties actually occurs, our business,financial condition and operating results could be materially and adverselyaffected. This report also contains forward-looking statements and thefollowing risks could cause our actual results to differ materially from thoseanticipated in such forward-looking statements.

 

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**RisksRelating to Our Business**

 

***The beauty products distributionindustry is highly competitive and is consolidating.***

 

Thebeauty products distribution industry is highly fragmented, and there are fewsignificant barriers to entry into the marketplaces for most of the types ofproducts and services we sell. Sally Beauty Supply competes with other domesticand international beauty product wholesale and retail outlets, including localand regional open line beauty supply stores, professional-only beauty supplystores, salons, mass merchandisers, drug stores and supermarkets. BSG competeswith other domestic and international beauty product wholesale and retailsuppliers and with manufacturers selling professional beauty products directlyto salons and individual salon professionals. We also face competition fromauthorized and unauthorized retailers as well as e-commerce retailers offeringprofessional salon-only and other products. The availability of divertedprofessional salon products in large format retail stores such as drug stores,grocery stores and others could have a negative impact on our business. Theprimary competitive factors in the beauty products distribution industry arethe price at which we purchase products from manufacturers, the quality,perceived value, consumer brand name recognition, packaging and mix of theproducts we sell, customer service, the efficiency of our distribution network andthe availability of desirable store locations. Competitive conditions may limitour ability to maintain prices or may require us to reduce prices to retainbusiness or marketplace share. Some of our competitors have greater financialand other resources than we do and are less leveraged than our business, andmay therefore be able to spend more aggressively on advertising and promotionalactivities and respond more effectively to changing business and economicconditions. We expect existing competitors, business partners and new entrantsto the beauty products distribution industry to constantly revise or improvetheir business models in response to challenges from competing businesses,including ours. If these competitors introduce changes or developments that wecannot address in a timely or cost-effective manner, our business may beadversely affected.

 

Inaddition, our industry is consolidating, which may give our competitorsincreased negotiating leverage with suppliers and greater marketing resources,resulting in a more effective ability to compete with us. For instance, we maylose customers if those competitors which have broad geographic reach attractadditional salons (individual and chain) that are currently BSG customers, orif professional beauty supply manufacturers align themselves with ourcompetitors. For example, BSG’s largest supplier, L’Oreal, has been able toshift a material amount of revenue out of the BSG nationwide distributionnetwork and into its competitive regional distribution networks. L’Oreal hasalso acquired one manufacturer (that does not currently do business with BSG)and distributors directly competitive with BSG in the southeastern U.S., themid-western U.S. and the west coast of the U.S. As a result, L’Oreal entered intodirect competition with BSG and there can be no assurance that there will notbe further revenue losses over time at BSG, due to potential losses ofadditional L’Oreal related products as well as from the increased competitionfrom L’Oreal-affiliated distribution networks. If L’Oreal (or another directcompetitor) were to acquire another manufacturer which conducts business withBSG, we could lose that revenue as well. Not only does consolidation indistribution pose risks from the competitive distributors, but it may alsoplace more leverage in the hands of those manufacturers to negotiate smallermargins on products sold through our network.

 

Ifwe are unable to compete effectively in our marketplace or if competitorsdivert our customers away from our networks, it would adversely impact ourbusiness, financial condition and results of operations.

 

***We may be unable to anticipatechanges in consumer preferences and buying trends or manage our product linesand inventory commensurate with consumer demand.***

 

Oursuccess depends in part on our ability to anticipate, gauge and react in atimely manner to changes in consumer spending patterns and preferences forspecific beauty products. If we do not timely identify and properly respond toevolving trends and consumer demands in the marketplace for beauty products andchanging consumer demands our sales may decline significantly and we may berequired to mark down unsold inventory to prices which can be significantlylower than normal prices, which could adversely impact our business, financialcondition and results of operations. In addition, we depend on our inventorymanagement and information technology systems in order to replenish inventoriesand deliver products to store locations in response to customer demands. Anysystems-related problems could result in difficulties satisfying the demands ofcustomers which, in turn, could adversely affect our sales and profitability.

 

Weexpect the aging baby boomer population to drive future growth in professionalbeauty supply sales through an increase in the use of hair color and hair lossproducts. Additionally, we expect continuously changing fashion-related trendsthat drive new hair styles to result in continued demand for hair stylingproducts. Changes in consumer tastes and fashion trends can have an impact onour financial performance. If we are unable to anticipate and respond to trendsin the marketplace for beauty products and changing consumer demands, ourbusiness could suffer.

 

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***Our comparable store sales andquarterly financial performance may fluctuate for a variety of reasons.***

 

Ourcomparable store sales and quarterly results of operations have fluctuated inthe past, and we expect them to continue to fluctuate in the future. A varietyof factors affect our comparable store sales and quarterly financialperformance, including:

 
| · | changes in our merchandising strategy or mix;                                                                                                                       |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                |
| · | the performance of our new stores;                                                                                                                                  |
|   |                                                                                                                                                                |
| · | our ability to increase sales and meet forecasted levels of  profitability at our existing stores;                                                                  |
|   |                                                                                                                                                                |
| · | the effectiveness of our inventory management;                                                                                                                      |
|   |                                                                                                                                                                |
| · | the timing and concentration of new store openings, including  additional human resource requirements and related pre-opening and other  start-up costs;            |
|   |                                                                                                                                                                |
| · | levels of pre-opening expenses associated with new stores;                                                                                                          |
|   |                                                                                                                                                                |
| · | a portion of a typical new store’s sales (or sales we make over the  internet channel) coming from customers who previously shopped at other  existing stores; |
|   |                                                                                                                                                                |
| · | expenditures on our distribution system;                                                                                                                            |
|   |                                                                                                                                                                |
| · | the timing and effectiveness of our marketing activities,  particularly our Sally Beauty Club promotions;                                                           |
|   |                                                                                                                                                                |
| · | the level of sales made through our internet channel;                                                                                                               |
|   |                                                                                                                                                                |
| · | actions by our existing or new competitors;                                                                                                                         |
|   |                                                                                                                                                                |
| · | worldwide economic conditions and, in particular, the retail sales  environment in the U.S.; and                                                                    |
|   |                                                                                                                                                                |
| · | changes in foreign currency exchange rates.                                                                                                                         |

 

Accordingly,our results for any one fiscal quarter are not necessarily indicative of theresults to be expected for any other quarter, and comparable store sales forany particular future period may decrease, which could have a material adverseeffect on our business, financial condition and results of operations.

 

***We depend upon manufacturers who maybe unable to provide products of adequate quality or who may be unwilling tocontinue to supply products to us.***

 

Wedo not manufacture any products we sell, and instead purchase our products fromrecognized brand manufacturers and exclusive-label fillers. We depend on alimited number of manufacturers for a significant percentage of the products wesell. For fiscal 2010, our five largest suppliers were P&G, ShiseidoCosmetics (America) Limited, Conair Corporation, L’Oreal and John Paul MitchellSystems and accounted for approximately 39.0% of our consolidated merchandisepurchases.

 

Sincewe purchase products from many manufacturers and fillers under at-willcontracts and contracts which can be terminated without cause upon 90 daysnotice or less, or which expire without express rights of renewal,manufacturers and fillers could discontinue sales to us immediately or uponshort notice. Some of our contracts with manufacturers may be terminated if wefail to meet specified minimum purchase requirements. If minimum purchaserequirements are not met, we do not have contractual assurances of continuedsupply. In lieu of termination, a manufacturer may also change the terms uponwhich it sells, for example, by raising prices or broadening distribution tothird parties. Infrequently, a supplier will seek to terminate a distributionrelationship through legal action. For example, in 2009 L’Oreal filed an actionwhich threatens a long-term distribution agreement with Armstrong McCall.Armstrong McCall is vigorously defending its rights under the agreement. Forthese and other reasons, we may not be able to acquire desired merchandise insufficient quantities or on acceptable terms in the future.

 

Changesin Sally Beauty Supply’s and BSG’s relationships with suppliers occur often,and could positively or negatively impact the net sales and operating profitsof both business segments.  Some of oursuppliers may seek to decrease their reliance on distribution intermediaries,including full-service/exclusive and open-line distributors like BSG and SallyBeauty Supply, by promoting their own distribution channels, as discussedabove. These suppliers may offer advantages, such as lower prices, when theirproducts are purchased from distribution channels they control. If our accessto supplier-provided products were to diminish relative to our competitors orwe were not able to purchase products at the same prices as our competitors,our business could be materially and adversely affected. Also, consolidationamong suppliers may increase their negotiating leverage, thereby providing themwith competitive advantages that may increase our costs and reduce ourrevenues, adversely affecting our business, financial condition and results ofoperations.

 

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Asdiscussed above, L’Oreal is entering into direct competition with BSG, andthere can be no assurance that there will not be further revenue losses overtime at BSG, due to potential losses of additional L’Oreal related products aswell as from the increased competition from L’Oreal-affiliated distributionnetworks. For example, L’Oreal could attempt to terminate our contracts tocarry certain of their products in BSG stores, which accounted forapproximately $100 million in U.S. sales for the 2010 fiscal year and have expirationdates at the end of 2012. Therefore, there can be no assurance that the impactof these developments will not adversely impact revenue to a greater degreethan we currently expect or that our efforts to mitigate the impact of thesedevelopments will be successful. If the impact of these developments is greaterthan we expect or our efforts to mitigate the impact of these developments arenot successful, this could have a material adverse effect on our business,financial condition or results of operations.

 

Althoughwe plan to mitigate the negative effects resulting from unfavorable changes inour relationships with suppliers, such as L’Oreal, there can be no assurancethat our efforts will partially or completely offset the loss of thesedistribution rights.

 

***Any significant interruption in thesupply of products by manufacturers and fillers could disrupt our ability todeliver merchandise to our stores and customers in a timely manner, which couldhave a material adverse effect on our business, financial condition and resultsof operations.***

 

Manufacturersand fillers of beauty supply products are subject to certain risks that couldadversely impact their ability to provide us with their products on a timelybasis, including inability to procure ingredients, industrial accidents,environmental events, strikes and other labor disputes, union organizingactivity, disruptions in logistics or information systems, loss or impairmentof key manufacturing sites, product quality control, safety, and licensingrequirements and other regulatory issues, as well as natural disasters andother external factors over which neither they nor we have control. Inaddition, our operating results depend to some extent on the orderly operationof our receiving and distribution processes, which depend on manufacturers’adherence to shipping schedules and our effective management of ourdistribution facilities and capacity.

 

Ifa material interruption of supply occurs, or a significant manufacturer orfiller ceases to supply us or materially decreases its supply to us, we may notbe able to acquire products with similar quality and consumer brand namerecognition as the products we currently sell or to acquire such products insufficient quantities to meet our customers’ demands or on favorable terms toour business, any of which could adversely impact our business, financialcondition and results of operations.

 

***If products sold by us are found tobe defective in labeling or content, our credibility and that of the brands wesell may be harmed, marketplace acceptance of our products may decrease, and wemay be exposed to liability in excess of our products liability insurancecoverage and manufacturer indemnities.***

 

Wedo not control the production process for the products we sell. We may not beable to identify a defect in a product we purchase from a manufacturer orfiller before we offer such product for resale. In many cases, we rely on representations of manufacturers and fillersabout the products we purchase for resale regarding whether such products havebeen manufactured in accordance with applicable governmentalregulations. Our sale of certain products exposes us to potential productliability claims, recalls or other regulatory or enforcement actions initiated byfederal, state or foreign regulatory authorities or through private causes ofaction. Such claims, recalls or actions could be based on allegations that,among other things, the products sold by us are misbranded, containcontaminants or impermissible ingredients, provide inadequate instructionsregarding their use or misuse, or include inadequate warnings concerningflammability or interactions with other substances. Claims against us couldalso arise as a result of the misuse by purchasers of such products or as aresult of their use in a manner different than the intended use. We may berequired to pay for losses or injuries actually or allegedly caused by theproducts we sell and to recall any product we sell that is alleged to be or isfound to be defective.

 

Anyactual defects or allegations of defects in products sold by us could result inadverse publicity and harm our credibility, which could adversely affect ourbusiness, financial condition and results of operations. Although we may haveindemnification rights against the manufacturers of many of the products wedistribute and rights as an “additional insured” under the manufacturers’insurance policies, it is not certain that any manufacturer or insurer will befinancially solvent and capable of making payment to any party suffering lossor injury caused by products sold by us. Further, some types of actions andpenalties, including many actions or penalties imposed by governmental agenciesand punitive damages awards, may not be remediable through reliance onindemnity agreements or insurance. Furthermore, potential product liabilityclaims may exceed the amount of indemnity or insurance coverage or be excludedunder the terms of an indemnity agreement or insurance policy. If we are forcedto pay to satisfy such claims, it could have an adverse effect on our business,financial condition and results of operations.

 

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***We could be adversely affected if wedo not comply with laws and regulations or if we become subject to additionalor more stringent laws and regulations.***

 

Weare subject to a number of federal, state and local laws and regulations, aswell as applicable laws and regulations in each foreign marketplace in which wedo business. These laws and regulations govern the composition, packaging,labeling and safety of the products we sell, the methods we use to sell andimport these products. Non-compliance with applicable laws and regulations ofgovernmental authorities, including the FDA and similar authorities in otherjurisdictions, by us or the manufacturers and fillers of the products sold byus could result in fines, product recalls and enforcement actions, andotherwise restrict our ability to market certain products, which couldadversely affect our business, financial condition and results of operations.The laws and regulations applicable to us or manufacturers of the products soldby us may become more stringent. Continued legal compliance could require thereview and possible reformulation or relabeling of certain products, as well asthe possible removal of some products from the marketplace. Legal compliancecould also lead to considerably higher internal regulatory costs. Manufacturersmay try to recover some or all of any increased costs of compliance byincreasing the prices at which we purchase products, and we may not be able torecover some or all of such increased cost in our own prices to our customers.We are also subject to state and local laws and regulations that affect ourfranchisor-franchisee relationships. Increased compliance costs and the loss ofsales of certain products due to more stringent or new laws and regulationscould adversely affect our business, financial condition and results ofoperations.

 

Lawsand regulations impact our business in many areas that have no direct relationto the products we sell. For example, as a reporting company, we are subject toa number of laws and regulations related to the issuance and sale of oursecurities. Another area of intense regulation is that of the relationships wehave with our employees, including compliance with many different wage and hourand nondiscrimination related regulatory schemes. Violation of any of the lawsor regulations governing our business or the assertion of individual orclass-wide claims could have an adverse effect on our business, financialcondition and results of operations.

 

***Product diversion could have an adverseimpact on our revenues.***

 

Themajority of the products that BSG sells, including those sold by our ArmstrongMcCall franchisees, are meant to be used exclusively by salons and individualsalon professionals or are meant to be sold exclusively by the purchasers, suchas salons, to their retail consumers. However, despite our efforts to preventdiversion, incidents of product diversion occur, whereby our products are soldby these purchasers (and possibly by other bulk purchasers such as franchisees)to wholesalers and ultimately to general merchandise retailers, among others.These retailers, in turn, sell such products to consumers. The diverted productmay be old, tainted or damaged and sold through unapproved outlets, all ofwhich could diminish the value of the particular brand. In addition, suchdiversion may result in lower net sales for BSG should consumers choose topurchase diverted products from retailers rather than purchasing from ourcustomers, or choose other products altogether because of the perceived loss ofbrand prestige.

 

Inthe BSG arena, product diversion is generally prohibited under ourmanufacturers’ contracts, and we are often under a contractual obligation tostop selling to salons, salon professionals and other bulk purchasers whichengage in product diversion. If we fail to comply with our anti-diversionobligations under these manufacturers’ contracts, (including any knowndiversion of products sold through our Armstrong McCall franchisees), thesecontracts could be adversely affected or even terminated. In addition, ourinvestigation and enforcement of our anti-diversion obligations may result inreduced sales to our customer base, thereby decreasing our revenues andprofitability.

 

***BSG’s financial results are affectedby the financial results of BSG’s franchised-based business (Armstrong McCall).***

 

BSGreceives revenue from products purchased by Armstrong McCall franchisees.Accordingly, a portion of BSG’s financial results is to an extent dependentupon the operational and financial success of these franchisees, includingtheir implementation of BSG’s strategic plans. If sales trends or economicconditions worsen for Armstrong McCall’s franchisees, their financial resultsmay worsen. Additionally, the failure of Armstrong McCall franchisees to renewtheir franchise agreements, any requirement that Armstrong McCall restructureits franchise agreements in connection with such renewals, or any failure ofArmstrong McCall to meet its obligations under its franchise agreements, could resultin decreased revenues for BSG or create legal issues with our franchisees ormanufacturers.

 

***Our internet-based business may beunsuccessful or may cause internal channel conflict.***

 

Weoffer many of our beauty products for sale through Sally Beauty’s websites inthe U.S. (such as *www.sallybeauty.com*)and abroad. Therefore, we encounter risks and difficulties frequentlyexperienced in internet-based businesses, including risks related to ourability to attract and retain customers on a cost-effective basis and ourability to operate, support, expand and develop our internet operations, SallyBeauty’s websites and our software and other related operational systems. Inaddition, our internet-based business may reduce the financial performance ofour Sally Beauty Supply and other stores. For example, customers may choose toshop online rather than purchasing products from our Sally Beauty Supplystores. Although we believe that our participation in both e-commerce andphysical store sales is a distinct advantage for us due to synergies and thepotential for new customers, conflicts between these offerings could createissues that have the potential to adversely affect our results of operations.For example, such conflict could cause some of our

 

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currentor potential internet customers to consider competing distributors of beautyproducts. These events could have an adverse effect on our business, financialcondition and results of operations.

 

***We may not be able to successfullyidentify acquisition candidates or successfully complete desirableacquisitions.***

 

Inthe past several years, we have completed multiple acquisitions. We intend topursue additional acquisitions. We actively review acquisition prospects whichwould complement our existing lines of business, increase the size andgeographic scope of our operations or otherwise offer growth and operatingefficiency opportunities. There can be no assurance that we will continue toidentify suitable acquisition candidates.

 

Ifsuitable candidates are identified, sufficient funds may not be available tomake such acquisitions. We compete against many other companies, some of whichare larger and have greater financial and other resources than we do. Increasedcompetition for acquisition candidates could result in fewer acquisitionopportunities and higher acquisition prices. In addition, we are highlyleveraged and the agreements governing our indebtedness contain limits on ourability to incur additional debt to pay for acquisitions.  Additionally, the amount of equity that SallyBeauty can issue to make acquisitions or raise additional capital is severelylimited. We may be unable to finance acquisitions that would increase ourgrowth or improve our financial and competitive position. To the extent thatdebt financing is available to finance acquisitions, our net indebtedness couldincrease as a result of any acquisitions.

 

***If we acquire any businesses in thefuture, they could prove difficult to integrate, disrupt our business or havean adverse effect on our results of operations.***

 

Anyacquisitions that we make may be difficult to integrate profitably into ourbusiness and may entail numerous risks, including:

 
| · | difficulties in assimilating acquired operations, stores or products,  including the loss of key employees from acquired businesses;                                        |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                        |
| · | difficulties and costs associated with integrating and evaluating the  distribution or information systems and/or internal control systems of  acquired businesses;         |
|   |                                                                                                                                                                        |
| · | expenses associated with the amortization of identifiable intangible  assets;                                                                                               |
|   |                                                                                                                                                                        |
| · | problems retaining key technical, operational and administrative  personnel;                                                                                                |
|   |                                                                                                                                                                        |
| · | diversion of management’s attention from our core business, including  loss of management focus on marketplace developments;                                           |
|   |                                                                                                                                                                        |
| · | complying with foreign regulatory requirements, including  multi-jurisdictional competition rules;                                                                          |
|   |                                                                                                                                                                        |
| · | enforcement of intellectual property rights in foreign countries;                                                                                                           |
|   |                                                                                                                                                                        |
| · | adverse effects on existing business relationships with suppliers and  customers, including the potential loss of suppliers of the acquired  businesses;                    |
|   |                                                                                                                                                                        |
| · | operating inefficiencies and negative impact on profitability;                                                                                                              |
|   |                                                                                                                                                                        |
| · | entering geographic areas or channels in which we have limited or no  prior experience; and                                                                                 |
|   |                                                                                                                                                                        |
| · | those related to general economic and political conditions, including  legal and other barriers to cross-border investment in general, or by U.S.  companies in particular. |

 

Inaddition, during the acquisition process, we may fail or be unable to discoversome of the liabilities of businesses that we acquire. These liabilities mayresult from a prior owner’s noncompliance with applicable laws and regulations.Acquired businesses may also not perform as we expect or we may not be able toobtain the expected financial improvements in the acquired businesses.

 

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***If we are unable to profitably openand operate new stores, our business, financial condition and results ofoperations may be adversely affected.***

 

Ourfuture growth strategy depends in part on our ability to open and profitablyoperate new stores in existing and additional geographic areas. The capitalrequirements to open a U.S.-based Sally Beauty Supply or BSG store, excludinginventory, average approximately $70,000 and $80,000, respectively, with thecapital requirements for international stores costing less or substantiallymore depending upon the marketplace. Despite these relatively low openingcosts, we may not be able to open all of the new stores we plan to open and anynew stores we open may not be profitable, either of which could have a materialadverse impact on our financial condition or results of operations. There areseveral factors that could affect our ability to open and profitably operatenew stores, including:

 
| · | the inability to identify and acquire suitable sites or to negotiate  acceptable leases for such sites;                                                                                                               |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                  |
| · | proximity to existing stores that may reduce the new store’s sales or  the sales of existing stores;                                                                                                             |
|   |                                                                                                                                                                                                                  |
| · | difficulties in adapting our distribution and other operational and  management systems to an expanded network of stores;                                                                                             |
|   |                                                                                                                                                                                                                  |
| · | the potential inability to obtain adequate financing to fund  expansion because of our high leverage and limitations on Sally Beauty’s  ability to issue equity under our credit agreements, among other things; |
|   |                                                                                                                                                                                                                  |
| · | increased (and sometimes unanticipated) costs associated with opening  stores in international locations;                                                                                                             |
|   |                                                                                                                                                                                                                  |
| · | difficulties in obtaining any governmental and third-party consents,  permits and licenses;                                                                                                                           |
|   |                                                                                                                                                                                                                  |
| · | limitations on capital expenditures which may be included in  financing documents that we enter into; and                                                                                                             |
|   |                                                                                                                                                                                                                  |
| · | difficulties in adapting existing operational and management systems  to the requirements of national or regional laws and local ordinances.                                                                          |

 

***The health of the economy in thechannels we serve may affect consumer purchases of discretionary items such asbeauty products and salon services, which could have a material adverse effecton our business, financial condition and results of operations.***

 

Ourresults of operations may be materially affected by conditions in the globalcapital markets and the economy generally, both in the U.S. andinternationally. Concerns over inflation, energy costs, geopolitical issues,the availability and cost of credit, the U.S. mortgage market and the realestate market in the U.S. have contributed to increased volatility anddiminished expectations for the economy. We appeal to a wide demographic consumer profile and offer a broadselection of beauty products sold directly to retail consumers and salons andsalon professionals. Continued uncertainty in the economy could adverselyimpact consumer purchases of discretionary items such as beauty products, aswell as adversely impact the frequency of salon services performed byprofessionals using products purchased from us. Factors that could affectconsumers’ willingness to make such discretionary purchases include generalbusiness conditions, levels of employment, interest rates, tax rates, theavailability of consumer credit and consumer confidence in future economicconditions. In the event of a prolonged economic downturn, consumer spendinghabits could be adversely affected and we could experience lower than expectednet sales. In addition, a reduction in traffic to, or the closing of, the other destinationretailers in the shopping areas where our stores are located couldsignificantly reduce our sales and leave us with unsold inventory.  The economic climate could also adversely affectour vendors.  The occurrence of any ofthese events could have a material adverse effect on our business,financial condition and results of operations.

 

***We are not certain that our ongoingcost control plans will continue to be successful.***

 

Ourbusiness strategy substantially depends on continuing to control or reduceoperating expenses. In furtherance of this strategy, we have engaged in ongoingactivities to reduce or control costs. We cannot assure you that our effortswill result in the increased profitability, cost savings or other benefits thatwe expect, which could have a material adverse effect on our business,financial condition and results of operations.

 

***If we are unable to protect ourintellectual property rights, specifically our trademarks and service marks,our ability to compete could be negatively impacted.***

 

Thesuccess of our business depends to a certain extent upon the value associatedwith our intellectual property rights. We own certain trademark and servicemark rights used in connection with our business including, but not limited to,“Sally,” “Sally Beauty,” “Sally Beauty Supply,” “Sally Beauty Club Card,” “BSG,”“CosmoProf,” “Proclub,” “Armstrong McCall,” “ion,” “Beyond the Zone” and “SalonServices.” We protect our intellectual property rights through a variety of methods,including, but not limited to, applying for and obtaining trademark protectionin the U.S., Canada and other countries throughout the world in which ourbusiness operates. We

 

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alsorely on trade secret laws, in addition to confidentiality agreements withvendors, employees, consultants and others who have access to our proprietaryinformation. While we intend to vigorously protect our trademarks againstinfringement, we may not be successful. In addition, the laws of certainforeign countries may not protect our intellectual property rights to the sameextent as the laws of the U.S. The costs required to protect our intellectualproperty rights and trademarks are expected to continue to be substantial.

 

***Our ability to conduct business ininternational marketplaces may be affected by legal, regulatory and economicrisks.***

 

Ourability to capitalize on growth in new international marketplaces and to growor maintain our current level of operations in our existing internationalmarketplaces is subject to risks associated with our international operations.These risks include: unexpected changes in regulatory requirements, tradebarriers to some international marketplaces, economic and foreign currencyfluctuations, potential difficulties in enforcing contracts, increasing levelsof violence or terrorism, an inability to properly protect assets (includingintellectual property) an inability to collect receivables, potential taxliabilities associated with repatriating funds from foreign operations anddifficulties and costs of staffing, managing and accounting for foreignoperations.

 

***We may be adversely affected by anydisruption in our information technology systems.***

 

Ouroperations are dependent upon our information technology systems, whichencompass all of our major business functions. We rely upon such informationtechnology systems to manage and replenish inventory, to fill and ship customerorders on a timely basis, to coordinate our sales activities across all of ourproducts and services and to coordinate our administrative activities. Asubstantial disruption in our information technology systems for any prolongedtime period (arising from, for example, system capacity limits from unexpectedincreases in our volume of business, outages or delays in our service) couldresult in delays in receiving inventory and supplies or filling customer ordersand adversely affect our customer service and relationships. Our systems mightbe damaged or interrupted by natural or man-made events or by computer viruses,physical or electronic break-ins and similar disruptions affecting theinternet. Such delays, problems or costs may have a material adverse effect onour business, financial condition and results of operations.

 

Asour operations grow in both size and scope, we continuously need to improve andupgrade our systems and infrastructure while maintaining their reliability andintegrity. The expansion of our systems and infrastructure will require us tocommit substantial financial, operational and technical resources before thevolume of our business increases, with no assurance that the volume of businesswill increase. For example, we have recently upgraded our financial reportingsystems in the U.S. and are in the process of designing and implementing astandardized ERP system internationally over the next few years. In addition,we are currently implementing a three-year point-of-sale system upgrade programin a number of our divisions (including our Sally Beauty Supply operations inthe U.S.), which we anticipate will provide significant benefits, includingenhanced tracking of customer sales and store inventory activity. These and anyother required upgrades to our systems and information technology, or newtechnology, now and in the future, will require that our management andresources be diverted from our core business to assist in meeting implementationobjectives. Many of our systems are proprietary, and as a result our optionsare limited in seeking third-party help with the operation and upgrade of thosesystems. There can be no assurance that the time and resources our managementwill need to devote to operations and upgrades, any delays due to theinstallation of any upgrade (and customer issues therewith), any resultingservice outages, and the impact on the reliability of our data from any upgradeor any legacy system, will not have a material adverse effect on our business,financial condition or results of operations.

 

***The occurrence of natural disastersor acts of violence or terrorism could adversely affect our operations andfinancial performance.***

 

Theoccurrence of natural disasters or acts of violence or terrorism could resultin physical damage to our properties, the temporary closure of stores ordistribution centers, the temporary lack of an adequate work force, thetemporary or long-term disruption in the supply of products (or a substantialincrease in the cost of those products) from domestic or foreign suppliers, thetemporary disruption in the delivery of goods to our distribution centers (or asubstantial increase in the cost of those deliveries), the temporary reductionin the availability of products in our stores, and/or the temporary reductionin visits to stores by customers.

 

Ifone or more natural disasters or acts of violence or terrorism were to impactour business, we could, among other things, incur significantly higher costsand longer lead times associated with distributing products. Furthermore,insurance costs associated with our business may rise significantly in theevent of a large scale natural disaster or act of violence or terrorism.

 

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***The accounting and other managementsystems, controls and resources of our ultimate parent, Sally Beauty, may notbe adequately prepared to meet the financial reporting and other requirementsto which Sally Beauty and we are subject.***

 

SallyBeauty, as a publicly-traded company, is directly subject to reporting andother obligations under the Exchange Act. In addition, as a result of theregistered exchange offers for our senior notes and our senior subordinatednotes completed in July of 2007, which we collectively refer to as theNotes, we are also directly subject to reporting and other obligations underthe Exchange Act. These obligations place significant demands on themanagement, administrative and operational resources, including accountingresources, of Sally Beauty, us and our subsidiaries. As reporting companies,Sally Beauty and Sally Holdings incur significant legal, accounting and otherexpenses. We also have significant compliance costs under SEC and New YorkStock Exchange rules and regulations.

 

Inaddition, as a reporting company we are subject to rules adopted by theSEC pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, whichrequire us to include in our Annual Report on Form 10-K our management’sreport on, and assessment of, the effectiveness of our internal controls overfinancial reporting. Furthermore, our independent registered public accountingfirm must attest to and report on the effectiveness of such internal controls.If we fail to properly assess and/or achieve and maintain the adequacy of ourinternal controls, there is a risk that we will not comply withSection 404. Moreover, effective internal controls are necessary to helpprevent financial fraud. Any adverse finding could result in a negativereaction in the financial marketplace due to loss of investor confidence in thereliability of our financial statements, which ultimately could harm our businessand could negatively impact the market price of our debt instruments.

 

Tocomply with these requirements, Sally Beauty, Sally Holdings and oursubsidiaries are continuously upgrading our systems, including informationtechnology systems, and implementing additional financial and managementcontrols, reporting systems and procedures. These and any other modificationsto our financial and management controls, reporting systems, informationtechnology systems and procedures under the financial reporting requirementsand other rules that apply to reporting companies, now and in the future,will require that our management and resources be diverted from our corebusiness to assist in compliance with the requirements. There can be noassurance that the time and resources our management will need to devote to therequirements, any delays due to the installation of any upgrade, any resultingservice outages, and any impact on the reliability of our data from an upgradewill not have a material adverse effect on our business, financial condition orresults of operations.

 

***We are a holding company with nooperations of our own, and we depend on our subsidiaries for cash.***

 

Weare a holding company and do not have any material assets or operations otherthan ownership of equity interests of our subsidiaries. Our operations areconducted almost entirely through our subsidiaries, and our ability to generatecash to meet our obligations or to pay dividends to Sally Beauty is highlydependent on the earnings of, and receipt of funds from, our subsidiariesthrough dividends or intercompany loans. The ability of our subsidiaries togenerate sufficient cash flow from operations to allow us and them to makescheduled payments on our obligations will depend on their future financialperformance, which will be affected by a range of economic, competitive andbusiness factors, many of which are outside of our control. We cannot assureyou that the cash flow and earnings of our operating subsidiaries will beadequate for our subsidiaries to service our and their debt obligations. If oursubsidiaries do not generate sufficient cash flow from operations to satisfytheir obligations, we may have to undertake alternative financing plans (suchas refinancing), restructure debt, sell assets, reduce or delay capitalinvestments, or seek to raise additional capital. We cannot assure you that anysuch alternative refinancing would be possible, that any assets could be sold,or, if sold, of the timing of the sales and the amount of proceeds realizedfrom those sales, that additional financing could be obtained on acceptableterms, if at all, or that additional financing would be permitted under theterms of our various debt instruments then in effect. Our inability to generatesufficient cash flow to satisfy our obligations, or to refinance ourobligations on commercially reasonable terms, would have an adverse effect onour business, financial condition and results of operations.

 

Furthermore,we and our subsidiaries may incur substantial additional indebtedness in thefuture that may severely restrict or prohibit our subsidiaries from makingdistributions, paying dividends or making loans to us.

 

**Risks Relating to Our Substantial Indebtedness**

 

***We have substantial debt and mayincur substantial additional debt, which could adversely affect our financialhealth, our ability to obtain financing in the future and our ability to reactto changes in our business.***

 

Inconnection with the Separation Transactions, together with certain of oursubsidiaries, we incurred approximately $1,850.0 million in debt. As ofSeptember 30, 2010, we had an aggregate principal amount of approximately$1,562.6 million, including capital lease obligations, of outstanding debt, anda total debt to equity ratio of – 3.14:1.00.

 

Our substantial debt could have importantconsequences. For example, it could:

 

·                              make it moredifficult for us to satisfy our obligations to our lenders, resulting inpossible defaults on and acceleration of such indebtedness;

 

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·                              limit ourability to obtain additional financing or raise even a small amount of equitycapital for working capital, capital expenditures, acquisitions, debt servicerequirements or general corporate purposes;

 

·                              require us todedicate a substantial portion of our cash flow from operations to the paymentof principal and interest on our indebtedness, thereby reducing theavailability of such cash flows to fund working capital, capital expendituresand other general corporate purposes;

 

·                              restrict theability of our subsidiaries to pay dividends or otherwise transfer assets tous, which could limit our ability to make required payments on our debtfacilities;

 

·                              increase ourvulnerability to general adverse economic and industry conditions, includinginterest rate fluctuations (because a portion of our borrowings are at variablerates of interest), including borrowings under our senior secured term loanfacilities and our asset-backed senior secured loan facility, which we refer tocollectively as the senior secured credit facilities;

 

·                              place us at acompetitive disadvantage compared to our competitors with proportionately lessdebt or comparable debt at more favorable interest rates and that, as a result,may be better positioned to withstand economic downturns;

 

·                              limit ourability to refinance indebtedness or cause the associated costs of suchrefinancing to increase; and

 

·                              limit ourflexibility to adjust to changing market conditions and ability to withstandcompetitive pressures, or prevent us from carrying out capital spending that isnecessary or important to our growth strategy and efforts to improve operatingmargins or our business.

 

Anyof the foregoing impacts of our substantial indebtedness could have a materialadverse effect on our business, financial condition and results of operations.

 

***Despite our current indebtednesslevels, we and our subsidiaries may be able to incur substantially more debt,including secured debt, which could further exacerbate the risks associatedwith our substantial indebtedness.***

 

Weand our subsidiaries may incur substantial additional indebtedness in thefuture. The terms of the instruments governing our indebtedness do not fullyprohibit us or our subsidiaries from doing so. As of September 30, 2010,our senior credit facilities provided us commitments for additional borrowingsof up to approximately $341.8 million under an asset-based senior securedloan (or ABL) facility, subject to borrowing base limitations. On November 12,2010, we entered into a new ABL facility. The new ABL facility has a 5-year maturity and we will continue to havethe substantially same commitments for additional borrowings as we did underour previous ABL facility. If new debt is added to our current debt levels, therelated risks that we face would increase, and we may not be able to meet allour debt obligations. In addition, the agreements governing our senior creditfacilities as well as the indentures governing our senior notes and seniorsubordinated notes, which we refer to collectively as the Notes, do not preventus from incurring obligations that do not constitute indebtedness.

 

***The agreements and instrumentsgoverning our debt contain restrictions and limitations that couldsignificantly impact our ability to operate our business.***

 

Thesenior secured term loan facilities, which we refer to as the Term Loans,contain covenants that, among other things, restrict our and our subsidiaries’ability to:

 

·             dispose of assets;

 

·             incur additional securedindebtedness (including guarantees of additional indebtedness);

 

·             pay dividends, repurchasestock or make other distributions;

 

·             make voluntary prepaymentson the Notes or make amendments to the terms thereof;

 

·             prepay certain other debt oramend specific debt agreements;

 

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·             create liens on assets;

 

·             make investments (includingjoint ventures);

 

·             make acquisitions of all ofthe business or assets of, or stock representing beneficial ownership of, anyperson;

 

·             engage in mergers,consolidations or sales of all or substantially all of our assets;

 

·             engage in certaintransactions with affiliates; and

 

·             permit restrictions on oursubsidiaries’ ability to pay dividends to us.

 

TheABL facility contains covenants that, among other things, restrict our and oursubsidiaries’ ability to:

 

·             dispose of assets;

 

·             incur additional indebtedness (including guaranteesof additional indebtedness);

 

·             pay dividends, repurchase stock or make otherdistributions;

 

·             create liens on assets;

 

·             make investments (including joint ventures);

 

·             make acquisitions of all of the business or assetsof, or stock representing beneficial ownership of, any person;

 

·             engage in mergers, consolidations or sales of all orsubstantially all of our assets;

 

·             make voluntary prepayments on the Notes or makeamendments to the terms thereof;

 

·             prepay certain other debt or amend specific debtagreements;

 

·             change our or our direct parent’s fiscal year; and

 

·             create or incur negative pledges.

 

Theterm loans contain a requirement that we not exceed a maximum ratio of netsenior secured debt to consolidated EBITDA (as those terms are defined in therelevant credit agreement). In addition, if we fail to maintain a specifiedminimum level of borrowing capacity under the ABL facility, we will then beobligated to maintain a specified fixed-charge coverage ratio. Our ability tocomply with these covenants in future periods will depend on our ongoingfinancial and operating performance, which in turn will be subject to economicconditions and to financial, market and competitive factors, many of which arebeyond our control. Our ability to comply with these covenants in futureperiods will also depend substantially on the pricing of our products, oursuccess at implementing cost reduction initiatives and our ability tosuccessfully implement our overall business strategy.

 

Theindentures governing the Notes also contain restrictive covenants that, amongother things, limit Sally Beauty’s and our ability and the ability of ourrestricted subsidiaries to:

 

·                              dispose ofassets;

 

·                              incuradditional indebtedness (including guarantees of additional indebtedness);

 

·                              pay dividends,repurchase stock or make other distributions;

 

·                              prepaysubordinated debt;

 

·                              create liens onassets (which, in the case of the senior subordinated notes, would be limitedin applicability to liens securing *paripassu* or subordinated indebtedness);

 

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·                              makeinvestments (including joint ventures);

 

·                              engage inmergers, consolidations or sales of all or substantially all of our assets;

 

·                              engage incertain transactions with affiliates; and

 

·                              permitrestrictions on our subsidiaries’ ability to pay dividends to us.

 

Therestrictions in the indentures governing our Notes and the terms of our seniorcredit facilities may prevent us from taking actions that we believe would bein the best interest of our business and may make it difficult for us tosuccessfully execute our business strategy or effectively compete withcompanies that are not similarly restricted. We may also incur future debtobligations that might subject us to additional restrictive covenants thatcould affect our financial and operational flexibility. We cannot assure youthat we will be granted waivers or amendments to these agreements if we areunable to comply with these agreements, or that we will be able to refinanceour debt on terms acceptable to us, or at all.

 

Ourability to comply with the covenants and restrictions contained in the seniorcredit facilities and the indentures for the Notes may be affected by economic,financial and industry conditions beyond our control. The breach of any ofthese covenants and restrictions could result in a default under either thesenior credit facilities or the indentures that would permit the applicablelenders or note holders, as the case may be, to declare all amounts outstandingthereunder to be due and payable, together with accrued and unpaid interest. Ifwe are unable to repay debt, lenders having secured obligations, such as thelenders under the senior credit facilities, could proceed against thecollateral securing the debt. In any such case, we may be unable to borrowunder the senior credit facilities and may not be able to repay the amounts dueunder the term loans and the Notes. This could have serious consequences to ourfinancial condition and results of operations and could cause us to becomebankrupt or insolvent.

 

***Our ability to generate thesignificant amount of cash needed to service all of our debt and our ability torefinance all or a portion of our indebtedness or obtain additional financingdepends on many factors beyond our control.***

 

Ourability to make scheduled payments on, or to refinance our obligations under,our debt will depend on our financial and operating performance, which, inturn, will be subject to prevailing economic and competitive conditions and tofinancial and business factors, many of which may be beyond our control,described under “Risks Relating to Our Business” above.

 

Ifour cash flow and capital resources are insufficient to fund our debt serviceobligations, we may be forced to reduce or delay capital expenditures, sellassets, seek to obtain additional equity capital or restructure our debt. Inthe future, our cash flow and capital resources may not be sufficient forpayments of interest on and principal of our debt, and such alternativemeasures may not be successful and may not permit us to meet our scheduled debtservice obligations.

 

Wecannot assure you that we will be able to refinance any of our indebtedness orobtain additional financing, particularly because of our high levels of debtand the debt incurrence restrictions imposed by the agreements governing ourdebt, as well as prevailing market conditions. In the absence of such operatingresults and resources, we could face substantial liquidity problems and mightbe required to dispose of material assets or operations to meet our debt serviceand other obligations. Our senior credit facilities and the indenturesgoverning the Notes restrict our ability to dispose of assets and use theproceeds from any such dispositions. We cannot assure you we will be able toconsummate those sales, or if we do, what the timing of the sales will be orwhether the proceeds that we realize will be adequate to meet debt serviceobligations when due.

 

***You should not expect Sally Capital to participatein making payments on the Notes.***

 

SallyCapital is our wholly-owned subsidiary, which acts as a co-issuer solely tofacilitate the issuance of the Notes. Sally Capital does not have anyoperations or assets of any kind and did not receive any proceeds from theissuance of the Notes. You should not expect Sally Capital to participate inservicing any of our obligations in the Notes.

 

***An increase in interest rates wouldincrease the cost of servicing our debt and could reduce our profitability.***

 

Asignificant portion of our outstanding debt, including under our senior creditfacilities, bears interest at variable rates. As a result, an increase ininterest rates, whether because of an increase in market interest rates or adecrease in our creditworthiness, would increase the cost of servicing our debtand could materially reduce our profitability and cash flows. The impact ofsuch an increase would be more significant for us than it would be for someother companies because of our substantial debt.

 

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***The impairment of other financial institutions could adversely affectus.***

 

We have exposure todifferent counterparties with regard to our interest rate swaps. Thesetransactions expose us to credit risk in the event of default of ourcounterparty. We also have exposure to financial institutions used asdepositories of our corporate cash balances. If our counterparties and financial institutions become impaired orinsolvent, this could have serious consequences to our financial condition andresults of operations.

 

**Risks Relating to Our Separation from Alberto-Culverand Relating to Sally Beauty’s Largest Stockholder**

 

***We rely upon Alberto-Culver for theaccuracy of certain historical services and information.***

 

Wesometimes rely upon Alberto-Culver for the accuracy and/or completeness ofcertain historical services and information provided to us when we were part ofthat company. For example, as the successor entity to Alberto-Culver after theseparation, we rely upon the prior-year federal income tax returns ofAlberto-Culver and accounting methods established therein, for certaincalculations that affect our U.S. federal income tax liability. We also relyupon Alberto-Culver for historical information related to our insuranceprograms and other benefits. There can be no assurance that our reliance uponthe accuracy or completeness of historical information or services previouslyprovided by them will not have an adverse impact on our business, financialcondition and results of operations.

 

***If the share distribution ofAlberto-Culver common stock in the transactions separating us fromAlberto-Culver did not constitute a tax-free distribution underSection 355 of the Internal Revenue Code of 1986, as amended, or the Code,or if Sally Beauty became liable for additional taxes owed by Alberto-Culver,then we may be responsible for payment of significant U.S. federal incometaxes.***

 

Thefollowing discussion describes the risk that the share distribution ofAlberto-Culver common stock in the Separation Transactions may have triggeredsignificant tax liabilities for Sally Beauty, our ultimate parent company,which could result in a material adverse effect on us. Since we have been amember of Sally Beauty’s consolidated group of companies for U.S. federalincome tax purposes and certain state tax purposes during the taxable year ofthe share distribution of Alberto-Culver common stock, we (and other SallyBeauty subsidiaries that were also members of such group) will generally beliable for the income tax liability of Sally Beauty’s consolidated group ofcompanies for that tax year. Therefore, if Sally Beauty incurred significantincome tax liability as a result of the share distribution of Alberto-Culvercommon stock and was unable to pay these taxes, we could be liable for suchtaxes to the taxing authorities. In connection with the share distribution ofAlberto-Culver common stock in the separation, Sally Beauty received:(i) a private letter ruling from the Internal Revenue Service, or IRS, and(ii) an opinion of Sidley Austin LLP, counsel to Alberto-Culver, in eachcase, to the effect that the transactions qualify as a reorganization underSection 368(a)(1)(D) of the Code and a distribution eligible fornon-recognition under Sections 355(a) and 361(c) of the Code. Theprivate letter ruling and the opinion of counsel were based, in part, onassumptions and representations as to factual matters made by, among others,Alberto-Culver, Sally Beauty and representatives of Mrs. Carol L. Bernick,Mr. Leonard H. Lavin and certain of Sally Beauty’s other stockholders towhom we refer to as the Lavin family stockholders, as requested by the IRS orcounsel, which, if incorrect, could jeopardize the conclusions reached by theIRS and counsel. The private letter ruling also did not address certainmaterial legal issues that could affect its conclusions, and reserved the rightof the IRS to raise such issues upon a subsequent audit. Opinions of counselneither bind the IRS or any court, nor preclude the IRS from adopting acontrary position.

 

Ifthe Alberto-Culver share distribution were not to qualify as a tax-freedistribution under Section 355 of the Code, Sally Beauty would recognizetaxable gain equal to the excess of the fair market value of the Alberto-Culvercommon stock distributed to its stockholders over Sally Beauty’s tax basis insuch Alberto-Culver common stock.

 

Evenif the Alberto-Culver share distribution otherwise qualified as a tax-freedistribution under Section 355 of the Code, it would result in significantU.S. federal income tax liabilities to Sally Beauty if there was an acquisitionof its stock or the stock of Alberto-Culver as part of a plan or series ofrelated transactions that includes the Alberto-Culver share distribution andthat results in an acquisition of 50% or more of Alberto-Culver’s or SallyBeauty’s outstanding common stock.

 

Inthe event that Sally Beauty recognizes a taxable gain in connection with theAlberto-Culver share distribution (either: (i) because the Alberto-Culvershare distribution did not qualify as a tax-free distribution underSection 355 of the Code, or (ii) because of an acquisition by CDRInvestors of 50% or more of Alberto-Culver or Sally Beauty’s outstanding commonstock as part of a plan or series of related transactions that includes theAlberto-Culver share distribution), the taxable gain recognized by Sally Beautywould result in significant U.S. federal income tax liabilities to SallyBeauty. Under the Code, Sally Beauty would be jointly and severally liable forthese taxes for which Alberto-Culver may be required to indemnify Sally Beautyunder their tax allocation agreement, and there can be no assurance thatAlberto-Culver would be able to fulfill its obligations under the taxallocation agreement if Alberto-Culver was determined to be responsible for thetaxes thereunder.

 

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Theprocess for determining whether a prohibited change in control has occurredunder the rules is complex, inherently factual and subject tointerpretation of the facts and circumstances of a particular case. IfAlberto-Culver did not carefully monitor its, or Sally Beauty did not carefullymonitor its, compliance with these rules, this might inadvertently cause orpermit a prohibited change in the ownership of Sally Beauty or ofAlberto-Culver to occur, thereby triggering Alberto-Culver’s or Sally Beauty’srespective obligations to indemnify the other pursuant to the tax allocationagreement, which would have a material adverse effect on Sally Beauty and us.

 

Ifany of the above events occur, Sally Beauty will be jointly and severallyliable for these taxes, and there can be no assurance that Alberto-Culver wouldbe able to fulfill its indemnification obligations to Sally Beauty under thetax allocation agreement if Alberto-Culver was determined to be responsible forthese taxes thereunder. In addition, these mutual indemnity obligations coulddiscourage or prevent a third party from making a proposal to acquire SallyBeauty.

 

***Actions taken bythe Lavin family stockholders or by the CDR investors could adversely affectthe tax-free nature of the share distribution of Alberto-Culver common stock inconnection with the transactions separating us from Alberto-Culver.***

 

Salesand/or acquisitions by the Lavin family stockholders of Sally Beauty’s commonstock or Alberto-Culver’s common stock may adversely affect the tax-free natureof the share distribution of Alberto-Culver’s common stock in the SeparationTransactions. First, with certain exceptions, sales by the Lavin familystockholders of Sally Beauty’s common stock or Alberto-Culver’s common stock atany time after the Separation Transactions might be considered evidence thatthe share distribution was used principally as a device for the distribution ofearnings and profits, particularly if the selling stockholder was found to havean intent to effect such sale at the time of the share distribution. If the IRSsuccessfully asserted that the share distribution was used principally as sucha device, the share distribution would not qualify as a tax-free distribution,and thus would be taxable to Sally Beauty. Second, with certain exceptions, ifany of the Lavin family stockholders had sold an amount of Sally Beauty’scommon stock that it received in connection with the Separation Transactions(or acquired additional shares of Sally Beauty’s common stock) within the twoyear period following completion of the Alberto-Culver share distribution, andthat amount of stock, if added to the common stock that was acquired by CDRInvestors were to equal or exceed 50% of Sally Beauty’s outstanding commonstock, as determined under the Code and applicable Treasury regulations, adeemed acquisition of control of Sally Beauty in connection with theAlberto-Culver share distribution would be presumed. If this presumption werenot rebutted, Sally Beauty would be subject to significant U.S. federal incometax liabilities, which, if not reimbursed by Alberto-Culver, would have amaterial adverse effect on Sally Beauty and us.

 

***The voting power of Sally Beauty’slargest stockholder may discourage third party acquisitions of Sally Beauty ata premium.***

 

CDRS,Sally Beauty’s largest stockholder, owns approximately 47.0% of its outstandingcommon stock on an undiluted basis. Pursuant to the stockholders agreemententered into by Sally Beauty, the CDR Investors and the Lavin familystockholders, which we refer to as the Stockholders Agreement, CDRS hasdesignated five of Sally Beauty’s initial eleven directors, as well as theDirector elected as Chairman of Sally Beauty’s Board of Directors, and CDRS’right to nominate a certain number of directors will continue so long as itowns specified percentages of Sally Beauty’s common stock. The CDR Investors’ownership of Sally Beauty’s common stock may have the effect of discouragingoffers to acquire control of Sally Beauty and may preclude holders of itscommon stock from receiving any premium above market price for their sharesthat may otherwise be offered in connection with any attempt to acquire controlof Sally Beauty.

 

***The interests of Sally Beauty’slargest stockholder may differ from the interests of other holders of itscommon stock.***

 

CDRS,Sally Beauty’s largest stockholder, owns approximately 47.0% of its outstandingcommon stock on an undiluted basis. Pursuant to the Stockholders Agreement, CDRShas designated five of Sally’s Beauty’s eleven directors and CDRS’ right tonominate a certain number of directors will continue so long as it ownsspecified percentages of Sally Beauty’s common stock, as discussed above. Inaddition, the current Chairman of Sally Beauty’s Board of Directors isaffiliated with CDRS. The interests of CDRS may differ from those of otherholders of Sally Beauty’s common stock in material respects. For example, CDRSmay have an interest in pursuing acquisitions, divestitures, financings,re-financings, stockholder dividends or other transactions that, in itsjudgment, could enhance its overall equity portfolio or the short-term value oftheir investment in Sally Beauty, even though such transactions might involvesubstantial risks to other holders of Sally Beauty’s common stock. The managerof CDRS’ ultimate parent is in the business of making investments in companies,and may acquire interests in businesses that directly or indirectly competewith certain portions of our business or are suppliers of us or our customers.Additionally, CDRS may determine that the disposition of some or all of itsinterests in Sally Beauty would be beneficial to it at a time when suchdisposition could be detrimental to Sally Beauty, us and/or to the otherholders of Sally Beauty’s common stock. Moreover, the ownership by CDRS of asignificant percentage of Sally Beauty’s outstanding common stock may have theeffect of discouraging offers to acquire control of Sally Beauty and maypreclude holders of Sally Beauty’s common stock from receiving any premiumabove market price for their shares that may otherwise be offered in connectionwith any attempt to acquire control of Sally Beauty.

 

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**ITEM 1B. UNRESOLVED STAFF COMMENTS**

 

Notapplicable.

 

**ITEM 2. PROPERTIES**

 

Substantiallyall of our store and warehouse locations are leased and our corporateheadquarters and four warehouses/distribution centers are owned. The averagestore lease is for a term of five years with customary renewal options. Thefollowing table provides the number of stores in the U.S. and globally, as ofSeptember 30, 2010:

 

 
| ** **                             | ** ** | **Sally Beauty Supply** | ** ** | **Beauty Systems Group** | ** ** |
|----------------------------------------|------------|-----------------------------------|------------|------------------------------------|------------|
| **Location**                           | ** ** | **Company-Operated**              | ** ** | **Franchise**                      | ** ** | **Company-Operated** | ** ** | **Franchise** | ** ** |
| United  States (excluding Puerto Rico) |       | 2,429                             |       | —                             |       | 777 |   | 130 |   |
| Puerto  Rico                           |       | 39                                |       | —                             |       | 3 |   | — |   |
| International:                         |       |                              |       |                               |       |   |   |   |   |
| United  Kingdom                        |       | 249                               |       | 5                                  |       | — |   | — |   |
| Belgium                                |       | 29                                |       | 5                                  |       | — |   | — |   |
| Canada                                 |       | 58                                |       | —                             |       | 88 |   | — |   |
| Chile                                  |       | 22                                |       | —                             |       | — |   | — |   |
| France                                 |       | 27                                |       | 2                                  |       | — |   | — |   |
| Germany                                |       | 27                                |       | —                             |       | — |   | — |   |
| Mexico                                 |       | 102                               |       | —                             |       | — |   | 29 |   |
| Other                                  |       | 24                                |       | 14                                 |       | — |   | — |   |
| Total  International                   |       | 538                               |       | 26                                 |       | 88 |   | 29 |   |
| Total  Store Count                     |       | 3,006                             |       | 26                                 |       | 868 |   | 159 |   |

 

Thefollowing table provides locations for our significant offices and warehousesand corporate headquarters, as of September 30, 2010:

 
| **Location**                    | ** ** | **Type of Facility** | ** ** | **Sq. Feet** | ** ** | **Business Segment** |   |
|---------------------------------|------------|--------------------------------|------------|-------------------|------------|---------------------------|--------|
| Company-Owned  Properties:      |       |                           |       |              |       |                      |   |
| Columbus,  Ohio                 |       | Warehouse                      |       | 246,000           |       |                      | (1)    |   |
| Denton,  Texas                  |       | Corporate Headquarters         |       | N/A               |       |                      | (1)(2) |   |
| Denton,  Texas                  |       | Warehouse                      |       | 45,000            |       |                      | (1)    |   |
| Jacksonville,  Florida          |       | Warehouse                      |       | 237,000           |       |                      | (1)    |   |
| Reno,  Nevada                   |       | Warehouse                      |       | 253,000           |       |                      | (1)    |   |
| Leased  Properties:             |       |                           |       |              |       |                      |   |   |
| Benicia,  California            |       | Office, Warehouse              |       | 187,000           |       |                      | (2)    |   |
| Clackamas,  Oregon              |       | Warehouse                      |       | 104,000           |       |                      | (2)    |   |
| Fresno,  California             |       | Warehouse                      |       | 200,000           |       |                      | (2)    |   |
| Greenville,  Ohio               |       | Office, Warehouse              |       | 246,000           |       |                      | (2)    |   |
| Pottsville,  Pennsylvania       |       | Office, Warehouse              |       | 160,000           |       |                      | (2)    |   |
| Spartanburg,  South Carolina    |       | Warehouse                      |       | 100,000           |       |                      | (2)    |   |
| Blackburn,  Lancashire, England |       | Warehouse                      |       | 107,000           |       |                      | (1)    |   |
| Calgary,  Alberta, Canada       |       | Warehouse                      |       | 62,000            |       |                      | (2)    |   |
| Gent,  Belgium                  |       | Office, Warehouse              |       | 83,000            |       |                      | (1)    |   |
| Guadalupe,  Nuevo Leon, Mexico  |       | Warehouse                      |       | 40,000            |       |                      | (1)    |   |
| Mississauga,  Ontario, Canada   |       | Office, Warehouse              |       | 60,000            |       |                      | (2)    |   |
| Ronse,  Belgium                 |       | Office, Warehouse              |       | 91,000            |       |                      | (1)    |   |
| Thornliebank,  Scotland         |       | Office, Warehouse              |       | 94,000            |       |                      | (1)    |   |

 

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(1)           Sally Beauty Supply

(2)           BSG

 

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**ITEM 3. LEGAL PROCEEDINGS**

 

Therewere no material legal proceedings pending against us or our subsidiaries as ofSeptember 30, 2010. We are involved in various claims and lawsuitsincidental to the conduct of our business in the ordinary course. We carryinsurance coverage in such amounts in excess of our self-insured retention aswe believe to be reasonable under the circumstances and that may or may notcover any or all of our liabilities in respect of claims and lawsuits. We donot believe that the ultimate resolution of these matters will have a materialadverse impact on our consolidated financial position, cash flows or results ofoperations.

 

Weare subject to a number of U.S., federal, state and local laws and regulations,as well as the laws and regulations applicable in each other marketplace inwhich we do business. These laws and regulations govern, among other things,the composition, packaging, labeling and safety of the products we sell, themethods we use to sell these products and the methods we use to import theseproducts.  We believe that we are inmaterial compliance with such laws and regulations, although no assurance canbe provided that this will remain true going forward.

 

On February 25, 2008, Sally Beauty disclosed ina Current Report on Form 8-K that on February 21, 2008, L’Oreal fileda lawsuit in the Superior Court of the State of California in and for theCounty of San Diego — Central Division naming, among others, SD Hair, Ltd.and Hair of Nevada, LLC (collectively, “SD Hair”), franchisees of oursubsidiary Armstrong McCall division (“AMLP”) of our BSG business unit, asdefendants.  The suit alleged, among other things, that SD Hair breachedits franchise agreement with AMLP by diverting (selling) Matrix brandedproducts to unauthorized buyers, and that L’Oreal is entitled to make claimsagainst SD Hair under the franchise agreement as a third-party beneficiary ofthat agreement.  On March 24, 2008, SD Hair filed a cross-complaintin the same case naming AMLP and BSG as cross-defendants, seeking, among otherthings, i) declaratory relief from BSG and AMLP in the form of a judicialfinding that SD Hair isnot in breach of its franchise agreement and that L’Oreal has no rights as athird-party beneficiary to SD Hair’s franchise agreement, and ii) injunctiverelief in the form of a judicial order compelling AMLP and BSG to takeappropriate legal action against L’Oreal to enforce SD Hair’s claimed rightsunder AMLP’s Matrix distribution agreement.  We have answered thecross-complaint.

 

OnJuly 30, 2009, Sally Beauty disclosed in a Current Report on Form 8-Kthat L’Oreal filed a Second Amended Complaint in connection with the previouslydisclosed lawsuit described above. The Second Amended Complaint alleges, amongother things, that AMLP, certain of its employees andothers were involved in selling Matrix branded products to unauthorized buyersand that certain of its employees (and others) engaged in improper businesstransactions for personal benefit from 2005 through 2007.  L’Oreal seeks money damages, certaininjunctive relief and a declaration that L’Oreal is entitled to terminate the1981 Matrix Distributor Agreement now in effect between L’Oreal and AMLP.  None of the employees involved in theallegations are executive officers of Sally Beauty or the Company.  Substantially all of these allegations weremade known by L’Oreal to the Company prior to the filing of the SecondAmended Complaint. L’Oreal also provided the Company with documents allegedlysupporting the allegations.

 

Asa result of these allegations made by L’Oreal, many of which areincorporated into the Second Amended Complaint, the Audit Committee of theBoard of Directors of Sally Beauty engaged independent special counsel toinvestigate whether certain employees engaged in improper business transactionsfor personal benefit.  After extensivereview, the Audit Committee and independent special counsel found insufficientevidence to support a conclusion that Sally Beauty or Company employees enteredinto improper transactions for personal benefit.

 

OnSeptember 8, 2009, AMLP and BSG filed a cross-complaint against L’Oreal. In the cross-complaint, AMLP and BSG allege that L’Oreal does not have agenuine interest in stopping diversion, and that L’Oreal’s anti-diversionpolicies have been discriminatorily applied to AMLP and BSG.  AMLPfurther alleges that L’Oreal is using diversion as a pretext to attempt toterminate the 1981 Matrix Distributor Agreement. L’Oreal has answered thecross-complaint and the matter is currently set for jury trial on February 18,2011.

 

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**ITEM 4. REMOVED AND RESERVED**

 

**PART II**

 

**ITEM 5. MARKET FOR REGISTRANT’S COMMONEQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES**

 

There is no established public trading market forthe member units of Sally Holdings LLC. Sally Investment Holdings LLC, a wholly-owned subsidiary of Sally BeautyHoldings, Inc., owns all of the member units of Sally Holdings LLC.

 

We do not expect to pay dividends in the foreseeablefuture.  The agreements governing our indebtednessrestrict our ability to pay dividends.  Please see “Risk Factors—RisksRelating to Our Substantial Indebtedness” and Note 12 of the “Notes toConsolidated Financial Statements” in “Item 8—Financial Statements and Supplementary Data.”

 

**ITEM 6. SELECTED FINANCIAL DATA**

 

Thefollowing table presents selected financial data of Sally Holdings LLC and itsconsolidated subsidiaries for the year ended September 30, 2010, 2009,2008 and 2007, and of Sally Holdings, Inc. and its consolidatedsubsidiaries for the year ended September 30, 2006 (dollars in thousands).Sally Holdings, Inc. was a wholly owned subsidiary of Alberto-Culver untilNovember 16, 2006 when it was converted to a Delaware limited liabilitycompany, was renamed “Sally Holdings LLC,” and became an indirect wholly ownedsubsidiary of Sally Beauty in connection with the Separation Transactions.Sally Beauty was formed in June of 2006 in connection with the SeparationTransactions.

 
| ** **                                                  | ** ** | **Year Ended September 30,** | ** ** |
|-------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                  | ** ** | **2010**                                    | ** ** | **2009** | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
| **Results of operations information:**                      |       |                                        |       |   |   |   |   |   |   |   |   |
| Net  sales                                                  |       | $                                           | 2,916,090  |   | $ | 2,636,600 |   | $ | 2,648,191 |   | $ | 2,513,772 |   | $ | 2,373,100 |   |
| Cost  of products sold and distribution expenses            |       | 1,511,716                                   |       | 1,393,283 |   | 1,413,597 |   | 1,360,025 |   | 1,286,329 |   |
| Gross  profit                                               |       | 1,404,374                                   |       | 1,243,317 |   | 1,234,594 |   | 1,153,747 |   | 1,086,771 |   |
| Selling,  general and administrative expenses(a)            |       | 1,004,660                                   |       | 891,056 |   | 895,632 |   | 850,159 |   | 798,211 |   |
| Depreciation  and amortization                              |       | 51,122                                      |       | 47,066 |   | 48,533 |   | 42,605 |   | 38,032 |   |
| Sales-based  service fee charged by Alberto-Culver          |       | —                                      |       | — |   | — |   | 3,779 |   | 28,852 |   |
| Transaction  expenses(b)                                    |       | —                                      |       | — |   | — |   | 21,502 |   | 41,475 |   |
| Operating  earnings                                         |       | 348,592                                     |       | 305,195 |   | 290,429 |   | 235,702 |   | 180,201 |   |
| Interest  expense(c)                                        |       | 112,953                                     |       | 132,043 |   | 158,897 |   | 145,972 |   | 92 |   |
| Earnings  before provision for income taxes                 |       | 235,639                                     |       | 173,152 |   | 131,532 |   | 89,730 |   | 180,109 |   |
| Provision  for income taxes                                 |       | 87,010                                      |       | 68,424 |   | 48,664 |   | 41,169 |   | 69,916 |   |
| Net  earnings                                               |       | $                                           | 148,629    |   | $ | 104,728 |   | $ | 82,868 |   | $ | 48,561 |   | $ | 110,193 |   |
|                                                        |       |                                        |       |   |   |   |   |   |   |   |   |
| **Operating data:**                                         |       |                                        |       |   |   |   |   |   |   |   |   |
| Number  of stores (end of period):                          |       |                                        |       |   |   |   |   |   |   |   |   |
| Sally  Beauty Supply                                        |       | 3,032                                       |       | 2,923 |   | 2,844 |   | 2,694 |   | 2,511 |   |
| Beauty  Systems Group                                       |       | 1,027                                       |       | 991 |   | 929 |   | 874 |   | 828 |   |
| Total                                                       |       | 4,059                                       |       | 3,914 |   | 3,773 |   | 3,568 |   | 3,339 |   |
| Professional  distributor sales consultants (end of period) |       | 1,051                                       |       | 1,022 |   | 984 |   | 1,002 |   | 1,163 |   |
| Same  store sales growth(d):                                |       |                                        |       |   |   |   |   |   |   |   |   |
| Sally  Beauty Supply                                        |       | 4.1                                         | %          | 2.1 | % | 1.2 | % | 2.7 | % | 2.4 | % |
| Beauty  Systems Group                                       |       | 6.2                                         | %          | 1.0 | % | 6.9 | % | 10.1 | % | 4.1 | % |
| Consolidated                                                |       | 4.6                                         | %          | 1.8 | % | 2.6 | % | 4.5 | % | 2.8 | % |
| **Financial condition information (at period end):**        |       |                                        |       |   |   |   |   |   |   |   |   |
| Working  capital                                            |       | $                                           | 351,593    |   | $ | 315,943 |   | $ | 348,560 |   | $ | 341,891 |   | $ | 479,107 |   |
| Cash,  cash equivalents and short-term investments          |       | 59,494                                      |       | 54,447 |   | 99,788 |   | 38,272 |   | 107,571 |   |
| Property,  plant and equipment, net                         |       | 168,117                                     |       | 151,249 |   | 156,260 |   | 154,068 |   | 142,735 |   |
| Total  assets                                               |       | 1,588,763                                   |       | 1,490,510 |   | 1,525,658 |   | 1,404,261 |   | 1,338,841 |   |
| Long-term  debt, excluding current maturities(c)            |       | 1,559,591                                   |       | 1,653,013 |   | 1,724,684 |   | 1,758,594 |   | 621 |   |
| Member’s  (deficit)/stockholder’s equity          |       | $                                           | (497,888   | ) | $ | (642,139 | ) | $ | (722,280 | ) | $ | (780,317 | ) | $ | 1,005,967 |   |

 

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| (a) | We account for share-based compensation awards in accordance with the  Financial Accounting Standards Board (“FASB”) Accounting Standards  Codification (“ASC”) 718, *Compensation-Stock  Compensation.* Selling, general and administrative expenses for the  fiscal years 2010, 2009, 2008, 2007 and 2006 include share-based compensation  expenses of $12.2 million, $8.0 million, $9.6 million, $12.3 |
|-----|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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|   | million and $5.2 million, respectively.                                                                                                                                                                                                                                                                                                                                                                                             |
|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                |
| (b)    | The fiscal year 2007 includes one-time charges associated with the  Separation Transactions and the fiscal year 2006 includes one-time charges  associated with the termination of a merger agreement. Please see Note 1 of  the “Notes to Consolidated Financial Statements” in “Item 8—Financial  Statements and Supplementary Data” for additional information about the  Separation Transactions. |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                |
| (c)    | After November 16, 2006, long-term debt primarily represents  debt incurred in connection with the Separation Transactions and interest  expense related mainly to such indebtedness. Prior to the Separation  Transactions, interest expense was attributable to notes payable to then-affiliates.                                                                                                                            |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                |
| (d)    | Same stores are defined as company-operated stores that have been  open for at least 14 months as of the last day of a month. Our same store  sales calculation includes internet-based sales (beginning in fiscal year  2009) and store expansions, if applicable, but does not generally include  sales from stores relocated.                                                                                                    |

 

Priorto November 16, 2006, Alberto-Culver owned all shares of issued andoutstanding common stock of Sally Holdings, Inc. Since November, 16, 2006,all members units of Sally Holdings LLC have been owned by Sally Investment, awholly-owned subsidiary of Sally Beauty.

 

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**ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

Thefollowing section discusses management’s view of the financial condition as of September 30,2010 and 2009, and the results of operations and cash flows for the fiscalyears ended September 30, 2010, 2009 and 2008, of Sally Holdings, awholly-owned subsidiary of Sally Investment Holdings LLC, or Sally Investment,a wholly-owned subsidiary of Sally Beauty Holdings, Inc. or Sally Beauty,and its consolidated subsidiaries. All of the interests of Sally Holdings arebeneficially owned by Sally Investment, and all of the interests of SallyInvestment are beneficially owned by Sally Beauty. This section should be readin conjunction with the audited consolidated financial statements of SallyHoldings and the related notes included elsewhere in this Annual Report. ThisManagement’s Discussion and Analysis of Financial Condition and Results ofOperations section contains forward-looking statements. Please see “CautionaryNotice Regarding Forward-Looking Statements” for a discussion of theuncertainties, risks and assumptions associated with these forward-lookingstatements that could cause results to differ materially from those reflectedin such forward-looking statements.

 

**Highlightsof the Fiscal Year Ended September 30, 2010**

 

·                  Our sales fromcompany-operated stores that have been open for at least 14 months as ofthe last day of a month, which we refer to as same store sales, increased 4.6%for the fiscal year ended September 30, 2010;

·                  Our consolidated net salesfor the fiscal year ended September 30, 2010 increased $279.5 million, or10.6%, to $2,916.1 million compared to the fiscal year ended September 30,2009. Net sales for the fiscal year ended September 30, 2010 reflectapproximately $17.2 million, or 0.7%, in net positive impact from changes inforeign currency exchange rates;

·                  Our consolidated grossprofit for the fiscal year ended September 30, 2010 increased $161.1million, or 13.0%, to $1,404.4 million compared to $1,243.3 million for thefiscal year ended September 30, 2009. As a percentage of net sales, grossprofit increased to 48.2% for the fiscal year ended September 30, 2010,compared to 47.2% for the fiscal year ended September 30, 2009;

·                  Our consolidated operatingearnings for the fiscal year ended September 30, 2010 increased $43.4million, or 14.2%, to $348.6 million compared to $305.2 million for the fiscalyear ended September 30, 2009. As a percentage of net sales, operatingearnings increased to 12.0% for the fiscal year ended September 30, 2010,compared to 11.6% for the fiscal year ended September 30, 2009;

·                  For the fiscal year ended September 30,2010, unallocated corporate expenses increased 15.9% to $72.2 million comparedto $62.3 million for the fiscal year ended September 30, 2009;

·                  Sally Beauty Supply and BSGopened or acquired 109 and 36 net new stores, respectively, during the fiscalyear ended September 30, 2010;

·                  In December of 2009, weacquired Sinelco, a wholesale distributor of professional beauty products basedin Ronse, Belgium, for approximately €25.2 million (approximately $36.6million);

·                  During fiscal year 2010, wemade a mandatory prepayment in the amount of $22.3 million and optionalprepayments in the aggregate amount of $102.7 million on our senior term loans,resulting in the prepayment in full of all borrowings under the Term Loan Afacility and partial prepayment of borrowings under the Term Loan B facility;and

·                  Cash provided by operationsdecreased by $5.9 million, or 2.6%, to $218.1 million for the fiscalyear ended September 30, 2010, compared to $224.0 million for thefiscal year ended September 30, 2009.

 

**Overview**

 

***Description ofBusiness***

 

Weoperate primarily through two business units, Sally Beauty Supply and BSG.Through Sally Beauty Supply and BSG (which operates stores under the CosmoProfservice mark), we operated a multi-channel platform of 3,874 stores andsupplied 185 franchised stores in North America, South America and selectedEuropean countries, as of September 30, 2010. We are the largestdistributor of professional beauty supplies in the U.S. based on store count.Within BSG, we also have one of the largest networks of professional distributorsales consultants in North America, with approximately 1,051 professionaldistributor sales consultants who sell directly to salons and salonprofessionals.  We provide our customerswith a wide variety of leading third-party branded and exclusive-label professionalbeauty supplies, including hair care products, styling appliances, skin andnail care products and other beauty items. Sally Beauty Supply stores targetretail consumers and salon professionals, while BSG exclusively targets salonsand salon professionals. For the year ended September 30, 2010, ourconsolidated net sales and operating earnings were $2,916.1 million and$348.6 million, respectively.

 

Webelieve Sally Beauty Supply is the largest open-line distributor ofprofessional beauty supplies in the U.S. based on store count. As of September 30,2010, Sally Beauty Supply operated 3,006 company-operated retail stores, 2,429of which are located in the U.S. (with the remainder in the United Kingdom andcertain other countries in Europe, Canada, Puerto Rico, Mexico and Chile) and

 

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supplied26 franchised stores located outside the U.S. Sally Beauty Supply stores in theU.S. and Canada range in size between 1,500 square feet and1,700 square feet and are primarily located in strip shopping centers. Theproduct selection in Sally Beauty Supply stores ranges between 4,000 and 8,000SKUs of beauty products and includes products for hair care, skin and nailcare, beauty sundries and electrical appliances targeting retail consumers andsalon professionals. Sally Beauty Supply stores carry leading third-partybrands such as Clairol, Revlon and Conair, as well as an extensive selection ofexclusive-label merchandise. For the year ended September 30, 2010, SallyBeauty Supply’s net sales and segment operating profit were$1,834.6 million and $320.5 million, respectively, representing 62.9%and 74.0% of our consolidated net sales and consolidated operating profitbefore unallocated corporate expenses, respectively. Store formats, includingaverage size and product selection, for Sally Beauty Supply outside the U.S.and Canada vary by marketplace.

 

Webelieve BSG is the largest full-service distributor of professional beautysupplies in the U.S. As of September 30, 2010, BSG had 868company-operated stores, supplied 159 franchised stores and had a sales forceof approximately 1,051 professional distributor sales consultants sellingexclusively to salons and salon professionals in substantially all states inthe U.S. and in portions of Canada, Puerto Rico, Mexico and certainEuropean countries. BSG stores average approximately 2,700 squarefeet and are primarily located in secondary strip shopping centers. Through BSG’slarge store base and sales force, BSG is able to access a significant portionof the highly fragmented U.S. salon channel. The product selection in BSGstores, ranging between 5,000 and 10,000 SKUs of beauty products, includes haircare and color, skin and nail care, beauty sundries and electrical appliances;targeting salons and salon professionals. BSG carries leading professionalbeauty product brands, intended for use in salons and for resale by the salonto consumers. Certain BSG products are sold under exclusive distributionagreements with suppliers, whereby BSG is designated as the sole distributorfor a product line within certain geographic territories. For the year endedSeptember 30, 2010, BSG’s net sales and segment operating profit were$1,081.5 million and $112.5 million, respectively, representing 37.1%and 26.0% of our consolidated net sales and consolidated operating profitbefore unallocated corporate expenses, respectively.

 

***Industry and BusinessTrends***

 

Weoperate within the large and growing U.S. professional beauty supplyindustry. Potential growth in the industry is expected to be driven byincreases in consumer demand for hair color, hair loss prevention and hairstyling products. We believe the following key industry and business trends andcharacteristics will influence our business and our financial results goingforward:

 

·             *High levelof marketplace fragmentation.*  TheU.S. salon channel is highly fragmented with over 250,000 hair salons. Giventhe fragmented and small-scale nature of the salon industry, we believe thatsalon operators will continue to depend on full-service/exclusive distributorsand open-line channels for a majority of their beauty supply purchases.

 

·             *Growth inbooth renting and frequent stocking needs.*  Salonprofessionals primarily rely on just-in-time inventory due to capitalconstraints and a lack of warehouse and shelf space at salons.  In addition, booth renters, who comprise asignificant percentage of total U.S. salon professionals, are often responsiblefor purchasing their own supplies. Historically, booth renters havesignificantly increased as a percentage of total salon professionals, and weexpect this trend to continue. Given their smaller individual purchases andrelative lack of financial resources, booth renters are likely to be dependenton frequent trips to professional beauty supply stores, like BSG and SallyBeauty Supply. We expect that these factors will continue to drive demand forconveniently located professional beauty supply stores.

 

·             *Increasinguse of exclusive-label products.*  We offer a broadrange of exclusive-label products.  Asour lines of exclusive-label products have matured and become better known inour retail stores, we have seen an increase in sales of these products. Generally,our exclusive-label products have higher gross margins than the leadingthird-party branded products and, accordingly, the growth in sales of theseproducts will likely enhance our overall gross margins. Please see “RiskFactors - We depend upon manufacturers who may be unable to provide products ofadequate quality or who may be unwilling to continue to supply products to us.”

 

·             *Favorabledemographic and consumer trends.*  We expect theaging baby-boomer population to drive future growth in professional beautysupply sales through an increase in the usage of hair color and hair lossproducts. Additionally, continuously changing fashion-related trends that drivenew hair styles are expected to result in continued demand for hair stylingproducts. Changes in consumer tastes and fashion trends can have an impact onour financial performance. Our continued success depends in large part on ourability to anticipate, gauge and react in a timely and effective manner tochanges in consumer spending patterns and preferences for beauty products. Wecontinuously adapt our marketing and merchandising initiatives for Sally BeautySupply in an effort to expand our market reach or to respond to changingconsumer preferences.  If we are unableto anticipate and respond to trends in the marketplace for beauty products andchanging consumer demands, our business could suffer.

 

·             *International growth strategies. *A key element of our growthstrategy depends on our ability to capitalize on growth in the internationalmarketplace and to grow our current level of non-U.S. operations. For example,on December 16, 2009, we acquired Sinelco, a wholesale distributor ofprofessional beauty products located in Belgium with sales throughout Europe.In addition, on September 4, 2009, we acquired Intersalon, a leadingdistributor of premier beauty supply products with 16 stores located in Chile.These acquisitions furthered our expansion plans in Europe and Latin America,key targets of Sally Beauty

 

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Supply’s international growthinitiative. We intend to continue to identify and evaluate non-U.S. acquisitionand/or organic growth targets. Our ability to grow our non-U.S. operations,integrate our new non-U.S. acquisitions and successfully pursue additionalnon-U.S. acquisition and/or organic growth targets may be affected by business,legal, regulatory and economic risks. Please see “Risk Factors - We may not beable to successfully identify acquisition candidates and complete desirableacquisitions,” “If we acquire any businesses in the future, they could provedifficult to integrate, disrupt our business or have an adverse effect on ourresults of operations” and “Our ability to conduct business in internationalmarketplaces may be affected by legal, regulatory and economic risks.”

 

·             *Continuingconsolidation.*  There is continuing consolidation amongprofessional beauty product distributors and professional beauty productmanufacturers. We plan to continue to examine ways in which we can benefit fromthis trend, including reviewing opportunities to shift business within theprofessional beauty products channel from competitive distributors to the BSGnetwork as well as seeking opportunistic, value-added acquisitions whichcomplement our long-term growth strategy. We believe that suppliers areincreasingly likely to focus on larger distributors and retailers with abroader scale and retail footprint. We also believe that we are well positionedto capitalize on this trend as well as participate in the ongoing consolidationat the distributor/retail level. However, changes often occur in ourrelationships with suppliers that may materially affect the net sales andoperating earnings of our business segments. Consolidation among supplierscould exacerbate the effects of these relationship changes and could increasepricing pressures. For example, as we announced in December 2006, ourlargest supplier, L’Oreal, moved a material amount of revenue out of the BSGnationwide distribution network and into competitive regional distribution networks.More recently, L’Oreal acquired distributors competing with BSG in thesoutheastern and west coast of the U.S. and, as a result, directly competeswith BSG in certain geographic areas. If L’Oreal acquired other distributors orsuppliers that conduct significant business with BSG, we could lose relatedrevenue. There can be no assurance that there will not be further loss ofrevenue over time by BSG (including within its franchise-based business) due topotential losses of additional products (both from L’Oreal and from othersuppliers) as well as from the increased competition from L’Oreal-affiliateddistribution networks. Please see “Risk Factors - The beauty productsdistribution industry is highly competitive and is consolidating” and “Wedepend upon manufacturers who may be unable to provide products of adequatequality or who may be unwilling to continue to supply products to us.”

 

·             *Relationshipswith suppliers.*   Sally Beauty Supply/BSG and theirsuppliers are dependent on each other for the distribution of beauty products.We do not manufacture the brand name or exclusive-label products we sell. Wepurchase our products from a limited number of manufacturers. As is typical indistribution businesses, these relationships are subject to change from time totime (including the expansion or loss of distribution rights in variousgeographies and the addition or loss of product lines). Since we purchaseproducts from many manufacturers on an at-will basis, under contracts which cangenerally be terminated without cause upon 90 days’ notice or less orwhich expire without express rights of renewal, such manufacturers coulddiscontinue sales to us at any time or upon the expiration of the distributionperiod. Some of our contracts with manufacturers may be terminated by suchmanufacturers if we fail to meet specified minimum purchase requirements. Insuch cases, we do not have contractual assurances of continued supply, pricingor access to new products and vendors may change the terms upon which theysell. Infrequently, a supplier will seek to terminate a distributionrelationship through legal action. For example, in 2007 Farouk Systems, Inc.filed an action seeking a declaratory judgment that it was entitled toterminate a long-term distribution agreement with Armstrong McCall. In 2010that matter was settled and BSG now sells Farouk products in some territories.Changes in our relationships with suppliers occur often and could positively ornegatively impact our net sales and operating profits. Although we focus ondeveloping new revenue and cost management initiatives to mitigate the negativeeffects resulting from unfavorable changes in our supplier relationships, therecan be no assurance that our efforts will continue to completely offset theloss of these or other distribution rights. Please see “Risk Factors —We dependupon manufacturers who may be unable to provide products of adequate quality orwho may be unwilling to continue to supply products to us.”

 

We expect to continue to expand our product lineofferings and to gain additional distribution rights over time through eitherfurther negotiation with suppliers or by strategic acquisitions of existingdistributors.  Although we are focused ondeveloping new revenue and cost management initiatives, there can be noassurance that our efforts will partially or completely offset any potentialloss of distribution rights in the future. Please see “Risk Factors —We dependupon manufacturers who may be unable to provide products of adequate quality orwho may be unwilling to continue to supply products to us.”

 

·            *High levelof competition.*  Sally Beauty Supply competes with otherdomestic and international beauty product wholesale and retail outlets,including local and regional open-line beauty supply stores, professional-onlybeauty supply stores, salons, mass merchandisers, drug stores and supermarkets,as well as sellers on the internet and salons retailing hair care items. BSGcompetes with other domestic and international beauty product wholesale andretail suppliers and manufacturers selling professional beauty productsdirectly to salons and individual salon professionals. We also face competitionfrom authorized and unauthorized retailers and internet sites offeringprofessional salon-only products. The increasing availability of unauthorizedprofessional salon products in large format retail stores such as drug stores,grocery stores and others could also have a negative impact on our business.Please see “Risk Factors —The beauty products distribution industry is highlycompetitive and is consolidating.”

 

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·             *Economic conditions.*  We appeal to a wide demographic consumerprofile and offer a broad selection of beauty products sold directly to retailconsumers and salons and salon professionals. Historically, these factors haveprovided us with reduced exposure to downturns in economic conditions in thecountries in which we operate.  However,a downturn in the economy, especially for an extended period of time, couldadversely impact consumer demand of discretionary items such as beauty productsand salon services, particularly affecting our electrical products category andour full-service sales business. In addition, higher freight costs resultingfrom increases in the cost of fuel, especially for an extended period of time,may impact our expenses at levels that we cannot pass through to ourcustomers.  These factors could have amaterial adverse effect on our business, financial condition and results ofoperations. Please see “Risk Factors*—*The health of theeconomy in the channels we serve may affect consumer purchases of discretionaryitems such as beauty products and salon services, which could have a materialadverse effect on our business, financial condition and results of operations.”

 

·             *Controlling expenses*.  Another important aspect of our business isour ability to control costs, especially in our BSG business segment, byright-sizing the business and maximizing the efficiency of our structure. In2009 we completed implementation of an approximately $22.0 million capitalspending program to consolidate warehouses and reduce administrative expensesrelated to BSG’s distribution network resulting in annualized cost savings**ofapproximately $14.0 million for the 2010 fiscal year. Please see “RiskFactors — We are not certain that our ongoing cost control plans will continueto be successful.”

 

·             *Opening new stores*.  Our future growth strategy depends in part onour ability to open and profitably operate new stores in existing andadditional geographic areas. The capital requirements to open a U.S.-basedSally Beauty Supply or BSG store, excluding inventory, average approximately$70,000 and $80,000, respectively, with the capital requirements forinternational stores costing less or substantially more depending upon themarketplace. We may not be able to open all of the new stores we plan to openand any new stores we open may not be profitable, any of which could have amaterial adverse impact on our financial condition or results of operations.Please see “Risk Factors — If we are unable to profitably open and operate newstores, our business, financial condition and results of operations may beadversely affected.”

 

·             *Changes to our informationtechnology systems*.  As ouroperations grow in both size and scope, we will continuously need to improveand upgrade our information systems and infrastructure while maintaining thereliability and integrity of our systems and infrastructure. The expansion ofour systems and infrastructure will require us to commit substantial financial,operational and technical resources in advance of any increase in the volume ofour business, with no assurance that the volume of business will increase.  For example, we have recently upgraded ourfinancial reporting systems in the U.S. and are in the process of designing andimplementing a standardized ERP system internationally over the next few years.In addition, we are currently implementing a three-year point-of-sale systemupgrade program in a number of our divisions (including our Sally Beauty Supplyoperations in the U.S.), which we anticipate will provide significant benefits,including enhanced tracking of customer sales and store inventory activity.These and any other required upgrades to our information systems andinformation technology (or new technology), now or in the future, will requirethat our management and resources be diverted from our core business to assistin completion of these projects. There can be no assurance that the time andresources our management will need to devote to these upgrades, service outagesor delays due to the installation of any new or upgraded technology (andcustomer issues therewith), or the impact on the reliability of our data fromany new or upgraded technology will not have a material adverse effect on ourfinancial reporting, business, financial condition or results ofoperations.  Please see “Risk Factors —We may be adversely affected by any disruption in our information technologysystems.”

 

***SignificantRecent Acquisitions***

 

OnDecember 16, 2009, we acquired Sinelco, a wholesale distributor ofprofessional beauty products based in Ronse, Belgium, for approximately €25.2million (approximately $36.6 million). We also assumed €4.0 million(approximately $5.8 million) of pre-acquisition debt, excluding capital leaseobligations, of Sinelco in connection with the acquisition. Sinelco serves over1,500 customers through a product catalog and website and has sales throughoutEurope. Goodwill of $5.2 million (which is not expected to be deductible fortax purposes) was recorded as a result of this acquisition. In addition, duringthe fiscal year 2010, we completed several other individually immaterialacquisitions at an aggregate cost of $9.0 million and recorded additionalgoodwill in the amount of $5.4 million (the majority of which is not expectedto be deductible for tax purposes) in connection with such acquisitions. Thevaluation of the assets acquired and liabilities assumed in connection with theall acquisitions completed during the fiscal year 2010 was based on their fairvalues at the acquisition date. We funded these acquisitions with cash fromoperations as well as borrowings under our ABL facility. Please see Note 2 ofthe “Notes to Consolidated Financial Statements” in Item 8 - “FinancialStatements and Supplementary Data” contained elsewhere in this Annual Reportfor additional information about the Company’s accounting policies inconnection with business combinations.

 

Duringthe fiscal year 2009, we acquired Schoeneman, a 43-store beauty supply chainlocated in the central northeastern United States, at a cost of approximately$71.0 million, subject to certain adjustments. We currently expect to realizeapproximately $10 million in present value of future tax savings as a result ofanticipated incremental depreciation and amortization tax deductions relatingto the assets acquired in this transaction. In the fiscal year 2009, goodwillof approximately $61.0 million (which is expected

 

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tobe deductible for tax purposes) was initially recorded as a result of thisacquisition. In addition, during the fiscal year 2009, we completed severalother individually immaterial acquisitions at an aggregate cost of $11.3million of which a significant portion was allocated to goodwill (the majorityof which is expected to be deductible for tax purposes). Generally, we fundedthese acquisitions with cash from operations. The purchase prices of certainacquisitions completed during the fiscal year 2009 (including the acquisitionof Schoeneman) were initially allocated to assets acquired and liabilitiesassumed based on their preliminary estimated fair values at the date ofacquisition. The final valuations of the assets acquired and liabilitiesassumed were completed during the fiscal year 2010. Accordingly, in the fiscalyear 2010, we recorded intangible assets subject to amortization of $24.9million and intangible assets with indefinite lives of $0.8 million inconnection with certain the acquisitions completed during the fiscal year 2009.These amounts were previously reported in Goodwill pending the valuation of theassets acquired.

 

Duringthe fiscal year 2008, we acquired Pro-Duo, a 40-store beauty supply chainlocated in Belgium, France and Spain for €19.3 million (approximately $29.8million) plus incidental acquisition costs capitalized, subject to certainadjustments. We also assumed €3.0 million (approximately $4.7 million) of debt,excluding capital lease obligations, of Pro-Duo in connection with theacquisition. Goodwill of $23.9 million (which is not expected to bedeductible for tax purposes) and certain identifiable intangible assets of$11.4 million were recorded as a result of this acquisition. In addition,during the fiscal year 2008, we completed several other individually immaterialacquisitions at an aggregate cost of $22.9 million of which a significantportion was allocated to intangible assets and goodwill (the majority of whichis not expected to be deductible for income tax purposes). The purchase pricesof these acquisitions have been allocated to assets acquired and liabilitiesassumed based on their estimated fair values at the date of acquisition. Thefinal valuations of the assets and liabilities acquired were completed during thefiscal year 2009. We funded these acquisitions with cash from operations aswell as borrowings under our ABL facility.

 

Inaddition, subsequent to the fiscal year 2010, we acquired Aerial Company, Inc.(“Aerial”), an 82-store professional-only beauty supply chain operating in theMidwestern and northwestern United States, for approximately $79.0 million,subject to certain adjustments. Thisacquisition will be accounted for using the purchase method of accounting and,accordingly, the results of operations of Aerial will be included in theCompany’s consolidated financial statements subsequent to the acquisitiondate.  The acquisition was funded withborrowings under our ABL facility in the amount of $78.0 million and with cashfrom operations.

 

***Our Separationfrom Alberto-Culver***

 

Priorto November 2006, our business constituted two operating segments withinthe operations of Alberto-Culver. In November 2006, we separated fromAlberto-Culver. We refer to our separation from Alberto-Culver as theSeparation Transactions. As a result: (i) we became an indirectwholly-owned subsidiary of Sally Beauty; (ii) Sally Beauty, through us,owns and operates the Sally Beauty Supply and BSG distribution businesses thatwere owned and operated by Alberto-Culver prior to the Separation Transactions;(iii) at the closing of the Separation Transactions, the stockholders ofAlberto-Culver prior thereto became the beneficial owners of approximately 52%of Sally Beauty’s outstanding common stock on an undiluted basis and the CDRInvestors, who in the aggregate invested $575.0 million in Sally Beauty,received an equity interest representing approximately 48% of Sally Beauty’soutstanding common stock on an undiluted basis; and (iv) Alberto-Culvercontinued to own and operate its consumer products business. In addition, inconnection with the Separation Transactions, we and certain of our subsidiariesincurred approximately $1,850.0 million of indebtedness. Please see Note 12 ofthe “Notes to Consolidated Financial Statements” in “Item 8—FinancialStatements and Supplementary Data” contained elsewhere in this Annual Report.

 

***Credit Facilities***

 

Borrowings under the TermLoans and the ABL facility are secured by substantially all of our assets,those of Sally Investment, those of our domestic subsidiaries and, in the caseof the ABL facility, those of our Canadian subsidiaries. The Term Loans may beprepaid at our option at any time without premium or penalty. Such facility issubject to mandatory prepayment in an amount equal to 50% of excess cash flow(as defined in the agreement governing the Term Loans) for any fiscal yearunless a specified leverage ratio is met. Additionally, the facility is subject to mandatory prepayment in anamount equal to 100% of the proceeds of specified asset sales that are notreinvested in the business or applied to repay borrowings under the ABLfacility. Please see “Liquidity and Capital Resources” for additionalinformation about our borrowings under the Term Loans.

 

OurNotes are unsecured obligations of us and Sally Capital and are guaranteed on asenior basis (in the case of the senior notes) and on a senior subordinatedbasis (in the case of the senior subordinated notes) by each of our materialdomestic subsidiaries (other than Sally Capital). Our Notes carry optionalredemption features whereby we have the option to redeem the Notes on or beforeNovember 15, 2010 and November 15, 2011, respectively, at par plus apremium, plus accrued and unpaid interest and, thereafter, at par plus a premiumdeclining ratably to par, plus accrued and unpaid interest.

 

Detailsof long-term debt (excluding capitalized leases) as of September 30, 2010are as follows (dollars in thousands):

 

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| ** **                | ** ** | **Amount** | ** ** | **Maturity dates** | ** **      | **Interest Rates**                                     | ** **                                             |
|---------------------------|------------|------------|------------|-------------------------|-----------------|-------------------------------------------------------------|--------------------------------------------------------|
| ABL facility(a)           |       | $          | —     |                    | Nov.  2011 |                                                        | (i)    Prime  plus up to 0.50% or; |   |
|                      |       |       |       |                    |            | (ii)   LIBOR(b) plus  (1.00% to 1.50%)  |                                                   |
| Term Loan B               |       | 843,856    |       | Nov.  2013         |            | (i)    Prime  plus (1.25% to 1.50%) or; |                                                   |
|                      |       |       |       |                    |            | (ii)   LIBOR  plus (2.25% to 2.50%)(c)       |                                                   |
| Other (d)                 |       | 6,675      |       | 2011-2014               |            | 4.05% to 6.75%                                              |                                                   |
| Total                     |       | $          | 850,531    |                    |            |                                                        |                                                   |   |
|                      |       |       |       |                    |            |                                                        |                                                   |
| Senior notes              |       | $          | 430,000    |                    | Nov.  2014 |                                                        | 9.25%                                                  |   |
| Senior subordinated notes |       | 275,000    |       | Nov.  2016         |            | 10.50%                                                      |                                                   |
| Total                     |       | $          | 705,000    |                    |            |                                                        |                                                   |   |

 

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(a)          In November 2010, theCompany entered into a new ABL facility. Please see “- Liquidity and CapitalResources — Credit Facilities.”

(b)         London Interbank OfferedRate (“LIBOR”).

(c)          At September 30, 2010,the interest rate for the Term Loan B was 2.51%.

(d)         Represents pre-acquisitiondebt of Pro-Duo and Sinelco.

 

InNovember 2010, we entered into a new agreement with lenders to replace ourABL facility with a new $400 million, 5-year credit facility (the “new ABLfacility”). The new ABL facility contains restrictions and limitations similarto those contained in the prior ABL facility and, similar to the prior ABLfacility, borrowings under the new ABL facility are secured by substantiallyall of our assets. The terms of the new ABL facility include interest rates atPrime plus 1.25% to 1.75% or LIBOR plus 2.25% to 2.75% and a commitment fee of0.50% on the unused portion of the facility.

 

***Other SignificantItems***

 

*DerivativeInstruments*

 

Asa multinational corporation, we are subject to certain market risks includingchanges in market interest rates and foreign currency fluctuations. We mayconsider a variety of practices in the ordinary course of business to managethese market risks, including, when deemed appropriate, the use of derivativefinancial instruments.

 

*Interest Rate Swap Agreements*

 

TheCompany is exposed to a wide variety of economic risks, including risks arisingfrom changing market interest rates. The Company manages its exposure tocertain economic risks (including liquidity, credit risk and changes ininterest rates) primarily (a) by closely managing its cash flows fromoperating and investing activities and the amounts and sources of its debtobligations; (b) by assessing periodically the creditworthiness of itsbusiness partners; and (c) through the use of interest rate swaps. TheCompany uses interest rate swaps as part of its overall economic riskmanagement strategy to add stability to the interest payments due in connectionwith its term loan obligations. Interest payments related to the term loans areimpacted by changes in LIBOR. Interest rate swap agreements involve theperiodic receipt by the Company of amounts based on a variable rate in exchangefor the Company making payments based on a fixed rate over the term of theagreements without exchange of the underlying notional amount.

 

InNovember 2006, we entered into four interest rate swap agreements with anaggregate notional amount of $500 million. Interest rate swap agreements withan aggregate notional amount of $150 million expired in November of 2008and agreements with a notional amount of $350 million expired in November of2009. These interest rate swap agreements did not qualify as hedges and,therefore, the changes in fair value of these agreements were recorded ininterest expense in our consolidated statements of earnings.

 

Additionally,in May 2008, we entered into two interest rate swap agreements with anaggregate notional amount of $300 million. These interest rate swap agreementsexpire in May of 2012 and are designated as effective hedges, consistentwith ASC 815. Accordingly, adjustments to reflect the change in the fair valuesof these interest rate swap agreements are recorded in accumulated othercomprehensive (loss) income, net of tax, until the hedged obligation is settledor the swap agreements expire, whichever is earlier. Any ineffectiveness isrecognized in interest expense in the Company’s consolidated statements ofearnings. Please see “Item 7A — Quantitative and Qualitative Disclosures aboutMarket Risk—Interest rate risk” and Note 13 of the “Notes to ConsolidatedFinancial Statements” in Item 8 - “Financial Statements and Supplementary Data”contained elsewhere in this Annual Report.

 

*ForeignCurrency Option and Forward Contracts*

 

TheCompany is exposed to potential gains or losses from foreign currencyfluctuations affecting its net investments in subsidiaries and earningsdenominated in foreign currencies. The Company’s primary exposures are tochanges in exchange rates for the U.S. dollar versus the British poundsterling, the Canadian dollar, the Euro, the Mexican peso, and the Chileanpeso. The Company’s various foreign currency exposures at times offset eachother providing a natural hedge against foreign currency risk. In connection

 

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withits exposure to foreign currency fluctuations, we may from time to time use foreigncurrency derivative instruments, such as foreign currency option contracts andforeign currency forward contracts, to manage such risk.

 

Asa result of our acquisition of Sinelco on December 16, 2009, the Companyuses foreign currency options, including, at September 30, 2010, foreigncurrency put options with an aggregate notional amount of €1.4 million ($1.9million, at the September 30, 2010 exchange rate) and foreign currencycall options with an aggregate notional amount of €0.8 million ($1.2 million,at the September 30, 2010 exchange rate), to manage the exposure tocertain non-Euro currencies resulting from Sinelco’s purchases of merchandisefrom third-party suppliers. Sinelco’s functional currency is the Euro. Theseforeign currency options are not designated as hedges and do not meet the hedgeaccounting requirements of ASC 815. Accordingly, the changes in the fairvalue of these derivative instruments (which are adjusted quarterly) arerecorded in our consolidated statements of earnings.

 

Inthe fourth quarter of the fiscal year 2010, we entered into four foreigncurrency forward agreements which expire in January of 2011. Two foreigncurrency forward agreements enable us to sell, in the aggregate, approximately€5.2 million ($7.1 million, at the September 30, 2010 exchange rate) atthe weighted average forward exchange rate of 1.3073. The other two foreigncurrency forward agreements enable us to buy, in the aggregate, approximately$7.0 million Canadian dollars ($6.8 million, at the September 30, 2010exchange rate) at the weighted average forward exchange rate of 1.0277. Theseforeign currency forward agreements are not designated as hedges and do notmeet the hedge accounting requirements of ASC 815. Accordingly, the changes in thefair value of these derivative instruments (which are adjusted quarterly) arerecorded in our consolidated statements of earnings.

 

InOctober 2010, the Company also entered into certain foreign currencyoption agreements, including foreign currency put options with an aggregate notionalamount of €4.0 million ($5.5 million, at the November 12, 2010 exchangerate) and foreign currency call options with an aggregate notional amount of€8.1 million ($11.1 million, at the November 12, 2010 exchange rate), tomanage the exposure to certain non-Euro currencies resulting from Sinelco’spurchases of merchandise from third-party suppliers. These foreign currencyoptions expire ratably through September 15, 2011, are not designated ashedges, and do not meet the hedge accounting requirements of ASC 815.Accordingly, the changes in the fair value of these derivativeinstruments (which will be adjusted quarterly) will be recorded in ourconsolidated statements of earnings.

 

Duringthe fiscal year ended September 30, 2010, selling general and administrativeexpenses included $0.2 million in net gains from all of the Company’s foreigncurrency option and forward agreements (net of non-cash losses of $0.3 millionresulting from our foreign currency forwards). In addition, selling general andadministrative expenses included $0.3 million in non-cash net gains related tocertain intercompany balances not permanently invested, which certain of thesederivative instruments are intended to hedge. Please see “Item 7A —Quantitative and Qualitative Disclosures about Market Risk—Foreign currencyexchange rate risk” and Note 13 of the “Notes to Consolidated FinancialStatements” in Item 8 - “Financial Statements and Supplementary Data” containedelsewhere in this Annual Report.

 

*Share-BasedPayments*

 

Wehave no share-based plans of our own. Since the Separation Transactions, wehave been a wholly-owned subsidiary of Sally Beauty, and certain of ouremployees have been granted stock options and share awards under itsshare-based compensation plans. For the fiscal years 2010, 2009 and 2008, totalshare-based compensation cost charged against earnings was $12.2 million, $8.0million and $9.6 million, respectively, and resulted in an increase in due toSally Beauty by the same amounts. Share-based compensation for the fiscal years2010, 2009 and 2008 included $2.5 million, $2.0 million and $3.1 million,respectively, of accelerated expense related to certain retirement eligibleemployees who are eligible to continue vesting awards upon retirement under theterms of the Sally Beauty Holdings, Inc. 2010 Omnibus Incentive Plan (the “2010Plan”) and certain predecessor plans, such as the Sally Beauty Holdings 2007Omnibus Incentive Plan and the Alberto-Culver Company Employee Stock OptionPlan of 2003. For the fiscal years 2010, 2009 and 2008, the total income taxbenefit recognized in the consolidated statements of earnings from allshare-based compensation plans in which our employees participate orparticipated was $4.0 million, $1.9 million and $2.3 million, respectively, andresulted in the recognition of deferred tax assets of the same amount. Ourconsolidated statements of cash flows reflect, for the fiscal years 2010 and2008, excess tax benefits of $0.2 million and $0.5 million, respectively and,for the fiscal year 2009, an excess tax shortfall of $0.2 million, fromemployee exercises of stock options as financing cash flows.  As of September 30, 2010, we had $9.4million of unrecognized compensation expense related to non-vested stock optionawards that is expected to be charged to expense over the weighted averageperiod of 2.2 years, and $2.0 million of unrecognized compensation expenserelated to non-vested restricted stock awards that is expected to be charged toexpense over the weighted average period of 3.2 years.

 

Priorto the Separation Transactions, we were a subsidiary of Alberto-Culver and hadno share-based compensation plans of our own; however, certain of our employeeshad been granted stock options and restricted stock awards under share-basedcompensation plans of Alberto-Culver. Upon completion of the SeparationTransactions, all outstanding Alberto-Culver stock options held by ouremployees became options to purchase shares of Sally Beauty’s common stock.

 

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**Resultsof Operations**

 

Thefollowing table shows the condensed results of operations of our business forthe fiscal years ended September 30, 2010, 2009 and 2008 (in millions):

 
| ** **                                       | ** ** | **Year Ended September 30,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                       | ** ** | **2010**                                    | ** ** | **2009** | ** ** | **2008** | ** ** |
| Net  sales                                       |       | $                                           | 2,916.1    |   | $ | 2,636.6 |   | $ | 2,648.2 |   |
| Cost  of products sold and distribution expenses |       | 1,511.7                                     |       | 1,393.3 |   | 1,413.6 |   |
| Gross  profit                                    |       | 1,404.4                                     |       | 1,243.3 |   | 1,234.6 |   |
| Total  other operating costs and expenses        |       | 1,055.8                                     |       | 938.1 |   | 944.2 |   |
| Operating  earnings                              |       | 348.6                                       |       | 305.2 |   | 290.4 |   |
| Interest  expense                                |       | 113.0                                       |       | 132.0 |   | 158.9 |   |
| Earnings  before provision for income taxes      |       | 235.6                                       |       | 173.2 |   | 131.5 |   |
| Provision  for income taxes                      |       | 87.0                                        |       | 68.5 |   | 48.6 |   |
| Net  earnings                                    |       | $                                           | 148.6      |   | $ | 104.7 |   | $ | 82.9 |   |

 

Thefollowing table shows the condensed results of operations of our business forthe fiscal years ended September 30, 2010, 2009 and 2008, expressed as apercentage of net sales for the respective periods:

 
| ** **                                       | ** ** | **Year Ended September 30,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                       | ** ** | **2010**                                    | ** ** | **2009** | ** ** | **2008** | ** ** |
| Net  sales                                       |       | 100.0                                       | %          | 100.0 | % | 100.0 | % |
| Cost  of products sold and distribution expenses |       | 51.8                                        | %          | 52.8 | % | 53.4 | % |
| Gross  profit                                    |       | 48.2                                        | %          | 47.2 | % | 46.6 | % |
| Total  other costs and expenses                  |       | 36.2                                        | %          | 35.6 | % | 35.6 | % |
| Operating  earnings                              |       | 12.0                                        | %          | 11.6 | % | 11.0 | % |
| Interest  expense                                |       | 3.9                                         | %          | 5.0 | % | 6.0 | % |
| Earnings  before provision for income taxes      |       | 8.1                                         | %          | 6.6 | % | 5.0 | % |
| Provision  for income taxes                      |       | 3.0                                         | %          | 2.6 | % | 1.9 | % |
| Net  earnings                                    |       | 5.1                                         | %          | 4.0 | % | 3.1 | % |

 

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***Key OperatingMetrics***

 

Thefollowing table sets forth, for the periods indicated, information concerningkey measures we rely on to gauge our operating performance (dollars inthousands):

 
| ** **                                                 | ** ** | **Year Ended September 30,** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                 | ** ** | **2010**                                    | ** ** | **2009** | ** ** | **2008** | ** ** |
| Net  sales:                                                |       |                                        |       |   |   |   |   |
| Sally  Beauty Supply                                       |       | $                                           | 1,834,631  |   | $ | 1,695,652 |   | $ | 1,672,897 |   |
| BSG                                                        |       | 1,081,459                                   |       | 940,948 |   | 975,294 |   |
|                                                       |       | $                                           | 2,916,090  |   | $ | 2,636,600 |   | $ | 2,648,191 |   |
| Gross  Profit                                              |       | $                                           | 1,404,374  |   | $ | 1,243,317 |   | $ | 1,234,594 |   |
| Gross  profit margin                                       |       | 48.2                                        | %          | 47.2 | % | 46.6 | % |
|                                                       |       |                                        |       |   |   |   |   |
| Selling,  general and administrative expenses              |       | $                                           | 1,004,660  |   | $ | 891,056 |   | $ | 895,632 |   |
| Depreciation  and amortization                             |       | $                                           | 51,122     |   | $ | 47,066 |   | $ | 48,533 |   |
|                                                       |       |                                        |       |   |   |   |   |
| Earnings  before provision for income taxes:               |       |                                        |       |   |   |   |   |
| Segment  operating profit:                                 |       |                                        |       |   |   |   |   |
| Sally  Beauty Supply                                       |       | $                                           | 320,456    |   | $ | 283,872 |   | $ | 285,615 |   |
| BSG                                                        |       | 112,495                                     |       | 91,604 |   | 80,927 |   |
| Segment  operating profit                                  |       | 432,951                                     |       | 375,476 |   | 366,542 |   |
| Unallocated  expenses                                      |       | (72,172                                     | )          | (62,289 | ) | (66,499 | ) |
| Share-based  compensation expense                          |       | (12,187                                     | )          | (7,992 | ) | (9,614 | ) |
| Operating  earnings                                        |       | 348,592                                     |       | 305,195 |   | 290,429 |   |
| Interest  expense                                          |       | (112,953                                    | )          | (132,043 | ) | (158,897 | ) |
| Earnings  before provision for income taxes                |       | $                                           | 235,639    |   | $ | 173,152 |   | $ | 131,532 |   |
|                                                       |       |                                        |       |   |   |   |   |
| Segment  operating profit margin:                          |       |                                        |       |   |   |   |   |
| Sally  Beauty Supply                                       |       | 17.5                                        | %          | 16.7 | % | 17.1 | % |
| BSG                                                        |       | 10.4                                        | %          | 9.7 | % | 8.3 | % |
| Consolidated  operating profit margin                      |       | 12.0                                        | %          | 11.6 | % | 11.0 | % |
| Number  of stores at end-of-period (including franchises): |       |                                        |       |   |   |   |   |
| Sally  Beauty Supply                                       |       | 3,032                                       |       | 2,923 |   | 2,844 |   |
| BSG                                                        |       | 1,027                                       |       | 991 |   | 929 |   |
|                                                       |       | 4,059                                       |       | 3,914 |   | 3,773 |   |
| Same  store sales growth(a)                                |       |                                        |       |   |   |   |   |
| Sally  Beauty Supply                                       |       | 4.1                                         | %          | 2.1 | % | 1.2 | % |
| BSG                                                        |       | 6.2                                         | %          | 1.0 | % | 6.9 | % |
| Consolidated                                               |       | 4.6                                         | %          | 1.8 | % | 2.6 | % |

 

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(a)          Same stores aredefined as company-operated stores that have been open for at least 14 monthsas of the last day of a month. Our same store sales calculation includesinternet-based sales (beginning in the fiscal year 2009) and store expansions,if applicable, but does not generally include sales from stores relocated.

 

***Description ofNet Sales and Expenses***

 

*Net Sales.*  Our net salesconsist primarily of the following:

 

·             *SallyBeauty Supply.*  Sally Beauty Supply generates net salesprimarily by selling products through its stores to both professional andretail customers. Sally Beauty Supply sells hair care, hair color, skin andnail care products, electrical appliances and other beauty related accessories.Because approximately 42% of our Sally Beauty Supply product sales come fromexclusive-label brands, most of these same products are generally not availablein most other retail stores or in our BSG business segment. Various factorsinfluence Sally Beauty Supply’s net sales including local competition, productassortment and availability, price, hours of operation and marketing andpromotional activity. Sally Beauty Supply’s product assortment and sales aregenerally not seasonal in nature.

 

·             *BeautySystems Group.*  BSG generates net sales by sellingproducts to salon professionals and independent stylists throughcompany-operated and franchised stores as well as through its network ofprofessional distributor sales consultants . BSG sells hair care, hair colorproducts, skin and nail care products, electrical appliances and other beautyrelated accessories. These products are not sold directly to the general publicand are generally not the same products as those sold in our Sally BeautySupply stores. Various factors influence BSG’s net sales, including productbreadth and availability, competitive activity,

 

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relationships withsuppliers, new product introductions and price. BSG’s product assortment andsales are generally not seasonal in nature.

 

*Cost of Products Sold and Distribution Expenses.*Cost ofproducts sold and distribution expenses consist of the cost to purchasemerchandise from suppliers, less rebates and allowances, and certain overheadexpenses including purchasing costs, freight from distribution centers tostores and handling costs in the distribution centers. Cost of products soldand distribution expenses are also affected by store inventory shrinkage, whichrepresents products that are lost, stolen or damaged at the store level.

 

*Selling, General and Administrative Expenses.*  Selling,general and administrative expenses consist primarily of personnel costs,commissions paid to professional distributor sales consultants, benefits,utilities, property maintenance, advertising, rent, insurance, freight anddistribution expenses for delivery to customers, administrative costs and costsassociated with our corporate support center.

 

*Interest Expense*.  Interest expense includes the amortization ofdeferred debt issuance costs and is stated net of interest income. Interestexpense is primarily associated with debt incurred in connection with theSeparation Transactions.

 

***The Fiscal Year Ended September 30, 2010compared to the Fiscal Year Ended September 30, 2009***

 

Thetable below presents net sales, gross profit and gross profit margin data foreach reportable segment (dollars in thousands).

 
| ** **                       | ** ** | **Fiscal Year Ended September 30,** | ** ** |
|----------------------------------|------------|---------------------------------------------------------|------------|
| ** **                       | ** ** | **2010**                                                | ** ** | **2009** | ** ** | **Increase** | ** ** |
| Net sales:                       |       |                                                    |       |   |   |   |   |   |   |
| Sally Beauty Supply              |       | $                                                       | 1,834,631  |   | $ | 1,695,652 |   | $ | 138,979 |   | 8.2 | % |
| BSG                              |       | 1,081,459                                               |       | 940,948 |   | 140,511 |   | 14.9 | % |
| Consolidated net sales           |       | $                                                       | 2,916,090  |   | $ | 2,636,600 |   | $ | 279,490 |   | 10.6 | % |
|                             |       |                                                    |       |   |   |   |   |   |   |
| Gross profit:                    |       |                                                    |       |   |   |   |   |   |   |
| Sally Beauty Supply              |       | $                                                       | 976,377    |   | $ | 878,738 |   | $ | 97,639 |   | 11.1 | % |
| BSG                              |       | 427,997                                                 |       | 364,579 |   | 63,418 |   | 17.4 | % |
| Consolidated gross profit        |       | $                                                       | 1,404,374  |   | $ | 1,243,317 |   | 161,057 |   | 13.0 | % |
|                             |       |                                                    |       |   |   |   |   |   |   |
| Gross profit margin:             |       |                                                    |       |   |   |   |   |   |   |
| Sally Beauty Supply              |       | 53.2                                                    | %          | 51.8 | % | 1.4 | % |   |   |
| BSG                              |       | 39.6                                                    | %          | 38.7 | % | 0.9 | % |   |   |
| Consolidated gross profit margin |       | 48.2                                                    | %          | 47.2 | % | 1.0 | % |   |   |

 

*Net Sales*

 

Consolidated net sales increased by $279.5 million, or 10.6%, for thefiscal year ended September 30, 2010, compared to the fiscal year ended September 30,2009. Company-operated stores that have been open for at least 14 monthscontributed an increase of approximately $179.1 million, or 6.8%, and salesfrom businesses acquired in the preceding 12 months contributed approximately$94.1 million, or 3.6%, more to consolidated net sales for the fiscal yearended September 30, 2010, compared to the fiscal year ended September 30,2009. Other sales channels (including sales through our BSG distributor salesconsultants and our BSG franchise-based businesses and from stores that havebeen open for less than 14 months), in the aggregate, contributed an increaseof $6.3 million, or 0.2%, compared to the fiscal year ended September 30,2009. Consolidated net sales for the fiscal year ended September 30, 2010,are inclusive of approximately $17.2 million in positive impact from changes inforeign currency exchange rates.

 

*Sally Beauty Supply*.  Net sales for Sally Beauty Supply increasedby $139.0 million, or 8.2%, for the fiscal year ended September 30, 2010,compared to the fiscal year ended September 30, 2009.  In the Sally Beauty Supply segment,company-operated stores that have

 

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been open for at least 14 months contributed an increase of approximately$127.3 million, or 7.5%, and sales from businesses acquired in the preceding 12months contributed approximately $13.2 million, or 0.8%, more to net sales forthe fiscal year ended September 30, 2010, compared to the fiscal yearended September 30, 2009. Other sales channels (including sales fromstores that have been open for less than 14 months and non-store sales), in theaggregate, experienced a minor decline in sales compared to the fiscal yearended September 30, 2009. Net sales for Sally Beauty Supply for the fiscalyear ended September 30, 2010, are inclusive of approximately $4.5 millionin positive impact from changes in foreign currency exchange rates.

 

*Beauty Systems Group*.  Net sales for BSG increased by $140.5million, or 14.9%, for the fiscal year ended September 30, 2010, comparedto the fiscal year ended September 30, 2009. Company-operated stores thathave been open for at least 14 months contributed an increase of approximately$51.8 million, or 5.5%, sales from stores that have been open for less than 14months contributed an increase of approximately $6.3 million, or 0.7%, andsales from businesses acquired in the preceding 12 months contributedapproximately $80.9 million, or 8.6%, more to net sales for the fiscal yearended September 30, 2010, compared to the fiscal year ended September 30,2009. Other sales channels (including sales through our distributor salesconsultants and our franchise-based businesses), in the aggregate, experienceda minor increase in sales compared to the fiscal year ended September 30,2009. Net sales for BSG for the fiscal year ended September 30, 2010, areinclusive of approximately $12.7 million in positive impact from changes inforeign currency exchange rates, primarily in connection with our Canadianoperations.

 

*GrossProfit*

 

Consolidated gross profit increased by $161.1 million, or 13.0%, for thefiscal year ended September 30, 2010, compared to the fiscal year ended September 30,2009, principally due to higher sales volume and improved gross margins in bothbusiness segments as more fully described below.

 

*Sally Beauty Supply*. Sally Beauty Supply’sgross profit increased by $97.6 million, or 11.1%, for the fiscal year ended September 30,2010, compared to the fiscal year ended September 30, 2009, principally asa result of higher sales volume and improved gross margins.  Sally Beauty Supply’s gross profit as apercentage of net sales increased to 53.2% for the fiscal year ended September 30,2010, compared to 51.8% for the fiscal year ended September 30, 2009. Thisincrease was the result of a shift in product and customer mix (including a year-over-yearincrease in sales of exclusive-label and other higher-margin products),continued benefits from low-cost sourcing initiatives and overall marginimprovements in certain of our Sally Beauty Supply international businesses.This increase also reflects a $2.7 million positive impact from changes inforeign currency exchange rates.

 

*Beauty Systems Group*.  BSG’s gross profit increased by $63.4million, or 17.4%, for the fiscal year ended September 30, 2010, comparedto the fiscal year ended September 30, 2009, principally as a result ofhigher sales volume and improved gross margins. BSG’s gross profit as apercentage of net sales increased to 39.6% for the fiscal year ended September 30,2010, compared to 38.7% for the fiscal year ended September 30, 2009. Thisincrease was principally the result of a favorable change in the sales andproduct mix across the business, previously anticipated savings realized fromthe warehouse optimization program and synergies from businesses acquiredduring the last 12 months. This increase also reflects a $5.5 million positiveimpact from changes in foreign currency exchange rates.

 

*Selling,General and Administrative Expenses*

 

Consolidated selling, general and administrative expenses increased by$113.6 million, or 12.7%, to $1,004.7 million for the fiscal year ended September 30,2010, compared to $891.1 million for the fiscal year ended September 30,2009. This increase was attributable to incremental expenses (includingemployee compensation, rent and other occupancy-related expenses) resultingfrom stores opened and from businesses acquired in the preceding 12 months(including an increase of 145 stores, or 3.7%, over the fiscal year 2009), aswell as higher share-based compensation expense of $4.2 million, higheradvertising expenses in the Sally Beauty Supply segment of $7.1 million andacquisition–related expenses of $0.7 million. Please see “Recent AccountingPronouncements” below for more information about the Company’s treatment ofacquisition–related expenses. Selling, general and administrative expenses, asa percentage of net sales, were 34.5% for the fiscal year ended September 30,2010, compared to 33.8% for the fiscal year ended September 30, 2009.

 

*Depreciationand Amortization*

 

Consolidateddepreciation and amortization increased to $51.1 million for the fiscal yearended September 30, 2010, compared to $47.1 million for the fiscal yearended September 30, 2009, due to the incremental expenses associated withbusinesses acquired in the last 12 months and depreciation related to capitalexpenditures mainly in connection with store openings in both operatingsegments, partially offset by the impact of assets that became fullydepreciated in the preceding 12 months.

 

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*Operating Earnings*

 

Thefollowing table sets forth, for the periods indicated, information concerningour operating earnings for each reportable segment (dollars in thousands):

 
| ** **                        | ** ** | **Fiscal Year Ended September 30,** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------|------------|
| ** **                        | ** ** | **2010**                                                | ** ** | **2009** | ** ** | **Increase** | ** ** |
| Operating  Earnings:              |       |                                                    |       |   |   |   |   |   |   |
| Segment  operating profit:        |       |                                                    |       |   |   |   |   |   |   |
| Sally  Beauty Supply              |       | $                                                       | 320,456    |   | $ | 283,872 |   | $ | 36,584 |   | 12.9 | % |
| BSG                               |       | 112,495                                                 |       | 91,604 |   | 20,891 |   | 22.8 | % |
| Segment  operating profit         |       | 432,951                                                 |       | 375,476 |   | 57,475 |   | 15.3 | % |
| Unallocated  expenses             |       | (72,172                                                 | )          | (62,289 | ) | 9,883 |   | 15.9 | % |
| Share-based  compensation expense |       | (12,187                                                 | )          | (7,992 | ) | 4,195 |   | 52.5 | % |
| Operating  earnings               |       | $                                                       | 348,592    |   | $ | 305,195 |   | $ | 43,397 |   | 14.2 | % |

 

Consolidated operating earnings increased by $43.4 million, or 14.2%, to$348.6 million for the fiscal year ended September 30, 2010, compared tothe fiscal year ended September 30, 2009. The increase in consolidatedoperating earnings was due primarily to an increase in the operating profits ofboth segments, partially offset by higher unallocated corporate expenses andshare-based compensation expense, as discussed below. Operating earnings, as apercentage of net sales, increased to 12.0% for the fiscal year ended September 30,2010, compared to 11.6% for the fiscal year ended September 30, 2009.

 

*Sally Beauty Supply*.  Sally Beauty Supply’s segment operatingearnings increased by $36.6 million, or 12.9%, to $320.5 million for the fiscalyear ended September 30, 2010, compared to the fiscal year ended September 30,2009. The increase in Sally Beauty Supply’s segment operating earnings wasprimarily a result of increased sales volume and improved gross margins,partially offset by higher advertising costs of approximately $7.1 million andthe incremental costs related to approximately 108 net additionalcompany-operated stores (stores opened or acquired during the past 12 months)operating during the fiscal year ended September 30, 2010.  Segment operating earnings, as a percentageof net sales, increased to 17.5% for the fiscal year ended September 30,2010, compared to 16.7% for the fiscal year ended September 30, 2009. Theincrease in Sally Beauty Supply’s operating earnings, as a percentage ofsegment net sales, was primarily a result of gross margin improvements.

 

*Beauty Systems Group*.  BSG’s segment operating earnings increased by$20.9 million, or 22.8%, to $112.5 million for the fiscal year ended September 30,compared to the fiscal year ended September 30, 2009. Segment operatingearnings, as a percentage of net sales, increased to 10.4% for the fiscal yearended September 30, compared to 9.7% for the fiscal year ended September 30,2009. The increase in BSG operating earnings was primarily a result of gross marginimprovements, the incremental operating earnings of businesses acquired andstores opened during the past 12 months, and to ongoing cost reductioninitiatives (including cost savings realized from the warehouse optimizationprogram that began in the fiscal year 2007).

 

*Unallocated expenses.*Unallocated expenses, whichrepresent corporate costs (such as payroll, employee benefits and travelexpenses for corporate staff, certain professional fees and corporategovernance expenses) that have not been charged to our operating segments,increased by $9.9 million, or 15.9%, to $72.2 million for the fiscal year endedSeptember 30, 2010, compared to the fiscal year ended September 30,2009. This increase was due primarily to higher employee compensation and compensation-relatedexpenses of approximately $3.6 million, an unfavorable change in foreigncurrency transactions of approximately $2.3 million resulting principally fromintercompany loans not permanently invested, other corporate expenses ofapproximately $2.6 million related primarily to recent upgrades to ourinformation technology and communication systems, and acquisition–relatedexpenses of approximately $0.7 million (representing legal fees and expenses,professional fees and other expenses).

 

*Share-based Compensation Expense.*Totalcompensation cost charged against income for share-based compensationarrangements increased by $4.2 million to $12.2 million for the fiscal year ended September 30, 2010, compared to the fiscalyear ended September 30, 2009. This increase was due to the higher fair value atthe grant date of stock option awards during the fiscalyear ended September 30, 2010, compared to stock option awards during the fiscal year ended September 30, 2009, and the incremental annual expensesresulting from such fiscal year 2010 stock option awards.

 

*InterestExpense*

 

Interestexpense decreased by $19.1 million, to $113.0 million for the fiscal year endedSeptember 30, 2010, compared to the fiscal year ended September 30,2009. Interest expense is net of interest income of $0.2 million and $0.3million for the fiscal year ended September 30, 2010 and 2009,respectively. The decrease in interest expense was primarily attributable tolower outstanding principal balances on our ABL facility and senior term loansand to lower prevailing LIBOR interest rates, partially offset by a $2.9million net 

 

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unfavorablechange in the fair value of certain interest rate swaps (Please see Note 13 ofthe Notes to Consolidated Financial Statements in Item 8 - “FinancialStatements and Supplementary Data” contained elsewhere in this Annual Reportfor additional information about the Company’s interest rate swap agreements).

 

*Provisionfor Income Taxes*

 

Provisionfor income taxes was $87.0 million during the fiscal year ended September 30,2010, compared to $68.4 million for the fiscal year ended September 30,2009.  The effective tax rate is 36.9%for fiscal year 2010, compared to 39.5% for fiscal year 2009.  The decrease in the annual effective tax rateprimarily relates to an increase in earnings in certain low tax jurisdictions,the release of certain valuation allowances and a reduction in unfavorablepermanent items.

 

*Net Earnings*

 

Asa result of the foregoing, consolidated net earnings increased by $43.9million, or 41.9%, to $148.6 million for the fiscal year ended September 30,2010, compared to $104.7 million for the fiscal year ended September 30,2009. Net earnings, as a percentage of net sales, were 5.1% for the fiscal yearended September 30, 2010, compared to 4.0% for the fiscal year ended September 30,2009.

 

***The Fiscal Year Ended September 30, 2009compared to the Fiscal Year Ended September 30, 2008***

 

Thetable below presents net sales, gross profit and gross profit margin data foreach reportable segment (dollars in thousands).

 
| ** **                       | ** ** | **Fiscal Year Ended September 30,** | ** ** |
|----------------------------------|------------|---------------------------------------------------------|------------|
| ** **                       | ** ** | **2009**                                                | ** ** | **2008** | ** ** | **Increase (Decrease)** | ** ** |
| Net sales:                       |       |                                                    |       |   |   |   |   |   |   |
| Sally Beauty Supply              |       | $                                                       | 1,695,652  |   | $ | 1,672,897 |   | $ | 22,755 |   | 1.4 | % |
| BSG                              |       | 940,948                                                 |       | 975,294 |   | (34,346 | ) | (3.5 | )% |
| Consolidated net sales           |       | $                                                       | 2,636,600  |   | $ | 2,648,191 |   | $ | (11,591 | ) | (0.4 | )% |
|                             |       |                                                    |       |   |   |   |   |   |   |
| Gross profit:                    |       |                                                    |       |   |   |   |   |   |   |
| Sally Beauty Supply              |       | $                                                       | 878,738    |   | $ | 858,375 |   | $ | 20,363 |   | 2.4 | % |
| BSG                              |       | 364,579                                                 |       | 376,219 |   | (11,640 | ) | (3.1 | )% |
| Consolidated gross profit        |       | $                                                       | 1,243,317  |   | $ | 1,234,594 |   | $ | 8,723 |   | 0.7 | % |
|                             |       |                                                    |       |   |   |   |   |   |   |
| Gross profit margin:             |       |                                                    |       |   |   |   |   |   |   |
| Sally Beauty Supply              |       | 51.8                                                    | %          | 51.3 | % | 0.5 | % |   |   |
| BSG                              |       | 38.7                                                    | %          | 38.6 | % | 0.1 | % |   |   |
| Consolidated gross profit margin |       | 47.2                                                    | %          | 46.6 | % | 0.6 | % |   |   |

 

*Net Sales*

 

Consolidated net sales decreased by $11.6 million, or 0.4%, for thefiscal year ended September 30, 2009, compared to the fiscal year ended September 30,2008. Company-operated stores that have been open for at least 14 monthscontributed an increase of approximately $70.5 million, or 2.7%, and salesthrough certain non-store sales channels contributed an increase ofapproximately $3.9 million, or 0.1%, to consolidated net sales. Other sales channelsexperienced declines compared to the fiscal year ended September 30, 2008.Sales through BSG’s franchise-based businesses declined by approximately $12.0million, or 0.5%, sales through our BSG distributor sales consultants declinedapproximately $29.2 million, or 1.1%, and sales through new stores (notincluding acquisitions) declined approximately $19.6 million, or 0.7%, due tofewer store openings through the twelve-month period ended September 30,2009, compared to the twelve-month period ended September 30, 2008. Inaddition, incremental sales from businesses acquired in the preceding 12 monthscontributed $25.2 million, or 1.0%, less to our consolidated net sales for thefiscal year ended 

 

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September 30, 2009, compared to the fiscal year ended September 30,2008. Consolidated net sales for the fiscal year ended September 30, 2009,are inclusive of approximately $86.0 million in negative impact from changes inforeign currency exchange rates.

 

*Sally Beauty Supply*.  Net sales for Sally Beauty Supply increasedby $22.8 million, or 1.4%, for the fiscal year ended September 30, 2009,compared to the fiscal year ended September 30, 2008.  In the Sally Beauty Supply segment,company-operated stores that have been open for at least 14 months contributedan increase of approximately $52.4 million, or 3.1%, while our non-store saleschannels contributed an increase of approximately $3.9 million, or 0.2%. Salesof businesses acquired in the preceding 12 months contributed $28.3 millionless to the Sally Beauty Supply segment’s net sales for the fiscal year ended September 30,2009, compared to the fiscal year ended September 30, 2008 and salesthrough new stores (not including acquisitions) declined approximately $5.3million, or 0.3%. Net sales for Sally Beauty Supply for the fiscal year ended September 30,2009, are inclusive of approximately $64.1 million in negative impact fromchanges in foreign currency exchange rates.

 

*Beauty Systems Group*.  Net sales for BSG decreased by $34.3 million,or 3.5%, for the fiscal year ended September 30, 2009, compared to thefiscal year ended September 30, 2008. While company-operated stores thathave been open for at least 14 months contributed an increase of approximately$18.1 million, or 1.9%, and sales from businesses acquired in the preceding 12months contributed $3.1 million more to the BSG segment’s net sales, othersales channels experienced declines compared to the fiscal year ended September 30,2008. Sales through BSG’s franchise-based businesses declined by approximately$12.0 million, or 1.2%, sales through distributor sales consultants declinedapproximately $29.2 million, or 3.0%, and sales through new stores (notincluding acquisitions) declined approximately $14.3 million, or 1.5%. Netsales for BSG for the fiscal year ended September 30, 2009, are inclusiveof approximately $21.9 million in negative impact from changes in foreigncurrency exchange rates.

 

*GrossProfit*

 

Consolidated gross profit increased by $8.7 million, or 0.7%, for thefiscal year ended September 30, 2009, compared to the fiscal year ended September 30,2008, principally due to higher sales volume for the Sally Beauty Supplysegment and improved gross margin percentages for both business segments. Thisincrease was partially offset by lower sales volume for the BSG segment, asmore fully described below.

 

*Sally Beauty Supply*. Sally Beauty Supply’sgross profit increased by $20.4 million, or 2.4%, for the fiscal year ended September 30,2009, compared to the fiscal year ended September 30, 2008, principally asa result of increased unit sales volume and improved margins.  Sally Beauty Supply’s gross profit as apercentage of net sales increased to 51.8% for the fiscal year ended September 30,2009, compared to 51.3% for the fiscal year ended September 30, 2008. Thisincrease was the result of recent marketing efforts, low-cost sourcinginitiatives and a shift in product mix (including an increase in sales ofexclusive-label products and other higher-margin products).

 

*Beauty Systems Group*.  BSG’s gross profit decreased by $11.6million, or 3.1%, for the fiscal year ended September 30, 2009, compared tothe fiscal year ended September 30, 2008, principally as a result of lowerunit sales volume. BSG’s gross profit as a percentage of net sales increasedslightly to 38.7% for the fiscal year ended September 30, 2009, comparedto 38.6% for the fiscal year ended September 30, 2008, principally as aresult of a favorable change in sales mix towards higher company-operated storesales volume (with higher gross profit margins as opposed to both franchisestore and distributor sales consultants’ sales).

 

*Selling,General and Administrative Expenses*

 

Consolidated selling, general and administrative expenses decreased by$4.6 million, or 0.5%, to $891.1 million for the fiscal year ended September 30,2009, compared to $895.6 million for the fiscal year ended September 30,2008. Selling, general and administrative expenses, as a percentage of netsales, were 33.8% for both the fiscal year ended September 30, 2009 andthe fiscal year ended September 30, 2008. The decrease in selling, generaland administrative expenses reflects lower share-based compensation of $1.6million, lower sales commissions of $4.7 million and a decrease in otherunallocated corporate expenses as a result of cost-saving initiatives as wellas favorable foreign currency transactions of $3.9 million resulting fromintercompany notes not permanently invested, partially offset by theincremental expenses related to businesses acquired in the last 12 months aswell as to an increase in advertising expenses of approximately $4.5 million.Selling, general and administrative expense for the fiscal year ended September 30,2008 included approximately $3.0 million for BSG retention incentives fordistributor sales consultants (resulting from the L’Oreal contractual changesreported during fiscal year 2007) and warehouse optimization expenses ofapproximately $2.4 million, with no similar expenses in the fiscal year ended September 30,2009.

 

*Depreciationand Amortization*

 

Consolidated depreciation and amortization decreased to $47.1 million forthe fiscal year ended September 30, 2009, compared to $48.5 million forthe fiscal year ended September 30, 2008, due to a favorable impact fromchanges in foreign currency exchange rates, partially offset by the expensesassociated with businesses acquired in the fiscal years 2008 and 2009.

 

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*Operating Earnings*

 

Thefollowing table sets forth, for the periods indicated, information concerningour operating earnings for each reportable segment (dollars in thousands):

 
| ** **                        | ** ** | **Fiscal Year Ended September 30,** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------|------------|
| ** **                        | ** ** | **2009**                                                | ** ** | **2008** | ** ** | **Increase (Decrease)** |
| Operating  Earnings:              |       |                                                    |       |   |   |   |   |   |   |
| Segment  operating profit:        |       |                                                    |       |   |   |   |   |   |   |
| Sally  Beauty Supply              |       | $                                                       | 283,872    |   | $ | 285,615 |   | $ | (1,743 | ) | (0.6 | )% |
| BSG                               |       | 91,604                                                  |       | 80,927 |   | 10,677 |   | 13.2 | % |
| Segment  operating profit         |       | 375,476                                                 |       | 366,542 |   | 8,934 |   | 2.4 | % |
| Unallocated  expenses             |       | (62,289                                                 | )          | (66,499 | ) | (4,210 | ) | (6.3 | )% |
| Share-based  compensation expense |       | (7,992                                                  | )          | (9,614 | ) | (1,622 | ) | (16.9 | )% |
| Operating  earnings               |       | $                                                       | 305,195    |   | $ | 290,429 |   | $ | 14,766 |   | 5.1 | % |

 

Consolidated operating earnings increased by $14.8 million, or 5.1%, to$305.2 million for the fiscal year ended September 30, 2009, compared to$290.4 million for the fiscal year ended September 30, 2008. Operatingearnings, as a percentage of net sales, were 11.6% for the fiscal year ended September 30,2009, compared to 11.0% for the fiscal year ended September 30, 2008. Theincrease in consolidated operating earnings was due primarily to an increase inBSG operating earnings and declines in unallocated expenses and share-basedcompensation expense, offset in part by a decline in the Sally Beauty Supply’soperating profits, as discussed below. Consolidated operating earnings for the fiscal year ended September 30,2009, are inclusive of approximately $1.4 million in negative impact fromchanges in foreign currency exchange rates.

 

*Sally Beauty Supply*.  Sally Beauty Supply’s segment operatingearnings decreased $1.7 million, or 0.6%, to $283.9 million for the fiscal yearended September 30, 2009, compared to $285.6 million for the fiscal yearended September 30, 2008.  Thedecrease in Sally Beauty Supply’s segment operating earnings was primarily aresult of higher advertising costs of approximately $6.4 million and theincremental costs related to approximately 78 additional company-operatedstores (stores opened or acquired during the past twelve months) operatingduring the fiscal year ended September 30, 2009, partially offset bydeclines in other segment operating expenses resulting from cost-savinginitiatives.  Segment operating earnings,as a percentage of net sales, were 16.7% for the fiscal year ended September 30,2009, compared to 17.1% for the fiscal year ended September 30, 2008. Thedecrease in Sally Beauty Supply’s segment operating earnings as a percentage ofsegment net sales was primarily a result of higher advertising costs as apercentage of segment net sales and continued softer sales in some of thesegment’s international operations.

 

*Beauty Systems Group*.  BSG’s segment operating earnings increased by$10.7 million, or 13.2%, to $91.6 million for the fiscal year ended September 30,2009, compared to $80.9 million for the fiscal year ended September 30,2008. Segment operating earnings, as a percentage of net sales, were 9.7% forthe fiscal year ended September 30, 2009, compared to 8.3% for the fiscalyear ended September 30, 2008. This increase was due primarily to adecline in segment operating expenses resulting from cost-saving initiativesand slightly higher segment gross profit, as discussed above. BSG’s segmentoperating earnings also reflect, for the fiscal year ended September 30,2008, approximately $3.0 million for retention incentives for distributor salesconsultants (resulting from the L’Oreal contractual changes reported duringfiscal year 2007). Segment operating earnings for the fiscal year ended September 30,2009, are inclusive of approximately $2.0 million in negative impact fromchanges in foreign currency exchange rates.

 

*Unallocated expenses.*Unallocated expenses, whichrepresent corporate costs (such as payroll, employee benefits and travelexpenses for corporate staff, certain professional fees and corporategovernance expenses) that have not been charged to our operating segmentsdecreased by $4.2 million, or 6.3%, to $62.3 million for the fiscal year ended September 30,2009, compared to $66.5 million for the fiscal year ended September 30,2008. This decrease was due primarily to favorable foreign currencytransactions of $5.1 million resulting from intercompany notes not permanentlyinvested, partially offset by an increase in corporate expenses mainly inconnection with recent upgrades to our information technology systems.

 

*Share-based Compensation Expense.*For the fiscal year ended September 30, 2009, total compensation cost charged against income forshare-based compensation arrangements was $8.0 million compared to $9.6 millionfor the fiscal year ended September 30, 2008. This decrease was due to a decline in thefair value per share of options awarded in the period ended September 30,2009, compared to options awarded in the period ended September 30,2008.  Duringthe fiscal year ended September 30, 2009 and 2008, the Sally Beautygranted to the Company’s employees and consultants approximately 2.7 millionand 2.8 million stock options, respectively, and approximately 123,000 and136,000 restricted share awards, respectively, under the 2007 Plan.

 

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*InterestExpense*

 

Interestexpense, net of interest income of $0.3 million, was $132.0 million for thefiscal year ended September 30, 2009, compared to $159.0 million, net ofinterest income of $0.7 million, for the fiscal year ended September 30,2008.  The decrease in interest expensewas primarily attributable to a $9.9 million favorable change in the fair valueof certain interest rate swaps (please see Note 13 of the “Notes toConsolidated Financial Statements” in Item 8 - “Financial Statements andSupplementary Data”) and to lower prevailing interest rates on our ABL andsenior term loan facilities and lower outstanding principal balances on oursenior term loans.

 

*Provisionfor Income Taxes*

 

Provisionfor income taxes was $68.4 million during the fiscal year ended September 30,2009, compared to $48.7 million for the fiscal year ended September 30,2008.  The effective tax rate is 39.5%for fiscal year 2009, compared to 37.0% for fiscal year 2008.  The increase in the effective tax rateprimarily relates to a reduction in earnings in low tax jurisdictions and areduction in favorable permanent items triggered by lower foreign earnings.

 

*NetEarnings*

 

Asa result of the foregoing, consolidated net earnings increased by $21.9million, or 26.3%, to $104.7 million for the fiscal year ended September 30,2009, compared to $82.9 million for the fiscal year ended September 30,2008. Net earnings, as a percentage of net sales, were 4.0% for the fiscal yearended September 30, 2009, compared to 3.1% for the fiscal year ended September 30,2008.

 

**FinancialCondition**

 

***September 30,2010 Compared to September 30, 2009***

 

Workingcapital (current assets less current liabilities) increased by $35.7 million to$351.6 million at September 30, 2010, compared to $315.9 million at September 30,2009. The ratio of current assets to current liabilities was 1.79 to 1.00 at September 30,2010 and 2009. The increase in working capital reflects an increase of $78.4million in current assets and an increase of $42.7 million in currentliabilities.  The increase in currentassets as of September 30, 2010 includes an increase of $44.7 million ininventory, an increase of $11.3 million in trade accounts receivable, anincrease of $7.6 million in deferred income tax assets, an increase of $5.4million in other receivables, an increase of $4.3 million in prepaid expensesand an increase of $5.0 million in cash and cash equivalents.  The increase in current liabilities as of September 30,2010 includes an increase of $44.8 million in accounts payable and accruedliabilities and an increase of $18.5 million in due to Sally Beauty, partiallyoffset by a decrease of $21.5 million in current maturities of long-term debt,as further described below.

 

Cashand cash equivalents increased by $5.0 million to $59.5 million at September 30,2010, compared to $54.4 million at September 30, 2009 due primarily tocash provided by operating activities during the fiscal year ended September 30,2010, partially offset by cash used in by investing and financing activities(Please see “Liquidity and Capital Resources” below).

 

Tradeaccounts receivable increased by $11.3 million to $55.0 million at September 30,2010, compared to $43.6 million at September 30, 2009 due primarily to theincrease in sales activity and to receivables of businesses acquired. Otherreceivables increased by $5.4 million to $29.5 million at September 30,2010, compared to $24.1 million at September 30, 2009 due primarily toaccrued vendor rebates and to other receivables of businesses acquired.Inventory increased by $44.7 million to $604.4 million at September 30,2010, compared to $559.7 million at September 30, 2009 due primarily tothe effect of stores opened and to the inventory of businesses acquired in thepreceding 12 months, partially offset by the effect of foreign currencytranslation adjustments of approximately $1.5 million. Prepaid expensesincreased by $4.3 million to $22.5 million at September 30, 2010, comparedto $18.3 million at September 30, 2009 due primarily to the timing ofstore rent and business insurance prepayments and to prepaid expenses ofbusinesses acquired. Deferred income tax assets, increased by $7.6 million to$23.3 million at September 30, 2010, compared to $15.6 million at September 30,2009 primarily due to the timing of differences between the treatment ofcertain elements of income and expenses for tax purposes versus for inclusionin our consolidated statements of earnings.

 

Accounts payable increased by $31.3 million to $224.9 million at September 30,2010, compared to $193.6 million at September 30, 2009 due primarily tothe accounts payable of businesses acquired and the timing of payments tosuppliers in connection with recent purchases of merchandise inventory. Accruedliabilities increased by $13.4 million to $167.3 million at September 30,2010, compared to $153.8 million at September 30, 2009 due primarily tothe timing of payments of employee compensation and compensation-relatedexpenses and to accrued liabilities of businesses acquired. The amount due toSally Beauty increased by $18.5 million to $40.5 million at September 30,2010, compared to $22.0 million at September 30, 2009 due primarily to anincrease in the federal income tax liability of the Company and itsconsolidated subsidiaries and to share-based compensation expense, partiallyoffset by corporate expenses (such as board of director expenses, professionalfees and other public company expenses) paid on behalf of our indirect parentSally Beauty. Current maturities of long-term debt decreased by $21.5 millionto $3.0 million at September 30, 2010 primarily due to a mandatoryprepayment of $22.3 million on the senior term loan facilities in January 2010(Please see “Liquidity and Capital Resources” below).

 

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Netproperty and equipment increased by $16.9 million to $168.1 million atSeptember 30, 2010, compared to $151.2 million at September 30,2009, primarily due to the capital expenditures and the property and equipmentof businesses acquired, partially offset by the fiscal year 2010 depreciationexpense and the effect of foreign currency translation adjustments.

 

Goodwilldecreased by $15.9 million to $478.2 million at September 30,2010, compared to $494.1 million at September 30, 2009, primarily dueto the reclassification, during the fiscal year 2010, of intangible assets inthe amount of $22.9 million and $2.8 million recorded in connection with the September 2009acquisitions of Schoeneman and Intersalon, respectively. These amounts werepreviously reported in Goodwill pending the valuation of the assets acquired.This decrease was partially offset by an increase in goodwill in the amount of$10.7 million resulting from businesses acquired during the fiscal year 2010.

 

Otherintangible assets increased by $30.7 million to $109.4 million atSeptember 30, 2010, compared to $78.7 million at September 30,2009, primarily due to the reclassification, during the fiscal year 2010, ofintangible assets in the amount of $22.9 million and $2.8 million recorded inconnection with the September 2009 acquisitions of Schoeneman andIntersalon, respectively. These amounts were previously reported in Goodwillpending the valuation of the assets acquired. Additionally, other intangibleassets increased by $15.1 million as a result of businesses acquired during thefiscal year 2010 (including Sinelco), partially offset by amortization expenseand the effect of foreign currency translation adjustments.

 

Otherassets decreased by $11.8 million to $38.9 million at September 30, 2010,compared to $50.7 million at September 30, 2009, primarily due toamortization of the debt issuance costs, which are being amortized as interestexpense over the term of the debt, and the unamortized debt issuance costs thatwere expensed in connection with repayments of debt during the fiscal year2010.

 

Long-term debt, excluding current portion, decreased by $93.4 million to$1,559.6 million at September 30, 2010, compared to $1,653.0 million at September 30,2009 due primarily to optional prepayments of $102.7 million on our senior termloan facilities (Please see “Liquidity and Capital Resources” below), partiallyoffset by the long-term portion of the pre-acquisition indebtedness, includingcapital leases, of Sinelco and the effect of foreign currency translationadjustments.

 

Deferredincome tax liabilities, net, increased by $8.4 million to $42.9 million at September 30,2010, compared to $34.4 million at September 30, 2009. This increase wasprimarily due to the timing of differences between depreciation andamortization included for tax purposes versus depreciation and amortizationincluded in our consolidated statements of earnings, and the tax effect ofdeferred (losses) gains on certain interest rate swaps.

 

Totalmember’s deficit decreased by $144.3 million to $497.9 million at September 30,2010, as a result of net earnings of $148.6 million, partially offset bycumulative translation adjustments and deferred losses on interest rate swaps,net of tax, as described below.

 

Accumulatedother comprehensive loss increased by $4.4 million, to $20.3 million at September 30,2010, due to foreign currency translation adjustments of $4.3 million anddeferred losses on hedged interest rate swaps of $0.1 million, net of incometax.

 

**Liquidityand Capital Resources**

 

Webroadly define liquidity as our ability to generate sufficient cash flow fromoperating activities to meet our obligations and commitments. In addition,liquidity includes the ability to obtain appropriate debt and equity financingand to convert into cash those assets that are no longer required to meetexisting strategic and financial objectives. Therefore, liquidity cannot beconsidered separately from capital resources that consist of current orpotentially available funds for use in achieving long-range business objectivesand meeting debt service commitments.

 

Weare highly leveraged and a substantial portion of our liquidity needs willarise from debt service on indebtedness incurred primarily in connection withthe Separation Transactions and from funding the costs of operations, workingcapital and capital expenditures. As a holding company, we depend on oursubsidiaries to distribute funds to us so that we may pay our obligations andexpenses. The ability of our subsidiaries to make such distributions will besubject to their operating results, cash requirements and financial conditionand their compliance with covenants and financial ratios related to theirexisting or future indebtedness. In addition, under Delaware law, the abilityof each of our subsidiaries to make distributions to us will be limited to theextent: (i) of its surplus, or if there is no surplus, of its net earningsfor the fiscal year in which the distribution is declared and/or the precedingfiscal year, if such subsidiary is a corporation; or (ii) the fair valueof its assets exceeds its liabilities, in the case of a subsidiary that is alimited liability company. If, as a consequence of these limitations, we cannotreceive sufficient distributions from our subsidiaries, we may not be able tomeet our obligations to fund general corporate expenses. Please see “RiskFactors—Risks Relating to Our Business,” and “—Risks Relating to OurSubstantial Indebtedness.”

 

Wemay from time to time repurchase or otherwise retire our debt and take othersteps to reduce our debt or otherwise improve our balance sheet. These actionsmay include open market repurchases of our notes, prepayments of our term loansor other retirements of outstanding debt. The amount of debt that may berepurchased or otherwise retired, if any, would be decided upon at the solediscretion of Sally Beauty’s Board of Directors and will depend on marketconditions, trading levels of the Company’s debt from time to time, the Company’scash position and other considerations.

 

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Thesenior term loan facilities may be prepaid at the option of Sally Holdings atany time without premium or penalty and are subject to mandatory prepayment inan amount equal to 50% of excess cash flow (as defined in the agreementgoverning the term loan facilities) for any fiscal year unless a specifiedleverage ratio is met. In January 2010, the Company made a mandatoryprepayment on the senior term loan facilities in the amount of $22.3 millionpursuant to such excess cash flow provision. Amounts paid pursuant to saidprovision may be applied, at the option of the Company, against minimum loanrepayments otherwise required of it over the twelve-month period following anysuch payment under the terms of the loan agreement. During the fiscal year endedSeptember 30, 2010, the Company also made optional prepayments in theaggregate amount of $102.7 million on its senior term loans. This amounttogether with the mandatory prepayment discussed above, resulted in theprepayment in full of borrowings under the Term Loan A facility. In connectionwith the mandatory prepayment and the optional prepayments made during thefiscal year 2010, the Company recorded losses on extinguishment of debt in theaggregate amount of $1.0 million, which are included in interest expense in theCompany’s consolidated statements of earnings.

 

Basedupon the current level of operations and anticipated growth, we anticipate thatexisting cash balances, funds expected to be generated by operations, and fundsavailable under the ABL facility will be sufficient to meet our working capitalrequirements and to finance anticipated capital expenditures over the next 12months.

 

Therecan be no assurance that our business will generate sufficient cash flows fromoperations, that anticipated net sales and operating improvements will berealized, or that future borrowings will be available under our ABL facility inan amount sufficient to enable us to service our indebtedness or to fund ourother liquidity needs. In addition, our ability to meet our debt serviceobligations and liquidity needs are subject to certain risks, which include,but are not limited to, increases in competitive activity, the loss of keysuppliers, rising interest rates, the loss of key personnel, the ability toexecute our business strategy and general economic conditions. Please see “RiskFactors.”

 

We utilize our ABL facilityfor the issuance of letters of credit as well as to manage normal fluctuationsin operational cash flow. In that regard, we may from time to time draw fundsunder the revolving credit facility for general corporate purposes includingacquisitions and interest payments due on our indebtedness.  Thefunds drawn on individual occasions during the fiscal year ended September 30,2010 have varied in amounts of up to $30.0**million,with total amounts outstanding ranging from zero up to $53.5 million. Theamounts drawn are generally paid down with cash provided by our operatingactivities.

 

Asof September 30, 2010, we had $341.8 million available for additionalborrowings under our ABL facility, subject to borrowing base limitations, asreduced by outstanding letters of credit.

 

OnNovember 12, 2010, we entered into a new $400.0 million ABLfacility.  Availability under the new ABLfacility is a function of a customary borrowing base of receivables andinventory levels.  The new ABL facilityhas a 5-year maturity and pricing levels at market rates.

 

Weare a holding company and do not have any material assets or operations otherthan ownership of equity interests of our subsidiaries. The agreements andinstruments governing our debt contain material limitations on our ability topay dividends and other restricted payments to Sally Beauty.

 

Underthe agreements and indentures governing the term loan facilities and the notes,we may not make certain restricted payments to Sally Beauty if a default thenexists under the credit agreement or the indentures or if our consolidatedinterest coverage ratio is less than 2.0 to 1.0 at the time of the making ofsuch restricted payment.  As of September 30,2010, our consolidated interest coverage ratio exceeded 2.0 to 1.0.  Further, the aggregate amount of restrictedpayments we are able to make is limited pursuant to various baskets ascalculated pursuant to the credit agreement and indentures.

 

Asof September 30, 2010, the net assets of our consolidated subsidiariesthat were unrestricted from transfer under our credit arrangements totaled$310.1 million, subject to certain adjustments**.**Under our new ABL facility, we may pay dividends and make other equitydistributions if availability under the facility exceeds certainthresholds.  For dividends anddistributions up to $30.0 million during each fiscal year, borrowingavailability must exceed the lesser of $80.0 million or 20% of the borrowingbase for 45 days prior to such dividend and distribution.  For dividends in excess of that amount, wemust maintain that same availability and our fixed charge coverage ratio mustexceed 1.10 to 1.00.  As of September 30, 2010, we wouldhave met all of these conditions.

 

Duringthe fiscal year ended September 30, 2010, we completed severalacquisitions at an aggregate cost of $45.6 million. In general, we funded theseacquisitions with cash from operations and borrowings under the ABL facility.For example, on December 16, 2009, we acquired Sinelco, a wholesaledistributor of professional beauty products based in Ronse, Belgium, forapproximately €25.2 million (approximately $36.6 million). We also assumed €4.0million (approximately $5.8 million) of pre-acquisition debt of Sinelco inconnection with the acquisition. In addition, during the fiscal year 2009, wecompleted several acquisitions at an aggregate cost of $82.3 million. Ingeneral, we funded these acquisitions with cash from operations. For example,on September 4, 2009, we acquired Intersalon, a leading distributor ofpremier beauty supply products with 16 stores located in Chile, forapproximately $6.4 million and, on September 30, 2009, we acquiredSchoeneman, a 43-store beauty supply chain located in the central northeastUnited States, for approximately $71.0 million (subject to certain adjustmentsand including incidental acquisition costs capitalized).

 

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***Historical CashFlows***

 

Our primary source of cashhas been from funds provided by operating activities and, for fiscal years2010, 2009 and 2008, from borrowings. The primary uses of cash during the pastthree years were for acquisitions and capital expenditures. The following tableshows our sources and uses of funds for the fiscal years endedSeptember 30, 2010, 2009 and 2008 (in thousands):

 
| ** **                                                                     | ** ** | **Fiscal Year Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2010**                                                | ** ** | **2009** | ** ** | **Change** | ** ** | **2009** | ** ** | **2008** | ** ** | **Change** | ** ** |
| Cash  provided by operating activities                                         |       | $                                                       | 218,054    |   | $ | 223,984 |   | $ | (5,930 | ) | $ | 223,984 |   | $ | 111,415 |   | $ | 112,569 |   |
| Cash  used by investing activities                                             |       | (85,022                                                 | )          | (118,559 | ) | 33,537 |   | (118,559 | ) | (98,162 | ) | (20,397 | ) |
| Cash  (used) provided by financing activities                                  |       | (127,319                                                | )          | (149,916 | ) | 22,597 |   | (149,916 | ) | 47,134 |   | (197,050 | ) |
| Effect  of foreign currency exchange rate changes on cash and cash equivalents |       | (666                                                    | )          | (850 | ) | 184 |   | (850 | ) | 1,129 |   | (1,979 | ) |
| Net  increase (decrease) in cash and cash equivalents                          |       | $                                                       | 5,047      |   | $ | (45,341 | ) | $ | 50,388 |   | $ | (45,341 | ) | $ | 61,516 |   | $ | (106,857 | ) |

 

*Cash Provided by OperatingActivities*

 

Netcash provided by operating activities during the fiscal year ended September 30,2010, which excludes cash used for acquisitions completed during the period,decreased by $5.9 million to $218.1 million compared to$224.0 million during the fiscal year ended September 30, 2009. Thedecrease was primarily due to changes in inventory levels of approximately$80.5 million (resulting from increases in inventory levels in the fiscal yearended September 30, 2010 and reductions in inventory levels in the fiscalyear ended September 30, 2009) and deferred income taxes of $9.3 million,partially offset by changes in accounts payable and accrued liabilities ofapproximately $19.7 million and amounts due to Sally Beauty of $12.5 millionand by an improvement in earnings of approximately $43.9 million for the fiscalyear ended September 30, 2010, compared to the fiscal year ended September 30,2009.

 

Netcash provided by operating activities during the fiscal year ended September 30,2009, which excludes cash used for acquisitions completed during the period,increased by $112.6 million to $224.0 million compared to$111.4 million during the fiscal year ended September 30, 2008. Theincrease was primarily due to a reduction of approximately $75.7 million ininventory levels, an increase in accounts payable and accrued liabilities ofapproximately $29.0 million, and an improvement of approximately $21.9 millionin earnings, partially offset by a change in other liabilities of $12.4 millionfor the fiscal year ended September 30, 2009, compared to the fiscal yearended September 30, 2008.

 

*CashUsed by Investing Activities*

 

Netcash used by investing activities during the fiscal year ended September 30,2010 decreased by $33.5 million to $85.0 million compared to$118.6 million during the fiscal year ended September 30, 2009.  This decrease was primarily due to $45.0million less in cash used for acquisitions, partially offset by higher capitalexpenditures (primarily as a result of more store openings) for the fiscal yearended September 30, 2010, compared to the fiscal year ended September 30,2009.

 

Netcash used by investing activities during the fiscal year ended September 30,2009 increased by $20.4 million to $118.6 million compared to$98.2 million during the fiscal year ended September 30, 2008.  This increase was primarily due to $28.6million more in cash used for acquisitions, partially offset by lower capitalexpenditures (primarily as a result of fewer store openings) for the fiscalyear ended September 30, 2009, compared to the fiscal year ended September 30,2008.

 

*Cash(Used) Provided by Financing Activities*

 

Netcash used by financing activities during the fiscal year ended September 30,2010 decreased by $22.6 million to $127.3 million compared to$149.9 million during the fiscal year ended September 30, 2009.  This decrease was primarily due to netrepayments of debt of $127.6 million (including the prepayment in full of ourTerm Loan A and including a mandatory repayment in the amount of $22.3 millionon our senior term loan facilities) during the fiscal year ended September 30,2010, compared to net repayments of debt of $148.1 million during the fiscalyear ended September 30, 2009. (Please see *Liquidityand Capital Resources* above).

 

Netcash (used) provided by financing activities during the fiscal year ended September 30,2009 changed by $197.1 million to cash used of $149.9 million compared tocash provided of $47.1 million during the fiscal year ended September 30,2008.  The change was primarily due tonet borrowings of $63.6 million under our ABL facility during the fiscal yearended September 30, 2008, compared to net repayments of $75.0 millionduring the fiscal year ended September 30, 2009. In addition, during thefiscal year ended September

 

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30,2009, the Company made scheduled payments in the aggregate amount of $6.1million, a mandatory repayment in the amount of $16.7 million and optionalrepayments in the aggregate amount of $45.0 million on its term loan facilitiesand the Company repurchased $5.0 million in par value of its seniorsubordinated notes.

 

***Credit Facilities***

 

InNovember of 2006, we: (i) entered into two term loan facilities (termloans A and B) in an aggregate amount of $1,070.0 million; (ii) issuedsenior notes in an aggregate amount of $430.0 million and senior subordinatednotes in an aggregate amount of $280.0 million (the Notes); and(iii) entered into the $400.0 million ABL facility, subject to borrowingbase limitations, of which approximately $70.0 million was drawn at closing,which resulted in the incurrence of aggregate indebtedness in connection withthe Separation Transactions of approximately $1,850.0 million. Proceeds fromthis new debt and the $575.0 million equity investment in Sally Beauty by theCDR Investors were used to pay a $25.00 per share cash dividend to holders ofrecord of Alberto-Culver shares as of the record date for the SeparationTransactions. Please see “Risk Factors—Risks Relating to Our SubstantialIndebtedness.”

 

Duringthe fiscal year ended September 30, 2010, the Company prepaid in full itsborrowings under the Term Loan A facility. As of September 30, 2010, therewere outstanding borrowings of $843.9 million under the Term Loan B facility,at an interest rate of 2.51%, and outstanding borrowings of $705.0 millionunder the Notes, at a weighted average interest rate of 9.75%. As of September 30,2010, we had $341.8 million available for additional borrowings under our ABLfacility, subject to borrowing base limitations, as reduced by outstandingletters of credit.

 

Theagreements and instruments governing our debt contain restrictions andlimitations that could significantly impact our ability to operate ourbusiness. These restrictions and limitations relate to:

 

·      disposal of assets

·      incurrence of additional indebtedness(including guarantees of additional indebtedness)

·      dividends and distributions

·      certain debt prepayments and modifications

·      liens on assets

·      making investments (including jointventures)

·      mergers, consolidations or sales of ourassets

·      ability of subsidiaries to pay dividends

·      making acquisitions of all of the businessor assets of or stock representing beneficial ownership of, any person

 

Borrowingsunder the term loan facilities and the ABL facility are secured bysubstantially all of our assets, those of Sally Investment, those of ourdomestic subsidiaries and, in the case of the ABL facility, those of ourCanadian subsidiaries and a pledge of certain intercompany notes. During thefiscal year ended September 30, 2010, the Company prepaid in full itsborrowings under the Term Loan A facility. The Term Loan B may be prepaid atour option at any time without premium or penalty and is subject to mandatoryprepayment in an amount equal to 50% of excess cash flow (as defined in theagreement governing the Term Loans) for any fiscal year unless a specifiedleverage ratio is met. Additionally, the Term Loan B is subject to mandatoryprepayment in an amount equal to 100% of the proceeds of specified asset salesthat are not reinvested in the business or applied to repay borrowings underthe ABL facility.

 

TheTerm Loans contain a covenant requiring us and our subsidiaries to meet certainmaximum consolidated secured leverage ratio levels, which decline over time.The consolidated secured leverage ratio is a ratio of (A) net consolidatedsecured debt to (B) Consolidated EBITDA as defined in the agreementunderlying the Term Loans. Compliance with the consolidated secured leverageratio is tested quarterly, with a maximum ratio of 4.00 as of September 30,2010. Failure to comply with the consolidated secured leverage ratio covenantunder the Term Loans would result in a default under such facilities.

 

Boththe previous and the new ABL facilities contain a covenant requiring us and oursubsidiaries to maintain a fixed-charge coverage ratio of at least 1.0 to 1.0in the event that availability under the ABL facility falls below certainthresholds.  In the new ABL facility, wemust comply with the ratio in the event availability is less than the greaterof: (a) the lesser of $60.0 million or 15% of the then current borrowingbase and (b) $40.0 million. The fixed-charge coverage ratio is defined asthe ratio of (A) EBITDA (as defined in the agreement underlying the ABLfacility, or Credit Agreement EBITDA) less unfinanced capital expenditures to (B) fixedcharges (as included in the definition of the fixed-charge coverage ratio inthe agreement governing the ABL facility).

 

Forpurposes of calculating either the consolidated secured leverage ratio or thefixed-charge coverage ratio, Consolidated EBITDA and Credit Agreement EBITDAare measured on a last-four-quarters basis. Accordingly, the calculation can bedisproportionately affected by a particularly strong or weak quarter and maynot be comparable to the measure for any previous or subsequent four-quarterperiod.

 

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Failureto comply with the fixed-charge coverage ratio covenant (if and whenapplicable) under the ABL facility would result in a default under suchfacility. A default could also result in a default under the other facility orfacilities, as the case may be, and the Notes. Absent a waiver or an amendmentfrom our lenders and note holders, such defaults could permit the accelerationof all indebtedness under the ABL facility, the Term Loans and the Notes, whichwould have a material adverse effect on our results of operations, financialposition and cash flows.

 

ConsolidatedEBITDA and Credit Agreement EBITDA are not recognized measurements underaccounting principles generally accepted in the United States of America, orGAAP, and should not be considered as a substitute for financial performanceand liquidity measures determined in accordance with GAAP, such as netearnings, operating income or operating cash flow. In addition, because othercompanies may calculate EBITDA differently, Consolidated EBITDA and CreditAgreement EBITDA likely will not be comparable to EBITDA or similarly titledmeasures reported by other companies or reported by us in our quarterlyearnings releases.

 

Webelieve that we are currently in compliance with the agreements and instrumentsgoverning our debt, including our financial covenants. Our ability to complywith these covenants in future periods will depend on our ongoing financial andoperating performance, which in turn will be subject to economic conditions andto financial, market and competitive factors, many of which are beyond ourcontrol. Our ability to comply with these covenants in future periods will alsodepend substantially on the pricing of our products, our success atimplementing cost reduction initiatives and our ability to successfullyimplement our overall business strategy. Please see “Risk Factors—RisksRelating to Our Substantial Indebtedness.”

 

***CapitalRequirements***

 

Duringthe fiscal year 2010, we had total capital expenditures of approximately $48.7million which were primarily to fund the addition of new stores; the remodel,expansion or relocation of existing stores in the ordinary course of ourbusiness; and corporate projects. For the fiscal year 2011, we anticipatecapital expenditures in the range of approximately $50.0 million to $55.0million, excluding acquisitions. Capital expenditures will be primarily for theaddition of new stores; the remodel, expansion or relocation of existing storesin the ordinary course of our business; and corporate projects.

 

**ContractualObligations**

 

Thefollowing table is a summary of our contractual cash obligations andcommitments outstanding by future payment dates at September 30, 2010 (inthousands):

 
| ** **                                                     | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                     | ** ** | **Less than 1********year**     | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than 5  years** | ** ** | **Total** | ** ** |
| Long-term  debt obligations, including interest obligations(a) |       | $                                         | 93,563     |   | $ | 201,305 |   | $ | 1,364,013 |   | $ | 310,854 |   | $ | 1,969,735 |   |
| Operating  leases obligations(b)                               |       | 135,142                                   |       | 200,391 |   | 91,455 |   | 49,158 |   | 476,146 |   |
| Purchase  obligations(c)                                       |       | 22,098                                    |       | 30,563 |   | 24,025 |   | 35,457 |   | 112,143 |   |
| Other  long-term obligations(d)(e)                             |       | 12,044                                    |       | 33,049 |   | 4,336 |   | 3,306 |   | 52,735 |   |
| Total                                                          |       | $                                         | 262,847    |   | $ | 465,308 |   | $ | 1,483,829 |   | $ | 398,775 |   | $ | 2,610,759 |   |

 

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| (a)    | Long-term debt includes capital leases and future interest payments  on debt facilities, based upon outstanding principal amounts and interest  rates as of September 30, 2010.                                                                                                                                                                                                                                                                                                                                        |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| (b)    | In accordance with GAAP, these obligations are not reflected in the  accompanying consolidated balance sheets. The amounts reported for operating  leases do not include executory costs.                                                                                                                                                                                                                                                                                                                                   |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| (c)    | Purchase obligations reflect legally binding agreements entered into  by us to purchase goods or services, that specify minimum quantities to be  purchased and with fixed or variable price provisions. In accordance with  GAAP, these obligations are not reflected in the accompanying consolidated  balance sheets. Amounts shown do not, however, reflect open purchase orders,  mainly for merchandise, to be fulfilled within one year, which are generally  cancellable.                                           |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| (d)    | Other long-term obligations principally represent obligations under  insurance and self-insurance programs, obligations under interest rate swap  agreements, certain liabilities related to uncertain income tax benefits and  commitments under various acquisition-related agreements including  non-compete, consulting and severance agreements and deferred compensation  arrangements. These obligations are included in accrued liabilities and other  liabilities in the accompanying consolidated balance sheets. |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| (e)    | The table above does not include $13.6 million of unrecognized tax  benefits due to uncertainty regarding the realization and timing of the  related future cash flows, if any.                                                                                                                                                                                                                                                                                                                                             |

 

Thetable above excludes amounts included in current liabilities, other than thecurrent portion of long-term debt, as these items will be paid within one year,and long-term liabilities not requiring cash payments, such as deferred leaseincentives.

 

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Ourassumptions with respect to the interest rates applicable to the Term Loans andthe ABL facility are subject to changes that may be material. In addition,other future events could cause actual payments to differ materially from theseamounts. Please see Note 12 of the “Notes to Consolidated Financial Statements”in “Item 8—Financial Statements and Supplementary Data” of this AnnualReport and “Item 7A—Quantitative and Qualitative Disclosures about MarketRisk—Interest rate risk” for a discussion of interest rate swap agreements.

 

Themajority of our operating leases are for Sally Beauty Supply and BSG stores,which typically are located in strip shopping centers. The use of operatingleases allows us to expand our business to new locations without makingsignificant up-front cash outlays for the purchase of land and buildings.

 

**Off-BalanceSheet Financing Arrangements**

 

AtSeptember 30, 2010 and 2009, we had no off-balance sheet financingarrangements other than operating leases incurred in the ordinary course ofbusiness, as well as outstanding letters of credit related to inventorypurchases and self insurance programs, which totaled $14.5 million and $13.4million, respectively.

 

**Inflation**

 

Webelieve that inflation currently does not have a material effect on our resultsof operations.

 

**CriticalAccounting Estimates**

 

Thepreparation of financial statements in conformity with GAAP requires us to makeestimates and assumptions that affect the reported amounts of assets,liabilities, revenues and expenses and disclosure of contingent assets andliabilities in the financial statements. Actual results may differ from theseestimates. We believe these estimates and assumptions are reasonable. Weconsider accounting policies to be critical when they require us to makeassumptions about matters that are highly uncertain at the time the accountingestimate is made and when different estimates that our management reasonablycould have used have a material effect on the presentation of our financialcondition, changes in financial condition or results of operations.

 

Ourcritical accounting estimates include but are not limited to the valuation ofinventory, vendor concessions, retention of risk, income taxes, assessment oflong-lived assets and certain intangible assets for impairment, share-basedpayments and related party transactions.

 

***Valuation ofInventory***

 

Whennecessary, we adjust the carrying value of inventory to the lower of cost ormarket, including costs to sell or dispose, and for estimated inventoryshrinkage. Inventory is stated at the lower of cost (first in, first out method)or market (net realizable value). Estimates of the future demand for ourproducts, age of the inventory and changes in stock-keeping units are some ofthe key factors used by our management in assessing the net realizable value ofinventory. We estimate inventory shrinkage based upon our historicalexperience. Actual results differing from these estimates could significantlyaffect our inventory and cost of products sold and distribution expenses.Inventory shrinkage averaged approximately 1.0% of consolidated net sales infiscal years 2010, 2009 and 2008. A 10% increase or decrease in our estimate ofinventory shrinkage at September 30, 2010, would impact net earnings byapproximately $1.4 million, net of income tax.

 

***Vendor Rebatesand Concessions***

 

Weaccount for cash consideration received from vendors under ASC 605-50, *Customer Payments and Incentives*. This standard statesthat cash consideration received by a customer is presumed to be a reduction ofthe cost of sales unless it is for an asset or service or a reimbursement of aspecific, incremental, identifiable cost incurred by the customer in sellingthe vendor’s products. The majority of cash consideration we receive isconsidered to be a reduction of the cost of sales and is allocated to cost of productssold and distribution expenses as the related inventory is sold. We considerthe facts and circumstances of the various contractual agreements with vendorsin order to determine the appropriate classification of amounts received in theconsolidated statements of earnings. We record cash consideration expected tobe received from vendors in other receivables. These receivables are recordedat the amount we believe will be collected based on the provisions of theprograms in place and are computed by estimating the point in time that we havecompleted our performance under the agreements and the amounts earned. Thesereceivables could be significantly affected if actual results differ frommanagement’s expectations. A 10% increase or decrease in these receivables at September 30,2010, would impact net earnings by approximately $1.3 million, net of incometax.

 

***Retention of Risk***

 

*EmployeeHealth Insurance Liability*

 

Wemaintain a largely self-funded program for healthcare benefits for employeeswho meet certain eligibility requirements. We cover the majority of expensesassociated with these benefits, other than payroll deductions and out-of pocketexpenses paid by the employees. Payments for healthcare benefits belowspecified amounts (currently $350,000 per individual per year and $1,000,000per

 

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individualfor a lifetime maximum) are self-insured by us. The Company intends to removesuch lifetime maximum limit during the fiscal year 2011 in accordance withfederal legislation recently enacted in the U.S. We base our estimate ofultimate liability on trends in claim payment history, historical trends inclaims incurred but not yet reported, and other components such as expectedincreases in medical costs, projected premium costs and the number of planparticipants. We review our liability on a regular basis and adjust ouraccruals accordingly. As of September 30, 2010 and 2009, we accrued anestimated liability relating to employee health insurance of $6.0 million and$5.6 million, respectively.

 

Changesin facts and circumstances may lead to a change in the estimated liability dueto revisions of the estimated ultimate costs of our employee healthcarebenefits. Estimates of medical costs and trends in claims are some of the keyfactors used by our management in determining our employee health insuranceliability. This liability could be significantly affected if actual resultsdiffer from management’s expectations. A 10% increase or decrease in ouremployee health insurance liability at September 30, 2010 would impact netearnings by approximately $0.4 million, net of income tax.

 

*Workers’Compensation Liability, General Liability and Automobile and Property Liability*

 

Wemaintain a large deductible insurance plan for workers’ compensation liability,general liability and automobile and property liability loss exposures. We baseour estimates of the ultimate liability on an actuarial analysis performed byan independent third-party actuary. We review our liability on a regular basisand adjust our accruals accordingly. As of September 30, 2010 and 2009,our balance sheet included an estimated liability related to the deductible andretention limits of approximately $22.8 million and $19.7 million,respectively.

 

Changesin facts and circumstances may lead to a change in the estimated liability dueto revisions of the estimated ultimate costs that affect our workers’ compensation,general liability and automobile and property liability insurance coverage.Changes in estimates occur over time due to such factors as claims incidenceand severity of injury or damages. Our liabilities could be significantlyaffected if actual results differ from management’s expectations or actuarialanalyses. A 10% increase or decrease in our workers’ compensation liability,general liability and automobile and property liability at September 30,2010 would impact net earnings by approximately $1.4 million, net of incometax.

 

Thechange in the self-insurance liability was as follows (in thousands):

 
| ** **                                       | ** ** | **Fiscal Year Ended September 30,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                       | ** ** | **2010**                                                | ** ** | **2009** | ** ** |
| Balance  at beginning of period                  |       | $                                                       | 26,920     |   | $ | 25,415 |   |
| Self-insurance  expense                          |       | 62,440                                                  |       | 54,566 |   |
| Self-insurance  liability of businesses acquired |       | —                                                  |       | 214 |   |
| Payments,  net of employee contributions         |       | (59,074                                                 | )          | (53,275 | ) |
| Balance  at end of period                        |       | $                                                       | 30,286     |   | $ | 26,920 |   |

 

***Income Taxes***

 

Werecord income tax provisions in our consolidated financial statements based onan estimation of current income tax liabilities. The development of theseprovisions requires judgments about tax issues, potential outcomes and timing.If we prevail in tax matters for which provisions have been established or arerequired to settle matters in excess of established provisions, our effectivetax rate for a particular period could be significantly affected.

 

Forthe fiscal years ended September 30, 2010, 2009 and 2008, the effectiveincome tax rates were 36.9%, 39.5% and 37.0%, respectively. For the fiscal year2011, we expect our annual effective income tax rate to be approximately 38.0%.The projected increase over the fiscal year 2010 annual effective tax rate isprimarily related to non-recurring tax benefits realized in the fiscal year2010 and the expiration of certain beneficial U.S. international tax lawprovisions. The increase is expected to be partially offset by a projecteddecrease in foreign losses subject to valuation allowances.

 

Deferredincome taxes are recognized for the future tax consequences attributable todifferences between the financial statement carrying amounts of assets andliabilities and their respective tax bases. Deferred tax assets and liabilitiesare measured using enacted tax rates expected to apply to taxable income in theyears in which temporary differences are estimated to be recovered or settled.We believe that it is more likely than not that our results of operations inthe future will generate sufficient taxable income to realize our deferred taxassets, net of the valuation allowance currently recorded. In the future, if wedetermine that certain deferred tax assets will not be realizable, the relatedadjustments could significantly affect our effective tax rate at that time.  The estimated tax benefit of an uncertain taxposition is recorded in our financial statements only after determining amore-likely-than-not probability that the uncertain tax position will withstandchallenge, if any, from applicable taxing authorities.

 

***Assessment of Long-Lived Assets and CertainIntangible Assets for Impairment***

 

Long-livedassets, such as property and equipment, including store equipment, andpurchased intangibles subject to amortization, are reviewed for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be

 

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recoverable.The recoverability of long-lived assets and purchased intangibles is measuredby a comparison of the carrying amount of an asset to estimated future cashflows expected to be generated by the asset. If the carrying amount of an assetexceeds its estimated future cash flows, an impairment charge is recognized bythe amount by which the carrying amount of the asset exceeds the fair value ofthe asset.

 

Goodwill,the cost of an acquisition less the fair value of the net assets of theacquired business, and purchased intangible assets with indefinite lives arereviewed for impairment at least annually, and whenever events or changes incircumstances indicate that it is more likely than not that the fair value of areporting unit or related intangible asset is less than its carrying amount.Management considers whether there has been a permanent impairment to the valueof goodwill and other intangible assets by evaluating if various factors(including current operating results, anticipated future results and cashflows, and market and economic conditions) indicate a possible impairment.Based on the reviews performed, after taking into account the economic downturnduring the past couple of years in certain geographic areas in which weoperate, there were no asset impairments recognized in the current or priorfiscal years presented.

 

***Share-BasedPayments***

 

Weaccount for stock-based compensation under ASC 718. We recognize compensationexpense on a straight-line basis over the vesting period or to the date aparticipant becomes eligible for retirement, if earlier. For fiscal years 2010,2009 and 2008, total compensation cost charged against income and included inselling, general and administrative expenses for share-based compensationarrangements was $12.2 million, $8.0 million and $9.6 million, respectively.

 

Theamount of stock option expense is determined based on the fair value of eachstock option grant, which is estimated on the date of grant using theBlack-Scholes option pricing model with the following assumptions: expectedlife, volatility, risk-free interest rate and dividend yield. The expected lifeof Sally Beauty’s stock options represents the period of time that the stockoptions granted are expected to be outstanding. We estimate the expected lifebased on historical exercise trends. We estimate expected volatility by usingthe average volatility of both Sally Beauty and similar companies (based onindustry sector) since it is not practicable to estimate the Sally Beauty’sexpected volatility on a stand-alone basis due to a lack of sufficient tradinghistory. The risk-free interest rate is based on the zero-coupon U.S. Treasuryissue at the date of the grant for the expected life of the stock options. Thedividend yield represents Sally Beauty’s anticipated cash dividend over theexpected life of the stock options. The amount of stock option expense recordedis significantly affected by these estimates. In addition, we record stockoption expense based on an estimate of the total number of stock optionsexpected to vest, which requires us to estimate future forfeitures. We usehistorical forfeiture experience as a basis for this estimate. Actual forfeituresdiffering from these estimates could significantly affect the timing of therecognition of stock option expense. We have based all these estimates on ourassumptions as of September 30, 2010. Our estimates for future periods maybe based on different assumptions and accordingly may differ.

 

Webelieve that our stock-based compensation expense is based on reasonableestimates and assumptions. However, if actual results are not consistent withour estimate or assumptions, we may be exposed to changes in stock-basedcompensation expense that could be material. A 10% change in our stock basedcompensation expense for the year ended September 30, 2010 would affectearnings by approximately $0.8 million, net of income tax.

 

***Related PartyTransactions***

 

InJanuary of 2007, we entered into an agreement with Sally Beauty underwhich we agreed to provide certain general and administrative services to SallyBeauty including accounting, finance, payroll, legal and tax sharing services.The cost of these services is based on a percentage of certain key employees’salaries and benefits, and may not necessarily be indicative of the costs whichwould be incurred by Sally Beauty as an independent standalone entity.

 

Inaddition, we have entered into a tax sharing agreement and we file consolidatedtax returns with our parent, Sally Beauty. See Note 17 of the “Notes to Consolidated Financial Statements” in “Item 8—FinancialStatements and Supplementary Data” of this report for further information.

 

**RecentAccounting Pronouncements**

 

InDecember 2007, the Financial Accounting Standards Board (“FASB”) revisedthe accounting standards for business combinations. This new standard(currently contained in ASC 805, *Business Combinations*(“ASC805”)), among other things, generally requires that an acquirer recognize theassets acquired and liabilities assumed measured at their “full fair values” onthe acquisition date. This practice replaced the practice, under predecessoraccounting standards, of allocating the cost of an acquisition to theindividual assets acquired and liabilities assumed based on their relativeestimated fair values.  This new standardfurther requires that acquisition-related costs be recognized separately fromthe related acquisition. The Company adopted this standard effective on October 1,2009. Selling, general and administrative expenses for the fiscal year ended September 30,2010 includes approximately $0.7 million of expenses related to acquisitions.

 

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InApril 2008, the FASB amended ASC 350, *Intangibles and Other* (“ASC 350”). This new accountingstandard, currently contained in ASC 350-30-35, specifically amends the factorsthat should be considered in developing renewal or extension assumptions usedto determine the useful life of a recognized intangible asset. The objective ofthis amendment is to improve the consistency between the useful life of a recognizedintangible asset and the period of expected cash flows used to measure the fairvalue of the asset. The Company adopted this standard during the first quarterof its fiscal year 2010 and its adoption did not have a material effect on theCompany’s consolidated financial position, results of operations or cash flows.

 

InAugust 2009, the FASB issued Accounting Standards Update (“ASU”) No. 2009-05which amended ASC 820 as it relates to the measurement of liabilities at fairvalue, effective for interim reporting periods beginning after August 26,2009. More specifically, this amendment provided clarification for liabilitiesin which a quoted price in an active market for an identical liability is notavailable. The Company adopted this amendment during the first quarter of itsfiscal year 2010 and its adoption did not have a material effect on the Company’sconsolidated financial position, results of operations or cash flows.

 

InJanuary 2010, the FASB issued ASU No. 2010-06 which amended ASC 820as it relates to certain disclosures of fair value measurements. This amendmentrequires, among other things, (a) disclosure of the sensitivity of anentity’s fair value measurements using Level 3 inputs to changes in suchinputs, (b) a reconciliation of changes in such fair value measurementsand (c) disclosure of transfers between fair value measurements usingLevel 1 and 2 inputs, if any. The Company adopted this amendment during thesecond quarter of its fiscal year 2010 and its adoption did not have a materialeffect on the Company’s consolidated financial position, results of operationsor cash flows.

 

TheCompany adopted the provisions of ASC 855, *Subsequent Events*(“ASC855”), during the third quarter of its fiscal year 2009. ASC 855 establishesstandards of accounting for and disclosure of transactions and events thatoccur after the balance sheet date but before the financial statements areissued and requires the disclosure, among other things, of the date throughwhich an entity has evaluated subsequent events. In February 2010, theFASB issued ASU No. 2010-09 which amended ASC 855. This amendment, whichwas effective upon issuance, removed the requirement for SEC registrants todisclose the date through which such registrants have evaluated subsequentevents.

 

**ITEM 7A. QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

Asa multinational corporation, we are subject to certain market risks includingforeign currency fluctuations, interest rates and credit risk. We may considera variety of practices in the ordinary course of business to manage thesemarket risks, including, when deemed appropriate, the use of derivativefinancial instruments.

 

**Foreigncurrency exchange rate risk**

 

Weare exposed to potential gains or losses from foreign currency fluctuationsaffecting net investments and earnings denominated in foreign currencies. Ourprimary exposures are to changes in exchange rates for the U.S. dollarversus the British pound sterling, Canadian dollar, Euro, Mexican peso andChilean peso. Our various foreign currency exposures at times offset eachother, sometimes providing a natural hedge against foreign currency risk. Forthe fiscal years 2010, 2009 and 2008, approximately 18%, 16% and 18%,respectively, of our sales were made in currencies other than the U.S. dollar.Consolidated net sales for the fiscal year ended September 30, 2010, areinclusive of approximately $17.2 million in positive impact from changes inforeign currency exchange rates. In addition, for the fiscal year ended September 30,2010, other comprehensive income reflects $4.3 million in foreign currencytranslation adjustments. For the fiscal years 2010, 2009 and 2008, fluctuationsin the U.S. dollar exchange rates did not otherwise have a material effecton our consolidated financial condition and consolidated results of operations.

 

A10% increase or decrease in the exchange rates for the U.S. dollar versus theforeign currencies to which we have exposure, would have impacted ourconsolidated net sales by approximately 1.8% in the fiscal year 2010, and wouldhave impacted our consolidated net assets by approximately 2.6% at September 30,2010.

 

Asa result of our acquisition of Sinelco on December 16, 2009, we useforeign currency options, including, at September 30, 2010, foreign currencyput options with an aggregate notional amount of €1.4 million ($1.9 million, atthe September 30, 2010 exchange rate) and foreign currency call optionswith an aggregate notional amount of €0.8 million ($1.2 million, at the September 30,2010 exchange rate), to manage the exposure to certain non-Euro currenciesresulting from Sinelco’s purchases of merchandise from third-party suppliers.Sinelco’s functional currency is the Euro. These foreign currency options arenot designated as hedges and do not meet the hedge accounting requirements ofASC 815. Accordingly, the changes in the fair value of these derivativeinstruments (which are adjusted quarterly) are recorded in our consolidatedstatements of earnings. Selling, general and administrative expenses include netgains of $0.5 millionrelated to these foreigncurrency options, including non-cash marked-to-market adjustments, for thefiscal year ended September 30, 2010. During the fiscal year endedSeptember 30, 2010, these derivative instruments did not have a materialimpact in our consolidated results of operations or consolidated cash flows.

 

Inthe fourth quarter of the fiscal year 2010, we entered into four foreigncurrency forward agreements which expire in January of 2011. Two foreigncurrency forward agreements enable the Company to sell, in the aggregate,approximately €5.2 million ($7.1 million at the September 30, 2010exchange rate) at the weighted average forward exchange rate of 1.3073. Theother two foreign

 

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currencyforward agreements enable the Company to buy, in the aggregate, approximately$7.0 million Canadian dollars ($6.8 million at the September 30, 2010exchange rate) at the weighted average forward exchange rate of 1.0277. Theseforeign currency forward agreements are not designated as hedges and do notmeet the hedge accounting requirements of ASC 815. Accordingly, the changes in the fairvalue of these derivative instruments (which are adjusted quarterly) arerecorded in our consolidated statements of earnings. Selling, general andadministrative expenses include net non-cash losses from marked-to-marketadjustments related to these foreign currency forward contracts of $0.3 millionfor the fiscalyear ended September 30, 2010. During the fiscal year endedSeptember 30, 2010, these derivative instruments did not have a materialimpact in our consolidated results of operations or consolidated cash flows.

 

**Interestrate risk**

 

Asa result of the debt financing incurred in connection with the SeparationTransactions, we are subject to interest rate market risk in connection withour long-term debt. The principal interest rate exposure relates to amountsborrowed under the Term Loan B and the ABL facilities. Based on theapproximately $843.9 million of borrowings under the Term Loan B and the ABLfacilities as of September 30, 2010, a change in the estimated applicableinterest rate up or down by 1/8% will increase or decrease earnings, beforeprovision for income taxes, by approximately $1.1 million on an annual basis,without considering the effect of any interest rate swap agreements we may havefrom time to time.

 

Weare sensitive to interest rate fluctuations. In order to enhance our ability tomanage risk relating to cash flow and interest rate exposure, we and/or ourother subsidiaries who are borrowers under the ABL facility may from time totime enter into and maintain derivative instruments, such as interest rate swapagreements, for periods consistent with the related underlying exposures. Inaddition, pursuant to the agreement underlying our Term Loans we hedge aportion of our floating interest rate exposure for a specified period as morefully described below. We do not purchase or hold any derivative instrumentsfor speculative or trading purposes.

 

InNovember 2006, we entered into four interest rate swap agreements with anaggregate notional amount of $500 million. Interest rate swap agreements withan aggregate notional amount of $150 million expired in November 2008 andagreements with a notional amount of $350 million expired in November 2009.These interest rate swap agreements did not qualify as hedges and,therefore, the change in the fair value of these agreements, which wereadjusted quarterly, were recorded in interest expense in our consolidatedstatements of earnings.

 

InMay 2008, we entered into two additional interest rate swap agreementswith an aggregate notional amount of $300 million (each agreement witha notional amount of $150 million). These agreements expire on May 31, 2012 and enable us to convert aportion of our variable interest rate obligations to fixed rate obligationswith interest ranging from 5.818% to 6.090%. These agreements are designated as effective cash flow hedges, inaccordance with ASC 815.  Accordingly,the changes in the fair value of these derivative instruments are recordedquarterly, net of income tax, in accumulated othercomprehensive (loss) income (“OCI”) until the hedged obligation is settled orthe swap agreements expire, whichever is earlier.  Any hedge ineffectiveness, as this term isused in ASC 815, is recognized in interest expense in ourconsolidated statements of earnings.

 

**Creditrisk**

 

Weare exposed to credit risk on certain assets, primarily cash equivalents,short-term investments and accounts receivable. We believe that the credit riskassociated with cash equivalents and short-term investments, if any, is largelymitigated by our policy of investing in a diversified portfolio of securitieswith high credit ratings.

 

Weprovide credit to customers in the ordinary course of business and performongoing credit evaluations. We believe that our exposure to concentrations ofcredit risk with respect to trade receivables is largely mitigated by our broadcustomer base. We believe our allowance for doubtful accounts is sufficient tocover customer credit risks.

 

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**ITEM 8. FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

 

Pleasesee “Index to Financial Statements” which is located on page 66 of thisAnnual Report.

 

**ITEM 9. CHANGES IN AND DISAGREEMENTSWITH ACCOUNTANTS ONACCOUNTING AND FINANCIAL DISCLOSURE**

 

None.

 

**ITEM 9A. CONTROLS AND PROCEDURES**

 

*Background.*  Attached asexhibits to this Annual Report on Form 10-K are certifications of ourChief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), which arerequired in accordance with Rule 13a-14 of the Exchange Act. This “Controlsand Procedures” section includes information concerning the controls andcontrols evaluation referred to in the certifications. Part II, Item8—Financial Statements and Supplementary Data of this Annual Report on Form 10-Ksets forth the attestation report of KPMG LLP, our independent registeredpublic accounting firm, regarding its audit of our internal control overfinancial reporting. This section should be read in conjunction with thecertifications and the KPMG attestation report for a more completeunderstanding of the topics presented.

 

*Controls Evaluation and Related CEO and CFOCertifications.*  Our management, with the participationof our CEO and CFO, conducted an evaluation of the effectiveness of the designand operation of our disclosure controls and procedures as of the end of theperiod covered by this Annual Report. The controls evaluation was conducted byour Disclosure Committee, comprised of senior representatives from our finance,accounting, internal audit, and legal departments under the supervision of ourCEO and CFO.

 

Certificationsof our CEO and our CFO, which are required in accordance with Rule 13a-14of the Exchange Act, are attached as exhibits to this Annual Report. This “Controlsand Procedures” section includes the information concerning the controlsevaluation referred to in the certifications, and it should be read inconjunction with the certifications for a more complete understanding of thetopics presented.

 

*Limitations on the Effectiveness of Controls.*  Wedo not expect that our disclosure controls and procedures will prevent allerrors and all fraud. A system of controls and procedures, no matter how wellconceived and operated, can provide only reasonable, not absolute, assurancethat the objectives of the system are met. Because of the limitations in allsuch systems, no evaluation can provide absolute assurance that all controlissues and instances of fraud, if any, within the Company have been detected.Furthermore, the design of any system of controls and procedures is based inpart upon certain assumptions about the likelihood of future events, and therecan be no assurance that any design will succeed in achieving its stated goalsunder all potential future conditions, regardless of how unlikely. Because ofthese inherent limitations in a cost-effective system of controls andprocedures, misstatements or omissions due to error or fraud may occur and notbe detected.

 

*Scope of the Controls Evaluation.*  Theevaluation of our disclosure controls and procedures included a review of theirobjectives and design, our implementation of the controls and procedures andthe effect of the controls and procedures on the information generated for usein this Annual Report. In the course of the evaluation, we sought to identifywhether we had any data errors, control problems or acts of fraud and toconfirm that appropriate corrective action, including process improvements, wasbeing undertaken if needed. This type of evaluation is performed on a quarterlybasis so that conclusions concerning the effectiveness of our disclosurecontrols and procedures can be reported in our Quarterly Reports onForm 10-Q and our Annual Reports on Form 10-K. Many of the componentsof our disclosure controls and procedures are also evaluated by our internalaudit department, by our legal department and by personnel in our financeorganization. The overall goals of these various evaluation activities are to monitorour disclosure controls and procedures on an ongoing basis, and to maintainthem as dynamic systems that change as conditions warrant.

 

*Conclusions regarding Disclosure Controls.*  Basedon the required evaluation of our disclosure controls and procedures, our CEOand CFO have concluded that, as of September 30, 2010, we maintaindisclosure controls and procedures that are effective in providing reasonableassurance that information required to be disclosed by us in the reports thatwe file or submit under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and forms,and that such information is accumulated and communicated to our management,including our CEO and CFO, as appropriate to allow timely decisions regardingrequired disclosure.

 

*Management’s Annual Report onInternal Control over Financial Reporting.*

 

Managementof the Company, including the CEO and CFO, is responsible for establishing andmaintaining adequate internal control over financial reporting as defined inRule 13a-15(f) under the Exchange Act. Our internal control systemwas designed to provide reasonable assurance to management and our Board ofDirectors regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles.

 

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Allinternal control systems, no matter how well designed, have inherentlimitations. A system of internal controls may become inadequate over timebecause of changes in conditions or deterioration in the degree of compliancewith the policies or procedures. Therefore, even those systems determined to beeffective can provide only reasonable assurance with respect to financialstatement preparation and presentation.

 

Managementassessed the effectiveness of our internal control over financial reporting asof September 30, 2010 using the criteria set forth by the Committee ofSponsoring Organizations of the Treadway Commission (“COSO”) in *Internal Control-Integrated Framework.*  Based on this assessment, management hasconcluded that, as of September 30, 2010 our internal control overfinancial reporting was effective to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with generally accepted accountingprinciples based on such criteria.

 

*Report of Independent RegisteredPublic Accounting Firm***. **Please refer to KPMG’sReport of Independent Registered Public Accounting Firm on Internal Controlover Financial Reporting on page F-1 of the financial statements, whichbegin on page 66 of this Annual Report.

 

*Changes in Internal Control over Financial Reporting.*  Duringour last fiscal quarter, there have been no changes in our internal controlover financial reporting identified in connection with the evaluation describedabove that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

**ITEM 9B. OTHER INFORMATION**

 

None.

 

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**PART III**

 

**ITEM 10.   DIRECTORS, EXECUTIVE OFFICERS AND CORPORATEGOVERNANCE**

 

Omitted pursuant to General Instruction I to Form 10-K

 

**ITEM 11.   EXECUTIVE COMPENSATION**

 

Omitted pursuant to General Instruction I to Form 10-K

 

**ITEM 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS ANDMANAGEMENT AND RELATED STOCKHOLDER MATTERS**

 

Omitted pursuant to General Instruction I to Form 10-K

 

**ITEM 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTORINDEPENDENCE**

 

Omitted pursuant to General Instruction I to Form 10-K

 

**ITEM 14.   PRINCIPAL ACCOUNTANT FEES AND SERVICES**

 

Omitted pursuant to General Instruction I to Form 10-K

 

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**PART IV**

 

**ITEM 15. EXHIBITS AND FINANCIALSTATEMENT SCHEDULES**

 

Documentsfiled as part of this Annual Report:

 

**(a)  Financial Statements and Financial Statement Schedules**

 

Pleasesee “Index to Financial Statements” which is located on page 66 of thisAnnual Report.

 

**(b)  ****Exhibits Required by Securities and ExchangeCommission****Regulation S-K**

 

The following exhibits arefiled as part of this Annual Report or are incorporated herein by reference:

 

**Exhibits**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|----------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                  |       | Investment Agreement, dated as of June 19, 2006, among  Alberto-Culver Company, New Aristotle Company, Sally Holdings, Inc., New  Sally Holdings, Inc. and CDRS Acquisition LLC, which is incorporated  herein by reference from Exhibit 2.1 to Amendment No. 3 to the  Registration Statement on Form S-4 of New Sally Holdings, Inc.  (File No. 333-136259) filed on October 10, 2006†                           |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 2.2                  |       | First Amendment to the Investment Agreement, dated as of October 3,  2006, among Alberto-Culver Company, New Aristotle Company, Sally  Holdings, Inc., New Sally Holdings, Inc. and CDRS Acquisition LLC,  which is incorporated herein by reference from Exhibit 2.2 to Amendment  No. 3 to the Registration Statement on Form S-4 of New Sally  Holdings, Inc. (File No. 333-136259) filed on October 10,  2006† |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 2.3                  |       | Second Amendment to the Investment Agreement, dated as of  October 26, 2006, among Alberto-Culver Company, New Aristotle Company,  Sally Holdings, Inc., New Sally Holdings, Inc. and CDRS Acquisition  LLC, which is incorporated herein by reference from Exhibit 2.02 to the  Current Report on Form 8-K of New Sally Holdings, Inc. (File  No. 333-136259) filed on October 30, 2006†                               |
| ** **           | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 2.4                  |       | Separation Agreement, dated as of June 19, 2006, among  Alberto-Culver Company, Sally Holdings, Inc., New Sally  Holdings, Inc. and New Aristotle Holdings, Inc., which is  incorporated herein by reference from Exhibit 2.3 to Amendment  No. 3 to the Registration Statement on Form S-4 of New Sally  Holdings, Inc. (File No. 333-136259) filed on October 10,  2006†                                    |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 2.5                  |       | First Amendment to the Separation Agreement, dated as of  October 3, 2006, among Alberto-Culver Company, Sally  Holdings, Inc., New Sally Holdings, Inc. and New Aristotle  Holdings, Inc., which is incorporated herein by reference from  Exhibit 2.4 to Amendment No. 3 to the Registration Statement on  Form S-4 of New Sally Holdings, Inc. (File No. 333-136259)  filed on October 10, 2006†           |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 2.6                  |       | Second Amendment to the Separation Agreement, dated as of  October 26, 2006, among Alberto-Culver Company, Sally  Holdings, Inc., New Sally Holdings, Inc. and New Aristotle  Holdings, Inc., which is incorporated herein by reference from  Exhibit 2.01 to the Current Report on Form 8-K of New Sally Holdings, Inc.  (File No. 333-136259) filed on October 30, 2006†                                         |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 2.7                  |       | Agreement and Plan of Merger by and among Beauty Systems Group LLC,  Lady Lynn Enterprises, Inc., Schoeneman Beauty Supply, Inc., the  Shareholders and F. Dale Schoeneman, dated September 30, 2009, which is  incorporated herein by reference from Exhibit 10.27 to the Annual Report  on Form 10-K of Sally Beauty Holdings, Inc. filed on  November 19, 2009†                                                           |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 3.1                  |       | Certificate of Formation of Sally Holdings LLC, which is incorporated  herein by reference from Exhibit 3.1 to the Registration Statement on  Form S-4 (File No. 333-144427) of Sally Holdings LLC and Sally  Capital Inc. filed on July 9, 2007                                                                                                                                                                                                 |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 3.2                  |       | Limited Liability Company Agreement of Sally Holdings LLC, which is  incorporated herein by reference from Exhibit 3.2 to the Registration  Statement on Form S-4 (File No. 333-144427) of Sally Holdings LLC  and Sally Capital Inc. filed on July 9, 2007                                                                                                                                                                                      |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 4.1                  |       | Stockholders Agreement, dated as of November 16, 2006, by and  among Sally Beauty Holdings, Inc., CDRS Acquisition LLC, CD&R  Parallel Fund VII, L.P. and the other stockholders party thereto, which is  incorporated herein by reference from Exhibit 4.8 to the Current Report  on Form 8-K of Sally Beauty Holdings, Inc. filed on  November 22, 2006                                                                          |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 4.2                  |       | First Amendment to the Stockholders Agreement, dated as of  December 13, 2006, between Sally Beauty Holdings, Inc. and CDRS  Acquisition LLC and Carol L. Bernick, as representative of the other  stockholders, which is incorporated herein by                                                                                                                                                                                                           |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |

 

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|   |   | reference from Exhibit 4.2 to the Annual Report on  Form 10-K of Sally Beauty Holdings, Inc. filed on December 22,  2006                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.3    |   | Indenture, dated as of November 16, 2006, by and among Sally  Holdings LLC and Sally Capital Inc., as Co-Issuers, the Subsidiary Guarantors  from time to time parties thereto, and Wells Fargo Bank, National  Association, as Trustee, governing the 9.25% Senior Notes due 2014, which is  incorporated herein by reference from Exhibit 4.1 to the Current Report  on Form 8-K of Sally Beauty Holdings, Inc. filed on  November 22, 2006                                                                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.4    |   | First Supplemental Indenture, dated as of May 30, 2007, by and  among Sally Holdings LLC and Sally Capital Inc., as co-Issuers, the  Subsidiary Guarantors named therein, and Wells Fargo Bank, National  Association, as trustee, governing the 9.25% Senior Notes due 2014, which is  incorporated herein by reference from Exhibit 4.2 from the Registration  Statement on Form S-4 (File No. 333-144427) of Sally Holdings LLC  and Sally Capital Inc. filed on July 9, 2007                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.5    |   | Indenture, dated as of November 16, 2006, by and among Sally  Holdings LLC and Sally Capital Inc., as Co-Issuers, the Subsidiary Guarantors  from time to time parties thereto, and Wells Fargo Bank, National  Association, as Trustee, governing the 10.5% Senior Subordinated Notes due  2016, which is incorporated herein by reference from Exhibit 4.2 to the Current  Report on Form 8-K of Sally Beauty Holdings, Inc. filed on  November 22, 2006                                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.6    |   | First Supplemental Indenture, dated as of May 30, 2007, by and  among Sally Holdings LLC and Sally Capital Inc., as co-Issuers, the  Subsidiary Guarantors named therein, and Wells Fargo Bank, National  Association, as trustee, governing the 10.5% Senior Subordinated Notes due  2016, which is incorporated herein by reference from Exhibit 4.4 from  the Registration Statement on Form S-4 (File No. 333-144427) of  Sally Holdings LLC and Sally Capital Inc. filed on July 9, 2007                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.7    |   | Exchange and Registration Rights Agreement, dated as of  November 16, 2006, by and among Sally Holdings LLC, Sally Capital Inc.,  the Subsidiary Guarantors parties thereto, Merrill Lynch, Pierce, Fenner &  Smith, Incorporated and the other financial institutions named therein,  relating to the 9.25% Senior Notes due 2014, which is incorporated herein by  reference from Exhibit 4.3 to the Current Report on Form 8-K of  Sally Beauty Holdings, Inc. filed on November 22, 2006                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.8    |   | Exchange and Registration Rights Agreement, dated as of  November 16, 2006, by and among Sally Holdings LLC, Sally Capital Inc.,  the Subsidiary Guarantors parties thereto, Merrill Lynch, Pierce,  Fenner & Smith, Incorporated and the other financial  institutions named therein, relating to the 10.5% Senior Subordinated Notes  due 2016, which is incorporated herein by reference from Exhibit 4.4 to  the Current Report on Form 8-K of Sally Beauty Holdings, Inc. filed  on November 22, 2006                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.9    |   | Credit Agreement, dated November 16, 2006, with respect to a  Term Loan Facility, by and among Sally Holdings LLC, the several lenders from  time to time parties thereto, and Merrill Lynch Capital Corporation, as  Administrative Agent and Collateral Agent, which is incorporated herein by  reference from Exhibit 4.5.1 to the Current Report on Form 8-K of  Sally Beauty Holdings, Inc. filed on November 22, 2006                                                                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.10   |   | Guarantee and Collateral Agreement, dated as of November 16,  2006, made by Sally Investment Holdings LLC, Sally Holdings LLC and certain  subsidiaries of Sally Holdings LLC in favor of Merrill Lynch Capital  Corporation, as Administrative Agent and Collateral Agent, which is  incorporated herein by reference from Exhibit 4.5.2 to the Current Report  on Form 8-K of Sally Beauty Holdings, Inc. filed on  November 22, 2006                                                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.11   |   | Credit Agreement, dated November 16, 2006, with respect to an  Asset-Based Loan Facility, among Sally Holdings LLC, Beauty Systems Group  LLC, Sally Beauty Supply LLC, any Canadian Borrower from time to time party  thereto, certain subsidiaries of Sally Holdings LLC, the several lenders from  time to time parties thereto, Merrill Lynch Capital, a division of Merrill  Lynch Business Financial Services Inc., as Administrative Agent and  Collateral Agent, and Merrill Lynch Capital Canada Inc., as Canadian Agent  and Canadian Collateral Agent, which is incorporated herein by reference from  Exhibit 4.6.1 to the Current Report on Form 8-K of Sally Beauty  Holdings, Inc. filed on November 22, 2006 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.12   |   | U.S. Guarantee and Collateral Agreement, dated as of  November 16, 2006, made by Sally Investment Holdings LLC, Sally Holdings  LLC and certain subsidiaries of Sally Holdings LLC in favor of Merrill Lynch  Capital, a division of Merrill Lynch Business Financial Services Inc., as  Administrative Agent and Collateral Agent, which is incorporated herein by  reference from Exhibit 4.6.2 to the Current Report on Form 8-K of  Sally Beauty Holdings, Inc. filed on November 22, 2006                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.13   |   | Canadian Guarantee and Collateral Agreement, dated as of  November 16, 2006, made by Sally Beauty (Canada) Corporation, Beauty  Systems Group (Canada), Inc., Sally Beauty Canada Holdings Inc. and  certain of their respective subsidiaries in favor of Merrill Lynch Capital  Canada Inc., as Canadian Agent and Canadian Collateral Agent, which is  incorporated herein by reference from Exhibit 4.6.3 to the Current  Report on Form 8-K of Sally Beauty Holdings, Inc. filed on  November 22, 2006                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.14   |   | Intercreditor Agreement, dated as of November 16, 2006, by and  between Merrill Lynch Capital Corporation, as Administrative Agent and  Collateral Agent under the Term Loan Facility, and Merrill Lynch Capital, a  division of Merrill Lynch Business Financial Services Inc., as Administrative  Agent and Collateral Agent under the Asset-Based Loan Facility, which is  incorporated herein by reference from Exhibit 4.7 to the Current Report  on Form 8-K of Sally Beauty Holdings, Inc. filed on  November 22, 2006                                                                                                                                                                                                |

 

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| 4.15   |   | Assignment and Acceptance of that certain Credit Agreement, dated as  of November 16, 2006, among Sally Holdings LLC, Beauty Systems Group  LLC, Sally Beauty Supply LLC, the Canadian Borrowers (as defined in the  Credit Agreement), the several banks and other financial institutions from  time to time parties thereto, Merrill Lynch Capital, a division of Merrill  Lynch Business Financial Services Inc., as administrative agent and  collateral agent for the Lenders and Merrill Lynch Capital Canada, Inc.,  as Canadian agent and Canadian collateral agent for the Lenders, which is  incorporated herein by reference from Exhibit 4.15 to the Annual Report  on Form 10-K of Sally Beauty Holdings, Inc. filed on  November 19, 2009 |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.1   |   | Tax Allocation Agreement, dated as of June 19, 2006, among  Alberto-Culver Company, New Aristotle Holdings, Inc., New Sally  Holdings, Inc. and Sally Holdings, Inc., which is incorporated  herein by reference from Exhibit 10.1 to Amendment No. 3 to the  Registration Statement on Form S-4 of New Sally Holdings, Inc.  (File No. 333-136259) filed on October 10, 2006                                                                                                                                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.2   |   | First Amendment to the Tax Allocation Agreement, dated as of  October 3, 2006, among Alberto-Culver Company, New Aristotle  Holdings, Inc., New Sally Holdings, Inc. and Sally  Holdings, Inc., which is incorporated herein by reference from  Exhibit 10.2 to Amendment No. 3 to the Registration Statement on  Form S-4 of New Sally Holdings, Inc. (File No. 333-136259)  filed on October 10, 2006                                                                                                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.3   |   | Second Amendment to the Tax Allocation Agreement, dated as of  October 26, 2006, among Alberto-Culver Company, New Aristotle  Holdings, Inc., New Sally Holdings, Inc. and Sally  Holdings, Inc., which is incorporated herein by reference from  Exhibit 10.01 to the Current Report on Form 8-K of New Sally  Holdings, Inc. filed on October 30, 2006                                                                                                                                                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.4   |   | Employee Matters Agreement, dated as of June 19, 2006, among  Alberto-Culver Company, New Aristotle Holdings, Inc., New Sally  Holdings, Inc. and Sally Holdings, Inc., which is incorporated  herein by reference from Exhibit 10.3 to Amendment No. 3 to the  Registration Statement on Form S-4 of New Sally Holdings, Inc.  (File No. 333-136259) filed on October 10, 2006                                                                                                                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.5   |   | First Amendment to the Employee Matters Agreement, dated  October 3, 2006, among Alberto-Culver Company, New Aristotle  Holdings, Inc., New Sally Holdings, Inc. and Sally  Holdings, Inc., which is incorporated herein by reference from  Exhibit 10.4 to Amendment No. 3 to the Registration Statement on  Form S-4 of New Sally Holdings, Inc. (File No. 333-136259)  filed on October 10, 2006                                                                                                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.6   |   | Second Amendment to the Employee Matters Agreement, dated as of  October 26, 2006, among Alberto-Culver Company, New Aristotle  Holdings, Inc., New Sally Holdings, Inc. and Sally  Holdings, Inc., which is incorporated herein by reference from  Exhibit 10.02 to the Current Report on Form 8-K of New Sally Holdings, Inc.  filed on October 30, 2006                                                                                                                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.7   |   | Support Agreement, dated as of June 19, 2006, among CDRS  Acquisition LLC, Alberto-Culver Company, New Sally Holdings, Inc. and  the stockholders party thereto, which is incorporated herein by reference  from Exhibit 10.10 to the Current Report on Form 8-K filed by  Alberto-Culver Company on June 22, 2006                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.8   |   | Support Agreement, dated as of June 19, 2006, among CDRS  Acquisition LLC, Alberto-Culver Company, New Sally Holdings, Inc. and  Howard B. Bernick, which is incorporated herein by reference from  Exhibit 10.11 to the Current Report on Form 8-K filed by  Alberto-Culver Company on June 22, 2006                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.9   |   | Termination Agreement, dated as of June 18, 2006, among  Alberto-Culver Company, Sally Holdings, Inc. and Gary G. Winterhalter,  which is incorporated herein by reference from Exhibit 10.9 to the  Current Report on Form 8-K filed by Alberto-Culver Company on  June 22, 2006                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.10  |   | Form of First Amendment to the Termination Agreement with Gary  G. Winterhalter, which is incorporated herein by reference from  Exhibit 10.1 to the Current Report on Form 8-K of Sally Beauty  Holdings, Inc. filed on January 29, 2007                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.11  |   | Sally Beauty Holdings, Inc. Independent Director Compensation  Policy, which is incorporated herein by reference from Exhibit 10.12 to  the Annual Report on Form 10-K of Sally Beauty Holdings, Inc. filed  on November 19, 2009                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.12  |   | Alberto-Culver Company 2003 Stock Option Plan for Non-Employee  Directors, which is incorporated herein by reference from Exhibit 10.17  to the Registration Statement on Form S-4 (File No. 333-144427) of  Sally Holdings LLC and Sally Capital Inc. filed on July 9, 2007                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.13  |   | Alberto-Culver Company 2003 Restricted Stock Plan, which is  incorporated herein by reference from Exhibit 10.18 to the Registration  Statement on Form S-4 (File No. 333-144427) of Sally Holdings LLC  and Sally Capital Inc. filed on July 9, 2007                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.14  |   | Sally Beauty Holdings, Inc. Annual Incentive Plan, which is  incorporated herein by reference from Exhibit 10.1 to the Quarterly  Report on Form 10-Q of Sally Beauty Holdings, Inc. filed on  May 8, 2008                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.15  |   | Sally Beauty Holdings, Inc. 2007 Omnibus Incentive Plan, which  is incorporated herein by reference from Exhibit 4.4 to the Registration  Statement on Form S-8 of Sally Beauty Holdings, Inc. filed on  May 3, 2007                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.16  |   | Form of Stock Option Agreement for Independent Directors  pursuant to the Sally Beauty Holdings, Inc. 2007 Omnibus Incentive Plan,  which is incorporated herein by reference from Exhibit 10.1 to the  Current Report on Form 8-K of Sally Beauty Holdings, Inc. filed on  April 27, 2007                                                                                                                                                                                                                                                                                                                                                                                                                                                              |

 

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| 10.17  |   | 2007 Form of Stock Option Agreement for Employees pursuant to  the Sally Beauty Holdings, Inc. 2007 Omnibus Incentive Plan, which is  incorporated herein by reference from Exhibit 10.2 to the Current Report  on Form 8-K of Sally Beauty Holdings, Inc. filed April 27,  2007                                                                                                                                                                  |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.18  |   | 2007 Form of Restricted Stock Unit Agreement for Independent  Directors pursuant to the Sally Beauty Holdings, Inc. 2007 Omnibus  Incentive Plan, which is incorporated herein by reference from  Exhibit 10.3 to the Current Report on Form 8-K of Sally Beauty  Holdings, Inc. filed on April 27, 2007                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.19  |   | 2007 Form of Restricted Stock Agreement for Employees pursuant  to the Sally Beauty Holdings, Inc. 2007 Omnibus Incentive Plan, which is  incorporated herein by reference from Exhibit 10.4 to the Current Report  on Form 8-K of Sally Beauty Holdings, Inc. filed on April 27,  2007                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.20  |   | 2009 Form of Stock Option Agreement for Employees pursuant to  the Sally Beauty Holdings, Inc. 2007 Omnibus Incentive Plan, which is  incorporated herein by reference from Exhibit 10.23 to the Annual Report  on Form 10-K of Sally Beauty Holdings, Inc. filed on  November 20, 2008                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.21  |   | 2009 Form of Restricted Stock Unit Agreement for Independent  Directors pursuant to the Sally Beauty Holdings, Inc. 2007 Omnibus  Incentive Plan, which is incorporated herein by reference from  Exhibit 10.24 to the Annual Report on Form 10-K of Sally Beauty  Holdings, Inc. filed on November 20, 2008                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.22  |   | 2009 Form of Restricted Stock Agreement for Employees pursuant  to the Sally Beauty Holdings, Inc. 2007 Omnibus Incentive Plan, which is  incorporated herein by reference from Exhibit 10.25 to the Annual Report  on Form 10-K of Sally Beauty Holdings, Inc. filed on  November 20, 2008                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.23  |   | Tax Sharing Agreement, dated as of November 16, 2006, made and  entered into by and among Sally Beauty Holdings, Inc., Sally Investment  Holdings LLC and Sally Holdings LLC, which is incorporated herein by  reference from Exhibit 10.14 of the Quarterly Report on Form 10-Q  of Sally Holdings LLC and Sally Capital Inc. filed on August 29, 2007                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.24  |   | Form of Option Exercise Period Extension Agreement for Retired  Executives, which is incorporated herein by reference from Exhibit 10.3  to the Quarterly Report on Form 10-Q of Sally Beauty Holdings, Inc.  filed on May 6, 2009                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.25  |   | Amendment and Restated Alberto-Culver Company Employee Stock Option  Plan of 2003, which is incorporated herein by reference from  Exhibit 10.28 to the Annual Report on Form 10-K of Sally Beauty  Holdings, Inc. filed on November 19, 2009                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.26  |   | 2010 Form of Restricted Stock Unit Agreement for Independent  Directors pursuant to the Sally Beauty Holdings, Inc. 2007 Omnibus  Incentive Plan, which is incorporated herein by reference from  Exhibit 10.29 to the Annual Report on Form 10-K of Sally Beauty  Holdings, Inc. filed on November 19, 2009                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.27  |   | 2010 Form of Restricted Stock Agreement for Employees pursuant  to the Sally Beauty Holdings, Inc. 2007 Omnibus Incentive Plan, which is  incorporated herein by reference from Exhibit 10.30 to the Annual Report  on Form 10-K of Sally Beauty Holdings, Inc. filed on  November 19, 2009                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.28  |   | 2010 Form of Stock Option Agreement for Employees pursuant to  the Sally Beauty Holdings, Inc. 2007 Omnibus Incentive Plan, which is  incorporated herein by reference from Exhibit 10.31 to the Annual Report  on Form 10-K of Sally Beauty Holdings, Inc. filed on  November 19, 2009                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.29  |   | 2010 Form of Stock Option Agreement for Employees pursuant to  the Alberto-Culver Company Employee Stock Option Plan of 2003, which is  incorporated herein by reference from Exhibit 10.32 to the Annual Report  on Form 10-K of Sally Beauty Holdings, Inc. filed on  November 19, 2009                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.30  |   | Form of Amended and Restated Indemnification Agreement with  Directors, which is incorporated herein by reference from Exhibit 10.33  to the Annual Report on Form 10-K of Sally Beauty Holdings, Inc.  filed on November 19, 2009                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.31  |   | Sally Beauty Holdings, Inc. 2010 Omnibus Incentive Plan, which  is incorporated herein by reference from Appendix A to the Definitive Proxy  Statement on Schedule 14A of Sally Beauty Holdings, Inc. filed on  December 11, 2009                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.32  |   | Amended and Restated Letter Agreement between Clayton,  Dubilier & Rice, LLC (“CD&R”) and Sally Beauty  Holdings, Inc. with respect to the provision of services by CD&R to  Sally Beauty Holdings, Inc. Board of Directors dated as of  February 24, 2010, which is incorporated herein by reference from  Exhibit 10.1 to the Quarterly Report on Form 10-Q of Sally Beauty  Holding, Inc. filed on May 4, 2010 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.33  |   | 2011 Form of Restricted Stock Agreement for Employees pursuant  to the Sally Beauty Holdings, Inc. 2010 Omnibus Incentive Plan, which is  incorporated herein by reference from Exhibit 10.32 to the Annual Report  on Form 10-K of Sally Beauty Holdings, Inc. filed on  November 18, 2010                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.34  |   | 2011 Form of Stock Option Agreement for Employees pursuant to  the Sally Beauty Holdings, Inc. 2010 Omnibus Incentive Plan, which is  incorporated herein by reference from Exhibit 10.32 to the Annual Report  on Form 10-K of Sally Beauty Holdings, Inc. filed on  November 18, 2010                                                                                                                                                           |

 

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| 10.35  |   | 2011 Form of Restricted Stock Unit Agreement for Independent  Directors pursuant to the Sally Beauty Holdings, Inc. 2010 Omnibus  Incentive Plan, which is incorporated herein by reference from  Exhibit 10.32 to the Annual Report on Form 10-K of Sally Beauty  Holdings, Inc. filed on November 18, 2010 |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                       |
| 23.1   |   | Consent of KPMG*                                                                                                                                                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                       |
| 31.1   |   | Rule 13(a)-14(a)/15(d)-14(a) Certification of Gary G.  Winterhalter*                                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                       |
| 31.2   |   | Rule 13(a)-14(a)/15(d)-14(a) Certification of Mark J.  Flaherty*                                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                       |
| 32.1   |   | Section 1350 Certification of Gary G. Winterhalter*                                                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                       |
| 32.2   |   | Section 1350 Certification of Mark J. Flaherty *                                                                                                                                                                                                                                                                                      |

 

----

*Includedherewith

†Certain schedules and exhibits have been omitted pursuant to Item 601(b)(2) ofRegulation S-K.  The Registrant agrees tofurnish supplementally to the Securities and Exchange Commission a copy of anyomitted schedule or exhibit upon request

 

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**SIGNATURES**

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized, on the 18th day ofNovember, 2010.

 
|   | SALLY HOLDINGS LLC                                       |
|--------|----------------------------------------------------------|
|   |                                                     |
|   | By:                                                      | /s/ GARY G. WINTERHALTER |
|   | Gary G. Winterhalter                                     |
|   | President, Chief Executive  Officer *                    |
|   |                                                     |   |
|   | By:                                                      | /s/ MARK J. FLAHERTY |
|   | Mark J. Flaherty                                         |
|   | Senior Vice President and  Chief Financial Officer       |
|   |                                                     |   |
|   | By:                                                      | /s/ JANNA S. MINTON |
|   | Janna S. Minton                                          |
|   | Vice President, Chief  Accounting Officer and Controller |

 

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Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

 
| **Signature**                 | ** ** | **Title**                                                                                                            | ** ** | **Date**               |
|-------------------------------|------------|----------------------------------------------------------------------------------------------------------------------|------------|------------------------|
| /s/ GARY G. WINTERHALTER      |       | President, Chief Executive  Officer (Principal Executive Officer) and Director of Sally Beauty  Holdings, Inc.* |       | November 18, 2010 |
| Gary G. Winterhalter          |       |                                                                                                                 |       |                   |
|                          |       |                                                                                                                 |       |                   |
| /s/ MARK J. FLAHERTY          |       | Senior Vice President and  Chief Financial Officer (Principal Financial Officer)                                     |       | November 18, 2010 |
| Mark J. Flaherty              |       |                                                                                                                 |       |                   |
|                          |       |                                                                                                                 |       |                   |
| /s/ JANNA S. MINTON           |       | Vice President, Chief  Accounting Officer and Controller (Principal Accounting Officer)                              |       | November 18, 2010 |
| Janna S. Minton               |       |                                                                                                                 |       |                   |
|                          |       |                                                                                                                 |       |                   |
| /s/ JAMES G. BERGES           |       | Chairman of the Board and  Director of Sally Beauty Holdings, Inc.*                                             |       | November 18, 2010 |
| James G. Berges               |       |                                                                                                                 |       |                   |
|                          |       |                                                                                                                 |       |                   |
| /s/ KATHLEEN J. AFFELDT       |       | Director of Sally Beauty  Holdings, Inc.*                                                                       |       | November 18, 2010 |
| Kathleen J. Affeldt           |       |                                                                                                                 |       |                   |
|                          |       |                                                                                                                 |       |                   |
| /s/ MARSHALL E. EISENBERG     |       | Director of Sally Beauty  Holdings, Inc.*                                                                       |       | November 18, 2010 |
| Marshall E. Eisenberg         |       |                                                                                                                 |       |                   |
|                          |       |                                                                                                                 |       |                   |
| /s/ KENNETH A. GIURICEO       |       | Director of Sally Beauty  Holdings, Inc.*                                                                       |       | November 18, 2010 |
| Kenneth A. Giuriceo           |       |                                                                                                                 |       |                   |
|                          |       |                                                                                                                 |       |                   |
| /s/ ROBERT R. MCMASTER        |       | Director of Sally Beauty  Holdings, Inc.*                                                                       |       | November 18, 2010 |
| Robert R. McMaster            |       |                                                                                                                 |       |                   |
|                          |       |                                                                                                                 |       |                   |
| /s/ WALTER L. METCALFE JR.    |       | Director of Sally Beauty  Holdings, Inc.*                                                                       |       | November 18, 2010 |
| Walter L. Metcalfe Jr.        |       |                                                                                                                 |       |                   |
|                          |       |                                                                                                                 |       |                   |
| /s/ JOHN A. MILLER            |       | Director of Sally Beauty  Holdings, Inc.*                                                                       |       | November 18, 2010 |
| John A. Miller                |       |                                                                                                                 |       |                   |
|                          |       |                                                                                                                 |       |                   |
| /s/  MARTHA MILLER DE LOMBERA |       | Director of Sally Beauty  Holdings, Inc.*                                                                       |       | November 18, 2010 |
| Martha Miller de Lombera      |       |                                                                                                                 |       |                   |
|                          |       |                                                                                                                 |       |                   |
| /s/ EDWARD W. RABIN           |       | Director of Sally Beauty  Holdings, Inc.*                                                                       |       | November 18, 2010 |
| Edward W. Rabin               |       |                                                                                                                 |       |                   |
|                          |       |                                                                                                                 |       |                   |
| /s/ RICHARD J. SCHNALL        |       | Director of Sally Beauty  Holdings, Inc.*                                                                       |       | November 18, 2010 |
| Richard J. Schnall            |       |                                                                                                                 |       |                   |

 

----

* Director of Sally Beauty Holdings, Inc., sole member of SallyInvestment Holdings LLC, sole member of Sally Holdings LLC.

 

65

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**SALLYHOLDINGS LLC AND SUBSIDIARIES**

 

FinancialStatements

Yearsended September 30, 2010, 2009 and 2008

 

**INDEX TOFINANCIAL STATEMENTS**

 
| ** **                                                                                                            | ** ** | **Page** |
|-----------------------------------------------------------------------------------------------------------------------|------------|----------|
| Report  of Independent Registered Public Accounting Firm                                                              |       | F-1      |
|                                                                                                                  |       |     |
| Consolidated  Financial Statements:                                                                                   |       | F-3      |
| Consolidated  Balance Sheets as of September 30, 2010 and 2009                                                   |       | F-4      |
| Consolidated  Statements of Earnings for the years ended September 30, 2010, 2009 and  2008                      |       | F-5      |
| Consolidated Statements of Cash Flows for the years  ended September 30, 2010, 2009 and 2008                     |       | F-6      |
| Consolidated Statements of Member’s Equity (Deficit)  for the years ended September 30, 2010, 2009 and 2008 |       | F-7      |
| Notes to Consolidated Financial Statements for the  years ended September 30, 2010, 2009 and 2008                |       | F-8      |

 

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**Report of Independent Registered Public Accounting Firm**

 

The Board of Directors

Sally Beauty Holdings, Inc.:

 

Wehave audited Sally Holdings LLC’s (the Company) internal control over financialreporting as of September 30, 2010, based on criteria established in *Internal Control—Integrated Framework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO).  The Company’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting,included in the accompanying Management’s Annual Report on Internal Controlover Financial Reporting.  Ourresponsibility is to express an opinion on the Company’s internal control overfinancial reporting based on our audit.

 

Weconducted our audit in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether effective internal control over financialreporting was maintained in all material respects.  Our audit included obtaining an understandingof internal control over financial reporting, assessing the risk that amaterial weakness exists, and testing and evaluating the design and operatingeffectiveness of internal control based on the assessed risk.  Our audit also included performing such otherprocedures as we considered necessary in the circumstances.  We believe that our audit provides areasonable basis for our opinion.

 

Acompany’s internal control over financial reporting is a process designed toprovide reasonable assurance regarding the reliability of financial reportingand the preparation of financial statements for external purposes in accordancewith generally accepted accounting principles. A company’s internal control over financial reporting includes thosepolicies and procedures that (1) pertain to the maintenance of recordsthat, in reasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

Becauseof its inherent limitations, internal control over financial reporting may notprevent or detect misstatements. Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

 

Inour opinion, Sally Holdings LLC maintained, in all material respects, effectiveinternal control over financial reporting as of September 30, 2010, basedon criteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission.

 

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the consolidated balance sheets ofSally Holdings LLC and subsidiaries as of September 30, 2010 and 2009, andthe related consolidated statements of earnings, cash flows and member’s equity(deficit) for each of the years in the three-year period ended September 30,2010, and our report dated November 17, 2010 expressed an unqualifiedopinion on those consolidated financial statements.

 

 

/s/ KPMG LLP

 

KPMGLLP

Dallas,Texas

November 17,2010

 

F-1

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Table ofContents

 

**Report of Independent Registered Public Accounting Firm**

 

The Board of Directors

Sally Beauty Holdings, Inc.:

 

Wehave audited the accompanying consolidated balance sheets of Sally Holdings LLC(the Company) and subsidiaries as of September 30, 2010 and 2009, and therelated consolidated statements of earnings, cash flows, and member’s equity(deficit) for each of the years in the three-year period ended September 30,2010.  These consolidated financialstatements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these consolidated financial statements based on our audits.

 

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation.  We believe that our auditsprovide a reasonable basis for our opinion.

 

Inour opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of Sally Holdings LLCand subsidiaries as of September 30, 2010 and 2009, and the results oftheir operations and their cash flows for each of the years in the three-yearperiod ended September 30, 2010, in conformity with U.S. generallyaccepted accounting principles.

 

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), Sally Holdings LLC’s internalcontrol over financial reporting as of September 30, 2010, based oncriteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO), and our report dated November 17, 2010expressed an unqualified opinion on the effectiveness of the Company’s internalcontrol over financial reporting.

 

 

/s/ KPMG LLP

 

KPMGLLP

Dallas,Texas

November 17,2010

 

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Table ofContents

 

**ConsolidatedFinancial Statements**

 

Thefollowing consolidated balance sheets as of September 30, 2010 and 2009 andthe related consolidated statements of earnings, cash flows and member’s equity(deficit) for each of the fiscal years in the three-year period ended September 30,2010 are those of Sally Holdings LLC and its consolidated subsidiaries(hereafter “Sally Holdings” or the “Company”). In November of 2006, SallyHoldings, Inc. was converted to a Delaware limited liability company, wasrenamed “Sally Holdings LLC” and became an indirect wholly-owned subsidiary ofSally Beauty Holdings, Inc. (“Sally Beauty”) in connection with ourseparation from the Alberto-Culver Company (“Alberto-Culver”). In thesefinancial statements and elsewhere in this Annual Report on Form 10-K, werefer to these transactions as the Separation Transactions. Sally Beauty wasformed in June of 2006 in connection with the Separation Transactions.

 

F-3

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Table of Contents

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

ConsolidatedBalance Sheets

September 30,2010 and 2009

(Inthousands)

 
| ** **                                                                                                                               | ** ** | **2010**   | ** ** | **2009**   | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Assets**                                                                                                                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                          |       |       |       |       |       |
| Cash and cash equivalents                                                                                                                |       | $          | 59,494     |       | $          | 54,447 |   |
| Trade accounts receivable, less allowance for  doubtful accounts of $2,756 and $2,266 at September 30, 2010 and 2009,  respectively |       | 54,989     |       | 43,649     |       |
| Other receivables                                                                                                                        |       | 29,510     |       | 24,090     |       |
| Inventory                                                                                                                                |       | 604,357    |       | 559,689    |       |
| Prepaid expenses                                                                                                                         |       | 22,521     |       | 18,261     |       |
| Deferred income tax assets, net                                                                                                          |       | 23,269     |       | 15,629     |       |
| Total current assets                                                                                                                     |       | 794,140    |       | 715,765    |       |
| Property and equipment, net of accumulated  depreciation of $291,185 and $265,329 at September 30, 2010 and 2009,  respectively     |       | 168,117    |       | 151,249    |       |
| Goodwill                                                                                                                                 |       | 478,240    |       | 494,135    |       |
| Other intangible assets, net of accumulated  amortization of $33,031 and $24,357 at September 30, 2010 and 2009,  respectively      |       | 109,352    |       | 78,685     |       |
| Other assets                                                                                                                             |       | 38,914     |       | 50,676     |       |
| Total assets                                                                                                                             |       | $          | 1,588,763  |       | $          | 1,490,510 |   |
| **Liabilities and Member’s Deficit**                                                                                                |       |       |       |       |       |
| Current liabilities:                                                                                                                     |       |       |       |       |       |
| Current maturities of long-term debt                                                                                                     |       | $          | 3,045      |       | $          | 24,517 |   |
| Accounts payable                                                                                                                         |       | 224,931    |       | 193,592    |       |
| Accrued liabilities                                                                                                                      |       | 167,259    |       | 153,842    |       |
| Income taxes payable                                                                                                                     |       | 6,812      |       | 5,829      |       |
| Due to Sally Beauty                                                                                                                      |       | 40,500     |       | 22,042     |       |
| Total current liabilities                                                                                                                |       | 442,547    |       | 399,822    |       |
| Long-term debt                                                                                                                           |       | 1,559,591  |       | 1,653,013  |       |
| Other liabilities                                                                                                                        |       | 40,692     |       | 43,586     |       |
| Deferred income tax liabilities, net                                                                                                     |       | 42,875     |       | 34,428     |       |
| Total liabilities                                                                                                                        |       | 2,085,705  |       | 2,130,849  |       |
| Stock options subject to redemption                                                                                                      |       | 946        |       | 1,800      |       |
| Member’s deficit:                                                                                                                   |       |       |       |       |       |
|                                                                                                                                     |       |       |       |       |       |
| Accumulated member’s deficit                                                                                                        |       | (477,612   | )          | (626,241   | )          |
| Accumulated other comprehensive loss, net of tax                                                                                         |       | (20,276    | )          | (15,898    | )          |
| Total member’s deficit                                                                                                              |       | (497,888   | )          | (642,139   | )          |
| Total liabilities and member’s deficit                                                                                              |       | $          | 1,588,763  |       | $          | 1,490,510 |   |

 

Theaccompanying notes to consolidated financial statements are an integral part ofthese financial statements.

 

F-4

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Table of Contents

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

ConsolidatedStatements of Earnings

FiscalYears ended September 30, 2010, 2009 and 2008

(Inthousands)

 
| ** **                                       | ** ** | **2010**  | ** ** | **2009**  | ** ** | **2008**  | ** ** |
|--------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Net  sales                                       |       | $         | 2,916,090  |      | $          | 2,636,600 |       | $ | 2,648,191 |   |
| Cost  of products sold and distribution expenses |       | 1,511,716 |       | 1,393,283 |       | 1,413,597 |       |
| Gross  profit                                    |       | 1,404,374 |       | 1,243,317 |       | 1,234,594 |       |
| Selling,  general and administrative expenses    |       | 1,004,660 |       | 891,056   |       | 895,632   |       |
| Depreciation  and amortization                   |       | 51,122    |       | 47,066    |       | 48,533    |       |
| Operating  earnings                              |       | 348,592   |       | 305,195   |       | 290,429   |       |
| Interest  expense                                |       | 112,953   |       | 132,043   |       | 158,897   |       |
| Earnings  before provision for income taxes      |       | 235,639   |       | 173,152   |       | 131,532   |       |
| Provision  for income taxes                      |       | 87,010    |       | 68,424    |       | 48,664    |       |
| Net  earnings                                    |       | $         | 148,629    |      | $          | 104,728   |       | $ | 82,868 |   |

 

Theaccompanying notes to consolidated financial statements are an integral part ofthese financial statements.

 

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**SALLY HOLDINGS LLC AND SUBSIDIARIES**

ConsolidatedStatements of Cash Flows

FiscalYears ended September 30, 2010, 2009 and 2008

(Inthousands)

 
| ** **                                                                           | ** ** | **2010** | ** ** | **2009** | ** ** | **2008** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Cash Flows from Operating Activities:**                                            |       |     |       |     |       |     |       |
| Net  earnings                                                                        |       | $        | 148,629    |     | $          | 104,728  |       | $ | 82,868 |   |
| Adjustments  to reconcile net earnings to net cash provided by operating activities: |       |     |       |     |       |     |       |
| Depreciation  and amortization                                                       |       | 51,122   |       | 47,066   |       | 48,533   |       |
| Share-based  compensation expense                                                    |       | 12,187   |       | 7,992    |       | 9,614    |       |
| Amortization  of deferred financing costs                                            |       | 7,775    |       | 8,319    |       | 8,469    |       |
| Excess  tax (benefit) shortfall from share-based compensation                        |       | (248     | )          | 194      |       | (451     | )          |
| Net  (gain) loss on disposal of property and equipment                               |       | (41      | )          | (56      | )          | 116      |       |
| Net  loss on extinguishment of debt                                                  |       | 985      |       | 1,017    |       | —   |       |
| Deferred  income taxes                                                               |       | (671     | )          | 8,627    |       | 745      |       |
| Changes  in (exclusive of effects of acquisitions):                                  |       |     |       |     |       |     |       |
| Trade  accounts receivable                                                           |       | (17      | )          | 3,708    |       | 7,629    |       |
| Other  receivables                                                                   |       | (4,520   | )          | (1,087   | )          | (58      | )          |
| Inventory                                                                            |       | (34,247  | )          | 46,208   |       | (29,527  | )          |
| Prepaid  expenses                                                                    |       | (3,635   | )          | 764      |       | (4,599   | )          |
| Other  assets                                                                        |       | 3,510    |       | 625      |       | 61       |       |
| Accounts  payable and accrued liabilities                                            |       | 37,526   |       | 17,805   |       | (11,200  | )          |
| Income  taxes payable                                                                |       | (2,263   | )          | (7,923   | )          | 5,394    |       |
| Due  to Sally Beauty                                                                 |       | 5,169    |       | (7,299   | )          | (11,900  | )          |
| Other  liabilities                                                                   |       | (3,207   | )          | (6,704   | )          | 5,721    |       |
| Net  cash provided by operating activities                                           |       | 218,054  |       | 223,984  |       | 111,415  |       |
|                                                                                 |       |     |       |     |       |     |       |
| **Cash Flows from Investing Activities:**                                            |       |     |       |     |       |     |       |
| Capital  expenditures                                                                |       | (48,702  | )          | (37,317  | )          | (45,576  | )          |
| Proceeds  from sale of property and equipment                                        |       | 143      |       | 217      |       | 288      |       |
| Acquisitions,  net of cash acquired                                                  |       | (36,463  | )          | (81,459  | )          | (52,874  | )          |
| Net  cash used by investing activities                                               |       | (85,022  | )          | (118,559 | )          | (98,162  | )          |
|                                                                                 |       |     |       |     |       |     |       |
| **Cash Flows from Financing Activities:**                                            |       |     |       |     |       |     |       |
| Change  in book cash overdraft                                                       |       | —   |       | (1,633   | )          | 1,633    |       |
| Proceeds  from issuance of long-term debt                                            |       | 334,000  |       | 95,577   |       | 527,735  |       |
| Repayments  of long-term debt                                                        |       | (461,567 | )          | (243,666 | )          | (482,685 | )          |
|                                                                                 |       |     |       |     |       |     |       |
| Excess  tax benefit (shortfall) from share-based compensation                        |       | 248      |       | (194     | )          | 451      |       |
|                                                                                 |       |     |       |     |       |     |       |
| Net  cash (used) provided by financing activities                                    |       | (127,319 | )          | (149,916 | )          | 47,134   |       |
|                                                                                 |       |     |       |     |       |     |       |
| Effect  of foreign currency exchange rate changes on cash and cash equivalents       |       | (666     | )          | (850     | )          | 1,129    |       |
| Net  increase (decrease) in cash and cash equivalents                                |       | 5,047    |       | (45,341  | )          | 61,516   |       |
| Cash  and cash equivalents, beginning of year                                        |       | 54,447   |       | 99,788   |       | 38,272   |       |
| Cash  and cash equivalents, end of year                                              |       | $        | 59,494     |     | $          | 54,447   |       | $ | 99,788 |   |
|                                                                                 |       |     |       |     |       |     |       |
| **Supplemental Cash Flow Information:**                                              |       |     |       |     |       |     |       |
|                                                                                 |       |     |       |     |       |     |       |
| Interest  paid                                                                       |       | $        | 108,733    |     | $          | 130,204  |       | $ | 149,842 |   |
| Income  taxes paid, net                                                              |       | $        | 8,093      |     | $          | 7,814    |       | $ | 6,432 |   |

 

Theaccompanying notes to consolidated financial statements are an integral part ofthese financial statements.

 

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Table of Contents

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

ConsolidatedStatements of Member’s Equity (Deficit)

FiscalYears ended September 30, 2010, 2009 and 2008

(Inthousands)

 
| ** **                                                             | ** ** | ** **        | ** ** | **Accumulated Other** | ** ** | **Total**         | ** ** |
|------------------------------------------------------------------------|------------|-------------------|------------|----------------------------|------------|-------------------|------------|
| ** **                                                             | ** ** | **Member’s** | ** ** | **Comprehensive**          | ** ** | **Member’s** | ** ** |
| ** **                                                             | ** ** | **Deficit**       | ** ** | **(Loss) Income**     | ** ** | **Deficit**       | ** ** |
| Balance  at September 30, 2007                                    |       | $                 | (814,839   | )                          | $          | 34,522            |       | $ | (780,317 | ) |
| Net  earnings                                                          |       | 82,868            |       | —                     |       | 82,868            |       |
| Deferred  gains on interest rate swaps, net of income taxes of $509    |       | —            |       | 793                        |       | 793               |       |
| Foreign  currency translation                                          |       | —            |       | (26,626                    | )          | (26,626           | )          |
| Total  comprehensive income                                            |       |              |       |                       |       | 57,035            |       |
| Adjustment  to distributions to Alberto-Culver                         |       | 1,002             |       | —                     |       | 1,002             |       |
|                                                                   |       |              |       |                       |       |              |       |
| Balance  at September 30, 2008                                    |       | (730,969          | )          | 8,689                      |       | (722,280          | )          |
| Net  earnings                                                          |       | 104,728           |       | —                     |       | 104,728           |       |
| Deferred  losses on interest rate swaps, net of income taxes of $6,471 |       | —            |       | (10,196                    | )          | (10,196           | )          |
| Foreign  currency translation                                          |       | —            |       | (14,391                    | )          | (14,391           | )          |
| Total  comprehensive income                                            |       |              |       |                       |       | 80,141            |       |
|                                                                   |       |              |       |                       |       |              |       |
| Balance  at September 30, 2009                                    |       | (626,241          | )          | (15,898                    | )          | (642,139          | )          |
| Net  earnings                                                          |       | 148,629           |       | —                     |       | 148,629           |       |
| Deferred  losses on interest rate swaps, net of income taxes of $64    |       | —            |       | (101                       | )          | (101              | )          |
| Foreign  currency translation                                          |       | —            |       | (4,277                     | )          | (4,277            | )          |
| Total  comprehensive income                                            |       |              |       |                       |       | 144,251           |       |
|                                                                   |       |              |       |                       |       |              |       |
| Balance  at September 30, 2010                                    |       | $                 | (477,612   | )                          | $          | (20,276           | )          | $ | (497,888 | ) |

 

Theaccompanying notes to consolidated financial statements are an integral part ofthese financial statements.

 

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Tableof Contents

 

Sally Holdings LLC andSubsidiaries

Notesto Consolidated Financial Statements

 

**1.  Description of Business and Basis of Presentation**

 

**Descriptionof Business**

 

SallyHoldings LLC is a wholly-owned subsidiary of Sally Investment Holdings LLC (“SallyInvestment”), a wholly-owned subsidiary of Sally Beauty.  All of the interests of Sally Holdings arebeneficially owned by Sally Investment, and all of the interests of SallyInvestment are beneficially owned by Sally Beauty.  The Company was a wholly-owned subsidiary ofAlberto-Culver until November 16, 2006 when it was converted to a Delawarelimited liability company, was renamed “Sally Holdings LLC” and became a wholly-ownedsubsidiary of Sally Investment and an indirect subsidiary of Sally Beauty inconnection with the separation of its business from Alberto-Culver. The Companyand its consolidated subsidiaries sell professional beauty supplies, primarilythrough its Sally Beauty Supply retail stores in the U.S., Puerto Rico, Mexico,Canada, Chile, Belgium, France, Italy, the United Kingdom and certainother countries in Europe. Additionally, the Company distributes professionalbeauty products to salons and professional cosmetologists through its BeautySystems Group (“BSG”) store operations and a commissioned direct sales forcethat calls on salons primarily in the U.S., Puerto Rico, Canada, the UnitedKingdom and certain other countries in Europe, and to franchises in thesouthern and southwestern U.S. and in Mexico through the operations of itssubsidiary Armstrong McCall, L.P. (“Armstrong McCall”). Certain beauty productssold by BSG and Armstrong McCall are sold under exclusive territory agreementswith the manufacturers of the products.

 

Priorto November of 2006, the Company was a wholly-owned subsidiary ofAlberto-Culver operating under the name “Sally Holdings, Inc.” InNovember of 2006, Alberto-Culver separated its consumer products businessand its Sally Beauty Supply/BSG distribution business into two separate,publicly-traded companies (the “Separation Transactions”). The separation waseffected pursuant to an investment agreement dated as of June 19, 2006(the “Investment Agreement”) among Alberto-Culver and certain of itssubsidiaries, including Sally Holdings, Inc., and CDRS Acquisition LLC (“CDRS”).Sally Beauty was formed in June of 2006, and became the accountingsuccessor company to Sally Holdings, Inc. upon the completion of theSeparation Transactions.

 

Pursuantto the Investment Agreement: (i) the stockholders of Alberto-Culverimmediately prior to the Separation Transactions became the beneficial ownersof approximately 52% of the outstanding common stock of Sally Beauty on anundiluted basis; and (ii) CDRS, a limited liability company organized byClayton, Dubilier & Rice Fund VII, L.P., invested$575.0 million to obtain an equity ownership of approximately 48% of theoutstanding common stock of Sally Beauty. In addition, the Company incurredapproximately $1,850.0 million of new long-term debt in connection withthe Separation Transactions.

 

Inthe ordinary course of business, the Company performs certain administrativeservices on behalf of Sally Beauty. These services are charged to Sally Beauty andnetted against the amount due to Sally Beauty. Please see Note 17 for furtherinformation.

 

**Basis ofPresentation**

 

Theconsolidated financial statements included herein have been prepared inaccordance with accounting principles generally accepted in the United Statesof America (“GAAP”). All references in these notes to “management” are to themanagement of Sally Holdings LLC. All references in these notes to the “Company”are to Sally Holdings LLC.

 

**2.  Significant Accounting Policies**

 

Thepreparation of financial statements in conformity with GAAP requires us tointerpret and apply accounting standards and to develop and follow accountingpolicies consistent with such standards. The following is a summary of thesignificant accounting policies used in preparing the Company’s consolidatedfinancial statements.

 

*Reclassifications*

 

Certainamounts for prior fiscal years have been reclassified to conform to the currentyear’s presentation.

 

*Principlesof Consolidation*

 

These consolidated financialstatements include the operations of Company and its subsidiaries. Allsignificant intercompany accounts and transactions have been eliminated in theconsolidated financial statements.

 

*Useof Estimates*

 

Thepreparation of financial statements in conformity with GAAP requires managementto make estimates and assumptions that affect the reported amounts of assets,liabilities, revenues and expenses and disclosures of contingent assets andliabilities in the financial statements. The level of uncertainty in estimatesand assumptions increases with the length of time until the underlyingtransactions are completed. Actual results may differ from these estimates inamounts that may be material to the financial statements. Management believesthat the estimates and assumptions used in the preparation of the Company’sconsolidated financial statements are reasonable.

 

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Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

*Cashand Cash Equivalents*

 

Allhighly liquid investments purchased by the Company from time to time which havean original maturity of three months or less are considered to be cash equivalents.These investments are stated at cost, which approximates market value. Alsoincluded in cash equivalents are proceeds due from customer credit and debitcard transactions, which generally settle within one to three days, and were$8.4 million and $7.2 million at September 30, 2010 and 2009,respectively.

 

*FairValue of Financial Instruments*

 

TheCompany’s financial instruments consist of cash and cash equivalents, trade andother accounts receivable, accounts payable, interest rate swap agreements,foreign currency option and forward agreements and long-term debt.

 

Thecarrying amounts of cash and cash equivalents, trade and other accountsreceivable and accounts payable approximate fair value due to the short-termnature of these financial instruments.

 

The aggregate fair value of the interest rate swap agreements held at September 30,2010 and 2009, was a net liability of $15.5 million and $15.4 million,respectively, and is included in other liabilities in the Company’sconsolidated balance sheets. The fair value amounts reported for theseagreements are based on third-party information and were determined usingproprietary models based upon well-recognized financial principles andreasonable estimates about relevant future market conditions. Please see Note13 for additional information about the Company’s interest rate swapagreements.

 

The aggregate fair value of the foreign currency option and forwardagreements held at September 30, 2010 was a net liability of $0.2 million,consisting of $0.3 million included in accrued liabilities and $0.1 millionincluded in prepaid expenses in the Company’s consolidated balance sheets. Thefair value amounts reported for these agreements are based onthird-party information and were determined using proprietary models based uponwell-recognized financial principles and reasonable estimates about relevantfuture market conditions. Please see Note 13 for additional information aboutthe Company’s foreign currency option and forward agreements.

 

AtSeptember 30, 2010 and 2009, the fair value of the Company’s long-termdebt (including capital leases) was approximately $1,596.2 million and $1,655.1million, while the carrying amount in the Company’s consolidated balance sheetswas $1,562.6 million and $1,677.5 million, respectively. The fair value amountsreported for the Company’s long-term debt are based on quoted market priceswhere available or, if not available, based on discounted future cash flowsusing current market interest rates. Long-term debt is stated at amortized costin the Company’s consolidated balance sheets.

 

*Derivative Instruments and Hedging Activities*

 

*Interest Rate Swap Agreements*

 

TheCompany utilizes derivative instruments, such as interest rate swap agreements,to manage its cash flow exposure associated with changing interest rates inconnection with its term loan obligations, and accounts for these agreements inaccordance with the Financial Accounting Standards Board (“FASB”) AccountingStandards Codification (“ASC”) Topic 815, *Derivatives and Hedging*(“ASC 815”). The Company does not purchase or hold any derivative instrumentsfor speculative or trading purposes. Interest rate swap agreements heldby the Company at September 30, 2010 are designated as effective cash flowhedges and adjustments to reflect the change in their fair values (which are adjustedquarterly) are recorded, net of income tax, in accumulated other comprehensiveincome until the hedged obligation is settled or the swap agreements expire,whichever is earlier.  Any hedgeineffectiveness, as this term is used in ASC 815, is recognized in interestexpense in our consolidated statements of earnings.

 

*Foreign Currency Option andForward Contracts*

 

TheCompany utilizes foreign currency derivative instruments, such as foreigncurrency option and forward contracts, to manage its cash flow exposureassociated with certain changing foreign currency exchange rates. The Company’svarious foreign currency exposures at times offset each other, providing anatural hedge against foreign currency risk. The Company does not purchase orhold any derivative instruments for speculative or trading purposes.

 

Asa result of our acquisition of Sinelco Group NV (“Sinelco”) on December 16,2009, the Company uses foreign currency options, including, at September 30,2010, foreign currency put options with an aggregate notional amount of €1.4million ($1.9 million, at the September 30, 2010 exchange rate) andforeign currency call options with an aggregate notional amount of €0.8 million($1.2 million, at the September 30, 2010 exchange rate), to manage theexposure to certain non-Euro currencies resulting from Sinelco’s purchases ofmerchandise from third-party suppliers. Sinelco’s functional currency is theEuro.

 

Inthe fourth quarter of the fiscal year 2010, we entered into four foreigncurrency forward agreements which expire in January of 2011. Two foreigncurrency forward agreements enable the Company to sell, in the aggregate,approximately €5.2 million ($7.1 million, at the September 30, 2010exchange rate) at the weighted average forward exchange rate of 1.3073. Theother two foreign

 

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Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

currencyforward agreements enable the Company to buy, in the aggregate, approximately$7.0 million Canadian dollars ($6.8 million, at the September 30, 2010exchange rate) at the weighted average forward exchange rate of 1.0277.

 

TheCompany’s foreign currency derivative instruments are not designated as hedgesand do not currently meet the requirements for hedge accounting. Accordingly, the changes in thefair value of our foreign currency derivative instruments(which are adjusted quarterly) are recorded in selling, general andadministrative expenses in our consolidated statements of earnings. Please see “Item7A — Quantitative and Qualitative Disclosures about Market Risk—Foreigncurrency exchange rate risk” contained elsewhere in this Annual Report, and Note 13 ofthe Notes to Consolidated Financial Statements.

 

*Concentrationof Credit Risk*

 

Financialinstruments that potentially expose the Company to concentration of credit riskconsist primarily of investments in cash equivalents, accounts receivable andderivative instruments.

 

TheCompany invests from time to time in securities of financial institutions withhigh credit quality. Accounts receivable are deemed by the Company to be highlydiversified due to the high number of entities comprising the Company’scustomer base and their dispersion across diverse geographical regions. Thecounterparties to all our derivative instruments are deemed by the Company tobe of substantial resources and strong creditworthiness. The Company believesthat no significant concentration of credit risk exists with respect to itsinvestments in cash equivalents, its accounts receivable and its derivative instrumentsat September 30, 2010 and 2009.

 

*TradeAccounts Receivable and Allowance for Doubtful Accounts*

 

Tradeaccounts receivable are recorded at the values invoiced to customers and do notbear interest. Trade accounts receivable are stated net of the allowance fordoubtful accounts. The allowance for doubtful accounts requires management toestimate the future collectability of amounts receivable at the balance sheetdate. Management records allowances for doubtful accounts based on historicalcollection data and current customer information. Customer account balances arecharged against the allowance after all means of collection have been exhaustedand the potential for recovery is considered remote. In the Company’sconsolidated statements of earnings, bad debt expense is included in selling,general and administrative expenses. The Company’s exposure to credit risk withrespect to trade receivables is mitigated by the Company’s broad customer baseand their dispersion across diverse geographical regions.

 

*OtherReceivables*

 

Otherreceivables consist primarily of amounts expected to be received from vendorsunder various contractual agreements. Other receivables are recorded at theamount management estimates will be collected.

 

*Inventory*

 

Inventoryconsists primarily of beauty supplies and related accessories and salonequipment for sale in the normal course of our business and is stated at thelower of cost, determined using the first-in, first-out (FIFO) method, ormarket (net realizable value). When necessary, the Company adjusts the carryingvalue of inventory to the lower of cost or market, including costs to sell ordispose, and for estimated inventory shrinkage. Estimates of the future demandfor the Company’s products, age of the inventory and changes in stock keepingunits (“SKUs”) are some of the key factors used by management in assessing thenet realizable value of inventories. The Company estimates inventory shrinkagebased on historical experience. Inventory shrinkage averaged approximately 1%of our consolidated net sales for the fiscal years 2010, 2009 and 2008.

 

*Propertyand Equipment*

 

Propertyand equipment are stated at cost less accumulated depreciation. Depreciation iscalculated using the straight-line method based on the estimated useful livesof the respective classes of assets and is reflected in depreciation andamortization expense in our consolidated statements of earnings. Buildings andbuilding improvements are depreciated over periods ranging from five to 40years. Leasehold improvements are amortized over the lesser of the estimateduseful lives of the assets or the term of the related lease, including renewalsdetermined to be reasonably assured. Furniture, fixtures and equipment aredepreciated over periods ranging from three to ten years. Expenditures formaintenance and repairs are expensed as incurred, while expenditures for majorrenewals and improvements are capitalized. Upon the disposition of property andequipment, the cost and related accumulated depreciation are removed from ouraccounts.

 

*LeaseAccounting*

 

TheCompany’s lease agreements for office space, retail stores andwarehouse/distribution facilities are generally accounted for as operatingleases, consistent with applicable GAAP. Rent expense (including any rentabatements or escalation charges) is recognized on a straight-line basis fromthe date the Company takes possession of the property to begin preparation ofthe site for occupancy, to the end of the lease term, including renewal optionsdetermined to be reasonably assured. Certain leases provide for contingentrents that are determined as a percentage of revenues in excess of specifiedlevels. The Company records a contingent rent liability along with

 

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Table ofContents

 

Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

thecorresponding rent expense when specified levels have been achieved or when managementdetermines that achieving the specified levels during the fiscal year isprobable.

 

Certainlease agreements to which the Company is a party provide for tenant improvementallowances. Such allowances are recorded as deferred lease credits, included inaccrued liabilities and other liabilities, as appropriate, on our consolidatedbalance sheets, and amortized on a straight-line basis over the lease term(including renewal options determined to be reasonably assured) as a reductionof rent expense. Such amortization period is generally consistent with theamortization period used for the constructed leasehold improvement asset.

 

*Valuationof Long-Lived Assets and Certain Intangible Assets*

 

Long-livedassets, such as property and equipment, including store equipment, andpurchased intangibles subject to amortization are reviewed for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be fully recoverable. Recoverability of long-lived assetsis measured by a comparison of the carrying amount of an asset to estimatedfuture cash flows expected to be generated by the asset. If the carrying amountof an asset exceeds its estimated future cash flows, an impairment charge isrecognized by the amount by which the carrying amount of the asset exceeds thefair value of the asset. There was no significant impairment of such assetsrecognized in our financial statements in the current or prior fiscal years.

 

*Goodwilland Other Intangible Assets*

 

Goodwillis the cost of an acquisition less the fair value of the net assets acquired ina business combination. Goodwill and intangible assets with indefinite livesare reviewed for impairment at least annually, and whenever events or changesin circumstances indicate it is more likely than not that the fair value of areporting unit is less than its carrying amount. Management considers whetherthere has been a permanent impairment to the value of goodwill and otherintangibles by evaluating if various factors (including current operatingresults, anticipated future results and cash flows, and market and economicconditions) indicate a possible impairment. Based on the reviews performed,after taking into account the recent economic downturn in certain geographicareas in which we operate, there was no impairment of goodwill or otherintangible assets recognized in our financial statements in the current orprior fiscal years.

 

Otherintangible assets with indefinite lives include trade names and certaindistribution rights. Other intangible assets subject to amortization includecustomer relationships, certain distribution rights and non-competitionagreements; and are amortized, on a straight-line basis, over periods of one totwelve years. For other intangible assets held at September 30, 2010,the weighted average amortization period is approximately seven years.Both other intangible assets with indefinite lives and other intangible assetssubject to amortization are reviewed for impairment at least annually, and wheneverevents or changes in circumstances indicate it is more likely than not thattheir fair values have declined below their carrying amounts.

 

*DeferredFinancing Costs*

 

Certainexpenses incurred in connection with the issuance of long-term debt were capitalizedand are being amortized over the life of the related debt agreements on astraight line-basis or by using the effective interest method. Thesecapitalized expenses are included in other assets in our consolidated balancesheets.

 

*Insurance/Self-InsurancePrograms*

 

TheCompany retains a substantial portion of the risk related to certain of itsworkers’ compensation, general and auto liability and property damage insurableloss exposure. Predetermined loss limits have been arranged with insurance companiesto limit the Company’s exposure per occurrence and aggregate cash outlay.Certain of our employees and their dependents are also covered by aself-insurance program for healthcare benefit purposes, up to a certain maximumlifetime limit at September 30, 2010. The Company intends to remove suchlifetime limit requirements during the fiscal year 2011 in accordance withfederal legislation recently enacted in the U.S. Currently these self-insurancecosts, less amounts recovered through payroll deductions and certainout-of-pocket amounts in connection with the employee healthcare program, arefunded by the Company. The Company maintains an annual stop-loss insurancepolicy for the healthcare benefits plan.

 

TheCompany records an estimated liability for the ultimate cost of claims incurredand unpaid as of the balance sheet date, which includes both claims filed andestimated losses incurred but not yet reported. The Company estimates theultimate cost based on an analysis of historical data and actuarial estimates.Workers’ compensation, general and auto liability and property damage insurableloss liabilities are recorded at the estimate of their net present value, whilehealthcare plan liabilities are not discounted. These estimates are reviewed ona regular basis to ensure that the recorded liability is adequate. The Companybelieves the amounts accrued at September 30, 2010 and 2009 are adequate,although actual losses may differ from the amounts provided.

 

*AdvertisingCosts*

 

Advertisingcosts relate mainly to print advertisements, digital marketing and trade shows.Advertising costs incurred in connection with print advertisements are expensedthe first time the advertisement is run. Other advertising costs are expensedwhen incurred.

 

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Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

Advertisingcosts of $64.6 million, $55.2 million and $50.6 million for the fiscal years2010, 2009 and 2008, respectively, are included in selling, general andadministrative expenses in our consolidated statements of earnings.

 

*VendorRebates and Concessions*

 

TheCompany deems a cash consideration received from a supplier to be a reductionof the cost of products sold unless it is in exchange for an asset or serviceor a reimbursement of a specific, incremental, identifiable cost incurred bythe Company in selling the vendor’s products. The majority of cashconsideration received by the Company is considered to be a reduction of thecost of the related products and is reflected in cost of products sold anddistribution expenses in our consolidated statements of earnings as the relatedproducts are sold. Any portion of such cash consideration received that isattributable to inventory on hand is reflected as a reduction of inventory.

 

*IncomeTaxes*

 

TheCompany recognizes deferred income taxes for the estimated future taxconsequences attributable to temporary differences between the financialstatement carrying amounts of existing assets and liabilities and theirrespective tax bases. Deferred tax assets and liabilities are measured usingenacted tax rates expected to apply to taxable income in the years in whichtemporary differences are estimated to be recovered or settled. The effect ondeferred taxes of a change in tax rates is recognized in the consolidatedstatements of earnings in the period of enactment. A valuation allowance isrecorded to reduce the carrying amounts of deferred tax assets to the amountexpected to be realized unless it is more-likely-than-not that such assets willbe realized in full.  The estimated taxbenefit of an uncertain tax position is recorded in our financial statements onlyafter determining a more-likely-than-not probability that the uncertain taxposition will withstand challenge, if any, from applicable taxing authorities.

 

*ForeignCurrency*

 

Thefunctional currency of each of the Company’s foreign operations is generallythe respective local currency. Balance sheet accounts are translated intoU.S. dollars (the Company’s reporting currency) at the rates of exchangein effect at the balance sheet date, while the results of operations aretranslated using the average exchange rates during the period presented. Theresulting translation adjustments are recorded as a component of accumulatedother comprehensive income in our consolidated balance sheets. Foreign currencytransaction gains or losses are included in our consolidated statements ofearnings when incurred and were not significant in any of the periods presentedin the accompanying financial statements.

 

*RevenueRecognition*

 

TheCompany recognizes sales revenue when a customer consummates a point-of-saletransaction in a store. The cost of sales incentive programs, such as customerand consumer coupons, are recognized as a reduction of revenue at the time ofsale. Taxes collected from customers and remitted to governmental authoritiesare recorded on a net basis and are excluded from revenue. The Company alsorecognizes revenue on merchandise shipped to customers when title and risk ofloss pass to the customer (generally upon shipment). Appropriate provisions forsales returns and cash discounts are made at the time the sales are recognized.Sales returns and allowances averaged approximately 2.2% of net sales duringeach of the past three fiscal years.

 

*Cost of Products Sold and Distribution Expenses*

 

Costof products sold and distribution expenses include actual product costs, thecost of transportation to the Company’s distribution centers, and certainshipping and handling costs, such as freight from the distribution centers tothe stores and handling costs incurred at the distribution centers. All othershipping and handling costs are included in selling, general and administrativeexpenses when incurred.

 

*Shippingand Handling*

 

Shippingand handling costs (including freight and distribution expenses) related todelivery to customers are included in selling, general and administrativeexpenses in our consolidated statements of earnings when incurred and amountedto $36.0 million, $30.3 million and $35.8 million for the fiscal years 2010,2009 and 2008, respectively.

 

*Share-BasedCompensation*

 

TheCompany measures the cost of employee services received in exchange for anaward of equity instruments based on the fair value at the date of grant of theaward, and recognizes compensation expense on a straight-line basis over thevesting period or to the date a participant becomes eligible for retirement, ifearlier.

 

Priorto November of 2006, the Company was a subsidiary of Alberto-Culver andhad no share-based compensation plans of its own, however, Alberto-Culver hadgranted to Company employees certain stock options, with a cash settlementprovision contingent upon the occurrence of certain change in control events,pursuant to its stock option plans. As such, the contingent cash settlement ofthese stock options as a result of such event would not be solely in thecontrol of the Company. Accordingly, the Company reported $0.9 million and$1.8 million in “Stock options subject to redemption” outside of member’sequity (deficit) on its consolidated balance

 

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Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

sheetsas of September 30, 2010 and 2009, respectively, and this amount will bereclassified back into additional paid-in capital in future periods as therelated stock options are exercised or canceled or otherwise terminated.

 

*Business Combinations*

 

TheCompany adopted the provisions of ASC Topic 805, *BusinessCombinations*(“ASC 805”), effective on October 1, 2009. ASC805, among other things, generally requires that an acquirer recognize theassets acquired and liabilities assumed measured at their “full fair values” onthe acquisition date. This practice replaced the practice, under predecessoraccounting standards, of allocating the cost of an acquisition to theindividual assets acquired and liabilities assumed based on their relativeestimated fair values.  ASC 805 furtherrequires that acquisition-related costs be recognized separately from therelated acquisition. Accordingly, selling, general and administrative expensesfor the fiscal year 2010 includes approximately $0.7 million of expensesrelated to acquisitions.

 

*Comprehensive Income*

 

Comprehensiveincome reflects changes in member’s equity (deficit) from sources other thanequity transactions with our parent and, as such, includes net earnings andcertain other specified components. The Company’s only components ofcomprehensive income, other than net earnings, are foreign currency translationadjustments and deferred gains (losses) on certain interest rate swapagreements, net of income tax.

 

*AccumulatedOther Comprehensive (Loss) Income*

 

Thecomponents of accumulated other comprehensive (loss) income at September 30,2010 and 2009, are as follows (in thousands):

 
| ** **                                                       | ** ** | **As of September 30,** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                       | ** ** | **2010**                               | ** ** | **2009** | ** ** |
| ** **                                                       | ** ** | **Amount  Before Tax**            | ** ** | **Deferred  Tax** | ** ** | **Net  Amount** | ** ** | **Amount  Before Tax** | ** ** | **Deferred  Tax** | ** ** | **Net  Amount** | ** ** |
| Cumulative foreign currency translation  adjustments             |       | $                                      | (10,772    | ) | — |   | $ | (10,772 | ) | $ | (6,495 | ) | — |   | $ | (6,495 | ) |
| Deferred  (losses) gains on interest rate swaps (a)              |       | (15,530                                | )          | 6,026 |   | (9,504 | ) | (15,365 | ) | 5,962 |   | (9,403 | ) |
| Total  accumulated other comprehensive (loss) income, net of tax |       | $                                      | (26,302    | ) | $ | 6,026 |   | $ | (20,276 | ) | $ | (21,860 | ) | $ | 5,962 |   | $ | (15,898 | ) |
|                                                                  |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(a)          Please see Note 13 for more information about theCompany’s interest rate swaps.

 

**3.   RecentAccounting Pronouncements and Accounting Changes**

 

**Recent AccountingPronouncements**

 

InDecember 2007, the FASB revised the accounting standards for businesscombinations. This new standard (currently contained in ASC 805), among otherthings, generally requires that an acquirer recognize the assets acquired andliabilities assumed measured at their “full fair values” on the acquisitiondate. This practice replaced the practice, under predecessor accountingstandards, of allocating the cost of an acquisition to the individual assetsacquired and liabilities assumed based on their relative estimated fair values.  This new standard further requires thatacquisition-related costs be recognized separately from the relatedacquisition. The Company adopted this standard effective October 1, 2009.Selling, general and administrative expenses for the fiscal year 2010 includesapproximately $0.7 million of expenses related to acquisitions.

 

InApril 2008, the FASB amended ASC Topic 350, *Intangiblesand Other* (“ASC 350”). This new accounting standard, currentlycontained in ASC 350-30-35, specifically amends the factors that should beconsidered in developing renewal or extension assumptions used to determine theuseful life of a recognized intangible asset. The objective of this amendmentis to improve the consistency between the useful life of a recognizedintangible asset and the period of expected cash flows used to measure the fairvalue of the asset. The Company adopted this standard during the first quarterof its fiscal year 2010 and its adoption did not have a material effect on theCompany’s consolidated financial position, results of operations or cash flows.

 

In April 2009, theFASB issued ASC Topic 805-20 *BusinessCombinations — Identifiable Assets and Liabilities and Any Non-controllingInterest*. This new accounting standard amended ASC 805 and appliesto assets acquired and liabilities assumed that arise from contingencies in abusiness combination. The Companyadopted this amendment during the first quarter of its fiscal year 2010 and itsadoption did not have a material effect on the Company’s consolidated financialposition, results of operations or cash flows.

 

InAugust 2009, the FASB issued Accounting Standards Update (“ASU”) No. 2009-05which amended ASC Topic 820, *Fair Value Measurementsand Disclosures* (“ASC 820”) as it relates to the measurement ofliabilities at fair value, effective for interim reporting periods beginningafter August 26, 2009. More specifically, this amendment providedclarification about the valuation of liabilities in which a quoted price in anactive market for an identical liability is not available. The Company adoptedthis amendment during the

 

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Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

firstquarter of its fiscal year 2010 and its adoption did not have a material effecton the Company’s consolidated financial position, results of operations or cashflows.

 

InJanuary 2010, the FASB issued ASU No. 2010-06 which amended ASC 820as it relates to certain disclosures of fair value measurements. This amendmentrequires, among other things, (a) disclosure of the sensitivity of anentity’s fair value measurements using Level 3 inputs to changes in suchinputs, (b) a reconciliation of changes in such fair value measurementsand (c) disclosure of transfers between fair value measurements usingLevel 1 and 2 inputs, if any. The Company adopted this amendment during thesecond quarter of its fiscal year 2010 and its adoption did not have a materialeffect on the Company’s consolidated financial position, results of operationsor cash flows.

 

TheCompany adopted the provisions of ASC Topic 855, *SubsequentEvents*(“ASC 855”), during the third quarter of its fiscal year2009. ASC 855 establishes standards of accounting for and disclosure oftransactions and events that occur after the balance sheet date but before thefinancial statements are issued and requires the disclosure, among otherthings, of the date through which an entity has evaluated subsequent events. InFebruary of 2010, the FASB issued ASU No. 2010-09 which amended ASC855. This amendment, which was effective upon issuance, removed the requirementfor SEC registrants to disclose the date through which such registrants haveevaluated subsequent events. Please see Note 20 for additional informationabout our subsequent events.

 

**Accounting Changes**

 

TheCompany made no other accounting changes during the fiscal year 2010.

 

**4.   Fair Value Measurements**

 

TheCompany measures on a recurring basis and discloses certain financialinstruments (including interest rate swap agreements, and foreign currencyoption and forward agreements) under the provisions of ASC 820, asamended.  The Company defines “fair value”as the price that would be received to sell an asset or paid to transfer aliability in an orderly transaction between market participants at themeasurement date. ASC 820 establishes a three-level hierarchy for measuringfair value and requires an entity to maximize the use of observable inputs andminimize the use of unobservable inputs when measuring fair value. Thisvaluation hierarchy is based upon the transparency of inputs to the valuationof an asset or liability on the measurement date.  The three levels of that hierarchy are definedas follows:

 

Level 1 - Unadjusted quoted pricesin active markets for identical assets or liabilities;

 

Level 2 - Unadjusted quoted pricesin active markets for similar assets or liabilities; or unadjusted quotedprices for identical or similar assets or liabilities in markets that are notactive; or inputs other than quoted prices that are observable for the asset orliability; or inputs that are derived principally from or corroborated byobservable market data; and

 

Level 3 - Unobservable inputs forthe asset or liability.

 

Consistentwith this hierarchy, the Company categorized certain of its financial assetsand liabilities as follows at September 30, 2010 (in thousands):

 
| ** **                     | ** ** | **As of September 30, 2010** | ** ** |
|--------------------------------|------------|--------------------------------------------------|------------|
| ** **                     | ** ** | **Total**                                        | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Assets                         |       |                                             |       |   |   |   |   |   |   |
| Foreign currency forwards (a)  |       | $                                                | 20         |   | — |   | $ | 20 |   | — |   |
| Foreign currency options (a)   |       | 99                                               |       | — |   | 99 |   | — |   |
| Total assets                   |       | $                                                | 119        |   |   |   | $ | 119 |   |   |   |
|                           |       |                                             |       |   |   |   |   |   |   |
| Liabilities                    |       |                                             |       |   |   |   |   |   |   |
| Long-term debt (b)             |       | $                                                | 1,596,228  |   | $ | 751,250 |   | $ | 844,978 |   | — |   |
| Hedged interest rate swaps (a) |       | 15,530                                           |       | — |   | 15,530 |   | — |   |
| Foreign currency forwards (a)  |       | 328                                              |       | — |   | 328 |   | — |   |
| Total liabilities              |       | $                                                | 1,612,086  |   | $ | 751,250 |   | $ | 860,836 |   |   |   |

 

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| (a) | Foreign  currency forwards and options and interest rate swaps are valued using  internal models based on market observable inputs, including market interest  rates and foreign currency exchange rates, as appropriate. Please see Note 13  for more information about the Company’s foreign currency forwards and  options and interest rate swaps. |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

(b)         Long-term debt, which iscarried at amortized cost in the Company’s consolidated financial statements,is valued for purposes of this disclosure using internal models based on marketobservable inputs, except for the senior and senior subordinated notes. Thesenior and senior subordinated notes are valued using quoted market prices forsuch debt securities.

 

Consistentwith this hierarchy, the Company categorized certain of its financial assetsand liabilities as follows at September 30, 2009 (in thousands):

 
| ** **                         | ** ** | **As of September 30, 2009** | ** ** |
|------------------------------------|------------|--------------------------------------------------|------------|
| ** **                         | ** ** | **Total**                                        | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Liabilities                        |       |                                             |       |   |   |   |   |   |   |
| Long-term debt (a)                 |       | $                                                | 1,655,076  |   | $ | 727,719 |   | $ | 927,357 |   | — |   |
| Hedged interest rate swaps (b)     |       | 15,365                                           |       | — |   | 15,365 |   | — |   |
| Non-hedged interest rate swaps (b) |       | 2,356                                            |       | — |   | 2,356 |   | — |   |
| Total liabilities                  |       | $                                                | 1,672,797  |   | $ | 727,719 |   | $ | 945,078 |   |   |   |

 

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| (a) | Long-term  debt, which is carried at amortized cost in the Company’s consolidated  financial statements, is valued for purposes of this disclosure using  internal models based on market observable inputs, except for the senior and  senior subordinated notes. The senior and senior subordinated notes are  valued using quoted market prices for such debt securities. |
|-----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (b) | Interest  rate swaps are valued using internal models based on market observable  inputs, including market interest rates. Please see Note 13 for more  information about the Company’s interest rate swaps.                                                                                                                                                                 |

 

**5.  Member’s Equity (Deficit)**

 

SinceNovember of 2006, all member units of the Company have been owned by SallyInvestment.

 

AtSeptember 30, 2007, the Company had a member’s deficit as a result ofdistributions to Sally Beauty and, prior to November of 2006, Alberto-Culver.  In connection with our separation fromAlberto-Culver, the Company received the proceeds from the issuance of the debtand contributed cash of approximately $1,809.7 million to Sally Beauty andSally Beauty paid a special cash dividend to Alberto-Culver, in connection withthe Separation Transactions.

 

Priorto November of 2006, the additional paid-in capital and the retainedearnings were part of the stockholder’s equity of Sally Holdings, Inc. andits subsidiaries. In November of 2006, Sally Holdings, Inc.contributed its stockholder’s equity to Sally Holdings LLC thereby convertingstockholder’s equity into member’s equity, in connection with the SeparationTransactions.

 

**6.  Share-Based Payments**

 

SinceNovember 16, 2006, the Company has been an indirect wholly-ownedsubsidiary of Sally Beauty and has no share based plans of its own; however,certain employees and consultants of the Company have been granted stock optionsand share awards under the plans of Sally Beauty.

 

InJanuary of 2010, Sally Beauty adopted the Sally Beauty Holdings, Inc.2010 Omnibus Incentive Plan (the “2010 Plan”), a share-based compensation planwhich allows for the issuance of up to 29.8 million shares of Sally Beauty’scommon stock. During the fiscal years 2010, 2009 and 2008, Sally Beauty grantedto the Company’s employees and consultants approximately 2.9 million, 2.7million and 2.8 million stock options and approximately 118,000, 123,000 and136,000 restricted share awards, respectively, under the 2010 Plan, the SallyBeauty Holdings, Inc. 2007 Omnibus Incentive Plan (the “2007 Plan”) or theAlberto-Culver Company Employee Stock Option Plan of 2003. After the adoptionof the 2010 Plan, Sally Beauty’s equity awards have been made under the 2010Plan and all future awards are currently expected to be made under such plan.

 

TheCompany measures the cost of services received from employees and consultantsin exchange for an award of equity instruments based on the fair value of theaward on the date of grant, and recognizes compensation expense on astraight-line basis over the vesting period or up to the date a participantbecomes eligible for retirement, if earlier. For the fiscal years 2010, 2009and 2008, total compensation cost charged against income and included inselling, general and administrative expenses in the Company’s consolidatedstatements of earnings for all share-based compensation arrangements was $12.2million, $8.0 million and $9.6 million, respectively, and resulted in anincrease in due to Sally Beauty by the same amounts. These amounts included,for the fiscal years 2010, 2009 and 2008, $2.5 million, $2.0 million and $3.1 million, respectively, of accelerated expenserelated to certain retirement eligible employees who continue vestingawards upon retirement, under the provisions of the 2010 Plan and certainpredecessor share-based plans such as the 2007 Plan. For fiscal years 2010,2009 and 2008, the total income tax benefit recognized in our consolidatedstatements of earnings from these plans was $4.0 million, $1.9 million and $2.3million, respectively.

 

Priorto the Separation Transactions, we were a wholly-owned subsidiary ofAlberto-Culver and had no share-based compensation plans of our own; however,certain of our employees had been granted stock options and restricted stockawards under share-based compensation plans of Alberto-Culver. Upon completionof the Separation Transactions, all outstanding Alberto-Culver stock optionsheld by our employees became options to purchase shares of Sally Beauty’scommon stock.

 

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Table ofContents

 

Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

**Stock Options**

 

Eachoption has an exercise price that equals 100% of the market price of SallyBeauty’s common stock on the date of grant and generally has a maximum term of10 years. Options generally vest ratably over a four-year period and aregenerally subject to forfeiture until the vesting period is complete, subjectto certain retirement provisions contained in the 2010 Plan and certainpredecessor share-based compensation plans such as the 2007 Plan.

 

Thefollowing table presents a summary of the activity for the Sally Beauty’s stockoption plans for the fiscal year ended September 30, 2010:

 
| ** **                             | ** ** | **Number of  Outstanding  Options (in  Thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term (in  Years)** | ** ** | **Aggregate  Intrinsic  Value (in  Thousands)** | ** ** |
|----------------------------------------|------------|---------------------------------------------------------------|------------|----------------------------------------|------------|----------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| Outstanding at September 30, 2009 |       | 10,025                                                        |       | $                                      | 7.40       |                                                                 | 7.7        |                                                 | $          | 10,678 |   |
| Granted                                |       | 2,917                                                         |       | 7.46                                   |       |                                                                 |       |                                                 |       |
| Exercised                              |       | (284                                                          | )          | 3.09                                   |       |                                                                 |       |                                                 |       |
| Forfeited or expired                   |       | (54                                                           | )          | 8.55                                   |       |                                                                 |       |                                                 |       |
| Outstanding at September 30, 2010 |       | 12,604                                                        |       | $                                      | 7.51       |                                                                 | 7.3        |                                                 | $          | 46,562 |   |
|                                   |       |                                                          |       |                                   |       |                                                                 |       |                                                 |       |
| Exercisable at September 30, 2010 |       | 6,185                                                         |       | $                                      | 7.86       |                                                                 | 6.3        |                                                 | $          | 20,669 |   |

 

Thefollowing table summarizes information about stock options under Sally Beauty’soption plans at September 30, 2010:

 
| ** **                                  | ** ** | **Options Outstanding**                                                   | ** ** | **Options Exercisable**                                         | ** ** |
|---------------------------------------------|------------|--------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | **Number  Outstanding at  September 30,  2010 (in  Thousands)** | ** ** | **Weighted  Average  Remaining  Contractual  Term (in  Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable at  September 30,  2010 (in  Thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $2.00                                       |       | 922                                                                            |       | 3.8                                                                  |       | $ | 2.00 |   | 922 |   | $ | 2.00 |   |
| $5.24 – 9.66                           |       | 11,682                                                                         |       | 7.6                                                                  |       | 7.94 |   | 5,263 |   | 8.88 |   |
| Total                                       |       | 12,604                                                                         |       | 7.3                                                                  |       | $ | 7.51 |   | 6,185 |   | $ | 7.86 |   |

 

TheCompany uses the Black-Scholes option pricing model to value Sally Beauty’sstock options for each stock option award. Using this option pricing model, thefair value of each stock option award is estimated on the date of grant. Thefair value of Sally Beauty’s stock option awards is expensed on a straight-linebasis over the vesting period (generally four years) of the stock options or tothe date a participant becomes eligible for retirement, if earlier.

 

Theweighted average assumptions relating to the valuation of Sally Beauty’s stockoptions are as follows:

 
| ** **                | ** ** | **Year Ended September 30,** | ** ** |
|---------------------------|------------|---------------------------------------------|------------|
| ** **                | ** ** | **2010**                                    | ** ** | **2009** | ** ** | **2008** | ** ** |
| Expected lives (in years) |       | 5.0                                         |       | 5.0 |   | 5.0 |   |
| Expected volatility       |       | 64.4                                        | %          | 47.9 | % | 37.5%-41.3% |   |
| Risk-free interest rate   |       | 2.4                                         | %          | 2.6 | % | 3.5%-4.0% |   |
| Dividend yield            |       | 0.0                                         | %          | 0.0 | % | 0.0% |   |

 

Theexpected life of options represents the period of time that the options grantedare expected to be outstanding and is based on historical experience ofemployees of the Company who have been granted stock options, including grantsunder stock option plans of Alberto-Culver prior to the SeparationTransactions. Expected volatility is derived using the average volatility ofboth Sally Beauty and similar companies (based on industry sector) since it isnot practicable to estimate Sally Beauty’s expected volatility on a stand-alonebasis due to a lack of sufficient trading history. The risk-free interest rateis based on the zero-coupon U.S. Treasury issue as of the date of the grant.Since Sally Beauty does not currently expect to pay dividends, the dividendyield is 0%.

 

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Table ofContents

 

Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

Theweighted average fair value per option at the date of grant, of the stockoptions issued to the Company’s grantees during the fiscal years 2010, 2009 and2008 was $4.15, $2.33 and $3.73, respectively. The total fair value of stockoptions issued to the Company’s grantees that vested during the fiscal years2010, 2009 and 2008 was $7.5 million, $6.2 million and $4.7 million,respectively.

 

Thetotal intrinsic value of options exercised during the fiscal years 2010, 2009and 2008 was $1.8 million, $1.0 million and $3.3 million, and the tax benefitrealized for the tax deductions from these option exercises was $0.5 million,$0.4 million and $1.3 million, respectively. The total cash received during thefiscal years 2010, 2009 and 2008 from these option exercises was $0.9 million,$0.7 million and $1.1 million, respectively.

 

AtSeptember 30, 2010, approximately $9.4 million of total unrecognizedcompensation costs related to unvested stock option awards are expected to berecognized over the weighted average period of 2.2 years.

 

**StockAwards**

 

***Restricted StockAwards***

 

Asa subsidiary of Sally Beauty, the Company has no employee stock award plans;however, certain employees and consultants of the Company from time to timehave been granted restricted stock awards under the 2010 Plan and predecessorplans, such as the 2007 Plan. A restricted stock award is an award of shares ofSally Beauty’s common stock (which have full voting and dividend rights but arerestricted with regard to sale or transfer) the restrictions over which lapseratably over a specified period of time (generally five years). Restrictedstock awards are independent of stock option grants and are generally subjectto forfeiture if employment terminates prior to these restrictions lapsing,subject to certain retirement provisions of the 2010 Plan and certainpredecessor share-based compensation plans such as the 2007 Plan.

 

TheCompany expenses the cost of the restricted stock awards, which is determinedto equal the fair value of the restricted stock award at the date of grant, ona straight-line basis over the period (the “vesting period”) in which therestrictions on these stock awards lapse (“vesting”) or to the date aparticipant becomes eligible for retirement, if earlier. For these purposes,the fair value of the restricted stock award is determined based on the closingprice of the Sally Beauty’s common stock on the date of grant.

 

Thefollowing table presents a summary of the activity for Sally Beauty’srestricted stock awards for the fiscal year ended September 30, 2010:

 
| **Restricted Stock Awards**              | ** ** | **Number of  Shares (in  Thousands)** | ** ** | **Weighted  Average Fair  Value Per Share** | ** ** | **Weighted  Average  Remaining  Vesting Term (in  Years)** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| Unvested at September 30, 2009 |       | 331                                             |       | $                                                          | 7.45       |                                                                 | 3.3        | ** ** |
| Granted                                            |       | 118                                             |       | 7.42                                                       |       |                                                                 |       |
| Vested                                             |       | (87                                             | )          | 7.69                                                       |       |                                                                 |       |
| Forfeited or expired                               |       | —                                          |       | —                                                     |       |                                                                 |       |
| Unvested at September 30, 2010                |       | 362                                             |       | $                                                          | 7.38       |                                                                 | 3.2        |   |

 

AtSeptember 30, 2010, approximately $2.0 million of unrecognizedcompensation expenses related to unvested restricted stock awards and areexpected to be recognized over the weighted average period of 3.2 years.

 

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Table of Contents

 

Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

**7.   Allowancefor Doubtful Accounts**

 

Thechange in the allowance for doubtful accounts was as follows (in thousands):

 
| ** **                                             | ** ** | **Year Ended September 30,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                             | ** ** | **2010**                                    | ** ** | **2009** | ** ** | **2008** | ** ** |
| Balance  at beginning of period                        |       | $                                           | 2,266      |   | $ | 2,702 |   | $ | 2,564 |   |
| Bad  debt expense                                      |       | 1,578                                       |       | 1,859 |   | 2,353 |   |
| Uncollected  accounts written off, net of recoveries   |       | (1,431                                      | )          | (2,648 | ) | (2,218 | ) |
| Allowance  for doubtful accounts of acquired companies |       | 343                                         |       | 353 |   | 3 |   |
| Balance  at end of period                              |       | $                                           | 2,756      |   | $ | 2,266 |   | $ | 2,702 |   |

 

**8.  Property and Equipment, Net**

 

Propertyand equipment, net consists of the following (in thousands):

 
| ** **                                      | ** ** | **September 30,** | ** ** |
|-------------------------------------------------|------------|------------------------|------------|
| ** **                                      | ** ** | **2010**               | ** ** | **2009** | ** ** |
| Land                                            |       | $                      | 11,124     |   | $ | 9,672 |   |
| Buildings  and building improvements            |       | 58,594                 |       | 49,608 |   |
| Leasehold  improvements                         |       | 155,476                |       | 139,642 |   |
| Furniture,  fixtures and equipment              |       | 234,108                |       | 217,656 |   |
| Total  property and equipment, gross            |       | 459,302                |       | 416,578 |   |
| Less  accumulated depreciation and amortization |       | (291,185               | )          | (265,329 | ) |
| Total  property and equipment, net              |       | $                      | 168,117    |   | $ | 151,249 |   |

 

Depreciation expense for thefiscal years 2010, 2009 and 2008 was $42.4 million, $40.9 million and $42.2million, respectively. As further described in Note 12, the term loanfacilities and the ABL facility are secured by substantially all of our assets,those of Sally Investment Holdings LLC, a wholly-owned subsidiary of SallyBeauty and the direct parent of Sally Holdings, those of our domesticsubsidiaries and, in the case of the ABL facility, those of our Canadiansubsidiaries.

 

**9.   Goodwill andOther Intangible Assets**

 

Thechanges in the carrying amounts of goodwill by operating segment for the fiscalyears 2009 and 2010 are as follows (in thousands):

 
| ** **                                    | ** ** | **Sally Beauty********Supply** | ** ** | **Beauty Systems********Group** | ** ** | **Total** | ** ** |
|-----------------------------------------------|------------|-------------------------------------|------------|--------------------------------------|------------|-----------|------------|
| Balance  at September 30, 2008           |       | $                                   | 65,188     |                                 | $          | 359,775   |       | $ | 424,963 |   |
| Additions,  net of purchase price adjustments |       | 10,264                              |       | 62,388                               |       | 72,652    |       |
| Foreign  currency translation                 |       | (2,244                              | )          | (1,236                               | )          | (3,480    | )          |
| Balance  at September 30, 2009           |       | 73,208                              |       | 420,927                              |       | 494,135   |       |
| Additions,  net of purchase price adjustments |       | 8,092                               |       | 2,568                                |       | 10,660    |       |
| Reclassifications                             |       | (2,780                              | )          | (22,920                              | )          | (25,700   | )          |
| Foreign  currency translation                 |       | (2,221                              | )          | 1,366                                |       | (855      | )          |
| Balance  at September 30, 2010           |       | $                                   | 76,299     |                                 | $          | 401,941   |       | $ | 478,240 |   |

 

Asdescribed in Note 16, during the fiscal year 2009, $61.0 million of theincrease in BSG’s goodwill was attributable to the acquisition of SchoenemanBeauty Supply, Inc. (“Schoeneman”) on September 30, 2009. Theremaining increase in BSG’s goodwill in the amount of $1.4 million and the$10.3 million increase in Sally Beauty Supply’s goodwill during the fiscal year2009 were attributable to acquisitions, which were not individually material,and to net purchase price adjustments. The purchase prices of certainacquisitions completed during the fiscal year 2009 were allocated to assetsacquired and liabilities assumed based on their preliminary estimated fairvalues at the date of acquisition. The final valuations of such assets andliabilities were completed during the fiscal year 2010.

 

Asdescribed in Note 16, during the fiscal year 2010, $5.2 million of theincrease in Sally Beauty Supply’s goodwill was attributable to the acquisitionof Sinelco on December 16, 2010. The remaining increase in Sally BeautySupply’s goodwill in the amount of $2.9 million and the $2.6 million increasein BSG’s goodwill during the fiscal year 2010 were attributable to acquisitionswhich were not individually material and to net purchase price adjustments.During the fiscal year 2010, intangible assets subject to amortization in theamount of $24.9 million were also recorded in connection with certain 2009acquisitions, including the acquisition of 

 

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Table ofContents

 

Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

Schoeneman,and intangible assets with indefinite lives in the amount of $0.8 million wererecorded in connection with such 2009 acquisitions. These amounts werepreviously reported in Goodwill pending completion of the final valuations ofthe assets acquired and liabilities assumed, as discussed in the precedingparagraph.

 

Thefollowing table provides the carrying value for intangible assets withindefinite lives and the gross carrying value and accumulated amortization forintangible assets subject to amortization (which we refer to, in the aggregate,as “other intangible assets”) by operating segment at September 30, 2010and 2009 (in thousands):

 
| ** **                                  | ** ** | **Sally Beauty********Supply** | ** **   | **Beauty Systems********Group** | ** ** | **Total**    | ** ** |
|---------------------------------------------|------------|-------------------------------------|--------------|--------------------------------------|------------|--------------|------------|
| Balance  at September 30, 2010:        |       |                                |         |                                 |       |         |       |
| Intangible  assets with indefinite lives:   |       |                                |         |                                 |       |         |       |
| Trade  names                                |       | $                                   |  28,046 |                                 | $          |  33,752 |       | $ |  61,798 |   |
| Other  intangibles                          |       | —                              |         | 5,700                                |       | 5,700        |       |
| Total                                       |       | 28,046                              |         | 39,452                               |       | 67,498       |       |
| Intangible  assets subject to amortization: |       |                                |         |                                 |       |         |       |
| Gross  carrying amount                      |       | 14,399                              |         | 60,486                               |       | 74,885       |       |
| Accumulated  amortization                   |       | (4,301                              | )            | (28,730                              | )          | (33,031      | )          |
| Net  value                                  |       | 10,098                              |         | 31,756                               |       | 41,854       |       |
| Total  intangible assets, net               |       | $                                   |  38,144 |                                 | $          |  71,208 |       | $ |  109,352 |   |
|                                        |       |                                |         |                                 |       |         |       |
| Balance  at September 30, 2009:        |       |                                |         |                                 |       |         |       |
| Intangible  assets with indefinite lives:   |       |                                |         |                                 |       |         |       |
| Trade  names                                |       | $                                   |  20,183 |                                 | $          |  33,815 |       | $ |  53,998 |   |
| Other  intangibles                          |       | —                              |         | 5,700                                |       | 5,700        |       |
| Total                                       |       | 20,183                              |         | 39,515                               |       | 59,698       |       |
| Intangible  assets subject to amortization: |       |                                |         |                                 |       |         |       |
| Gross  carrying amount                      |       | 6,933                               |         | 36,411                               |       | 43,344       |       |
| Accumulated  amortization                   |       | (2,299                              | )            | (22,058                              | )          | (24,357      | )          |
| Net  value                                  |       | 4,634                               |         | 14,353                               |       | 18,987       |       |
| Total  intangible assets, net               |       | $                                   |  24,817 |                                 | $          |  53,868 |       | $ |  78,685 |   |

 

Amortizationexpense totaled $8.7 million, $6.2 million and $6.3 million for the fiscalyears 2010, 2009 and 2008, respectively. As of September 30, 2010, futureamortization expense related to intangible assets subject to amortization isestimated to be as follows (in thousands):

 
| **Fiscal Year:** | ** ** | ** ** | ** ** |
|-----------------------|------------|------------|------------|
| 2011                  |       | $          | 8,052      |   |
| 2012                  |       | 6,583      |       |
| 2013                  |       | 4,819      |       |
| 2014                  |       | 4,501      |       |
| 2015                  |       | 4,067      |       |
| Thereafter            |       | 13,832     |       |
|                  |       | $          | 41,854     |   |

 

Theweighted average amortization period for intangible assets subject toamortization is approximately 7 years.

 

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Table of Contents

 

Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

**10.   Accrued Liabilities**

 

Accruedliabilities consist of the following (in thousands):

 
| ** **                    | ** ** | **September 30,** | ** ** |
|-------------------------------|------------|------------------------|------------|
| ** **                    | ** ** | **2010**               | ** ** | **2009** | ** ** |
| Compensation  and benefits    |       | $                      | 74,446     |   | $ | 60,811 |   |
| Interest  payable             |       | 26,518                 |       | 28,612 |   |
| Deferred  revenue             |       | 13,099                 |       | 12,392 |   |
| Rental  obligations           |       | 11,531                 |       | 10,708 |   |
| Property  and other taxes     |       | 4,480                  |       | 4,355 |   |
| Insurance  reserves           |       | 8,428                  |       | 6,805 |   |
| Acquisition  related payables |       | 1,077                  |       | 1,950 |   |
| Operating  accruals and other |       | 27,680                 |       | 28,209 |   |
| Total  accrued liabilities    |       | $                      | 167,259    |   | $ | 153,842 |   |

 

**11.   LeaseCommitments and Contingencies**

 

**Lease Commitments**

 

TheCompany’s principal leases relate to retail stores and warehousing properties.At September 30, 2010, future minimum payments under non-cancelableoperating leases, net of sublease income, are as follows (in thousands):

 
| **Fiscal Year:** | ** ** | ** ** | ** ** |
|-----------------------|------------|------------|------------|
| 2011                  |       | $          | 135,142    |   |
| 2012                  |       | 113,168    |       |
| 2013                  |       | 87,223     |       |
| 2014                  |       | 57,900     |       |
| 2015                  |       | 33,555     |       |
| Thereafter            |       | 49,158     |       |
|                  |       | $          | 476,146    |   |

 

Certainof the Company’s leases require the Company to pay a portion of real estatetaxes, insurance, maintenance and special assessments assessed by the lessor.Also, certain of the Company’s leases include renewal options and escalationclauses.

 

Totalrental expense for operating leases amounted to $178.5 million, $166.3 millionand $163.7 million for the fiscal years 2010, 2009 and 2008, respectively, andis included in selling, general and administrative expenses in our consolidatedstatements of earnings. These amounts include $0.5 million, $0.4 million and$0.8 million for contingent rents for the fiscal years 2010, 2009 and 2008,respectively.

 

**Contingencies**

 

***Legal Proceedings***

 

Therewere no material legal proceedings pending against the Company or itssubsidiaries, as of September 30, 2010. The Company is involved in variousclaims and lawsuits incidental to the conduct of its business in the ordinarycourse. The Company does not believe that the ultimate resolution of thesematters will have a material adverse impact on its consolidated financialposition, statements of earnings or cash flows.

 

On February 25, 2008, Sally Beauty disclosed ina Current Report on Form 8-K that on February 21, 2008, L’Oreal fileda lawsuit in the Superior Court of the State of California in and for theCounty of San Diego — Central Division naming, among others, SD Hair, Ltd.and Hair of Nevada, LLC (collectively, “SD Hair”), franchisees of oursubsidiary Armstrong McCall division (“AMLP”) of our BSG business unit, asdefendants.  The suit alleged, among other things, that SD Hair breachedits franchise agreement with AMLP by diverting (selling) Matrix brandedproducts to unauthorized buyers, and that L’Oreal is entitled to make claimsagainst SD Hair under the franchise agreement as a third-party beneficiary ofthat agreement.  On March 24, 2008, SD Hair filed a cross-complaintin the same case naming AMLP and BSG as cross-defendants, seeking, among otherthings, i) declaratory relief from BSG and AMLP in the form of a judicialfinding that SD Hair isnot in breach of its franchise agreement and that L’Oreal has no rights as athird-party beneficiary to SD Hair’s franchise agreement, and ii) injunctiverelief in the form of a judicial order compelling AMLP and BSG to takeappropriate legal action against L’Oreal to enforce SD Hair’s claimed rightsunder AMLP’s Matrix distribution agreement.  We have answered thecross-complaint.

 

OnJuly 30, 2009, Sally Beauty disclosed in a Current Report on Form 8-Kthat L’Oreal filed a Second Amended Complaint in connection with the previouslydisclosed lawsuit described above.  TheSecond Amended Complaint alleges, among other things, that

 

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Table ofContents

 

Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

AMLP, certain ofits employees and others were involved in selling Matrix branded productsto unauthorized buyers and that certain of its employees (and others) engagedin improper business transactions for personal benefit during 2005 through2007.  L’Oreal seeks money damages,certain injunctive relief and a declaration that L’Oreal is entitled toterminate the 1981 Matrix Distributor Agreement now in effect between L’Orealand AMLP.  None of the employees involvedin the allegations are executive officers of the Company.  Substantially all of these allegations weremade known by L’Oreal to the Company prior to the filing of the SecondAmended Complaint.  L’Oreal also providedthe Company with documents allegedly supporting the allegations.

 

Asa result of these allegations made by L’Oreal, many of which areincorporated into the Second Amended Complaint, the Audit Committee of theBoard of Directors of Sally Beauty engaged independent special counsel toinvestigate whether certain employees engaged in improper business transactionsfor personal benefit.  After extensivereview, the Audit Committee and independent special counsel found insufficientevidence to support a conclusion that Sally Beauty or Company employees enteredinto improper transactions for personal benefit.

 

OnSeptember 8, 2009, AMLP and BSG filed a cross-complaint against L’Oreal. In the cross-complaint, AMLP and BSG allege that L’Oreal does not have agenuine interest in stopping diversion, and that L’Oreal’s anti-diversionpolicies have been discriminatorily applied to AMLP and BSG.  AMLPfurther alleges that L’Oreal is using diversion as a pretext to attempt toterminate the 1981 Matrix Distributor Agreement. L’Oreal has answered thecross-complaint and the matter is currently set for jury trial on February 18,2011.

 

***Other Contingencies***

 

TheCompany provides healthcare benefits to most of its full-time employees. TheCompany is largely self-funded for the cost of the healthcare plan (includinghealthcare claims), other than certain fees and out-of-pocket amounts paid bythe employees. In addition, the Company retains a substantial portion of therisk related to certain workers’ compensation, general liability, andautomobile and property insurance. The Company records an estimated liabilityfor the ultimate cost of claims incurred and unpaid as of the balance sheet date.The estimated liability is included in accrued liabilities (current portion)and other liabilities (long-term portion) in our consolidated balance sheets.The Company carries insurance coverage in such amounts in excess of itsself-insured retention which management believes to be reasonable.

 

Liabilitiesfor loss contingencies, arising from claims, assessments, litigation, fines,penalties and other sources are recorded when it is probable that a liabilityhas been incurred and the amount of the assessment can be reasonably estimated.The Company has no significant liabilities for loss contingencies atSeptember 30, 2010 and 2009.

 

**12.  Long-Term Debt**

 

Detailsof long-term debt are as follows (in thousands):

 
| ** **                   | ** ** | **September 30,  2010** | ** ** | **Maturity dates** | ** ** | **Interest Rates**                      | ** **                          |
|------------------------------|------------|------------------------------|------------|-------------------------|------------|----------------------------------------------|-------------------------------------|
| ABL facility                 |       | $                            | —     |                    | Nov. 2011  |                                         | (i)  Prime and up to 0.50% or; |   |
|                         |       |                         |       |                    |       | (ii)  LIBOR(a) plus (1.00% to 1.50%)    |                                |
|                         |       |                         |       |                    |       |                                         |                                |
| Term Loan B                  |       | 843,856                      |       | Nov. 2013               |       | (i)  Prime plus (1.25% to 1.50%) or;    |                                |
|                         |       |                         |       |                    |       | (ii)  LIBOR(a) plus (2.25% to 2.50%)(b) |                                |
| Other (c)                    |       | 6,675                        |       | 2011-2014               |       | 4.05% to 6.75%                               |                                |
| Total                        |       | $                            | 850,531    |                    |       |                                         |                                |   |
|                         |       |                         |       |                    |       |                                         |                                |   |
| Senior notes                 |       | $                            | 430,000    |                    | Nov. 2014  |                                         | 9.25%                               |   |   |
| Senior subordinated notes    |       | 275,000                      |       | Nov. 2016               |       | 10.50%                                       |                                |   |
| Total                        |       | $                            | 705,000    |                    |       |                                         |                                |   |   |
|                         |       |                         |       |                    |       |                                         |                                |
| Capitalized leases and other |       | $                            | 7,105      |                    |       |                                         |                                |   |
| Less: current portion        |       | (3,045                       | )          |                    |       |                                         |                                |
| Total long-term debt         |       | $                            | 1,559,591  |                    |       |                                         |                                |   |

 

----

(a)          London Interbank OfferedRate (“LIBOR”).

(b)         At September 30, 2010,the interest rate for the Term Loan B was 2.51%.

(c)          Represents pre-acquisitiondebt of Pro-Duo NV (“Pro-Duo”) and Sinelco.

 

Inconnection with the Separation Transactions in November of 2006, theCompany and certain of its subsidiaries incurred $1,850.0 million ofindebtedness by (i) drawing on a $400.0 million revolving, asset-basedlending (“ABL”) facility in the amount of $70.0 million, (ii) enteringinto two senior term loan facilities (term loans A and B) in an aggregateamount of $1,070.0 million, and (iii) together (jointly and severally)with another of the Company’s indirect subsidiaries, Sally Capital Inc.,issuing senior notes in an 

 

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Table ofContents

 

Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

aggregateamount of $430.0 million and senior subordinated notes in an aggregate amountof $280.0 million. The Company incurred approximately $58.5 million in costsrelated to the issuance of the debt, which were capitalized and are beingamortized to interest expense over the life of the related debt obligations.Proceeds from the initial debt were used primarily to pay the $1,809.7 milliondistribution to Sally Beauty and for certain expenses associated with theSeparation Transactions.

 

TheABL facility provides for senior secured revolving loans up to a maximumaggregate principal amount of $400.0 million, subject to borrowing baselimitations. The availability of funds under the ABL facility is subject to aborrowing base calculation, which is based on specified percentages of thevalue of eligible inventory and eligible accounts receivables, subject tocertain reserves and other adjustments and reduced by certain outstandingletters of credit. At September 30, 2010, the Company had $341.8 millionavailable for borrowing under the ABL facility. Additionally, the Company isrequired to pay a commitment fee ranging from 0.20% to 0.35% on the unusedportion of the ABL facility. At September 30, 2010, the commitment feerate was 0.20%. In November 2010, Sally Holdings entered into a newagreement with lenders to replace its ABL facility with a new $400 million,5-year credit facility (the “new ABL facility”). Please see Note 20 foradditional information about the new ABL facility.

 

TheABL facility contains a covenant requiring us and our subsidiaries to maintaina fixed-charge coverage ratio of at least 1.0 to 1.0 when availability underthe ABL facility falls below $40.0 million. The fixed-charge coverage ratio isdefined as the ratio of EBITDA (as defined in the agreement underlying the ABLfacility, or Credit Agreement EBITDA) less unfinanced capital expenditures tofixed charges (as included in the definition of the fixed-charge coverage ratioin the agreement governing the ABL facility).

 

Thesenior term loan facilities consisted of (i) a $150.0 million senior termloan A facility and (ii) a $920.0 million senior term loan B facility.Principal and interest is payable on a quarterly basis. During the fiscal yearended September 30, 2010, the Company prepaid in full its borrowings underthe Term Loan A facility.

 

Thesenior term loan facilities contain a covenant requiring the Company and itssubsidiaries to meet certain maximum consolidated secured leverage ratiolevels, which decline over time. The consolidated secured leverage ratio is aratio of (A) net consolidated secured debt to (B) Consolidated EBITDAas defined in the agreement underlying the senior term loan facilities.Compliance with the consolidated secured leverage ratio is tested quarterly,with a maximum ratio of 4.00 as of September 30, 2010. Failure to complywith the consolidated secured leverage ratio covenant under the senior termloan facilities would result in a default under such facilities.

 

Thesenior term loan facilities and the ABL facility are secured by substantiallyall of our assets, those of Sally Investment, those of our domesticsubsidiaries and, in the case of the ABL facility, those of our Canadiansubsidiaries. Borrowings under the senior term loan facilities may be prepaidat the option of Sally Holdings at any time without premium or penalty and aresubject to mandatory prepayment in an amount equal to 50% of excess cash flow(as defined in the agreement governing the senior term loan facilities) for anyfiscal year unless a specified leverage ratio is met. In January 2010, theCompany made a mandatory prepayment on the senior term loan facilities in theamount of $22.3 million. Amounts paid pursuant to said provision may beapplied, at the option of the Company, against minimum loan repaymentsotherwise required of it over the twelve-month period following any suchpayment under the terms of the loan agreements. During the fiscal year ended September 30,2010, the Company also made optional prepayments in the aggregate amount of$102.7 million on its senior term loans. This amount together with themandatory prepayment discussed above, resulted in the prepayment in full ofborrowings under the Term Loan A facility. In connection with the mandatoryprepayment and the optional prepayments made during the fiscal year 2010, theCompany recorded losses on extinguishment of debt in the aggregate amount of$1.0 million, which are included in interest expense in the Company’sconsolidated statements of earnings. Additionally, borrowings under the seniorterm loan facilities would be subject to mandatory repayment in an amount equalto 100% of the proceeds of specified asset sales that are not reinvested in thebusiness or applied to repay borrowings under the ABL facility. We believe thatthe Company is currently in compliance with the agreements and instrumentsgoverning our debt, including our financial covenants.

 

The senior notes and senior subordinated notes areunsecured obligations of the issuers and are jointly and severally guaranteedon a senior basis (in the case of the senior notes) and on a seniorsubordinated basis (in the case of the senior subordinated notes) by eachmaterial domestic subsidiary of the Company (other than Sally Capital). Thesenior notes and the senior subordinated notes carry optional redemptionfeatures whereby the Company has the option to redeem the notes before November 15,2010 and November 15, 2011, respectively, at par plus a premium, plusaccrued and unpaid interest, and on or after November 15, 2010 and November 15,2011, respectively, at par plus a premium declining ratably to par, plusaccrued and unpaid interest. Interest on the senior notes and seniorsubordinated notes is payable semi-annually. Furthermore, the agreementsunderlying the Company’s credit facilities contain terms which significantlyrestrict the ability of us and our subsidiaries to pay dividends or otherwisetransfer assets to Sally Beauty.

 

Inthe fiscal year 2008, the Company entered into two interest rate swap agreementswith an aggregate notional amount of $300.0 million. The Company uses interestrate swaps, as part of its overall economic risk management strategy, to addstability to the interest payments due in connection with its term loanobligations. Interest payments related to our term loans are impacted bychanges in LIBOR. Please see Note 13 for additional information about theCompany’s interest rate swap agreements.

 

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Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

Maturitiesof the Company’s long-term debt are as follows at September 30, 2010 (inthousands):

 
| **Fiscal Year:**     | ** ** | ** ** | ** **      |
|---------------------------|------------|------------|-----------------|
| 2011                      |       | $          |  2,685     |   |
| 2012                      |       | 10,278     |            |
| 2013                      |       | 10,145     |            |
| 2014                      |       | 827,326    |            |
| 2015                      |       | 430,097    |            |
| Thereafter                |       | 275,000    |            |
|                      |       | $          |  1,555,531 |   |
| Capital  leases and other |       | 7,105      |            |
| Less:  current portion    |       | (3,045     | )               |
| Total                     |       | $          |  1,559,591 |   |

 

Weare a holding company and do not have any material assets or operations otherthan ownership of equity interests of our subsidiaries.  The agreements and instruments governing thedebt of the Company and its subsidiaries contain material limitations on ourability to pay dividends and other restricted payments to Sally Beauty.

 

Underthe agreements and indentures governing the term loan facilities and the notes,we may not make certain restricted payments to Sally Beauty if a default thenexists under the credit agreement or the indentures or if our consolidatedinterest coverage ratio is less than 2.0 to 1.0 at the time of the making ofsuch restricted payment.  As of September 30,2010, our consolidated interest coverage ratio exceeded 2.0 to 1.0.  Further, the aggregate amount of restrictedpayments we are able to make is limited pursuant to various baskets ascalculated pursuant to the credit agreement and indentures.

 

Theagreements governing our ABL facility generally permit the making ofdistributions and certain other restricted payments so long as the borrowingavailability under the facility equals or exceeds $60.0 million. If theborrowing availability falls below this amount, the Company may neverthelessmake restricted payments to Sally Beauty in the aggregate since the date of theSeparation Transactions, together with the aggregate cash amounts paid inconnection with acquisitions since said date, of not greater than $50.0million, together with certain other exceptions.  As of September 30, 2010, borrowingavailability under the ABL facility exceeded $60.0 million.  As of September 30, 2010, the net assetsof our consolidated subsidiaries that were unrestricted from transfer under ourcredit arrangements totaled $310.1 million, subject to certain adjustments. Theagreements governing our ABL facility and the senior term loan facilities, aswell as the indentures covering the Company’s 9.25% Senior Notes and its 10.5%Senior Subordinated Notes contain customary cross-default and/orcross-acceleration provisions.

 

AtSeptember 30, 2010 and 2009, the Company had no off-balance sheetfinancing arrangements other than operating leases incurred in the ordinarycourse of business as disclosed in Note 11, and outstanding letters of creditrelated to inventory purchases and self-insurance programs which totaled $14.5million and $13.4 million at September 30, 2010 and 2009, respectively.

 

**13.  Derivative Instruments and Hedging Activities**

 

**Risk Management objectives of Using Derivative Instruments**

 

TheCompany is exposed to a wide variety of risks, including risks arising fromchanging economic conditions. The Company manages its exposure to certaineconomic risks (including liquidity, credit risk, and changes in interest ratesand in foreign currency exchange rates) primarily (a) by closely managingits cash flows from operating and investing activities and the amounts andsources of its debt obligations; (b) by assessing periodically thecreditworthiness of its business partners; and (c) through the use ofinterest rate swaps and foreign currency options and forwards.

 

TheCompany uses interest rate swaps, as part of its overall economic riskmanagement strategy, to add stability to the interest payments due inconnection with its term loan obligations. Interest payments related to ourterm loans are impacted by changes in LIBOR. Interest rate swap agreementsinvolve the periodic receipt by the Company of amounts based on a variable ratein exchange for the Company making payments based on a fixed rate over the termof the interest rate swap agreements, without exchange of the underlyingnotional amount.

 

TheCompany uses foreign currency options and forwards, as part of its overalleconomic risk management strategy, to fix the amount of certain foreign assetsand obligations relative to its functional currency (the U.S. dollar) or to addstability to cash flows resulting from its net investments (includingintercompany notes not permanently invested) and earnings denominated inforeign currencies. Such cash flows may be materially affected (favorably or unfavorably)by changes in the exchange rates for the U.S. dollar versus the Britishpound sterling, Canadian dollar, Euro, Mexican peso and Chilean peso. TheCompany’s foreign currency exposures at times offset each other, providing anatural hedge against its foreign currency risk. The Company uses foreigncurrency options and 

 

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Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

forwardsto effectively fix the foreign currency exchange rate applicable to specificanticipated foreign currency-denominated cash flows, thus limiting thepotential losses resulting from such cash flows.

 

AtSeptember 30, 2010, the Company did not purchase or hold any derivativeinstruments for trading or speculative purposes.

 

**Designated Cash Flow Hedges**

 

Inthe fiscal year 2008, the Company entered into two interest rate swapagreements with an aggregate notional amount of $300million (each agreement with a notional amount of $150 million). Theseagreements expire in May of 2012 and are designated and qualify aseffective cash flow hedges, in accordance with ASC 815.  Accordingly, changes in the fair value of thesederivative instruments are recorded quarterly, net of income tax, inaccumulated other comprehensive (loss) income (“OCI”) until the hedgedobligation is settled or the swap agreements expire, whichever is earlier. Anyhedge ineffectiveness, as this term is used in ASC 815, is recognized ininterest expense in our consolidated statements of earnings. No hedgeineffectiveness on cash flow hedges was recognized during the fiscal years2010, 2009 and 2008.

 

Amounts reported in OCIrelated to interest rate swaps are reclassified into interest expense, as ayield adjustment, in the same period in which interest on the Company’svariable-rate debt obligations affect earnings. During the fiscal years 2010,2009 and 2008, interest expense resulting from such reclassifications was $10.1million, $7.9 million and $1.2 million, respectively.  During the twelve-month period ending September 30,2011, the Company estimates that an additional $9.7 million, before income tax,of the amount reported in OCI will be reclassified into interest expense.

 

**Non-designated Cash Flow Hedges**

 

The Company may use fromtime to time derivative instruments (such as interest rate swaps, and foreigncurrency options and forwards) not designated as hedges, or that do not meetthe requirements for hedge accounting, to manage its exposure to interest rateor foreign currency exchange rate movements.

 

In November of 2006, theCompany entered into certain interest rate swap agreements with an aggregatenotional amount of $500 million. These interest rate swapagreements expired on or before November 2009 and were not designatedas hedges and, accordingly, the changes in fair value of these interest rateswap agreements (which were adjusted quarterly) were recorded in interestexpense in our consolidated statements of earnings. During the fiscal yearsended September 30, 2009 and 2008, interest expense of $7.5 million and$10.5 million, respectively, resulted from these interest rate swap agreements.In the fiscal year ended September 30, 2010, interest expense resultingfrom these agreements was less than $0.1 million.

 

Asa result of our acquisition of Sinelco Group NV (“Sinelco”) on December 16,2009, the Company uses foreign currency options, including, at September 30,2010, foreign currency put options with an aggregate notional amount of €1.4million ($1.9 million, at the September 30, 2010 exchange rate) andforeign currency call options with an aggregate notional amount of €0.8 million($1.2 million, at the September 30, 2010 exchange rate), to manage theexposure to certain non-Euro currencies resulting from Sinelco’s purchases ofmerchandise from third-party suppliers. These foreign currency options expireratably through December 1, 2010. Sinelco’s functional currency is theEuro.

 

Inaddition, in the fourth quarter of the fiscal year 2010, the Company enteredinto four foreign currency forward agreements which expire in January of2011. These derivative instruments are intended to mitigate our exposure tochanges in foreign currency exchange rates in connection with certainintercompany balances not permanently invested. Two foreign currency forwardagreements enable the Company to sell, in the aggregate, approximately €5.2million ($7.1 million, at the September 30, 2010 exchange rate) at theweighted average forward exchange rate of 1.3073. The other two foreigncurrency forward agreements enable the Company to buy, in the aggregate,approximately $7.0 million Canadian dollars ($6.8 million, at the September 30,2010 exchange rate) at the weighted average forward exchange rate of 1.0277.

 

TheCompany’s foreign currency option and forward agreements are not designated ashedges and do not currently meet the requirements for hedge accounting.However, these derivative instruments are intended to offset and do offset theCompany’s exposure to foreign currencies resulting from specific anticipatedcash flow transactions. The changes in the fair value of all thesederivative instruments (which are adjusted quarterly) are recorded in selling,general and administrative expenses in our consolidated statements of earnings.During the fiscal years ended September 30, 2010, selling generaland administrative expenses included $0.2 million in net gains from all of theCompany’s foreign currency option and forward agreements (net of non-cashlosses of $0.3 million resulting from our foreign currency forwards). Inaddition, selling general and administrative expenses included $0.3 million innet non-cash gains, related to such intercompany balances not permanentlyinvested.

 

Thetable below presents the fair value of the Company’s derivative financialinstruments as well as their classification on the consolidated balance sheetas of September 30, 2010 (in thousands):

 

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Tableof Contents

 

Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

**TabularDisclosure of Fair Values of Derivative Instruments**

 
| ** **                                               | ** ** | **Asset Derivatives  As of September 30, 2010** | ** ** | **Liability Derivatives  As of September 30, 2010** | ** **   |
|----------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|--------------|
| ** **                                               | ** ** | **Balance Sheet  Location**                                         | ** ** | **Fair Value**                                                          | ** **   | **Balance Sheet  Location** | ** ** | **Fair Value** | ** ** |
| Derivatives designated as hedging instruments:           |       |                                                                     |       |                                                                         |         |   |   |   |   |
| Interest Rate Swaps                                      |       | Other  assets                                                            |       | $                                                                            |  — |   | Other  liabilities |   | $ |  15,530 |   |
| Total derivatives designated as hedging  instruments     |       |                                                                     |       | $                                                                            |  — |   |   |   | $ |  15,530 |   |
|                                                     |       |                                                                     |       |                                                                         |         |   |   |   |   |
| Derivatives not designated as hedging instruments:       |       |                                                                     |       |                                                                         |         |   |   |   |   |
| Foreign Currency Options and Forwards                    |       | Prepaid  expenses                                                        |       | $                                                                            |  119    |   | Accrued  liabilities |   | $ |  328 |   |
| Interest Rate Swaps                                      |       | Prepaid  expenses                                                        |       | —                                                                       |         | Accrued  liabilities |   | — |   |
| Total derivatives not designated as hedging  instruments |       |                                                                     |       | $                                                                            |  119    |   |   |   | $ |  328 |   |

 

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Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

Thetable below presents the fair value of the Company’s derivative financialinstruments as well as their classification on the consolidated balance sheetas of September 30, 2009 (in thousands):

 

**TabularDisclosure of Fair Values of Derivative Instruments**

 
| ** **                                               | ** ** | **Asset Derivatives  As of September 30, 2009** | ** ** | **Liability Derivatives  As of September 30, 2009** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| ** **                                               | ** ** | **Balance Sheet  Location**                                         | ** ** | **Fair Value**                                                          | ** ** | **Balance Sheet  Location** | ** ** | **Fair Value** | ** ** |
| Derivatives designated as hedging instruments:           |       |                                                                     |       |                                                                         |       |   |   |   |   |
| Interest Rate Swaps                                      |       | Other  assets                                                            |       | $                                                                            | —     |   | Other  liabilities |   | $ | 15,365 |   |
| Total derivatives designated as hedging  instruments     |       |                                                                     |       | $                                                                            | —     |   |   |   | $ | 15,365 |   |
|                                                     |       |                                                                     |       |                                                                         |       |   |   |   |   |
| Derivatives not designated as hedging instruments:       |       |                                                                     |       |                                                                         |       |   |   |   |   |
| Interest Rate Swaps                                      |       | Prepaid  expenses                                                        |       | $                                                                            | —     |   | Accrued  liabilities |   | $ | 2,356 |   |
| Total derivatives not designated as hedging  instruments |       |                                                                     |       | $                                                                            | —     |   |   |   | $ | 2,356 |   |

 

 

Thetable below presents the effect of the Company’s derivative financialinstruments on the consolidated statements of earnings for the fiscal yearended September 30, 2010 (in thousands):

 

**Tabular Disclosure of the Effect of DerivativeInstruments on the Statement of**

**Earnings for the**

**Fiscal YearEnded September 30, 2010**

 
| **Derivatives in Cash Flow  Hedging Relationships** | ** ** | **Amount of  Gain or  (Loss)  Recognized  in OCI on  Derivative  (Effective  Portion),  net of tax** | ** ** | **Location of Gain or  (Loss) Reclassified  from Accumulated  OCI into Income  (Effective Portion)** | ** **        | **Amount of  Gain or (Loss)  Reclassified  from  Accumulated  OCI into  Income  (Effective  Portion)** | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative  (Ineffective Portion  and Amount  Excluded from  Effectiveness Testing)** | ** ** | **Amount of Gain  or (Loss)  Recognized in  Income on  Derivative  (Ineffective  Portion and  Amount  Excluded from  Effectiveness  Testing)** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|-------------------|----------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Interest Rate Swaps                                                     |       | $                                                                                                                                  | (101       | )                                                                                                                                            | Interest  expense |                                                                                                                       | $          | (10,067                                                                                                                                                                                             | )          | Interest expense                                                                                                                                                                  |       | $ | — |   |
|                                                                         |            |                                                                                                                                    |            |                                                                                                                                              |                   |                                                                                                                            |            |                                                                                                                                                                                                     |            |                                                                                                                                                                                   |            |  |  |  |

 
| **Derivatives Not Designated as Hedging  Instruments** | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative** | ** ** | **Amount of  Gain or (Loss)  Recognized in  Income on  Derivative** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|
| Foreign Currency Options and Forwards                                      |       | Selling,  general and administrative expenses                                                          |       | $                                                                                            | 203        |   |
| Interest Rate Swaps                                                        |       | Interest  expense                                                                                      |       | (24                                                                                          | )          |
| Total derivatives not designated as hedging  instruments                   |       |                                                                                                   |       | $                                                                                            | 179        |   |

 

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Table ofContents

 

Sally Holdings LLC andSubsidiaries

Notes to Consolidated FinancialStatements

 

Thetable below presents the effect of the Company’s derivative financialinstruments on the consolidated statements of earnings for the fiscal yearended September 30, 2009 (in thousands):

 

**Tabular Disclosure of the Effect of Derivative Instrumentson the Statement of**

**Earnings for the**

**Fiscal YearEnded September 30, 2009**

 
| **Derivatives in Cash Flow  Hedging Relationships** | ** ** | **Amount of  Gain or  (Loss)  Recognized  in OCI on  Derivative  (Effective  Portion),  net of tax** | ** ** | **Location of Gain or  (Loss) Reclassified  from Accumulated  OCI into Income  (Effective Portion)** | ** **        | **Amount of  Gain or (Loss)  Reclassified  from  Accumulated  OCI into  Income  (Effective  Portion)** | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative  (Ineffective Portion  and Amount  Excluded from  Effectiveness Testing)** | ** ** | **Amount of Gain  or (Loss)  Recognized in  Income on  Derivative  (Ineffective  Portion and  Amount  Excluded from  Effectiveness  Testing)** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|-------------------|----------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Interest Rate Swaps                                                     |       | $                                                                                                                                  | (10,196    | )                                                                                                                                            | Interest  expense |                                                                                                                       | $          | (7,935                                                                                                                                                                                              | )          | Interest expense                                                                                                                                                                  |       | $ | — | ** ** |
|                                                                         |            |                                                                                                                                    |            |                                                                                                                                              |                   |                                                                                                                            |            |                                                                                                                                                                                                     |            |                                                                                                                                                                                   |            |  |  |  |

 
| **Derivatives Not Designated as Hedging  Instruments** | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative** | ** ** | **Amount of  Gain or (Loss)  Recognized in  Income on  Derivative** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|
| Interest Rate Swaps                                                        |       | Interest  expense                                                                                      |       | $                                                                                            | (7,488     | ) |
|                                                                            |            |                                                                                                        |            |                                                                                              |            |  |

 

 

Thetable below presents the effect of the Company’s derivative financialinstruments on the consolidated statements of earnings for the fiscal yearended September 30, 2008 (in thousands):

 

**Tabular Disclosure of the Effect of Derivative Instrumentson the Statement of**

**Earnings for the**

**Fiscal YearEnded September 30, 2008**

 
| **Derivatives in Cash Flow  Hedging Relationships** | ** ** | **Amount of  Gain or  (Loss)  Recognized  in OCI on  Derivative  (Effective  Portion),  net of tax** | ** ** | **Location of Gain or  (Loss) Reclassified  from Accumulated  OCI into Income  (Effective Portion)** | ** **        | **Amount of  Gain or (Loss)  Reclassified  from  Accumulated  OCI into  Income  (Effective  Portion)** | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative  (Ineffective Portion  and Amount  Excluded from  Effectiveness Testing)** | ** ** | **Amount of Gain  or (Loss)  Recognized in  Income on  Derivative  (Ineffective  Portion and  Amount  Excluded from  Effectiveness  Testing)** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|-------------------|----------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Interest Rate Swaps                                                     |       | $                                                                                                                                  | 793        |                                                                                                                                         | Interest  expense |                                                                                                                       | $          | (1,174                                                                                                                                                                                              | )          | Interest expense                                                                                                                                                                  |       | $ | — |   |
|                                                                         |            |                                                                                                                                    |            |                                                                                                                                              |                   |                                                                                                                            |            |                                                                                                                                                                                                     |            |                                                                                                                                                                                   |            |  |  |  |

 
| **Derivatives Not Designated as Hedging  Instruments** | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative** | ** ** | **Amount of  Gain or (Loss)  Recognized in  Income on  Derivative** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|
| Interest Rate Swaps                                                        |       | Interest  expense                                                                                      |       | $                                                                                            | (10,481    | ) |
|                                                                            |            |                                                                                                        |            |                                                                                              |            |  |

 

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Table ofContents

 

Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

**Credit-risk-related Contingent Features**

 

The agreements governing theCompany’s interest rate swaps contain provisions pursuant to which the Companycould be declared in default on its interest rate swap obligations in the eventthe Company defaulted under certain terms of the loan documents governing theCompany’s ABL facility. As of September 30, 2010, the fair value ofinterest rate swaps in a liability position related to these agreements was$15.5 million and the Company was under no obligation to post and had notposted any collateral related to these agreements. If the Company breached anyof these provisions, it would be required to settle its obligations under theswap agreements at their termination value of $15.9 million, including accruedinterest and other termination costs.

 

At September 30, 2010,the aggregate fair value of all foreign currency option and forward agreementsheld was a net liability of $0.2 million, consisting of derivative instrumentsin a liability position of $0.3 million and derivative instruments in an assetposition of $0.1 million. The Company was under no obligation to post andhad not posted any collateral related to these agreements.

 

The counterparties to all our derivativeinstruments are deemed by the Company to be of substantialresources and strong creditworthiness. However, these transactions result inexposure to credit risk in the event of default by a counterparty. The recentfinancial crisis affecting the banking systems and financial markets resultedin many well-known financial institutions becoming less creditworthy or havingdiminished liquidity, which could expose us to an increased level ofcounterparty risk.  In the event that acounterparty defaults in its obligation under our interest rate swaps and/orforeign currency derivative instruments, we could incur substantial financiallosses. However, at the present time, no such losses are deemed probable.

 

**14.  401(k) and Profit Sharing Plan**

 

TheCompany has no benefit plans of its own. Since the Separation Transactions, theCompany has been an indirect wholly-owned subsidiary of Sally Beauty, and itsemployees participate in benefits provided under the plans of Sally Beauty.Sally Beauty sponsors the Sally Beauty 401(k) and Profit Sharing Plan (the“401k Plan”), which is a qualified defined contribution plan. The 401k Plancovers employees of the Company who meet certain eligibility requirements andwho are not members of a collective bargaining unit. Under the terms of the401k Plan, employees may contribute a percentage of their annual compensationto the 401k Plan up to certain maximums, as defined by the 401k Plan and by theU. S. Internal Revenue Code. The Company currently matches a portion ofemployee contributions to the plan. The Company recognized expense of $4.7million, $4.0 million and $3.8 million in the fiscal years 2010, 2009 and 2008,respectively, related to such employer matching contributions under the plan.These amounts are included in selling, general and administrative expenses.

 

Inaddition, pursuant to the 401k Plan, the Company may make profit sharingcontributions to the accounts of employees who meet certain eligibilityrequirements and who are not members of a collective bargaining unit. TheCompany’s profit sharing contributions to the 401k Plan are determined by theCompensation Committee of Sally Beauty’s Board of Directors. The Companyrecognized expense of $2.7 million, $2.4 million and $7.1 million in the fiscalyears 2010, 2009 and 2008, respectively, related to such profit sharingcontributions under the plan. These amounts are included in selling, generaland administrative expenses.

 

**15.  Income Taxes**

 

SallyBeauty and its subsidiaries, including the Company, file consolidated incometax returns in the U.S. federal jurisdiction and most state jurisdictions aswell as in various foreign jurisdictions. As described in Note 17, the Companyhas entered into a tax sharing agreement with its ultimate parent, SallyBeauty.

 

Theprovision for income taxes for the fiscal years 2010, 2009 and 2008 consists ofthe following (in thousands):

 
| ** **                      | ** ** | **Year Ended September 30,** | ** ** |
|---------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **2010**                                    | ** ** | **2009** | ** ** | **2008** | ** ** |
| Current:                        |       |                                        |       |   |   |   |   |
| Federal                         |       | $                                           | 71,572     |   | $ | 50,738 |   | $ | 33,194 |   |
| Foreign                         |       | 4,432                                       |       | 4,276 |   | 8,763 |   |
| State                           |       | 11,636                                      |       | 5,734 |   | 4,203 |   |
| Total  current portion          |       | 87,640                                      |       | 60,748 |   | 46,160 |   |
| Deferred:                       |       |                                        |       |   |   |   |   |
| Federal                         |       | 2,888                                       |       | 8,601 |   | 2,242 |   |
| Foreign                         |       | (2,814                                      | )          | (1,676 | ) | 346 |   |
| State                           |       | (704                                        | )          | 751 |   | (84 | ) |
| Total  deferred portion         |       | (630                                        | )          | 7,676 |   | 2,504 |   |
| Total  provision for income tax |       | $                                           | 87,010     |   | $ | 68,424 |   | $ | 48,664 |   |

 

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Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

Thedifference between the U.S. statutory federal income tax rate and theeffective income tax rate is summarized below:

 
| ** **                                      | ** ** | **Year Ended September 30,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                      | ** ** | **2010**                                    | ** ** | **2009** | ** ** | **2008** | ** ** |
| Statutory  tax rate                             |       | 35.0                                        | %          | 35.0 | % | 35.0 | % |
| State  income taxes, net of federal tax benefit |       | 2.9                                         |       | 2.6 |   | 2.0 |   |
| Effect  of foreign operations                   |       | (1.1                                        | )          | 0.8 |   | (2.1 | ) |
| Other,  net                                     |       | 0.1                                         |       | 1.1 |   | 2.1 |   |
| Effective  tax rate                             |       | 36.9                                        | %          | 39.5 | % | 37.0 | % |

 

Thetax effects of temporary differences that give rise to the Company’s deferredtax assets and liabilities are as follows (in thousands):

 
| ** **                                 | ** ** | **September 30,** | ** ** |
|--------------------------------------------|------------|------------------------|------------|
| ** **                                 | ** ** | **2010**               | ** ** | **2009** | ** ** |
| Deferred  tax assets attributable to:      |       |                   |       |   |   |
| Share-based  compensation expense          |       | $                      | 15,430     |   | $ | 11,624 |   |
| Accrued  liabilities                       |       | 23,159                 |       | 18,739 |   |
| Inventory  adjustments                     |       | 3,303                  |       | 2,378 |   |
| Foreign  loss carryforwards                |       | 16,675                 |       | 12,593 |   |
| Long-term  liabilities                     |       | —                 |       | 913 |   |
| Unrecognized  tax benefits                 |       | 577                    |       | 1,127 |   |
| Interest  rate swaps                       |       | 6,026                  |       | 5,962 |   |
| Other                                      |       | 2,548                  |       | 1,264 |   |
| Total  deferred tax assets                 |       | 67,718                 |       | 54,600 |   |
| Valuation  allowance                       |       | (16,552                | )          | (14,640 | ) |
| Total  deferred tax assets, net            |       | 51,166                 |       | 39,960 |   |
| Deferred  tax liabilities attributable to: |       |                   |       |   |   |
| Depreciation  and amortization             |       | 70,772                 |       | 58,759 |   |
| Total  deferred tax liabilities            |       | 70,772                 |       | 58,759 |   |
| Net  deferred tax liability                |       | $                      | 19,606     |   | $ | 18,799 |   |

 

Managementbelieves that it is more likely than not that the results of future operationswill generate sufficient taxable income to realize the deferred tax assets, netof the valuation allowance. The Company has recorded a valuation allowance toaccount for uncertainties regarding recoverability of certain deferred taxassets, primarily foreign loss carryforwards.

 

Domesticearnings before provision for income taxes were $223.6 million, $173.4 millionand $106.4 million in the fiscal years 2010, 2009 and 2008, respectively.Foreign operations had earnings (losses) before provision for income taxes of$12.0 million, $(0.3) million and $25.1 million in the fiscal years 2010,2009 and 2008, respectively.

 

Taxreserves are evaluated and adjusted as appropriate, while taking into accountthe progress of audits by various taxing jurisdictions and other changes inrelevant facts and circumstances evident at each balance sheet date. Managementdoes not expect the outcome of tax audits to have a material adverse effect onthe Company’s financial condition, results of operations or cash flow.

 

AtSeptember 30, 2010, undistributed earnings of the Company’s foreign operationsare intended to remain permanently invested to finance anticipated futuregrowth and expansion. Accordingly, federal and state income taxes have not beenprovided on accumulated but undistributed earnings of $76.5 million and $56.4million as of September 30, 2010 and 2009, respectively, as such earningshave been permanently reinvested in the business.  The determination of the amount of theunrecognized deferred tax liability related to the undistributed earnings isnot practicable.

 

AtSeptember 30, 2010 and 2009, the Company had total operating losscarry-forwards of $53.3 million and $40.7 million, of which $46.1 million and$39.3 million are subject to a valuation allowance, respectively. At September 30,2010, operating loss carry-forwards of $22.6 million expire between 2012 and2030 and operating loss carry-forwards of $30.7 million have no expirationdate. At September 30, 2010, the Company had tax credit carryforwards of$0.8 million which have no expiration date and, of which $0.4 million aresubject to a valuation allowance.  Therewere no net tax credit carry-forwards available to the Company at September 30,2009.

 

Thetransactions separating us from Alberto-Culver were intended to qualify as areorganization under Section 368(a)(1)(D) of the Internal RevenueCode of 1986, as amended (the “Code”) and a distribution eligible fornon-recognition under Sections 355(a) and 361(c) of the Code. Inconnection with the share distribution of Alberto-Culver common stock in theSeparation Transactions, Sally

 

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Notes to ConsolidatedFinancial Statements

 

Beautyreceived: (i) a private letter ruling from the IRS; and (ii) anopinion of Sidley Austin LLP, counsel to Alberto-Culver, in each case, to theeffect that the transactions qualify as a reorganization underSection 368(a)(1)(D) of the Code and a distribution eligible fornon-recognition under Sections 355(a) and 361(c) of the Code.

 

Certaininternal restructurings also occurred at or immediately prior to the SeparationTransactions. As a result of the internal restructurings and SeparationTransactions, Sally Beauty inherited the federal tax identification number ofthe old Alberto-Culver parent for U.S. federal income tax purposes. Inaddition, as the successor entity to Alberto-Culver after the SeparationTransactions, Sally Beauty relies upon the prior year federal income taxreturns of Alberto-Culver, and accounting methods established therein, forcertain calculations that affect Sally Beauty’s and the Company’s current U.S.federal income tax liability.

 

SallyBeauty and Alberto-Culver entered into a tax allocation agreement as part ofthe Separation Transactions. The agreement provides generally that Sally Beautyis responsible for its pre-separation income tax liabilities, calculated on astand-alone basis, and Alberto-Culver is responsible for the remainder. In theevent additional U.S federal income tax liability related to the period priorto the Separation Transactions was determined, Sally Beauty will be jointly andseverally liable for these taxes, and there can be no assurance thatAlberto-Culver would be able to fulfill its indemnification obligations toSally Beauty under the tax allocation agreement if Alberto-Culver wasdetermined to be responsible for these taxes thereunder.

 

Thechanges in the amount of unrecognized tax benefits for the fiscal year ended September 30,2010 and 2009 are as follows (in thousands):

 
| ** **                                       | ** ** | **2010** | ** **   | **2009** | ** ** |
|--------------------------------------------------|------------|----------|--------------|----------|------------|
| Balance  at beginning of the fiscal year         |       | $        |  14,378 |     | $          |  4,291 |   |
| Increases  related to prior year tax positions   |       | 1,895    |         | 7,379    |       |
| Decreases  related to prior year tax positions   |       | —   |         | (1,482   | )          |
| Increases  related to current year tax positions |       | 620      |         | 4,722    |       |
| Settlements                                      |       | (1,131   | )            | —   |       |
| Lapse  of statute                                |       | (2,115   | )            | (532     | )          |
| Balance  at end of fiscal year                   |       | $        |  13,647 |     | $          |  14,378 |   |

 

Ifrecognized, these positions would affect the Company’s effective tax rate.

 

TheCompany classifies and recognizes interest and penalties accrued related tounrecognized tax benefits in income tax expense. The total amount of accrued interestand penalties as of September 30, 2010 and 2009 was $4.6 million and $4.0million, respectively.

 

Becauseexisting tax positions will continue to generate increased liabilities forunrecognized tax benefits over the next 12 months, and the fact that weare routinely under audit by various taxing authorities, it is reasonablypossible that the amount of unrecognized tax benefits will change during thenext 12 months. An estimate of the amount or range of such change cannotbe made at this time. However, we do not expect the change, if any, to have amaterial effect on our consolidated financial condition or results ofoperations within the next 12 months.

 

TheIRS has initiated an examination of Sally Beauty’s consolidated federal incometax returns for the fiscal years ended September 30, 2008 and 2007. TheIRS had previously audited Sally Beauty’s consolidated federal income taxreturns through the tax year ended September 30, 2006, thus the statuteremains open from the year ended September 30, 2007 forward.  Our foreign subsidiaries are impacted byvarious statutes of limitations, which are generally open from 2004 forward.Generally, states’ statutes in the United States are open for tax reviews from2005 forward.

 

**16.  Acquisitions**

 

OnDecember 16, 2009, the Company acquired Sinelco, a wholesale distributorof professional beauty products based in Ronse, Belgium, for approximately€25.2 million (approximately $36.6 million). We also assumed €4.0 million(approximately $5.8 million) of pre-acquisition debt, excluding capital leaseobligations, of Sinelco in connection with the acquisition. Sinelco serves over1,500 customers through a product catalog and website and has sales throughoutEurope. Goodwill of $5.2 million (which is not deductible for tax purposes) andother intangible assets of $14.0 million were recorded as a result of thisacquisition. In addition, during the fiscal year 2010, the Company completedseveral other individually immaterial acquisitions at an aggregate cost of $9.0million and recorded additional goodwill in the amount of $5.4 million (themajority of which is not deductible for tax purposes) in connection with suchacquisitions. The assets acquired and liabilities assumed in connection withall acquisitions completed during the fiscal year 2010 were recorded at fairvalues at the acquisition date in accordance with ASC 805. We funded theseacquisitions with cash from operations and borrowings on our ABL facility. Inaddition, during the fiscal year 2010, the Company recorded intangible assetssubject to amortization in the amount of $24.9 million and intangible assetswith indefinite lives 

 

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Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

inthe amount of $0.8 million in connection with certain 2009 acquisitions,including the acquisition of Schoeneman. These amounts were previously reportedin Goodwill pending completion of the final valuations of the assets acquiredand liabilities assumed, as discussed in the following paragraph.

 

OnSeptember 30, 2009, the Company acquired Schoeneman at a cost ofapproximately $71.0 million, subject to certain adjustments. The acquisition ofSchoeneman, a 43-store beauty supply chain located in the central northeastUnited States, was pursuant to a merger agreement between Schoeneman, theformer stockholders of Schoeneman and a subsidiary of the Company. The Companycurrently expects to realize approximately $10 million in present value offuture tax savings as a result of anticipated incremental depreciation andamortization tax deductions relating to the assets acquired in thistransaction. In the fiscal year 2009, goodwill of approximately$61.0 million (which is deductible for tax purposes) was initiallyrecorded as a result of this acquisition. In addition, during the fiscal year2009, the Company completed several other individually immaterial acquisitionsat an aggregate cost of $11.3 million of which a significant portion wasallocated to goodwill (the majority of which is deductible for tax purposes).The purchase prices of certain acquisitions completed during the fiscal year2009 (including the acquisition of Schoeneman) were initially allocated toassets acquired and liabilities assumed based on their preliminary estimatedfair values at the date of acquisition. The final valuations of the assetsacquired and liabilities assumed were completed during the fiscal year 2010. Generally,we funded these acquisitions with cash from operations.

 

InMay of 2008, the Company acquired Pro-Duo, a 40-store beauty supply chainlocated in Belgium, France and Spain for €19.3 million (approximately $29.8million) plus incidental acquisition costs capitalized, subject to certainadjustments. We also assumed €3.0 million (approximately $4.7 million) of debt,excluding capital lease obligations, of Pro-Duo in connection with theacquisition. Goodwill of $23.9 million (which is not deductible for taxpurposes) and certain identifiable intangible assets of $11.4 million wererecorded as a result of such acquisition. Of this amount, $10.2 million wasassigned to registered trade names and $1.2 million to other identifiableintangible assets, which will be amortized over a weighted average life ofapproximately eight years. In addition, during the fiscal year 2008, theCompany completed several other individually immaterial acquisitions at anaggregate cost of $22.9 million of which a significant portion was allocated tointangible assets and goodwill (the majority of which is not deductible forincome tax purposes). The purchase prices of these acquisitions have beenallocated to assets acquired and liabilities assumed based on their estimatedfair values at the date of acquisition. The final valuations of the assets andliabilities acquired were completed during the fiscal year 2009. We fundedthese acquisitions with cash from operations and borrowings on our ABL facility.

 

These businesscombinations have been accounted for using the purchase method of accountingand, accordingly, the results of operations of the entities acquired have beenincluded in the Company’s consolidated financial statements since theirrespective dates of acquisition.

 

**17.  Related Party Transactions**

 

InJanuary 2007, the Company entered into an agreement with Sally Beautyunder which the Company agreed to provide certain general and administrativeservices to Sally Beauty including accounting, finance, payroll, legal and taxsharing services. The cost of these services, which were based on a percentageof certain key employees’ salaries and benefits, is approximately $182,000 permonth, and totaled approximately $2.2 million, $2.2 million and $2.1 millionfor fiscal years 2010, 2009 and 2008, respectively.  The cost of these services may notnecessarily be indicative of the costs which would be incurred by Sally Beautyas an independent standalone entity.

 

Asdescribed more fully in Note 6, certain employees and consultants of theCompany have been granted stock options and share awards under share-basedcompensation plans of Sally Beauty.

 

TheCompany has entered into a tax sharing agreement with its parent, Sally Beauty.In accordance with this tax sharing agreement, Sally Beauty shall cause each ofits subsidiaries that are eligible to be a member of the relevant combined taxgroup to join in filing a combined tax return with respect to each jurisdictionfor all tax years for which such subsidiary is eligible to do so under theapplicable tax law.  Sally Beauty shallmake all payments to the applicable taxing authority of all combined taxes thatthe relevant combined tax group is required to pay.

 

Whereallowed by current tax law, the Company is included in the consolidated incometax returns filed by Sally Beauty. The Company’s provision for income taxes isrecorded on the basis of filing a separate income tax return.  Income taxes currently payable or receivableunder the consolidated income tax returns are paid to or received from SallyBeauty.

 

Asof September 30, 2010 and 2009, the Company had a net intercompany payableto Sally Beauty of approximately $40.5 million and $22.0 million, respectively.This consists primarily of income tax and share-based compensation expenses,which are partially offset by general and administrative services provided toSally Beauty.

 

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Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

**18.   BusinessSegments and Geographic Area Information**

 

TheCompany’s business is organized into two separate segments: (i) SallyBeauty Supply, a domestic and international chain of cash and carry retailstores which offers professional beauty supplies to both salon professionalsand retail customers in North America and parts of South America and Europe and(ii) BSG (including its franchise-based business, Armstrong McCall), afull service beauty supply distributor which offers professional brands ofbeauty products directly to salons through its own sales force and professionalonly stores (including franchise stores) in generally exclusive geographicterritories in North America and parts of Europe.

 

Theaccounting policies of both of our business segments are the same as describedin the summary of significant accounting policies contained in Note 2. Salesbetween segments, which were eliminated in consolidation, were not material forthe fiscal years ended September 30, 2010, 2009 and 2008.

 

***Business SegmentsInformation***

 

Segmentdata for the fiscal years ended September 30, 2010, 2009 and 2008 is asfollows (in thousands):

 
| ** **                                   | ** ** | **Year Ended September 30,** | ** ** |
|----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                   | ** ** | **2010**                                    | ** ** | **2009** | ** ** | **2008** | ** ** |
| Net  sales:                                  |       |                                        |       |   |   |   |   |
| Sally  Beauty Supply                         |       | $                                           | 1,834,631  |   | $ | 1,695,652 |   | $ | 1,672,897 |   |
| BSG                                          |       | 1,081,459                                   |       | 940,948 |   | 975,294 |   |
| Total                                        |       | $                                           | 2,916,090  |   | $ | 2,636,600 |   | $ | 2,648,191 |   |
| Earnings  before provision for income taxes: |       |                                        |       |   |   |   |   |
| Segment  operating profit:                   |       |                                        |       |   |   |   |   |
| Sally  Beauty Supply                         |       | $                                           | 320,456    |   | $ | 283,872 |   | $ | 285,615 |   |
| BSG                                          |       | 112,495                                     |       | 91,604 |   | 80,927 |   |
| Segment  operating profit                    |       | 432,951                                     |       | 375,476 |   | 366,542 |   |
| Unallocated  expenses(a)                     |       | (72,172                                     | )          | (62,289 | ) | (66,499 | ) |
| Share-based  compensation expense            |       | (12,187                                     | )          | (7,992 | ) | (9,614 | ) |
| Interest  expense                            |       | (112,953                                    | )          | (132,043 | ) | (158,897 | ) |
| Total                                        |       | $                                           | 235,639    |   | $ | 173,152 |   | $ | 131,532 |   |
| Identifiable  assets:                        |       |                                        |       |   |   |   |   |
| Sally  Beauty Supply                         |       | $                                           | 729,380    |   | $ | 652,184 |   | $ | 696,780 |   |
| BSG                                          |       | 808,842                                     |       | 792,879 |   | 752,029 |   |
| Sub-total                                    |       | 1,538,222                                   |       | 1,445,063 |   | 1,448,809 |   |
| Shared  services                             |       | 50,541                                      |       | 45,447 |   | 76,849 |   |
| Total                                        |       | $                                           | 1,588,763  |   | $ | 1,490,510 |   | $ | 1,525,658 |   |
| Depreciation  and amortization:              |       |                                        |       |   |   |   |   |
| Sally  Beauty Supply                         |       | $                                           | 26,426     |   | $ | 24,175 |   | $ | 23,134 |   |
| BSG                                          |       | 20,081                                      |       | 18,735 |   | 20,666 |   |
| Corporate                                    |       | 4,615                                       |       | 4,156 |   | 4,733 |   |
| Total                                        |       | $                                           | 51,122     |   | $ | 47,066 |   | $ | 48,533 |   |
| Capital  expenditures:                       |       |                                        |       |   |   |   |   |
| Sally  Beauty Supply                         |       | $                                           | 30,366     |   | $ | 23,203 |   | $ | 22,094 |   |
| BSG                                          |       | 11,252                                      |       | 8,470 |   | 18,683 |   |
| Corporate                                    |       | 7,084                                       |       | 5,644 |   | 4,799 |   |
| Total                                        |       | $                                           | 48,702     |   | $ | 37,317 |   | $ | 45,576 |   |

 

----

(a)          Unallocatedexpenses consist of corporate and shared costs.

 

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Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

***Geographic Area Information***

 

Geographicdata for the fiscal years ended September 30, 2010, 2009 and 2008 is asfollows (in thousands):

 
| ** **            | ** ** | **Year Ended September 30,** | ** ** |
|-----------------------|------------|---------------------------------------------|------------|
| ** **            | ** ** | **2010**                                    | ** ** | **2009** | ** ** | **2008** | ** ** |
| Net  sales:(a)        |       |                                        |       |   |   |   |   |
| United  States        |       | $                                           | 2,402,085  |   | $ | 2,202,218 |   | $ | 2,170,708 |   |
| Foreign               |       | 514,005                                     |       | 434,382 |   | 477,483 |   |
| Total                 |       | $                                           | 2,916,090  |   | $ | 2,636,600 |   | $ | 2,648,191 |   |
| Identifiable  assets: |       |                                        |       |   |   |   |   |
| United  States        |       | $                                           | 1,133,652  |   | $ | 1,105,026 |   | $ | 1,098,614 |   |
| Foreign               |       | 404,570                                     |       | 340,037 |   | 350,195 |   |
| Shared  services      |       | 50,541                                      |       | 45,447 |   | 76,849 |   |
| Total                 |       | $                                           | 1,588,763  |   | $ | 1,490,510 |   | $ | 1,525,658 |   |

 

----

(a)          Net sales areattributable to individual countries based on the location of the customer. 

 

**19.   Guarantor and Non-Guarantor CondensedConsolidated Financial Statements**

 

Thefollowing condensed consolidating financial information presents the CondensedConsolidated Balance Sheets as of September 30, 2010 and 2009, theCondensed Consolidated Statements of Earnings for the years ended September 30,2010, 2009 and 2008, and the Condensed Consolidated Statements of Cash Flowsfor the years ended September 30, 2010, 2009 and 2008 of: (i) SallyHoldings LLC, or “the Parent;” (ii) the guarantor subsidiaries; (iii) thenon-guarantor subsidiaries; (iv) elimination entries necessary toconsolidate the Parent with the guarantor and non-guarantor subsidiaries; and (v) theParent on a consolidated basis.

 

Investmentsin subsidiaries are accounted for using the equity method for purposes of theconsolidating presentation. The principal elimination entries relate toinvestments in subsidiaries and intercompany balances and transactions.Separate financial statements and other disclosures with respect to thesubsidiary guarantors have not been provided as management believes thefollowing information is sufficient, as guarantor subsidiaries are 100 percentindirectly owned by the Parent and all guarantees are full andunconditional.  Additionally,substantially all of the assets of the guarantor subsidiaries are pledged underthe term loan facilities and the ABL facility and consequently may not beavailable to satisfy the claims of general creditors.

 

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Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

CondensedConsolidated Balance Sheet

September 30,2010

(Inthousands)

 
| ** **                                                                  | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally  Holdings  LLC &  Subsidiaries** | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|---------------------------------------------------|------------|
| **Assets**                                                                  |       |       |       |                        |       |                              |       |             |       |                                              |       |
| Cash and cash equivalents                                                   |       | $          | 20         |                        | $          | 32,975                            |       | $                | 26,499     |                                              | $          | — |   | $ | 59,494 |   |
| Trade accounts and other receivables, less  allowance for doubtful accounts |       | —     |       | 51,860                      |       | 32,639                            |       | —           |       | 84,499                                            |       |
| Due from affiliates                                                         |       |       |       | 547,722                     |       | 6,763                             |       | (554,485         | )          | —                                            |       |
| Inventory                                                                   |       | —     |       | 458,837                     |       | 145,520                           |       | —           |       | 604,357                                           |       |
| Prepaid expenses                                                            |       | 114        |       | 10,958                      |       | 11,449                            |       | —           |       | 22,521                                            |       |
| Deferred income tax assets                                                  |       | —     |       | 25,666                      |       | (2,397                            | )          | —           |       | 23,269                                            |       |
| Property and equipment, net                                                 |       | —     |       | 117,053                     |       | 51,064                            |       | —           |       | 168,117                                           |       |
| Investment in subsidiaries                                                  |       | 1,583,202  |       | 318,533                     |       | —                            |       | (1,901,735       | )          | —                                            |       |
| Goodwill and other intangible assets, net                                   |       | —     |       | 425,106                     |       | 162,486                           |       | —           |       | 587,592                                           |       |
| Other assets                                                                |       | 24,666     |       | 8,854                       |       | 5,394                             |       | —           |       | 38,914                                            |       |
| Total assets                                                                |       | $          | 1,608,002  |                        | $          | 1,997,564                         |       | $                | 439,417    |                                              | $          | (2,456,220 | ) | $ | 1,588,763 |   |
|                                                                        |       |       |       |                        |       |                              |       |             |       |                                              |       |
| **Liabilities and Member’s  (Deficit) Equity**                         |       |       |       |                        |       |                              |       |             |       |                                              |       |
| Accounts payable                                                            |       | $          | —     |                        | $          | 170,663                           |       | $                | 54,268     |                                              | $          | — |   | $ | 224,931 |   |
| Due to affiliates                                                           |       | 520,404    |       | 6,763                       |       | 27,318                            |       | (554,485         | )          | —                                            |       |
| Accrued liabilities                                                         |       | 26,477     |       | 115,572                     |       | 25,210                            |       | —           |       | 167,259                                           |       |
| Due to Sally Beauty                                                         |       | —     |       | 40,500                      |       | —                            |       | —           |       | 40,500                                            |       |
| Income taxes                                                                |       | 4,232      |       | 3,419                       |       | (839                              | )          | —           |       | 6,812                                             |       |
| Long-term debt                                                              |       | 1,548,856  |       | 77                          |       | 13,703                            |       | —           |       | 1,562,636                                         |       |
| Other liabilities                                                           |       | 15,530     |       | 24,090                      |       | 1,072                             |       | —           |       | 40,692                                            |       |
| Deferred income tax liabilities                                             |       | (10,555    | )          | 53,278                      |       | 152                               |       | —           |       | 42,875                                            |       |
| Total liabilities                                                           |       | 2,104,944  |       | 414,362                     |       | 120,884                           |       | (554,485         | )          | 2,085,705                                         |       |
| Stock options subject to redemption                                         |       | 946        |       | —                      |       | —                            |       | —           |       | 946                                               |       |
| Total member’s (deficit) equity                                        |       | (497,888   | )          | 1,583,202                   |       | 318,533                           |       | (1,901,735       | )          | (497,888                                          | )          |
| Total liabilities and member’s (deficit) equity                        |       | $          | 1,608,002  |                        | $          | 1,997,564                         |       | $                | 439,417    |                                              | $          | (2,456,220 | ) | $ | 1,588,763 |   |

 

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Notes to ConsolidatedFinancial Statements

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

CondensedConsolidated Balance Sheet

September 30,2009

(Inthousands)

 
| ** **                                                                  | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally  Holdings  LLC &  Subsidiaries** | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|---------------------------------------------------|------------|
| **Assets**                                                                  |       |       |       |                        |       |                              |       |             |       |                                              |       |
| Cash and cash equivalents                                                   |       | $          | 20         |                        | $          | 37,593                            |       | $                | 16,834     |                                              | $          | — |   | $ | 54,447 |   |
| Trade accounts and other receivables, less  allowance for doubtful accounts |       | —     |       | 49,128                      |       | 18,611                            |       | —           |       | 67,739                                            |       |
| Due from affiliates                                                         |       |       |       | 297,407                     |       | 11,169                            |       | (308,576         | )          | —                                            |       |
| Inventory                                                                   |       | —     |       | 439,396                     |       | 120,293                           |       | —           |       | 559,689                                           |       |
| Prepaid expenses                                                            |       | 113        |       | 9,165                       |       | 8,983                             |       | —           |       | 18,261                                            |       |
| Deferred income tax assets                                                  |       | 929        |       | 18,015                      |       | (3,315                            | )          | —           |       | 15,629                                            |       |
| Property and equipment, net                                                 |       | —     |       | 115,459                     |       | 35,790                            |       | —           |       | 151,249                                           |       |
| Investment in subsidiaries                                                  |       | 1,320,325  |       | 265,511                     |       | —                            |       | (1,585,836       | )          | —                                            |       |
| Goodwill and other intangible assets, net                                   |       | —     |       | 427,555                     |       | 145,265                           |       | —           |       | 572,820                                           |       |
| Other assets                                                                |       | 33,384     |       | 12,655                      |       | 4,637                             |       | —           |       | 50,676                                            |       |
| Total assets                                                                |       | $          | 1,354,771  |                        | $          | 1,671,884                         |       | $                | 358,267    |                                              | $          | (1,894,412 | ) | $ | 1,490,510 |   |
|                                                                        |       |       |       |                        |       |                              |       |             |       |                                              |       |
| **Liabilities and Member’s  (Deficit) Equity**                         |       |       |       |                        |       |                              |       |             |       |                                              |       |
| Accounts payable                                                            |       | $          | —     |                        | $          | 145,845                           |       | $                | 47,747     |                                              | $          | — |   | $ | 193,592 |   |
| Due to affiliates                                                           |       | 276,767    |       | 11,169                      |       | 20,640                            |       | (308,576         | )          | —                                            |       |
| Accrued liabilities                                                         |       | 30,994     |       | 102,573                     |       | 20,275                            |       | —           |       | 153,842                                           |       |
| Due to Sally Beauty                                                         |       | —     |       | 22,042                      |       | —                            |       | —           |       | 22,042                                            |       |
| Income taxes                                                                |       | 5,217      |       | 1,929                       |       | (1,317                            | )          | —           |       | 5,829                                             |       |
| Long-term debt                                                              |       | 1,673,856  |       | 191                         |       | 3,483                             |       | —           |       | 1,677,530                                         |       |
| Other liabilities                                                           |       | 15,365     |       | 27,157                      |       | 1,064                             |       | —           |       | 43,586                                            |       |
| Deferred income tax liabilities                                             |       | (7,089     | )          | 40,653                      |       | 864                               |       | —           |       | 34,428                                            |       |
| Total liabilities                                                           |       | 1,995,110  |       | 351,559                     |       | 92,756                            |       | (308,576         | )          | 2,130,849                                         |       |
| Stock options subject to redemption                                         |       | 1,800      |       | —                      |       | —                            |       | —           |       | 1,800                                             |       |
| Total member’s (deficit) equity                                        |       | (642,139   | )          | 1,320,325                   |       | 265,511                           |       | (1,585,836       | )          | (642,139                                          | )          |
| Total liabilities and member’s (deficit) equity                        |       | $          | 1,354,771  |                        | $          | 1,671,884                         |       | $                | 358,267    |                                              | $          | (1,894,412 | ) | $ | 1,490,510 |   |

 

F-35

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Table of Contents

 

Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

CondensedConsolidated Statement of Earnings

FiscalYear Ended September 30, 2010

(Inthousands)

 
| ** **                                           | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally  Holdings  LLC &  Subsidiaries** | ** ** |
|------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|---------------------------------------------------|------------|
|                                                 |       |       |       |                        |       |                              |       |             |       |                                              |       |
| Net sales                                            |       | $          | —     |                        | $          | 2,365,838                         |       | $                | 550,252    |                                              | $          | — |   | $ | 2,916,090 |   |
| Related party sales                                  |       | —     |       | 2,881                       |       | —                            |       | (2,881           | )          | —                                            |       |
| Cost of products sold and distribution expenses      |       | —     |       | 1,211,220                   |       | 303,377                           |       | (2,881           | )          | 1,511,716                                         |       |
| Gross profit                                         |       | —     |       | 1,157,499                   |       | 246,875                           |       | —           |       | 1,404,374                                         |       |
| Selling, general and administrative expenses         |       | 659        |       | 787,828                     |       | 216,173                           |       | —           |       | 1,004,660                                         |       |
| Depreciation and amortization                        |       | —     |       | 36,414                      |       | 14,708                            |       | —           |       | 51,122                                            |       |
| Operating earnings (loss)                            |       | (659       | )          | 333,257                     |       | 15,994                            |       | —           |       | 348,592                                           |       |
| Interest income                                      |       | —     |       | (74                         | )          | (84                               | )          | —           |       | (158                                              | )          |
| Interest expense                                     |       | 112,278    |       | 93                          |       | 740                               |       | —           |       | 113,111                                           |       |
| Earnings (losses) before provision for income  taxes |       | (112,937   | )          | 333,238                     |       | 15,338                            |       | —           |       | 235,639                                           |       |
| Provision (benefit) for income taxes                 |       | (43,829    | )          | 128,463                     |       | 2,376                             |       | —           |       | 87,010                                            |       |
| Equity in earnings of subsidiaries (net of tax)      |       | 217,737    |       | 12,962                      |       | —                            |       | (230,699         | )          | —                                            |       |
| Net earnings                                         |       | $          | 148,629    |                        | $          | 217,737                           |       | $                | 12,962     |                                              | $          | (230,699 | ) | $ | 148,629 |   |

 

F-36

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Table of Contents

 

Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

CondensedConsolidated Statement of Earnings

FiscalYear Ended September 30, 2009

(Inthousands)

 
| ** **                                           | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally  Holdings  LLC &  Subsidiaries** | ** ** |
|------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|---------------------------------------------------|------------|
|                                                 |       |       |       |                        |       |                              |       |             |       |                                              |       |
| Net sales                                            |       | $          | —     |                        | $          | 2,169,528                         |       | $                | 467,072    |                                              | $          | — |   | $ | 2,636,600 |   |
| Related party sales                                  |       | —     |       | 2,823                       |       | —                            |       | (2,823           | )          | —                                            |       |
| Cost of products sold and distribution expenses      |       | —     |       | 1,127,447                   |       | 268,659                           |       | (2,823           | )          | 1,393,283                                         |       |
| Gross profit                                         |       | —     |       | 1,044,904                   |       | 198,413                           |       | —           |       | 1,243,317                                         |       |
| Selling, general and administrative expenses         |       | 727        |       | 711,055                     |       | 179,274                           |       | —           |       | 891,056                                           |       |
| Depreciation and amortization                        |       | —     |       | 35,157                      |       | 11,909                            |       | —           |       | 47,066                                            |       |
| Operating earnings (loss)                            |       | (727       | )          | 298,692                     |       | 7,230                             |       | —           |       | 305,195                                           |       |
| Interest income                                      |       | —     |       | (205                        | )          | (140                              | )          | —           |       | (345                                              | )          |
| Interest expense                                     |       | 131,698    |       | 378                         |       | 312                               |       | —           |       | 132,388                                           |       |
| Earnings (losses) before provision for income  taxes |       | (132,425   | )          | 298,519                     |       | 7,058                             |       | —           |       | 173,152                                           |       |
| Provision (benefit) for income taxes                 |       | (44,559    | )          | 107,193                     |       | 5,790                             |       | —           |       | 68,424                                            |       |
| Equity in earnings of subsidiaries (net of tax)      |       | 192,594    |       | 1,268                       |       | —                            |       | (193,862         | )          | —                                            |       |
| Net earnings                                         |       | $          | 104,728    |                        | $          | 192,594                           |       | $                | 1,268      |                                              | $          | (193,862 | ) | $ | 104,728 |   |

 

F-37

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Table of Contents

 

Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

**SALLY HOLDINGS, INC. AND SUBSIDIARIES**

CondensedConsolidated Statement of Earnings

FiscalYear Ended September 30, 2008

(Inthousands)

 
| ** **                                           | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally  Holdings  LLC &  Subsidiaries** | ** ** |
|------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|---------------------------------------------------|------------|
|                                                 |       |       |       |                        |       |                              |       |             |       |                                              |       |
| Net sales                                            |       | $          | —     |                        | $          | 2,137,113                         |       | $                | 511,078    |                                              | $          | — |   | $ | 2,648,191 |   |
| Related party sales                                  |       | —     |       | 2,827                       |       | —                            |       | (2,827           | )          | —                                            |       |
| Cost of products sold and distribution expenses      |       | —     |       | 1,135,903                   |       | 280,521                           |       | (2,827           | )          | 1,413,597                                         |       |
| Gross profit                                         |       | —     |       | 1,004,037                   |       | 230,557                           |       | —           |       | 1,234,594                                         |       |
| Selling, general and administrative expenses         |       | 827        |       | 787,586                     |       | 107,219                           |       | —           |       | 895,632                                           |       |
| Depreciation and amortization                        |       | —     |       | 36,082                      |       | 12,451                            |       | —           |       | 48,533                                            |       |
| Operating earnings (loss)                            |       | (827       | )          | 180,369                     |       | 110,887                           |       | —           |       | 290,429                                           |       |
| Interest income                                      |       | —     |       | (139                        | )          | (606                              | )          | —           |       | (745                                              | )          |
| Interest expense                                     |       | 158,762    |       | 423                         |       | 457                               |       | —           |       | 159,642                                           |       |
| Earnings (losses) before provision for income  taxes |       | (159,589   | )          | 180,085                     |       | 111,036                           |       | —           |       | 131,532                                           |       |
| Provision (benefit) for income taxes                 |       | (61,598    | )          | 103,616                     |       | 6,646                             |       | —           |       | 48,664                                            |       |
| Equity in earnings of subsidiaries (net of tax)      |       | 180,859    |       | 104,390                     |       | —                            |       | (285,249         | )          | —                                            |       |
| Net earnings                                         |       | $          | 82,868     |                        | $          | 180,859                           |       | $                | 104,390    |                                              | $          | (285,249 | ) | $ | 82,868 |   |

 

F-38

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Table of Contents

 

Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

CondensedConsolidated Statement of Cash Flows

FiscalYear Ended September 30, 2010

(Inthousands)

 
| ** **                                                                 | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally  Holdings  LLC &  Subsidiaries** | ** ** |
|----------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|---------------------------------------------------|------------|
|                                                                       |       |       |       |                        |       |                              |       |             |       |                                              |       |
| **Net cash provided by operating  activities**                             |       | $          | 125,000    |                        | $          | 31,148                            |       | $                | 61,906     |                                              | $          | — |   | $ | 218,054 |   |
|                                                                       |       |       |       |                        |       |                              |       |             |       |                                              |       |
| **Cash Flows from Investing  Activities:**                                 |       |       |       |                        |       |                              |       |             |       |                                              |       |
| Capital expenditures, net of proceeds from sale of  property and equipment |       | —     |       | (32,070                     | )          | (16,489                           | )          | —           |       | (48,559                                           | )          |
| Acquisitions, net of cash acquired                                         |       | —     |       | (3,830                      | )          | (32,633                           | )          | —           |       | (36,463                                           | )          |
| Net cash used by investing activities                                      |       | —     |       | (35,900                     | )          | (49,122                           | )          | —           |       | (85,022                                           | )          |
|                                                                       |       |       |       |                        |       |                              |       |             |       |                                              |       |
| **Cash Flows from Financing  Activities:**                                 |       |       |       |                        |       |                              |       |             |       |                                              |       |
| Proceeds from issuance of long-term debt                                   |       | 334,000    |       | —                      |       | —                            |       | —           |       | 334,000                                           |       |
| Repayments of long-term debt                                               |       | (459,000   | )          | (114                        | )          | (2,453                            | )          | —           |       | (461,567                                          | )          |
| Excess tax benefit from share-based compensation                           |       | —     |       | 248                         |       | —                            |       | —           |       | 248                                               |       |
| Net cash used by financing activities                                      |       | (125,000   | )          | 134                         |       | (2,453                            | )          | —           |       | (127,319                                          | )          |
|                                                                       |       |       |       |                        |       |                              |       |             |       |                                              |       |
| Effect of foreign exchange rate changes on cash  and cash equivalents      |       | —     |       | —                      |       | (666                              | )          | —           |       | (666                                              | )          |
| Net (decrease) increase in cash and cash  equivalents                      |       | —     |       | (4,618                      | )          | 9,665                             |       | —           |       | 5,047                                             |       |
| Cash and cash equivalents, beginning of period                             |       | 20         |       | 37,593                      |       | 16,834                            |       | —           |       | 54,447                                            |       |
| Cash and cash equivalents, end of period                                   |       | $          | 20         |                        | $          | 32,975                            |       | $                | 26,499     |                                              | $          | — |   | $ | 59,494 |   |

 

F-39

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Table of Contents

 

Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

CondensedConsolidated Statement of Cash Flows

FiscalYear Ended September 30, 2009

(Inthousands)

 
| ** **                                                                 | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally  Holdings  LLC &  Subsidiaries** | ** ** |
|----------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|---------------------------------------------------|------------|
|                                                                       |       |       |       |                        |       |                              |       |             |       |                                              |       |
| **Net cash provided by operating  activities**                             |       | $          | 147,735    |                        | $          | 49,387                            |       | $                | 26,862     |                                              | $          | — |   | $ | 223,984 |   |
|                                                                       |       |       |       |                        |       |                              |       |             |       |                                              |       |
| **Cash Flows from Investing  Activities:**                                 |       |       |       |                        |       |                              |       |             |       |                                              |       |
| Capital expenditures, net of proceeds from sale of  property and equipment |       | —     |       | (24,705                     | )          | (12,395                           | )          | —           |       | (37,100                                           | )          |
| Acquisitions, net of cash acquired                                         |       | —     |       | (72,084                     | )          | (9,375                            | )          | —           |       | (81,459                                           | )          |
| Net cash used by investing activities                                      |       | —     |       | (96,789                     | )          | (21,770                           | )          | —           |       | (118,559                                          | )          |
|                                                                       |       |       |       |                        |       |                              |       |             |       |                                              |       |
| **Cash Flows from Financing  Activities:**                                 |       |       |       |                        |       |                              |       |             |       |                                              |       |
| Change in book cash overdraft                                              |       | (1,633     | )          | —                      |       | —                            |       | —           |       | (1,633                                            | )          |
| Proceeds from issuance of long-term debt                                   |       | 94,637     |       | —                      |       | 940                               |       | —           |       | 95,577                                            |       |
| Repayments of long-term debt                                               |       | (242,364   | )          | (195                        | )          | (1,107                            | )          | —           |       | (243,666                                          | )          |
| Excess tax benefit from share-based compensation                           |       | —     |       | (194                        | )          | —                            |       | —           |       | (194                                              | )          |
| Net cash used by financing activities                                      |       | (149,360   | )          | (389                        | )          | (167                              | )          | —           |       | (149,916                                          | )          |
|                                                                       |       |       |       |                        |       |                              |       |             |       |                                              |       |
| Effect of foreign exchange rate changes on cash  and cash equivalents      |       | —     |       | —                      |       | (850                              | )          | —           |       | (850                                              | )          |
| Net (decrease) increase in cash and cash  equivalents                      |       | (1,625     | )          | (47,791                     | )          | 4,075                             |       | —           |       | (45,341                                           | )          |
| Cash and cash equivalents, beginning of period                             |       | 1,645      |       | 85,384                      |       | 12,759                            |       | —           |       | 99,788                                            |       |
| Cash and cash equivalents, end of period                                   |       | $          | 20         |                        | $          | 37,593                            |       | $                | 16,834     |                                              | $          | — |   | $ | 54,447 |   |

 

F-40

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Table of Contents

 

Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

**SALLY HOLDINGS, INC. AND SUBSIDIARIES**

CondensedConsolidated Statement of Cash Flows

FiscalYear Ended September 30, 2008

(Inthousands)

 
| ** **                                                             | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally  Holdings  LLC &  Subsidiaries** | ** ** |
|------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|---------------------------------------------------|------------|
|                                                                   |       |       |       |                        |       |                              |       |             |       |                                              |       |
| **Net cash provided (used) by  operating activities**                  |       | $          | (64,781    | )                           | $          | 144,625                           |       | $                | 31,571     |                                              | $          | — |   | $ | 111,415 |   |
|                                                                   |       |       |       |                        |       |                              |       |             |       |                                              |       |
| **Cash Flows from Investing  Activities:**                             |       |       |       |                        |       |                              |       |             |       |                                              |       |
| Capital expenditures and proceeds from sale of  property and equipment |       | —     |       | (36,048                     | )          | (9,240                            | )          | —           |       | (45,288                                           | )          |
| Acquisitions, net of cash acquired                                     |       | —     |       | (14,896                     | )          | (37,978                           | )          | —           |       | (52,874                                           | )          |
| Net cash used by investing activities                                  |       | —     |       | (50,944                     | )          | (47,218                           | )          | —           |       | (98,162                                           | )          |
|                                                                   |       |       |       |                        |       |                              |       |             |       |                                              |       |
| **Cash Flows from Financing  Activities:**                             |       |       |       |                        |       |                              |       |             |       |                                              |       |
| Change in book cash overdraft                                          |       | —     |       | 1,633                       |       | —                            |       | —           |       | 1,633                                             |       |
| Proceeds from issuance of long-term debt                               |       | 496,185    |       | 72                          |       | 31,478                            |       | —           |       | 527,735                                           |       |
| Repayments of long-term debt                                           |       | (449,285   | )          | (250                        | )          | (33,150                           | )          | —           |       | (482,685                                          | )          |
| Debt issuance costs                                                    |       | —     |       | —                      |       | —                            |       | —           |       | —                                            |       |
| Excess tax benefit from share-based compensation                       |       | —     |       | 451                         |       | —                            |       | —           |       | 451                                               |       |
| Distributions to Sally Beauty                                          |       | —     |       | —                      |       | —                            |       | —           |       | —                                            |       |
| Distributions received (made)                                          |       | 19,519     |       | (19,519                     | )          | —                            |       | —           |       | —                                            |       |
| Net cash provided (used) by financing activities                       |       | 66,419     |       | (17,613                     | )          | (1,672                            | )          | —           |       | 47,134                                            |       |
|                                                                   |       |       |       |                        |       |                              |       |             |       |                                              |       |
| Effect of foreign exchange rate changes on cash  and cash equivalents  |       | —     |       | —                      |       | 1,129                             |       | —           |       | 1,129                                             |       |
| Net (decrease) increase in cash and cash  equivalents                  |       | 1,638      |       | 76,068                      |       | (16,190                           | )          | —           |       | 61,516                                            |       |
| Cash and cash equivalents, beginning of period                         |       | 7          |       | 9,316                       |       | 28,949                            |       | —           |       | 38,272                                            |       |
| Cash and cash equivalents, end of period                               |       | $          | 1,645      |                        | $          | 85,384                            |       | $                | 12,759     |                                              | $          | — |   | $ | 99,788 |   |

 

F-41

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Table of Contents

 

Sally Holdings LLC andSubsidiaries

Notes to ConsolidatedFinancial Statements

 

**20.  Subsequent Events**

 

OnOctober 1, 2010, the Company acquired Aerial Company, Inc. (“Aerial”),an 82-store professional-only beauty supply chain operating in the Midwesternand northwestern United States, for approximately $79.0 million, subject tocertain adjustments. This acquisitionwill be accounted for using the purchase method of accounting and, accordingly,the results of operations of Aerial will be included in the Company’sconsolidated financial statements subsequent to the acquisition date. Theacquisition was funded with borrowings under our ABL facility in the amount of$78.0 million and with cash from operations.

 

InOctober 2010, the Company also entered into certain foreign currencyoption agreements, including foreign currency put options with an aggregatenotional amount of €4.0 million ($5.5 million, at the November 12, 2010exchange rate) and foreign currency call options with an aggregate notionalamount of €8.1 million ($11.1 million, at the November 12, 2010 exchangerate), to manage the exposure to certain non-Euro currencies resulting fromSinelco’s purchases of merchandise from third-party suppliers. These foreigncurrency options expire ratably through September 15, 2011, are notdesignated as hedges, and do not meet the hedge accounting requirements of ASC815. Accordingly, the changes in the fair value of these derivativeinstruments (which will be adjusted quarterly) will be recorded in ourconsolidated statements of earnings.

 

InNovember 2010, the Company entered into a new agreement with lenders toreplace its ABL facility with a new $400 million, 5-year credit facility (the “newABL facility”). The new ABL facility contains restrictions and limitationssimilar to those contained in the prior ABL facility and, similar to the priorABL facility, borrowings under the new ABL facility are secured bysubstantially all of our assets. The terms of the new ABL facility includeinterest rates at Prime plus 1.25% to 1.75% or LIBOR plus 2.25% to 2.75% and acommitment fee of 0.50% on the unused portion of the facility.

 

**21.   QuarterlyFinancial Data (Unaudited)**

 

Certainunaudited quarterly consolidated statement of earnings information for thefiscal years ended September 30, 2010 and 2009 is summarized below (inthousands, except per share data):

 
| ** Fiscal Year** | ** ** | **1****st********Quarter** | ** ** | **2****nd********Quarter** | ** ** | **3****rd********Quarter** | ** ** | **4****th********Quarter** | ** ** |
|----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|
| 2010:                      |       |                       |       |                       |       |                       |       |                       |       |
| Net  sales                 |       | $                          | 704,851    |                       | $          | 720,467                    |       | $                          | 742,975    |   | $ | 747,797 |   |
| Gross  profit              |       | $                          | 333,214    |                       | $          | 344,284                    |       | $                          | 360,859    |   | $ | 366,016 |   |
| Net  earnings              |       | $                          | 27,361     |                       | $          | 35,866                     |       | $                          | 42,277     |   | $ | 43,125 |   |
|                       |       |                       |       |                       |       |                       |       |                       |       |
| 2009:                      |       |                       |       |                       |       |                       |       |                       |       |
| Net  sales                 |       | $                          | 645,576    |                       | $          | 641,511                    |       | $                          | 673,337    |   | $ | 676,176 |   |
| Gross  profit              |       | $                          | 303,544    |                       | $          | 302,112                    |       | $                          | 317,845    |   | $ | 319,816 |   |
| Net  earnings              |       | $                          | 17,207     |                       | $          | 25,739                     |       | $                          | 32,855     |   | $ | 28,927 |   |

 

F-42

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