**UNITEDSTATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 

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| **x**  | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|--------|------------|---------------------------------------------------------------------------------------------------------|
|   |       |                                                                                                    |
|   |       | **FOR THE QUARTERLY PERIOD ENDED: DECEMBER 31, 2007**                                                   |
|   |       |                                                                                                    |
|   |       | **-OR-**                                                                                                |
|   |       |                                                                                                    |
| **o**  | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

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| **SALLY HOLDINGS  LLC**                                 | ** ** | **SALLY CAPITAL  INC.**                                 |
|---------------------------------------------------------|------------|---------------------------------------------------------|
| (Exact name of registrant as  specified in its charter) |       | (Exact name of registrant as  specified in its charter) |
|                                                    |       |                                                    |
| **Delaware**                                            | ** ** | **Delaware**                                            |
| (State or other jurisdiction of                         |       | (State or other jurisdiction of                         |
| incorporation or organization)                          |       | incorporation or organization)                          |
|                                                    |       |                                                    |
| **36-4472381**                                          | ** ** | **56-2620323**                                          |
| (I.R.S. Employer Identification  Number)                |       | (I.R.S. Employer Identification  Number)                |
|                                                    |       |                                                    |
| **333-144427**                                          | ** ** | **333-144427-10**                                       |
| (Commission file number)                                |       | (Commission file number)                                |

 

**3001 Colorado BoulevardDenton, Texas 76210**

(Address of principal executive offices)

 

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

 

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 is a large accelerated filer, anaccelerated filer or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the ExchangeAct. Large accelerated filer   o   Accelerated filer   o  Non-accelerated filer  x

 

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

 

Novoting or non-voting common equity of the registrant’s were held bynon-affiliates of the registrants’ as of December 31, 2007. As of February 4,2008, all member units were owned by Sally Investment Holdings LLC, awholly-owned subsidiary of Sally Beauty Holdings, Inc.

 

 

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**TABLE OF CONTENTS**

** **
|         |                                                                                        |   | **Page** |
|--------------|---------------------------------------------------------------------------------------------|--------|----------|
|         |                                                                                        |   |     |
|         | PART I – FINANCIAL INFORMATION                                                    |   |     |
|         |                                                                                        |   |     |
| Item 1.      | Financial Statements                                                                        |   | 5        |
| Item 2.      | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   | 26       |
| Item 3. | Quantitative  and Qualitative Disclosures About Market Risk                                 |   | 39       |
| Item 4.      | Controls and  Procedures                                                                    |   | 40       |
|         |                                                                                        |   |     |
|         | PART II – OTHER  INFORMATION                                                      |   |     |
|         |                                                                                        |   |     |
| Item 1.      |  Legal Proceedings                                                                     |   | 41       |
| Items 1A.    | Risk Factors                                                                                |   | 41       |
| Item 2.      | Unregistered  Sales of Equity Securities and Use of Proceeds                                |   | 41       |
| Item 3.      | Defaults  Upon Senior Securities                                                            |   | 41       |
| Item 4.      | Submission  of Matters to a Vote of Security Holders                                        |   | 41       |
| Item 5.      | Other Information                                                                           |   | 41       |
| Item 6.      | Exhibits                                                                                    |   | 42       |
|              |                                                                                             |        |          |  |

 

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Since November 16, 2006, Sally Holdings LLC, which we refer to as “Sally Holdings,” a limitedliability company organized under the laws of the State of Delaware, isa wholly-owned subsidiary of Sally Investment Holdings LLC, which we refer toas “Sally Investment,” a wholly-owned subsidiary of Sally Beauty Holdings, Inc.,which we refer to as “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. 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, which we refer toas “Alberto-Culver.” On November 16, 2006, Sally Holdings, Inc. wasconverted to a Delaware limited liability company, was renamed “Sally HoldingsLLC” and became a wholly-owned subsidiary of Sally Investment and an indirectsubsidiary of Sally Beauty in connection with the separation of Sally Holdings’business from Alberto-Culver. All operations of Sally Investment and SallyBeauty are conducted through Sally Holdings and its consolidated subsidiaries. SallyCapital Inc., a Delaware corporation which we refer to as “Sally Capital,” is awholly-owned subsidiary of Sally Holdings and does not have any assets oroperations of any kind.

 

In this report, references to the “Company,” “SallyHoldings,” “our company,” “we,” “our,” “ours” and “us” refer to Sally HoldingsLLC and its consolidated subsidiaries for periods after the separation fromAlberto-Culver and to Sally Holdings, Inc. and its consolidatedsubsidiaries for periods prior to the separation from Alberto-Culver unless otherwiseindicated or context otherwise requires.

 

Cautionary Notice Regarding Forward-LookingStatements

 

Statements in this report which are not purelyhistorical facts or which depend upon future events may be forward-lookingstatements within the meaning of Section 27A of the Securities Act of1933, as amended, and Section 21E of the Securities Exchange Act of 1934,as amended. Words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,”“plan,” “project,” “target,” “can,” “could,” “may,” “should,” “will,” “would,”or similar expressions may also identify such forward-looking statements.

 

Readers are cautioned not to place undue reliance onforward-looking statements as such statements speak only as of the date theywere made. Any forward-looking statements involve risks and uncertainties thatcould cause actual events or results to differ materially from the events orresults described in the forward-looking statements, including, but not limitedto, risks and uncertainties related to:

 

·                  Sally Beauty’s limited history as astand-alone company;

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

·                  the representativeness of our historicalconsolidated financial information with respect to our future financialposition, results of operations or cash flows;

·                  realizing theanticipated benefits of our separation from Alberto-Culver;

·                  since ourseparation from Alberto-Culver, our inability to achieve the benefits of scalethat were achieved by Alberto-Culver prior to our separation fromAlberto-Culver;

·                  Sally Capitaland Sally Beauty being holding companies with no operations of their own, anddepending on their subsidiaries for cash;

·                  the highlycompetitive and consolidating nature of the beauty products distributionindustry;

·                  anticipatingchanges in consumer preferences and buying trends or to manage our productlines and inventory;

·                  our dependenceupon manufacturers who may be unwilling or unable to continue to supplyproducts to us;

·                  products sold byus being found to be defective in labeling or content;

·                  compliance withlaws and regulations, or becoming subject to additional or more stringent lawsand regulations;

·                  productdiversion;

 

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·                  the operationaland financial performance of our Armstrong McCall business;

·                  the success ofour new Internet-based business;

·                  successfullyidentifying acquisition candidates or successfully completing desirableacquisitions;

·                  integration ofbusinesses acquired in the future;

·                  opening andoperating new stores profitably;

·                  the success ofour cost control plans;

·                  protecting ourintellectual property rights, specifically our trademarks;

·                  conductingbusiness in international markets;

·                  disruption inour information technology systems;

·                  naturaldisasters or acts of terrorism;

·                  our substantialindebtedness;

·                  the possibilitythat we may incur substantial additional debt;

·                  restrictions andlimitations in the agreements and instruments governing our debt;

·                  generating thesignificant amount of cash needed to service all of our debt and refinancingall or a portion of our indebtedness or obtaining additional financing;

·                  changes in interestrates increasing the cost of servicing our debt or increasing our interestexpense due to our interest rate swap agreements;

·                  the sharedistribution of Alberto-Culver common stock in our separation fromAlberto-Culver not constituting a tax-free distribution;

·                  actions taken bycertain large shareholders of Sally Beauty adversely affecting the tax-freenature of the share distribution of Alberto-Culver common stock;

·                  significantrestrictions on Sally Beauty’s ability to issue equity securities;

·                  the voting powerof Sally Beauty’s largest stockholder discouraging third party acquisitions ofSally Beauty at a premium; and

·                  the interests ofSally Beauty’s largest stockholder differing from the interests of otherholders of Sally Beauty’s common stock.

 

Additionalfactors that could cause actual events or results to differ materially from theevents or results described in the forward-looking statements can be found inour Annual Report on Form 10-K for the fiscal year ended September 30,2007, as filed with the Securities and Exchange Commission. The eventsdescribed in the forward-looking statements might not occur or might occur to adifferent extent or at a different time than we have described. As a result,our actual results may differ materially from the results contemplated by theseforward-looking statements. Weassume no obligation to publicly update or revise any forward-lookingstatements.

 

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# **PART I – FINANCIALINFORMATION**

 

# **Item 1. Financial Statements.**

 

The following are our consolidated balancesheets as of December 31, 2007 and September 30, 2007 and ourconsolidated statements of earnings and cash flows for the three months ended December 31,2007 and 2006. On November 16, 2006, Sally Holdings, Inc. wasconverted to a Delaware limited liability company, was renamed “Sally HoldingsLLC” and became an indirect wholly owned subsidiary of Sally Beauty Holdings, Inc.in connection with our separation from the Alberto-Culver Company (“Alberto-Culver”).In these financial statements and elsewhere in this Quarterly Report on Form 10-Q,we refer to these transactions as the Separation Transactions. See the Company’sAnnual Report on Form 10-K for the fiscal year ended September 30,2007 for additional information about the Separation Transactions. SallyCapital is a wholly-owned subsidiary of Sally Holdings and does not have assetsor operations of any kind.

 

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**SALLYHOLDINGS LLC AND SUBSIDIARIES**Consolidated Statements of Earnings(In thousands)

(Unaudited)

 
| ** **                                         | ** ** | **Three Months Ended  December 31,** | ** ** |
|----------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                         | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
| Net sales                                          |       | $                                                   | 655,787    |   | $ | 629,879 |   |
| Cost of products  sold and distribution expenses   |       | 349,618                                             |       | 345,387 |   |
| Gross profit                                       |       | 306,169                                             |       | 284,492 |   |
| Selling, general  and administrative expenses (a)  |       | 222,895                                             |       | 212,257 |   |
| Depreciation and  amortization                     |       | 11,752                                              |       | 9,790 |   |
| Sales-based  service fee charged by Alberto-Culver |       | —                                              |       | 3,779 |   |
| Transaction  expenses (b)                          |       | —                                              |       | 21,457 |   |
| Operating  earnings                                |       | 71,522                                              |       | 37,209 |   |
| Interest  expense, net (c)                         |       | 46,483                                              |       | 19,103 |   |
| Earnings before  provision for income taxes        |       | 25,039                                              |       | 18,106 |   |
| Provision for  income taxes                        |       | 9,693                                               |       | 14,404 |   |
| Net earnings                                       |       | $                                                   | 15,346     |   | $ | 3,702 |   |

 

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(a)                                  Selling,general and administrative expenses include allocated overhead costs fromAlberto-Culver of $1.0 million for the three months ended December 31,2006 and share-based compensation of $5.4 million and $5.7 million for thethree months ended December 31, 2007 and 2006, respectively.

 

(b)                                 Transactionexpenses are one-time charges associated with the separation fromAlberto-Culver.

 

(c)                                  Interestexpense, net of interest income of $0.2 million and $1.0 million for the threemonths ended December 31, 2007 and 2006, respectively, includes expense of$5.7 million and income of $1.0 million of marked-to-market adjustments relatedto interest rate swaps for the three months ended December 31, 2007 and2006, respectively.

 

Earnings per share is notpresented since prior to November 16, 2006, Alberto-Culver owned allshares of issued and outstanding common stock of Sally Holdings, Inc. SinceNovember 16, 2006, all member units of Sally Holdings LLC have been ownedby Sally Investment, a wholly-owned subsidiary of Sally Beauty.

 

The accompanyingcondensed notes, together with the Notes to Consolidated Financial Statementscontained in the Company’s Annual Report on Form 10-K for the fiscal yearended September 30, 2007, are an integral part of these financialstatements.

 

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**SALLY HOLDINGS LLC AND SUBSIDIARIES**Consolidated Balance Sheets(In thousands)

 
| ** **                                                                                                                                  | ** ** | **December 31,  2007** | ** ** | **September 30,  2007** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                  | ** ** | **(Unaudited)**             | ** ** | ** **                   | ** ** |
| **Assets**                                                                                                                                  |       |                        |       |                         |       |
| Current assets:                                                                                                                             |       |                        |       |                         |       |
| Cash and cash  equivalents                                                                                                                  |       | $                           | 43,147     |                         | $          | 38,272 |   |
| Trade accounts  receivable, less allowance for doubtful accounts of $2,610 at  December 31, 2007 and $2,564 at September 30, 2007 |       | 47,724                      |       | 51,409                       |       |
| Other  receivables                                                                                                                          |       | 27,260                      |       | 22,194                       |       |
| Inventories                                                                                                                                 |       | 595,701                     |       | 569,404                      |       |
| Prepaid expenses                                                                                                                            |       | 14,995                      |       | 15,375                       |       |
| Deferred income  tax assets                                                                                                                 |       | 17,801                      |       | 15,291                       |       |
| Total current assets                                                                                                                        |       | 746,628                     |       | 711,945                      |       |
| Property and  equipment, net of accumulated depreciation of $223,875 at                                                                     |       |                        |       |                         |       |
| December 31,  2007 and $215,826 at September 30, 2007                                                                             |       | 156,293                     |       | 154,068                      |       |
| Goodwill                                                                                                                                    |       | 406,093                     |       | 406,623                      |       |
| Intangible  assets, net of accumulated amortization of $13,815 at                                                                           |       |                        |       |                         |       |
| December 31,  2007 and $11,904 at September 30, 2007                                                                              |       | 70,332                      |       | 70,505                       |       |
| Other assets                                                                                                                                |       | 58,786                      |       | 61,120                       |       |
| Total assets                                                                                                                                |       | $                           | 1,438,132  |                         | $          | 1,404,261 |   |
| **Liabilities  and Member’s Deficit**                                                                                                  |       |                        |       |                         |       |
| Current  liabilities:                                                                                                                       |       |                        |       |                         |       |
| Current  maturities of long-term debt                                                                                                       |       | $                           | 18,994     |                         | $          | 17,147 |   |
| Accounts payable                                                                                                                            |       | 163,943                     |       | 176,660                      |       |
| Accrued expenses                                                                                                                            |       | 138,194                     |       | 153,671                      |       |
| Due to Sally  Beauty                                                                                                                        |       | 22,945                      |       | 18,864                       |       |
| Income taxes                                                                                                                                |       | 5,660                       |       | 3,712                        |       |
| Total current  liabilities                                                                                                                  |       | 349,736                     |       | 370,054                      |       |
| Long-term debt                                                                                                                              |       | 1,794,542                   |       | 1,758,594                    |       |
| Other  liabilities                                                                                                                          |       | 25,383                      |       | 18,828                       |       |
| Deferred income  tax liabilities                                                                                                            |       | 31,508                      |       | 30,553                       |       |
| Total liabilities                                                                                                                           |       | 2,201,169                   |       | 2,178,029                    |       |
|                                                                                                                                        |       |                        |       |                         |       |
| Stock options  subject to redemption                                                                                                        |       | 6,390                       |       | 6,549                        |       |
|                                                                                                                                        |       |                        |       |                         |       |
| Member’s deficit:                                                                                                                      |       |                        |       |                         |       |
| Member’s deficit                                                                                                                       |       | (799,493                    | )          | (814,839                     | )          |
| Accumulated  other comprehensive income – foreign currency translation                                                                 |       | 30,066                      |       | 34,522                       |       |
| Total member’s deficit                                                                                                                 |       | (769,427                    | )          | (780,317                     | )          |
| Total liabilities and  member’s deficit                                                                                                |       | $                           | 1,438,132  |                         | $          | 1,404,261 |   |

 

Prior to November 16, 2006, Alberto-Culver owned all shares ofissued and outstanding common stock of Sally Holdings, Inc. Since November 16,2006, all member units of Sally Holdings LLC have been owned by SallyInvestment, a wholly-owned subsidiary of Sally Beauty.

 

The accompanyingcondensed notes, together with the Notes to Consolidated Financial Statementscontained in the Company’s Annual Report on Form 10-K for the fiscal yearended September 30, 2007, are an integral part of these financialstatements.

 

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**SALLYHOLDINGS LLC AND SUBSIDIARIES**Consolidated Statements of Cash Flows(In thousands)

(Unaudited)

 
| ** **                                                                                                           | ** ** | **Three Months Ended  December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                           | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
| **Cash  Flows from Operating Activities:**                                                                           |       |                                                |       |   |   |
| Net earnings                                                                                                         |       | $                                                   | 15,346     |   | $ | 3,702 |   |
| Adjustments to  reconcile net earnings to net cash (used) provided by operating activities:                          |       |                                                |       |   |   |
| Depreciation and  amortization                                                                                       |       | 11,752                                              |       | 9,790 |   |
| Share-based compensation  expense (net of deferred tax benefit of $1,965 and $1,679 in 2007 and 2006,  respectively) |       | 3,482                                               |       | 4,028 |   |
| Amortization of  deferred financing costs                                                                            |       | 2,131                                               |       | — |   |
| Excess tax  benefit from share-based compensation                                                                    |       | (129                                                | )          | (145 | ) |
| Net loss on disposal  of leaseholds and other property                                                               |       | 150                                                 |       | 631 |   |
| Deferred income  taxes                                                                                               |       | 628                                                 |       | 1,437 |   |
| Changes in (exclusive of effects of acquisitions):                                                                   |       |                                                |       |   |   |
| Trade accounts  receivable                                                                                           |       | 3,455                                               |       | (1,031 | ) |
| Other  receivables                                                                                                   |       | (5,241                                              | )          | (2,111 | ) |
| Inventories                                                                                                          |       | (28,626                                             | )          | 19,377 |   |
| Prepaid expenses                                                                                                     |       | 195                                                 |       | (3,830 | ) |
| Other assets                                                                                                         |       | 215                                                 |       | (529 | ) |
| Accounts payable  and accrued expenses                                                                               |       | (28,600                                             | )          | (6,061 | ) |
| Income taxes                                                                                                         |       | 2,036                                               |       | 2,580 |   |
| Due from  Alberto-Culver                                                                                             |       | —                                              |       | 463 |   |
| Due (to) from  Sally Beauty                                                                                          |       | (1,525                                              | )          | 21,788 |   |
| Other liabilities                                                                                                    |       | 6,781                                               |       | 8,297 |   |
| Net cash (used)  provided by operating activities                                                                    |       | (17,950                                             | )          | 58,386 |   |
| **Cash  Flows from Investing Activities:**                                                                           |       |                                                |       |   |   |
| Capital  expenditures                                                                                                |       | (12,280                                             | )          | (9,189 | ) |
| Proceeds from  sale of property and equipment                                                                        |       | 115                                                 |       | 41 |   |
| Acquisitions, net  of cash acquired                                                                                  |       | (3,112                                              | )          | (5,738 | ) |
| Net cash used by  investing activities                                                                               |       | (15,277                                             | )          | (14,886 | ) |
| **Cash  Flows from Financing Activities:**                                                                           |       |                                                |       |   |   |
| Change in book  cash overdraft                                                                                       |       | 1,175                                               |       | (6,515 | ) |
| Proceeds from  issuance of long-term debt                                                                            |       | 142,976                                             |       | 1,885,109 |   |
| Repayments of  long-term debt                                                                                        |       | (105,194                                            | )          | (88,021 | ) |
| Debt issuance  costs                                                                                                 |       | —                                              |       | (58,816 | ) |
| Excess tax  benefit from share-based compensation                                                                    |       | 129                                                 |       | 145 |   |
| Distributions to  Sally Beauty                                                                                       |       | —                                              |       | (1,809,740 | ) |
| Distributions to  Alberto-Culver                                                                                     |       | —                                              |       | (41,936 | ) |
| Net cash  provided (used) by financing activities                                                                    |       | 39,086                                              |       | (119,774 | ) |
| Effect of  foreign exchange rate changes on cash and cash equivalents                                                |       | (984                                                | )          | (221 | ) |
| Net increase  (decrease) in cash and cash equivalents                                                                |       | 4,875                                               |       | (76,495 | ) |
| Cash and cash  equivalents, beginning of period                                                                      |       | 38,272                                              |       | 107,571 |   |
| Cash and cash  equivalents, end of period                                                                            |       | $                                                   | 43,147     |   | $ | 31,076 |   |

 

The accompanyingcondensed notes, together with the Notes to Consolidated Financial Statementscontained in the Company’s Annual Report on Form 10-K for the fiscal yearended September 30, 2007, are an integral part of these financialstatements.

 

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Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

 

##### **1.     Descriptionof Business and Basis of Presentation**

##### ** **

Description of Business

 

Sally Holdings LLC (“Sally Holdings” or the “Company”)is a wholly-owned subsidiary of Sally Investment Holdings LLC (“SallyInvestment”), a wholly-owned subsidiary of Sally Beauty Holdings, Inc. (“SallyBeauty”). All of the interests of Sally Holdings are beneficially owned bySally Investment, and all of the interests of Sally Investment are beneficiallyowned by Sally Beauty. Sally Holdings 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 awholly-owned subsidiary of Sally Investment and an indirect subsidiary of SallyBeauty in connection with the separation of its business from Alberto-Culver.The Company and its consolidated subsidiaries sell professional beautysupplies, primarily through its Sally Beauty Supply retail stores, in the U.S.,Puerto Rico, Mexico, Canada, Japan, United Kingdom and certain other countries inEurope. Additionally, the Company distributes professional beauty products tosalons and professional cosmetologists through its Beauty Systems Group (“BSG”)store operations and a commissioned direct sales force that calls on salons inthe U.S., Canada, United Kingdom and certain other countries in Europe, and tofranchises in the southern and southwestern U.S. and Mexico through theoperations of its subsidiary Armstrong McCall, L.P. (“Armstrong McCall”).Certain beauty products sold by BSG and Armstrong McCall are sold throughexclusive territory agreements with the manufacturers of the products.

 

On November 16, 2006, pursuant to an investmentagreement among Alberto-Culver and certain of its subsidiaries, including SallyHoldings, Inc. (“Sally Holdings”), and CDRS Acquisition LLC (“CDRS”),Alberto-Culver separated its consumer products business and its Sally BeautySupply/BSG distribution business into two separate, publicly-traded companies(the “Separation Transactions”). Sally Holdings was a wholly-owned subsidiaryof Alberto-Culver until the Separation Transactions, when it was converted to aDelaware limited liability company, was renamed Sally Holdings LLC and becamean indirect wholly-owned subsidiary of Sally Beauty. Sally Beauty was formed onJune 16, 2006, and became the accounting successor company to SallyHoldings upon the completion of the Separation Transactions. See the Company’sAnnual Report on Form 10-K for the fiscal year ended September 30,2007 for more information about the Separation Transactions.

 

All references in these notes to “management” are tothe management of Sally Holdings. All references in these notes to the “Company”are to Sally Holdings LLC and prior to November 16, 2006, Sally Holdings, Inc.

 

In the ordinary course of business, theCompany performs certain administrative services on behalf of Sally Beauty. Theseservices are charged to Sally Beauty and netted against the amount due to SallyBeauty. In addition, we have entered into a tax sharing agreement and we fileconsolidated tax returns with our parent, Sally Beauty. See the Company’sAnnual Report on Form 10-K for the fiscal year ended September 30,2007 for more information about related parties.

 

Basis of Presentation

 

The consolidated interim financial statementsincluded herein are unaudited and have been prepared by the Company pursuant tothe rules and regulations of the Securities and Exchange Commission (“SEC”).Certain information and note disclosures normally included in annual financialstatements prepared in accordance with generally accepted accounting principles(“GAAP”) have been condensed or omitted pursuant to those rules andregulations, although the Company believes that the disclosures made areadequate to make the information not misleading. The consolidated interimfinancial statements include the accounts of the Company and its subsidiaries. Allsignificant inter-company accounts and transactions have been eliminated inconsolidation. In the opinion of management, these consolidated financialstatements reflect all adjustments which are of a normal recurring nature andwhich are necessary to present fairly the consolidated financial position as ofDecember 31, 2007 and September 30, 2007, the results of 

 

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Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

 

operations and cash flows for the three monthsended December 31, 2007 and 2006. The results of operations for theseinterim periods are not necessarily indicative of the results that may beexpected for the entire fiscal year.

 

These consolidated interim financialstatements should be read in conjunction with the financial statements andnotes thereto included in the Company’s Annual Report on Form 10-K for thefiscal year ended September 30, 2007. The Company adheres to the sameaccounting policies in preparation of interim financial statements. Aspermitted under GAAP, interim accounting for certain expenses, including incometaxes, are based on full year assumptions. Such amounts are expensed in full inthe year incurred. For interim financial reporting purposes, income taxes arerecorded based upon estimated annual effective income tax rates.

 

Certain amounts for prior periods have beenreclassified to conform to the current period’s presentation.

 

##### **2.     Share-BasedPayments**

##### ** **

The Company measures the cost of employee servicesreceived in exchange for an award of equity instruments based on the grant-datefair value of the award and recognizes compensation expense on a straight-linebasis over the vesting period or to the date a participant becomes eligible forretirement, if earlier.

 

The Company is an indirect wholly-owned subsidiary ofSally Beauty and has no share-based plans of its own; however, certainemployees of the Company have been granted stock options and share awards underthe plans of Sally Beauty.

 

During fiscal year 2007, Sally Beauty adopted the 2007Omnibus Incentive Plan (the “2007 Plan”), a share-based compensation plan,which allows for the issuance of up to 10.0 million shares of Sally Beauty’scommon stock. During the first quarter of fiscal year 2008, Sally Beautygranted approximately 2.6 million stock options to the Company’s employeesunder the 2007 Plan. Upon issuance of such grants, the Company recognizedaccelerated share-based compensation expense of $3.1 million in connection withcertain retirement eligible employees who are eligible to continue vestingawards upon retirement under the terms of the 2007 Plan.

 

Prior to November 16, 2006, the Company was asubsidiary of Alberto-Culver and had no share-based compensation plans of itsown; however, certain employees of the Company had been granted stock optionsand stock awards under share-based compensation plans of Alberto-Culver.Alberto-Culver treated the Separation Transactions as though they constituted achange in control for purposes of Alberto-Culver’s stock options and stockawards. As a result, in accordance with the terms of these plans, alloutstanding stock options and stock awards of Alberto-Culver, including thoseheld by the Company’s employees, became fully vested upon completion of theSeparation Transactions on November 16, 2006. Due to the SeparationTransactions, the Company recorded a charge during the first quarter of fiscalyear 2007 equal to the amount of future compensation expense of approximately$5.3 million that would have been recognized in subsequent periods as the stockoptions and stock awards for the Company’s employees vested over the originalvesting periods. Upon completion of the Separation Transactions, alloutstanding Alberto-Culver stock options and stock awards held by employees ofthe Company became options to purchase shares of Sally Beauty’s common stock.

 

10

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Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

 

The following table presents the total compensationcost charged against income and included in selling, general and administrativeexpenses for share-based compensation arrangements and the related tax benefitsrecognized in the statements of earnings (in thousands):

 
| ** **                                                      | ** ** | **Three Months Ended December 31,** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                      | ** ** | **2007**                                                | ** ** | **2006** | ** ** |
| ** **                                                      | ** ** | ** **                                              | ** ** | ** ** | ** ** |
| Share-based  compensation expense                               |       | $                                                       | 5,447      | (a) | $ | 5,707 | (b) |
|                                                            |       |                                                    |       |   |   |
| Income tax  benefit related to share-based compensation expense |       | $                                                       | 1,965      |   | $ | 1,679 |   |

 

----

(a)          Includes $3.1 million ofaccelerated expense related to certain retirement eligible employees who areeligible to continue vesting awards upon retirement under the terms of the 2007plan.

 

(b)         Includes $5.3 million ofaccelerated expense related to the separation from Alberto-Culver.

 

## **StockOptions**

 

Each option has an exercise price that equals 100% ofthe market price of Sally Beauty’s stock on the date of grant and generally hasa maximum term of 10 years. Options generally vest ratably over a four yearperiod and are subject to forfeiture until the four year vesting period iscomplete.

 

The following table presents a summary of the activityfor Sally Beauty’s stock option plans issued to the Company’s employees for thethree months ended December 31, 2007:

 
| ** **                              | ** ** | **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, 2007 |       | 6,724                                                         |       | $                                      | 7.33       |                                                                 |       |                                                 |       |   |
| Granted                                 |       | 2,560                                                         |       | 8.80                                   |       |                                                                 |       |                                                 |       |
| Exercised                               |       | (108                                                          | )          | 2.00                                   |       |                                                                 |       |                                                 |       |
| Forfeited or  expired                   |       | (57                                                           | )          | 9.00                                   |       |                                                                 |       |                                                 |       |
| Outstanding at  December 31, 2007  |       | 9,119                                                         |       | $                                      | 7.79       |                                                                 | 8.8        |                                                 | $          | 14,028 |   |
|                                    |       |                                                          |       |                                   |       |                                                                 |       |                                                 |       |
| Exercisable at  December 31, 2007  |       | 3,047                                                         |       | $                                      | 4.94       |                                                                 | 7.5        |                                                 | $          | 13,182 |   |

 

The following table summarizes information about stock options, held bythe Company’s employees, under Sally Beauty’s option plans at December 31,2007:

 
| ** **                                  | ** **       | **Options Outstanding**                                                  | ** ** | **Options Exercisable**                                         | ** ** |
|---------------------------------------------|------------------|-------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| **Range of Exercise Prices** | ** **       | **Number  Outstanding at  December 31,  2007 (in  Thousands)** | ** ** | **Weighted  Average  Remaining  Contractual  Term (in  Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable at  December 31,  2007 (in  Thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $                                           | 2.00             |                                                                          | 1,860      |                                                                 | 6.5        |   | $ | 2.00 |   | 1,860 |   | $ | 2.00 |   |
| $                                           | 7.70 – 9.66 |                                                                          | 7,259      |                                                                 | 9.4        |   | 9.28 |   | 1,187 |   | 9.53 |   |
| Total                                       |             | 9,119                                                                         |       | 8.8                                                                  |       | $ | 7.79 |   | 3,047 |   | $ | 4.94 |   |

 

11

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Sally Holdings LLC and Subsidiaries

CondensedNotes to Consolidated Financial Statements

 

The Company uses the Black-Scholes option-pricingmethod to value Sally Beauty’s stock options for each stock option award. Usingthis option-pricing model, the fair value of each stock option award isestimated on the date of grant. The fair value of Sally Beauty’s stock optionawards, which generally vest ratably over a four year period, is expensed on astraight-line basis over the vesting period of the stock options or to the datea participant becomes eligible for retirement, if earlier.

 

The weighted average assumptions relating to thevaluation of Sally Beauty’s stock options are as follows:

 
| ** **               | ** ** | **Three Months Ended December 31,** | ** ** |
|--------------------------|------------|---------------------------------------------------------|------------|
| ** **               | ** ** | **2007**                                                | ** ** | **2006** | ** ** |
| Expected lives  (years)  |       | 5.0                                                     |       | 5.0 |   |
| Expected  volatility     |       | 37.5                                                    | %          | 41.9 | % |
| Risk-free  interest rate |       | 4.0                                                     | %          | 4.4 | % |
| Dividend yield           |       | 0.0                                                     | %          | 0.0 | % |

 

The expected life of options represents the period oftime that the options granted are expected to be outstanding and is based onhistorical experience of employees of the Company that have been granted stockoptions under stock option plans of Alberto-Culver prior to the SeparationTransactions. Expected volatility is derived by using the average volatility ofthe Sally Beauty and similar companies since it is not practicable to estimate SallyBeauty’s expected volatility on a stand alone basis due to a lack of tradinghistory. The risk-free interest rate is based on the zero-coupon U.S. Treasuryissue as of the date of the grant. Since Sally Beauty does not expect to paydividends, the dividend yield is 0%.

 

The weighted average fair value of Sally Beauty’sstock options issued to Company employees at the date of grant in the threemonths ended December 31, 2007 and 2006 was $3.46 and $3.65 per option,respectively. The total intrinsic value of options exercised during the threemonths ended December 31, 2007 was $0.8 million. The total cash receivedfrom these option exercises was $0.2 million and the tax benefit realized forthe tax deductions from these option exercises was $0.3 million.

 

At December 31, 2007, approximately $13.8 million of total unrecognizedcompensation cost related to non-vested stock option awards is expected to berecognized over the weighted average period of 3.4 years.

 

Stock Awards

 

**Restricted Stock Awards**

 

A restricted stock award is an award of shares of Sally Beauty’s commonstock that is subject to time-based vesting during a specified period.Restricted stock awards are independent of option grants and are generallysubject to forfeiture if employment terminates prior to the vesting of theawards. Participants have full voting and dividend rights with respect toshares of restricted stock awards.

 

The Company expenses the cost of the restricted stock awards, which isdetermined to be the fair market value of the restricted stock award at thedate of grant, on a straight-line basis over the vesting period. For thesepurposes, the fair market value of the restricted stock award is determinedbased on the closing price of Sally Beauty’s common stock on the grant date.

 

12

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Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

 

The following table presents a summary of the activityfor Sally Beauty’s restricted stock awards for the three months ended December 31,2007:

 
| **Restricted Stock Awards**                | ** ** | **Number of   Shares (In   Thousands)** | ** ** | **Weighted   Average Fair   Value Per Share** | ** ** | **Weighted   Average   Remaining  Vesting Term (In  Years)** | ** ** |
|------------------------------------------------------|------------|-------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| Non-vested at September 30, 2007 |       | 350                                                         |       | $                                                                      |  8.10 |                                                                             |       |   |
| Granted                                              |       | 101                                                         |       | 8.80                                                                   |       |                                                                             |       |
| Vested                                               |       | —                                                      |       | —                                                                 |       |                                                                             |       |
| Forfeited                                            |       | —                                                      |       | —                                                                 |       |                                                                             |       |
| Non-vested at  December 31, 2007                |       | 451                                                         |       | $                                                                      | 8.26       |                                                                             | 4.3        |   |

 

At December 31,2007, approximately $3.2 million of total unrecognized compensation costrelated to non-vested restricted stock awards is expected to be recognized overthe weighted average period of 4.3 years.

 

##### **3.   Long-TermDebt**

##### ** **

In connection with the Separation Transactionson November 16, 2006, the Company and certain subsidiaries incurred$1,850.0 million of indebtedness by (i) drawing on a revolving(asset-based lending) facility (the “ABL facility”) in an amountequal to $70.0 million, (ii) entering into two term loan facilities (termloans A and B) in an aggregate amount of $1,070.0 million, and (iii) issuingsenior notes in an aggregate amount of $430.0 million and senior subordinatednotes in an aggregate amount of $280.0 million.

 

The term loan facilitiesand the ABL facility are secured by substantially all of the Company’s assets,those of Sally Investment, those of the Company’s domestic subsidiaries and, inthe case of the ABL facility, those of the Company’s Canadian subsidiaries. Theterm loan facilities may be prepaid at the Company’s option at any time withoutpremium or penalty and is subject to mandatory prepayment in an amount equal to50% of excess cash flow (as defined in the agreement governing the term loanfacilities) for any fiscal year (commencing in fiscal year 2008) unless aspecified leverage ratio is met and 100% of the proceeds of specified assetsales that are not reinvested in the business or applied to repay borrowingsunder the ABL facility.

 

The senior notes and senior subordinated notes(collectively, the “Notes”) are unsecured obligations of Sally Holdings and itsco-issuer Sally Capital and are guaranteed on a senior basis (in the case ofthe senior notes) and on a senior subordinated basis (in the case of the seniorsubordinated notes) by each material domestic subsidiary of Sally Holdings(other than the co-issuer). Furthermore, the terms of the debt agreementssignificantly restrict the ability of Sally Holdings to pay dividends orotherwise transfer assets.  Please seethe Company’s Annual Report on Form 10-K for fiscal year ended September 30,2007 for additional information on long-term debt.

 

13

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Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

 

Details of long-term debt are as follows (inthousands):

 
| ** **                    | ** ** | **December 31,   2007** | ** ** | **Maturity dates  (Fiscal Year)** | ** ** | **Interest Rates** | ** **                           |
|-------------------------------|------------|-----------------------------------|------------|---------------------------------------------|------------|-------------------------|--------------------------------------|
| ABL facility                  |       | $                                 | 53,400     |                                        | 2012       |                    | (i)                                  | PRIME and up to 0.50% or; |   |
|                          |       |                              |       |                                        |       | (ii)                    | LIBOR (a) plus (1.00% to 1.50%) |   |
| Term Loan A                   |       | 140,625                           |       | 2013                                        |       | (i)                     | PRIME plus (1.00 to 1.50%) or;       |   |
|                          |       |                              |       |                                        |       | (ii)                    | LIBOR plus  (2.00% to 2.50%)         |   |
| Term Loan B                   |       | 908,500                           |       | 2014                                        |       | (i)                     | PRIME plus (1.25 to 1.50%) or;       |   |
|                          |       |                              |       |                                        |       | (ii)                    | LIBOR plus  (2.25% to 2.50%)         |   |
| Total                         |       | $                                 | 1,102,525  |                                        |       |                    |                                 |   |
|                          |       |                              |       |                                        |       |                    |                                 |   |
| Senior notes                  |       | $                                 | 430,000    |                                        | 2015       |                    | 9.25                                 | % |   |
| Senior  subordinated notes    |       | 280,000                           |       | 2017                                        |       | 10.50                   | %                                    |   |
| Total                         |       | $                                 | 710,000    |                                        |       |                    |                                 |   |
|                          |       |                              |       |                                        |       |                    |                                 |
| Capitalized  leases and other |       | $                                 | 1,011      |                                        |       |                    |                                 |   |
| Less: current  portion        |       | (18,994                           | )          |                                        |       |                    |                                 |
| Total long-term  debt         |       | $                                 | 1,794,542  |                                        |       |                    |                                 |   |
|                               |            |                                   |            |                                             |            |                         |                                      |  |  |  |  |

----

(a) LondonInterbank Offered Rate (“LIBOR”)

 

Maturities of the Company’s long-term debt are asfollows (in thousands):

 
| **Fiscal Year:**     | ** ** | ** ** | ** ** |
|---------------------------|------------|------------|------------|
| 2008                      |       | $          | 12,525     |   |
| 2009                      |       | 24,200     |       |
| 2010                      |       | 24,200     |       |
| 2011                      |       | 39,200     |       |
| 2012                      |       | 137,600    |       |
| Thereafter                |       | 1,574,800  |       |
|                      |       | $          | 1,812,525  |   |
| Capital leases  and other |       | 1,011      |       |
| Less: current  portion    |       | (18,994    | )          |
| Total                     |       | $          | 1,794,542  |   |

##### ** **

##### ** 4.    Interest Rate Swaps**

 

In connection with the Separation Transactions, during November 2006,the Company entered into two interest rate swap agreements. The Company doesnot purchase or hold any derivative instruments for trading purposes. Theinterest rate swap agreements do not currently qualify as hedges and,therefore, the change in fair value of the interest rate swap agreements, whichare adjusted quarterly, are recorded in the results of operations. The fairvalue of the swap agreements was a liability of approximately $8.7 million at December 31,2007 and an asset of approximately $1.0 million at December 31, 2006.Please see the Company’s Annual Report on Form 10-K for fiscal year ended September 30,2007 for additional information on these interest rate swap agreements.

 

Fair value estimates presented for the swapagreements are based on third-party information and were determined usingproprietary models based upon well-recognized financial principles andreasonable estimates about relevant future market conditions.

 

The counter-parties to these swap instruments are large financial institutionswhich the Company believes are of high quality creditworthiness. While theCompany may be exposed to potential losses due to the credit risk ofnon-performance by these counter-parties, such losses are not anticipated.

 

The marked-to-market impact of the swaparrangements on interest expense was an increase of 

 

14

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Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

 

approximately $5.7 million and a decrease of approximately$1.0 million in the three months ended December 31, 2007 and 2006,respectively.

 

##### **5.   Goodwill and Other Intangibles**

##### ** **

The change in the carrying amounts of goodwillby operating segment for the three months ended December 31, 2007 is asfollows (in thousands):

 
| ** **                                        | ** ** | **Sally Beauty   Supply** | ** **   | **Beauty Systems  Group** | ** ** | **Total**     | ** ** |
|---------------------------------------------------|------------|-------------------------------------|--------------|--------------------------------|------------|---------------|------------|
| Balance at September 30, 2007 |       | $                                   |  42,523 |                           | $          |  364,100 |       | $ |  406,623 |   |
| Additions, net  of purchase price adjustments     |       | 711                                 |         | —                         |       | 711           |       |
| Foreign currency  translation                     |       | (910                                | )            | (331                           | )          | (1,241        | )          |
| Balance at  December 31, 2007                |       | $                                   | 42,324       |                           | $          | 363,769       |       | $ | 406,093 |   |

 

The following table provides the grosscarrying value and accumulated amortization for intangible assets withindefinite lives and intangible assets subject to amortization by operating segmentat December 31, 2007 (in thousands):

 
| ** **                                  | ** ** | **Sally Beauty   Supply** | ** ** | **Beauty Systems  Group** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|-------------------------------------|------------|--------------------------------|------------|-----------|------------|
| Balance at  December 31, 2007:         |       |                                |       |                           |       |      |       |
| Intangible  assets with indefinite lives:   |       |                                |       |                           |       |      |       |
| Trade names                                 |       | $                                   | 15,349     |                           | $          | 34,740    |       | $ | 50,089 |   |
| Other intangibles                           |       | —                              |       | 6,053                          |       | 6,053     |       |
| Total                                       |       | 15,349                              |       | 40,793                         |       | 56,142    |       |
| Intangible  assets subject to amortization: |       |                                |       |                           |       |      |       |
| Gross carrying  amount                      |       | 540                                 |       | 27,465                         |       | 28,005    |       |
| Accumulated  amortization                   |       | (45                                 | )          | (13,770                        | )          | (13,815   | )          |
| Net value                                   |       | 495                                 |       | 13,695                         |       | 14,190    |       |
| Total intangible  assets, net               |       | $                                   | 15,844     |                           | $          | 54,488    |       | $ | 70,332 |   |

##### ** **

##### **6.     ComprehensiveIncome**

 

Comprehensive income consists of net earningsand foreign currency translation adjustments as follows for the three monthsended December 31, 2007 and 2006 (in thousands):

 
| ** **                                                           | ** ** | **Three Months Ended December 31,** |
|----------------------------------------------------------------------|------------|---------------------------------------------------------|
| ** **                                                           | ** ** | **2007**                                                | ** ** | **2006** | ** ** |
| Net earnings                                                         |       | $                                                       | 15,346 |   | $ | 3,702 |   |
| Other  comprehensive income adjustments-foreign currency translation |       | (4,456                                                  | ) | (721 | ) |
| Comprehensive  income                                                |       | $                                                       | 10,890 |   | $ | 2,981 |   |

 

15

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Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

 

##### **7.   IncomeTaxes**

 

Sally Beauty and itssubsidiaries, file income tax returns in the U.S. federal jurisdiction, as wellas in various foreign and most state jurisdictions.

 

The Separation Transactions were intended toqualify as a reorganization under Section 368(a)(1)(D) of the Codeand a distribution eligible for non-recognition under Sections 355(a) and361(c) of the Internal Revenue Code of 1986, as amended (the “Code”). Inconnection with the share distribution of Alberto-Culver common stock in theSeparation Transactions, Sally Beauty received: (i) aprivate letter ruling from the IRS; and (ii) an opinion of Sidley AustinLLP, counsel to Alberto-Culver, in each case, to the effect that thetransactions qualify as a reorganization under Section 368(a)(1)(D) ofthe Code and a distribution eligible for non-recognition under Sections 355(a) and361(c) of the Code. Certain internal restructurings also occurred at orimmediately prior to the Separation Transactions. As a result of the internalrestructurings and Separation Transactions, Sally Beauty inherited the federal tax identification number of the oldAlberto-Culver parent for U.S. federal income tax purposes.

 

A tax allocationagreement was signed as part of the Separation Transactions. The agreementprovides generally that Sally Beauty is responsible for its pre-separationincome tax liabilities, calculated on a stand-alone basis, and Alberto-Culver isresponsible for the remainder.

 

In addition, as thesuccessor entity to Alberto-Culver after the Separation Transactions, SallyBeauty relies upon the prior year federal income tax returns of Alberto-Culver,and accounting methods established therein, for certain calculations thataffect our current U.S. federal income tax liability.

 

In the event anadditional U.S. federal income tax liability related to the period prior to theSeparation Transactions were determined, Sally Beauty  and the Company 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 the Company under the taxallocation agreement if Alberto-Culver was determined to be responsible forthese taxes thereunder. The Company has entered into a tax sharing agreementwith its parent, Sally Beauty.  Inaccordance with this agreement, Sally Beauty shall cause each of itssubsidiaries that are eligible to be a member of the relevant combined taxgroup to join in filing a consolidated 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.

 

Where allowed by currenttax law, the Company is included in the consolidated income tax returns filedby Sally Beauty.  The Company’s provisionfor income taxes is recorded on the basis of filing a separate income taxreturn.  Income taxes currently payableor receivable under the consolidated income tax returns are paid to or receivedfrom Sally Beauty.

 

In June 2006, theFASB issued Interpretation No. 48, “*Accountingfor Uncertainty in Income Taxes*”, an interpretation of SFAS No. 109,“*Accounting for Income Taxes*” (“FIN48”), to create a single model to address accounting for uncertainty in taxpositions. This interpretation, which became effective for fiscal yearsbeginning after December 15, 2006, clarifies the accounting for incometaxes, by prescribing a minimum recognition threshold a tax position isrequired to meet before being recognized in the financial statements. FIN 48also provides guidance on (1) the recognition, derecognition, andmeasurement of uncertain tax positions in a period subsequent to that in whichthe tax position is taken; (2) the accounting for interest and penalties; (3) thepresentation and classification of recorded amounts in the financialstatements; and (4) disclosure requirements.

 

The Company adopted theprovisions of FIN 48 on October 1, 2007. The adoption of FIN 48 did not require a change to the Company’sliability for unrecognized tax benefits and had no impact on the Company’sopening balance of retained deficit.  Thetotal amount of unrecognized tax benefits (including 

 

16

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Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

 

interest accruals) as ofthe date of adoption on October 1, 2007 is $3.9 million.  If recognized, these positions would affectthe Company’s effective tax rate.

 

Sally Beauty and theCompany classifies and recognizes interest and penalties accrued related tounrecognized tax benefits in income tax expense.    The total amount of accrued interest andpenalties as of October 1, 2007 is $1.0 million.

 

Over the next 12 months,management anticipates that it is reasonably possible for the amount ofunrecognized benefits (including interest accruals) to be increased by $2.5million as a result of additional federal, state, and foreign taxpositions.  This amount includes $1.0million of tax positions for which the ultimate deductibility is highly certainbut for which there is uncertainty about the timing of such deductibility.  Because of the impact of the deferred taxaccounting, other than interest, the disallowance of the shorter deductibilityperiod would not affect the annual effective tax rate but would accelerate thepayment of cash to the taxing authority to an earlier period.

The Internal RevenueService (“IRS”) has previously audited the consolidated federal income taxreturns of Alberto-Culver through the fiscal year ending September 30,2004. The Company has not recorded a reserve for Alberto-Culver relatedliability because the Company believes any exposure is immaterial.

 

The IRS has contactedSally Beauty regarding an examination for the tax years ended 2005 and 2006,thus our statute remains open from the year ended September 30, 2005,forward.  Our European subsidiaries areimpacted by various statutes of limitations, which are generally open from 2004forward. The statute of limitations on our Canadian operations is open from2004 forward.  Generally, states’statutes in the United States are open from 2002 forward.

 

##### **8.     BusinessSegments**

##### ** **

The Company’s business is organized into twoseparate segments: (i) Sally Beauty Supply, a domestic and internationalchain of cash and carry retail stores, which offers professional beauty suppliesto both salon professionals and retail customers, and (ii) BSG, includingits franchise-based business Armstrong McCall is a full service beauty supplydistributor, which offers professional brands of beauty products directly tosalons through its own sales force and professional only stores (includingfranchise stores) in generally exclusive geographical territories in NorthAmerica and parts of Europe.

 

17

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Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

 

The Company does not sell betweensegments.  Segment data for the threemonths ended December 31, 2007 and 2006 is as follows (in thousands):

 
| ** **                                         | ** ** | **Three Months Ended   December 31,** | ** ** |
|----------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                         | ** ** | **2007**                                                  | ** ** | **2006** | ** ** |
| Net sales:                                         | ** ** | ** **                                                | ** ** | ** ** | ** ** |
| Sally Beauty  Supply                               |       | $                                                         | 408,290    |   | $ | 371,949 |   |
| BSG                                                |       | 247,497                                                   |       | 257,930 |   |
| Total net sales                                    |       | $                                                         | 655,787    |   | $ | 629,879 |   |
| Earnings before  provision for income taxes:       | ** ** | ** **                                                | ** ** | ** ** | ** ** |
| Segment  operating profit:                         |       |                                                      |       |   |   |
| Sally Beauty  Supply                               |       | $                                                         | 71,543     |   | $ | 65,493 |   |
| BSG                                                |       | 21,130                                                    |       | 18,722 |   |
| Segment  operating profit                          |       | 92,673                                                    |       | 84,215 |   |
| Unallocated  corporate expenses (1)                |       | (15,704                                                   | )          | (16,063 | ) |
| Share-based  compensation expense                  |       | (5,447                                                    | )          | (5,707 | ) |
| Sales-based  service fee charged by Alberto-Culver |       | —                                                    |       | (3,779 | ) |
| Transaction  expenses (2)                          |       | —                                                    |       | (21,457 | ) |
| Interest  expense, net of interest income          |       | (46,483                                                   | )          | (19,103 | ) |
| Earnings before  provision for income taxes        |       | $                                                         | 25,039     |   | $ | 18,106 |   |

 

----

(1)           Unallocated corporateexpenses consist of corporate and shared costs. The amounts include $0.0million and $1.0 million of overhead charges allocated from Alberto-Culver forthe three months ended December 31, 2007 and 2006, respectively. 

(2)           Transactionexpenses are one-time charges associated with the separation fromAlberto-Culver in the three months ended December 31, 2006.

 

###### **9.**RecentAccounting Pronouncements

###### ** **

In December 2007, theFinancial Accounting Standards Board, or FASB, issued Statement of FinancialAccounting Standards No. 160, *Noncontrolling Interestsin Consolidated Financial Statements, an amendment to ARB No. 51*or SFAS 160, which requires, among other things, that the noncontrollinginterest (previously referred to as minority interest) in a consolidatedsubsidiary’s equity be reported as a component of equity separate from theparent’s interest and that net income or loss attributable to thenoncontrolling interest be included in consolidated net income on the face ofthe income statement. In addition, purchases and sales of equity interest thatdo not result in a change in control will be accounted as equity transactionsand, upon a loss of control, the interest sold, as well as any interestretained, will be recorded at fair value with any gain or loss recognized inearnings. SFAS 160 is effective for periods on or after December 15, 2008.  We are currently assessing the effect of thispronouncement on our consolidated financial statements.

 

In December 2007, the FASB, issued SFAS No. 141(Revised 2007): *Business Combinations* or SFAS141R. Among other things, SFAS 141R generally requires that an acquirerrecognize the assets acquired and liabilities assumed measured at their “fullfair values” on the acquisition date. This practice replaces the practice,under predecessor SFAS No. 141: *Business Combinations,*of allocating the cost of an acquisition 

 

18

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Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

 

to the individual assets acquired and liabilitiesassumed based on their relative estimated fair values.  SFAS 141R further requires thatacquisition-related costs be recognized separately from the relatedacquisition. SFAS 141R is effective in fiscal years beginning on or after December 15,2008. We are currently assessing the effect of this pronouncement on ourconsolidated financial statements.

 

In February 2007, the FASB issued SFAS No. 159,*The Fair Value Option for Financial Assets andFinancial Liabilities - including an amendment of FASB Statement No. 115*,or SFAS 159. SFAS 159 permits entities to choose to measure many financialinstruments and certain other items at fair value that are not currentlyrequired to be measured at fair value, with unrealized gains and losses relatedto these financial instruments reported in earnings at each subsequent reportingdate. SFAS 159 is effective in fiscal years beginning after November 15,2007. We are currently assessing the effect of this pronouncement on ourconsolidated financial statements.

 

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements*, or SFAS 157,which defines fair value, establishes a framework for measuring fair value inGAAP, and expands disclosures about fair value measurements. SFAS 157 iseffective in fiscal years beginning after November 15, 2007. In November 2007, the FASB provided aone year deferral for the implementation of SFAS 157 for other nonfinancialassets and liabilities. We are currently assessing the effect of thispronouncement on our consolidated financial statements.

 

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

 

The following condensed consolidatingfinancial information presents the Condensed Consolidated Balance Sheet as of December 31,2007 and September 30, 2007, the Condensed Consolidated Statement ofEarnings and the Condensed Consolidated Statement of Cash Flows for the threemonths ended December 31, 2007 and 2006 of (a) Sally Holdings LLC or “Parent”;(b) Sally Capital, Inc. or “Co-Issuer” (c) the guarantorsubsidiaries; (d) the non-guarantor subsidiaries; (e) eliminationentries necessary to consolidate the Parent with the guarantor andnon-guarantor subsidiaries; and (f) the Parent on a consolidated basis.

 

Investments in subsidiaries are accounted forusing the equity method for purposes of the consolidating presentation.  The principal elimination entries relate toinvestments in subsidiaries and intercompany balances and transactions.  Separate financial statements and otherdisclosures with respect to the guarantor subsidiaries have not been provided as management believes the followinginformation is sufficient, as guarantor subsidiaries are 100 percent indirectlyowned by the Parent and all guarantees are full and unconditional.  Additionally, substantially all of the assetsof the guarantor subsidiaries are pledged under the term loan facilities andthe ABL facility and consequently may not be available to satisfy the claims ofgeneral creditors.

 

19

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Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

 

**SALLYHOLDINGS LLC AND SUBSIDIARIES**

**CondensedConsolidated Balance SheetDecember 31, 2007**

**(Inthousands)**

**(Unaudited)**

 
| ** **                                                                  | ** ** | ** ** | ** ** | ** **    | ** ** | ** **       | ** ** | **Non-**         | ** ** | ** **       | ** ** | **Sally**                   | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|---------------|------------|------------------|------------|------------------|------------|------------------|------------|-----------------------------|------------|
| ** **                                                                  | ** ** | ** ** | ** ** | ** **    | ** ** | **Guarantor**    | ** ** | **Guarantor**    | ** ** | ** **       | ** ** | **Holdings LLC**       | ** ** |
| ** **                                                                  | ** ** | **Parent** | ** ** | **Co-Issuer** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **& Subsidiaries** | ** ** |
| **Assets**                                                                  | ** ** | ** ** | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** | ** **                  | ** ** |
| Cash and cash  equivalents                                                  |       | $          | 1,180      |          | $          | —           |       | $                | 7,764      |             | $          | 34,203                      |       | $ | — |   | $ | 43,147 |   |
| Trade accounts  and other receivables, less allowance for doubtful accounts |       | —     |       | —        |       | 54,465           |       | 20,519           |       | —           |       | 74,984                      |       |
| Due from  affiliates                                                        |       | 106,822    |       | —        |       | 10,742           |       | 4,979            |       | (122,543         | )          | —                      |       |
| Inventories                                                                 |       | —     |       | —        |       | 468,022          |       | 127,679          |       | —           |       | 595,701                     |       |
| Prepaid expenses                                                            |       | 103        |       | —        |       | 7,100            |       | 7,792            |       | —           |       | 14,995                      |       |
| Deferred income  tax assets                                                 |       | 1,489      |       | —        |       | 19,325           |       | (3,013           | )          | —           |       | 17,801                      |       |
| Property and  equipment, net                                                |       | —     |       | —        |       | 117,851          |       | 38,442           |       | —           |       | 156,293                     |       |
| Investment in  subsidiaries                                                 |       | 918,073    |       | —        |       | 257,601          |       | —           |       | (1,175,674       | )          | —                      |       |
| Goodwill and  other intangible assets, net                                  |       | —     |       | —        |       | 362,006          |       | 114,419          |       | —           |       | 476,425                     |       |
| Other assets                                                                |       | 49,070     |       | —        |       | 1,155            |       | 8,561            |       | —           |       | 58,786                      |       |
| Total assets                                                                |       | $          | 1,076,737  |          | $          | —           |       | $                | 1,306,031  |             | $          | 353,581                     |       | $ | (1,298,217 | ) | $ | 1,438,132 |   |
| **Liabilities  and Member’s (Deficit) Equity**                         |       |       |       |          |       |             |       |             |       |             |       |                        |       |
| Accounts payable                                                            |       | $          | 1,175      |          | $          | —           |       | $                | 118,313    |             | $          | 44,455                      |       | $ | — |   | $ | 163,943 |   |
| Due to  affiliates                                                          |       | —     |       | —        |       | 106,847          |       | 15,696           |       | (122,543         | )          | —                      |       |
| Accrued expenses                                                            |       | 18,515     |       | —        |       | 97,581           |       | 22,098           |       | —           |       | 138,194                     |       |
| Due to Sally  Beauty                                                        |       | —     |       | —        |       | 19,864           |       | 3,081            |       | —           |       | 22,945                      |       |
| Income taxes                                                                |       | —     |       | —        |       | 503              |       | 5,157            |       | —           |       | 5,660                       |       |
| Long-term debt                                                              |       | 1,812,525  |       | —        |       | 550              |       | 461              |       | —           |       | 1,813,536                   |       |
| Other  liabilities                                                          |       | 7,559      |       | —        |       | 15,944           |       | 1,880            |       | —           |       | 25,383                      |       |
| Deferred income  tax liabilities                                            |       | —     |       | —        |       | 28,356           |       | 3,152            |       | —           |       | 31,508                      |       |
| Total  liabilities                                                          |       | 1,839,774  |       | —        |       | 387,958          |       | 95,980           |       | (122,543         | )          | 2,201,169                   |       |
| Stock options  subject to redemption                                        |       | 6,390      |       | —        |       | —           |       | —           |       | —           |       | 6,390                       |       |
| Total member’s  (deficit) equity                                       |       | (769,427   | )          | —        |       | 918,073          |       | 257,601          |       | (1,175,674       | )          | (769,427                    | )          |
| Total  liabilities and member’s (deficit) equity                       |       | $          | 1,076,737  |          | $          | —           |       | $                | 1,306,031  |             | $          | 353,581                     |       | $ | (1,298,217 | ) | $ | 1,438,132 |   |

 

20

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Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

 

**SALLYHOLDINGS LLC AND SUBSIDIARIES**

**CondensedConsolidated Balance Sheet**

**September 30,2007**

**(Inthousands)**

 
| ** **                                                                  | ** ** | **Parent** | ** ** | **Co-Issuer** | ** ** | **Guarantor   Subsidiaries** | ** ** | **Non-Guarantor   Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally   Holdings   LLC &   Subsidiaries** | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|---------------|------------|-----------------------------------|------------|---------------------------------------|------------|------------------|------------|---------------------------------------------------------------------|------------|
| **Assets**                                                                  |       |       |       |          |       |                              |       |                                  |       |             |       |                                                                |       |
| Cash and cash  equivalents                                                  |       | $          | 7          |          | $          | —                            |       | $                                     | 9,316      |             | $          | 28,949                                                              |       | $ | — |   | $ | 38,272 |   |
| Trade accounts  and other receivables, less allowance for doubtful accounts |       | 286        |       | —        |       | 47,884                            |       | 25,433                                |       | —           |       | 73,603                                                              |       |
| Due from  affiliates                                                        |       | 105,771    |       | —        |       | 10,112                            |       | 13,777                                |       | (129,660         | )          | —                                                              |       |
| Inventories                                                                 |       | —     |       | —        |       | 442,978                           |       | 126,426                               |       | —           |       | 569,404                                                             |       |
| Prepaid expenses                                                            |       | 43         |       | —        |       | 6,702                             |       | 8,630                                 |       | —           |       | 15,375                                                              |       |
| Deferred income  tax assets                                                 |       | 1,191      |       | —        |       | 16,885                            |       | (2,785                                | )          | —           |       | 15,291                                                              |       |
| Property and  equipment, net                                                |       | —     |       | —        |       | 115,048                           |       | 39,020                                |       | —           |       | 154,068                                                             |       |
| Investment in  subsidiaries                                                 |       | 878,650    |       | —        |       | 255,144                           |       | —                                |       | (1,133,794       | )          | —                                                              |       |
| Goodwill and  other intangible assets, net                                  |       | —     |       | —        |       | 361,013                           |       | 116,115                               |       | —           |       | 477,128                                                             |       |
| Other assets                                                                |       | 51,135     |       | —        |       | 1,866                             |       | 8,119                                 |       | —           |       | 61,120                                                              |       |
| Total assets                                                                |       | $          | 1,037,083  |          | $          | —                            |       | $                                     | 1,266,948  |             | $          | 363,684                                                             |       | $ | (1,263,454 | ) | $ | 1,404,261 |   |
|                                                                        |       |       |       |          |       |                              |       |                                  |       |             |       |                                                                |       |
| **Liabilities  and Member’s (Deficit) Equity**                         |       |       |       |          |       |                              |       |                                  |       |             |       |                                                                |       |
| Accounts payable                                                            |       | $          | —     |          | $          | —                            |       | $                                     | 132,658    |             | $          | 44,002                                                              |       | $ | — |   | $ | 176,660 |   |
| Due to  affiliates                                                          |       | —     |       | —        |       | 103,225                           |       | 26,435                                |       | (129,660         | )          | —                                                              |       |
| Accrued expenses                                                            |       | 34,540     |       | —        |       | 93,099                            |       | 26,032                                |       | —           |       | 153,671                                                             |       |
| Due to Sally  Beauty                                                        |       | —     |       | —        |       | 16,291                            |       | 2,573                                 |       | —           |       | 18,864                                                              |       |
| Income taxes                                                                |       | —     |       | —        |       | 392                               |       | 3,320                                 |       | —           |       | 3,712                                                               |       |
| Long-term debt                                                              |       | 1,774,700  |       | —        |       | 558                               |       | 483                                   |       | —           |       | 1,775,741                                                           |       |
| Other  liabilities                                                          |       | 3,047      |       | —        |       | 13,866                            |       | 1,915                                 |       | —           |       | 18,828                                                              |       |
| Deferred income  tax liabilities                                            |       | (1,436     | )          | —        |       | 28,209                            |       | 3,780                                 |       | —           |       | 30,553                                                              |       |
| Total  liabilities                                                          |       | 1,810,851  |       | —        |       | 388,298                           |       | 108,540                               |       | (129,660         | )          | 2,178,029                                                           |       |
| Stock options  subject to redemption                                        |       | 6,549      |       | —        |       | —                            |       | —                                |       | —           |       | 6,549                                                               |       |
| Total member’s  (deficit) equity                                       |       | (780,317   | )          | —        |       | 878,650                           |       | 255,144                               |       | (1,133,794       | )          | (780,317                                                            | )          |
| Total  liabilities and member’s (deficit) equity                       |       | $          | 1,037,083  |          | $          | —                            |       | $                                     | 1,266,948  |             | $          | 363,684                                                             |       | $ | (1,263,454 | ) | $ | 1,404,261 |   |

 

21

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Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

 

**SALLYHOLDINGS LLC AND SUBSIDIARIES**

**CondensedConsolidated Statement of EarningsThree months ended December 31, 2007**

**(Inthousands)**

**(Unaudited)**

** **
| ** **                                           | ** ** | ** ** | ** ** | ** **    | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | **Sally   Holdings LLC** | ** ** |
|------------------------------------------------------|------------|------------|------------|---------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------------------------|------------|
| ** **                                           | ** ** | **Parent** | ** ** | **Co-Issuer** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**  | ** ** | **Eliminations** | ** ** | **& Subsidiaries**        | ** ** |
| ** **                                           | ** ** | ** ** | ** ** | ** **    | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **                         | ** ** |
| Net sales                                            |       | $          | —     |          | $          | —           |       | $                 | 524,731    |             | $          | 131,056                            |       | $ | — |   | $ | 655,787 |   |
| Related party  sales                                 |       | —     |       | —        |       | 772              |       | -                 |       | (772             | )          | -                                  |       |
| Cost of products  sold and distribution expenses     |       | —     |       | —        |       | 277,825          |       | 72,565            |       | (772             | )          | 349,618                            |       |
| Gross profit                                         |       | —     |       | —        |       | 247,678          |       | 58,491            |       | —           |       | 306,169                            |       |
| Selling, general  and administrative expenses        |       | 235        |       | —        |       | 177,611          |       | 45,049            |       | —           |       | 222,895                            |       |
| Depreciation and  amortization                       |       |       |       | —        |       | 8,759            |       | 2,993             |       | —           |       | 11,752                             |       |
| Operating  earnings (loss)                           |       | (235       | )          | —        |       | 61,308           |       | 10,449            |       | —           |       | 71,522                             |       |
| Interest income                                      |       | —     |       | —        |       | (14              | )          | (206              | )          | —           |       | (220                               | )          |
| Interest expense                                     |       | 46,592     |       | —        |       | 108              |       | 3                 |       | —           |       | 46,703                             |       |
| Earnings  (losses) before provision for income taxes |       | (46,827    | )          | —        |       | 61,214           |       | 10,652            |       | —           |       | 25,039                             |       |
| Provision  (benefit) for income taxes                |       | (18,294    | )          | —        |       | 24,248           |       | 3,739             |       | —           |       | 9,693                              |       |
| Equity in  earnings of subsidiaries (net of tax)     |       | 43,879     |       | —        |       | 6,913            |       | —            |       | (50,792          | )          | —                             |       |
| Net earnings                                         |       | $          | 15,346     |          | $          | —           |       | $                 | 43,879     |             | $          | 6,913                              |       | $ | (50,792 | ) | $ | 15,346 |   |

 

22

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Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

 

**SALLYHOLDINGS LLC AND SUBSIDIARIES**

**CondensedConsolidated Statement of EarningsThree months ended December 31, 2006**

**(Inthousands)**

**(Unaudited)**

** **
| ** **                                           | ** ** | ** ** | ** ** | ** **    | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | **Sally Holdings   LLC** | ** ** |
|------------------------------------------------------|------------|------------|------------|---------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------------------------|------------|
| ** **                                           | ** ** | **Parent** | ** ** | **Co-Issuer** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**    | ** ** | **Eliminations** | ** ** | **& Subsidiaries**        | ** ** |
|                                                 | ** ** | ** ** | ** ** | ** **    | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **                         | ** ** |
| Net sales                                            |       | $          | —     |          | $          | —           |       | $                   | 537,038    |             | $          | 92,841                             |       | $ | — |   | $ | 629,879 |   |
| Related party  sales                                 |       | —     |       | —        |       | 665              |       | —              |       | (665             | )          | —                             |       |
| Cost of products  sold and distribution expenses     |       | —     |       | —        |       | 294,558          |       | 51,494              |       | (665             | )          | 345,387                            |       |
| Gross profit                                         |       | —     |       | —        |       | 243,145          |       | 41,347              |       | —           |       | 284,492                            |       |
| Selling, general  and administrative expenses        |       | —     |       | —        |       | 182,582          |       | 29,675              |       | —           |       | 212,257                            |       |
| Depreciation and  amortization                       |       | —     |       | —        |       | 7,676            |       | 2,114               |       | —           |       | 9,790                              |       |
| Sales-based  service fee charged by Alberto-Culver   |       | —     |       | —        |       | 3,779            |       | —              |       | —           |       | 3,779                              |       |
| Transaction  expenses                                |       | 21,457     |       | —        |       | —           |       | —              |       | —           |       | 21,457                             |       |
| Operating  earnings (loss)                           |       | (21,457    | )          | —        |       | 49,108           |       | 9,558               |       | —           |       | 37,209                             |       |
| Interest income                                      |       | (5,895     | )          | —        |       | (139             | )          | (137                | )          | 5,158            |       | (1,013                             | )          |
| Interest expense                                     |       | 19,795     |       | —        |       | 4,634            |       | 845                 |       | (5,158           | )          | 20,116                             |       |
| Earnings  (losses) before provision for income taxes |       | (35,357    | )          | —        |       | 44,613           |       | 8,850               |       | —           |       | 18,106                             |       |
| Provision  (benefit) for income taxes                |       | (5,851     | )          | —        |       | 16,966           |       | 3,289               |       | —           |       | 14,404                             |       |
| Equity in  earnings of subsidiaries (net of tax)     |       | 33,208     |       | —        |       | 5,561            |       | —              |       | (38,769          | )          | —                             |       |
| Net earnings                                         |       | $          | 3,702      |          | $          | —           |       | $                   | 33,208     |             | $          | 5,561                              |       | $ | (38,769 | ) | $ | 3,702 |   |

 

23

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Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

 

**SALLYHOLDINGS LLC AND SUBSIDIARIES**

**CondensedConsolidated Statement of Cash FlowsThree months ended December 31, 2007**

**(Inthousands)**

**(Unaudited)**

 
| ** **                                                             | ** ** | ** ** | ** ** | ** **    | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | **Sally Holdings,   LLC** | ** ** |
|------------------------------------------------------------------------|------------|------------|------------|---------------|------------|------------------|------------|---------------------|------------|------------------|------------|-------------------------------------|------------|
| ** **                                                             | ** ** | **Parent** | ** ** | **Co-Issuer** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**    | ** ** | **Eliminations** | ** ** | **& Subsidiaries**         | ** ** |
| ** **                                                             |       |       |       |          |       |             |       |                |       |             |       |                                |       |
| **Net  cash (used) provided by operating activities**                  |       | $          | (36,609    | )             | $          | —           |       | $                   | 9,697      |             | $          | 8,962                               |       | $ | — |   | $ | (17,950 | ) |
| **Cash  Flows from Investing Activities:**                             |       |       |       |          |       |             |       |                |       |             |       |                                |       |
| Capital  expenditures and proceeds from sale of property and equipment |       | —     |       | —        |       | (9,498           | )          | (2,667              | )          | —           |       | (12,165                             | )          |
| Acquisitions,  net of cash acquired                                    |       | —     |       | —        |       | (3,055           | )          | (57                 | )          | —           |       | (3,112                              | )          |
| Net cash used by  investing activities                                 |       | —     |       | —        |       | (12,553          | )          | (2,724              | )          | —           |       | (15,277                             | )          |
| **Cash  Flows from Financing Activities:**                             |       |       |       |          |       |             |       |                |       |             |       |                                |       |
| Change in book  cash overdraft                                         |       | —     |       | —        |       | 1,175            |       | —              |       | —           |       | 1,175                               |       |
| Proceeds from  issuance of long-term debt                              |       | 142,976    |       | —        |       | —           |       | —              |       | —           |       | 142,976                             |       |
| Repayments of  long-term debt                                          |       | (105,194   | )          | —        |       | —           |       | —              |       | —           |       | (105,194                            | )          |
| Excess tax  benefit from share-based compensation                      |       | —     |       | —        |       | 129              |       | —              |       | —           |       | 129                                 |       |
| Net cash  provided by financing activities                             |       | 37,782     |       | —        |       | 1,304            |       | —              |       | —           |       | 39,086                              |       |
| Effect of  foreign exchange rate changes on cash and cash equivalents  |       | —     |       | —        |       | —           |       | (984                | )          | —           |       | (984                                | )          |
| Net (decrease)  increase in cash and cash equivalents                  |       | 1,173      |       | —        |       | (1,552           | )          | 5,254               |       | —           |       | 4,875                               |       |
| Cash and cash  equivalents, beginning of period                        |       | 7          |       | —        |       | 9,316            |       | 28,949              |       | —           |       | 38,272                              |       |
| Cash and cash  equivalents, end of period                              |       | $          | 1,180      |          | $          | —           |       | $                   | 7,764      |             | $          | 34,203                              |       | $ | — |   | $ | 43,147 |   |

 

24

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Sally Holdings LLC andSubsidiaries

Condensed Notes to Consolidated FinancialStatements

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

**Condensed Consolidated Statement of Cash FlowsThree months ended December 31, 2006**

**(In thousands)**

**(Unaudited)**

 
| ** **                                                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** **       | ** ** | **Non-**         | ** ** | ** **       | ** ** | **Sally Holdings**     | ** ** |
|------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------------|------------|------------------|------------|------------------|------------|-----------------------------|------------|
| ** **                                                             | ** ** | ** ** | ** ** | **Co-**    | ** ** | **Guarantor**    | ** ** | **Guarantor**    | ** ** | ** **       | ** ** | **LLC**                     | ** ** |
| ** **                                                             | ** ** | **Parent** | ** ** | **Issuer** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **& Subsidiaries** | ** ** |
| **Net cash (used) provided by operating activities**                   |       | $          | 39,775     |       | $          | —           |       | $                | (66,739    | )                | $          | 85,350                      |       | $ | — |   | $ | 58,386 |   |
| **Cash Flows from Investing Activities:**                              |       |       |       |       |       |             |       |             |       |             |       |                        |       |
| Capital expenditures and proceeds from sale of  property and equipment |       | —     |       | —     |       | (5,828           | )          | (3,320           | )          | —           |       | (9,148                      | )          |
| Acquisitions, net of cash acquired                                     |       | —     |       | —     |       | (5,485           | )          | (253             | )          | —           |       | (5,738                      | )          |
| Net cash used by investing activities                                  |       | —     |       | —     |       | (11,313          | )          | (3,573           | )          | —           |       | (14,886                     | )          |
| **Cash Flows from Financing Activities:**                              |       |       |       |       |       |             |       |             |       |             |       |                        |       |
| Change in book cash overdraft                                          |       | —     |       | —     |       | (6,515           | )          | —           |       | —           |       | (6,515                      | )          |
| Proceeds from issuance of long-term debt                               |       | 1,885,109  |       | —     |       | —           |       | —           |       | —           |       | 1,885,109                   |       |
| Repayments of long-term debt                                           |       | (88,021    | )          | —     |       | —           |       | —           |       | —           |       | (88,021                     | )          |
| Debt Issuance Costs                                                    |       | (58,816    | )          | —     |       | —           |       | —           |       | —           |       | (58,816                     | )          |
| Proceeds related to notes with affiliates                              |       | 19,148     |       | —     |       | 58,581           |       | —           |       | (77,729          | )          | —                      |       |
| Payments related to notes with affiliates                              |       | —     |       | —     |       | —           |       | (77,729          | )          | 77,729           |       | —                      |       |
| Distributions to Sally Beauty                                          |       | (1,809,740 | )          | —     |       | —           |       | —           |       | —           |       | (1,809,740                  | )          |
| Distributions to Alberto-Culver                                        |       | (41,936    | )          | —     |       | —           |       | —           |       | —           |       | (41,936                     | )          |
| Excess tax benefit from share-based compensation                       |       | —     |       | —     |       | 145              |       | —           |       | —           |       | 145                         |       |
| Net cash (used) provided by financing activities                       |       | (94,256    | )          | —     |       | 52,211           |       | (77,729          | )          | —           |       | (119,774                    | )          |
| Effect of foreign exchange rate changes on cash and  cash equivalents  |       | 705        |       | —     |       | (271             | )          | (655             | )          | —           |       | (221                        | )          |
| Net (decrease) increase in cash and cash equivalents                   |       | (53,776    | )          | —     |       | (26,112          | )          | 3,393            |       | —           |       | (76,495                     | )          |
| Cash and cash equivalents, beginning of period                         |       | 53,792     |       | —     |       | 36,634           |       | 17,145           |       | —           |       | 107,571                     |       |
| Cash and cash equivalents, end of period                               |       | $          | 16         |       | $          | —           |       | $                | 10,522     |             | $          | 20,538                      |       | $ | — |   | $ | 31,076 |   |

 

25

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# **Item 2. Management’sDiscussion and Analysis of Financial Condition and Results of Operations.**

 

The following section discussesmanagement’s view of the financial condition, results of operations and cashflows of Sally Holdings LLC, a wholly-owned subsidiary of Sally InvestmentHoldings LLC, a wholly-owned subsidiary of Sally Beauty Holdings, Inc.,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 beread in conjunction with the audited consolidated financing statements and therelated notes included in our Annual Report on Form 10-K for the fiscalyear ended September 30, 2007, as well as the Risk Factors section ofthat Annual Report, and information contained elsewhere in this QuarterlyReport, including the consolidated financial statements and condensed notes tothose statements. This Management’s Discussion and Analysis of FinancialCondition and Results of Operations contain forward-looking statements. See “CautionaryNotice Regarding Forward-Looking Statements,” included at the beginning of thisQuarterly Report, for a discussion of the uncertainties, risks and assumptionsassociated with these forward-looking statements that could cause results todiffer materially from those reflected in such forward-looking statements.

 

**Highlights of First Quarter of FiscalYear 2008**

 
| • |   | Our net sales  for the three months ended December 31, 2007 increased $25.9 million, or  4.1%, to $655.8 million compared to the same period in 2006;                                                                                                                                                                                                                                                                                                          |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| • |   | Sales for stores  that have been open for at least 14 months as of the balance sheet date,  which we refer to as comparable store sales, increased 2.1%, while operations  acquired during the last twelve months contributed a 4.1% increase in sales.  These increases were partly offset by the anticipated lower sales of L’Oreal  brand products, resulting from the changes in the L’Oreal distribution  agreement as reported in fiscal year 2007; |
| • |   | Our consolidated  gross profit for the three months ended December 31, 2007 increased 7.6%  to $306.2 million compared to the same period in 2006. As a percentage of net  sales, gross profit for the three months ended December 31, 2007  increased to 46.7% from 45.2% compared to the same period in 2006;                                                                                                                                           |
| • |   | Our operating  earnings for the three months ended December 31, 2007 increased $34.3  million, or 92.2%, to $71.5 million compared to the same period in 2006. As a  percentage of net sales, operating earnings were 10.9% for the three months  ended December 31, 2007 compared to 5.9% for the same period in 2006;                                                                                                                                   |
| • |   | Sally Beauty  Supply and Beauty Systems Group, which we refer to as BSG, opened 32 and 31 net  stores, respectively, in the first quarter of fiscal year 2008;                                                                                                                                                                                                                                                                                                      |
| • |   | We acquired  certain assets and the distribution rights in four states from two  distributors of Goldwell/KMS products and began distributing these products  in 12 additional states during the first quarter of fiscal year 2008;                                                                                                                                                                                                                                 |
| • |   | We  began distributing Henkel’s Schwarzkopf brands in BSG stores and the  distributor sales consultant (which we refer to as “DSC”) channel in 4  northeastern states; and                                                                                                                                                                                                                                                                           |
| • |   | We are in the  second year of our 2-year program to consolidate warehouses and reduce  administrative expenses of the BSG segment.                                                                                                                                                                                                                                                                                                                                  |

 

## **Overview**

## ** **

##### **Description of Business**

##### ** **

We are the largestdistributor of professional beauty supplies in the U.S. based on store count.We operate primarily through two business units, Sally Beauty Supply and BSG.Through Sally Beauty Supply and BSG, we operate a multi-channel platform of3,429 stores and supply 202 franchised stores in North America as well asselected European countries and Japan, as of December 31, 2007. WithinBSG, we also have one of the largest networks of professional distributor salesconsultants in North America, with approximately 1,100 professional distributorsales consultants who sell directly to salons and salon professionals. Weprovide our customers with a wide variety of leading third-party branded andexclusive-label professional beauty supplies, including hair care products,styling appliances, skin and nail care products and other beauty items. SallyBeauty Supply stores target retail consumers and salon professionals, while BSGexclusively targets salons and salon professionals. For the three months ended

 

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December 31, 2007,our consolidated net sales and operating earnings were $655.8 million and$71.5 million, respectively.

 

Sally Beauty Supply isthe largest open-line distributor of professional beauty supplies in theU.S. based on store count. As of December 31, 2007, Sally BeautySupply operated 2,701 company-owned stores and supplied 25 franchised stores(all outside the U.S.), with 2,240 stores located in the U.S., and theremainder in Puerto Rico, Mexico, Canada, Japan, United Kingdom and certainother countries in Europe. Sally Beauty Supply stores averageapproximately 1,700 square feet and are primarily located in stripshopping centers. The product selection in Sally Beauty Supply stores rangesbetween 5,000 and 7,700 stock keeping units (“SKUs”) of beauty products, andincludes products for hair care, nail care, beauty sundries and appliances,targeting retail consumers and salon professionals. Sally Beauty Supply storescarry leading third-party brands such as Clairol, Revlon and Conair, as well asan extensive selection of exclusive-label merchandise.

 

We believe BSG is the largestfull-service distributor of professional beauty supplies in the U.S. As ofDecember 31, 2007, BSG operated 728 company-owned stores, supplied177 franchised stores and had a sales force of approximately 1,100 professionaldistributor sales consultants selling exclusively to salons and salonprofessionals in 47 U.S. states and portions of Canada, 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 market. The product selection in BSGstores, ranging between 3,500 and 9,800 SKUs of beauty products, includes haircare, nail care, beauty sundries and appliances targeting salons and salonprofessionals. BSG carries leading professional beauty product brands, intendedfor use in salons and for resale by the salon to consumers. Certain BSGproducts are sold under exclusive distribution agreements with suppliers,whereby BSG is designated as the sole distributor for a product line withincertain geographic territories.

 

##### **Business Trends**

##### ** **

We operate within thelarge and growing U.S. professional beauty supply industry. Potentialgrowth in the industry is expected to be driven by increases in hair color,hair loss prevention and hair styling products. We believe the following keyindustry and business trends and characteristics will influence our businessand our financial results going forward:

 

•                  *High level of customer fragmentation.*TheU.S. salon market is highly fragmented with over 230,000salons. Given the fragmented and small-scale nature of the salon industry,we believe that salon operators will continue to depend on full-service/exclusivedistributors and open-line channels for a majority of their beauty supplypurchases.

 

•                  *Growth in booth 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. These factors are key todriving demand for conveniently located professional beauty supply stores.

 

•                  *Increasing Use of Exclusive-Label Products.*Weoffer a broad range of private label and control label products, which wegenerally refer to collectively as “exclusive-label products.” Private labelproducts are brands for which we own or license the trademark and, in someinstances, the formula. Control 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 theleading third-party branded products and we believe this area offers potentialgrowth.

 

•                  *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. We have recentlymade several non-U.S. acquisitions, including our acquisition in 2007 of Chapelton21 Limited. We intend to continue to identify and evaluate non-U.S. acquisitiontargets. Our ability to grow our non-U.S. operations, integrate our newnon-U.S. acquisitions and to successfully pursue additional non-U.S.acquisitions may be affected by business, legal, regulatory and economicrisks. Please see “Risk Factors –

 

27

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We may not be able to successfullyidentify acquisition candidates...” “If we acquire any businesses in the future...”and “Our ability to conduct business in international markets...” in Item 1A ofour Annual Report on Form 10-K for the fiscal year ended September 30,2007.

 

•                  *Continuing consolidation.*There iscontinuing consolidation among professional beauty product distributors andprofessional beauty product manufacturers. We plan to continue to examine waysin which we can benefit from this trend, including reviewing opportunities toshift business from competitive distributors to the BSG network as well asseeking opportunistic value-added acquisitions. We believe that suppliers areincreasingly likely to focus on larger distributors and retailers with broaderscale and retail footprint. We also believe that we are well positioned tocapitalize on this trend as well as participate in the ongoing consolidation atthe distributor/retail level. However, changes often occur in our relationshipswith suppliers that may materially affect the net sales and operatingearnings of our business segments. Consolidation among suppliers couldexacerbate the effects of these relationship changes and could increase pricingpressures. For example, as we announced in December 2006, our largestsupplier, L’Oreal, moved a material amount of revenue out of the BSG nationwidedistribution network and into competitive regional distribution networks. Morerecently, L’Oreal also announced the acquisitions of distributors competingwith BSG in the southeastern and west coast of the U.S. and of a supplier(Pureology) that does not currently do business with BSG. As a result, L’Orealis entering into direct competition with BSG. If L’Oreal acquired otherdistributors or suppliers that conduct significant business with BSG, we couldlose that revenue as well. There can be no assurance that there will not be furtherloss of revenue over time by BSG (including within its franchise-basedbusiness) due to potential losses of additional L’Oreal related products aswell as from the increased competition from L’Oreal-affiliated distributionnetworks. Please see “Risk Factors – The beauty products distribution industryis highly competitive and is consolidating” and “We depend upon manufacturers”in Item 1A of our Annual Report on Form 10-K for the fiscal year ended September 30,2007.

 

•                  *High level of competition.*Sally BeautySupply competes with other domestic and international beauty product wholesaleand retail outlets, including local and regional open-line beauty supplystores, professional-only beauty supply stores, salons, mass merchandisers,drug stores and supermarkets, as well as sellers on the Internet and salonsretailing hair care items. BSG competes with other domestic and internationalbeauty product wholesale and retail suppliers and manufacturers sellingprofessional beauty products directly to salons and individual salonprofessionals. We also face competition from authorized and unauthorizedretailers and Internet sites offering professional salon-only products. Theincreasing availability of unauthorized professional salon products in largeformat retail stores such as drug stores, grocery stores and others could havea negative impact on our business.

 

•                  *Favorable demographic and consumer trends.*Theaging baby-boomer population is expected to drive future growth in professionalbeauty supply sales through an increase in the usage of hair color andhair-loss products. Additionally, continuously changing fashion-related trendsthat drive new hair styles are expected to result in continued demand for hairstyling products. Changes in consumer tastes and fashion trends can have animpact on our financial performance. Our continued success depends in large part onour ability to anticipate, gauge and react in a timely and effective manner tochanges in consumer spending patterns and preferences for beauty products. Ifwe are unable to anticipate and respond to trends in the market for beautyproducts and changing consumer demands, our business could suffer.

 

•                  *Controlling expenses*. Another important aspect of ourbusiness is our ability to control costs, especially in our BSG businesssegment by right-sizing the business (including some targetedreductions-in-force) and maximizing the efficiency of our structure. In fiscalyear 2007, in response to the loss of L’Oreal related revenue discussed above,BSG’s sales force was reduced and the remaining affected distributor salesconsultants were offered certain compensation related incentives to stay withBSG as BSG has sought and continues to seek to replace lost L’Oreal revenue. Wealso continue to study our distribution function as we seek to rationalize ourinfrastructure. BSG has substantially completed a store re-branding projectthat repositioned all of its North American company-owned stores under a commonname and store identity, CosmoProf. This project is expected to provide brandconsistency, save on advertising and promotional costs and allow for a morefocused marketing strategy. During fiscal year 2007, we began implementing atwo-year, $19.0 million capital spending program to consolidate warehouses andreduce administrative expenses related to BSG’s distribution networkoptimization program. We currently believe that this plan could producesignificant annual expense savings within the next two years. Please see “RiskFactors – We

 

28

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are not certain that our ongoing cost controlplans will continue to be successful” in Item 1A of our Annual Report on Form 10-Kfor the fiscal year ended September 30, 2007.

 

•                  *Opening New Stores*. Our future growth strategy depends inpart, on our ability to open and profitably operate new stores in existing andadditional geographic markets. The capital requirements to open a U.S. basedSally Beauty Supply or BSG store, excluding inventory, average approximately$60,000 and $75,000, respectively. However, we may not be able to open allof the new stores we plan to open and any new stores we open may not beprofitable, either of which could have a material adverse impact on ourfinancial condition or results of operations. Please see “Risk Factors – If weare unable to profitably open...” in Item 1A of our Annual Report on Form 10-Kfor the fiscal year ended September 30, 2007.

 

•                  *Changes to our information technology 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. Inparticular, during fiscal year 2008, we will be upgrading our financialreporting system, our distribution information systems (in connection with ourcapital spending program to consolidate warehouses, as discussed above),implementing new warehouse information systems at our Armstrong McCall, L.P. (“ArmstrongMcCall”) warehouse and implementing a new point-of-sale system for trackingcustomer sales. These and any other required upgrades to our informationsystems and information technology, or new technology, now and in the future,will require that our management and resources be diverted from our corebusiness to assist in completion of these projects. There can be no assurancethat the time and resources our management will need to devote to theseupgrades, service outages or delays due to the installation of any new orupgraded technology (and customer issues therewith), or the impact on thereliability of our data from any new or upgraded technology will not have amaterial adverse effect on our business, financial condition or results ofoperations.

 

•                  *Relationships with suppliers*. We do not manufacture thebrand name or exclusive-label products we sell, and instead purchase ourproducts from manufacturers. We depend upon a limited number of manufacturersfor a significant percentage of the products we sell, and our relationships withthese suppliers change often. Please see the next section, Relationships withsuppliers, for more information on this trend.

 

***Relationships with suppliers***

 

Most of the net sales ofSally Beauty Supply and BSG are generated through retail stores with respect tothe Sally Beauty Supply business, and both professional only stores andprofessional distribution sales consultants with respect to the BSG business.In addition, BSG has a number of franchisees located primarily in the south andsouthwestern portions of the U.S. and in Mexico, which buy products directlyfrom BSG for resale in their assigned territories. A very small percentage ofsales are generated through franchisees or sub-distributors (primarily inEurope), which also buy products directly from Sally Beauty Supply or BSG forresale. Sally Beauty Supply/BSG and their suppliers are dependent on each otherfor the distribution of beauty products. As is typical in distributionbusinesses, these relationships are subject to change from time to time (includingthe expansion or loss of distribution rights in various geographies and theaddition or loss of products lines). Changes in our relationships withsuppliers occur often, and could positively or negatively impact our net salesand operating profits. For example, during the second quarter of 2007, FaroukSystems, Inc. (“Farouk Systems”), terminated its distribution agreementwith us. Subsequently, effective July 2007, BSG stores and professionaldistributor sales consultants were once again given approval to distributeFarouk Systems products, with an expanded distribution area.

 

On December 19,2006, we announced that: (i) BSG, other than its Armstrong McCalldivision, would not retain its rights to distribute the professional productsof L’Oreal through its distributor sales consultants (effective January 30,2007, with exclusivity ending December 31, 2006) or in its stores onan exclusive basis (effective January 1, 2007) in those geographicareas within the U.S. in which BSG had distribution rights, and (ii) BSG’sArmstrong McCall division would not retain the rights to distribute Redkenprofessional products through its franchises. In an effort to replace theserights, BSG entered into long-term agreements with L’Oreal under which, as of January 1,2007, BSG had non-exclusive rights to distribute the same L’Oreal professionalproducts in its stores that it previously had exclusive rights to in its storesand through its sales consultants. Armstrong McCall retained its exclusiverights to distribute Matrix professional products in its territories.

 

29

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In fiscal year 2007, weadopted a plan to mitigate the negative effects resulting from unfavorablechanges in our relationships with suppliers, such as L’Oreal, which includesthe following steps: (i) adding new products to replace lines with ourdistributor sales consultants; (ii) adding new product lines to our BSGstores; (iii) expanding existing product lines into new territories; and (iv) managingcosts to maximize the efficiency of the BSG structure (in fiscal year 2007 weundertook a right-sizing of the BSG business, including some targetedreductions-in-force). Although we are focused on developing new revenue andcost management initiatives, there can be no assurance that our efforts willpartially or completely offset the loss of these distribution rights. See “*Risk Factors—We depend upon manufacturers who may be unable toprovide products of adequate quality or who may be unwilling to continueto supply products to us*” contained in Item 1A of our Annual Reporton Form 10-K for the fiscal year ended September 30, 2007.

 

Regarding other suppliers,during fiscal year 2007 and first quarter of fiscal year 2008, our expansion ofthe BSG segment included the acquisition of certain assets, and the award ofdistribution rights, which allow us to distribute Goldwell/KMS products andPaul Mitchell products in various markets, as well as a number of other brands,in additional segments of the marketplace. We expect to gain certain otherdistribution rights over time through either further awards or by acquisitionsof existing distributors.

 

### ***Our Separation from Alberto-Culver***

### *** ***

On November 16,2006, pursuant to an investment agreement among Alberto-Culver and certain ofits subsidiaries, including Sally Holdings, Inc., and CDRS AcquisitionLLC, Alberto-Culver separated its consumer products business and its SallyBeauty Supply/BSG distribution business into two separate, publicly-tradedcompanies (the “Separation Transactions”). Sally Holdings, Inc. was awholly-owned subsidiary of Alberto-Culver until the Separation Transactions,when it was converted to a Delaware limited liability company, was renamedSally Holdings LLC and became an indirect wholly-owned subsidiary of SallyBeauty. Sally Beauty was formed on June 16, 2006 and became the accountingsuccessor company to Sally Holdings upon the completion of the SeparationTransactions. See the Company’s Annual Report on Form 10-K for the fiscalyear ended September 30, 2007 for more information about the SeparationTransactions.

 

### ***Results of Operations***

### *** ***

The following table showsthe condensed results of operations of our business for the three months ended December 31,2007 and 2006, expressed as a percentage of net sales for the respectiveperiods (dollars in thousands):

 

| ** **                                      | ** ** | **Three Months Ended December 31,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                      | ** ** | **2007**                                                | ** ** | **2006** | ** ** |
| Net sales                                       |       | $                                                       | 655,787    |   | 100.0 | % | $ | 629,879 |   | 100.0 | % |
| Cost of products sold and distribution expenses |       | 349,618                                                 |       | 53.3 | % | 345,387 |   | 54.8 | % |
| Gross profit                                    |       | 306,169                                                 |       | 46.7 | % | 284,492 |   | 45.2 | % |
| Total other operating costs and expenses        |       | 234,647                                                 |       | 35.8 | % | 247,283 |   | 39.3 | % |
| Operating earnings                              |       | 71,522                                                  |       | 10.9 | % | 37,209 |   | 5.9 | % |
| Interest expense, net                           |       | 46,483                                                  |       | 7.1 | % | 19,103 |   | 3.0 | % |
| Earnings before provision for income taxes      |       | 25,039                                                  |       | 3.8 | % | 18,106 |   | 2.9 | % |
| Provision for income taxes                      |       | 9,693                                                   |       | 1.5 | % | 14,404 |   | 2.3 | % |
| Net earnings                                    |       | $                                                       | 15,346     |   | 2.3 | % | $ | 3,702 |   | 0.6 | % |

 

30

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##### **Key Operating Metrics**

##### ** **

The following table setsforth, for the periods indicated, information concerning key measures we relyon to gauge our operating performance (dollars in thousands):

 
| ** **                                                 | ** ** | **Three Months Ended  December 31,** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                 | ** ** | **2007**                                            | ** ** | **2006 ****(1)** | ** ** |
| Net sales:                                                 |       |                                                |       |   |   |
| Sally Beauty Supply                                        |       | $                                                   | 408,290    |   | $ | 371,949 |   |
| BSG                                                        |       | 247,497                                             |       | 257,930 |   |
|                                                       |       | $                                                   | 655,787    |   | $ | 629,879 |   |
| Gross Profit                                               |       | $                                                   | 306,169    |   | $ | 284,492 |   |
| Gross profit margin                                        |       | 46.7                                                | %          | 45.2 | % |
| Selling, general and administrative expenses               |       | $                                                   | 222,895    |   | $ | 212,257 |   |
| Depreciation and amortization                              |       | $                                                   | 11,752     |   | $ | 9,790 |   |
| Earnings before provision for income taxes:                |       |                                                |       |   |   |
| Segment operating profit:                                  |       |                                                |       |   |   |
| Sally Beauty Supply                                        |       | $                                                   | 71,543     |   | $ | 65,493 |   |
| BSG                                                        |       | 21,130                                              |       | 18,722 |   |
| Segment operating profit                                   |       | 92,673                                              |       | 84,215 |   |
| Unallocated expenses                                       |       | (15,704                                             | )          | (16,063 | ) |
| Share-based compensation expense                           |       | (5,447                                              | )          | (5,707 | ) |
| Sales-based service fee charged by Alberto-Culver          |       | —                                              |       | (3,779 | ) |
| Transaction expenses                                       |       | —                                              |       | (21,457 | ) |
| Operating earnings                                         |       | 71,522                                              |       | 37,209 |   |
| Interest expense, net of interest income                   |       | (46,483                                             | )          | (19,103 | ) |
| Earnings before provision for income taxes                 |       | $                                                   | 25,039     |   | $ | 18,106 |   |
| Segment operating profit margin:                           |       |                                                |       |   |   |
| Sally Beauty Supply                                        |       | 17.5                                                | %          | 17.6 | % |
| BSG                                                        |       | 8.5                                                 | %          | 7.3 | % |
| Consolidated operating profit margin                       |       | 10.9                                                | %          | 5.9 | % |
| Number of stores at end-of-period (including  franchises): |       |                                                |       |   |   |
| Sally Beauty Supply                                        |       | 2,726                                               |       | 2,531 |   |
| BSG                                                        |       | 905                                                 |       | 836 |   |
| Total                                                      |       | 3,631                                               |       | 3,367 |   |
| Comparable store sales growth (2)                          |       |                                                |       |   |   |
| Sally Beauty Supply                                        |       | 0.3                                                 | %          | 3.4 | % |
| BSG                                                        |       | 7.5                                                 | %          | 9.9 | % |
| Consolidated                                               |       | 2.1                                                 | %          | 5.0 | % |

 

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(1)          Certain amounts for prior periods have been reclassified to conform tothe current period’s presentation.

(2)          Comparable stores are defined as company-owned stores that have beenopen for at least 14 months as of the last day of a month.

 

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***Comparisonof the Three Months Ended December 31, 2007 and 2006***

 

The table below presentsnet sales, gross profit and gross profit margin data for each reportablesegment (in thousands of dollars).

 
| ** **                       | ** ** | **Three Months Ended December 31,** | ** ** |
|----------------------------------|------------|---------------------------------------------------------|------------|
| ** **                       | ** ** | **2007**                                                | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| Net sales:                       |       |                                                    |       |   |   |   |   |   |   |
| Sally Beauty Supply              |       | $                                                       | 408,290    |   | $ | 371,949 |   | $ | 36,341 |   | 9.8 | % |
| BSG                              |       | 247,497                                                 |       | 257,930 |   | (10,433 | ) | (4.0 | )% |
| Consolidated net sales           |       | $                                                       | 655,787    |   | $ | 629,879 |   | $ | 25,908 |   | 4.1 | % |
|                             |       |                                                    |       |   |   |   |   |   |   |
| Gross profit:                    |       |                                                    |       |   |   |   |   |   |   |
| Sally Beauty Supply              |       | $                                                       | 210,939    |   | $ | 189,004 |   | $ | 21,935 |   | 11.6 | % |
| BSG                              |       | 95,230                                                  |       | 95,488 |   | (258 | ) | (0.3 | )% |
| Consolidated gross profit        |       | $                                                       | 306,169    |   | $ | 284,492 |   | $ | 21,677 |   | 7.6 | % |
|                             |       |                                                    |       |   |   |   |   |   |   |
| Gross profit margin:             |       |                                                    |       |   |   |   |   |   |   |
| Sally Beauty Supply              |       | 51.7                                                    | %          | 50.8 | % | 0.8 | % |   |   |
| BSG                              |       | 38.5                                                    | %          | 37.0 | % | 1.5 | % |   |   |
| Consolidated gross profit margin |       | 46.7                                                    | %          | 45.2 | % | 1.5 | % |   |   |

### *** ***

### ***NetSales***

### *** ***

Consolidated net sales increased$25.9 million or 4.1% for the three months ended December 31, 2007 ascompared to the same period in 2006. The net sales increase related principallyto acquisitions of approximately $26.1 million, a positive impact from foreignexchange rates of approximately $8.1 million, a comparable store sales growthof 2.1% and the opening of new stores, including 164 net new stores openedduring the last twelve months (excluding acquisitions). These increases wereoffset, in part, by lower BSG net sales, as a result of the changes in the L’Orealdistribution agreement reported in fiscal year 2007, of approximately $27.8million and the loss of approximately $8.8 million of lower marginfranchise-based sales.

 

*Sally BeautySupply*. Net sales for Sally Beauty Supply increased$36.3 million or 9.8% for the three months ended December 31, 2007 ascompared to the same period in 2006. The net sales increased principally fromthe incremental sales of approximately $25.3 million from acquisitions, acomparable store sales growth of 0.3%, the opening of new stores, including 95net new stores opened during the last twelve months (excluding acquisitions)and a positive impact from foreign exchange rates of approximately $3.4 million.Comparable store sales were positively impacted by continued growth ofexclusive-label products and certain merchandise categories such as hairextensions and negatively impacted by a continued decline in same store numberof transactions. Sally Beauty Supply also believes inclement weather inDecember, 2007 and a generally weak retail selling environment contributed toweaker same store sales during the three months ended December 31, 2007.

 

*BeautySystems Group*. Net sales for BSG decreased $10.4 million or4.0% for the three months ended December 31, 2007 as compared to the sameperiod in 2006. The net sales decreased principally as a result of lower L’Orealsales resulting from the changes in the distribution agreement reported infiscal year 2007 of approximately $27.8 million and the loss of approximately$8.8 million of lower margin franchise-based sales. These decreases wereoffset, in part, by a comparable store sales growth of 7.5%, the opening of newstores, including 69 new stores over the twelve month period ending December 31,2007 (excluding acquisitions), a positive impact from foreign exchange rates ofapproximately $4.7 million and incremental sales of approximately $0.8 millionfrom acquisitions. In addition, BSG net sales were positively impacted by theintroduction of new product lines.

 

### ***GrossProfit***

### *** ***

Consolidated gross profitincreased $21.7 million or 7.6% for the three months ended December 31,2007 as compared to the same period in 2006, principally due to acquisitionsfor Sally Beauty Supply and improved gross margins in both operating segments.

 

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*Sally BeautySupply*. Sally Beauty Supply’s gross profit increased$21.9 million or 11.6% for the three months ended December 31, 2007 ascompared to the same period in 2006, principally as a result of acquisitionsand the increased unit sales volume. Gross profit margin as a percent of netsales improved for the three months ended December 31, 2007 as compared tothe same period in 2006, principally as a result of a shift in product mixincluding, among other things, continued increase in sales of exclusive-labelproducts and gross profit margin increase on certain products. These grossprofit margin improvements were partially offset by the gross profit marginimpact of the additional acquisition revenues in Sally Beauty Supplyinternational business.

 

*Beauty Systems Group*. BSG’s grossprofit decreased $0.3 million or 0.3% for the three months ended December 31,2007 as compared to the same period in 2006, principally as a result of lowersales volume. Gross profit margins as a percentage of net sales improved forthe three months ended December 31, 2007 as compared to the three monthsended December 31, 2006 primarily due to margin pressure of lower marginbusiness in our franchise-based business for the three months ended December 31,2006 that was not repeated during the three months ended December 31, 2007.In addition, BSG’s gross margins during the three months ended December 31,2007 have benefited from a shift in revenue with higher store sales versusdistributor sales consultants’ revenues as store sales generally have a highergross profit margin.

 

#### ***Selling,General and Administrative Expenses***

#### *** ***

Consolidated selling, generaland administrative expenses increased $10.6 million, or 5.0%, to $222.9 millionfor the three months ended December 31, 2007 compared to $212.3 millionfor the same period in 2006. Selling, general and administrative expenses, as apercentage of net sales, were 34.0% for the three months ended December 31,2007 compared to 33.7% for the same period in 2006. This increase isattributable principally to expenses directly associated with the net salesincrease, including the effects of acquisitions, for freight and deliveryexpense of approximately $0.8 million, employee compensation of approximately$9.2 million, rent expense related to increased rent on existing stores andaddition of new stores of approximately $4.6 million and additional expenses atthe Company’s corporate support center of approximately $1.2 million. Theseincreases were partially offset by a $1.0 million decrease in expenses from theinclusion in the results for the three months ended December 31, 2006,related to allocated overhead charges from Alberto-Culver prior to theSeparation Transactions, with no comparable charges in the three months ended December 31,2007 and by lower sales commissions of approximately $1.8 million andadvertising expense of approximately $1.5 million. Selling, general andadministrative expense for the three months ended December 31, 2007includes approximately $1.7 million for BSG retention incentives for DSC’s dueto the L’Oreal contractual changes reported during fiscal year 2007.

 

#### ***Depreciationand Amortization***

#### *** ***

Consolidated depreciation andamortization increased $2.0 million, or 20.4%, to $11.8 million for threemonths ended December 31, 2007 compared to $9.8 million for the sameperiod in 2006. The increase was primarily due to the amortization ofintangible assets associated with acquisitions and the capital expenditures forunit growth of both operating segments.

 

#### ***Sales-basedService Fee Charged by Alberto-Culver***

#### *** ***

The sales-based service feecharged by Alberto-Culver was $3.8 million for the three months ended December 31,2006 with no comparable expense for the three months ended December 31,2007 as a result of the cancellation of the agreement in connection with theSeparation Transactions.

 

#### ***TransactionExpenses***

#### *** ***

We recorded $21.5 million inexpenses related to the Separation Transactions for the three months ended December 31,2006. These expenses were for fees allocated to us by Alberto-Culver, forseverance payments to certain former officers and for other professional fees. Wedid not incur any comparable expenses related to the Separation Transactions inthe three months ended December 31, 2007.

 

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#### ***OperatingEarnings***

#### *** ***

Consolidated operating earnings increased $34.3 million to $71.5million for the three months ended December 31, 2007 compared to $37.2million for the same period in 2006. Operating earnings, as a percentage of netsales, were 10.9% for the three months ended December 31, 2007 compared to5.9% for the same period in 2006. The increase in consolidated operating earnings was primarily due toimproved gross profit of $21.9 million by Sally Beauty Supply as well as the non-reoccurrence of fees incurred during the three months endedDecember 31, 2006 of $21.5 million in connection with the SeparationTransactions.

 

*Sally BeautySupply*. Sally Beauty Supply’s segment operatingearnings increased $6.0 million, or 9.2%, to $71.5 million for the three monthsended December 31, 2007 compared to $65.5 million for the same period in2006. Segment operating earnings, as a percentage of net sales, were 17.5% forthe three months ended December 31, 2007 compared to 17.6% for the sameperiod in 2006. Sally Beauty Supply’s segment operating earning margins wereimpacted by the additional revenues from the Sally Beauty Supply internationalacquisition, as this is generally a lower operating earnings margin business.

 

*BeautySystems Group*. BSG’s segment operating earningsincreased $2.4 million, or 12.8%, to $21.1 million for the three months ended December 31,2007 compared to $18.7 million for the same period in 2006. Segment operatingearnings, as a percentage of net sales, were 8.5% for the three months ended December 31,2007 compared to 7.3% for the same period in 2006. BSG’s segment operatingearnings were positively impacted by improvement in gross profit margins aswell as lower selling, general and administrative expenses, principally salescommission, advertising and delivery/freight expenses and the savings ofconsulting fees of approximately $1.0 million not incurred for the three monthsended December 31, 2007. These improvements were offset, in part, by theoperating expenses attributable to stores opened and the businesses acquired inthe twelve month period ending on December 31, 2007.

 

#### ***NetInterest Expense***

#### *** ***

Interest expense, net ofinterest income of $0.2 million, was $46.5 million for the three months ended December 31,2007 compared to $19.1 million, net of interest income of $1.0 million, for thesame period in 2006. The increase in interest expense was primarilyattributable to the interest associated with the new debt incurred on November 16,2006. Net interest expense also reflects non-cash expense of $ 5.7 million andincome of $1.0 million of marked-to-market adjustments for the interest rateswaps, as described in Note 4 of the Condensed Notes to Consolidated FinancialStatements, for the three months ended December 31, 2007 and 2006,respectively.

 

#### ***Provisionfor Income Taxes***

#### *** ***

Provision for income taxes was $9.7 million during the three monthsended December 31, 2007 compared to $14.4 million for the same period in2006. Income taxes for the interim periods ended December 31, 2007 and December 31,2006 have been included in the accompanying financial statements on the basisof an estimated annual effective rate. The estimated annual effective tax rate(excluding discrete items) is 36.0% for fiscal year 2008 compared to 39.1% forfiscal year 2007. The reduction in the estimated annual effective tax rateprimarily relates to the reduced impact of permanent items on higher earningsand a reduction in foreign statutory tax rates.

 

#### ***NetEarnings***

#### *** ***

As a result of theforegoing, consolidated net earnings increased $11.6 million, to $15.3 millionfor the three months ended December 31, 2007 compared to $3.7 million forthe same period in 2006. Net earnings, as a percentage of net sales, were 2.3%for the three months ended December 31, 2007 compared to 0.6% for thethree months ended December 31, 2006. The improved net earnings reflectedthe improved operating performance of both the Sally Beauty Supply segment andthe BSG segment, as discussed above, and the non-recurrence for the threemonths ended December 31, 2007, of the expenses related to the SeparationTransactions that were incurred in the three months ended December 31,2006. These improvements were offset in part by increased interest expenseassociated with the debt we incurred on November 16, 2006.

 

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#### ***Financial Condition***

#### *** ***

### ***December 31,2007 Compared to September 30, 2007***

### *** ***

Working capital (current assets less current liabilities) at December 31,2007 was $396.9 million compared to $341.9 million at September 30, 2007,representing an increase of $55.0 million. The resulting ratio of currentassets to current liabilities was 2.13 to 1.00 at December 31, 2007compared to 1.92 to 1.00 at September 30, 2007. The increase in workingcapital reflects a $34.7 million increase in current assets combined with a$20.3 decrease in current liabilities. Current assets reflect a $26.3 millionincrease in inventory levels and a $5.1 million increase in other receivables. Thedecrease in current liabilities was primarily the result of a decrease in accountspayable and accrued expenses.

 

Inventories increased $26.3million to $595.7 million at December 31, 2007 compared to $569.4 millionat September 30, 2007 while other receivables increased by $5.1 million to$27.3 million at December 31, 2007. The increase in inventory wasprimarily due to purchases in connection with new and expanded BSG brands andthe build up of certain products for Sally Beauty Supply. The increase in otherreceivables relates principally to the timing of billing and collections ofcertain vendor credits including higher volume purchase rebates in connectionwith the procurement of inventory during the three months ended December 31,2007.

 

Accounts payable decreased by$12.8 million to $163.9 million at December 31, 2007 from $176.7 millionat September 30, 2007 primarily due to the timing of payments related toinventory and property and equipment purchased during the fourth quarter offiscal year 2007. Accrued expenses decreased by $15.5 million to $138.2 millionat December 31, 2007 from $153.7 million at September 30, 2007primarily due to payments of accrued interest on long-term debt.

 

Member’s deficit decreased by$15.3 million as a result of earnings for the three months ended December 31,2007, offset in part by a $4.4 million decrease in accumulated othercomprehensive income. Accumulated other comprehensive income - foreign currencytranslation decreased by $4.4 million to $30.1 million at December 31,2007, compared to $34.5 million at September 30, 2007.

 

## **Liquidity and CapitalResources**

## ** **

We broadly defineliquidity as our ability to generate sufficient cash flow from operatingactivities to meet our obligations and commitments. In addition, liquidityincludes the ability to obtain appropriate debt and equity financing and toconvert into cash those assets that are no longer required to meet existingstrategic and financial objectives. Therefore, liquidity cannot be consideredseparately from capital resources that consist of current or potentiallyavailable funds for use in achieving long-range business objectives and meetingdebt service commitments.

 

Following the completion of the SeparationTransactions, we are highly leveraged and a substantial portion of ourliquidity needs will arise from debt service on indebtedness incurred inconnection with the Separation Transactions and from funding the costs ofoperations, working capital and capital expenditures. As a holding company, wedepend on our subsidiaries to distribute funds to us so that we may payour obligations and expenses. Please see the Company’s Annual Report on Form 10-Kfor fiscal year ended September 30, 2007 for additional information onliquidity and capital resources.

 

We utilize our revolving (asset-based lending)facility (the “ABL facility”) for the issuance of letters of credit, as well asto manage normal fluctuations in operational cash flow. In that regard, we may fromtime to time draw funds under the revolving credit facility for generalcorporate purposes including interest payments due on our indebtedness. Thefunds drawn on individual occasions during the three months ended December 31,2007 have varied in amounts of up to *$***35.7**million, with total amounts outstanding ranging from $2.2 million up to $86.9million. The amounts drawn are generally outstanding for a short period of timeand are generally paid down as cash is received from our operating activities.

 

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Our primary source ofcash has been from funds provided by operating activities and borrowings underour ABL facility for the three months ended December 31, 2007.Historically, the primary use of cash was for acquisitions and capitalexpenditures and, for the three months ended December 31, 2006, for thecash distribution paid in connection with the Separation Transactions. Thefollowing table shows our sources and uses of funds for the three months ended December 31,2007 and 2006 (in thousands):

 

| ** **                                           | ** ** | **Three Months Ended December  31,** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                           | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
| Net cash (used) provided by operating activities     |       | $                                                   | (17,950    | ) | $ | 58,386 |   |
| Net cash used by investing activities                |       | (15,277                                             | )          | (14,886 | ) |
| Net cash provided (used) by financing activities     |       | 39,086                                              |       | (119,774 | ) |
| Effect of foreign exchange rates                     |       | (984                                                | )          | (221 | ) |
| Net increase (decrease) in cash and cash equivalents |       | $                                                   | 4,875      |   | $ | (76,495 | ) |

 

### ***Net Cash (Used) Provided by Operating Activities***

### *** ***

Net cash (used) providedby operating activities, which excludes the effects of acquisitions, during thethree months ended December 31, 2007 decreased by $76.4 million to$18.0 million of net cash used, compared to net cash provided of$58.4 million during the three months ended December 31, 2006. Thedecrease was primarily due to an increase in cash used to purchase inventory ofapproximately $48.0 million and to reduce accounts payable and accrued expensesof $22.5 million and income taxes payable of $0.5 million. This decrease wasoffset, in part, by improved earnings for the three months ended December 31,2007 of approximately $11.2 million.

 

### ***Net Cash Used by Investing Activities***

### *** ***

Net cash used byinvesting activities during the three months ended December 31, 2007increased by $0.4 million to $15.3 million, compared to$14.9 million during the three months ended December 31, 2006. Thisincrease was primarily due to an increase in capital expenditures for newstores, remodels of existing facilities and capital spending on our program toconsolidate warehouses, offset in part, by a reduction in cash used foracquisitions. For the three months ended December 31, 2007, the $3.1million of cash used for acquisitions consisted primarily of goodwill andintangible assets.

 

### ***Net Cash Provided (Used) by Financing Activities***

### *** ***

Net cash provided (used)by financing activities during the three months ended December 31, 2007increased by $158.9 million to cash provided of $39.1 million, compared tocash used of $119.8 million during the three months ended December 31,2006. The increase was primarily due to the exclusion of distributions toAlberto-Culver and costs associated with the Separation Transactions, includingdebt issuance costs, and special cash dividend paid in the three months ended December 31,2006. This increase was offset, in part, by lower levels of borrowings and theabsence of capital contributions during the three months ended December 31,2007.

 

##### ***CapitalRequirements***

##### ** **

For fiscal year 2008, weanticipate total capital expenditures of approximately $60.0 million. Capitalexpenditures will be used primarily for the addition of new stores, our BSGdistribution project, the remodel, expansion or relocation of existingfacilities and various corporate projects. During the three months ended December 31,2007, capital expenditures were approximately $12.3 million.

 

**Contractual Obligations**

 

There have been nomaterial changes outside the ordinary course of business in any of ourcontractual obligations since September 30, 2007.

 

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## **Off-Balance SheetFinancing Arrangements**

## ** **

We had no off-balancesheet financing arrangements other than operating leases incurred in theordinary course of business, as well as outstanding letters of credit relatedto inventory purchases and self insurance programs which totaled $7.7 millionand $9.4 million at December 31, 2007 and September 30, 2007,respectively.

 

## **Inflation**

## ** **

We believe that inflationcurrently does not have a material effect on our results of operations.

 

## **Critical AccountingPolicies and Estimates**

## ** **

The preparation offinancial statements in conformity with GAAP requires us to make estimates andassumptions that affect the reported amounts of assets, liabilities, revenuesand expenses and disclosure of contingent assets and liabilities in thefinancial statements. Actual results may differ from these estimates. Webelieve these estimates and assumptions are reasonable. We consider accountingpolicies to be critical when they require us to make assumptions about mattersthat are highly uncertain at the time the accounting estimate is made and whendifferent estimates that our management reasonably could have used have amaterial effect on the presentation of our financial condition, changes infinancial condition or results of operations.

 

Our critical accountingpolicies, as described in our Annual Report on Form 10-K for the fiscalyear ended September 30, 2007, relate to the valuation of inventories,vendor allowances, retention of risk, income taxes,  share-based payments and related partytransactions. There have been no material changes to our critical accountingpolicies since September 30, 2007, except for the adoption of FIN 48,which is discussed in Note 7 of the Condensed Notes to Consolidated FinancialStatements.

 

## **Related Party Transactions**

## ** **

In the ordinary course of business, the Companyperforms certain administrative services on behalf of Sally Beauty. Theseservices are charged to Sally Beauty and netted against the amount due to SallyBeauty. In addition, wehave entered into a tax sharing agreement and we file consolidated tax returnswith our parent, Sally Beauty. See the Company’s Annual Report on Form 10-Kfor the fiscal year ended September 30, 2007 for more information aboutrelated party transactions.

 

## **Recent Accounting Pronouncements**

## ** **

InDecember 2007, the Financial Accounting Standards Board, or FASB, issuedStatement of Financial Accounting Standards No. 160, *NoncontrollingInterests in Consolidated Financial Statements, an amendment to ARB No. 51*or SFAS 160, which requires, among other things, that the noncontrollinginterest (previously referred to as minority interest) in a consolidatedsubsidiary’s equity be reported as a component of equity separate from theparent’s interest and that net income or loss attributable to thenoncontrolling interest be included in consolidated net income on the face ofthe income statement. In addition, purchases and sales of equity interest thatdo not result in a change in control will be accounted as equity transactionsand, upon a loss of control, the interest sold, as well as any interestretained, will be recorded at fair value with any gain or loss recognized inearnings. SFAS 160 is effective for periods on or after December 15, 2008.We are currently assessing the effect of this pronouncement on our consolidatedfinancial statements.

 

In December 2007,the FASB, issued SFAS No. 141 (Revised 2007): *BusinessCombinations* or SFAS 141R. Among other things, SFAS 141R generallyrequires that an acquirer recognize the assets acquired and liabilities assumedmeasured at their fair values on the acquisitions date. This practice replacesthe practice, under predecessor SFAS No. 141: *BusinessCombinations,* of allocating the cost of an acquisition to theindividual assets acquired and liabilities assumed based on their relativeestimated fair values. SFAS 141R further requires that acquisition-relatedcosts be recognized separately from the related acquisition. SFAS 141R iseffective in fiscal years beginning after December 15, 2008. We are currentlyassessing the effect of this pronouncement on our consolidated financialstatements.

 

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In February 2007,the FASB issued SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities - including an amendment ofFASB Statement No. 115*, or SFAS 159. SFAS 159 permits entitiesto choose to measure many financial instruments and certain other items at fairvalue that are not currently required to be measured at fair value, withunrealized gains and losses related to these financial instruments reported inearnings at each subsequent reporting date. SFAS 159 is effective in fiscalyears beginning after November 15, 2007. We are currently assessing theeffect of this pronouncement on our consolidated financial statements.

 

In September 2006,the FASB issued SFAS No. 157, *Fair Value Measurements*,or SFAS 157, which defines fair value, establishes a framework for measuringfair value in generally accepted accounting principles, and expands disclosuresabout fair value measurements. SFAS 157 is effective in fiscal yearsbeginning after November 15, 2007. In November 2007, the FASB provided a one year deferral for theimplementation of SFAS 157 for other nonfinancial assets and liabilities. Weare currently assessing the effect of this pronouncement on our consolidatedfinancial statements.

 

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# **Item 3. Quantitativeand Qualitative Disclosures About Market Risk.**

 

As a multinationalcorporation, we are subject to certain market risks including foreign currencyfluctuations, interest rates and government actions. We consider a variety ofpractices to manage these market risks, including, when deemed appropriate, theoccasional use of derivative financial instruments.

 

## **Foreign currency exchangerate risk**

## ** **

We are exposed topotential gains or losses from foreign currency fluctuations affecting netinvestments and earnings denominated in foreign currencies. Our primaryexposures are to changes in exchange rates for the U.S. dollar versus theBritish pound sterling, Canadian dollar, Euro and Mexican peso. Our variouscurrency exposures at times offset each other providing a natural hedge againstcurrency risk. Fluctuations in U.S. dollar exchange rates within the rangeof the rates for the three months ended December 31, 2007 and 2006 did nothave a material effect on our financial condition and results of operations. Wedo not use derivative financial instruments to manage foreign currency exchangerate risk.

 

## **Interest rate risk**

## ** **

As a result of the debtfinancing incurred in connection with the Separation Transactions, we aresubject to interest rate market risk in connection with our long-term debt. Theprincipal interest rate exposure relates to amounts borrowed under the TermLoans and the ABL facility. Based on the approximately $1.1 billion ofborrowings under the Term Loans and the ABL facility as of December 31,2007, a change in the estimated interest rate up or down by 1/8% will increaseor decrease earnings before provision for income taxes by approximately $1.3million on an annual basis, without considering the effect of any interest rateswap agreements we may have from time to time.

 

We are sensitive tointerest rate fluctuations. In order to enhance our ability to manage riskrelating to cash flow and interest rate exposure, we and/or our othersubsidiaries 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, the agreement underlying our Term Loans requires that we hedge aportion of our floating interest rate exposure for a specified period.

 

On November 24,2006, we entered into two interest rate swap agreements with a notional amountof $150.0 million and $350.0 million, respectively. These agreements expire on November 24,2008 and 2009, respectively. The agreements allow us to convert a portion ofour variable rate interest to a fixed rate of 4.9975% plus (2.00% to 2.50%) and4.94% plus (2.00% to 2.50%), respectively. As discussed in Part I, “Item1A. Risk Factors” of our Annual Report on Form 10-K for the fiscal yearended September 30, 2007, changes in the fair value of these interest rateswap agreements driven by interest rate changes will increase or decrease ournet interest expense and may therefore affect our earnings.

 

## **Credit risk**

## ** **

We are exposed to creditrisk on certain assets, primarily cash equivalents, short-term investments andaccounts receivable. The credit risk associated with cash equivalents andshort-term investments is mitigated by our policy of investing in a diversifiedportfolio of securities with high credit ratings.

 

We provide credit tocustomers in the ordinary course of business and perform ongoing creditevaluations. Our exposure to concentrations of credit risk with respect totrade receivables is mitigated by our broad customer base. We believe ourallowance for doubtful accounts is sufficient to cover customer credit risks.

 

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# **Item 4. Controlsand Procedures.**

 

*Controls Evaluation and Related CEOand CFO Certifications.*Our management, with theparticipation of our principal executive officer, who also serves as theprincipal executive officer of Sally Capital (“CEO”), and principal financialofficer, who also serves as the principal financial officer of Sally Capital (“CFO”),conducted an evaluation of the effectiveness of the design and operation of ourdisclosure controls and procedures as of the end of the period covered by thisreport. The controls evaluation was conducted by our Disclosure Committee,comprised of senior representatives from our finance, accounting, internalaudit, and legal departments under the supervision of our CEO.

 

Certifications of our CEO and our CFO, which arerequired in accordance with Rule 13a-14 of the Securities Exchange Act of1934, as amended (“Exchange Act”), are attached as exhibits to this report.This “Controls and Procedures” section includes the information concerningthe controls evaluation referred to in the certifications, and it should beread in conjunction with the certifications for a more complete understandingof the topics presented.

 

*Limitations on the Effectiveness ofControls.*We do not expect that our disclosure controls andprocedures will prevent all errors and all fraud. A system of controls andprocedures, no matter how well conceived and operated, can provide onlyreasonable, not absolute, assurance that the objectives of the system are met.Because of the limitations in all such systems, no evaluation can provideabsolute assurance that all control issues and instances of fraud, if any, havebeen detected. Furthermore, the design of any system of controls and proceduresis based in part upon certain assumptions about the likelihood of futureevents, and there can be no assurance that any design will succeed in achievingits stated goals under all potential future conditions, regardless of howunlikely. Because of these inherent limitations in a cost-effective system ofcontrols and procedures, misstatements or omissions due to error or fraud may occurand not be 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 report. In the course of the evaluation, we sought to identify whetherwe had any data errors, control problems or acts of fraud and to confirm thatappropriate corrective action, including process improvements, was beingundertaken if needed. This type of evaluation is performed on a quarterly basisso that conclusions concerning the effectiveness of our disclosure controls andprocedures can be reported in our quarterly reports on Form 10-Q and ourannual reports on Form 10-K. Many of the components of our disclosurecontrols and procedures are also evaluated by our internal audit department,our legal department and by personnel in our finance organization. The overallgoals of these various evaluation activities are to monitor our disclosurecontrols and procedures on an ongoing basis, and to maintain them as dynamicsystems that change as conditions warrant.

 

*Conclusions regarding DisclosureControls.*Based on the required evaluation of our disclosurecontrols and procedures, our CEO and CFO have concluded that, as of December 31,2007, we maintain disclosure controls and procedures that are effective inproviding reasonable assurance that information required to be disclosed by usin the reports that we file or submit under the Exchange Act is recorded,processed, summarized and reported within the time periods specified in the SEC’srules and forms, and that such information is accumulated and communicatedto our management, including our CEO and CFO, as appropriate to allow timelydecisions regarding required disclosure.

 

*Changesin Internal Control over Financial Reporting.*During our lastfiscal quarter, there have been no changes in our internal control overfinancial reporting identified in connection with the evaluation describedabove that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

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# **PART II – OTHER INFORMATION**

 

# **Item 1. LegalProceedings.**

 

There were no materiallegal proceedings pending against us or our subsidiaries, as of December 31,2007. We are involved in various claims and lawsuits incidental to the conductof our business in the ordinary course. We carry insurance coverage in suchamounts in excess of our self-insured retention as we believe to be reasonableunder the circumstances and that may or may not cover any or all ofour liabilities in respect of claims and lawsuits. We do not believe that theultimate resolution of these matters will have a material adverse impact on ourconsolidated financial position, cash flows or results of operations.

 

We are subject to anumber of U.S., federal, state and local laws and regulations, as well as thelaws and regulations applicable in each other market in which we do business.These laws and regulations govern, among other things, the composition,packaging, labeling and safety of the products we sell, the methods we use tosell these products and the methods we use to import these products. We believethat we are in material compliance with such laws and regulations, although noassurance can be provided that this will remain true going forward.

 

# **Items 1A. RiskFactors.**

 

## **In addition to the other information set forth in thisreport, you should carefully consider the factors contained in Part I,Item 1A. “Risk Factors” in our Annual Report on Form 10-K for the yearended September 30, 2007, which could materially affect our business,financial condition or future results. There have been no material changes fromthe risk factors disclosed in our Annual Report. The risks described in thatreport are not the only risks facing our company. Additional risks anduncertainties not currently known to us or that we currently deem to beimmaterial also may materially adversely affect our business, financialcondition and/or operating results.**

 

**Item 2. Unregistered Sales ofEquity Securities and Use of Proceeds.**

 

 (a) Not applicable

 

(b) Not applicable

 

(c) Not applicable

 

**Item 3. Defaults Upon Senior Securities.**

 

Not applicable

 

**Item 4. Submission of Matters toa Vote of Security Holders.**

 

Not applicable

 

# **Item 5. OtherInformation.**

 

 (a) Not applicable

 

(b) Not applicable

 

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# **Item 6. 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 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  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  by reference from Exhibit 2.02 to the Current Report on Form 8-K of  New Sally Holdings, Inc. 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 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 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 by reference from Exhibit 2.01 to the Current Report on Form 8-K  of New Sally Holdings, Inc. filed on October 30, 2006                                                                                                                                                                         |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 2.7                  |       | Agreement for the sale and purchase of the entire issued share capital  of Chapelton 21 Limited, a private company incorporated in Scotland, dated as  of February 15, 2007 by and among Ogee Limited, a company incorporated  under the laws of England and Wales and an indirect wholly-owned subsidiary  of Sally Beauty Holdings, Inc., and the shareholders named therein,  which is incorporated by reference from Exhibit 2.7 to the Quarterly  Report on Form 10-Q of Sally Beauty Holdings, Inc. filed May 10,  2007 |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 3.1                  |       | Certificate of Formation of Sally Holdings LLC, which is incorporated  by reference to 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 by reference to 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                                                                                                                                                                                                                                                                                |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 3.3                  |       | Certificate of Incorporation of Sally Capital Inc., which is  incorporated by reference to Exhibit 3.3 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                                                                                                                                                                                                                                                                                       |
| 3.4                  |       | By-Laws of Sally Capital Inc., which is incorporated by reference to Exhibit 3.4  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 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                                                                                                                                                                                                                                                                                                                                                                                                                                                    |

 

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|   |   | Holdings, Inc., CDRS Acquisition LLC and Carol L. Bernick, as  representative of the other stockholders, which is incorporated herein by  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 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 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 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 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 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 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 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 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                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |

 

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|      |   | (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 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, a division of Merrill Lynch Business Financial  Services Inc., 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 by reference  from Exhibit 4.7 to the Current Report on Form 8-K of Sally Beauty  Holdings, Inc. filed on November 22, 2006 |
|      |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 31.1-31.2 |   | Rule 13(a)-14(a)/15(d)-14(a) Certifications *                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|      |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 32.1-32.2 |   | Section 1350 Certifications *                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |

 

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*Included herewith

 

PLEASE NOTE: It is inappropriatefor investors to assume the accuracy of any covenants, representations orwarranties that may be contained in agreements or other documents filed asexhibits to this Quarterly Report on Form 10-Q. In certain instances thedisclosure schedules to such agreements or documents contain information thatmodifies, qualifies and creates exceptions to the representations, warrantiesand covenants. Moreover, some of the representations and warranties may notbe complete or accurate as of a particular date because they are subject to acontractual standard of materiality that is different from those generallyapplicable to stockholders and/or were used for the purpose of allocating riskamong the parties rather than establishing certain matters as facts.Accordingly, you should not rely on the representations and warranties as characterizationsof the actual state of facts at the time they were made or otherwise.

 

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SIGNATURE

 

Pursuant to therequirements of the Securities Exchange Act of 1934, each registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
| Date:  | February 14,  2008 |                                                      |
|--------|-------------------------|-----------------------------------------------------------|
|   |                    |                                                      |
|   | SALLY HOLDINGS  LLC     |
|   |                    |                                                      |
|   |                    |                                                      |
|   | By:                     | /s/ MARK J.  FLAHERTY                                     |   |
|   | Name:                   | Mark J. Flaherty                                          |
|   | Title:                  | Vice President,  Chief Accounting Officer and  Controller |
|   |                    |                                                      |
| Date:  | February 14,  2008 |                                                      |   |
|   |                    |                                                      |   |
|   |                    |                                                      |   |
|   | SALLY CAPITAL  INC.     |
|   |                    |
|   |                    |
|   | By:                     | /s/ MARK J.  FLAHERTY                                     |   |
|   | Name:                   | Mark J. Flaherty                                          |
|   | Title:                  | Vice President,  Chief Accounting Officer and  Controller |

 

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