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**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 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE QUARTERLY PERIOD ENDED:JUNE 30, 2010**

 

**-OR-**

 

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

 

**Commission File No. 333-144427**

 

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**SALLY HOLDINGS LLC**

(Exact name ofregistrant as specified in its charter)

 

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| **Delaware**                                                    | ** ** | **36-4472381**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer Identification  No.) |
| ** **                                                      | ** ** | ** **                            |
| **3001 Colorado Boulevard****Denton, Texas**                    | ** ** | **76210**                             |
| (Address of principal executive  offices)                       |       | (zip code)                            |

 

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

 

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Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.  YES  x    NO    o

 

Indicate by check mark whether the registrant hassubmitted electronically and posted on its corporate Web site, if any, everyInteractive Data File required to be submitted and posted pursuant to Rule 405of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months(or for such shorter period that the registrant was required to submit and postsuch files). Yes  o    No  o

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, a non-accelerated filer, or asmaller reporting company. See the definitions of “large accelerated filer,” “acceleratedfiler” and “smaller reporting company” in Rule 12b-2 of the ExchangeAct.

 

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

 

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

 

No voting or non-voting common equity of theregistrant was held by non-affiliates of the registrant as of June 30,2010.  As of July 30, 2010, allmember units were owned by Sally Investment Holdings LLC, a wholly-ownedsubsidiary 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 | 34       |
| ITEM 3.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                      | 52       |
| ITEM 4. CONTROLS  AND PROCEDURES                                                                    | 53       |
|                                                                                                |     |
| PART II — OTHER  INFORMATION                                                              |     |
|                                                                                                |     |
| ITEM 1. LEGAL  PROCEEDINGS                                                                          | 55       |
| ITEM 1A. RISK FACTORS                                                                               | 55       |
| ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS                                | 56       |
| ITEM 3.  DEFAULTS UPON SENIOR SECURITIES                                                            | 56       |
| ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                        | 56       |
| ITEM 5. OTHER  INFORMATION                                                                          | 56       |
| ITEM  6. EXHIBITS                                                                                   | 57       |

 

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SinceNovember 2006, Sally Holdings LLC, which we refer to as “Sally Holdings,”a limited liability company organized under the laws of the State of Delaware,has been a wholly-owned subsidiary of Sally Investment Holdings LLC, which werefer to as “Sally Investment,” a wholly-owned subsidiary of Sally BeautyHoldings, Inc., which we refer to as “Sally Beauty.” All of the interestsof Sally Holdings are beneficially owned by Sally Investment, and all of theinterests of Sally Investment are beneficially owned by Sally Beauty.  Prior to November 2006, Sally Holdingswas a Delaware corporation named “Sally Holdings, Inc.” and was awholly-owned subsidiary of the Alberto-Culver Company, which we refer to as “Alberto-Culver.”In November 2006, Sally Holdings, Inc. was converted to a Delawarelimited liability company, was renamed “Sally Holdings LLC” and became awholly-owned subsidiary of Sally Investment and an indirect subsidiary of SallyBeauty in connection with the separation of Sally Holdings’ business fromAlberto-Culver. All operations of Sally Investment and Sally Beauty areconducted through Sally Holdings and its consolidated subsidiaries.

 

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

 

Cautionary Notice Regarding Forward-LookingStatements

 

Statements in this Quarterly Report on Form 10-Qand in the documents incorporated by reference herein which are not purelyhistorical facts or which depend upon future events may constituteforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended, which we refer to as the Exchange Act. Wordssuch as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan,” “project,”“target,” “can,” “could,” “may,” “should,” “will,” “would” or similarexpressions 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:

 

·             the highly competitive nature of, and the increasing consolidation of,the beauty products distribution industry;

·             anticipating changes in consumer preferences and buying trends andmanaging our product lines and inventory;

·             potential fluctuation in our same store sales and quarterly financialperformance;

·             our dependence upon manufacturers who may be unwilling or unable tocontinue to supply products to us;

·             the possibility of material interruptions in the supply of beauty supplyproducts by our manufacturers;

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

·             compliance with laws and regulations or becoming subject to additionalor more stringent laws and regulations;

·             product diversion;

·             the operational and financial performance of our Armstrong McCall, L.P.(“Armstrong McCall”) business;

·             the success of our internet-based business;

·             successfully identifying acquisition candidates or successfullycompleting desirable acquisitions;

·             integrating businesses acquired in the future;

·             opening and operating new stores profitably;

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

·             the success of our cost control plans;

·             protecting our intellectual property rights, specifically ourtrademarks;

·             conducting business outside the United States;

·             disruption in our information technology systems;

 

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·             natural disasters or acts of terrorism;

·             the preparedness of our accounting and other management systems to meetfinancial reporting and other requirements and the upgrade of our existingfinancial reporting system;

·             we, along with Sally Capital Inc., are holding companies with nooperations of our own, and we depend on our subsidiaries for cash;

·             our substantial indebtedness;

·             the possibility that we may incur substantial additional debt;

·             restrictions and limitations in the agreements and instruments governingour debt;

·             generating the significant amount of cash needed to service all of ourdebt and refinancing all or a portion of our indebtedness or obtainingadditional financing;

·             changes in interest rates increasing the cost of servicing our debt orincreasing our interest expense due to our interest rate swap agreements;

·             the potential impact on us if the financial institutions we deal withbecome impaired;

·             the representativeness of our historical consolidated financialinformation with respect to our future financial position, results ofoperations or cash flows;

·             our reliance upon Alberto-Culver for the accuracy of certain historicalservices and information;

·             the share distribution of Alberto-Culver common stock in our separationfrom Alberto-Culver not constituting a tax-free distribution;

·             actions taken by certain large stockholders of Sally Beauty adverselyaffecting the tax-free nature of the share distribution of Alberto-Culvercommon stock;

·             the voting power of Sally Beauty’s largest stockholder discouragingthird-party acquisitions of Sally Beauty at a premium; and

·             the interests of Sally Beauty’s largest stockholder differing from theinterests of other holders of Sally Beauty’s common stock.

 

Additional factors that could cause actual events orresults to differ materially from the events or results described in theforward-looking statements can be found in our Annual Report on Form 10-Kfor the fiscal year ended September 30, 2009, as filed with the Securitiesand Exchange Commission. The events described in the forward-looking statementsmight not occur or might occur to a different extent or at a different timethan we have described. As a result, our actual results may differ materiallyfrom the results contemplated by these forward-looking statements. We assume noobligation to publicly update or revise any forward-looking statements.

 

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**PART I — FINANCIALINFORMATION**

 

**Item 1.  Financial Statements.**

 

The following are our consolidated balance sheets asof June 30, 2010 and September 30, 2009, our consolidated statementsof earnings for the three and nine months ended June 30, 2010 and 2009 andour consolidated statements of cash flows for the nine months ended June 30,2010 and 2009.  In November 2006,Sally Holdings, Inc. was converted to a Delaware limited liabilitycompany, was renamed “Sally Holdings LLC,” which we refer to as Sally Holdings,and became an indirect wholly-owned subsidiary of Sally Beauty Holdings, Inc.in connection with our separation from Alberto-Culver.  In these financial statements and elsewherein this Quarterly Report on Form 10-Q, we refer to these transactions asthe Separation Transactions.  See the Company’sAnnual Report on Form 10-K for the fiscal year ended September 30,2009 for additional information about the Separation Transactions.

 

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

(Unaudited)

 
| ** **                                       | ** ** | **Three Months Ended  June 30,** | ** ** | **Nine Months Ended  June 30,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                       | ** ** | **2010**                              | ** ** | **2009**                             | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net sales                                        |       | $                                     | 742,975    |                                 | $          | 673,337 |   | $ | 2,168,293 |   | $ | 1,960,424 |   |
| Cost of products sold and  distribution expenses |       | 382,116                               |       | 355,492                              |       | 1,129,936 |   | 1,036,923 |   |
| Gross profit                                     |       | 360,859                               |       | 317,845                              |       | 1,038,357 |   | 923,501 |   |
| Selling, general and  administrative expenses    |       | 253,730                               |       | 222,039                              |       | 747,956 |   | 662,050 |   |
| Depreciation and  amortization                   |       | 12,666                                |       | 11,642                               |       | 36,985 |   | 34,860 |   |
| Operating earnings                               |       | 94,463                                |       | 84,164                               |       | 253,416 |   | 226,591 |   |
| Interest expense                                 |       | 28,255                                |       | 31,063                               |       | 85,120 |   | 102,694 |   |
| Earnings before provision  for income taxes |       | 66,208                                |       | 53,101                               |       | 168,296 |   | 123,897 |   |
| Provision for income taxes                       |       | 23,931                                |       | 20,246                               |       | 62,792 |   | 48,096 |   |
| Net earnings                                     |       | $                                     | 42,277     |                                 | $          | 32,855 |   | $ | 105,504 |   | $ | 75,801 |   |

 

Theaccompanying condensed notes, together with the Notes to Consolidated FinancialStatements contained in the Company’s Annual Report on Form 10-K for the fiscalyear ended September 30, 2009, are an integral part of these financialstatements.

 

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

 
| ** **                                                                                                                              | ** ** | **June 30,********2010** | ** ** | **September 30,********2009** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                                              | ** ** | **(Unaudited)**               | ** ** | ** **                         | ** ** |
| **Assets**                                                                                                                              | ** ** | ** **                    | ** ** | ** **                         | ** ** |
| Current assets:                                                                                                                         |       |                          |       |                               |       |
| Cash and cash equivalents                                                                                                               |       | $                             | 28,303     |                               | $          | 54,447 |   |
| Trade accounts receivable,  less allowance for doubtful accounts of $2,316 at June 30, 2010 and  $2,266 at September 30, 2009 |       | 52,172                        |       | 43,649                             |       |
| Other receivables                                                                                                                       |       | 29,924                        |       | 24,090                             |       |
| Inventory                                                                                                                               |       | 586,573                       |       | 559,689                            |       |
| Prepaid expenses                                                                                                                        |       | 22,649                        |       | 18,261                             |       |
| Deferred income tax assets                                                                                                              |       | 15,697                        |       | 15,629                             |       |
| Total current assets                                                                                                                    |       | 735,318                       |       | 715,765                            |       |
| Property and equipment,  net of accumulated depreciation of $288,161 at June 30, 2010 and  $265,329 at September 30, 2009     |       | 163,958                       |       | 151,249                            |       |
| Goodwill                                                                                                                                |       | 478,963                       |       | 494,135                            |       |
| Other intangible assets,  net of accumulated amortization of $30,445 at June 30, 2010 and $24,357  at September 30, 2009      |       | 96,732                        |       | 78,685                             |       |
| Other assets                                                                                                                            |       | 40,791                        |       | 50,676                             |       |
| Total assets                                                                                                                            |       | $                             | 1,515,762  |                               | $          | 1,490,510 |   |
| **Liabilities  and Member’s Deficit**                                                                                              |       |                          |       |                               |       |
| Current liabilities:                                                                                                                    |       |                          |       |                               |       |
| Current maturities of  long-term debt                                                                                                   |       | $                             | 14,477     |                               | $          | 24,517 |   |
| Accounts payable                                                                                                                        |       | 223,705                       |       | 193,592                            |       |
| Accrued liabilities                                                                                                                     |       | 143,129                       |       | 153,842                            |       |
| Due to Sally Beauty                                                                                                                     |       | 32,795                        |       | 22,042                             |       |
| Income taxes payable                                                                                                                    |       | 7,872                         |       | 5,829                              |       |
| Total current liabilities                                                                                                               |       | 421,978                       |       | 399,822                            |       |
| Long-term debt                                                                                                                          |       | 1,572,265                     |       | 1,653,013                          |       |
| Other liabilities                                                                                                                       |       | 41,822                        |       | 43,586                             |       |
| Deferred income tax  liabilities                                                                                                        |       | 36,834                        |       | 34,428                             |       |
| Total liabilities                                                                                                                       |       | 2,072,899                     |       | 2,130,849                          |       |
| Stock options subject to  redemption                                                                                                    |       | 1,639                         |       | 1,800                              |       |
| Member’s deficit:                                                                                                                  |       |                          |       |                               |       |
|                                                                                                                                    |       |                          |       |                               |       |
| Member’s deficit                                                                                                                   |       | (520,737                      | )          | (626,241                           | )          |
|                                                                                                                                    |       |                          |       |                               |       |
| Accumulated other  comprehensive loss, net of tax                                                                                       |       | (38,039                       | )          | (15,898                            | )          |
| Total member’s deficit                                                                                                             |       | (558,776                      | )          | (642,139                           | )          |
| Total liabilities and  member’s deficit                                                                                            |       | $                             | 1,515,762  |                               | $          | 1,490,510 |   |

 

Theaccompanying condensed notes, together with the Notes to Consolidated FinancialStatements contained in the Company’s Annual Report on Form 10-K for thefiscal year ended September 30, 2009, are an integral part of thesefinancial statements.

 

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

(Unaudited)

 
| ** **                                                                           | ** ** | **Nine Months Ended********June 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                           | ** ** | **2010**                                   | ** ** | **2009** | ** ** |
| **Cash  Flows from Operating Activities:**                                           |       |                                       |       |   |   |
| Net earnings                                                                         |       | $                                          | 105,504    |   | $ | 75,801 |   |
| Adjustments to reconcile  net earnings to net cash provided by operating activities: |       |                                       |       |   |   |
| Depreciation and  amortization                                                       |       | 36,985                                     |       | 34,860 |   |
| Share-based compensation  expense                                                    |       | 9,445                                      |       | 6,336 |   |
| Amortization of deferred  financing costs                                            |       | 5,912                                      |       | 6,289 |   |
| Excess tax (benefit)  shortfall from share-based compensation                        |       | (59                                        | )          | 204 |   |
| Net gain on disposal of  leaseholds and other property                               |       | (33                                        | )          | (66 | ) |
| Net loss on extinguishment  of debt                                                  |       | 766                                        |       | 715 |   |
| Deferred income taxes                                                                |       | 2,511                                      |       | 1,019 |   |
| Changes in (exclusive of effects of  acquisitions):                                  |       |                                       |       |   |   |
| Trade accounts receivable                                                            |       | 871                                        |       | 3,986 |   |
| Other receivables                                                                    |       | (5,184                                     | )          | (2,255 | ) |
| Inventory                                                                            |       | (23,804                                    | )          | 30,683 |   |
| Prepaid expenses                                                                     |       | (4,258                                     | )          | (1,835 | ) |
| Other assets                                                                         |       | 3,116                                      |       | 571 |   |
| Accounts payable and  accrued liabilities                                            |       | 16,977                                     |       | 23,889 |   |
| Income taxes payable                                                                 |       | 342                                        |       | (6,858 | ) |
| Due to Sally Beauty                                                                  |       | 1,146                                      |       | (2,911 | ) |
| Other liabilities                                                                    |       | (2,255                                     | )          | (5,972 | ) |
| Net cash provided by  operating activities                                           |       | 147,982                                    |       | 164,456 |   |
| **Cash  Flows from Investing Activities:**                                           |       |                                       |       |   |   |
| Capital expenditures                                                                 |       | (36,011                                    | )          | (26,290 | ) |
| Proceeds from sale of  property and equipment                                        |       | 110                                        |       | 147 |   |
| Acquisitions, net of cash  acquired                                                  |       | (34,445                                    | )          | (1,987 | ) |
| Net cash used by investing  activities                                               |       | (70,346                                    | )          | (28,130 | ) |
| **Cash  Flows from Financing Activities:**                                           |       |                                       |       |   |   |
| Change in book cash  overdraft                                                       |       | —                                     |       | (1,586 | ) |
| Proceeds from issuance of  long-term debt                                            |       | 232,000                                    |       | 95,104 |   |
| Repayments of long-term  debt                                                        |       | (334,025                                   | )          | (223,267 | ) |
| Excess tax benefit  (shortfall) from share-based compensation                        |       | 59                                         |       | (204 | ) |
| Net cash used by financing  activities                                               |       | (101,966                                   | )          | (129,953 | ) |
| Effect of foreign exchange  rate changes on cash and cash equivalents                |       | (1,814                                     | )          | (219 | ) |
| Net (decrease) increase in  cash and cash equivalents                                |       | (26,144                                    | )          | 6,154 |   |
| Cash and cash equivalents,  beginning of period                                      |       | 54,447                                     |       | 99,788 |   |
| Cash and cash equivalents,  end of period                                            |       | $                                          | 28,303     |   | $ | 105,942 |   |
|                                                                                 |       |                                       |       |   |   |
| **Supplemental  Cash Flow Information:**                                             |       |                                       |       |   |   |
|                                                                                 |       |                                       |       |   |   |
| Interest paid                                                                        |       | $                                          | 100,241    |   | $ | 116,995 |   |
| Income taxes paid, net                                                               |       | $                                          | 4,896      |   | $ | 5,205 |   |

 

Theaccompanying condensed notes, together with the Notes to Consolidated FinancialStatements contained in the Company’s Annual Report on Form 10-K for thefiscal year ended September 30, 2009, are an integral part of thesefinancial statements.

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

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

 

**Description of Business**

 

Sally Holdings is a wholly-owned subsidiary of SallyInvestment, a wholly-owned subsidiary of Sally Beauty.  All of the interests of Sally Holdings arebeneficially owned by Sally Investment, and all of the interests of SallyInvestment are beneficially owned by Sally Beauty. The Company was awholly-owned subsidiary of Alberto-Culver until November 16, 2006 when itwas converted to a Delaware limited liability company, was renamed “SallyHoldings LLC” and became a wholly-owned subsidiary of Sally Investment and anindirect subsidiary of Sally Beauty in connection with the separation of itsbusiness from Alberto-Culver. The Company and its consolidated subsidiariessell professional beauty supplies, primarily through its Sally Beauty Supplyretail stores in the U.S., Puerto Rico, Mexico, Canada, Chile, Belgium, France, Italy,the United Kingdom and certain other countries in Europe. Additionally, theCompany distributes professional beauty products to salons and professionalcosmetologists through its Beauty Systems Group (“BSG”) store operations and acommissioned direct sales force that calls on salons primarily in the U.S.,Puerto Rico, Canada, the United Kingdom and certain other countries in Europeand to franchises in the southern and southwestern U.S. and in Mexico throughthe operations of its subsidiary Armstrong McCall. Certain beauty products soldby BSG and Armstrong McCall are sold under exclusive territory agreements withthe manufacturers of the products.

 

Sally Beauty was formed in June 2006 and becamethe accounting successor company to Sally Holdings, Inc. upon thecompletion of the Separation Transactions. Please see the Company’s AnnualReport on Form 10-K for the fiscal year ended September 30, 2009 formore information about the Separation 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, we have enteredinto a tax sharing agreement and we file consolidated tax returns with ourindirect parent, Sally Beauty.  See theCompany’s Annual Report on Form 10-K for the fiscal year ended September 30,2009 for more information about related parties.

 

**Basis of Presentation**

 

The consolidated interim financial statementsinclude the accounts of the Company and its subsidiaries. All significantinter-company accounts and transactions have been eliminated in consolidation.In the opinion of management, these consolidated financial statements reflectall adjustments which are of a normal recurring nature and which are necessaryto present fairly the Company’s consolidated financial position as of June 30,2010 and September 30, 2009, its consolidated results of operations forthe three and nine months ended June 30, 2010 and 2009 and itsconsolidated cash flows for the nine months ended June 30, 2010 and 2009.

 

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.

 

**2.  ****Significant Accounting Policies**

 

The consolidated interim financial statements includedherein are unaudited and have been prepared by the Company pursuant to the rules andregulations of the Securities and Exchange Commission (“SEC”). Certaininformation and note disclosures normally included in annual financialstatements prepared in accordance with accounting principles generally acceptedin the United States (“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. These consolidated interimfinancial statements should be read in conjunction with the financialstatements and notes thereto included in the Company’s Annual Report on Form 10-Kfor the fiscal year ended September 30, 2009. The Company adheres to thesame accounting policies in the preparation of its interim financialstatements. As permitted under GAAP, interim accounting for certain expenses,including income taxes, is based on full year assumptions. Such amounts areexpensed in full in the year incurred. For interim financial reportingpurposes, income taxes are recorded based upon estimated annual effectiveincome tax rates.

 

The results of operations for these interim periodsare not necessarily indicative of the results that may be expected for anyfuture interim period or the entire fiscal year.

 

The Company’s financial instruments consist of cashand cash equivalents, trade and other accounts receivable, accounts payable,interest rate swap agreements, foreign currency options and long-term debt.There were no

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

significant changes in the methods and significantassumptions used to estimate the fair value of the Company’s financialinstruments since September 30, 2009.

 

The carrying amounts of cash and cash equivalents,trade and other accounts receivable and accounts payable approximate fair valuedue to the short-term nature of these financial instruments.

 

Theaggregate fair value of the interest rate swap agreements held at June 30,2010 was a net liability of $15.8 million included in other liabilities in the Company’s consolidated balance sheet. Fair value amounts reported forthese agreements are based on third-party information and were determined usingproprietary models based upon well-recognized financial principles andreasonable estimates about relevant future market conditions. Please see Note 8for more information about the Company’s interest rate swaps.

 

The aggregate fair value of all foreign currencyoption agreements held at June 30, 2010 was a net asset of $0.5 millionincluded in prepaid expenses in the Company’s consolidatedbalance sheet. Fair value amounts reported for these agreements are based onthird-party information and were determined using proprietary models based uponwell-recognized financial principles and reasonable estimates about relevantfuture market conditions. Please see Note 8 for more information about the Company’sforeign currency options.

 

AtJune 30, 2010, the fair value of the Company’s long-term debt (includingcapital leases) was approximately $1,582.7 million, while the carrying amountin the Company’s consolidated balance sheet was $1,586.7 million. Fair valueamounts reported for long-term borrowings are based on quoted market priceswhere available or, if not available, based on discounted future cash flowsusing current market interest rates.

 

As required by Accounting Standards Codification (“ASC”)815,*Derivatives and Hedging*, as amended,the Company records all derivative instruments on its balance sheet at fairvalue.  The accounting for changes in the fair value of derivativeinstruments depends on the intended use of the derivative, whether the Companyhas elected to designate a derivative instrument in a hedging relationship andapply hedge accounting, and whether the hedging relationship has satisfied thecriteria necessary to apply hedge accounting. Derivative instruments designatedand qualifying as a hedge of the exposure to variability in expected futurecash flows, or other types of forecasted transactions, are considered cash flowhedges. Hedge accounting generally provides for the matching of the timing ofgain or loss recognition on the hedging instrument with the recognition of theimpact on earnings of the hedged transaction or transactions. The Company mayfrom time to time enter into derivative contracts that are intended to hedgecertain economic risks even though hedge accounting does not apply or theCompany elects not to apply hedge accounting to such derivative contracts.Please see Note 8 for more details about the Company’s derivative instrumentsand hedging activities as of June 30, 2010.

 

The Company has adopted the provisions of ASC 820, *Fair Value Measurements and Disclosures*(“ASC 820”), as itrelates to its financial instruments. ASC 820, as amended, establishes a three-level hierarchy for measuringfair value and requires an entity to maximize the use of observable inputs andminimize the use of unobservable inputs when measuring fair value. Thisvaluation hierarchy is based upon the transparency of inputs to the valuationof an asset or liability on the measurement date.  The three levels of that hierarchy aredefined as follows:

 

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

 

Level 2 -Unadjusted quoted prices in active markets for similar assets or liabilities;or unadjusted quoted prices for identical or similar assets or liabilities inmarkets that are not active; or inputs other than quoted prices that areobservable for the asset or liability; or inputs that are derived principallyfrom or corroborated by observable market data; and

 

Level 3 -Unobservable inputs for the asset or liability.

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

The Company measures certain financial instruments atfair value on a recurring basis, including interest rate swaps and foreigncurrency options. In accordance with ASC 820, the Company categorized certainof its financial assets and liabilities, based on priority of the inputs to thevaluation technique for the instruments, as follows at June 30, 2010 (inthousands):

 
| ** **                      | ** ** | **As of June 30, 2010** | ** ** |
|---------------------------------|------------|------------------------------|------------|
| ** **                      | ** ** | **Total**                    | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Assets                          |       |                         |       |   |   |   |   |   |   |
| Foreign currency options  (b)   |       | $                            | 458        |   |   |   | $ | 458 |   |   |   |
| Total assets                    |       | $                            | 458        |   |   |   | $ | 458 |   |   |   |
| Liabilities                     |       |                         |       |   |   |   |   |   |   |
| Long-term debt (a)              |       | $                            | 1,582,653  |   | $ | 737,625 |   | $ | 845,028 |   |   |   |
| Hedged interest rate swaps  (b) |       | 15,750                       |       | — |   | 15,750 |   |   |   |
| Total liabilities               |       | $                            | 1,598,403  |   | $ | 737,625 |   | $ | 860,778 |   |   |   |

 

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(a)   Long-term debt, which is carried at amortizedcost in the Company’s financial statements, is valued using internal modelsbased on market observable inputs, except for the senior and seniorsubordinated notes. The senior and senior subordinated notes are valued usingquoted market prices for such debt securities.

(b)   Interest rate swaps and foreign currencyoptions are valued using internal models based on market observable inputs,including market interest rates and foreign currency exchange rates, asappropriate. Please see Note 8 for more information about the Company’sinterest rate swaps and foreign currency options.

 

The Company categorized certain of its financialassets and liabilities, based on priority of the inputs to the valuationtechnique for the instruments, as follows at September 30, 2009 (inthousands):

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

 

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(a)   Long-term debt, which is carried at amortizedcost in the Company’s financial statements, is valued using internal modelsbased on market observable inputs, except for the senior and seniorsubordinated notes. The senior and senior subordinated notes are valued usingquoted market prices for such debt securities.

(b)   Interest rate swaps are valued using internalmodels based on market observable inputs, including market interest rates.Please see Note 8 for more information about the Company’s interest rate swaps.

 

**3. Recent Accounting Pronouncements**

 

In December 2007, the Financial AccountingStandards Board (“FASB”) revised the accounting standards for businesscombinations. This new standard (currently contained in ASC 805, *Business Combinations*(“ASC 805”)), among other things,generally requires that an acquirer recognize the assets acquired andliabilities assumed measured at their “full fair values” on the acquisitiondate. This practice replaced the practice, under predecessor accountingstandards, of allocating the cost of an acquisition to the individual assetsacquired and liabilities assumed based on their relative estimated fair values.  This new standard further requires thatacquisition-related costs be recognized separately from the relatedacquisition. The Company adopted this standard during the first quarter of itsfiscal year 2010. Selling, general and administrative expenses for the nine monthsended June 30, 2010 includes approximately $0.5 million of expensesrelated to acquisitions.

 

InApril 2008, the FASB amended ASC 350, *Intangibles and Other* (“ASC 350”). This new accountingstandard, currently contained in ASC 350-30-35, specifically amends the factorsthat should be considered in developing 

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

renewalor extension assumptions used to determine the useful life of a recognizedintangible asset. The objective of this amendment is to improve the consistencybetween the useful life of a recognized intangible asset and the period ofexpected cash flows used to measure the fair value of the asset. The Companyadopted this standard during the first quarter of its fiscal year 2010 and itsadoption did not have a material effect on the Company’s consolidated financialposition, results of operations or cash flows.

 

In August 2009, the FASB issued AccountingStandards Update (“ASU”) No. 2009-05 which amended ASC 820 as it relatesto the measurement of liabilities at fair value, effective for interim reportingperiods beginning after August 26, 2009. More specifically, this amendmentprovided clarification for liabilities in which a quoted price in an activemarket for an identical liability is not available. The Company adopted thisamendment during the first quarter of its fiscal year 2010 and its adoption didnot have a material effect on the Company’s consolidated financial position,results of operations or cash flows.

 

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

 

The Company adopted the provisions of ASC 855, *Subsequent Events*(“ASC 855”), during the third quarter ofits fiscal year 2009. ASC 855 establishes standards of accounting for anddisclosure of transactions and events that occur after the balance sheet datebut before the financial statements are issued and requires the disclosure,among other things, of the date through which an entity has evaluatedsubsequent events. In February 2010, the FASB issued ASU No. 2010-09which amended ASC 855. This amendment, which was effective upon issuance,removed the requirement for SEC registrants to disclose the date through whichsuch registrants have evaluated subsequent events.

 

**4.   Accumulated Comprehensive Income (Loss)**

 

Comprehensive income consists of net earnings,foreign currency translation adjustments and deferred (loss) gain on interestrate swaps as follows (in thousands):

 
| ** **                                       | ** ** | **Three Months Ended********June 30,** | ** ** | **Nine Months Ended********June 30,** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                       | ** ** | **2010**                                              | ** ** | **2009**                                             | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net earnings                                     |       | $                                                     | 42,277     |                                                 | $          | 32,855 |   | $ | 105,504 |   | $ | 75,801 |   |
| Other comprehensive income  adjustments:         |       |                                                  |       |                                                 |       |   |   |   |   |
| Foreign currency  translation adjustments (a)    |       | (14,214                                               | )          | 21,653                                               |       | (21,905 | ) | (17,857 | ) |
| Deferred (loss) gain on interest  rate swaps (b) |       | (395                                                  | )          | 2,968                                                |       | (236 | ) | (9,241 | ) |
| Comprehensive income                             |       | $                                                     | 27,668     |                                                 | $          | 57,476 |   | $ | 83,363 |   | $ | 48,703 |   |

 

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(a)   There were no income tax amounts related toforeign currency translation adjustments recorded in other comprehensive incomefor the three and nine months ended June 30, 2010 and 2009.

(b)   Amounts are net of an income tax benefit of$0.3 million and income tax expense of $1.9 million for the three months endedJune 30, 2010 and 2009, and net of an income tax benefit of $0.1 million and$5.8 million for the nine months ended June 30, 2010 and 2009, respectively.

 

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Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated FinancialStatements

(Unaudited)

 

The components of accumulated other comprehensive(loss) income, net of tax, as of June 30, 2010 and September 30, 2009are as follows (in thousands):

 
| ** **                                                       | ** ** | **As of  June 30, 2010** | ** ** | **As of  September 30, 2009** | ** ** |
|------------------------------------------------------------------|------------|-------------------------------|------------|------------------------------------|------------|
| ** **                                                       | ** ** | **Amount  Before Tax**        | ** ** | **Deferred********Tax**            | ** ** | **Net********Amount** | ** ** | **Amount  Before Tax** | ** ** | **Deferred********Tax** | ** ** | **Net********Amount** | ** ** |
| Cumulative foreign  currency translation adjustments             |       | $                             | (28,400    | )                                  | $          | — |   | $ | (28,400 | ) | $ | (6,495 | ) | $ | — |   | $ | (6,495 | ) |
| Deferred (losses) gains on interest rate swaps (a)               |       | (15,750                       | )          | 6,111                              |       | (9,639 | ) | (15,365 | ) | 5,962 |   | (9,403 | ) |
| Total accumulated other comprehensive (loss) income,  net of tax |       | $                             | (44,150    | )                                  | $          | 6,111 |   | $ | (38,039 | ) | $ | (21,860 | ) | $ | 5,962 |   | $ | (15,898 | ) |

 

----

(a)          See Note 8 for more information about our interest rate swaps.

 

**5.  Share-Based Payments**

 

Since November 16, 2006, the Company has been anindirect wholly-owned subsidiary of Sally Beauty and has no share-based plansof its own; however, certain employees and consultants of the Company have beengranted stock options and share awards under the plans of Sally Beauty.

 

The Company accounts for stock option and stockawards, which include share-based payment plans, in accordance with ASC 718, *Compensation — Stock Compensation.* Accordingly, the Companymeasures the cost of employee and consultant services received in exchange foran award of equity instruments based on the fair value of the award on thegrant date and recognizes compensation expense on a straight-line basis overthe vesting period or to the date a participant becomes eligible forretirement, if earlier. On January 27, 2010, Sally Beauty adopted theSally Beauty Holdings, Inc. 2010 Omnibus Incentive Plan (the “2010 Plan”),a share-based compensation plan which allows for the issuance of up to 29.8million shares of Sally Beauty’s common stock.

 

Sally Beauty granted approximately 2.9 million and 2.7million stock options to the Company’s employees and consultants during thenine months ended June 30, 2010 and 2009, respectively. The amounts for thenine months ended June 30, 2010 include 2.3 million stock options underthe Sally Beauty Holdings 2007 Omnibus Incentive Plan (the “2007 Plan”), 0.5million stock options under the Alberto-Culver Company Employee Stock OptionPlan of 2003 (the “2003 Plan”) and 0.1 million stock options under the 2010Plan. Upon issuance of such grants, the Company recognized acceleratedshare-based compensation expense of $2.5 million and $2.0 million in the fiscalyears 2010 and 2009, respectively, in connection with certain retirementeligible employees who are eligible to continue vesting awards upon retirementunder the terms contained in the 2010 Plan, the 2007 Plan and certainpredecessor share-based compensation plans such as the 2003 Plan.

 

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 our consolidated statements of earnings (in thousands):

 
| ** **                                                      | ** ** | **Three Months Ended********June 30,** | ** ** | **Nine Months Ended********June 30,** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                      | ** ** | **2010**                                    | ** ** | **2009**                                   | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                      | ** ** | ** **                                  | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Share-based compensation  expense                               |       | $                                           | 2,391      |                                       | $          | 1,444 |   | $ | 9,445 |   | $ | 6,336 |   |
| Income tax benefit related  to share-based compensation expense |       | $                                           | 851        |                                       | $          | 435 |   | $ | 3,312 |   | $ | 1,800 |   |

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

**Stock Options**

 

Each option has an exercise price that equals 100% ofthe market price of Sally Beauty’s common stock on the date of grant andgenerally has a maximum term of 10 years. Options generally vest ratably over afour year period and are generally subject to forfeiture until the four yearvesting period is complete, subject to certain retirement provisions containedin the 2010 Plan and certain predecessor share-based compensation plans.

 

The following table presents a summary of the activityfor Sally Beauty’s stock options issued to the Company’s employees andconsultants for the nine months ended June 30, 2010:

 
| ** **                              | ** ** | **Number of  Outstanding  Options (in  Thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term (in  Years)** | ** ** | **Aggregate  Intrinsic  Value (in  Thousands)** | ** ** |
|-----------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------|------------|-----------------------------------------------------------------|------------|-------------------------------------------------|------------|
| Outstanding at  September 30, 2009 |       | 10,025                                              |       | $                                      | 7.40       |                                                            | 7.7        |                                            | $          | 10,678 |   |
| Granted                                 |       | 2,917                                               |       | 7.46                                   |       |                                                            |       |                                            |       |
| Exercised                               |       | (71                                                 | )          | 2.99                                   |       |                                                            |       |                                            |       |
| Forfeited or expired                    |       | (47                                                 | )          | 8.62                                   |       |                                                            |       |                                            |       |
| Outstanding at  June 30, 2010      |       | 12,824                                              |       | $                                      | 7.43       |                                                            | 7.5        |                                            | $          | 16,683 |   |
|                                    |       |                                                |       |                                   |       |                                                            |       |                                            |       |
| Exercisable at  June 30, 2010      |       | 5,868                                               |       | $                                      | 7.54       |                                                            | 6.5        |                                            | $          | 8,705 |   |

 

The following table summarizes information about SallyBeauty’s stock options held by the Company’s employees and consultants underSally Beauty’s option plans at June 30, 2010:

 
| ** **                     | ** ** | **Options Outstanding**                                    | ** ** | **Options Exercisable**                                         | ** ** |
|--------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **Range of  Exercise  Prices** | ** ** | **Number  Outstanding  at June 30,  2010 (in  Thousands)** | ** ** | **Weighted  Average  Remaining  Contractual  Term (in  Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable  at June 30,  2010 (in  Thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $2.00                          |       | 1,085                                                      |       | 4.0                                                             |       | $ | 2.00 |   | 1,085 |   | $ | 2.00 |   |
| $5.24 – 9.66              |       | 11,739                                                     |       | 7.8                                                             |       | 7.94 |   | 4,783 |   | 8.80 |   |
| Total                          |       | 12,824                                                     |       | 7.5                                                             |       | $ | 7.43 |   | 5,868 |   | $ | 7.54 |   |

 

The Company uses the Black-Scholes option pricingmodel 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:

 
| ** **                | ** ** | **Nine Months Ended  June 30,** | ** ** |
|---------------------------|------------|--------------------------------------|------------|
| ** **                | ** ** | **2010**                             | ** ** | **2009** | ** ** |
| Expected lives (in years) |       | 5.0                                  |       | 5.0 |   |
| Expected volatility       |       | 64.4                                 | %          | 47.9 | % |
| Risk-free interest rate   |       | 2.4                                  | %          | 2.6 | % |
| 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 who have been granted stockoptions, including grants under stock option plans of Alberto-Culver prior tothe Separation Transactions. Expected volatility is derived

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes to ConsolidatedFinancial Statements

(Unaudited)

 

using the average volatility of both Sally Beauty andsimilar companies (based on industry sector) since it is not practicable toestimate Sally Beauty’s expected volatility on a stand-alone basis due to alack of sufficient trading history. The risk-free interest rate is based on thezero-coupon U.S. Treasury issue as of the date of the grant. Since Sally Beautydoes not currently expect to pay dividends, the dividend yield is 0%.

 

The weighted average fair value of the Sally Beautystock options issued to the Company’s employees (and consultants) at the dateof grant in the nine months ended June 30, 2010 and 2009 was $4.15 and$2.33 per option, respectively. The total intrinsic value of options exercisedduring the nine months ended June 30, 2010 was $0.5 million. Cash proceedsfrom these option exercises were $0.2 million and the tax benefit realized forthe tax deductions from these option exercises was $0.2 million.

 

At June 30, 2010, approximately $12.0 million oftotal unrecognized compensation costs related to unvested stock option awardsare expected to be recognized over the weighted average period of 2.3 years.

 

**Stock Awards**

 

***RestrictedStock Awards***

 

As an indirect subsidiary of Sally Beauty, the Companyhas no employee stock award plans; however certain employees and consultants ofthe Company have been granted restricted stock awards under Sally Beauty’sstock award plans. A restricted stock award is an award of shares of SallyBeauty’s common stock (which have full voting rights but are restricted withregard to sale or transfer), the restrictions over which lapse ratably over aspecified period of time (generally five years). Restricted stock awards areindependent of stock option grants and are generally subject to forfeiture ifemployment terminates prior to these restrictions lapsing, subject to certainretirement provisions contained in the 2010 Plan, the 2007 Plan and certainpredecessor share-based compensation plans such as the 2003 Plan.

 

The Company expenses the cost of the restricted stockawards, which is determined to be the fair value of the restricted stock awardat the date of grant, on a straight-line basis over the period (the “vestingperiod”) in which the restrictions on these stock awards lapse (“vesting”). Forthese purposes, the fair value of the restricted stock award is determinedbased on the closing price of Sally Beauty’s common stock on the grant date.

 

The following table presents a summary of the activityfor Sally Beauty’s restricted stock awarded to the Company’s employees andconsultants for the nine months ended June 30, 2010:

 
| **Restricted Stock Awards**          | ** ** | **Number of  Shares (in  Thousands)** | ** ** | **Weighted  Average Fair  Value Per Share** | ** ** | **Weighted  Average  Remaining  Vesting Term  (in Years)** | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|---------------------------------------------|------------|------------------------------------------------------------|------------|
| Unvested at  September 30, 2009 |       | 331                                   |       | $                                           | 7.45       |                                                       | 3.3        |   |
| Granted                              |       | 118                                   |       | 7.42                                        |       |                                                       |       |
| Vested                               |       | (81                                   | )          | 7.71                                        |       |                                                       |       |
| Forfeited                            |       | —                                |       | —                                      |       |                                                       |       |
| Unvested at June 30,  2010      |       | 368                                   |       | $                                           | 7.38       |                                                       | 3.4        |   |

 

At June 30, 2010, approximately $2.2 million oftotal unrecognized compensation costs related to unvested restricted stockawards are expected to be recognized over the weighted average period of 3.4years.

 

**6.   Goodwill and Other Intangibles**

 

During the nine months ended June 30, 2010,intangible assets subject to amortization in the amount of $22.9 million and$1.9 million were recorded in connection with the September 2009acquisitions of Schoeneman Beauty Supply, Inc. and DistribuidoraIntersalon Limitada, respectively. In addition, during the nine months ended June 30,2010, intangible assets with indefinite lives in the amount of $0.9 millionwere recorded in connection with the acquisition of Distribuidora IntersalonLimitada. These amounts were previously reported in Goodwill pending thevaluation of the assets acquired. Please see Note 15 to our financialstatements contained in Item 8 of our Annual Report on Form 10-K for thefiscal year ended September 30, 2009.

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

The change in the carrying amounts of goodwill byoperating segment for the nine months ended June 30, 2010 is as follows(in thousands):

 
| ** **                                    | ** ** | **Sally Beauty  Supply** | ** ** | **Beauty Systems  Group** | ** ** | **Total** | ** ** |
|-----------------------------------------------|------------|--------------------------|------------|---------------------------|------------|-----------|------------|
| Balance at  September 30, 2009           |       | $                        | 73,208     |                      | $          | 420,927   |       | $ | 494,135 |   |
| Additions and purchase  price adjustments (a) |       | 18,627                   |       | 1,664                     |       | 20,291    |       |
| Reclassifications                             |       | (2,780                   | )          | (22,920                   | )          | (25,700   | )          |
| Foreign currency  translation                 |       | (9,345                   | )          | (418                      | )          | (9,763    | )          |
| Balance at June 30,  2010                |       | $                        | 79,710     |                      | $          | 399,253   |       | $ | 478,963 |   |

 

----

(a)   Pleasesee Note 10 for additional information about businesses acquired.

 

The following table provides the carrying value forintangible assets with indefinite lives and the gross carrying value andaccumulated amortization for intangible assets subject to amortization (whichwe refer to, in the aggregate, as “other intangible assets”) by operatingsegment at June 30, 2010 (in thousands):

 
| ** **                                  | ** ** | **Sally Beauty  Supply** | ** ** | **Beauty Systems  Group** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|--------------------------|------------|---------------------------|------------|-----------|------------|
| Balance at June 30,  2010              |       |                     |       |                      |       |      |       |
| Intangible assets with  indefinite lives:   |       |                     |       |                      |       |      |       |
| Trade names                                 |       | $                        | 18,987     |                      | $          | 33,568    |       | $ | 52,555 |   |
| Other intangibles                           |       | —                   |       | 5,700                     |       | 5,700     |       |
| Total                                       |       | 18,987                   |       | 39,268                    |       | 58,255    |       |
| Intangible assets subject  to amortization: |       |                     |       |                      |       |      |       |
| Gross carrying amount                       |       | 8,482                    |       | 60,440                    |       | 68,922    |       |
| Accumulated amortization                    |       | (3,357                   | )          | (27,088                   | )          | (30,445   | )          |
| Net value                                   |       | 5,125                    |       | 33,352                    |       | 38,477    |       |
| Total other intangible  assets, net         |       | $                        | 24,112     |                      | $          | 72,620    |       | $ | 96,732 |   |

 

Amortization expense was $2.0 million and $1.6 millionfor the three months ended June 30, 2010 and 2009, and $6.1 million and$4.5 million for the nine months ended June 30, 2010 and 2009,respectively. As of June 30, 2010, future amortization expense related tointangible assets subject to amortization is estimated to be as follows (inthousands):

 
| **Fiscal  Year:** | ** ** | ** ** | ** ** |
|-------------------|------------|------------|------------|
| 2010              |       | $          | 1,923      |   |
| 2011              |       | 7,059      |       |
| 2012              |       | 6,118      |       |
| 2013              |       | 3,657      |       |
| 2014              |       | 4,076      |       |
| Thereafter        |       | 15,644     |       |
|              |       | $          | 38,477     |   |

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

**7.   Long-Term Debt**

 

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

 
| ** **                   | ** ** | **As of********June 30, 2010** | ** ** | **Maturity  dates** | ** **     | **Interest Rates**                         | ** **                            |
|------------------------------|------------|-------------------------------------|------------|---------------------|----------------|--------------------------------------------|---------------------------------------|
| ABL facility                 |       | $                                   | 5,000      |                | —         |                                       | (i)  Prime  plus up to 0.50% or; |   |
|                         | * *   | * *                            |       |                |           | (ii) LIBOR plus (1.00% to 1.50%)           |                                  |
| Term Loan A                  |       | —                              |       | —              |           |                                       |                                  |
| Term Loan B                  |       | 863,856                             |       | Nov. 2013      |           | (i)  Prime  plus (1.25% to 1.50%) or; |                                  |
|                         | * *   | * *                            |       |                |           | (ii) LIBOR plus (2.25% to 2.50%)(a)        |                                  |
| Other (b)                    |       | 6,311                               |       | 2010-2014           |           |   4.05% to 6.75%                 |                                  |
| Total                        |       | $                                   | 875,167    |                |           |                                       |                                  |   |
|                         |       |                                |       |                |           |                                       |                                  |
| Senior notes                 |       | $                                   | 430,000    |                | Nov. 2014 |                                       |   9.25%                     |   |
| Senior subordinated notes    |       | 275,000                             |       | Nov. 2016      |           | 10.50%                                     |                                  |
| Total                        |       | $                                   | 705,000    |                |           |                                       |                                  |   |
|                         |       |                                |       |                |           |                                       |                                  |
| Capitalized leases and other |       | $                                   | 6,575      |                |           |                                       |                                  |   |
| Less: current portion        |       | (14,477                             | )          |                |           |                                       |                                  |
| Total long-term debt         |       | $                                   | 1,572,265  |                |           |                                       |                                  |   |

 

----

(a)                            At June 30, 2010, the interest rate for the term loan B is 2.6%.

(b)                           Represents pre-acquisition debt of Pro-Duo NV and Sinelco Group NV.Please see Note 10.

 

In connection with the Separation Transactions in November 2006,the Company and Sally Investment incurred $1,850.0 million of indebtedness by (i) drawingon a revolving (asset-based lending (“ABL”)) facility in the amount of $70.0million, (ii) entering into two term loan facilities (term loans A and B)in an aggregate amount of $1,070.0 million and (iii) together (jointly andseverally) with another of Sally Beauty’s indirect subsidiaries, Sally CapitalInc., issuing senior notes in an aggregate amount of $430.0 million and seniorsubordinated notes in an aggregate amount of $280.0 million.

 

The term loan facilities and the ABL facility aresecured by substantially all of our assets, those of Sally Investment, those ofour domestic subsidiaries and, in the case of the ABL facility, those of ourCanadian subsidiaries. The senior term loan facilities may be prepaid at theoption of the Company at any time without premium or penalty and are subject tomandatory prepayment in an amount equal to 50% of excess cash flow (as definedin the agreement governing the senior term loan facilities) for any fiscal yearunless a specified leverage ratio is met. In January 2010, the Companymade a mandatory prepayment on the senior term loan facilities in the amount of$22.3 million. Amounts paid pursuant to said provision may be applied, at theoption of the Company, against minimum loan repayments otherwise required of usover the twelve-month period following any such payment under the terms of theloan agreement. Additionally, borrowings under the senior term loan facilitywould be subject to mandatory prepayment in an amount equal to 100% of theproceeds of specified asset sales that are not reinvested in the business or appliedto repay borrowings under the ABL facility.

 

During the nine months ended June 30, 2010, theCompany also made optional prepayments in the aggregate amount of $82.7 millionon its senior term loans. This amount includes $54.7 million prepaid during thequarter ended June 30, 2010 and, together with the mandatory prepaymentdiscussed in the preceding paragraph, resulted in the prepayment in full ofborrowings under the Term Loan A facility. In connection with the mandatoryprepayment discussed in the preceding paragraph and the optional prepaymentsmade during the nine months ended June 30, 2010, the Company recordedlosses on extinguishment of debt in the aggregate amount of $0.8 million, whichare included in interest expense in the Company’s consolidated statements ofearnings.

 

The senior notes and seniorsubordinated notes are unsecured obligations of the issuers and are jointly andseverally guaranteed on a senior basis (in the case of the senior notes) and ona senior subordinated basis (in the case of the senior subordinated notes) byeach material domestic subsidiary of the Company. Furthermore, the agreements underlying the Company’s credit facilities contain termswhich significantly restrict the ability of us and our

 

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Tableof Contents

 

Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

subsidiaries to pay dividends or otherwise transferassets to Sally Beauty. Please see the Company’s Annual Report on Form 10-Kfor the fiscal year ended September 30, 2009, for additional informationabout the Company’s long-term debt.

 

Maturities of the Company’s long-term debt are as followsas of June 30, 2010 (in thousands):

 
| **Fiscal  Year:**        | ** ** | ** ** | ** ** |
|--------------------------|------------|------------|------------|
| 2010                     |       | $          | 6,125      |   |
| 2011                     |       | 10,621     |       |
| 2012                     |       | 10,250     |       |
| 2013                     |       | 10,130     |       |
| 2014                     |       | 838,041    |       |
| Thereafter               |       | 705,000    |       |
|                     |       | $          | 1,580,167  |   |
| Capital leases and other |       | 6,575      |       |
| Less: current portion    |       | (14,477    | )          |
| Total                    |       | $          | 1,572,265  |   |

 

We are a holding company and do not have any materialassets or operations other than ownership of equity interests of oursubsidiaries. The agreements and instruments governing the debt of the Companyand our subsidiaries contain material limitations on our ability to paydividends and other restricted payments to our indirect parent, Sally Beauty.

 

Under the agreements and indentures governing the termloan facilities and the notes, we may not make certain restricted payments toSally Beauty if a default then exists under the credit agreement or theindentures or if our consolidated interest coverage ratio is less than 2.0 to1.0 at the time of the making of such restricted payment. As of June 30,2010, our consolidated interest coverage ratio exceeded 2.0 to 1.0.  Further, the aggregate amount of restrictedpayments we are able to make is limited pursuant to various baskets ascalculated pursuant to the credit agreement and indentures.

 

The agreements governing our ABL facility generallypermit the making of distributions and certain other restricted payments solong as borrowing availability under the facility equals or exceeds $60.0million. If borrowing availability falls below this amount, we may neverthelessmake restricted payments to Sally Beauty in the aggregate since the date of theSeparation Transactions, together with the aggregate cash amount paid inacquisitions since said date, of not greater than $50.0 million, together withcertain other exceptions. As of June 30, 2010, borrowing availabilityunder the ABL facility exceeded $60.0 million. As of June 30, 2010, thenet assets of the Company and its consolidated subsidiaries that wereunrestricted from transfer under our credit arrangements totaled $284.4million, subject to certain adjustments. The ABL facility and the senior termloan facilities, as well as the Company’s 9.25% Senior Notes indenture and its10.5% Senior Subordinated Notes indenture contain customary cross-defaultand/or cross-acceleration provisions.

 

**8.   Derivative Instruments and HedgingActivities**

 

**Risk Management Objectives of Using Derivative Instruments**

 

TheCompany is exposed to a wide variety of risks, including risks arising fromchanging economic conditions. The Company manages its exposure to certain economicrisks (including liquidity, credit risk and changes in interest rates)primarily (a) by closely managing its cash flows from operating andinvesting activities and the amounts and sources of its debt obligations; (b) byassessing periodically the creditworthiness of its business partners; and (c) throughthe use of interest rate swaps.  TheCompany uses interest rate swaps as part of its overall economic riskmanagement strategy to add stability to the interest payments due in connectionwith its term loan obligations. Interest payments related to the term loans areimpacted by changes in LIBOR. Interest rate swap agreements involve theperiodic receipt by the Company of amounts based on a variable rate in exchangefor the Company making payments based on a fixed rate over the term of theinterest rate swap agreements, without exchange of the underlying notionalamount. As of June 30, 2010, the Company did not purchase or hold anyderivative instruments for trading or speculative purposes.

 

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Table of Contents

 

Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

**Designated Cash Flow Hedges**

 

In May 2008, the Company entered into twointerest rate swap agreements with an aggregate notionalamount of $300 million (each agreement with a notional amount of $150 million).These agreements expire on May 31, 2012, and are designated and qualify aseffective cash flow hedges, in accordance with ASC 815. Accordingly, changes inthe fair value of these derivative instruments are recorded quarterly, net ofincome tax, in accumulated other comprehensive (loss) income (“OCI”) until thehedged obligation is settled or the swap agreements expire, whichever isearlier. Any hedge ineffectiveness, as this term is used in ASC 815, isrecognized in interest expense in our consolidated statements of earnings. Nohedge ineffectiveness on cash flow hedges was recognized during the nine monthsended June 30, 2010 or 2009. Please see the Company’s Annual Report on Form 10-Kfor the fiscal year ended September 30, 2009 for additional informationabout the Company’s interest rate swap agreements.

 

Amountsreported in OCI related to interest rate swaps are reclassified into interestexpense, as a yield adjustment, in the same period in which interest on theCompany’s variable-rate debt obligations affect earnings. Interest expenseresulting from such reclassifications was $2.5 million and $2.4 million duringthe three months ended June 30, 2010 and 2009, and $7.6 million and $5.4million during the nine months ended June 30, 2010 and 2009, respectively.During the twelve months ending June 30, 2011, the Company estimates thatan additional $8.9 million, before income tax, of the amount reported in OCIwill be reclassified into interest expense.

 

**Non-designated Cash Flow Hedges**

 

In connection with the Separation Transactions in November 2006, theCompany entered into four interest rate swap agreements with an aggregatenotional amount of $500 million. Interestrate swap agreements with an aggregate notional amount of $150 million expiredin November 2008 and interest rate swap agreements with a notional amountof $350 million expired in November 2009. Theseinterest rate swap agreements were not designated as hedges and, accordingly,the changes in fair value of these interest rate swap agreements (which wereadjusted quarterly) were recorded in interest expense in our consolidatedstatements of earnings. Interest expense includesnon-cash income of $2.5 million of marked-to-market adjustments related tothese interest rate swaps for the three months ended June 30, 2009 with nocomparable amount for the three months ended June 30, 2010. Interestexpense includes non-cash income of $2.4 million and $1.7 million ofmarked-to-market adjustments related to these interest rate swaps for the ninemonths ended June 30, 2010 and 2009, respectively. Please see the Company’sAnnual Report on Form 10-K for the fiscal year ended September 30,2009 for additional information about these interest rate swap agreements.

 

As aresult of the Company’s acquisition of Sinelco Group NV (“Sinelco”) on December 16,2009, the Company, through Sinelco, uses foreign currency options (including,at June 30, 2010, foreign currency put options with an aggregate notionalamount of €2.9 million ($3.6 million, at the June 30, 2010 exchange rate)and foreign currency call options with an aggregate notional amount of €1.8million ($2.2 million, at the June 30, 2010 exchange rate)) to manage theexposure to certain non-Euro currencies resulting from Sinelco’s purchases ofmerchandise from third-party suppliers. Sinelco’s functional currency is theEuro. These foreign currency option agreements are not designated as hedges anddo not meet the hedge accounting requirements of ASC 815. Accordingly, the changes in fair value ofthese derivative instruments (which are adjusted quarterly) are recorded in ourconsolidated statements of earnings. Included in selling, general andadministrative expenses are gains of $0.4 millionand $0.7 millionrelated to these foreign currency options,including marked-to-market adjustments, for the three and nine months ended June 30,2010, respectively. Please see Note 10 for information about the acquisition of Sinelco.

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

The table below presents the fair value of the Company’sderivative financial instruments as well as their classification on the balancesheet as of June 30, 2010 (in thousands):

 

**Tabular Disclosure of FairValues of Derivative Instruments**
| ** **                                               | ** ** | **Asset Derivatives**        | ** ** | **Liability Derivatives**    | ** ** |
|----------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                               | ** ** | **As of June 30, 2010** | ** ** | **As of June 30, 2010** | ** ** |
| ** **                                               | ** ** | **Balance Sheet  Location**  | ** ** | **Fair Value**               | ** ** | **Balance Sheet  Location** | ** ** | **Fair Value** | ** ** |
| Derivatives designated as  hedging instruments:          |       |                         |       |                         |       |   |   |   |   |
| Interest Rate Swaps                                      |       | Other assets                 |       | $                            | —     |   | Other liabilities |   | $ | 15,750 |   |
| Total derivatives  designated as hedging instruments     |       |                         |       | $                            | —     |   |   |   | $ | 15,750 |   |
|                                                     |       |                         |       |                         |       |   |   |   |   |
| Derivatives not designated  as hedging instruments:      |       |                         |       |                         |       |   |   |   |   |
| Foreign Currency Options                                 |       | Prepaid expenses             |       | $                            | 458        |   | Accrued liabilities |   | $ | — |   |
| Interest Rate Swaps                                      |       | Prepaid expenses             |       | —                       |       | Accrued liabilities |   | — |   |
| Total derivatives not  designated as hedging instruments |       |                         |       | $                            | 458        |   |   |   | $ | — |   |

 

 

The table below presents the fair value of the Company’sderivative financial instruments as well as their classification on the balancesheet as of September 30, 2009 (in thousands):

 

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

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

The tables below present the effect of the Company’sderivative financial instruments on the statements of earnings for the threemonths ended June 30, 2010 and 2009 (in thousands):

 

**Tabular Disclosure of theEffect of Derivative Instruments on the Statement of Earnings for the**

**Three Months Ended June 30,2010**
| **Derivatives in Cash  Flow Hedging  Relationships** | ** ** | **Amount of  Gain or  (Loss)  Recognized  in OCI on  Derivative  (Effective  Portion), net  of tax** | ** ** | **Location of Gain or  (Loss) Reclassified from  Accumulated OCI into  Income (Effective  Portion)** | ** **       | **Amount of  Gain or (Loss)  Reclassified  from  Accumulated  OCI into  Income  (Effective  Portion)** | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative  (Ineffective Portion  and Amount  Excluded from  Effectiveness Testing)** | ** ** | **Amount of Gain  or (Loss)  Recognized in  Income on  Derivative  (Ineffective  Portion and  Amount  Excluded from  Effectiveness  Testing)** | ** ** |
|------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------------|--------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Interest Rate Swaps                                  |       | $                                                                                                    | (395       | )                                                                                                    | Interest expense |                                                                                                   | $          | (2,491                                                                                                                                       | )          | Interest expense                                                                                                                               |       | $ | — |   |
|                                                      |            |                                                                                                      |            |                                                                                                      |                  |                                                                                                        |            |                                                                                                                                              |            |                                                                                                                                                |            |  |  |  |

 
| **Derivatives Not Designated as Hedging  Instruments**   | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative** | ** ** | **Amount of  Gain or (Loss)  Recognized in  Income on  Derivative** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|------------|------------|------------|------------|
| Foreign Currency Options                                 |       | Selling, general and administrative expenses                        |       | $                                                                   | 439        |       |       |       |       |   |
| Interest Rate Swaps                                      |       | Interest expense                                                    |       |                                                                | —     |       |       |       |       |   |
| Total derivatives not  designated as hedging instruments |       |                                                                |       | $                                                                   | 439        |       |       |       |       |   |

 

 

**Tabular Disclosure of theEffect of Derivative Instruments on the Statement of Earnings for the**

**Three Months Ended June 30,2009**
| **Derivatives in Cash  Flow Hedging  Relationships** | ** ** | **Amount of  Gain or  (Loss)  Recognized  in OCI on  Derivative  (Effective  Portion), net  of tax** | ** ** | **Location of Gain or  (Loss) Reclassified  from Accumulated  OCI into Income  (Effective Portion)** | ** **       | **Amount of  Gain or (Loss)  Reclassified  from  Accumulated  OCI into  Income  (Effective  Portion)** | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative  (Ineffective Portion  and Amount Excluded  from Effectiveness  Testing)** | ** ** | **Amount of Gain  or (Loss)  Recognized in  Income on  Derivative  (Ineffective  Portion and  Amount Excluded  from  Effectiveness  Testing)** | ** ** |
|------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------------|--------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Interest Rate Swaps                                  |       | $                                                                                                    | 2,968      |                                                                                                 | Interest expense |                                                                                                   | $          | (2,397                                                                                                                                       | )          | Interest expense                                                                                                                               |       | $ | — |   |
|                                                      |            |                                                                                                      |            |                                                                                                      |                  |                                                                                                        |            |                                                                                                                                              |            |                                                                                                                                                |            |  |  |  |

 
| **Derivatives Not Designated  as Hedging  Instruments** | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative** | ** ** | **Amount of  Gain or (Loss)  Recognized in  Income on  Derivative** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|------------|------------|------------|------------|
| Interest Rate Swaps                                     |       | Interest expense                                                    |       | $                                                                   | (964       | )          |       |       |       |   |
|                                                         |            |                                                                     |            |                                                                     |            |            |            |            |            |  |

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

The tables below present the effect of the Company’sderivative financial instruments on the statements of earnings for the ninemonths ended June 30, 2010 and 2009 (in thousands):

 

**Tabular Disclosure of theEffect of Derivative Instruments on the Statement of Earnings for the**

**Nine Months Ended June 30,2010**
| **Derivatives in Cash  Flow Hedging  Relationships** | ** ** | **Amount of  Gain or  (Loss)  Recognized  in OCI on  Derivative  (Effective  Portion), net  of tax** | ** ** | **Location of Gain or  (Loss) Reclassified from  Accumulated OCI into  Income (Effective  Portion)** | ** **       | **Amount of  Gain or (Loss)  Reclassified  from  Accumulated  OCI into  Income  (Effective  Portion)** | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative  (Ineffective Portion  and Amount  Excluded from  Effectiveness Testing)** | ** ** | **Amount of Gain  or (Loss)  Recognized in  Income on  Derivative  (Ineffective  Portion and  Amount  Excluded from  Effectiveness  Testing)** | ** ** |
|------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------------|--------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Interest Rate Swaps                                  |       | $                                                                                                    | (236       | )                                                                                                    | Interest expense |                                                                                                   | $          | (7,562                                                                                                                                       | )          | Interest expense                                                                                                                               |       | $ | — |   |
|                                                      |            |                                                                                                      |            |                                                                                                      |                  |                                                                                                        |            |                                                                                                                                              |            |                                                                                                                                                |            |  |  |  |

 
| **Derivatives Not Designated  as Hedging  Instruments**  | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative** | ** ** | **Amount of  Gain or (Loss)  Recognized in  Income on  Derivative** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|------------|------------|------------|------------|
| Foreign Currency Options                                 |       | Selling, general and administrative expenses                        |       | $                                                                   | 700        |       |       |       |       |   |
| Interest Rate Swaps                                      |       | Interest expense                                                    |       |                                                                | (24        | )          |       |       |       |   |
| Total derivatives not  designated as hedging instruments |       |                                                                |       | $                                                                   | 676        |       |       |       |       |   |

 

 

**Tabular Disclosure of theEffect of Derivative Instruments on the Statement of Earnings for the**

**Nine Months Ended June 30,2009**
| **Derivatives in Cash  Flow Hedging  Relationships** | ** ** | **Amount of  Gain or  (Loss)  Recognized  in OCI on  Derivative  (Effective  Portion), net  of tax** | ** ** | **Location of Gain or  (Loss) Reclassified  from Accumulated  OCI into Income  (Effective Portion)** | ** **       | **Amount of  Gain or (Loss)  Reclassified  from  Accumulated  OCI into  Income  (Effective  Portion)** | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative  (Ineffective Portion  and Amount Excluded  from Effectiveness  Testing)** | ** ** | **Amount of Gain  or (Loss)  Recognized in  Income on  Derivative  (Ineffective  Portion and  Amount Excluded  from  Effectiveness  Testing)** | ** ** |
|------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------------|--------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Interest Rate Swaps                                  |       | $                                                                                                    | (9,241     | )                                                                                                    | Interest expense |                                                                                                   | $          | (5,410                                                                                                                                       | )          | Interest expense                                                                                                                               |       | $ | — |   |
|                                                      |            |                                                                                                      |            |                                                                                                      |                  |                                                                                                        |            |                                                                                                                                              |            |                                                                                                                                                |            |  |  |  |

 
| **Derivatives Not Designated  as Hedging  Instruments** | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative** | ** ** | **Amount of  Gain or (Loss)  Recognized in  Income on  Derivative** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|------------|------------|------------|------------|
| Interest Rate Swaps                                     |       | Interest expense                                                    |       | $                                                                   | (7,152     | )          |       |       |       |   |
|                                                         |            |                                                                     |            |                                                                     |            |            |            |            |            |  |

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

**Credit-risk-related Contingent Features**

 

Theagreements governing the Company’s interest rate swaps contain provisionspursuant to which the Company could be declared in default on its interest rateswap obligations in the event the Company defaulted under certain terms of theloan documents governing the Company’s ABL facility. As of June 30, 2010,the fair value of interest rate swaps in a liability position related to theseagreements was $15.8 million and the Company was under no obligation to postand had not posted any collateral related to these agreements. If the Companybreached any of these provisions, it would be required to settle itsobligations under the agreements at their termination value of $16.2 million,including accrued interest and other termination costs.

 

The Company’s foreign operations expose the Companyto fluctuations in foreign currency exchange rates and foreign interestrates.  These fluctuations may impact,among other things, the amount of the Company’s future cash flows in terms ofthe Company’s functional currency, the U.S. dollar.  As a result of the Company’s acquisition ofSinelco on December 16, 2009, the Company, through Sinelco, uses foreigncurrency options to manage the exposure to certain non-Euro currenciesresulting from Sinelco’s purchases of merchandise from third-party suppliers.Sinelco’s functional currency is the Euro. Please see Note 10 for information about theacquisition of Sinelco.

 

The counterparties to all our derivative instruments are deemed by the Company to be of substantial resources and strongcreditworthiness. However, these transactions result in exposure to credit riskin the event of default by a counterparty. The recent financial crisisaffecting the banking systems and financial markets resulted in many well-knownfinancial institutions becoming less creditworthy or having diminishedliquidity which could expose us to an increased level of counterparty creditrisk. In the event that a counterparty defaults in its obligation under ourderivative instruments, we could incur substantial financial losses. However,at the present time, no such losses are deemed probable.

 

**9.  Income Taxes**

 

Sally Beauty and itssubsidiaries, including the Company, file consolidated income tax returns inthe U.S. federal jurisdiction and most state jurisdictions, as well as invarious foreign jurisdictions.

 

The transactions separating us from Alberto-Culverwere intended to qualify as a reorganization under Section 368(a)(1)(D) ofthe Internal Revenue Code of 1986, as amended (the “Code”) and a distributioneligible for non-recognition under Sections 355(a) and 361(c) of theCode. In connection with the share distribution of Alberto-Culver common stockin the Separation Transactions, Sally Beauty received: (i) a privateletter ruling from the IRS and (ii) an opinion of Sidley Austin LLP,counsel to Alberto-Culver, in each case, to the effect that the transactionsqualify 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 Code. Certain internal restructurings also occurred at or immediatelyprior to the Separation Transactions. As a result of the internalrestructurings and Separation Transactions, Sally Beauty inherited the federaltax identification number of the old Alberto-Culver parent for U.S. federalincome tax purposes.

 

Sally Beauty and Alberto-Culver entered into a taxallocation agreement 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-Culveris responsible for the remainder. In the event additional U.S. federal incometax liability related to the period prior to the Separation Transactions wasdetermined, Sally Beauty will be jointly and severally liable for these taxes, andthere can be no assurance that Alberto-Culver would be able to fulfill itsindemnification obligations to Sally Beauty under the tax allocation agreementif Alberto-Culver was determined to be responsible for these taxes thereunder.

 

In addition, as the successor entity to Alberto-Culverafter the Separation Transactions, Sally Beauty relies upon the prior yearfederal income tax returns of Alberto-Culver and accounting methods establishedtherein for certain calculations that affect Sally Beauty’s and the Company’scurrent consolidated U.S. federal income tax liability.

 

The IRS has initiated an examination of Sally Beauty’sconsolidated federal income tax returns for the fiscal years ended September 30,2008 and 2007. The IRS had previously audited Sally Beauty’s consolidatedfederal income tax returns through the tax year ended September 30, 2006,thus the statute remains open from the year ended September 30, 2007forward.  Our foreign subsidiaries areimpacted by various statutes of limitations, which are

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

generally open from 2004 forward. Generally, states’statutes in the United States are open for tax reviews from 2005 forward.

 

**10.   Acquisitions**

 

On December 16, 2009, the Company acquiredSinelco, a wholesale distributor of professional beauty products based inRonse, Belgium, for approximately €25.2 million (approximately $36.6 million).Sinelco serves over 1,500 customers through a product catalog and website andhas sales throughout Europe. Goodwill of $17.2 million was recorded as a resultof this acquisition. In addition, during the nine months ended June 30,2010, the Company completed several other individually immaterial acquisitionsat an aggregate cost of $5.3 million and recorded goodwill in the amount of$3.1 million. The valuation of the assets acquired and liabilities assumed inconnection with all acquisitions completed during the nine months ended June 30,2010 was based on their estimated fair values at the acquisition date. Thefinal valuation of the assets acquired and liabilities assumed will becompleted during the fiscal year 2010.

 

**11.  Business Segments**

 

The Company’s business is organized into two separatesegments: (i) Sally Beauty Supply, a domestic and international chain ofcash and carry retail stores which offers professional beauty supplies to bothsalon professionals and retail customers and (ii) BSG, including itsfranchise-based business Armstrong McCall, 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 generallyexclusive geographical territories in North America and parts of Europe.

 

Sales between segments, which were eliminated inconsolidation, were not material during the periods ended June 30, 2010and 2009.  Segment data for the three andnine months ended June 30, 2010 and 2009 is as follows (in thousands):

 
| ** **                                   | ** ** | **Three months ended********June 30,** | ** ** | **Nine months ended********June 30,** | ** ** |
|----------------------------------------------|------------|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                   | ** ** | **2010**                                    | ** ** | **2009**                                   | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net sales:                                   |       |                                        |       |                                       |       |   |   |   |   |
| Sally Beauty Supply                          |       | $                                           | 467,428    |                                       | $          | 434,732 |   | $ | 1,359,377 |   | $ | 1,257,607 |   |
| BSG                                          |       | 275,547                                     |       | 238,605                                    |       | 808,916 |   | 702,817 |   |
| Total net sales                              |       | $                                           | 742,975    |                                       | $          | 673,337 |   | $ | 2,168,293 |   | $ | 1,960,424 |   |
| Earnings before provision  for income taxes: |       |                                        |       |                                       |       |   |   |   |   |
| Segment operating profit:                    |       |                                        |       |                                       |       |   |   |   |   |
| Sally Beauty Supply                          |       | $                                           | 85,116     |                                       | $          | 76,748 |   | $ | 235,743 |   | $ | 212,413 |   |
| BSG                                          |       | 30,086                                      |       | 25,632                                     |       | 81,709 |   | 66,227 |   |
| Total segment operating  profit              |       | 115,202                                     |       | 102,380                                    |       | 317,452 |   | 278,640 |   |
| Unallocated corporate  expenses (a)          |       | (18,348                                     | )          | (16,772                                    | )          | (54,591 | ) | (45,713 | ) |
| Share-based compensation  expense            |       | (2,391                                      | )          | (1,444                                     | )          | (9,445 | ) | (6,336 | ) |
| Interest expense                             |       | (28,255                                     | )          | (31,063                                    | )          | (85,120 | ) | (102,694 | ) |
| Earnings before provision  for income taxes  |       | $                                           | 66,208     |                                       | $          | 53,101 |   | $ | 168,296 |   | $ | 123,897 |   |

 

----

(a)   Unallocated expenses consist of corporate andshared costs.

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

**12.  Guarantor and Non-Guarantor Condensed Consolidated Financial Statements**

 

The following condensed consolidating financialinformation presents the condensed consolidated balance sheets as of June 30,2010 and September 30, 2009, the condensed consolidated statements ofearnings for the three and nine months ended June 30, 2010 and 2009, andthe condensed consolidated statements of cash flows for the nine months ended June 30,2010 and 2009 of: (i) Sally Holdings, or “the Parent;” (ii) theguarantor subsidiaries; (iii) the non-guarantor subsidiaries; (iv) eliminationentries necessary to consolidate the Parent with the guarantor andnon-guarantor subsidiaries; and (v) the Parent on a consolidated basis.

 

Investments in subsidiaries are accounted for usingthe 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 subsidiary guarantors have not been provided asmanagement believes the following information is sufficient, as guarantorsubsidiaries are 100 percent indirectly owned by the Parent and all guaranteesare full and unconditional. Additionally, substantially all of the assets of the guarantorsubsidiaries are pledged under the term loan facilities and the ABL facilityand consequently may not be available to satisfy the claims of generalcreditors.

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

Condensed Consolidating Balance Sheet

June 30, 2010

(In thousands)

 
| ** **                                                                  | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally  Holdings  LLC &  Subsidiaries** | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|---------------------------------------------------|------------|
| **Assets**                                                                  |       |       |       |                        |       |                              |       |             |       |                                              |       |
| Cash and cash equivalents                                                   |       | $          | 20         |                        | $          | 8,837                             |       | $                | 19,446     |                                              | $          | — |   | $ | 28,303 |   |
| Trade accounts and other  receivables, less allowance for doubtful accounts |       | —     |       | 53,064                      |       | 29,032                            |       | —           |       | 82,096                                            |       |
| Due from affiliates                                                         |       | —     |       | 509,463                     |       | 5,977                             |       | (515,440         | )          | —                                            |       |
| Inventory                                                                   |       | —     |       | 458,263                     |       | 128,310                           |       | —           |       | 586,573                                           |       |
| Prepaid expenses                                                            |       | 107        |       | 10,807                      |       | 11,735                            |       | —           |       | 22,649                                            |       |
| Deferred income tax assets                                                  |       | 928        |       | 18,016                      |       | (3,247                            | )          | —           |       | 15,697                                            |       |
| Property and equipment,  net                                                |       | —     |       | 116,681                     |       | 47,277                            |       | —           |       | 163,958                                           |       |
| Investment in subsidiaries                                                  |       | 1,506,360  |       | 294,678                     |       | —                            |       | (1,801,038       | )          | —                                            |       |
| Goodwill and other  intangible assets, net                                  |       | —     |       | 425,693                     |       | 150,002                           |       | —           |       | 575,695                                           |       |
| Other assets                                                                |       | 26,705     |       | 9,215                       |       | 4,871                             |       | —           |       | 40,791                                            |       |
| Total assets                                                                |       | $          | 1,534,120  |                        | $          | 1,904,717                         |       | $                | 393,403    |                                              | $          | (2,316,478 | ) | $ | 1,515,762 |   |
|                                                                        |       |       |       |                        |       |                              |       |             |       |                                              |       |
| **Liabilities  and Member’s (Deficit) Equity**                         |       |       |       |                        |       |                              |       |             |       |                                              |       |
| Accounts payable                                                            |       | $          | —     |                        | $          | 177,992                           |       | $                | 45,713     |                                              | $          | — |   | $ | 223,705 |   |
| Due to affiliates                                                           |       | 494,534    |       | 5,977                       |       | 14,929                            |       | (515,440         | )          | —                                            |       |
| Accrued liabilities                                                         |       | 8,911      |       | 111,100                     |       | 23,118                            |       | —           |       | 143,129                                           |       |
| Due to Sally Beauty                                                         |       | —     |       | 32,795                      |       | —                            |       | —           |       | 32,795                                            |       |
| Income taxes payable                                                        |       | 4,038      |       | 3,378                       |       | 456                               |       | —           |       | 7,872                                             |       |
| Long-term debt                                                              |       | 1,573,856  |       | 99                          |       | 12,787                            |       | —           |       | 1,586,742                                         |       |
| Other liabilities                                                           |       | 15,750     |       | 25,065                      |       | 1,007                             |       | —           |       | 41,822                                            |       |
| Deferred income tax  liabilities                                            |       | (5,832     | )          | 41,951                      |       | 715                               |       | —           |       | 36,834                                            |       |
| Total liabilities                                                           |       | 2,091,257  |       | 398,357                     |       | 98,725                            |       | (515,440         | )          | 2,072,899                                         |       |
| Stock options subject to  redemption                                        |       | 1,639      |       | —                      |       | —                            |       | —           |       | 1,639                                             |       |
| Total member’s (deficit)  equity                                       |       | (558,776   | )          | 1,506,360                   |       | 294,678                           |       | (1,801,038       | )          | (558,776                                          | )          |
| Total liabilities and  member’s (deficit) equity                       |       | $          | 1,534,120  |                        | $          | 1,904,717                         |       | $                | 393,403    |                                              | $          | (2,316,478 | ) | $ | 1,515,762 |   |

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

Condensed Consolidating Balance Sheet

September 30, 2009

(In thousands)

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

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

Condensed Consolidating Statement of Earnings

Three months ended June 30, 2010

(In thousands)

 
| ** **                                           | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally Holdings  LLC &  Subsidiaries** | ** ** |
|------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|--------------------------------------------------|------------|
|                                                 |       |       |       |                        |       |                              |       |             |       |                                             |       |
| Net sales                                            |       | $          | —     |                        | $          | 605,792                           |       | $                | 137,183    |                                             | $          | — |   | $ | 742,975 |   |
| Related party sales                                  |       | —     |       | 698                         |       | —                            |       | (698             | )          | —                                           |       |
| Cost of products sold and  distribution expenses     |       | —     |       | 306,367                     |       | 76,447                            |       | (698             | )          | 382,116                                          |       |
| Gross profit                                         |       | —     |       | 300,123                     |       | 60,736                            |       | —           |       | 360,859                                          |       |
| Selling, general and  administrative expenses        |       | 129        |       | 199,961                     |       | 53,640                            |       | —           |       | 253,730                                          |       |
| Depreciation and  amortization                       |       | —     |       | 9,233                       |       | 3,433                             |       | —           |       | 12,666                                           |       |
| Operating earnings (loss)                            |       | (129       | )          | 90,929                      |       | 3,663                             |       | —           |       | 94,463                                           |       |
| Interest income                                      |       |       |       | (26                         | )          | (22                               | )          | —           |       | (48                                              | )          |
| Interest expense                                     |       | 28,090     |       | 19                          |       | 194                               |       | —           |       | 28,303                                           |       |
| Earnings (losses) before  provision for income taxes |       | (28,219    | )          | 90,936                      |       | 3,491                             |       | —           |       | 66,208                                           |       |
| Provision (benefit) for  income taxes                |       | (10,624    | )          | 34,201                      |       | 354                               |       | —           |       | 23,931                                           |       |
| Equity in earnings of  subsidiaries (net of tax)     |       | 59,872     |       | 3,137                       |       | —                            |       | (63,009          | )          | —                                           |       |
| Net earnings                                         |       | $          | 42,277     |                        | $          | 59,872                            |       | $                | 3,137      |                                             | $          | (63,009 | ) | $ | 42,277 |   |

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes to ConsolidatedFinancial Statements

(Unaudited)

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

Condensed Consolidating Statement of Earnings

Three months ended June 30, 2009

(In thousands)

 
| ** **                                           | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally Holdings  LLC &  Subsidiaries** | ** ** |
|------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|--------------------------------------------------|------------|
| ** **                                           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **                                       | ** ** |
| Net sales                                            |       | $          | —     |                        | $          | 557,884                           |       | $                | 115,453    |                                             | $          | — |   | $ | 673,337 |   |
| Related party sales                                  |       | —     |       | 701                         |       | —                            |       | (701             | )          | —                                           |       |
| Cost of products sold and  distribution expenses     |       | —     |       | 288,788                     |       | 67,405                            |       | (701             | )          | 355,492                                          |       |
| Gross profit                                         |       | —     |       | 269,797                     |       | 48,048                            |       | —           |       | 317,845                                          |       |
| Selling, general and  administrative expenses        |       | 130        |       | 178,141                     |       | 43,768                            |       | —           |       | 222,039                                          |       |
| Depreciation and  amortization                       |       | —     |       | 8,792                       |       | 2,850                             |       | —           |       | 11,642                                           |       |
| Operating earnings (loss)                            |       | (130       | )          | 82,864                      |       | 1,430                             |       | —           |       | 84,164                                           |       |
| Interest income                                      |       | —     |       | (60                         | )          | (57                               | )          | —           |       | (117                                             | )          |
| Interest expense                                     |       | 30,982     |       | 122                         |       | 76                                |       | —           |       | 31,180                                           |       |
| Earnings (losses) before  provision for income taxes |       | (31,112    | )          | 82,802                      |       | 1,411                             |       | —           |       | 53,101                                           |       |
| Provision (benefit) for  income taxes                |       | (8,735     | )          | 26,242                      |       | 2,739                             |       | —           |       | 20,246                                           |       |
| Equity in earnings of  subsidiaries (net of tax)     |       | 55,232     |       | (1,328                      | )          | —                            |       | (53,904          | )          | —                                           |       |
| Net earnings                                         |       | $          | 32,855     |                        | $          | 55,232                            |       | $                | (1,328     | )                                                | $          | (53,904 | ) | $ | 32,855 |   |

 

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Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

Condensed Consolidating Statement of Earnings

Nine months ended June 30, 2010

(In thousands)

** **
| ** **                                           | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally Holdings  LLC &  Subsidiaries** | ** ** |
|------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|--------------------------------------------------|------------|
| ** **                                           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **                                       | ** ** |
| Net sales                                            |       | $          | —     |                        | $          | 1,765,152                         |       | $                | 403,141    |                                             | $          | — |   | $ | 2,168,293 |   |
| Related party sales                                  |       | —     |       | 2,172                       |       | —                            |       | (2,172           | )          | —                                           |       |
| Cost of products sold and  distribution expenses     |       | —     |       | 908,404                     |       | 223,704                           |       | (2,172           | )          | 1,129,936                                        |       |
| Gross profit                                         |       | —     |       | 858,920                     |       | 179,437                           |       | —           |       | 1,038,357                                        |       |
| Selling, general and  administrative expenses        |       | 458        |       | 587,457                     |       | 160,041                           |       | —           |       | 747,956                                          |       |
| Depreciation and  amortization                       |       | —     |       | 27,134                      |       | 9,851                             |       | —           |       | 36,985                                           |       |
| Operating earnings (loss)                            |       | (458       | )          | 244,329                     |       | 9,545                             |       | —           |       | 253,416                                          |       |
| Interest income                                      |       | —     |       | (59                         | )          | (64                               | )          | —           |       | (123                                             | )          |
| Interest expense                                     |       | 84,575     |       | 80                          |       | 588                               |       | —           |       | 85,243                                           |       |
| Earnings (losses) before  provision for income taxes |       | (85,033    | )          | 244,308                     |       | 9,021                             |       | —           |       | 168,296                                          |       |
| Provision (benefit) for  income taxes                |       | (32,015    | )          | 92,516                      |       | 2,291                             |       | —           |       | 62,792                                           |       |
| Equity in earnings of  subsidiaries (net of tax)     |       | 158,522    |       | 6,730                       |       | —                            |       | (165,252         | )          | —                                           |       |
| Net earnings                                         |       | $          | 105,504    |                        | $          | 158,522                           |       | $                | 6,730      |                                             | $          | (165,252 | ) | $ | 105,504 |   |

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

Condensed Consolidating Statement of Earnings

Nine months ended June 30, 2009

(In thousands)

 
| ** **                                           | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally Holdings  LLC &  Subsidiaries** | ** ** |
|------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|--------------------------------------------------|------------|
| ** **                                           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **                                       | ** ** |
| Net sales                                            |       | $          | —     |                        | $          | 1,623,260                         |       | $                | 337,164    |                                             | $          | — |   | $ | 1,960,424 |   |
| Related party sales                                  |       | —     |       | 2,141                       |       | —                            |       | (2,141           | )          | —                                           |       |
| Cost of products sold and  distribution expenses     |       | —     |       | 846,644                     |       | 192,420                           |       | (2,141           | )          | 1,036,923                                        |       |
| Gross profit                                         |       | —     |       | 778,757                     |       | 144,744                           |       | —           |       | 923,501                                          |       |
| Selling, general and  administrative expenses        |       | 473        |       | 527,555                     |       | 134,022                           |       | —           |       | 662,050                                          |       |
| Depreciation and  amortization                       |       |       |       | 26,528                      |       | 8,332                             |       | —           |       | 34,860                                           |       |
| Operating earnings (loss)                            |       | (473       | )          | 224,674                     |       | 2,390                             |       | —           |       | 226,591                                          |       |
| Interest income                                      |       | —     |       | (171                        | )          | (150                              | )          | —           |       | (321                                             | )          |
| Interest expense                                     |       | 102,494    |       | 275                         |       | 246                               |       | —           |       | 103,015                                          |       |
| Earnings (losses) before  provision for income taxes |       | (102,967   | )          | 224,570                     |       | 2,294                             |       | —           |       | 123,897                                          |       |
| Provision (benefit) for  income taxes                |       | (38,881    | )          | 85,443                      |       | 1,534                             |       | —           |       | 48,096                                           |       |
| Equity in earnings of  subsidiaries (net of tax)     |       | 139,887    |       | 760                         |       | —                            |       | (140,647         | )          | —                                           |       |
| Net earnings                                         |       | $          | 75,801     |                        | $          | 139,887                           |       | $                | 760        |                                             | $          | (140,647 | ) | $ | 75,801 |   |

 

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Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

Condensed Consolidating Statement of Cash Flows

Nine months ended June 30, 2010

(In thousands)

 
| ** **                                                                 | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally Holdings  LLC & Subsidiaries** | ** ** |
|----------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|-------------------------------------------------|------------|
| **Net cash  provided (used) by operating activities**                      |       | $          | 100,000    |                        | $          | (1,145                            | )          | $                | 49,127     |                                            | $          | — |   | $ | 147,982 |   |
| ** **                                                                 |       |       |       |                        |       |                              |       |             |       |                                            |       |
| **Cash  Flows from Investing Activities:**                                 |       |       |       |                        |       |                              |       |             |       |                                            |       |
| Capital expenditures, net  of proceeds from sale of property and equipment |       | —     |       | (23,701                     | )          | (12,200                           | )          | —           |       | (35,901                                         | )          |
| Acquisitions, net of cash  acquired                                        |       | —     |       | (3,876                      | )          | (30,569                           | )          | —           |       | (34,445                                         | )          |
| Net cash used by investing  activities                                     |       | —     |       | (27,577                     | )          | (42,769                           | )          | —           |       | (70,346                                         | )          |
| ** **                                                                 |       |       |       |                        |       |                              |       |             |       |                                            |       |
| **Cash  Flows from Financing Activities:**                                 |       |       |       |                        |       |                              |       |             |       |                                            |       |
| Change in book cash  overdraft                                             |       | —     |       | —                      |       | —                            |       | —           |       | —                                          |       |
| Proceeds from issuance of  long-term debt                                  |       | 232,000    |       | —                      |       | —                            |       | —           |       | 232,000                                         |       |
| Repayments of long-term  debt                                              |       | (332,000   | )          | (93                         | )          | (1,932                            | )          | —           |       | (334,025                                        | )          |
| Excess tax benefit  from share-based compensation                          |       | —     |       | 59                          |       | —                            |       | —           |       | 59                                              |       |
| Net cash used by financing  activities                                     |       | (100,000   | )          | (34                         | )          | (1,932                            | )          | —           |       | (101,966                                        | )          |
| Effect of foreign exchange  rate changes on cash and cash equivalents      |       | —     |       | —                      |       | (1,814                            | )          | —           |       | (1,814                                          | )          |
|                                                                       |       |       |       |                        |       |                              |       |             |       |                                            |       |
| Net increase (decrease) in  cash and cash equivalents                      |       | —     |       | (28,756                     | )          | 2,612                             |       | —           |       | (26,144                                         | )          |
| Cash and cash equivalents,  beginning of period                            |       | 20         |       | 37,593                      |       | 16,834                            |       | —           |       | 54,447                                          |       |
| Cash and cash equivalents,  end of period                                  |       | $          | 20         |                        | $          | 8,837                             |       | $                | 19,446     |                                            | $          | — |   | $ | 28,303 |   |

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

(Unaudited)

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

Condensed Consolidated Statement of Cash Flows

Nine months ended June 30, 2009

(In thousands)

 
| ** **                                                                 | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | **Sally Holdings  LLC &** | ** ** |
|----------------------------------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------------------------|------------|
| ** **                                                                 | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**    | ** ** | **Eliminations** | ** ** | **Subsidiaries**                   | ** ** |
| ** **                                                                 |       |       |       |             |       |                |       |             |       |                               |       |   |   |   |   |   |
| **Net cash  provided by operating activities**                             |       | $          | 127,734    |             | $          | 22,839              |       | $                | 13,883     |                               | $          | — |   | $ | 164,456 |   |
|                                                                       |       |       |       |             |       |                |       |             |       |                               |       |
| **Cash  Flows from Investing Activities:**                                 |       |       |       |             |       |                |       |             |       |                               |       |
| Capital expenditures, net  of proceeds from sale of property and equipment |       | —     |       | (17,144          | )          | (8,999              | )          | —           |       | (26,143                            | )          |
| Acquisitions, net of cash  acquired                                        |       | —     |       | (1,280           | )          | (707                | )          | —           |       | (1,987                             | )          |
|                                                                       |       |       |       |             |       |                |       |             |       |                               |       |
| Net cash used by investing  activities                                     |       | —     |       | (18,424          | )          | (9,706              | )          | —           |       | (28,130                            | )          |
|                                                                       |       |       |       |             |       |                |       |             |       |                               |       |
| **Cash  Flows from Financing Activities:**                                 |       |       |       |             |       |                |       |             |       |                               |       |
| Change in book cash  overdraft                                             |       | (1,586     | )          | —           |       | —              |       | —           |       | (1,586                             | )          |
| Proceeds from issuance of  long-term debt                                  |       | 94,637     |       | —           |       | 467                 |       | —           |       | 95,104                             |       |
| Repayments of long-term  debt                                              |       | (222,364   | )          | (159             | )          | (744                | )          | —           |       | (223,267                           | )          |
| Excess tax shortfall  from share-based compensation                        |       | —     |       | (204             | )          | —              |       | —           |       | (204                               | )          |
|                                                                       |       |       |       |             |       |                |       |             |       |                               |       |
| Net cash used by financing  activities                                     |       | (129,313   | )          | (363             | )          | (277                | )          | —           |       | (129,953                           | )          |
| Effect of foreign exchange  rate changes on cash and cash equivalents      |       | —     |       | —           |       | (219                | )          | —           |       | (219                               | )          |
| Net (decrease) increase in  cash and cash equivalents                      |       | (1,579     | )          | 4,052            |       | 3,681               |       | —           |       | 6,154                              |       |
| Cash and cash equivalents,  beginning of period                            |       | 1,645      |       | 85,384           |       | 12,759              |       | —           |       | 99,788                             |       |
| Cash and cash equivalents,  end of period                                  |       | $          | 66         |             | $          | 89,436              |       | $                | 16,440     |                               | $          | — |   | $ | 105,942 |   |

 

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**Item 2.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.**

 

Thissection discusses management’s view of the financial condition, results ofoperations and cash flows of Sally Holdings and its consolidated subsidiaries.All of the interests of Sally Holdings are beneficially owned by SallyInvestment, and all of the interests of Sally Investment are beneficially ownedby Sally Beauty. This section should be read in conjunction with the auditedconsolidated financial statements and the related notes included in our AnnualReport on Form 10-K for the fiscal year ended September 30, 2009, aswell as the Risk Factors section contained in that Annual Report, andinformation contained elsewhere in this Quarterly Report, including theconsolidated interim financial statements and condensed notes to thosestatements. This Management’s Discussion and Analysis of Financial Conditionand Results of Operations section may 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 For the Nine Months Ended June 30,2010:**

 

·                  Our consolidated same store sales increased by 4.4% for the nine monthsended June 30, 2010;

·                  Our consolidated net sales for the nine months ended June 30, 2010,increased by $207.9 million, or 10.6%, to $2,168.3 million compared to $1,960.4million for the nine months ended June 30, 2009;

·                  Net sales reported for the nine months ended June 30, 2010, reflectapproximately $21.1 million, or 1.1%, in positive impact from changes inforeign exchange rates;

·                  Our consolidated gross profit for the nine months ended June 30,2010, increased $114.9 million, or 12.4%, to $1,038.4 million compared to$923.5 million for the nine months ended June 30, 2009. As a percentage ofnet sales, gross profit increased 80 basis points to 47.9% for the nine monthsended June 30, 2010 compared to 47.1% for the nine months ended June 30,2009;

·                  Our consolidated operating earnings for the nine months ended June 30,2010, increased $26.8 million, or 11.8%, to $253.4 million compared to $226.6million for the nine months ended June 30, 2009;

·                  Net earnings increased $29.7 million, or 39.2%, to $105.5 million forthe nine months ended June 30, 2010 compared to $75.8 million for the ninemonths ended June 30, 2009;

·                  Cash provided by operations decreased by $16.5 million to$148.0 million for the nine months ended June 30, 2010 compared to$164.5 million for the nine months ended June 30, 2009; and

·                  On December 16, 2009, we acquired Sinelco Group NV (“Sinelco”), awholesale distributor of professional beauty products based in Ronse, Belgium,for approximately €25.2 million (approximately $36.6 million).

 

**Overview**

 

***Descriptionof Business***

 

We operate primarily through two business units, SallyBeauty Supply and BSG. Through Sally Beauty Supply and BSG (which operatesstores under the CosmoProf service mark), we operated a multi-channel platformof 3,802 stores and supplied 184 franchised stores in North America, SouthAmerica and selected European countries, as of June 30, 2010. We are thelargest distributor of professional beauty supplies in the U.S. based on storecount. Within BSG, we also have one of the largest networks of professionaldistributor sales consultants in North America, with approximately 1,055professional distributor sales consultants who sell directly to salons andsalon professionals.  We provide ourcustomers 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 nine months ended June 30,2010, our consolidated net sales and operating earnings were$2,168.3 million and $253.4 million, respectively.

 

As of June 30, 2010, Sally Beauty Supply operated2,947 company-operated retail stores, 2,383 of which are located in the U.S.(with the remainder in the United Kingdom and certain other countries inEurope, Canada, Puerto Rico, Mexico and Chile) and supplied 26 franchisedstores located outside the U.S. We believe Sally Beauty Supply is the largestopen-line distributor of professional beauty supplies in the U.S. based onstore count. Sally Beauty Supply stores in the U.S. range in size between1,200 square feet and 1,700 square feet and are primarily located in stripshopping centers. The product selection in Sally Beauty Supply stores ranges between4,000 and 8,000 SKUs of beauty products and includes products for hair care,skin and nail care, beauty sundries and electrical appliances targeting retailconsumers and salon professionals. Sally Beauty Supply stores carry leadingthird-party brands such as Clairol, Revlon and Conair, as well as an extensiveselection of exclusive-label merchandise.

 

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As of June 30, 2010, BSG had 855 company-operatedstores, supplied 158 franchised stores and had a sales force of approximately1,055 professional distributor sales consultants selling exclusively to salonsand salon professionals in substantially all states in the U.S. and inportions of Canada, Puerto Rico, Mexico and certain European countries. Webelieve BSG is the largest full-service distributor of professional beautysupplies in the U.S. BSG stores average approximately2,700 square feet and are primarily located in secondary strip shoppingcenters. Through BSG’s large store base and sales force, BSG is able to accessa significant portion of the highly fragmented U.S. salon channel. Theproduct selection in BSG stores, ranging between 4,000 and 9,000 SKUs of beautyproducts, includes hair care and color, skin and nail care, beauty sundries andelectrical appliances and targets salons and salon professionals. BSG carriesleading professional beauty product brands intended for use in salons and forresale by the salon to consumers. Certain BSG products are sold under exclusivedistribution agreements with suppliers whereby BSG is designated as the soledistributor for a product line within certain geographic territories.

 

***Industry andBusiness Trends***

 

We operate within the large and growingU.S. professional beauty supply industry. Potential growth in the industryis expected to be driven by increases in hair color, hair loss prevention andhair styling products. We believe the following key industry and businesstrends and characteristics will influence our business and our financialresults going forward:

 

·             *High level of marketplace fragmentation.*  The U.S. salon channel is highly fragmented with over250,000 salons. Given the fragmented and small-scale nature of the salonindustry, we believe that salon operators will continue to depend onfull-service/exclusive distributors and open-line channels for a majority oftheir beauty supply purchases.

 

·             *Growth in booth renting and frequent stocking needs.*  Salon professionals primarily rely on just-in-time inventorydue to capital constraints and a lack of warehouse and shelf space atsalons.  In addition, booth renters, whocomprise a significant percentage of total U.S. salon professionals, are oftenresponsible for purchasing their own supplies. Historically, booth renters havesignificantly increased as a percentage of total salon professionals, and weexpect this trend to continue. Given their smaller individual purchases andrelative lack of financial resources, booth renters are likely to be dependenton frequent trips to professional beauty supply stores, like BSG and SallyBeauty Supply. We expect that these factors will continue to drive demand forconveniently located professional beauty supply stores.

 

·             *Increasing use of exclusive-label products.*  We offer a broad range of private label and control labelproducts, which we generally refer to collectively as “exclusive-labelproducts.” Private label products are brands for which we own or license thetrademark and, in some instances, the formula. Control label products arebrands that are owned by the manufacturer, but for which we have been grantedsole distribution rights. Generally, our exclusive-label products have highergross margins than the leading third-party branded products, and we believethis area offers potential growth. Please see “Risk Factors - We depend uponmanufacturers who may be unable to provide products of adequate quality or whomay be unwilling to continue to supply products to us” in Item 1A of our AnnualReport on Form 10-K for the fiscal year ended September 30, 2009.

 

·             *Favorable demographic and consumer trends.*  We expect the aging baby-boomer population to drive futuregrowth in professional beauty supply sales through an increase in the usage ofhair color and hair loss products. Additionally, continuously changingfashion-related trends that drive new hair styles are expected to result incontinued demand for hair styling products. Changes in consumer tastes andfashion trends can have an impact on our financial performance. Our continuedsuccess depends in large part on our ability to anticipate, gauge and react ina timely and effective manner to changes in consumer spending patterns andpreferences for beauty products. We continuously adapt our marketing andmerchandising initiatives for Sally Beauty Supply in an effort to expand ourmarket reach or to respond to changing consumer preferences.  If we are unable to anticipate and respond totrends in the marketplace for beauty products and changing consumer demands,our business could suffer.

 

·             *International growth strategies. *A key element of our growth strategy depends onour ability to capitalize on growth in the international marketplace and togrow our current level of non-U.S. operations. For example, on December 16,2009, we acquired Sinelco Group NV (“Sinelco”), a wholesale distributor ofprofessional beauty products with sales throughout Europe. In addition, on September 4,2009, we acquired Distribuidora Intersalon Limitada, a leading distributor ofpremier beauty supply products with 16 stores located in Chile.  These acquisitions furthered our expansionplans in Europe and Latin America, key targets of Sally Beauty Supply’sinternational growth initiative. We intend to continue to identify and evaluatenon-U.S. acquisition targets.  Ourability to grow our non-U.S. operations, integrate our new non-U.S.

 

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acquisitions and successfully pursue additionalnon-U.S. acquisitions may be affected by business, legal, regulatory andeconomic risks. Please see “Risk Factors - We may not be able to successfullyidentify acquisition candidates and complete desirable acquisitions,” “If weacquire any businesses in the future they could prove difficult to integrate,disrupt our business or have an adverse effect on our results of operations”and “Our ability to conduct business in international marketplaces may beaffected by legal, regulatory and economic risks” in Item 1A of our AnnualReport on Form 10-K for the fiscal year ended September 30, 2009.

 

·             *Continuing consolidation.*  There is continuing consolidation among professional beautyproduct distributors and professional beauty product manufacturers. We plan tocontinue to examine ways in which we can benefit from this trend, includingreviewing opportunities to shift business within the professional beautyproducts channel from competitive distributors to the BSG network as well asseeking opportunistic, value-added acquisitions which complement our long-termgrowth strategy. We believe that suppliers are increasingly likely to focus onlarger distributors and retailers with a broader scale and retail footprint. Wealso believe that we are well positioned to capitalize on this trend as well asparticipate in the ongoing consolidation at the distributor/retail level.However, changes often occur in our relationships with suppliers that maymaterially affect the net sales and operating earnings of our businesssegments. Consolidation among suppliers could exacerbate the effects of theserelationship changes and could increase pricing pressures. For example, as weannounced in December 2006, our largest supplier, L’Oreal, moved amaterial amount of revenue out of the BSG nationwide distribution network andinto competitive regional distribution networks. More recently, L’Orealacquired distributors competing with BSG in the southeastern and west coast ofthe U.S. and, as a result, directly competes with BSG in certain geographicareas. If L’Oreal acquired other distributors or suppliers that conduct significantbusiness with BSG, we could lose related revenue. There can be no assurancethat there will not be further loss of revenue over time by BSG (includingwithin its franchise-based business) due to potential losses of additionalproducts (both from L’Oreal and from other suppliers) as well as from theincreased competition from L’Oreal-affiliated distribution networks. Please see“Risk Factors - The beauty products distribution industry is highly competitiveand is consolidating” and “We depend upon manufacturers who may be unable toprovide products of adequate quality or who may be unwilling to continue tosupply products to us” in Item 1A of our Annual Report on Form 10-K forthe fiscal year ended September 30, 2009.

 

·             *Relationships with suppliers.*   Sally Beauty Supply/BSG and their suppliers are dependenton each other for the distribution of beauty products. We do not manufacturethe brand name or exclusive-label products we sell. We purchase our productsfrom a limited number of manufacturers. As is typical in distributionbusinesses, these relationships are subject to change from time to time(including the expansion or loss of distribution rights in various geographiesand the addition or loss of product lines). Since we purchase products frommany manufacturers on an at-will basis, under contracts which can generally beterminated without cause upon 90 days’ notice or less or which expirewithout express rights of renewal, such manufacturers could discontinue salesto us at any time or upon the expiration of the distribution period. Some ofour contracts with manufacturers may be terminated by such manufacturers if wefail to meet specified minimum purchase requirements. In such cases, we do nothave contractual assurances of continued supply, pricing or access to newproducts and vendors may change the terms upon which they sell. Infrequently, asupplier will seek to terminate a distribution relationship through legalaction. Changes in our relationships with suppliers occur often and couldpositively or negatively impact our net sales and operating profits. Althoughwe focus on developing new revenue and cost management initiatives to mitigatethe negative effects resulting from unfavorable changes in our supplier relationships,there can be no assurance that our efforts will continue to completely offsetthe loss of these or other distribution rights. Please see “Risk Factors*—* We depend upon manufacturers who may beunable to provide products of adequate quality or who may be unwilling tocontinue to supply products to us” in Item 1A of our Annual Report on Form 10-Kfor the fiscal year ended September 30, 2009.

 

We expect to continue to expand our product lineofferings and to gain additional distribution rights over time through eitherfurther negotiation with suppliers or by strategic acquisitions of existingdistributors.  Although we are focused ondeveloping new revenue and cost management initiatives, there can be no assurancethat our efforts will partially or completely offset any potential loss ofdistribution rights in the future. Please see “Risk Factors—We depend uponmanufacturers who may be unable to provide products of adequate quality or whomay be unwilling to continue to supply products to us” in Item 1A of our AnnualReport on Form 10-K for the fiscal year ended September 30, 2009.

 

·             *High level of competition.  *Sally Beauty Supply competes with otherdomestic and international beauty product wholesale and retail outlets,including local and regional open-line beauty supply stores,

 

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professional-onlybeauty supply stores, salons, mass merchandisers, drug stores and supermarkets,as well as sellers on the internet and salons retailing hair care items. BSGcompetes with other domestic and international beauty product wholesale andretail suppliers and manufacturers selling professional beauty productsdirectly to salons and individual salon professionals. We also face competitionfrom authorized and unauthorized retailers and internet sites offeringprofessional salon-only products. The increasing availability of unauthorizedprofessional salon products in large format retail stores such as drug stores,grocery stores and others could also have a negative impact on our business. Please see “Risk Factors — The beauty products distribution industry ishighly competitive and is consolidating” in Item 1A of our Annual Report on Form 10-Kfor the fiscal year ended September 30, 2009.

 

·             *Economic conditions.*  We appeal to a wide demographic consumerprofile and offer a broad selection of beauty products sold directly to retailconsumers and salons and salon professionals. Historically, these factors haveprovided us with reduced exposure to downturns in economic conditions in thecountries in which we operate.  However,a downturn in the economy, especially for an extended period of time, couldadversely impact consumer demand of discretionary items such as beauty productsand salon services, particularly affecting our electrical products category andour full-service sales business. In addition, higher freight costs resultingfrom increases in the cost of fuel, especially for an extended period of time,may impact our expenses at levels that we cannot pass through to our customers.These factors could have a material adverse effect on our business, financialcondition and results of operations. Please see “Risk Factors — A further downturnin the economy may affect consumer purchases of discretionary items such asbeauty products and salon services, which could have a material adverse effecton our business, financial condition and results of operations” in Item1A of our Annual Report on Form 10-K for the fiscal year ended September 30,2009.

 

·             *Controlling expenses*.  Another important aspect of our business isour ability to control costs, especially in our BSG business segment, byright-sizing the business and maximizing the efficiency of our structure. Inlate fiscal year 2009, we completed implementation of an approximately $22.0million capital spending program to consolidate warehouses and reduceadministrative expenses related to BSG’s distribution network optimizationprogram resulting in annualized cost savings**of approximately$10.0 million beginning with this fiscal year. Please see “Risk Factors — Weare not certain that our ongoing cost control plans will continue to besuccessful” in Item 1A of our Annual Report on Form 10-K for the fiscalyear ended September 30, 2009.

 

·             *Opening new stores*.  Our future growth strategy depends in part onour ability to open and profitably operate new stores in existing andadditional geographic areas. The capital requirements to open a U.S. - basedSally Beauty Supply or BSG store, excluding inventory, average approximately$70,000 and $80,000, respectively, with the capital requirements forinternational stores costing less or substantially more depending upon themarketplace. However, in response to economic conditions and to allow flexibilityto capitalize on potential real estate revaluations in key locations, in thefiscal year 2009 we slowed our new store openings. We may not be able to openall of the new stores we plan to open and any new stores we open may not beprofitable, any of which could have a material adverse impact on our financialcondition or results of operations. Please see “Risk Factors — If we are unableto profitably open and operate new stores, our business, financial conditionand results of operations may be adversely affected” in Item 1A of our AnnualReport on Form 10-K for the fiscal year ended September 30, 2009.

 

·             *Changes to our information technology systems*.  As our operations grow in bothsize and scope, we will continuously need to improve and upgrade ourinformation systems and infrastructure while maintaining the reliability andintegrity of our systems and infrastructure. The expansion of our systems andinfrastructure will require us to commit substantial financial, operational andtechnical resources in advance of any increase in the volume of our business,with no assurance that the volume of business will increase.  For example, in fiscal year 2009, we beganupgrading our distribution information systems (in connection with our capitalspending program to consolidate warehouses, as discussed above), upgrading ourAS400 iSeries servers and installing Hyperion software to enhance ourfinancial reporting system. These and any other required upgrades to ourinformation systems and information technology (or new technology), now or inthe future, will require that our management and resources be diverted from ourcore business to assist in completion of these projects. There can be noassurance that the time and resources our management will need to devote tothese upgrades, 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 financial reporting, business, financialcondition or results of operations. Please see “Risk Factors — We may be adversely affected by anydisruption in our information technology systems” in Item 1A of our AnnualReport on Form 10-K for the fiscal year ended September 30, 2009.

 

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***OurSeparation from Alberto-Culver***

 

In November 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 inconnection with our separation from Alberto-Culver.  In this Quarterly Report on Form 10-Q,we refer to these transactions as the Separation Transactions. Sally Beauty wasformed in June 2006 and became the accounting successor company to SallyHoldings, Inc. upon the completion of the Separation Transactions.  See the Company’s Annual Report on Form 10-Kfor the fiscal year ended September 30, 2009 for more information aboutthe Separation Transactions.

 

***OtherSignificant Items***

 

*Derivative Instruments*

 

The Company is exposed to a wide variety of risks,including risks arising from changing economic conditions. The Company managesits exposure to certain economic risks (including liquidity, credit risk andchanges in interest rates) primarily (a) by closely managing its cashflows from operating and investing activities and the amounts and sources ofits debt obligations; (b) by assessing periodically the creditworthinessof its business partners; and (c) through the use of interest rateswaps.  The Company uses interest rateswaps as part of its overall economic risk management strategy to add stabilityto the interest payments due in connection with its term loan obligations.Interest payments related to the term loans are impacted by changes in LIBOR.Interest rate swap agreements involve the periodic receipt by the Company ofamounts based on a variable rate in exchange for the Company making paymentsbased on a fixed rate over the term of the agreements without exchange of theunderlying notional amount.

 

In November 2006, the Company entered into fourinterest rate swap agreements with an aggregate notional amount of $500million. Interest rate swap agreements with an aggregate notional amount of$150 million expired in November 2008 and agreements with a notionalamount of $350 million expired in November 2009. These interest rate swapagreements did not qualify as hedges and, therefore, the changes in fair valueof these agreements were recorded in interest expense in our consolidatedstatements of earnings.

 

Additionally, in May 2008, the Company enteredinto two interest rate swap agreements with an aggregate notional amount of$300 million. These interest rate swap agreements expire in May 2012 andare designated as effective hedges, consistent with ASC 815.  Accordingly, adjustments to reflect thechange in the fair values of these interest rate swap agreements are recordedin accumulated other comprehensive (loss) income, net of tax, until the hedgedobligation is settled or the swap agreements expire, whichever is earlier.  Any ineffectiveness is recognized in interestexpense in the consolidated statements of earnings. Please see “Item3—Quantitative and Qualitative Disclosures about Market Risk—Interest rate risk”and Note 12 of the “Notes to Consolidated Financial Statements” in Item 8 - “FinancialStatements and Supplementary Data” contained in our Annual Report on Form 10-Kfor the fiscal year ended September 30, 2009.

 

The Company is exposed to potential gains or lossesfrom foreign currency fluctuations affecting our net investments insubsidiaries and earnings denominated in foreign currencies. The Company’sprimary exposures are to changes in exchange rates for the U.S. dollar versusthe British pound sterling, the Canadian dollar, the Euro, the Chilean peso,and the Mexican peso. The Company’s various foreign currency exposures at timesoffset each other providing a natural hedge against foreign currency risk.

 

As aresult of the Company’s acquisition of Sinelco on December 16, 2009, theCompany, through Sinelco, uses foreign currency options (including, at June 30,2010, foreign currency put options with an aggregate notional amount of €2.9million ($3.6 million, at the June 30, 2010 exchange rate) and foreigncurrency call options with an aggregate notional amount of €1.8 million ($2.2million, at the June 30, 2010 exchange rate)) to manage the exposure tocertain non-Euro currencies resulting from Sinelco’s purchases of merchandisefrom third-party suppliers. Sinelco’s functional currency is the Euro. Theseforeign currency option agreements are not designated as hedges and do not meetthe hedge accounting requirements of ASC 815. Accordingly, the changes in fair value of these derivative instruments (which areadjusted quarterly) are recorded in our consolidated statements of earnings.Included in selling, general and administrative expenses are gains of $0.4 million and $0.7 millionrelated to these foreign currency options, including marked-to-marketadjustments, for the three and nine months ended June 30, 2010,respectively. During the nine monthsended June 30, 2010, these derivative instruments did not have a materialimpact on results of operations or cash flows.

 

Our counterparties in the Company’s interest rateswaps and foreign currency options are deemed to be of substantial resourcesand strong creditworthiness. However, these transactions result in exposure tocredit risks in the event of default by a counterparty. The recent financialcrisis affecting the banking systems and financial markets has resulted in manywell-known financial institutions becoming less creditworthy or havingdiminished liquidity, which could expose us to an increased level ofcounterparty risk.  In the event that acounterparty defaults 

 

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in its obligation under our derivative instruments, wecould incur substantial financial loss. At June 30, 2010, the aggregatefair value of all our interest rate swaps was a net liability of $15.8 million and the aggregate fair value of all our foreign currency optionswas a net asset of $0.5 million.

 

**Resultsof Operations**

 

The following table shows the condensed results ofoperations of our business for the three and nine months ended June 30,2010 and 2009 (in thousands):

 
| ** **                                       | ** ** | **Three Months Ended  June 30,** | ** ** | **Nine Months Ended  June 30,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                       | ** ** | **2010**                              | ** ** | **2009**                             | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net sales                                        |       | $                                     | 742,975    |                                 | $          | 673,337 |   | $ | 2,168,293 |   | $ | 1,960,424 |   |
| Cost of products sold and  distribution expenses |       | 382,116                               |       | 355,492                              |       | 1,129,936 |   | 1,036,923 |   |
| Gross profit                                     |       | 360,859                               |       | 317,845                              |       | 1,038,357 |   | 923,501 |   |
| Total other operating  costs and expenses        |       | 266,396                               |       | 233,681                              |       | 784,941 |   | 696,910 |   |
| Operating earnings                               |       | 94,463                                |       | 84,164                               |       | 253,416 |   | 226,591 |   |
| Interest expense                                 |       | 28,255                                |       | 31,063                               |       | 85,120 |   | 102,694 |   |
| Earnings before provision  for income taxes      |       | 66,208                                |       | 53,101                               |       | 168,296 |   | 123,897 |   |
| Provision for income taxes                       |       | 23,931                                |       | 20,246                               |       | 62,792 |   | 48,096 |   |
| Net earnings                                     |       | $                                     | 42,277     |                                 | $          | 32,855 |   | $ | 105,504 |   | $ | 75,801 |   |

 

The following table shows the condensed results ofoperations of our business for the three and nine months ended June 30,2010 and 2009, expressed as a percentage of net sales for each respectiveperiod shown:

 
| ** **                                       | ** ** | **Three Months Ended  June 30,** | ** ** | **Nine Months Ended  June 30,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                       | ** ** | **2010**                              | ** ** | **2009**                             | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net sales                                        |       | 100.0                                 | %          | 100.0                                | %          | 100.0 | % | 100.0 | % |
| Cost of products sold and  distribution expenses |       | 51.4                                  | %          | 52.8                                 | %          | 52.1 | % | 52.9 | % |
| Gross profit                                     |       | 48.6                                  | %          | 47.2                                 | %          | 47.9 | % | 47.1 | % |
| Total other operating  costs and expenses        |       | 35.9                                  | %          | 34.7                                 | %          | 36.2 | % | 35.5 | % |
| Operating earnings                               |       | 12.7                                  | %          | 12.5                                 | %          | 11.7 | % | 11.6 | % |
| Interest expense                                 |       | 3.8                                   | %          | 4.6                                  | %          | 3.9 | % | 5.3 | % |
| Earnings before provision  for income taxes      |       | 8.9                                   | %          | 7.9                                  | %          | 7.8 | % | 6.3 | % |
| Provision for income taxes                       |       | 3.2                                   | %          | 3.0                                  | %          | 2.9 | % | 2.4 | % |
| Net earnings                                     |       | 5.7                                   | %          | 4.9                                  | %          | 4.9 | % | 3.9 | % |

 

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***KeyOperating Metrics***

 

The following table sets forth, for the periodsindicated, information concerning key measures we rely on to gauge ouroperating performance (dollars in thousands):

 
| ** **                                                 | ** ** | **Three Months Ended  June 30,** | ** ** | **Nine Months Ended  June 30,** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                 | ** ** | **2010**                              | ** ** | **2009**                             | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net sales:                                                 |       |                                  |       |                                 |       |   |   |   |   |
| Sally Beauty Supply                                        |       | $                                     | 467,428    |                                 | $          | 434,732 |   | $ | 1,359,377 |   | $ | 1,257,607 |   |
| BSG                                                        |       | 275,547                               |       | 238,605                              |       | 808,916 |   | 702,817 |   |
| Consolidated                                               |       | $                                     | 742,975    |                                 | $          | 673,337 |   | $ | 2,168,293 |   | $ | 1,960,424 |   |
| Gross profit                                               |       | $                                     | 360,859    |                                 | $          | 317,845 |   | $ | 1,038,357 |   | $ | 923,501 |   |
| Gross profit margin                                        |       | 48.6                                  | %          | 47.2                                 | %          | 47.9 | % | 47.1 | % |
| Selling, general and  administrative expenses              |       | $                                     | 253,730    |                                 | $          | 222,039 |   | $ | 747,956 |   | $ | 662,050 |   |
| Depreciation and  amortization                             |       | $                                     | 12,666     |                                 | $          | 11,642 |   | $ | 36,985 |   | $ | 34,860 |   |
| Earnings before provision  for income taxes:               |       |                                  |       |                                 |       |   |   |   |   |
| Segment operating profit:                                  |       |                                  |       |                                 |       |   |   |   |   |
| Sally Beauty Supply                                        |       | $                                     | 85,116     |                                 | $          | 76,748 |   | $ | 235,743 |   | $ | 212,413 |   |
| BSG                                                        |       | 30,086                                |       | 25,632                               |       | 81,709 |   | 66,227 |   |
| Segment operating profit                                   |       | 115,202                               |       | 102,380                              |       | 317,452 |   | 278,640 |   |
| Unallocated expenses                                       |       | (18,348                               | )          | (16,772                              | )          | (54,591 | ) | (45,713 | ) |
| Share-based compensation  expense                          |       | (2,391                                | )          | (1,444                               | )          | (9,445 | ) | (6,336 | ) |
| Operating earnings                                         |       | 94,463                                |       | 84,164                               |       | 253,416 |   | 226,591 |   |
| Interest expense                                           |       | (28,255                               | )          | (31,063                              | )          | (85,120 | ) | (102,694 | ) |
| Earnings before provision  for income taxes                |       | $                                     | 66,208     |                                 | $          | 53,101 |   | $ | 168,296 |   | $ | 123,897 |   |
| Segment operating profit  margin:                          |       |                                  |       |                                 |       |   |   |   |   |
| Sally Beauty Supply                                        |       | 18.2                                  | %          | 17.7                                 | %          | 17.3 | % | 16.9 | % |
| BSG                                                        |       | 10.9                                  | %          | 10.7                                 | %          | 10.1 | % | 9.4 | % |
| Consolidated operating  profit margin                      |       | 12.7                                  | %          | 12.5                                 | %          | 11.7 | % | 11.6 | % |
| Number of stores at  end-of-period (including franchises): |       |                                  |       |                                 |       |   |   |   |   |
| Sally Beauty Supply                                        |       |                                  |       |                                 |       | 2,973 |   | 2,879 |   |
| BSG                                                        |       |                                  |       |                                 |       | 1,013 |   | 942 |   |
|                                                       |       |                                  |       |                                 |       | 3,986 |   | 3,821 |   |
| Same store sales growth  (a)                               |       |                                  |       |                                 |       |   |   |   |   |
| Sally Beauty Supply                                        |       | 3.6                                   | %          | 3.2                                  | %          | 3.9 | % | 1.7 | % |
| BSG                                                        |       | 7.4                                   | %          | 0.6                                  | %          | 5.9 | % | 1.2 | % |
| Consolidated                                               |       | 4.6                                   | %          | 2.6                                  | %          | 4.4 | % | 1.6 | % |

 

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(a)     Same stores are defined as company-operated stores that have been openfor at least 14 months as of the last day of a month. Our same store salescalculation includes internet-based sales but does not generally include salesfrom stores relocated.

 

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***The Three Months Ended June 30,2010 compared to the Three Months Ended June 30, 2009***

 

The table below presents net sales, gross profit andgross profit margin data for each reportable segment (dollars in thousands).

 
|                              |   | **Three  Months Ended June 30,** |       |
|-----------------------------------|--------|---------------------------------------|------------|
|                              |   | **2010**                              | ** ** | **2009** | ** ** | **Increase** |   |
| Net sales:                        |   |                                  |       |   |   |   |   |   |   |
| Sally Beauty Supply               |   | $                                     | 467,428    |   | $ | 434,732 |   | $ | 32,696 |   | 7.5 | % |
| BSG                               |   | 275,547                               |       | 238,605 |   | 36,942 |   | 15.5 | % |
| Consolidated net sales            |   | $                                     | 742,975    |   | $ | 673,337 |   | $ | 69,638 |   | 10.3 | % |
|                              |   |                                  |       |   |   |   |   |   |   |
| Gross profit:                     |   |                                  |       |   |   |   |   |   |   |
| Sally Beauty Supply               |   | $                                     | 249,520    |   | $ | 224,752 |   | $ | 24,768 |   | 11.0 | % |
| BSG                               |   | 111,339                               |       | 93,093 |   | 18,246 |   | 19.6 | % |
| Consolidated gross  profit        |   | $                                     | 360,859    |   | $ | 317,845 |   | $ | 43,014 |   | 13.5 | % |
|                              |   |                                  |       |   |   |   |   |   |   |
| Gross profit margin:              |   |                                  |       |   |   |   |   |   |   |
| Sally Beauty Supply               |   | 53.4                                  | %          | 51.7 | % | 1.7 | % |   |   |
| BSG                               |   | 40.4                                  | %          | 39.0 | % | 1.4 | % |   |   |
| Consolidated gross  profit margin |   | 48.6                                  | %          | 47.2 | % | 1.4 | % |   |   |

 

***Net Sales***

 

Consolidated net sales increased by $69.6 million,or 10.3%, for the three months ended June 30, 2010, compared to the threemonths ended June 30, 2009. Company-operated stores that have been openfor at least 14 months contributed an increase of approximately $41.8 million,or 6.2%, and sales from businesses acquired in the preceding 12 monthscontributed approximately $25.1 million, or 3.7%, more to consolidated netsales for the three months ended June 30, 2010, compared to the threemonths ended June 30, 2009. Other sales channels (including sales throughour BSG distributor sales consultants and our BSG franchise-based businessesand from stores that have been open for less than 14 months), in the aggregate,contributed an increase of $2.7 million, or 0.4%, compared to the three monthsended June 30, 2009. Consolidated net sales for the three months ended June 30,2010, are inclusive of approximately $0.4 million in net positive impact fromchanges in foreign exchange rates.

 

*Sally Beauty Supply*.  Net sales for Sally BeautySupply increased by $32.7 million, or 7.5%, for the three months ended June 30,2010, compared to the three months ended June 30, 2009.  In the Sally Beauty Supply segment,company-operated stores that have been open for at least 14 months contributedan increase of approximately $27.3 million, or 6.3%, and sales from businessesacquired in the preceding 12 months contributed approximately $5.6 million, or1.3%, more for the three months ended June 30, 2010, compared to the threemonths ended June 30, 2009. Other sales channels (including sales fromstores that have been open for less than 14 months and non-store sales), in theaggregate, experienced a minor decline in sales compared to the three monthsended June 30, 2009. Net sales for Sally Beauty Supply for the threemonths ended June 30, 2010, are inclusive of approximately $2.5 million innegative impact from changes in foreign exchange rates.

 

*Beauty Systems Group*.  Net sales for BSG increased by $36.9 million,or 15.5%, for the three months ended June 30, 2010, compared to the threemonths ended June 30, 2009. In the BSG segment, company-operated storesthat have been open for at least 14 months contributed an increase ofapproximately $14.5 million, or 6.1% and sales from stores that have been openfor less than 14 months contributed an increase of approximately $1.8 million,or 0.8%, while sales from businesses acquired in the preceding 12 monthscontributed approximately $19.5 million, or 8.2%, more for the three monthsended June 30, 2010, compared to the three months ended June 30,2009. Other sales channels (including sales through our distributor salesconsultants and our franchise-based businesses), in the aggregate, contributedan increase of $1.1 million, or 0.4%, compared to the three months ended June 30,2009. Net 

 

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sales for BSG for the three months ended June 30,2010, are inclusive of approximately $2.9 million in positive impact fromchanges in foreign exchange rates.

 

***Gross Profit***

 

Consolidated gross profit increased by $43.0million, or 13.5%, for the three months ended June 30, 2010, compared tothe three months ended June 30, 2009, principally due to higher salesvolume and improved gross margins in both business segments as more fullydescribed below.

 

*Sally Beauty Supply*. Sally Beauty Supply’s gross profit increased by $24.8 million, or 11.0%,for the three months ended June 30, 2010, compared to the three monthsended June 30, 2009, principally as a result of higher sales volume andimproved gross margins.  Sally BeautySupply’s gross profit as a percentage of net sales increased to 53.4% for thethree months ended June 30, 2010, compared to 51.7% for the three monthsended June 30, 2009. This increase was principally the result of a shiftin product and customer mix (including an increase in sales of exclusive-labelproducts and other higher-margin products) and continued benefits from low-costsourcing initiatives. This increase was net of a $0.8 million negative impactfrom changes in foreign exchange rates.

 

*BeautySystems Group*.  BSG’s gross profit increased by $18.2million, or 19.6%, for the three months ended June 30, 2010, compared tothe three months ended June 30, 2009, principally as a result of highersales volume and improved gross margins. BSG’s gross profit as a percentage ofnet sales was 40.4% for the three months ended June 30, 2010, compared to39.0% for the three months ended June 30, 2009. This increase wasprincipally the result of a favorable change in the sales mix across thebusiness. This increase also reflects a $1.3 million positive impact fromchanges in foreign exchange rates.

 

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

 

Consolidated selling, general and administrativeexpenses increased by $31.7 million, or 14.3%, to $253.7 million for the threemonths ended June 30, 2010, compared to $222.0 million for the three monthsended June 30, 2009. This increase was attributable to incrementalexpenses (including employee compensation, rent and other occupancy-relatedexpenses) resulting from stores opened and from businesses acquired in thepreceding 12 months, as well as higher share-based compensation expense of $0.9million and higher advertising expenses in the Sally Beauty Supply segment of$2.3 million. Selling, general and administrative expenses, as a percentage ofnet sales, were 34.2% for the three months ended June 30, 2010, comparedto 33.0% for the three months ended June 30, 2009.

 

***Depreciation and Amortization***

 

Consolidated depreciation and amortization was $12.7million for the three months ended June 30, 2010, compared to $11.6million for the three months ended June 30, 2009. This increase reflectsthe incremental expenses associated with businesses acquired in the last 12months and depreciation related to capital expenditures mainly in connectionwith store openings in both operating segments, partially offset by the impactof assets that became fully depreciated in the preceding 12 months.

 

***OperatingEarnings***

 

The following table sets forth, for the periodsindicated, information concerning our operating earnings for each reportablesegment (dollars in thousands):

 
|                             |   | **Three Months Ended June 30,** |       |
|----------------------------------|--------|--------------------------------------|------------|
|                             |   | **2010**                             | ** ** | **2009** | ** ** | **Increase** |   |
| Operating Earnings:              |   |                                 |       |   |   |   |   |   |   |
| Segment operating profit:        |   |                                 |       |   |   |   |   |   |   |
| Sally Beauty Supply              |   | $                                    | 85,116     |   | $ | 76,748 |   | $ | 8,368 |   | 10.9 | % |
| BSG                              |   | 30,086                               |       | 25,632 |   | 4,454 |   | 17.4 | % |
| Segment operating profit         |   | 115,202                              |       | 102,380 |   | 12,822 |   | 12.5 | % |
| Unallocated expenses             |   | (18,348                              | )          | (16,772 | ) | 1,576 |   | 9.4 | % |
| Share-based compensation expense |   | (2,391                               | )          | (1,444 | ) | 947 |   | 65.6 | % |
| Operating earnings               |   | $                                    | 94,463     |   | $ | 84,164 |   | $ | 10,299 |   | 12.2 | % |

 

Consolidated operating earnings increased by $10.3million, or 12.2%, to $94.5 million for three months ended June 30, 2010,compared to $84.2 million for the three months ended June 30, 2009. Theincrease in consolidated operating earnings was due primarily to an increase inthe operating profits of both segments, partially offset by higher unallocatedcorporate expenses and share-based compensation expense, as discussed below.Operating 

 

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earnings, as a percentage of net sales, were 12.7%for the three months ended June 30, 2010, compared to 12.5% for the threemonths ended June 30, 2009.

 

*Sally Beauty Supply*.  Sally Beauty Supply’s segmentoperating earnings increased by $8.4 million, or 10.9%, to $85.1 million forthree months ended June 30, 2010, compared to $76.7 million for the threemonths ended June 30, 2009.  Theincrease in Sally Beauty Supply’s segment operating earnings was primarily aresult of increased sales volume and improved gross margins, partially offsetby higher advertising costs of approximately $2.3 million and the incrementalcosts related to approximately 94 additional company-operated stores (storesopened or acquired during the past twelve months) operating during the threemonths ended June 30, 2010. Segment operating earnings, as a percentage ofnet sales, were 18.2% for the three months ended June 30, 2010, comparedto 17.7% for the three months ended June 30, 2009. The increase, in SallyBeauty Supply’s operating earnings as a percentage of segment net sales, wasprimarily a result of gross margin improvements.

 

*Beauty Systems Group*.  BSG’s segment operating earningsincreased by $4.5 million, or 17.4%, to $30.1 million for the three monthsended June 30, 2010, compared to $25.6 million for the three months ended June 30,2009. Segment operating earnings, as a percentage of net sales, increased to10.9% for the three months ended June 30, 2010, compared to 10.7% for thethree months ended June 30, 2009. The increase in BSG operating earningswas primarily a result of gross margin improvements, the incremental operatingearnings of businesses acquired and stores opened, and to ongoing costreduction initiatives (including cost savings realized from the warehouseoptimization program that began in the fiscal year 2007).

 

*Unallocated expenses.*Unallocatedexpenses, which represent corporate costs (such as payroll, employee benefitsand travel expenses for corporate staff, certain professional fees andcorporate governance expenses) that have not been charged to our operatingsegments, increased by $1.6 million, or 9.4%, to $18.3 million for the threemonths ended June 30, 2010, compared to $16.8 million for the three monthsended June 30, 2009. This increase was due primarily to higher employeecompensation and compensation-related expenses of approximately $0.7 millionand a change in foreign currency transactions of approximately $0.9 millionresulting principally from intercompany notes not permanently invested.

 

*Share-basedCompensation Expense.*Total compensation cost charged against income for share-basedcompensation arrangements increased $0.9 million to $2.4 million for the three months ended June 30, 2010,compared to $1.4 million for the three months ended June 30, 2009. This increase wasmainly due to the higher fair value at the grant date of stock option awardsduring the fiscal year 2010, compared to stock option awards during the fiscalyear 2009.

 

***InterestExpense***

 

Interest expense decreased $2.8 million to $28.3million for the three months ended June 30, 2010, compared to $31.1million for the three months ended June 30, 2009.  Interest expense for the three months ended June 30,2009 is net of interest income of $0.1 million. The decrease in interestexpense was primarily attributable to lower outstanding principal balances onour ABL facility and senior term loans and lower prevailing LIBOR interestrates, partially offset by non-cash income of $2.5 million of marked-to-marketadjustments for certain interest rate swaps (please see Note 8 of the CondensedNotes to Consolidated Financial Statements contained in Item 1 of this report) in the three months ended June 30, 2009 with no comparable amountin 2010.

 

***Provisionfor Income Taxes***

 

Provision for income taxes was $23.9 million duringthe three months ended June 30, 2010, compared to $20.2 million for thethree months ended June 30, 2009. Income taxes for the interim periods ended June 30, 2010 and 2009have been included in the accompanying financial statements on the basis of anestimated annual effective rate.  Theestimated annual effective tax rate (excluding discrete items) is 37.8% for thefiscal year 2010, versus a comparable actual tax rate of 39.0% for the full fiscalyear 2009.  The decrease in the estimatedannual effective tax rate primarily relates to a decrease in losses subject toa valuation allowance.

 

The actual tax rate for the three months ended June 30,2010 is less than the estimated annual effective tax rate (excluding discreteitems) for the fiscal year 2010 primarily because of the impact of discrete taxitems recorded in the three months ended June 30, 2010.

 

***Net Earnings***

 

As a result of the foregoing, consolidated netearnings increased by $9.4 million, or 28.7%, to $42.3 million for the threemonths ended June 30, 2010, compared to $32.9 million for the three monthsended June 30, 2009. Net 

 

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earnings, as a percentage of net sales, were 5.7% forthe three months ended June 30, 2010, compared to 4.9% for the threemonths ended June 30, 2009.

 

***The Nine Months Ended June 30,2010 compared to the Nine Months Ended June 30, 2009***

 

The table below presents net sales, gross profit andgross profit margin data for each reportable segment (dollars in thousands).

 
|                              |   | **Nine  Months Ended June 30,** |       |
|-----------------------------------|--------|--------------------------------------|------------|
|                              |   | **2010**                             | ** ** | **2009** | ** ** | **Increase** |   |
| Net sales:                        |   |                                 |       |   |   |   |   |   |   |
| Sally Beauty Supply               |   | $                                    | 1,359,377  |   | $ | 1,257,607 |   | $ | 101,770 |   | 8.1 | % |
| BSG                               |   | 808,916                              |       | 702,817 |   | 106,099 |   | 15.1 | % |
| Consolidated net sales            |   | $                                    | 2,168,293  |   | $ | 1,960,424 |   | $ | 207,869 |   | 10.6 | % |
|                              |   |                                 |       |   |   |   |   |   |   |
| Gross profit:                     |   |                                 |       |   |   |   |   |   |   |
| Sally Beauty Supply               |   | $                                    | 720,724    |   | $ | 652,445 |   | $ | 68,279 |   | 10.5 | % |
| BSG                               |   | 317,633                              |       | 271,056 |   | 46,577 |   | 17.2 | % |
| Consolidated gross  profit        |   | $                                    | 1,038,357  |   | $ | 923,501 |   | $ | 114,856 |   | 12.4 | % |
|                              |   |                                 |       |   |   |   |   |   |   |
| Gross profit margin:              |   |                                 |       |   |   |   |   |   |   |
| Sally Beauty Supply               |   | 53.0                                 | %          | 51.9 | % | 1.1 | % |   |   |
| BSG                               |   | 39.3                                 | %          | 38.6 | % | 0.7 | % |   |   |
| Consolidated gross  profit margin |   | 47.9                                 | %          | 47.1 | % | 0.8 | % |   |   |

 

***Net Sales***

 

Consolidated net sales increased by $207.9 million,or 10.6%, for the nine months ended June 30, 2010, compared to the ninemonths ended June 30, 2009. Company-operated stores that have been openfor at least 14 months contributed an increase of approximately $140.8 million,or 7.2%, and sales from businesses acquired in the preceding 12 monthscontributed approximately $62.1 million, or 3.2%, more to consolidated salesfor the nine months ended June 30, 2010, compared to the nine months endedJune 30, 2009. Other sales channels (including sales through our BSGdistributor sales consultants and our BSG franchise-based businesses and fromstores that have been open for less than 14 months), in the aggregate,contributed an increase of $5.0 million, or 0.2%, compared to the nine monthsended June 30, 2009. Consolidated net sales for the nine months ended June 30,2010, are inclusive of approximately $21.1 million in positive impact fromchanges in foreign exchange rates.

 

*Sally Beauty Supply*.  Net sales for Sally BeautySupply increased by $101.8 million, or 8.1%, for the nine months ended June 30,2010, compared to the nine months ended June 30, 2009.  In the Sally Beauty Supply segment,company-operated stores that have been open for at least 14 months contributedan increase of approximately $101.4 million, or 8.1%. Net sales for SallyBeauty Supply for the nine months ended June 30, 2010, are inclusive ofapproximately $9.5 million in positive impact from changes in foreign exchangerates.

 

*Beauty Systems Group*.  Net sales for BSG increased by $106.1million, or 15.1%, for the nine months ended June 30, 2010, compared tothe nine months ended June 30, 2009. Company-operated stores that havebeen open for at least 14 months contributed an increase of approximately $39.4million, or 5.6%, sales from stores that have been open for less than 14 monthscontributed an increase of approximately $4.1 million, or 0.6%, and sales frombusinesses acquired in the preceding 12 months contributed approximately $61.8million, or 8.8%, more to net sales 

 

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for the nine months ended June 30, 2010, comparedto the nine months ended June 30, 2009. Other sales channels (includingsales through our distributor sales consultants and our franchise-basedbusinesses), in the aggregate, contributed an increase of $0.8 million, or0.1%, compared to the nine months ended June 30, 2009.  Net sales for BSG for the nine months ended June 30,2010, are inclusive of approximately $11.6 million in positive impact fromchanges in foreign exchange rates.

 

***Gross Profit***

 

Consolidated gross profit increased by $114.9million, or 12.4%, for the nine months ended June 30, 2010, compared tothe nine months ended June 30, 2009, principally due to higher salesvolume and improved gross margins in both business segments as more fullydescribed below.

 

*Sally Beauty Supply*. Sally Beauty Supply’s gross profit increased by $68.3 million, or10.5%, for the nine months ended June 30, 2010, compared to the ninemonths ended June 30, 2009, principally as a result of higher sales volumeand improved gross margins.  Sally BeautySupply’s gross profit as a percentage of net sales increased to 53.0% for thenine months ended June 30, 2010, compared to 51.9% for the nine monthsended June 30, 2009. This increase was the result of a shift in productand customer mix (including an increase in sales of exclusive-label productsand other higher-margin products) and continued benefits from low-cost sourcinginitiatives. This increase also reflects a $4.8 million favorable impact fromchanges in foreign exchange rates.

 

*BeautySystems Group*.  BSG’s gross profit increased by $46.6million, or 17.2%, for the nine months ended June 30, 2010, compared tothe nine months ended June 30, 2009, principally as a result of highersales volume and improved gross margins. BSG’s gross profit as a percentage ofnet sales increased to 39.3% for the nine months ended June 30, 2010,compared to 38.6% for the nine months ended June 30, 2009. This increasewas principally the result of a favorable change in the sales mix across thebusiness. This increase also reflects a $5.0 million favorable impact fromchanges in foreign exchange rates.

 

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

 

Consolidated selling, general and administrativeexpenses increased by $85.9 million, or 13.0%, to $748.0 million for the ninemonths ended June 30, 2010, compared to $662.1 million for the nine monthsended June 30, 2009. This increase was attributable to incrementalexpenses (including employee compensation, rent and other occupancy-relatedexpenses) resulting from stores opened and from businesses acquired in thepreceding 12 months, as well as higher share-based compensation expense of $3.1million, higher advertising expenses in the Sally Beauty Supply segment of $6.0million and acquisition—related expenses of $0.5 million. Please see “RecentAccounting Pronouncements” below for more information about the Company’streatment of acquisition—related expenses. Selling, general and administrativeexpenses, as a percentage of net sales, were 34.5% for the nine months ended June 30,2010, compared to 33.8% for the nine months ended June 30, 2009.

 

***Depreciationand Amortization***

 

Consolidated depreciation and amortization was $37.0million for the nine months ended June 30, 2010, compared to $34.9 millionfor the nine months ended June 30, 2009. This increase reflects theincremental expenses associated with businesses acquired in the last 12 monthsand depreciation related to capital expenditures mainly in connection withstore openings in both operating segments, partially offset by the impact ofassets that became fully depreciated in the preceding 12 months.

 

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***OperatingEarnings***

 

The following table sets forth, for the periodsindicated, information concerning our operating earnings for each reportablesegment (dollars in thousands):

 
|                             |   | **Nine Months Ended June 30,** |       |
|----------------------------------|--------|-------------------------------------|------------|
|                             |   | **2010**                            | ** ** | **2009** | ** ** | **Increase** |   |
| Operating Earnings:              |   |                                |       |   |   |   |   |   |   |
| Segment operating profit:        |   |                                |       |   |   |   |   |   |   |
| Sally Beauty Supply              |   | $                                   | 235,743    |   | $ | 212,413 |   | $ | 23,330 |   | 11.0 | % |
| BSG                              |   | 81,709                              |       | 66,227 |   | 15,482 |   | 23.4 | % |
| Segment operating profit         |   | 317,452                             |       | 278,640 |   | 38,812 |   | 13.9 | % |
| Unallocated expenses             |   | (54,591                             | )          | (45,713 | ) | 8,878 |   | 19.4 | % |
| Share-based compensation expense |   | (9,445                              | )          | (6,336 | ) | 3,109 |   | 49.1 | % |
| Operating earnings               |   | $                                   | 253,416    |   | $ | 226,591 |   | $ | 26,825 |   | 11.8 | % |

 

Consolidated operating earnings increased by $26.8million, or 11.8%, to $253.4 million for the nine months ended June 30,2010, compared to $226.6 million for the nine months ended June 30, 2009.The increase in consolidated operating earnings was due primarily to anincrease in the operating profits of both segments, partially offset by higherunallocated corporate expenses and share-based compensation expense, asdiscussed below. Operating earnings, as a percentage of net sales, were 11.7%for the nine months ended June 30, 2010, compared to 11.6% for the ninemonths ended June 30, 2009.

 

*Sally Beauty Supply*.  Sally Beauty Supply’s segmentoperating earnings increased by $23.3 million, or 11.0%, to $235.7 million forthe nine months ended June 30, 2010, compared to $212.4 million for thenine months ended June 30, 2009. The increase in Sally Beauty Supply’ssegment operating earnings was primarily a result of increased sales volume andimproved gross margins, partially offset by higher advertising costs ofapproximately $6.0 million and the incremental costs related to approximately94 additional company-operated stores (stores opened or acquired during thepast twelve months) operating during the nine months ended June 30,2010.  Segment operating earnings, as apercentage of net sales, increased to 17.3% for the nine months ended June 30,2010, compared to 16.9% for the nine months ended June 30, 2009. Theincrease in Sally Beauty Supply’s operating earnings, as a percentage ofsegment net sales, was primarily a result of gross margin improvements.

 

*Beauty Systems Group*.  BSG’s segment operating earningsincreased by $15.5 million, or 23.4%, to $81.7 million for the nine monthsended June 30, 2010, compared to $66.2 million for the nine months ended June 30,2009. Segment operating earnings, as a percentage of net sales, increased to10.1% for the nine months ended June 30, 2010, compared to 9.4% for thenine months ended June 30, 2009. The increase in BSG operating earningswas primarily a result of gross margin improvements, the incremental operatingearnings of businesses acquired and stores opened, and to ongoing costreduction initiatives (including cost savings realized from the warehouseoptimization program that began in the fiscal year 2007).

 

*Unallocated expenses.*Unallocatedexpenses, which represent corporate costs (such as payroll, employee benefitsand travel expenses for corporate staff, certain professional fees andcorporate governance expenses) that have not been charged to our operatingsegments, increased by $8.9 million, or 19.4%, to $54.6 million for the ninemonths ended June 30, 2010, compared to $45.7 million for the nine monthsended June 30, 2009. This increase was due primarily to higher employeecompensation and compensation-related expenses of approximately $4.4 million, achange in foreign currency transactions of approximately $1.8 million resultingprincipally from intercompany notes not permanently invested, other corporateexpenses of approximately $2.2 million related primarily to recent upgrades toour information technology systems, and acquisition—related expenses ofapproximately $0.5 million (representing legal, professional fees and otherexpenses).

 

*Share-basedCompensation Expense.*Total compensation cost charged against income for share-based compensationarrangements increased $3.1 million to $9.4 million for the nine months ended June 30, 2010,compared to $6.3 million for the nine months ended June 30, 2009. This increase wasdue to the higher fair value at the grant date of stock option awards duringthe nine months ended June 30, 2010, compared to stock option awardsduring the nine months ended June 30, 2009.

 

***InterestExpense***

 

Interest expense decreased $17.6 million to $85.1million for the nine months ended June 30, 2010, compared to $102.7 millionfor the nine months ended June 30, 2009. Interest expense is net of interest income of $0.1 million and $0.3million for the nine months ended June 30, 2010 and 2009, respectively.The decrease in interest expense was primarily attributable to loweroutstanding principal balances on our ABL facility and senior term loans and to

 

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lower prevailing LIBOR interest rates and to a $0.6million favorable change in the fair value of certain interest rate swaps(please see Note 8 of the Condensed Notes to Consolidated Financial Statementscontained in Item 1 of this report).

 

***Provisionfor Income Taxes***

 

Provision for income taxes was $62.8 million duringthe nine months ended June 30, 2010, compared to $48.1 million for thenine months ended June 30, 2009. Income taxes for the interim periods ended June 30, 2010 and 2009have been included in the accompanying financial statements on the basis of anestimated annual effective rate.  Theestimated annual effective tax rate (excluding discrete items) is 37.8% for thefiscal year 2010, versus a comparable actual tax rate of 39.0% for the fullfiscal year 2009.  The decrease in theestimated annual effective tax rate primarily relates to a decrease in lossessubject to a valuation allowance.

 

The actual tax rate for the nine months ended June 30,2010 is lower than the estimated annual effective tax rate (excluding discreteitems) for the fiscal year 2010 primarily because of the impact of discrete taxitems recorded in the nine months ended June 30, 2010.

 

***Net Earnings***

 

As a result of the foregoing, consolidated netearnings increased by $29.7 million, or 39.2%, to $105.5 million for the ninemonths ended June 30, 2010, compared to $75.8 million for the nine monthsended June 30, 2009. Net earnings, as a percentage of net sales, were 4.9%for the nine months ended June 30, 2010, compared to 3.9% for the ninemonths ended June 30, 2009.

 

**FinancialCondition**

 

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

 

Working capital (current assets less currentliabilities) decreased $2.6 million to $313.3 million at June 30, 2010,compared to $315.9 million at September 30, 2009. The ratio of currentassets to current liabilities was 1.74 to 1.00 at June 30, 2010, comparedto 1.79 to 1.00 at September 30, 2009. The decrease in working capitalreflects an increase of $19.6 million in current assets and an increase of$22.2 million in current liabilities. The increase in current assets as of June 30, 2010 includes anincrease of $26.9 million in inventory levels, an increase of $8.5 million intrade accounts receivable, an increase of $5.8 million in other receivables andan increase of $4.4 million in prepaid expenses, partially offset by areduction of $26.1 million in cash and cash equivalents.  The increase in current liabilities as of June 30,2010 includes an increase of $19.4 million in accounts payable and accruedliabilities and an increase of $10.8 million in the amount due to Sally Beauty,partially offset by a reduction of $10.0 million in current maturities oflong-term debt.

 

Inventory increased $26.9 million to $586.6 millionat June 30, 2010, compared to $559.7 million at September 30, 2009due primarily to the effect of stores opened and businesses acquired in thepreceding 12 months, partially offset by the effect of foreign currencytranslation adjustments of approximately $8.9 million. Trade accountsreceivable increased $8.5 million to $52.2 million at June 30, 2010,compared to $43.6 million at September 30, 2009 due primarily to theincrease in sales activity and to businesses acquired. Other receivablesincreased $5.8 million to $29.9 million at June 30, 2010, compared to$24.1 million at September 30, 2009 due primarily to accrued vendorrebates and to businesses acquired. Prepaid expenses increased $4.4 million to$22.6 million at June 30, 2010, compared to $18.3 million at September 30,2009 due primarily to the timing of store rent and business insuranceprepayments and to businesses acquired.

 

Accounts payable increased $30.1 million to $223.7million at June 30, 2010, compared to $193.6 million at September 30,2009 due primarily to businesses acquired and the timing of payments tosuppliers in connection with recent purchases of merchandise inventory. Accruedliabilities decreased $10.7 million to $143.1 million at June 30, 2010,compared to $153.8 million at September 30, 2009 due primarily to thetiming of payments of interest on long-term debt, partially offset bybusinesses acquired. The amount due to Sally Beauty increased $10.8 million to$32.8 million at June 30, 2010, compared to $22.0 million at September 30,2009 due primarily to an increase in the federal income tax liability of theCompany and its consolidated subsidiaries and to share-based compensationexpense, partially offset by corporate expenses (such as board of directorexpenses, professional fees and other public company expenses) paid on behalfof our indirect parent Sally Beauty.

 

Long-term debt, including current portion, decreased$90.8 million to $1,586.7 million at June 30, 2010, compared to $1,677.5million at September 30, 2009 due primarily to prepayments of $105.0million (including a mandatory prepayment of $22.3 million — please see “Liquidityand Capital Resources” below) on our senior Term Loan A, partially offset bythe pre-acquisition indebtedness, including capital leases, of Sinelco.

 

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Total member’s deficit, for the nine months ended June 30,2010, decreased by $83.4 million primarily as a result of net earnings of$105.5 million, partially offset by foreign currency translation adjustments of$21.9 million.

 

**Liquidityand Capital Resources**

 

We broadly define liquidity as our ability to generatesufficient cash flow from operating activities to meet our obligations andcommitments. In addition, liquidity includes the ability to obtain appropriatedebt and equity financing and to convert into cash those assets that are nolonger required to meet existing strategic and financial objectives. Therefore,liquidity cannot be considered separately from capital resources that consistof current or potentially available funds for use in achieving long-rangebusiness objectives and meeting debt service commitments. Please see our AnnualReport on Form 10-K for the fiscal year ended September 30, 2009 foradditional information on liquidity and capital resources.

 

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 primarilyin connection 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 pay ourobligations and expenses. Please see “Risk Factors—Risks Relating to OurBusiness,” and “—Risks Relating to Our Substantial Indebtedness” in Item 1A ofour Annual Report on Form 10-K for the fiscal year ended September 30,2009.

 

The senior term loan facilities may be prepaid at theoption of the Company at any time without premium or penalty and are subject tomandatory prepayment in an amount equal to 50% of excess cash flow (as definedin the agreement governing the term loan facilities) for any fiscal year unlessa specified leverage ratio is met. In January 2010, the Company made amandatory prepayment on the senior term loan facilities in the amount of $22.3million. Amounts paid pursuant to said provision may be applied, at the optionof the Company, against minimum loan repayments otherwise required of us overthe twelve-month period following any such payment under the terms of the loanagreement.

 

During the nine months ended June 30, 2010, theCompany also made optional prepayments in the aggregate amount of $82.7 millionon its senior term loans. This amount includes $54.7 million prepaid during thequarter ended June 30, 2010 and, together with the mandatory prepaymentdiscussed in the preceding paragraph, resulted in the prepayment in full ofborrowings under the Term Loan A facility. In connection with the mandatoryprepayment discussed in the preceding paragraph and the optional prepaymentsmade during the nine months ended June 30, 2010, the Company recordedlosses on extinguishment of debt in the aggregate amount of $0.8 million, whichare included in interest expense in the Company’s consolidated statements ofearnings.

 

Based upon the current level of operations andanticipated growth, we anticipate that existing cash balances, funds expectedto be generated by operations and funds available under the ABL facility willbe sufficient to meet our working capital requirements and to financeanticipated capital expenditures and potential acquisitions over the next 12months.

 

There can be no assurance that our business willgenerate sufficient cash flows from operations, that anticipated net salesgrowth and operating improvements will be realized or that future borrowingswill be available under our ABL facility in an amount sufficient to enable usto service our indebtedness or to fund our other liquidity needs. In addition,our ability to meet our debt service obligations and liquidity needs aresubject to certain risks, which include, but are not limited to, increases incompetitive activity, the loss of key suppliers, rising interest rates, theloss of key personnel, the ability to execute our business strategy and generaleconomic conditions. Please see “Risk Factors” in Item 1A of our Annual Report on Form 10-K for the yearended September 30, 2009.

 

Weutilize our ABL facility for the issuance of letters of credit, as well as tomanage normal fluctuations in operational cash flow. In that regard, we mayfrom time to time draw funds under the revolving credit facility for generalcorporate purposes including acquisitions and interest payments due on ourindebtedness.  The funds drawn on individual occasions duringthe nine months ended June 30, 2010 have varied in amounts of up to $30.0**million, with total amounts outstandingranging from zero up to $53.5 million. The amounts drawn are generally paiddown with cash provided by our operating activities.

 

Asof June 30, 2010, we had $341.5 million available for additionalborrowings under our ABL facility, subject to borrowing base limitations, asreduced by outstanding letters of credit.

 

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

 

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marketconditions, trading levels of the Company’s debt from time to time, the Company’scash position and other considerations.

 

We are a holding company and do not have any materialassets or operations other than ownership of equity interests of oursubsidiaries.  The agreements andinstruments governing our debt contain material limitations on our ability topay dividends and other restricted payments to our indirect parent, SallyBeauty.

 

Under the agreements and indentures governing the termloan facilities and the notes, we may not make certain restricted payments toSally Beauty if a default then exists under the credit agreement or the indenturesor if our consolidated interest coverage ratio is less than 2.0 to 1.0 at thetime of the making of such restricted payment. As of June 30, 2010, our consolidated interest coverage ratioexceeded 2.0 to 1.0.  Further, theaggregate amount of restricted payments we are able to make is limited pursuantto various baskets as calculated pursuant to the credit agreement andindentures.

 

The agreements governing our ABL facility generallypermit the making of distributions and certain other restricted payments solong as borrowing availability under the facility equals or exceeds $60.0million. If borrowing availability falls below this amount, we may neverthelessmake restricted payments to Sally Beauty in the aggregate since the date of theSeparation Transactions, together with the aggregate cash amounts paid inacquisitions since said date, of not greater than $50.0 million, together withcertain other exceptions.  As of June 30,2010, borrowing availability under the ABL facility exceeded $60.0 million.  As of June 30, 2010, the net assets ofthe Company and its consolidated subsidiaries that were unrestricted fromtransfer under our credit arrangements totaled $284.4 million, subject tocertain adjustments. The ABL facility and the senior term loan facilities, aswell as the Company’s 9.25% Senior Notes indenture and its 10.5% SeniorSubordinated Notes indenture contain customary cross-default and/orcross-acceleration provisions.

 

On December 16, 2009, the Company acquiredSinelco, a wholesale distributor of professional beauty products based inRonse, Belgium, for approximately €25.2 million (approximately $36.6 million).Sinelco serves over 1,500 customers through a product catalog and website andhas sales throughout Europe. Goodwill of $17.2 million was recorded as a resultof this acquisition. In addition, during the nine months ended June 30,2010, the Company completed several other individually immaterial acquisitionsat an aggregate cost of $5.3 million and recorded goodwill in the amount of$3.1 million. We funded these acquisitions with cash from operations andborrowings under our ABL facility. As of June 30, 2010, borrowings underour ABL facility were $5.0 million.

 

Our primary source of cash has been from fundsprovided by operating activities and borrowings under our ABL facility for thenine months ended June 30, 2010 and 2009. Historically, our primary use ofcash has been for acquisitions, capital expenditures and repayments of debt.The following table shows our sources and uses of funds for the nine monthsended June 30, 2010 and 2009 (in thousands):

 
| ** **                                                     | ** ** | **Nine Months Ended****June 30,** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                     | ** ** | **2010**                                    | ** ** | **2009** | ** ** |
| Net cash provided by  operating activities                     |       | $                                           | 147,982    |   | $ | 164,456 |   |
| Net cash used by investing  activities                         |       | (70,346                                     | )          | (28,130 | ) |
| Net cash used by financing  activities                         |       | (101,966                                    | )          | (129,953 | ) |
| Effect of foreign exchange  rates on cash and cash equivalents |       | (1,814                                      | )          | (219 | ) |
| Net (decrease) increase in  cash and cash equivalents          |       | $                                           | (26,144    | ) | $ | 6,154 |   |

 

*NetCash Provided by Operating Activities*

 

Net cash provided by operating activities (whichexcludes cash used for acquisitions completed during the period) during thenine months ended June 30, 2010 decreased by $16.5 million to$148.0 million, compared to $164.5 million during the nine monthsended June 30, 2009. The decrease was primarily due to changes ininventory levels of approximately $54.5 million (resulting from reductions ininventory levels in the nine months ended June 30, 2009 and increases ininventory levels in the nine months ended June 30, 2010) and in accountspayable and accrued liabilities of approximately $6.9 million, partially offsetby changes in income taxes payable of $7.2 million and in amounts due to SallyBeauty of $4.1 million, and by an improvement in earnings of approximately$29.7 million for the nine months ended June 30, 2010 compared to the ninemonths ended June 30, 2009.

 

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*NetCash Used by Investing Activities*

 

Net cash used by investing activities during the ninemonths ended June 30, 2010 increased by $42.2 million to$70.3 million, compared to $28.1 million during the nine months endedJune 30, 2009.  This increase wasdue to an increase of $32.5 million in cash used for acquisitions, net of cashacquired, and a $9.7 million increase in capital expenditures (primarily as aresult of more store openings) for the nine months ended June 30, 2010compared to the nine months ended June 30, 2009.

 

*NetCash Used by Financing Activities*

 

Net cash used by financing activities during thenine months ended June 30, 2010 decreased by $28.0 million to cash used of$102.0 million, compared to $130.0 million during the nine monthsended June 30, 2009.  The decreasewas primarily due to net repayments of debt of $102.0 million, including theprepayment in full of our Term Loan A, during the nine months ended June 30,2010 compared to $128.2 million during the nine months ended June 30,2009.

 

**Capital Requirements**

 

During the nine months ended June 30, 2010,capital expenditures were $36.0 million. For fiscal year 2010, we anticipatetotal capital expenditures in the range of approximately $45.0 million to $50.0million, excluding acquisitions. We expect that capital expenditures will beprimarily for the addition of new stores and the remodeling, expansion and/orrelocation of existing stores in the ordinary course of our business as well ascertain corporate projects.

 

**ContractualObligations**

 

There have been no material changes outside theordinary course of business in any of our contractual obligations since September 30,2009.

 

**Off-BalanceSheet Financing Arrangements**

 

At June 30, 2010 and September 30, 2009, wehad no off-balance sheet financing arrangements other than operating leasesincurred in the ordinary course of business, as well as outstanding letters ofcredit related to inventory purchases and self insurance programs. Such lettersof credit totaled $14.3 million and $13.4 million at June 30, 2010 and September 30,2009, respectively.

 

**Inflation**

 

We believe that inflation currently does not have amaterial effect on our results of operations.

 

**CriticalAccounting Policies and Estimates**

 

The preparation of financial statements in conformitywith GAAP requires us to make estimates and assumptions that affect the reportedamounts of assets, liabilities, revenues and expenses and disclosure ofcontingent assets and liabilities in the financial statements. Actual resultsmay differ from these estimates. We believe these estimates and assumptions arereasonable. We consider accounting policies to be critical when they require usto make assumptions about matters that are highly uncertain at the time theaccounting estimate is made and when the use of different estimates that ourmanagement reasonably could have used could have a material effect on thepresentation of our financial condition, changes in financial condition orresults of operations.

 

Our critical accounting policies, as described in ourAnnual Report on Form 10-K for the fiscal year ended September 30,2009, include but are not limited to the valuation of inventory, vendorconcessions, retention of risk, income taxes, long-lived assets impairmentassessment, share-based payments, and related party transactions. There havebeen no material changes to our critical accounting policies, estimates orassumptions since September 30, 2009.

 

As required by ASC 815,*Derivativesand Hedging*, as amended, the Company records all derivativeinstruments on its balance sheet at fair value.  The accounting forchanges in the fair value of derivative instruments depends on the intended useof the derivative, whether the Company has elected to designate a derivativeinstrument in a hedging relationship and apply hedge accounting and whether thehedging relationship has satisfied the criteria necessary to apply hedgeaccounting. Derivative instruments designated and qualifying as a hedge of theexposure to variability in expected future cash flows, or other types offorecasted transactions, are considered cash flow hedges. Hedge accountinggenerally provides for the matching of the timing of gain or loss recognitionon the hedging instrument with the recognition of the impact on earnings of thehedged transaction or transactions. The Company may from time to time enterinto derivative contracts that are intended to hedge certain economic riskseven though hedge accounting does not apply or the Company elects not to applyhedge accounting to such derivative contracts.

 

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The Company has adopted the provisions of ASC 820 asit relates to its financial instruments. ASC 820, as amended, establishes a three-level hierarchy for measuringfair value and requires an entity to maximize the use of observable inputs andminimize the use of unobservable inputs when measuring fair value. Thisvaluation hierarchy is based upon the transparency of inputs to the valuationof an asset or liability on the measurement date.  The three levels of that hierarchy aredefined as follows:

 

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

 

Level 2 -Unadjusted quoted prices in active markets for similar assets or liabilities;or unadjusted quoted prices for identical or similar assets or liabilities inmarkets that are not active; or inputs other than quoted prices that areobservable for the asset or liability; or inputs that are derived principallyfrom or corroborated by observable market data; and

 

Level 3 -Unobservable inputs for the asset or liability.

 

The Company measures certain financial instruments atfair value on a recurring basis, including interest rate swaps and foreigncurrency options. In accordance with ASC 820, the Company categorized certainof its financial assets and liabilities based on priority of the inputs to thevaluation technique for the instruments, as follows (in thousands):

 
| ** **                      | ** ** | **As of June 30, 2010** | ** ** |
|---------------------------------|------------|------------------------------|------------|
| ** **                      | ** ** | **Total**                    | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Assets                          |       |                         |       |   |   |   |   |   |   |
| Foreign currency options  (b)   |       | $                            | 458        |   |   |   | $ | 458 |   |   |   |
| Total assets                    |       | $                            | 458        |   |   |   | $ | 458 |   |   |   |
|                            |       |                         |       |   |   |   |   |   |   |
| Liabilities                     |       |                         |       |   |   |   |   |   |   |
| Long-term debt (a)              |       | $                            | 1,582,653  |   | $ | 737,625 |   | $ | 845,028 |   |   |   |
| Hedged interest rate swaps  (b) |       | 15,750                       |       | — |   | 15,750 |   |   |   |
| Total liabilities               |       | $                            | 1,598,403  |   | $ | 737,625 |   | $ | 860,778 |   |   |   |

 

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(a)   Long-term debt, which is carried at amortized cost in the Company’sfinancial statements, is valued using internal models based on marketobservable inputs, except for the senior and senior subordinated notes. Thesenior and senior subordinated notes are valued using quoted market prices forsuch debt securities.

(b)   Interest rate swaps and foreign currency options are valued usinginternal models based on market observable inputs, including market interestrates and foreign currency exchange rates, as appropriate. Please see Note 8 ofthe Condensed Notes to Consolidated Financial Statements contained in Item 1 ofthis report for more information about the Company’s interest rate swaps andforeign currency options.

 

**Recent Accounting Pronouncements**

 

In December 2007, the FASB revised the accountingstandards for business combinations. This new standard (currently contained inASC 805, *Business Combinations*(“ASC 805”)),among other things, generally requires that an acquirer recognize the assetsacquired and liabilities assumed measured at their “full fair values” on theacquisition date. This practice replaced the practice, under predecessoraccounting standards, of allocating the cost of an acquisition to theindividual assets acquired and liabilities assumed based on their relativeestimated fair values.  This new standardfurther requires that acquisition-related costs be recognized separately fromthe related acquisition. The Company adopted this standard during the firstquarter of the fiscal year 2010. Selling, general and administrative expensesfor the nine months ended June 30, 2010 includes approximately $0.5million of expenses related to acquisitions.

 

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

 

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

 

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

 

The Company adopted the provisions of ASC 855,Subsequent Events (“ASC 855”), during the third quarter of the fiscal year2009. ASC 855 establishes standards of accounting for and disclosure oftransactions and events that occur after the balance sheet date but before thefinancial statements are issued and requires the disclosure, among otherthings, of the date through which an entity has evaluated subsequent events. InFebruary 2010, the FASB issued ASU No. 2010-09 which amended ASC 855.This amendment, which was effective upon issuance, removed the requirement forSEC registrants to disclose the date through which such registrants haveevaluated subsequent events.

 

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

 

As a multinational corporation, we are subject tocertain market risks including foreign currency fluctuations, interest ratesand government actions. We consider a variety of practices to manage thesemarket risks, including, when deemed appropriate, the occasional use ofderivative financial instruments.

 

**Foreigncurrency exchange rate risk**

 

We are exposed to potential gains or losses fromforeign currency fluctuations affecting our net investments in subsidiaries andearnings denominated in foreign currencies. Our primary exposures are tochanges in exchange rates for the U.S. dollar versus the British poundsterling, the Canadian dollar, the Euro, the Chilean peso, and the Mexicanpeso. Our various foreign currency exposures at times offset each otherproviding a natural hedge against foreign currency risk. For fiscal year 2009,2008 and 2007, approximately 16%, 18% and 16%, respectively, of our sales weremade in currencies other than the U.S. dollar. Consolidated net sales for thenine months ended June 30, 2010, reflect approximately $21.1 million inpositive impact from changes in foreign currency exchange rates. In addition,for the nine months ended June 30, 2010, other comprehensive incomereflects $21.9 million in foreign currency translation adjustments.Fluctuations in the U.S. dollar exchange rates did not otherwise have amaterial effect on our consolidated financial condition and consolidatedresults of operations.

 

As a result of the Company’s acquisition of Sinelco onDecember 16, 2009, the Company, through Sinelco, uses foreign currencyoptions (including, at June 30, 2010, foreign currency put options with anaggregate notional amount of €2.9 million ($3.6 million, at the June 30,2010 exchange rate) and foreign currency call options with an aggregatenotional amount of €1.8 million ($2.2 million, at the June 30, 2010exchange rate)) to manage the exposure to certain non-Euro currencies resultingfrom Sinelco’s purchases of merchandise from third-party suppliers. Sinelco’sfunctional currency is the Euro. These foreign currency option agreements arenot designated as hedges and do not meet the hedge accounting requirements ofASC 815. Accordingly, the changes in fair valueof these derivative instruments (which are adjusted quarterly) are recorded inour consolidated statements of earnings. Included in selling, general andadministrative expenses are gains of $0.4 millionand $0.7 millionrelated to these foreign currency options, including marked-to-marketadjustments, for the three and nine months ended June 30, 2010,respectively. During the nine monthsended June 30, 2010, these derivative instruments did not have a materialimpact in results of operations or cash flows.

 

A 10% increase or decrease in the exchange rates forthe U.S. dollar versus the foreign currencies to which we have exposure wouldhave impacted consolidated net sales by approximately 1.7% in the nine months ended June 30, 2010 andwould have impacted consolidated net assets by 2.5% at June 30, 2010.

 

**Interestrate risk**

 

As a result of the debt financing incurred inconnection with the Separation Transactions, we are subject to interest ratemarket risk in connection with our long-term debt. The principal interest rateexposure relates to amounts borrowed under the term loans and the ABL facility.Based on the approximately $868.9 million of aggregate 

 

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borrowings under the Company’s term loans and the ABLfacility as of June 30, 2010, a change in the estimated interest rate upor down by 1/8% would increase or decrease earnings before provision for incometaxes by approximately $1.1 million on an annual basis, without considering theeffect of any interest rate swap agreements we may have from time to time.

 

We and certain of our subsidiaries 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 to timeenter into and maintain derivative instruments, such as interest rate swapagreements, for periods consistent with the related underlying exposures. We donot purchase or hold any derivative instruments for speculative or tradingpurposes.

 

In November 2006, weentered into four interest rate swap agreements with an aggregate notionalamount of $500 million. Interest rate swap agreementswith an aggregate notional amount of $150 million expired in November 2008and agreements with a notional amount of $350 million expired in November 2009.These interest rate swap agreements did notqualify as hedges and, therefore, the change in the fair value of theseagreements, which were adjusted quarterly, were recorded in interest expense inthe Company’s results of operations.

 

In May 2008, we entered into two additionalinterest rate swap agreements with anaggregate notional amount of $300 million (each agreementwith a notional amount of $150 million). These agreements expire on May 31,2012 and enable us to convert a portion of our variable interest rateobligations to fixed rate obligations with interest ranging from 5.818% to6.090%.  These agreements are designatedas effective cash flow hedges, in accordance with ASC 815.  Accordingly, changes in the fair value ofthese derivative instruments are recorded quarterly, net of income tax, inaccumulated other comprehensive (loss) income (“OCI”) until the hedgedobligation is settled or the swap agreements expire, whichever is earlier. Anyhedge ineffectiveness, as this term is used in ASC 815, is recognized ininterest expense in our consolidated statements of earnings.

 

**Credit risk**

 

We are exposed to credit risk on certain assets,primarily cash equivalents, short-term investments and accounts receivable. Webelieve that the credit risk associated with cash equivalents and short-terminvestments, if any, is largely mitigated by our policy of investing in adiversified portfolio of securities with high credit ratings.

 

We provide credit to customers in the ordinary courseof business and perform ongoing credit evaluations. We believe that ourexposure to concentrations of credit risk with respect to trade receivables islargely mitigated by our broad customer base. We believe our allowance fordoubtful accounts, as of June 30, 2010, is sufficient to cover customercredit risks.

 

**Item 4.  Controls and Procedures.**

 

*Controls Evaluation and Related CEO and CFO Certifications.*  Our management, with the participation of our principalexecutive officer (“CEO”) and principal financial officer (“CFO”), conducted anevaluation of the effectiveness of the design and operation of our disclosurecontrols and procedures as of the end of the period covered by this report. Thecontrols evaluation was conducted by our Disclosure Committee, comprised ofsenior representatives from our finance, accounting, internal audit, and legaldepartments under the supervision of our CEO.

 

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

 

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

 

*Scope of the Controls Evaluation.*  The evaluation of our disclosure controls and proceduresincluded a review of their objectives and design, our implementation of thecontrols and procedures and the effect of the controls and 

 

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procedureson the information generated for use in this report. In the course of theevaluation, we sought to identify whether we had any data errors, controlproblems or acts of fraud and to confirm that appropriate corrective action,including process improvements, was being undertaken if needed. This type ofevaluation is performed on a quarterly basis so that conclusions concerning theeffectiveness of our disclosure controls and procedures can be reported in ourQuarterly Reports on Form 10-Q and our Annual Reports on Form 10-K.Many of the components of our disclosure controls and procedures are alsoevaluated by our internal audit department, our legal department and bypersonnel in our finance organization. The overall goals of these variousevaluation activities are to monitor our disclosure controls and procedures onan ongoing basis and to maintain them as dynamic systems that change asconditions warrant.

 

*Conclusions regarding Disclosure Controls.*  Based on the required evaluation of our disclosure controlsand procedures, our CEO and CFO have concluded that, as of June 30, 2010,we maintain disclosure controls and procedures that are effective in providingreasonable assurance that information required to be disclosed by us in thereports that we file or submit under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules andforms, and that such information is accumulated and communicated to ourmanagement, including our CEO and CFO, as appropriate to allow timely decisionsregarding required disclosure.

 

*Changes in Internal Control overFinancial 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.  Legal Proceedings.**

 

There were no material legal proceedings pendingagainst us or our subsidiaries as of June 30, 2010. We are involved invarious claims and lawsuits incidental to the conduct of our business in theordinary course. We carry insurance coverage in such amounts in excess of ourself-insured retention as we believe to be reasonable under the circumstancesand that may or may not cover any or all of our liabilities in respect ofclaims and lawsuits. We do not believe that the ultimate resolution of thesematters will have a material adverse impact on our consolidated financialposition, cash flows or results of operations.

 

We are subject to a number of federal, state and locallaws and regulations, as well as the laws and regulations applicable in eachother marketplace in which we do business. These laws and regulations govern,among other things, the composition, packaging, labeling and safety of theproducts we sell, the methods we use to sell these products and the methods weuse to import these products. We believe that we are in material compliancewith such laws and regulations, although no assurance can be provided that thiswill remain true going forward.

 

On February 25,2008, Sally Beauty disclosed in a Current Report on Form 8-K that on February 21,2008, L’Oreal filed a lawsuit in the Superior Court of the State of Californiain and for the County of San Diego — Central Division naming, among others, SDHair, Ltd. and Hair of Nevada, LLC (collectively, “SD Hair”), franchiseesof our subsidiary Armstrong McCall division (“AMLP”) of our BSG business unit,as defendants.  The suit alleged, among other things, that SD Hairbreached its franchise agreement with AMLP by diverting (selling) Matrixbranded products to unauthorized buyers, and that L’Oreal is entitled to makeclaims against SD Hair under the franchise agreement as a third-partybeneficiary of that agreement. On March 24, 2008, SD Hair filed across-complaint in the same case naming AMLP and BSG as cross-defendants,seeking, among other things, i) declaratory relief from BSG and AMLP in theform of a judicial finding that SD Hair is not in breach of its franchise agreement and that L’Oreal hasno rights as a third-party beneficiary to SD Hair’s franchise agreement, andii) injunctive relief in the form of a judicial order compelling AMLP and BSGto take appropriate legal action against L’Oreal to enforce SD Hair’s claimedrights under AMLP’s Matrix distribution agreement. We have answered thecross-complaint.

 

On July 30, 2009, Sally Beauty disclosed in aCurrent Report on Form 8-K that L’Oreal filed a Second Amended Complaintin connection with the previously disclosed lawsuit described above.  The Second Amended Complaint alleges, amongother things, that AMLP, certain of its employees andothers were involved in selling Matrix branded products to unauthorized buyersand that certain of its employees (and others) engaged in improper businesstransactions for personal benefit during 2005 through 2007. L’Oreal seeks moneydamages, certain injunctive relief and a declaration that L’Oreal is entitledto terminate the 1981 Matrix Distributor Agreement now in effect between L’Orealand AMLP. None of the employees involved in the allegations are executiveofficers of the Company or Sally Beauty. Substantially all of these allegations were made known by L’Orealto Sally Beauty prior to the filing of the Second Amended Complaint. L’Orealalso provided Sally Beauty with documents allegedly supporting the allegations.

 

Asa result of these allegations made by L’Oreal, many of which areincorporated into the Second Amended Complaint, the Audit Committee of the Boardof Directors of Sally Beauty engaged independent special counsel to investigatewhether certain employees engaged in improper business transactions forpersonal benefit. After extensive review, the Audit Committee and independentspecial counsel found insufficient evidence to support a conclusion thatemployees of the Company or Sally Beauty entered into improper transactions forpersonal benefit.

 

OnSeptember 8, 2009, AMLP and BSG filed a cross-complaint against L’Oreal. Inthe cross-complaint, AMLP and BSG allege that L’Oreal does not have a genuineinterest in stopping diversion, and that L’Oreal’s anti-diversion policies havebeen discriminatorily applied to AMLP and BSG. AMLP further allegesthat L’Oreal is using diversion as a pretext to attempt to terminate the 1981Matrix Distributor Agreement. L’Oreal has answered the cross-complaint and thematter is currently set for jury trial on February 18, 2011.

 

**Items 1A.  Risk Factors.**

 

In addition to the other information set forth inthis report, you should carefully consider the factors contained in Part I, Item1A. “Risk Factors” in our Annual Report on Form 10-K for the fiscal yearended September 30, 2009, 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.

 

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**Item 2.  Unregistered Sales of Equity Securities andUse of Proceeds.**

 

(a) Not applicable

 

(b) Not applicable

 

(c) Not applicable

 

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

 

Not applicable

 

**Item 4.  Submission of Matters to a Vote of SecurityHolders.**

 

Not applicable

 

**Item 5.  Other Information.**

 

(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 herein by reference from Exhibit 2.1 to Amendment  No. 3 to the Registration Statement on Form S-4 of New Sally  Holdings, Inc. (File No. 333-136259) filed on October 10,  2006†                                                               |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 2.2                  |       | First Amendment to the Investment Agreement, dated  as of October 3, 2006, among Alberto-Culver Company, New Aristotle  Company, Sally Holdings, Inc., New Sally Holdings, Inc. and CDRS  Acquisition LLC, which is incorporated herein by reference from  Exhibit 2.2 to Amendment No. 3 to the Registration Statement on  Form S-4 of New Sally Holdings, Inc. (File No. 333-136259)  filed on October 10, 2006†                                      |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 2.3                  |       | Second Amendment to the Investment Agreement, dated  as of October 26, 2006, among Alberto-Culver Company, New Aristotle  Company, Sally Holdings, Inc., New Sally Holdings, Inc. and CDRS  Acquisition LLC, which is incorporated herein by reference from  Exhibit 2.02 to the Current Report on Form 8-K of New Sally  Holdings, Inc. filed on October 30, 2006†                                                                                               |
|                 | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 2.4                  |       | Separation Agreement, dated as of June 19,  2006, among Alberto-Culver Company, Sally Holdings, Inc., New Sally  Holdings, Inc. and New Aristotle Holdings, Inc., which is  incorporated herein by reference from Exhibit 2.3 to Amendment  No. 3 to the Registration Statement on Form S-4 of New Sally  Holdings, Inc. (File No. 333-136259) filed on October 10,  2006†                                                                         |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 2.5                  |       | First Amendment to the Separation Agreement, dated  as of October 3, 2006, among Alberto-Culver Company, Sally  Holdings, Inc., New Sally Holdings, Inc. and New Aristotle  Holdings, Inc., which is incorporated herein by reference from  Exhibit 2.4 to Amendment No. 3 to the Registration Statement on  Form S-4 of New Sally Holdings, Inc. (File No. 333-136259)  filed on October 10, 2006†                                                |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 2.6                  |       | Second Amendment to the Separation Agreement, dated  as of October 26, 2006, among Alberto-Culver Company, Sally  Holdings, Inc., New Sally Holdings, Inc. and New Aristotle  Holdings, Inc., which is incorporated herein by reference from  Exhibit 2.01 to the Current Report on Form 8-K of New Sally Holdings, Inc.  filed on October 30, 2006†                                                                                                         |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 2.7                  |       | Agreement and Plan of Merger by and among Beauty  Systems Group LLC, Lady Lynn Enterprises, Inc., Schoeneman Beauty  Supply, Inc., the Shareholders and F. Dale Schoeneman, dated  September 30, 2009, which is incorporated herein by reference from  Exhibit 10.27 to the Annual Report on Form 10-K of Sally Beauty  Holdings, Inc. filed on November 19, 2009†                                                                                                |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 3.1                  |       | Certificate of Formation of Sally Holdings LLC,  which is incorporated herein by reference from Exhibit 3.1 to the  Registration Statement on Form S-4 (File No. 333-144427) of Sally  Holdings LLC and Sally Capital Inc. filed on July 9, 2007                                                                                                                                                                                                                                      |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 3.2                  |       | Limited Liability Company Agreement of Sally  Holdings LLC, which is incorporated herein by reference from Exhibit 3.2  to the Registration Statement on Form S-4 (File No. 333-144427) of  Sally Holdings LLC and Sally Capital Inc. filed on July 9, 2007                                                                                                                                                                                                                           |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 4.1                  |       | Stockholders Agreement, dated as of  November 16, 2006, by and among Sally Beauty Holdings, Inc., CDRS  Acquisition LLC, CD&R Parallel Fund VII, L.P. and the other stockholders  party thereto, which is incorporated herein by reference from  Exhibit 4.8 to the Current Report on Form 8-K of Sally Beauty  Holdings, Inc. filed on November 22, 2006                                                                                                               |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 4.2                  |       | First Amendment to the Stockholders Agreement, dated  as of December 13, 2006, between Sally Beauty Holdings, Inc., 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 herein by reference from Exhibit 4.1 to the  Current Report on Form 8-K of Sally Beauty Holdings, Inc. filed on  November 22, 2006                                    |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 4.4                  |       | First Supplemental Indenture, dated as of  May 30, 2007, by and among Sally Holdings LLC and Sally Capital Inc., as  co-Issuers, the Subsidiary Guarantors named therein, and Wells Fargo Bank,  National Association, as trustee, governing the 9.25% Senior Notes due 2014,  which is incorporated herein by reference from Exhibit 4.2 from the  Registration Statement on Form S-4 (File No. 333-144427) of Sally  Holdings LLC and Sally Capital Inc. filed on July 9, 2007 |

 

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| 4.5    |   | Indenture, dated as of November 16, 2006, by  and among Sally Holdings LLC and Sally Capital Inc., as Co-Issuers, the  Subsidiary Guarantors from time to time parties thereto, and Wells Fargo  Bank, National Association, as Trustee, governing the 10.5% Senior  Subordinated Notes due 2016, which is incorporated herein by reference from  Exhibit 4.2 to the Current Report on Form 8-K of Sally Beauty  Holdings, Inc. filed on November 22, 2006                                                                                                                                                                                                                                                                   |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.6    |   | First Supplemental Indenture, dated as of  May 30, 2007, by and among Sally Holdings LLC and Sally Capital Inc., as  co-Issuers, the Subsidiary Guarantors named therein, and Wells Fargo Bank,  National Association, as trustee, governing the 10.5% Senior Subordinated  Notes due 2016, which is incorporated herein by reference from  Exhibit 4.4 from the Registration Statement on Form S-4 (File  No. 333-144427) of Sally Holdings LLC and Sally Capital Inc. filed on  July 9, 2007                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.7    |   | Exchange and Registration Rights Agreement, dated as  of November 16, 2006, by and among Sally Holdings LLC, Sally Capital  Inc., the Subsidiary Guarantors parties thereto, Merrill Lynch, Pierce,  Fenner & Smith, Incorporated and the other financial  institutions named therein, relating to the 9.25% Senior Notes due 2014,  which is incorporated herein by reference from Exhibit 4.3 to the  Current Report on Form 8-K of Sally Beauty Holdings, Inc. filed on  November 22, 2006                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.8    |   | Exchange and Registration Rights Agreement, dated as  of November 16, 2006, by and among Sally Holdings LLC, Sally Capital  Inc., the Subsidiary Guarantors parties thereto, Merrill Lynch, Pierce,  Fenner & Smith, Incorporated and the other financial  institutions named therein, relating to the 10.5% Senior Subordinated Notes  due 2016, which is incorporated herein by reference from Exhibit 4.4 to  the Current Report on Form 8-K of Sally Beauty Holdings, Inc. filed  on November 22, 2006                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.9    |   | Credit Agreement, dated November 16, 2006, with  respect to a Term Loan Facility, by and among Sally Holdings LLC, the several  lenders from time to time parties thereto, and Merrill Lynch Capital  Corporation, as Administrative Agent and Collateral Agent, which is  incorporated herein by reference from Exhibit 4.5.1 to the Current  Report on Form 8-K of Sally Beauty Holdings, Inc. filed on  November 22, 2006                                                                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.10   |   | Guarantee and Collateral Agreement, dated as of  November 16, 2006, made by Sally Investment Holdings LLC, Sally Holdings  LLC and certain subsidiaries of Sally Holdings LLC in favor of Merrill Lynch  Capital Corporation, as Administrative Agent and Collateral Agent, which is  incorporated herein by reference from Exhibit 4.5.2 to the Current  Report on Form 8-K of Sally Beauty Holdings, Inc. filed on November 22,  2006                                                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.11   |   | Credit Agreement, dated November 16, 2006, with  respect to an Asset-Based Loan Facility, among Sally Holdings LLC, Beauty  Systems Group LLC, Sally Beauty Supply LLC, any Canadian Borrower from time  to time party thereto, certain subsidiaries of Sally Holdings LLC, the  several lenders from time to time parties thereto, Merrill Lynch Capital, a  division of Merrill Lynch Business Financial Services Inc., as Administrative  Agent and Collateral Agent, and Merrill Lynch Capital Canada Inc., as  Canadian Agent and Canadian Collateral Agent, which is incorporated herein by  reference from Exhibit 4.6.1 to the Current Report on Form 8-K of  Sally Beauty Holdings, Inc. filed on November 22, 2006 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.12   |   | U.S. Guarantee and Collateral Agreement, dated as of  November 16, 2006, made by Sally Investment Holdings LLC, Sally Holdings  LLC and certain subsidiaries of Sally Holdings LLC in favor of Merrill Lynch  Capital, a division of Merrill Lynch Business Financial Services Inc., as  Administrative Agent and Collateral Agent, which is incorporated herein by  reference from Exhibit 4.6.2 to the Current Report on Form 8-K of  Sally Beauty Holdings, Inc. filed on November 22, 2006                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.13   |   | Canadian Guarantee and Collateral Agreement, dated  as of November 16, 2006, made by Sally Beauty (Canada) Corporation,  Beauty Systems Group (Canada), Inc., Sally Beauty Canada Holdings Inc.  and certain of their respective subsidiaries in favor of Merrill Lynch  Capital Canada Inc., as Canadian Agent and Canadian Collateral Agent, which  is incorporated herein by reference from Exhibit 4.6.3 to the Current  Report on Form 8-K of Sally Beauty Holdings, Inc. filed on  November 22, 2006                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.14   |   | Intercreditor Agreement, dated as of  November 16, 2006, by and between Merrill Lynch Capital Corporation, as  Administrative Agent and Collateral Agent under the Term Loan Facility, and  Merrill Lynch Capital, a division of Merrill Lynch Business Financial  Services Inc., as Administrative Agent and Collateral Agent under the  Asset-Based Loan Facility, which is incorporated herein by reference from  Exhibit 4.7 to the Current Report on Form 8-K of Sally Beauty  Holdings, Inc. filed on November 22, 2006                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.15   |   | Assignment and Acceptance of that certain Credit  Agreement, dated as of November 16, 2006, among Sally Holdings LLC,  Beauty Systems Group LLC, Sally Beauty Supply LLC, the Canadian Borrowers (as  defined in the Credit Agreement), the several banks and other financial  institutions from time to time parties thereto, Merrill Lynch Capital, a division  of’ Merrill Lynch Business Financial Services Inc., as administrative agent  and collateral agent for the Lenders and Merrill Lynch Capital  Canada, Inc., as Canadian agent and Canadian collateral agent for the  Lenders,                                                                                                                                         |

 

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|   |   | which is incorporated herein by reference from  Exhibit 4.15 to the Annual Report on Form 10-K of Sally Beauty  Holdings, Inc. filed on November 19, 2009                                                                                                                                                                                                                                                                                                          |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.1   |   | Amended and Restated Letter Agreement between  Clayton, Dubilier & Rice, LLC (“CD&R”) and Sally Beauty  Holdings, Inc. with respect to the provision of services by CD&R to  Sally Beauty Holdings, Inc’s Board of Directors dated as of February 24,  2010, which is incorporated herein by reference from Exhibit 10.1 to the  Quarterly Report on Form 10-Q of Sally Beauty Holdings, Inc. filed  on May 4, 2010 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 31.1   |   | Rule 13(a)-14(a)/15(d)-14(a) Certification  of Gary G. Winterhalter*                                                                                                                                                                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 31.2   |   | Rule 13(a)-14(a)/15(d)-14(a) Certification  of Mark J. Flaherty*                                                                                                                                                                                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 32.1   |   | Section 1350 Certification of Gary G.  Winterhalter*                                                                                                                                                                                                                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 32.2   |   | Section 1350 Certification of Mark J. Flaherty*                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |

 

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*Included herewith

 

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

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

 
|                           | SALLY HOLDINGS LLC                                         |
|--------------------------------|------------------------------------------------------------|
|                           | (Registrant)                                               |
|                           |                                                       |
| Date: August 4, 2010 |                                                       |
|                           |                                                       |
|                           |                                                       |
|                           | By:                                                        | /s/ Mark J. Flaherty |
|                           | Mark J. Flaherty                                           |
|                           | Senior Vice President and Chief Financial Officer          |
|                           | For  the Registrant and as its Principal Financial Officer |

 

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