Table of Contents

 

 

 

**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

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| **x** | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|------------|--------------------------------------------------------------------------------------------------------|

 

**FOR THE QUARTERLY PERIOD ENDED: DECEMBER 31, 2008**

 

**-OR-**

 

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

 

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| **SALLY  HOLDINGS LLC**                                | ** ** | **SALLY  CAPITAL INC.**                                |
|--------------------------------------------------------|------------|--------------------------------------------------------|
| (Exact name of registrant as specified in its charter) |       | (Exact name of registrant as specified in its charter) |

 

| **Delaware**                            | ** ** | **Delaware**                            |
|-----------------------------------------|------------|-----------------------------------------|
| (State or other jurisdiction of         |       | (State or other jurisdiction of         |
| incorporation or organization)          |       | incorporation or organization)          |
|                                    |       |                                    |
| **36-4472381**                          | ** ** | **56-2620323**                          |
| (I.R.S. Employer Identification Number) |       | (I.R.S. Employer Identification Number) |
|                                    |       |                                    |
| **333-144427**                          | ** ** | **333-144427-10**                       |
| (Commission file number)                |       | (Commission file number)                |

 

**3001Colorado BoulevardDenton, Texas 76210**

(Address of principal executive offices)

 

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

 

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

 

Indicateby check mark whether the registrant is a large accelerated filer, an acceleratedfiler, a non-accelerated filer or a smaller reporting company. See definitionof “accelerated filer,” “large accelerated filer” and “smaller reportingcompany” in Rule 12b-2 of the Exchange Act.

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

 

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

 

Novoting or non-voting common equity of the registrant’s were held bynon-affiliates of the registrants’ as of December 31, 2008.  As of January 30, 2009, all member unitswere owned by Sally Investment Holdings LLC, a wholly-owned subsidiary of SallyBeauty Holdings, Inc.

 

 

 

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Table of Contents

 

**TABLE OF CONTENTS**

** **
| ** **                                                                                          | **Page** |
|-----------------------------------------------------------------------------------------------------|----------|
|                                                                                                |     |
| PART I – FINANCIAL INFORMATION                                                            |     |
|                                                                                                |     |
| ITEM 1.  FINANCIAL STATEMENTS                                                                       | 5        |
| ITEM 2. MANAGEMENT’S DISCUSSION AND  ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS | 26       |
| ITEM 3. QUANTITATIVE AND QUALITATIVE  DISCLOSURES ABOUT MARKET RISK                            | 41       |
| ITEM 4. CONTROLS AND PROCEDURES                                                                     | 42       |
|                                                                                                |     |
| PART II – OTHER INFORMATION                                                               |     |
|                                                                                                |     |
| ITEM 1. LEGAL PROCEEDINGS                                                                           | 43       |
| ITEM 1A. RISK FACTORS                                                                               | 43       |
| ITEM 2. UNREGISTERED SALES OF EQUITY  SECURITIES AND USE OF PROCEEDS                                | 43       |
| ITEM 3. DEFAULTS UPON SENIOR SECURITIES                                                             | 43       |
| ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF  SECURITY HOLDERS                                        | 44       |
| ITEM 5. OTHER INFORMATION                                                                           | 44       |
| ITEM 6. EXHIBITS                                                                                    | 45       |

 

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Since November 16,2006, Sally Holdings LLC, which we refer to as “Sally Holdings,” a limitedliability company organized under the laws of the State of Delaware, is awholly-owned subsidiary of Sally Investment Holdings LLC, which we refer to as “SallyInvestment,” a wholly-owned subsidiary of Sally Beauty Holdings, Inc.,which we refer to as “Sally Beauty.” All of the interests of Sally Holdings arebeneficially owned by Sally Investment, and all of the interests of SallyInvestment are beneficially owned by Sally Beauty.  Prior to November 16, 2006, SallyHoldings was a Delaware corporation named “Sally Holdings, Inc.” and was awholly-owned subsidiary of Alberto-Culver Company, which we refer to as “Alberto-Culver.”On November 16, 2006, Sally Holdings, Inc. was converted to aDelaware limited liability company, was renamed “Sally Holdings LLC” and becamea wholly-owned subsidiary of Sally Investment and an indirect subsidiary ofSally Beauty in connection with the separation of Sally Holdings’ business fromAlberto-Culver. All operations of Sally Investment and Sally Beauty areconducted through Sally Holdings and its consolidated subsidiaries.  Sally Capital Inc., a Delaware corporationwhich we refer to as “Sally Capital,” is a wholly-owned subsidiary of SallyHoldings and does not have any assets or operations of any kind.

 

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

 

Cautionary Notice Regarding Forward-Looking Statements

 

Statementsin this report which are not purely historical facts or which depend uponfuture events may be forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended.  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 competitivenature of, and the increasing consolidation of, the beauty productsdistribution industry;

·            anticipating changesin consumer preferences and buying trends and managing our product lines andinventory;

·            potential fluctuationin our same store sales and quarterly financial performance;

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

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

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

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

·            product diversion tomass retailers;

·            the operational andfinancial performance of our Armstrong McCall, L.P. business;

·            the success of our newInternet-based business;

·            successfullyidentifying acquisition candidates or successfully completing desirableacquisitions;

·            integrating businessesacquired in the future;

·            opening and operatingnew stores profitably;

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

·            the success of ourcost control plans;

·            protecting ourintellectual property rights, specifically our trademarks;

·            conducting businessoutside the United States;

 

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·            disruption in ourinformation technology systems;

·            natural disasters oracts of terrorism;

·            the preparedness ofour accounting and other management systems to meet financial reporting andother requirements and the upgrade of our existing financial reporting system;

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

·            our substantialindebtedness;

·            the possibility thatwe may incur substantial additional debt;

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

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

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

·            the potential impacton us if the financial institutions we deal with become impaired;

·            the representativenessof our historical consolidated financial information with respect to our futurefinancial position, results of operations or cash flows;

·            our reliance uponAlberto-Culver for the accuracy of certain historical services and information;

·            the share distributionof Alberto-Culver common stock in our separation from Alberto-Culver notconstituting a tax-free distribution;

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

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

·            the interests of Sally Beauty’s largeststockholder differing from the interests of other holders of Sally Beauty’scommon 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, 2008, 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– FINANCIAL INFORMATION**

 

# **Item1.  Financial Statements.**

 

The following are our consolidated balance sheets as of December 31,2008 and September 30, 2008 and our consolidated statements of earningsand cash flows for the three months ended December 31, 2008 and 2007.  In November 2006, Sally Holdings, Inc.was converted to a Delaware limited liability company, was renamed “SallyHoldings LLC” and became an indirect wholly owned subsidiary of Sally BeautyHoldings, Inc. in connection with our separation from the Alberto-CulverCompany (“Alberto-Culver”).  In thesefinancial statements and elsewhere in this Quarterly Report on Form 10-Q,we refer to these transactions as the Separation Transactions.  See the Company’s Annual Report on Form 10-Kfor the fiscal year ended September 30, 2008 for additional informationabout the Separation Transactions. Sally Capital (the “Co-Issuer”) is awholly-owned subsidiary of Sally Holdings and does not have assets oroperations of any kind.

 

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**SALLYHOLDINGS LLC AND SUBSIDIARIES**

ConsolidatedStatements of Earnings

(In thousands)

(Unaudited)

 
| ** **                                            | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                            | ** ** | **December 31,**            | ** ** |
| ** **                                            | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| Net sales                                             |       | $                                | 645,576    |   | $ | 655,787 |   |
| Cost of products sold and distribution  expenses      |       | 342,032                          |       | 349,618 |   |
| Gross profit                                          |       | 303,544                          |       | 306,169 |   |
| Selling, general and administrative  expenses **(a)** |       | 223,537                          |       | 222,895 |   |
| Depreciation and amortization                         |       | 11,747                           |       | 11,752 |   |
| Operating earnings                                    |       | 68,260                           |       | 71,522 |   |
| Interest expense, net **(b)**                         |       | 39,673                           |       | 46,483 |   |
| Earnings before provision for income  taxes      |       | 28,587                           |       | 25,039 |   |
| Provision  for income taxes                           |       | 11,380                           |       | 9,693 |   |
| Net earnings                                          |       | $                                | 17,207     |   | $ | 15,346 |   |

 

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(a)                                 Selling,general and administrative expenses include share-based compensation of $3.5million and $5.4 million for the three months ended December 31, 2008 and2007, respectively.

 

(b)                                Interestexpense, net of interest income of $0.1 million and $0.2 million, includesexpense of $3.0 million and $5.7 million of marked-to-market adjustmentsrelated to interest rate swaps for the three months ended December 31,2008 and 2007, respectively.

 

The accompanyingcondensed notes, together with the Notes to Consolidated Financial Statementscontained in the Company’s Annual Report on Form 10-K for the fiscal yearended September 30, 2008, are an integral part of these financialstatements.

 

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**SALLYHOLDINGS LLC AND SUBSIDIARIES**

ConsolidatedBalance Sheets

(In thousands)

 
| ** **                                                                                                                                  | ** ** | **December 31,  2008** | ** ** | **September 30,  2008** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                  | ** ** | **(Unaudited)**             | ** ** | ** **                   | ** ** |
| **Assets**                                                                                                                                  |       |                        |       |                         |       |
| Current assets:                                                                                                                             |       |                        |       |                         |       |
| Cash and cash equivalents                                                                                                                   |       | $112,617                    |       | $99,788                      |       |
| Trade accounts receivable, less allowance  for doubtful accounts of $2,460 at December 31, 2008 and $2,702 at  September 30, 2008 |       | 39,812                      |       | 44,481                       |       |
| Other receivables                                                                                                                           |       | 30,201                      |       | 21,596                       |       |
| Inventories                                                                                                                                 |       | 571,650                     |       | 598,195                      |       |
| Prepaid expenses                                                                                                                            |       | 16,756                      |       | 19,449                       |       |
| Deferred income tax assets                                                                                                                  |       | 20,885                      |       | 20,772                       |       |
| Total current assets                                                                                                                        |       | 791,921                     |       | 804,281                      |       |
|                                                                                                                                        |       |                        |       |                         |       |
| Property and equipment, net of accumulated  depreciation of $245,655 at December 31, 2008 and $243,185 at  September 30, 2008     |       | 149,157                     |       | 156,260                      |       |
| Goodwill                                                                                                                                    |       | 413,580                     |       | 424,963                      |       |
| Intangible assets, net of accumulated  amortization of $19,665 at December 31, 2008 and $18,203 at  September 30, 2008            |       | 81,094                      |       | 85,434                       |       |
| Other assets                                                                                                                                |       | 50,645                      |       | 54,720                       |       |
| Total assets                                                                                                                                |       | $1,486,397                  |       | $1,525,658                   |       |
| **Liabilities and Member’s Deficit**                                                                                                   |       |                        |       |                         |       |
| Current liabilities:                                                                                                                        |       |                        |       |                         |       |
| Current maturities of long-term debt                                                                                                        |       | $100,360                    |       | $100,601                     |       |
| Accounts payable                                                                                                                            |       | 166,263                     |       | 171,962                      |       |
| Accrued expenses                                                                                                                            |       | 144,580                     |       | 154,529                      |       |
| Income taxes                                                                                                                                |       | 10,283                      |       | 11,386                       |       |
| Due to Sally Beauty                                                                                                                         |       | 26,504                      |       | 17,243                       |       |
| Total current liabilities                                                                                                                   |       | 447,990                     |       | 455,721                      |       |
| Long-term debt                                                                                                                              |       | 1,718,559                   |       | 1,724,684                    |       |
| Other liabilities                                                                                                                           |       | 33,315                      |       | 23,708                       |       |
| Deferred income tax liabilities                                                                                                             |       | 29,112                      |       | 37,941                       |       |
| Total liabilities                                                                                                                           |       | 2,228,976                   |       | 2,242,054                    |       |
| Stock options subject to redemption                                                                                                         |       | 5,650                       |       | 5,884                        |       |
| Member’s deficit:                                                                                                                      |       |                        |       |                         |       |
| Member’s deficit                                                                                                                       |       | (713,762                    | )          | (730,969                     | )          |
| Accumulated other comprehensive (loss)  income                                                                                              |       | (34,467                     | )          | 8,689                        |       |
| Total member’s deficit                                                                                                                 |       | (748,229                    | )          | (722,280                     | )          |
| Total liabilities and member’s deficit                                                                                                 |       | $1,486,397                  |       | $1,525,658                   |       |

 

The accompanying condensed notes, together with theNotes to Consolidated Financial Statements contained in the Company’s AnnualReport on Form 10-K for the fiscal year ended September 30, 2008, arean integral part of these financial statements.

 

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**SALLYHOLDINGS LLC AND SUBSIDIARIES**

ConsolidatedStatements of Cash Flows

(In thousands)

(Unaudited)

 
| ** **                                                                                           | ** ** | **Three Months Ended  December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                           | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| **Cash Flows from Operating Activities:**                                                            |       |                                                |       |   |   |
| Net earnings                                                                                         |       | $                                                   | 17,207     |   | $ | 15,346 |   |
| Adjustments to reconcile net earnings to  net cash provided (used) by operating activities:          |       |                                                |       |   |   |
| Depreciation and amortization                                                                        |       | 11,747                                              |       | 11,752 |   |
| Share-based compensation expense (net of  deferred tax benefit of $1,322 in 2008 and $1,965 in 2007) |       | 2,146                                               |       | 3,482 |   |
| Amortization of deferred financing costs                                                             |       | 2,103                                               |       | 2,131 |   |
| Excess tax shortfall (benefit) from  share-based compensation                                        |       | 111                                                 |       | (129 | ) |
| Net (gain) loss on disposal of leaseholds  and other property                                        |       | (2                                                  | )          | 150 |   |
| Deferred income taxes                                                                                |       | 612                                                 |       | 628 |   |
| Changes in (exclusive of effects of  acquisitions):                                                  |       |                                                |       |   |   |
| Trade accounts receivable                                                                            |       | 2,927                                               |       | 3,455 |   |
| Other receivables                                                                                    |       | (9,694                                              | )          | (5,241 | ) |
| Inventories                                                                                          |       | 9,850                                               |       | (28,626 | ) |
| Prepaid expenses                                                                                     |       | 1,478                                               |       | 195 |   |
| Other assets                                                                                         |       | 45                                                  |       | 215 |   |
| Accounts payable and accrued expenses                                                                |       | (5,609                                              | )          | (28,600 | ) |
| Income taxes                                                                                         |       | (396                                                | )          | 2,036 |   |
| Due (to) from Sally Beauty                                                                           |       | 5,564                                               |       | (1,525 | ) |
| Other liabilities                                                                                    |       | (6,803                                              | )          | 6,781 |   |
| Net cash provided (used) by operating  activities                                                    |       | 31,286                                              |       | (17,950 | ) |
| **Cash Flows from Investing Activities:**                                                            |       |                                                |       |   |   |
| Capital expenditures                                                                                 |       | (8,400                                              | )          | (12,280 | ) |
| Proceeds from sale of property and equipment                                                         |       | 32                                                  |       | 115 |   |
| Acquisitions, net of cash acquired                                                                   |       | (1,755                                              | )          | (3,112 | ) |
| Net cash used by investing activities                                                                |       | (10,123                                             | )          | (15,277 | ) |
| **Cash Flows from Financing Activities:**                                                            |       |                                                |       |   |   |
| Change in book cash overdraft                                                                        |       | (1,633                                              | )          | 1,175 |   |
| Proceeds from issuance of long-term debt                                                             |       | 82,638                                              |       | 142,976 |   |
| Repayments of long-term debt                                                                         |       | (89,021                                             | )          | (105,194 | ) |
| Excess tax (shortfall) benefit from  share-based compensation                                        |       | (111                                                | )          | 129 |   |
| Net cash (used) provided by financing  activities                                                    |       | (8,127                                              | )          | 39,086 |   |
| Effect of foreign exchange rate changes on  cash and cash equivalents                                |       | (207                                                | )          | (984 | ) |
| Net increase in cash and cash equivalents                                                            |       | 12,829                                              |       | 4,875 |   |
| Cash and cash equivalents, beginning of  period                                                      |       | 99,788                                              |       | 38,272 |   |
| Cash and cash equivalents, end of period                                                             |       | $                                                   | 112,617    |   | $ | 43,147 |   |
|                                                                                                 |       |                                                |       |   |   |
| **Supplemental Cash Flow Information:**                                                              |       |                                                |       |   |   |
| Cash paid for:                                                                                       |       |                                                |       |   |   |
| Interest                                                                                             |       | $                                                   | 57,732     |   | $ | 63,929 |   |
| Income taxes                                                                                         |       | $                                                   | 888        |   | $ | 708 |   |

 

The accompanyingcondensed notes, together with the Notes to Consolidated Financial Statementscontained in the Company’s Annual Report on Form 10-K for the fiscal yearended September 30, 2008, are an integral part of these financialstatements.

 

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Sally Holdings LLCand Subsidiaries

##### ***Condensed Notes to ConsolidatedFinancial Statements***

##### *** ***

##### ***1.   Description of Business andBasis of Presentation***

##### *** ***

Description of Business

 

Sally Holdings LLC, or Sally Holdings, is awholly-owned subsidiary of Sally Investment Holdings LLC (“Sally Investment”),a wholly-owned subsidiary of Sally Beauty. 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.  The Company was awholly-owned subsidiary of Alberto-Culver until November 16, 2006 when itwas converted to a Delaware limited liability company, was renamed “Sally HoldingsLLC” and became a wholly-owned subsidiary of Sally Investment and an indirectsubsidiary of Sally Beauty in connection with the separation of its businessfrom Alberto-Culver.  The Company and itsconsolidated subsidiaries sell professional beauty supplies, primarily throughits Sally Beauty Supply retail stores, in the U.S., Puerto Rico, Mexico,Canada, Japan, the United Kingdom and certain other countries in Europe.Additionally, the Company distributes professional beauty products to salonsand professional cosmetologists through its Beauty Systems Group (“BSG”) storeoperations and a commissioned direct sales force that calls on salons in theU.S., Canada, the United Kingdom and certain other countries in Europe, and tofranchises in the southern and southwestern U.S. and in Mexico through theoperations of its subsidiary Armstrong McCall, L.P. (“Armstrong McCall”).Certain beauty products sold by BSG and Armstrong McCall are sold throughexclusive territory agreements with the manufacturers of the products.

 

In November 2006, the stockholders ofAlberto-Culver approved a plan to separate its consumer products business andits Sally Beauty Supply/BSG distribution business into two separate,publicly-traded companies. Sally Holdings, Inc. was a wholly-ownedsubsidiary of Alberto-Culver until November 16, 2006, when it wasconverted to a Delaware limited liability company, was renamed “Sally HoldingsLLC,” and became an indirect wholly-owned subsidiary of Sally Beauty. SallyBeauty was formed in June 2006, and became the accounting successorcompany to Sally Holdings, Inc. upon the completion of the SeparationTransactions. See the Company’s Annual Report on Form 10-K for the fiscalyear ended September 30, 2008 for more information about the SeparationTransactions.

 

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 ourparent, Sally Beauty.  See the Company’sAnnual Report on Form 10-K for the fiscal year ended September 30,2008 for more information about related parties.

 

Basis of Presentation

 

The consolidated interim financial statements included herein areunaudited and have been prepared by the Company pursuant to the rules andregulations of the Securities and Exchange Commission (“SEC”).  Certain information and note disclosuresnormally included in annual financial statements prepared in accordance withaccounting principles generally accepted in the United States (“GAAP”) havebeen condensed or omitted pursuant to those rules and regulations,although the Company believes that the disclosures made are adequate to makethe information not misleading. 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 consolidated financial position as of December 31,2008 and September 30, 2008, the consolidated results of operations andconsolidated cash flows for the three months ended December 31, 2008 and2007.  The results of operations forthese interim periods are not necessarily indicative of the results that may beexpected for the entire fiscal year.

 

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

 

These consolidated interim financial statements shouldbe read in conjunction with the financial statements and notes thereto includedin the Company’s Annual Report on Form 10-K for the fiscal year ended 

 

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Sally Holdings LLCand Subsidiaries

Condensed Notes to Consolidated Financial Statements

 

September 30, 2008.  TheCompany adheres to the same accounting policies in preparation of interimfinancial statements.  As permitted underGAAP, interim accounting for certain expenses, including income taxes, arebased on full year assumptions.  Suchamounts are expensed in full in the year incurred.  For interim financial reporting purposes,income taxes are recorded based upon estimated annual effective income taxrates.

 

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

 

##### ***2.   ***RecentAccounting Pronouncements

##### *** ***

The Company adopted theprovisions of Statement of Financial Accounting Standards (“SFAS”) No. 157,*Fair Value Measurements* (“SFAS 157”), asit relates to its financial instruments, effective as of October 1,2008.  SFAS 157 defines fair value,establishes a framework for measuring fair value and expands disclosures aboutfair value measurements. This statement does not require any new fair valuemeasurements; rather, it amends other accounting pronouncements that require orpermit fair value measurements.   SFAS157 defines “fair value” as the price that would be received to sell an assetor paid to transfer a liability in the principal or most advantageous market inan orderly transaction between market participants on the measurementdate.  SFAS 157 establishes a three-levelhierarchy for measuring fair value and requires an entity to maximize the useof observable inputs and minimize the use of unobservable inputs when measuringfair value.

 

This valuation hierarchyis based upon the transparency of inputs to the valuation of an asset orliability on the measurement date.  Thethree levels of that hierarchy are defined as follows:

 

Level 1  – Unadjusted quoted prices in active markets for identical assets orliabilities

 

Level2  – Unadjusted quoted prices in active markets for similar assets orliabilities; or

Unadjusted quoted pricesfor identical or similar assets or liabilities in markets that are not active;or

Inputs other than quotedprices that are observable for the asset and liability

 

Level 3  – Unobservable inputs for the asset or liability

 

The Company measurescertain financial assets and liabilities at fair value on a recurring basis,including interest rate swaps.  Inaccordance with SFAS 157, the Company categorized certain of its financialassets and liabilities based on priority of the inputs to the valuationtechnique for the instruments, as follows (in thousands):

 
| ** **                         | ** ** | **As of December 31, 2008** | ** ** |
|------------------------------------|------------|-------------------------------------------------|------------|
| ** **                         | ** ** | **Total**                                       | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Liabilities                        |       |                                            |       |   |   |   |   |   |   |
| Hedged interest rate swaps (1)     |       | $                                               | 16,522     |   |   |   | $ | 16,522 |   |   |   |
| Non-hedged interest rate swaps (1) |       | 10,661                                          |       |   |   | 10,661 |   |   |   |
| Total                              |       | $                                               | 27,183     |   |   |   | $ | 27,183 |   |   |   |

 

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(1) Interest rateswaps are valued using internal models based on market observable inputs,including market interest rates.

 

In October 2008, theFASB issued Staff Position FAS No. 157-3, *Determiningthe Fair Value of a Financial Asset When the Market for That Asset Is NotActive*, which clarifies the application of SFAS 157. FSP-FAS 157-3was effective upon issuance and its adoption did not have a material impact onthe Company’s financial statements.

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes toConsolidated Financial Statements

 

Effective on October 1,2008, the Company also adopted the provisions of SFAS 159, *The FairValue Option for Financial Assets and Financial Liabilities - includingan amendment of FASB Statement No. 115* (“SFAS 159”), whichpermits entities to choose to measure certain financial assets and liabilitiesat fair value. The Company elected not to measure at fair value any additionalassets or liabilities that were not already measured at fair value prior tosuch adoption.  As a result, the adoptionof SFAS 159 did not have an impact on the Company’s consolidated financialposition, results of operations or cash flows.

 

We have not yet adoptedand are currently assessing any potential effect of the pronouncementsdiscussed below on our consolidated financial statements.

 

In June 2008, theEmerging Issues Task Force reached consensus on Emerging Issues Task ForceIssue No. 08-3, *Accounting by Lesseesfor Nonrefundable Maintenance Deposits* (“EITF 08-3”). Under EITF08-3, lessees should account for nonrefundable maintenance deposits as depositassets if it is probable that maintenance activities will occur and the depositis therefore realizable. Amounts on deposit that are not probable of being usedto fund future maintenance activities should be expensed. EITF 08-3 iseffective for fiscal years beginning after December 15, 2008. Earlyapplication is not permitted.

 

In April 2008, theFinancial Accounting Standards Board (“FASB”) issued Staff Position FAS No. 142-3,*Determination of the Useful Life of IntangibleAssets* (“FAS 142-3”). FAS 142-3 amends the factors that should beconsidered in developing renewal or extension assumptions used to determine theuseful life of a recognized intangible asset under SFAS No. 142, *Goodwill and Other Intangible Assets* (“SFAS 142”). Theobjective of the Staff Position is to improve the consistency between the usefullife of a recognized intangible asset under SFAS 142 and the period ofexpected cash flows used to measure the fair value of the asset under SFAS No. 141(Revised 2007): *Business Combinations* (“SFAS 141R”)and other GAAP. FAS 142-3 is effective for fiscal years beginning after December 15,2008. Early application is not permitted.

 

In March 2008, the FASB issued SFAS No. 161,*Disclosures about Derivative Instruments andHedging Activities, an Amendment of FASB Statement No. 133* (“SFAS161”). SFAS 161 requires companies to provide qualitative disclosures about theobjectives and strategies for using derivatives, quantitative data about thefair value of and gains and losses on derivative contracts, and details ofcredit-risk-related contingent features in their hedged positions.  The statement also requires companies todisclose more information about the location and amounts of derivativeinstruments in financial statements; how derivatives and related hedges areaccounted for under SFAS 133, *Accounting for DerivativeInstruments and Hedging Activities*; and how the hedges affect theentity’s financial position, financial performance and cash flows. SFAS 161 iseffective for fiscal years and interim periods beginning after November 15,2008.

 

In December 2007, the FASB issued SFAS No. 160,*Noncontrolling Interests in Consolidated FinancialStatements, an amendment to ARB No. 51* (“SFAS 160”), whichrequires, among other things, that the noncontrolling interest (previouslyreferred to as minority interest) in a consolidated subsidiary’s equity bereported as a component of equity separate from the parent’s interest and thatnet income or loss attributable to the noncontrolling interest be included inconsolidated net income on the face of the income statement. In addition,purchases and sales of equity interests that do not result in a change incontrol will be accounted for as equity transactions and, upon a loss ofcontrol, the interest sold, as well as any interest retained, will be recordedat fair value with any gain or loss recognized in earnings. SFAS 160 iseffective for fiscal years, and interim periods within those fiscal years,beginning on or after December 15, 2008. Early application is not permitted.

 

In December 2007, the FASB issued SFAS 141R, *Business Combinations* (“SFAS 141R”). Among other things,SFAS 141R generally requires that an acquirer recognize the assets acquired andliabilities assumed measured at their “full fair values” on the acquisitiondate. This practice replaces the practice, under predecessor SFAS 141: *Business Combinations,* of allocating the cost of anacquisition to the individual assets acquired and liabilities assumed based ontheir relative estimated fair values. SFAS 141R further requires that acquisition-related costs be recognizedseparately from the related acquisition. SFAS 141R must be appliedprospectively to business combinations consummated on or after the first annualreporting period beginning on or after December 15, 2008.  Early application is not permitted.

 

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Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

 

##### ***3.   Comprehensive (Loss) Income***

##### *** ***

Comprehensive (loss) income consists of net earnings, foreign currencytranslation adjustments and deferred gains on interest rate swaps as follows(in thousands):

 
| ** **                                                | ** ** | **Three Months Ended December 31,** | ** ** |
|-----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| Net earnings                                              |       | $                                                       | 17,207     |   | $ | 15,346 |   |
| Other comprehensive (loss) income adjustments:            |       |                                                    |       |   |   |
| Foreign currency translation adjustments                  |       | (32,283                                                 | )          | (4,456 | ) |
| Deferred loss on interest rate swaps, net of income taxes |       | (10,873                                                 | )          | — |   |
| Comprehensive (loss) income                               |       | $                                                       | (25,949    | ) | $ | 10,890 |   |

 

##### ***4.   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 stock awardplans, which we refer to as share-based payment plans, in accordance withSFAS 123(R) *Share-Based Payment*.Accordingly, the Company measures the cost of employee services received inexchange for an award of equity instruments based on the grant-date fair valueof the award and recognizes compensation expense on a straight-line basis overthe vesting period or to the date a participant becomes eligible for retirement,if earlier. During fiscal year 2007, Sally Beauty adopted the  Sally Beauty Holdings 2007 Omnibus IncentivePlan (the “2007 Plan”), a share-based compensation plan which allows for theissuance of up to 10.0 million shares of Sally Beauty’s common stock.

 

Sally Beauty granted approximately 2.7 million and 2.6million stock options to the Company’s employees and consultants during thethree months ended December 31, 2008 and 2007, respectively, under the2007 Plan. Upon issuance of such grants, the Company recognized acceleratedshare-based compensation expense of $2.0 million and $3.1 million in the firstquarter of fiscal years 2009 and 2008, respectively, in connection with certainretirement eligible employees who are eligible to continue vesting awards uponretirement under the terms of the 2007 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 the statements of earnings (in thousands):

 

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Condensed Notes to Consolidated Financial Statements

 
| ** **                                                     | ** ** | **Three Months Ended December 31,** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                     | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| ** **                                                     | ** ** | ** **                                              | ** ** | ** ** | ** ** |
| Share-based compensation expense                               |       | $                                                       | 3,468      |   | $ | 5,447 |   |
| Income tax benefit related to share-based compensation expense |       | $                                                       | 1,322      |   | $ | 1,965 |   |

 

## **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 of the 2007Plan.

 

The following table presents a summary of the activityfor Sally Beauty’s stock options issued to the Company’s employees and consultantsfor the three months ended December 31, 2008:

 
| ** **                             | ** ** | **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, 2008 |       | 8,138                                                         |       | $                                      | 7.99       |                                                                 |       |                                                 |       |   |
| Granted                                |       | 2,657                                                         |       | 5.24                                   |       |                                                                 |       |                                                 |       |
| Exercised                              |       | (105                                                          | )          | 2.00                                   |       |                                                                 |       |                                                 |       |
| Forfeited or expired                   |       | (109                                                          | )          | 8.72                                   |       |                                                                 |       |                                                 |       |
| Outstanding at December 31, 2008  |       | 10,581                                                        |       | $                                      | 7.35       |                                                                 | 8.4        |                                                 | $          | 6,054 |   |
|                                   |       |                                                          |       |                                   |       |                                                                 |       |                                                 |       |
| Exercisable at December 31, 2008  |       | 3,999                                                         |       | $                                      | 6.96       |                                                                 | 7.4        |                                                 | $          | 4,860 |   |

 

The following table summarizes information about stockoptions held by the Company’s employees and consultants under Sally Beauty’soption plans at December 31, 2008:

 
| ** **                          | ** ** | **Options Outstanding**                                                  | ** ** | **Options Exercisable**                                         | ** ** |
|-------------------------------------|------------|-------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| **Range of  Exercise  Prices** | ** ** | **Number  Outstanding  at December  31, 2008 (in  Thousands)** | ** ** | **Weighted  Average  Remaining  Contractual  Term (in  Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable  at December  31, 2008 (in  Thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $2.00                               |       | 1,317                                                                         |       | 5.5                                                                  |       | $ | 2.00 |   | 1,317 |   | $ | 2.00 |   |
| $5.24 – 9.66                   |       | 9,264                                                                         |       | 8.8                                                                  |       | 8.11 |   | 2,682 |   | 9.40 |   |
| Total                               |       | 10,581                                                                        |       | 8.4                                                                  |       | $ | 7.35 |   | 3,999 |   | $ | 6.96 |   |

 

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:

 

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Condensed Notes to Consolidated Financial Statements

 
| ** **              | ** ** | **Three Months Ended December 31,** | ** ** |
|-------------------------|------------|---------------------------------------------------------|------------|
| ** **              | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| Expected lives (years)  |       | 5.0                                                     |       | 5.0 |   |
| Expected volatility     |       | 47.9                                                    | %          | 37.5 | % |
| Risk-free interest rate |       | 2.6                                                     | %          | 4.0 | % |
| 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 using the averagevolatility of both Sally Beauty and similar companies (based on industrysector) since it is not practicable to estimate Sally Beauty’s expectedvolatility on a stand alone basis due to a lack of sufficient trading history.The risk-free interest rate is based on the zero-coupon U.S. Treasury issue asof the date of the grant. Since Sally Beauty does not expect to pay dividends,the dividend yield is 0%.

 

The weighted average fair value of the Sally Beautystock options issued, in the three months ended December 31, 2008 and2007, to the Company’s employees and consultants at the date of grant was $2.33and $3.46 per option, respectively. The total intrinsic value of optionsexercised during the three months ended December 31, 2008 was $0.2 million.  The total cash received from these optionexercises was $0.2 million and the tax benefit realized for the tax deductionsfrom these option exercises was $0.07 million.

 

At December 31, 2008, approximately $13.1 millionof total unrecognized compensation cost related to non-vested stock optionawards is expected to be recognized over the weighted average period of 3.0years.

 

## **Stock Awards**

##  

##### ***Restricted Stock Awards***

##### *** ***

As a subsidiary of Sally Beauty, the Company has noemployee stock award plans; however certain employees and consultants of theCompany have been granted restricted stock awards under Sally Beauty’s stockaward plans. A restricted stock award is an award of shares of Sally Beauty’scommon stock (which have full voting rights but are restricted with regards tosale or transfer) the restrictions over which lapse ratably over a specifiedperiod of time (generally 5 years). Restricted stock awards are independent ofstock option grants and are generally subject to forfeiture if employment terminatesprior to the restrictions lapsing, subject to certain retirement provisions ofthe 2007 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 in which therestrictions lapse (the “vesting period”). For these purposes, the fair valueof the restricted stock award is determined based on the closing price of SallyBeauty’s common stock on the grant date.

 

The following table presents a summary of the activityfor Sally Beauty’s restricted stock awards for the three months ended December 31,2008:

 
| **Restricted Stock Awards** | ** ** | **Number of  Shares (In  Thousands)** | ** ** | **Weighted  Average Fair  Value Per Share** | ** ** | **Weighted  Average  Remaining  Vesting Term  (In Years)** | ** ** |
|---------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| Non-vested at September 30, 2008 |       | 296                                             |       | $                                                          | 8.44       |                                                                 | 3.8        |   |
| Granted                               |       | 103                                             |       | 5.24                                                       |       |                                                                 |       |
| Vested                                |       | (21                                             | )          | 8.80                                                       |       |                                                                 |       |
| Forfeited                             |       | —                                          |       | —                                                     |       |                                                                 |       |
| Non-vested at December 31, 2008  |       | 378                                             |       | $                                                          | 7.55       |                                                                 | 4.0        |   |

 

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Condensed Notes to Consolidated Financial Statements

 

At December 31, 2008, approximately $2.5 millionof total unrecognized compensation cost related to non-vested restricted stockawards is expected to be recognized over the weighted average period of 4.0years.

 

##### ***5.   Goodwill and OtherIntangibles***

##### *** ***

The change in the carrying amounts of goodwill by operating segment forthe three months ended December 31, 2008 is as follows (in thousands):

 
| ** **                                   | ** ** | **Sally Beauty  Supply** | ** ** | **Beauty Systems  Group** | ** ** | **Total** | ** ** |
|----------------------------------------------|------------|-------------------------------|------------|--------------------------------|------------|-----------|------------|
| Balance at September 30, 2008           |       | $                             | 65,188     |                           | $          | 359,775   |       | $ | 424,963 |   |
| Additions, net of purchase price adjustments |       | 359                           |       | 195                            |       | 554       |       |
| Foreign currency translation                 |       | (5,366                        | )          | (6,571                         | )          | (11,937   | )          |
| Balance at December 31, 2008            |       | $                             | 60,181     |                           | $          | 353,399   |       | $ | 413,580 |   |

 

The following table provides the gross carrying value and accumulatedamortization for intangible assets with indefinite lives and intangible assetssubject to amortization by operating segment at December 31, 2008 (inthousands):

 
| ** **                                 | ** ** | **Sally Beauty  Supply** | ** ** | **Beauty Systems  Group** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|-------------------------------|------------|--------------------------------|------------|-----------|------------|
| Balance at December 31, 2008          |       |                          |       |                           |       |      |       |
| Intangible assets with indefinite lives:   |       |                          |       |                           |       |      |       |
| Trade names                                |       | $                             | 18,803     |                           | $          | 33,491    |       | $ | 52,294 |   |
| Other intangibles                          |       | —                        |       | 6,053                          |       | 6,053     |       |
| Total                                      |       | 18,803                        |       | 39,544                         |       | 58,347    |       |
| Intangible assets subject to amortization: |       |                          |       |                           |       |      |       |
| Gross carrying amount                      |       | 6,676                         |       | 35,736                         |       | 42,412    |       |
| Accumulated amortization                   |       | (1,506                        | )          | (18,159                        | )          | (19,665   | )          |
| Net value                                  |       | 5,170                         |       | 17,577                         |       | 22,747    |       |
| Total intangible assets, net               |       | $                             | 23,973     |                           | $          | 57,121    |       | $ | 81,094 |   |

 

Amortization expense was $1.5 million and $1.9 million for the threemonths ended December 31, 2008 and 2007, respectively. There have been nomaterial changes to the Company’s future amortization expense schedule since September 30,2008.

 

##### ***6.   Long-Term Debt***

##### *** ***

In connection with the Separation Transactions on November 16,2006, the Company and certain of its subsidiaries incurred $1,850.0 million ofindebtedness by (i) drawing on a revolving (asset-based lending) facility(the “ABL facility”) in an amount equal to $70.0 million, (ii) enteringinto two term loan facilities (term loans A and B) in an aggregate amount of$1,070.0 million and (iii) issuing senior notes in an aggregate amount of$430.0 million and senior subordinated notes in an aggregate amount of $280.0million.

 

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 term loan facilities may be prepaid at our option atany time without premium or penalty and are subject to mandatory prepayment inan amount equal to 50% of excess cash flow (as defined in the agreementgoverning the term loan facilities) for any fiscal year (commencing in fiscalyear 2008) unless a 

 

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Sally Holdings LLC andSubsidiaries

Condensed Notes to Consolidated Financial Statements

 

specified leverage ratio is met. In January 2009,the Company made a mandatory repayment on the term loan facilities in theamount of $16.7 million. Amounts paid pursuant to said provision may beapplied, at the option of the Company, against minimum loan repaymentsotherwise required over the twelve month period following any such payment,under the terms of the loan agreement. Additionally, borrowings under the termloan facility would be subject to mandatory prepayment in an amount equal to100% of the proceeds of specified asset sales that are not reinvested in thebusiness or applied to repay borrowings under the ABL facility.

 

The senior notes and seniorsubordinated notes are unsecured obligations of the issuers and are guaranteedon a senior basis (in the case of the senior notes) and on a seniorsubordinated basis (in the case of the senior subordinated notes) by eachmaterial domestic subsidiary of the Company (other than Sally Capital).Furthermore, the agreements underlying the Company’s credit facilitiescontain terms, which significantly restrict the ability of Sally Holdings andits subsidiaries to pay dividends or otherwise transfer assets to Sally Beauty.Please see the Company’s Annual Report on Form 10-K for fiscal year ended September 30,2008 for additional information about the Company’s long-term debt.

 

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

 
| ** **                   | ** ** | **As of  December 31,  2008** | ** ** | **Maturity  dates  (Fiscal  Year)** | ** ** | **Interest  Rates** | ** **                      |
|------------------------------|------------|------------------------------------|------------|-------------------------------------|------------|---------------------|---------------------------------|
| ABL facility                 |       | $                                  | 75,000     |                                | 2012       |                | (i)                             | PRIME and up to 0.50% or; |   |
|                         |       |                               |       |                                |       | (ii)                | LIBOR plus (1.00% to 1.50%)     |   |
| Term Loan A                  |       | 131,250                            |       | 2013                                |       | (i)                 | PRIME plus (1.00% to 1.50%) or; |   |
|                         |       |                               |       |                                |       | (ii)                | LIBOR plus (2.00% to 2.50%)     |   |
| Term Loan B                  |       | 899,300                            |       | 2014                                |       | (i)                 | PRIME plus (1.25% to 1.50%) or; |   |
|                         |       |                               |       |                                |       | (ii)                | LIBOR plus (2.25% to 2.50%)     |   |
| Other (a)                    |       | 2,695                              |       | 2009-2014                           |       | 4.05% to 7.00%      |                            |
| Total                        |       | $                                  | 1,108,245  |                                |       |                |                            |   |
|                         |       |                               |       |                                |       |                |                            |
| Senior notes                 |       | $                                  | 430,000    |                                | 2015       |                | 9.25%                           |   |
| Senior subordinated notes    |       | 280,000                            |       | 2017                                |       | 10.50%              |                            |
| Total                        |       | $                                  | 710,000    |                                |       |                |                            |   |
|                         |       |                               |       |                                |       |                |                            |
| Capitalized leases and other |       | $                                  | 674        |                                |       |                |                            |   |
| Less: current portion        |       | (100,360                           | )          |                                |       |                |                            |
| Total long-term debt         |       | $                                  | 1,718,559  |                                |       |                |                            |   |

 

----

(a) Represents pre-acquisition debt of Pro-Duo,N.V.

 

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Condensed Notes to Consolidated Financial Statements

 

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

 

| **Fiscal Year:**         | ** ** | ** ** | ** ** |
|--------------------------|------------|------------|------------|
| 2009                     |       | $          | 94,206     |   |
| 2010                     |       | 24,816     |       |
| 2011                     |       | 39,558     |       |
| 2012                     |       | 84,520     |       |
| 2013                     |       | 9,390      |       |
| Thereafter               |       | 1,565,755  |       |
|                     |       | $          | 1,818,245  |   |
| Capital leases and other |       | 674        |       |
| Less: current portion    |       | (100,360   | )          |
| Total                    |       | $          | 1,718,559  |   |

 

##### ***7.***                 Interest Rate Swaps

##### *** ***

The Company utilizesinterest rate swap agreements to manage its cash flow exposure associated withchanging interest rates in connection with its term loan obligations. TheCompany does not currently purchase or hold any derivative instruments fortrading or speculative purposes.

 

In connection with the SeparationTransactions, effective November 2006, the Company entered into fourinterest rate swap agreements with an aggregate notional amount of $500million. Interestrate swap agreements with an aggregate notional amount of $150.0 millionexpired in November 2008 and interest rate swap agreements with a notionalamount of $350.0 million expire in November 2009. These interest rate swap agreements do notcurrently qualify as hedges and, therefore, the change in fair value of theseinterest rate swap agreements, which are adjusted quarterly, are recorded inthe results of operations. EffectiveMay 2008, the Company entered into two additional interest rate swapagreements with an aggregate notional amount of $300 million. These interest rate swap agreements are designated as effective cashflow hedges, in accordance with SFAS 133. Adjustments to reflect the change in the fair values of these interestrate swap agreements, which are adjustedquarterly, are recorded,net of income tax, in accumulated other comprehensive (loss) income until thehedged obligation is settled or the swap agreements expire, whichever isearlier. Any hedge ineffectiveness, as this term is used in SFAS 133, isrecognized in net interest expense in the consolidated statements of earnings.Please see the Company’s Annual Report on Form 10-K for fiscal year ended September 30,2008 for additional information about the Company’s interest rate swapagreements.

 

The aggregate fair value of all interest rateswap agreements held at December 31, 2008 was an aggregate liability of$27.2 million, consisting of $10.7 million included in accrued expenses and$16.5 million in other liabilities. Fair value estimates used for the swapagreements held by the Company are based on third-party information and weredetermined using proprietary models based upon well-recognized financialprinciples and reasonable estimates about relevant future market conditions.

 

Thecounterparties to all our interest rate swap instruments aredeemed by the Company to be of substantial resources and strongcreditworthiness. However, these transactions result in exposure to creditrisks in the event of default by a counterparty. The current financial crisisaffecting the banking systems and financial markets has resulted in manywell-known financial institutions becoming less creditworthy or havingdiminished liquidity and, thus, we could be exposed to an increased level ofcounterparty risk.  In the event that acounterparty defaults in its obligation under our interest rate swaps, we couldincur substantial financial losses. However, at the present time, no suchlosses are deemed probable.

 

There were nogains or losses reclassified into earnings, from accumulated other comprehensive(loss) income, in connection with the swap agreements during the three monthsended December 31, 2008 or 2007. The marked-to-marketimpact of the swap arrangements on interest expense was an increase ofapproximately $3.0 million and $5.7 million in the three months ended December 31,2008 and 2007, respectively.

 

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** **

Sally Holdings LLC andSubsidiaries

Condensed Notes to Consolidated Financial Statements

** **

**8.**                 Income Taxes

** **

**SallyBeauty and its subsidiaries, including the Company, file income tax returns inthe U.S. federal jurisdiction and most state jurisdictions, as well as invarious foreign jurisdictions.**

** **

TheSeparation Transactions were 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 Internal Revenue Service (“IRS”) and (ii) anopinion of Sidley Austin LLP, counsel to Alberto-Culver, in each case, to theeffect that the transactions qualify as a reorganization under Section 368(a)(1)(D) ofthe Code and a distribution eligible for non-recognition under Sections 355(a) and361(c) of the Code. Certain internal restructurings also occurred at orimmediately prior to the Separation Transactions. As a result of the internalrestructurings and Separation Transactions, Sally Beauty inherited the federaltax identification number of the old Alberto-Culver parent for U.S. federalincome tax purposes.

 

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

 

Inaddition, as the successor entity to Alberto-Culver after the SeparationTransactions, Sally Beauty relies upon the prior year federal income taxreturns of Alberto-Culver, and accounting methods established therein, forcertain calculations that affect our current U.S. federal income tax liability.

 

##### ***9.***                 Business Segments

##### *** ***

TheCompany’s business is organized into two separate segments: (i) SallyBeauty Supply, a domestic and international chain of cash and carry retailstores which offers professional beauty supplies to both salon professionalsand retail customers and (ii) BSG, including its franchise-based businessArmstrong McCall, a full service beauty supply distributor which offersprofessional brands of beauty products directly to salons through its own salesforce and professional only stores (including franchise stores) in generally exclusivegeographical territories in North America and parts of Europe.

 

The Company does not sell between segments.  Segment data for the three months ended December 31,2008 and 2007 is as follows (in thousands):

 

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Condensed Notes to Consolidated Financial Statements

 
| ** **                                  | ** ** | **Three Months Ended  December 31,** | ** ** |
|---------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                  | ** ** | **2008**                                  | ** ** | **2007** | ** ** |
| Net sales:                                  |       |                                      |       |   |   |
| Sally Beauty Supply                         |       | $                                         | 410,537    |   | $ | 409,564 |   |
| BSG                                         |       | 235,039                                   |       | 246,223 |   |
| Total net sales                             |       | $                                         | 645,576    |   | $ | 655,787 |   |
| Earnings before provision for income taxes: |       |                                      |       |   |   |
| Segment operating profit:                   |       |                                      |       |   |   |
| Sally Beauty Supply                         |       | $                                         | 65,286     |   | $ | 71,733 |   |
| BSG                                         |       | 20,236                                    |       | 21,030 |   |
| Segment operating profit                    |       | 85,522                                    |       | 92,763 |   |
| Unallocated corporate expenses **(1)**      |       | (13,794                                   | )          | (15,794 | ) |
| Share-based compensation expense            |       | (3,468                                    | )          | (5,447 | ) |
| Interest expense, net of interest income    |       | (39,673                                   | )          | (46,483 | ) |
| Earnings before  provision for income taxes |       | $                                         | 28,587     |   | $ | 25,039 |   |

 

----

(1)  Unallocated corporate expensesconsist of corporate and shared costs.

 

## **10.**          Guarantor and Non-GuarantorCondensed Consolidated Financial Statements

##  

The following condensed consolidating financialinformation presents the Condensed Consolidated Balance Sheets as of December 31,2008 and September 30, 2008, the Condensed Consolidated Statements ofEarnings for the three months ended December 31, 2008 and 2007, and theCondensed Consolidated Statements of Cash Flows for the three months ended December 31,2008 and 2007 of: (i) Sally Holdings LLC, or “the Parent;” (ii) SallyCapital Inc., or “Co-Issuer;” (iii) the guarantor subsidiaries; (iv) thenon-guarantor subsidiaries; (v) elimination entries necessary toconsolidate the Parent with the guarantor and non-guarantor subsidiaries; and (vi) theParent 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

CondensedNotes to Consolidated Financial Statements

 

**SALLYHOLDINGS LLC AND SUBSIDIARIES**

Condensed ConsolidatingBalance Sheet

December 31, 2008

(In thousands)

(Unaudited)

 
| ** **                                                                  | ** ** | **Parent** | ** ** | **Co-Issuer** | ** ** | **Guarantor Subsidiaries** | ** ** | **Non-  Guarantor Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally  Holdings LLC &  Subsidiaries** | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|---------------|------------|----------------------------|------------|----------------------------------|------------|------------------|------------|--------------------------------------------------|------------|
| **Assets**                                                                  | ** ** | ** ** | ** ** | ** **    | ** ** | ** **                 | ** ** | ** **                       | ** ** | ** **       | ** ** | ** **                                       | ** ** |
| Cash and cash equivalents                                                   |       | $          | 18         |          | $          | —                     |       | $                                | 92,711     |             | $          | 19,888                                           |       | $ | — |   | $ | 112,617 |   |
| Trade accounts and other receivables, less  allowance for doubtful accounts |       | 1,015      |       | —        |       | 51,529                     |       | 17,469                           |       | —           |       | 70,013                                           |       |
| Due from affiliates                                                         |       | —     |       | —        |       | 14,157                     |       | 9,288                            |       | (23,445          | )          | —                                           |       |
| Inventories                                                                 |       | —     |       | —        |       | 452,304                    |       | 119,346                          |       | —           |       | 571,650                                          |       |
| Prepaid expenses                                                            |       | 179        |       | —        |       | 10,211                     |       | 6,366                            |       | —           |       | 16,756                                           |       |
| Deferred income tax assets                                                  |       | 2,968      |       | —        |       | 21,250                     |       | (3,333                           | )          | —           |       | 20,885                                           |       |
| Property and equipment, net                                                 |       | —     |       | —        |       | 118,152                    |       | 31,005                           |       | —           |       | 149,157                                          |       |
| Investment in subsidiaries                                                  |       | 1,071,781  |       | —        |       | 239,819                    |       | —                           |       | (1,311,600       | )          | —                                           |       |
| Goodwill and other intangible assets, net                                   |       | —     |       | —        |       | 370,214                    |       | 124,460                          |       | —           |       | 494,674                                          |       |
| Other assets                                                                |       | 40,628     |       | —        |       | 1,399                      |       | 8,618                            |       | —           |       | 50,645                                           |       |
| Total assets                                                                |       | $          | 1,116,589  |          | $          | —                     |       | $                                | 1,371,746  |             | $          | 333,107                                          |       | $ | (1,335,045 | ) | $ | 1,486,397 |   |
|                                                                        |       |       |       |          |       |                       |       |                             |       |             |       |                                             |       |
| **Liabilities and Member’s (Deficit) Equity**                          | ** ** | ** ** | ** ** | ** **    | ** ** | ** **                 | ** ** | ** **                       | ** ** | ** **       | ** ** | ** **                                       | ** ** |
| Accounts payable                                                            |       | $          | —     |          | $          | —                     |       | $                                | 117,851    |             | $          | 48,412                                           |       | $ | — |   | $ | 166,263 |   |
| Due to affiliates                                                           |       | 7,080      |       | —        |       | 2,208                      |       | 14,157                           |       | (23,445          | )          | —                                           |       |
| Accrued expenses                                                            |       | 23,766     |       | —        |       | 100,661                    |       | 20,153                           |       | —           |       | 144,580                                          |       |
| Due to Sally Beauty                                                         |       | —     |       | —        |       | 26,504                     |       | —                           |       | —           |       | 26,504                                           |       |
| Income taxes                                                                |       | 5,727      |       | —        |       | 519                        |       | 4,037                            |       | —           |       | 10,283                                           |       |
| Long-term debt                                                              |       | 1,815,550  |       | —        |       | 326                        |       | 3,043                            |       | —           |       | 1,818,919                                        |       |
| Other liabilities                                                           |       | 16,522     |       | —        |       | 15,860                     |       | 933                              |       | —           |       | 33,315                                           |       |
| Deferred income tax liabilities                                             |       | (9,477     | )          | —        |       | 36,036                     |       | 2,553                            |       | —           |       | 29,112                                           |       |
| Total liabilities                                                           |       | 1,859,168  |       | —        |       | 299,965                    |       | 93,288                           |       | (23,445          | )          | 2,228,976                                        |       |
| Stock options subject to redemption                                         |       | 5,650      |       | —        |       | —                     |       | —                           |       | —           |       | 5,650                                            |       |
| Total member’s (deficit) equity                                        |       | (748,229   | )          | —        |       | 1,071,781                  |       | 239,819                          |       | (1,311,600       | )          | (748,229                                         | )          |
| Total liabilities and member’s (deficit)  equity                       |       | $          | 1,116,589  |          | $          | —                     |       | $                                | 1,371,746  |             | $          | 333,107                                          |       | $ | (1,335,045 | ) | $ | 1,486,397 |   |

 

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Sally Holdings LLC andSubsidiaries

CondensedNotes to Consolidated Financial Statements

 

**SALLYHOLDINGS LLC AND SUBSIDIARIES**

Condensed ConsolidatingBalance Sheet

September 30, 2008

(In thousands)

 
| ** **                                                                  | ** ** | **Parent** | ** ** | **Co-Issuer** | ** ** | **Guarantor Subsidiaries** | ** ** | **Non-  Guarantor Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally  Holdings LLC &  Subsidiaries** | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|---------------|------------|----------------------------|------------|----------------------------------|------------|------------------|------------|--------------------------------------------------|------------|
| **Assets**                                                                  | ** ** | ** ** | ** ** | ** **    | ** ** | ** **                 | ** ** | ** **                       | ** ** | ** **       | ** ** | ** **                                       | ** ** |
| Cash and cash equivalents                                                   |       | $          | 1,645      |          | $          | —                     |       | $                                | 85,384     |             | $          | 12,759                                           |       | $ | — |   | $ | 99,788 |   |
| Trade accounts and other receivables, less  allowance for doubtful accounts |       | —     |       | —        |       | 45,631                     |       | 20,446                           |       | —           |       | 66,077                                           |       |
| Due from affiliates                                                         |       | 36,219     |       | —        |       | 15,389                     |       | 15,860                           |       | (67,468          | )          | —                                           |       |
| Inventories                                                                 |       | —     |       | —        |       | 465,319                    |       | 132,876                          |       | —           |       | 598,195                                          |       |
| Prepaid expenses                                                            |       | 113        |       | —        |       | 10,532                     |       | 8,804                            |       | —           |       | 19,449                                           |       |
| Deferred income tax assets                                                  |       | 2,968      |       | —        |       | 21,251                     |       | (3,447                           | )          | —           |       | 20,772                                           |       |
| Property and equipment, net                                                 |       | —     |       | —        |       | 120,051                    |       | 36,209                           |       | —           |       | 156,260                                          |       |
| Investment in subsidiaries                                                  |       | 1,064,199  |       | —        |       | 272,094                    |       | —                           |       | (1,336,293       | )          | —                                           |       |
| Goodwill and other intangible assets, net                                   |       | —     |       | —        |       | 370,178                    |       | 140,219                          |       | —           |       | 510,397                                          |       |
| Other assets                                                                |       | 44,034     |       | —        |       | 1,612                      |       | 9,074                            |       | —           |       | 54,720                                           |       |
| Total assets                                                                |       | $          | 1,149,178  |          | $          | —                     |       | $                                | 1,407,441  |             | $          | 372,800                                          |       | $ | (1,403,761 | ) | $ | 1,525,658 |   |
|                                                                        |       |       |       |          |       |                       |       |                             |       |             |       |                                             |       |
| **Liabilities and Member’s (Deficit) Equity**                          | ** ** | ** ** | ** ** | ** **    | ** ** | ** **                 | ** ** | ** **                       | ** ** | ** **       | ** ** | ** **                                       | ** ** |
| Accounts payable                                                            |       | $          | 1,633      |          | $          | —                     |       | $                                | 120,917    |             | $          | 49,412                                           |       | $ | — |   | $ | 171,962 |   |
| Due to affiliates                                                           |       | —     |       | —        |       | 52,079                     |       | 15,389                           |       | (67,468          | )          | —                                           |       |
| Accrued expenses                                                            |       | 31,503     |       | —        |       | 100,678                    |       | 22,348                           |       | —           |       | 154,529                                          |       |
| Due to Sally Beauty.                                                        |       | 474        |       | —        |       | 16,769                     |       | —                           |       | —           |       | 17,243                                           |       |
| Income taxes                                                                |       | 5,727      |       | —        |       | 476                        |       | 5,183                            |       | —           |       | 11,386                                           |       |
| Long-term debt                                                              |       | 1,821,600  |       | —        |       | 386                        |       | 3,299                            |       | —           |       | 1,825,285                                        |       |
| Other liabilities                                                           |       | 7,163      |       | —        |       | 15,436                     |       | 1,109                            |       | —           |       | 23,708                                           |       |
| Deferred income tax liabilities                                             |       | (2,526     | )          | —        |       | 36,501                     |       | 3,966                            |       | —           |       | 37,941                                           |       |
| Total liabilities                                                           |       | 1,865,574  |       | —        |       | 343,242                    |       | 100,706                          |       | (67,468          | )          | 2,242,054                                        |       |
| Stock options subject to redemption                                         |       | 5,884      |       | —        |       | —                     |       | —                           |       | —           |       | 5,884                                            |       |
| Total member’s (deficit) equity                                        |       | (722,280   | )          | —        |       | 1,064,199                  |       | 272,094                          |       | (1,336,293       | )          | (722,280                                         | )          |
| Total liabilities and member’s (deficit)  equity                       |       | $          | 1,149,178  |          | $          | —                     |       | $                                | 1,407,441  |             | $          | 372,800                                          |       | $ | (1,403,761 | ) | $ | 1,525,658 |   |

 

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Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

 

**SALLYHOLDINGS LLC AND SUBSIDIARIES**

CondensedConsolidating Statement of EarningsThree months ended December 31, 2008

(In thousands)

(Unaudited)

** **
| ** **                                           | ** ** | ** ** | ** ** | ** **    | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | **Sally  Holdings LLC** | ** ** |
|------------------------------------------------------|------------|------------|------------|---------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------------------|------------|
| ** **                                           | ** ** | **Parent** | ** ** | **Co-Issuer** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**    | ** ** | **Eliminations** | ** ** | **& Subsidiaries**  | ** ** |
| ** **                                           | ** ** | ** ** | ** ** | ** **    | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **                   | ** ** |
| Net sales                                            |       | $          | —     |          | $          | —           |       | $                   | 526,444    |             | $          | 119,132                      |       | $ | — |   | $ | 645,576 |   |
| Related party sales                                  |       | —     |       | —        |       | 777              |       | —              |       | (777             | )          | —                       |       |
| Cost of products sold and distribution  expenses     |       | —     |       | —        |       | 275,555          |       | 67,254              |       | (777             | )          | 342,032                      |       |
| Gross profit                                         |       | —     |       | —        |       | 251,666          |       | 51,878              |       | —           |       | 303,544                      |       |
| Selling, general and administrative  expenses        |       | 209        |       | —        |       | 176,652          |       | 46,676              |       | —           |       | 223,537                      |       |
| Depreciation and amortization                        |       | —     |       | —        |       | 9,039            |       | 2,708               |       | —           |       | 11,747                       |       |
| Operating earnings (loss)                            |       | (209       | )          | —        |       | 65,975           |       | 2,494               |       | —           |       | 68,260                       |       |
| Interest income                                      |       | —     |       | —        |       | (62              | )          | (86                 | )          | —           |       | (148                         | )          |
| Interest expense                                     |       | 39,647     |       | —        |       | 68               |       | 106                 |       | —           |       | 39,821                       |       |
| Earnings (losses) before provision for  income taxes |       | (39,856    | )          | —        |       | 65,969           |       | 2,474               |       | —           |       | 28,587                       |       |
| Provision (benefit) for income taxes                 |       | (16,729    | )          | —        |       | 27,531           |       | 578                 |       | —           |       | 11,380                       |       |
| Equity in earnings of subsidiaries (net of  tax)     |       | 40,334     |       | —        |       | 1,896            |       | —              |       | (42,230          | )          | —                       |       |
| Net earnings                                         |       | $          | 17,207     |          | $          | —           |       | $                   | 40,334     |             | $          | 1,896                        |       | $ | (42,230 | ) | $ | 17,207 |   |

 

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Sally Holdings LLCand Subsidiaries

Condensed Notes toConsolidated Financial Statements

 

**SALLYHOLDINGS LLC AND SUBSIDIARIES**

CondensedConsolidating Statement of EarningsThree months ended December 31, 2007

(In thousands)

(Unaudited)

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

 

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Sally Holdings LLCand Subsidiaries

Condensed Notes toConsolidated Financial Statements

 

**SALLYHOLDINGS LLC AND SUBSIDIARIES**

CondensedConsolidating Statement of Cash FlowsThree months ended December 31, 2008

(In thousands)

(Unaudited)

 
| ** **                                                                 | ** ** | ** ** | ** ** | ** **    | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | **Sally Holdings  LLC**     | ** ** |
|----------------------------------------------------------------------------|------------|------------|------------|---------------|------------|------------------|------------|---------------------|------------|------------------|------------|-----------------------------|------------|
| ** **                                                                 | ** ** | **Parent** | ** ** | **Co-Issuer** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**    | ** ** | **Eliminations** | ** ** | **& Subsidiaries** | ** ** |
| **Net cash provided by operating activities**                              |       | $          | 6,056      |          | $          | —           |       | $                   | 14,787     |             | $          | 10,443                      |       | $ | — |   | $ | 31,286 |   |
| **Cash Flows from Investing Activities:**                                  |       |       |       |          |       |             |       |                |       |             |       |                        |       |
| Capital expenditures, net of proceeds from  sale of property and equipment |       | —     |       | —        |       | (6,204           | )          | (2,164              | )          | —           |       | (8,368                      | )          |
| Acquisitions, net of cash acquired                                         |       | —     |       | —        |       | (1,085           | )          | (670                | )          | —           |       | (1,755                      | )          |
| Net cash used by investing activities                                      |       | —     |       | —        |       | (7,289           | )          | (2,834              | )          | —           |       | (10,123                     | )          |
| **Cash Flows from Financing Activities:**                                  |       |       |       |          |       |             |       |                |       |             |       |                        |       |
| Change in book cash overdraft                                              |       | (1,633     | )          | —        |       | —           |       | —              |       | —           |       | (1,633                      | )          |
| Proceeds from issuance of long-term debt                                   |       | 81,000     |       | —        |       | —           |       | 1,638               |       | —           |       | 82,638                      |       |
| Repayments of long-term debt                                               |       | (87,050    | )          | —        |       | (60              | )          | (1,911              | )          | —           |       | (89,021                     | )          |
| Excess tax provision from share-based  compensation                        |       | —     |       | —        |       | (111             | )          | —              |       | —           |       | (111                        | )          |
| Net cash used by financing activities                                      |       | (7,683     | )          | —        |       | (171             | )          | (273                | )          | —           |       | (8,127                      | )          |
| Effect of foreign exchange rate changes on  cash and cash equivalents      |       | —     |       | —        |       | —           |       | (207                | )          | —           |       | (207                        | )          |
| Net (decrease) increase in cash and cash  equivalents                      |       | (1,627     | )          | —        |       | 7,327            |       | 7,129               |       | —           |       | 12,829                      |       |
| Cash and cash equivalents, beginning of  period                            |       | 1,645      |       | —        |       | 85,384           |       | 12,759              |       | —           |       | 99,788                      |       |
| Cash and cash equivalents, end of period                                   |       | $          | 18         |          | $          | —           |       | $                   | 92,711     |             | $          | 19,888                      |       | $ | — |   | $ | 112,617 |   |

 

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Sally Holdings LLCand Subsidiaries

Condensed Notes toConsolidated Financial Statements

 

**SALLYHOLDINGS LLC AND SUBSIDIARIES**

CondensedConsolidating Statement of Cash FlowsThree months ended December 31, 2007

(In thousands)

(Unaudited)

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

 

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

# ** **

The following sectiondiscusses management’s view of the financial condition, results of operationsand cash flows of Sally Holdings LLC, a wholly-owned subsidiary of SallyInvestment Holdings LLC, or Sally Investment, a wholly-owned subsidiary ofSally Beauty Holdings, Inc., or SallyBeauty, 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 conjunctionwith the audited consolidated financial statements and the related notesincluded in our Annual Report on Form 10-K for the fiscal year ended September 30,2008, as well as the Risk Factors section of that Annual Report, andinformation contained elsewhere in this Quarterly Report, including theconsolidated financial statements and condensed notes to those statements.  This Management’s Discussion and Analysis ofFinancial Condition and Results of Operations contains forward-lookingstatements. See “Cautionary Notice Regarding Forward-Looking Statements,”included at the beginning of this Quarterly Report, for a discussion of theuncertainties, risks and assumptions associated with these forward-lookingstatements that could cause results to differ materially from those reflectedin such forward-looking statements.

 

**Highlights of First Quarter of Fiscal Year 2009:**

 

·                  Oursame store sales increased slightly for the three months ended December 31,2008;

 

·                  Ourconsolidated net sales for the three months ended December 31, 2008decreased by $10.2 million, or 1.6%, to $645.6 million compared to $655.8million for the three months ended December 31, 2007;

 

·                  Netsales reported for the three months ended December 31, 2008 were impactedby an unfavorable foreign currency exchange impact of $24.8 million, or 3.8%;

 

·                  Ourconsolidated gross profit for the three months ended December 31, 2008decreased $2.6 million, or 0.9%, to $303.5 million compared to $306.2 millionfor the three months ended December 31, 2007. As a percentage of netsales, gross profit increased 30 basis points to 47.0% for the three monthsended December 31, 2008 compared to 46.7% for the three months ended December 31,2007;

 

·                  Ourconsolidated operating earnings for the three months ended December 31,2008 decreased $3.3 million, or 4.6%, to $68.3 million compared to $71.5million for the three months ended December 31, 2007.  As a percentage of net sales, operatingearnings were 10.6% for the three months ended December 31, 2008 comparedto 10.9% for the three months ended December 31, 2007;

 

·                  Netearnings increased $1.9 million, or 12.1%, to $17.2 million for the threemonths ended December 31, 2008 compared to $15.3 million for the threemonths ended December 31, 2007; and

 

·                  Cashflows from operations for the three months ended December 31, 2008increased by $49.2 million to net cash provided of $31.3 million,compared to net cash used of $18.0 million for the three months ended December 31,2007.

 

**Overview**

 

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

##### *** ***

We are the largest distributor of professional beautysupplies in the U.S. based on store count. We operate primarily through twobusiness units, Sally Beauty Supply and BSG. Through Sally Beauty Supply andBSG (which operates stores under the CosmoProf service mark), we operated amulti-channel platform of 3,582 stores and supplied 187 franchised stores inNorth America, as well as in certain European countries and Japan, as of December 31,2008. Within BSG, we also have one of the largest networks of professionaldistributor sales consultants in North America, with approximately 977professional 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 three months ended December 31,2008, our net sales and operating earnings were $645.6 million and$68.3 million, respectively.

 

We believe that Sally Beauty Supply is the largestopen-line distributor of professional beauty supplies in the U.S. based onstore count. As of December 31, 2008, Sally Beauty Supply operated 2,824company-operated retail stores and supplied 25 franchised stores (all locatedoutside the U.S.). Of these stores, 2,309 are located in the U.S. (with theremainder in the United Kingdom and certain other countries in Europe, Canada,Puerto Rico, Mexico and

 

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Japan). Sally Beauty Supply storesaverage 1,700 square feet and are primarily located in strip shoppingcenters. The product selection in Sally Beauty Supply stores ranges between5,000 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.

 

Webelieve that BSG is the largest full-service distributor of professional beautysupplies in the U.S. As of December 31, 2008, BSG had758 company-operated stores, supplied 162 franchised stores and had asales force of approximately 977 professional distributor sales consultants sellingexclusively to salons and salon professionals in substantially all states inthe U.S. and in portions of Canada, Mexico and certain European countries.BSG stores average 2,700 square feet and are primarily located insecondary strip shopping centers. Through BSG’s large store base and salesforce, BSG is able to access a significant portion of the highly fragmentedU.S. salon channel. The product selection in BSG stores, ranging between4,000 and 9,600 SKUs of beauty products, includes hair care and color, skin andnail care, beauty sundries and electrical appliances targeting salons and salonprofessionals. BSG carries leading professional beauty product brands, intendedfor use in salons and for resale by the salon to consumers. Certain BSG productsare sold under exclusive distribution agreements with suppliers, whereby BSG isdesignated as the sole distributor for a product line within certain geographicterritories.

 

##### ***Industryand Business 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, offset by lower sales of electrical products duringperiods of prolonged economic slowdown. We believe the following key industryand business trends and characteristics will influence our business and ourfinancial results going forward:

 

·             *High level of customer fragmentation.*  The U.S. salon channel ishighly fragmented with over 225,000 salons. Given the fragmented andsmall-scale nature of the salon industry, we believe that salon operators willcontinue to depend on full-service/exclusive distributors and open-linechannels for a majority of their beauty supply purchases.

 

·             *Growth in booth renting and frequent stocking needs.*  Salon professionals primarilyrely on just-in-time inventory due to capital constraints and a lack ofwarehouse and shelf space at salons.  Inaddition, booth renters, who comprise a significant percentage of total U.S.salon professionals, are often responsible for purchasing their own supplies.Historically, booth renters have significantly increased as a percentage oftotal salon professionals and we expect this trend to continue. Given theirsmaller individual purchases and relative lack of financial resources, boothrenters are likely to be dependent on frequent trips to professional beautysupply stores, like BSG and Sally Beauty Supply.  These factors continue to drive demand forconveniently located professional beauty supply stores.

 

·             *Increasing Use of Exclusive-Label Products.*  We offer a broad range of privatelabel and control label products, 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 believe thisarea 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, 2008.

 

·             *InternationalGrowth Strategies. *A key element of our growth strategy dependson our ability to capitalize on growth in the international marketplace and togrow our current level of non-U.S. operations. In May 2008, we acquired Pro-Duo, N.V., a cash and carry retailerof both professional and retail hair products with approximately 40 storeslocated in Belgium, France and Spain. In February 2007, we acquired Chapelton21 Limited, a private company based in Scotland with almost 100 stores locatedin the United Kingdom, Ireland, Germany, France and Spain, which we refer to asSalon Services.  These acquisitionsfurthered our expansion plans in Europe, a significant part of Sally BeautySupply’s international growth initiative. We intend to continue to identify and evaluate non-U.S. acquisitiontargets and are actively considering expansion into South America.  Our ability to grow our non-U.S. operations,integrate our new non-U.S. 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 

 

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economic risks” in Item 1A of our AnnualReport on Form 10-K for the fiscal year ended September 30, 2008.

 

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

quality or who may be unwilling to continueto supply products to us” in Item 1A of our Annual report on Form 10-K forthe 

fiscal year ended September 30, 2008.

 

·             *High level of competition.*  Sally Beauty Supply competes with other domestic andinternational beauty product wholesale and retail outlets, including local andregional open-line beauty supply stores, professional-only beauty supply stores,salons, mass merchandisers, drug stores and supermarkets, as well as sellers onthe Internet and salons retailing hair care items. BSG competes with otherdomestic and international beauty product wholesale and retail suppliers andmanufacturers selling professional beauty products directly to salons andindividual salon professionals. We also face competition from authorized andunauthorized retailers and Internet sites offering professional salon-onlyproducts. The increasing availability of unauthorized professional salonproducts in large format retail stores such as drug stores, grocery stores andothers could also have a negative impact on our business.

 

·             *Favorable demographic and consumer trends.*  The aging baby-boomer populationis expected to drive future growth in professional beauty supply sales throughan increase in the usage of hair color and hair loss products. Additionally,continuously changing fashion-related trends that drive new hair styles areexpected to result in continued demand for hair styling products. Changes inconsumer tastes and fashion trends can have an impact on our financialperformance. Our continued success depends in large part on our ability toanticipate, gauge and react in a timely and effective manner to changes inconsumer spending patterns and preferences for beauty products. We continuouslyadapt our marketing and merchandising initiatives for Sally Beauty Supply in aneffort to expand our market reach or to respond to changing consumerpreferences.  If we are unable toanticipate and respond to trends in the marketplace for beauty products andchanging consumer demands, our business could suffer.

 

·             *Economicconditions.*  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 continued downturn in the economy, especially for an extended period of time,could adversely impact consumer demand of discretionary items such as beautyproducts and salon services, particularly affecting our electrical productscategory and our full-service sales business. In addition, higher freight costsresulting from increases in the cost of fuel, especially for an extended periodof time, may impact our expenses at levels that we cannot pass through to ourcustomers.  These factors could have amaterial adverse effect on our business, financial condition and results ofoperations.

 

·             *Controllingexpenses*.  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.  During late fiscal year 2007, we beganimplementing an approximately $22.0 million capital spending program toconsolidate warehouses and reduce administrative expenses related to BSG’sdistribution network optimization program. We believe that cost savings fromthis program could range between $5

 

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millionand $7 million in fiscal year 2009 and annualized savings of $10 millionbeginning in fiscal year 2010.  Inaddition, during the fiscal 2009 first quarter we implemented a temporary hiringfreeze for all personnel, deferred merit increases for upper management andinstituted variable expense reductions related to benefits and payroll relatedcosts.  Please see “Risk Factors – We arenot certain that our ongoing cost control plans will continue to be successful”in Item 1A of our Annual Report on Form 10-K for the fiscal year ended September 30,2008.

 

·             *OpeningNew Stores*.  Our future growth strategy depends in part,on our 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. However, in response to economic conditionsor to allow flexibility to capitalize on potential real estate revaluations inkey locations, we may not be able to open all of the new stores we plan to openand any new stores we open may not be profitable, either of which could have amaterial adverse impact on our financial condition or results of operations.Please see “Risk Factors – If we are unable to profitably open and operate newstores, our business, financial condition and results of operations may beadversely affected” in Item 1A of our Annual Report on Form 10-K for thefiscal year ended September 30, 2008.

 

·             *Changesto 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 and infrastructure will require us tocommit substantial financial, operational and technical resources in advance ofany increase in the volume of our business, with no assurance that the volumeof business will increase.  For example,in fiscal year 2008 we upgraded our Lawson financial reporting system andimplemented Customer Relationship Management, or CRM, programs for our SallyBeauty Supply stores and are currently upgrading our distribution information systems(in connection with our capital spending program to consolidate warehouses, asdiscussed above), upgrading our AS400 iSeries servers and implementing anew point-of-sale system for tracking customer sales.  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, 2008.

 

·             *Relationshipswith suppliers*.  We do not manufacture the brand name orexclusive-label products we sell, and instead purchase our products frommanufacturers. We depend upon a limited number of manufacturers for asignificant percentage of the products we sell, and our relationships withthese suppliers change often.  Please see“Relationships with Suppliers.”

 

##### ***Relationships with Suppliers***

##### *** ***

Most of our net sales are generated through retailstores with respect to the Sally Beauty Supply business, and both professionalonly stores and professional distribution sales consultants with respect to theBSG business. In addition, BSG has a number of franchisees located primarily inthe south and southwestern portions of the U.S. and in Mexico, which buyproducts directly from BSG for resale in their assigned territories. A verysmall percentage of sales are generated through franchisees or sub-distributors(primarily in Europe), which also buy products directly from Sally BeautySupply or BSG for resale. Sally Beauty Supply/BSG and their suppliers aredependent on each other for the distribution of beauty products. As is typicalin distribution businesses, these relationships are subject to change from timeto time (including the expansion or loss of distribution rights in variousgeographies and the addition or loss of product lines).

 

Since we purchase products from many manufacturers onan at-will basis, under contracts which can generally be terminated withoutcause upon 90 days’ notice or less or which expire without express rightsof renewal, such manufacturers could discontinue sales to us at any time orupon the expiration of the distribution period. Some of our contracts withmanufacturers may be terminated by such manufacturers if we fail to meetspecified minimum purchase requirements. In such cases, we do not havecontractual assurances of continued supply, pricing or access to new productsand vendors may change the terms upon which they sell. Infrequently, a supplierwill seek to terminate a distribution relationship through legal action.

 

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Changes in our relationships with suppliers occuroften, and could positively or negatively impact our net sales and operatingprofits. For example, during the 2009 first quarter, BSG gained additionaldistribution of Henkel’s Schwarzkopf brand in stores accross four states.  In addition, during the second quarter offiscal year 2007, Farouk Systems, Inc., or Farouk Systems, terminated itsdistribution agreement with us. Subsequently, effective July 2007, BSGstores and professional distributor sales consultants were once again givenapproval to distribute Farouk Systems products, with an expanded distributionarea. In the first quarter of fiscal 2009, Farouk Systems again terminated itsdistribution agreement with BSG. The agreement through which our ArmstrongMcCall franchisees are supplied is currently unaffected by this event. In December 2006,we announced the loss of certain L’Oreal distribution rights, including (amongother things) distribution rights through our BSG distributor sales consultantsand the loss of exclusive rights to distribute L’Oreal products in our BSGstores.  These losses have resulted in margin pressure on BSG’s remainingL’Oreal revenues, and this pressure has continued into fiscal year 2009. Asdiscussed above, L’Oreal has entered into direct competition with BSG and therecan be no assurance that there will not be further revenue losses over time atBSG due to potential losses of additional L’Oreal related products as well asfrom the increased competition from L’Oreal-affiliated distribution networks.BSG has entered into long-term agreements with L’Oreal under which, as of January 1,2007, BSG had non-exclusive rights to distribute the same L’Oreal professionalproducts in its stores that it previously had exclusive rights to distribute inits stores and through its sales consultants. Armstrong McCall retained itsexclusive rights to distribute Matrix professional products in its territories.Although we have focused on developing new revenue and cost management initiativesto mitigate the negative effects resulting from unfavorable changes in oursupplier relationships, there can be no assurance that our efforts willcontinue to completely offset the loss of these or other distribution rights.Please see “Risk Factors*—* Wedepend upon manufacturers who may be unable to provide products of adequatequality or who may be unwilling to continue to supply products to us” in Item1A of our Annual Report on Form 10-K for the fiscal year ended September 30,2008.

 

We expect to continue to expand our product lineofferings and to gain additional distribution rights over time through eitherfurther negotiation with suppliers, or by strategic acquisitions of existingdistributors.  Although we are focused ondeveloping new revenue and cost management initiatives, there can be noassurance that our efforts will partially or completely offset any potentialloss of distribution rights in the future. Please see “Risk Factors—We dependupon manufacturers who may be unable to provide products of adequate quality orwho may be unwilling to continue to supply products to us” in Item 1A of ourAnnual Report on Form 10-K for the fiscal year ended September 30,2008.

 

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

##### *** ***

InNovember 2006, pursuant to an investment agreement among Alberto-Culverand certain of its subsidiaries, including Sally Holdings, and CDRS AcquisitionLLC (“CDRS”), Alberto-Culver separated its consumer products business and itsSally Beauty Supply/BSG distribution business into two separate,publicly-traded companies (the “Separation Transactions”).  Sally Holdings was a wholly-owned subsidiaryof Alberto-Culver until the Separation Transactions, when it was converted to aDelaware limited liability company, was renamed Sally Holdings LLC and becamean indirect wholly-owned subsidiary of Sally Beauty.  Sally Beauty was formed in June 2006 andbecame the accounting successor company to Sally Holdings upon the completionof the Separation Transactions.  See theCompany’s Annual Report on Form 10-K for the fiscal year ended September 30,2008 for more information about the Separation Transactions.

 

##### ***Other Significant Items***

##### *** ***

*Interest Rate Swap Agreements*

 

The Company utilizes interest rate swap agreements tomanage its cash flow risk associated with changing interest rates as it relatesto its term loans. We do not currently purchase or hold any derivativeinstruments for trading or speculative purposes. The counterparties are deemedto be of substantial resources and strong creditworthiness. However, thesetransactions result in exposure to credit risks in the event of default by acounterparty. The current financial crisis affecting the banking systems andfinancial markets has resulted in many well-known financial institutionsbecoming less creditworthy or having diminished liquidity and, thus, we couldbe exposed to an increased level of counterparty risk.  In the event that a counterparty defaults inits obligation under our interest rate swaps, we could incur substantialfinancial loss. At December 31, 2008, the aggregate fair value of all ourinterest rate swaps was a net liability of $27.2 million.

 

Effective in November 2006, the Company enteredinto four interest rate swap agreements with an aggregate notional amount of$500.0 million. Interest rate swap agreements with an aggregate notional amountof $150.0 million expired in November 2008 and interest rate swapagreements with a notional amount of $350.0 million expire in November 2009.These interest rate swap agreements do not currently qualify as hedges and,therefore, the change in fair value of these interest rate swap agreements isrecorded in net interest expense in the consolidated statements of earnings.

 

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# **Additionally,effective in May 2008, the Company entered into two interest rate swapagreements with an aggregate notional amount of $300.0 million. These interestrate swap agreements are designated as effective hedges, consistent withStatement of Financial Accounting Standards No. 133, *Accountingfor Derivative Instruments and Hedging Activities*.  Adjustments to reflect the change in the fairvalues of these interest rate swap agreements are recorded in accumulated othercomprehensive (loss) income until the hedged obligation is settled or the swapagreements expire, whichever is earlier. Any ineffectiveness is recognized in net interest expense in theconsolidated statements of earnings. Please see “Item 3—Quantitative andQualitative Disclosures about Market Risk—Interest rate risk” and Note 12 ofthe “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, 2008.**

# ** **

## **Results of Operations**

##  

The following table shows the condensed results ofoperations of our business for the three months ended December 31, 2008and 2007, expressed as a percentage of net sales for the respective periods(dollars in thousands):

 
| ** **                                       | ** ** | **Three Months Ended December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                       | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| Net sales                                        |       | $                                                       | 645,576    |   | 100.0 | % | $ | 655,787 |   | 100.0 | % |
| Cost of products sold and distribution  expenses |       | 342,032                                                 |       | 53.0 | % | 349,618 |   | 53.3 | % |
| Gross profit                                     |       | 303,544                                                 |       | 47.0 | % | 306,169 |   | 46.7 | % |
| Total other operating costs and expenses         |       | 235,284                                                 |       | 36.4 | % | 234,647 |   | 35.8 | % |
| Operating earnings                               |       | 68,260                                                  |       | 10.6 | % | 71,522 |   | 10.9 | % |
| Interest expense, net                            |       | 39,673                                                  |       | 6.2 | % | 46,483 |   | 7.1 | % |
| Earnings before provision for income taxes       |       | 28,587                                                  |       | 4.4 | % | 25,039 |   | 3.8 | % |
| Provision for income taxes                       |       | 11,380                                                  |       | 1.7 | % | 9,693 |   | 1.5 | % |
| Net earnings                                     |       | $                                                       | 17,207     |   | 2.7 | % | $ | 15,346 |   | 2.3 | % |

 

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##### ***Key OperatingMetrics***

##### *** ***

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 December 31,** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                 | ** ** | **2008**                                                | ** ** | **2007(a)** | ** ** |
| Net sales:                                                 |       |                                                    |       |   |   |
| Sally Beauty Supply                                        |       | $                                                       | 410,537    |   | $ | 409,564 |   |
| BSG                                                        |       | 235,039                                                 |       | 246,223 |   |
|                                                       |       | $                                                       | 645,576    |   | $ | 655,787 |   |
| Gross Profit                                               |       | $                                                       | 303,544    |   | $ | 306,169 |   |
| Gross profit margin                                        |       | 47.0                                                    | %          | 46.7 | % |
| Selling, general and administrative  expenses              |       | $                                                       | 223,537    |   | $ | 222,895 |   |
| Depreciation and amortization                              |       | $                                                       | 11,747     |   | $ | 11,752 |   |
| Earnings before provision for income taxes:                |       |                                                    |       |   |   |
| Segment operating profit:                                  |       |                                                    |       |   |   |
| Sally Beauty Supply                                        |       | $                                                       | 65,286     |   | $ | 71,733 |   |
| BSG                                                        |       | 20,236                                                  |       | 21,030 |   |
| Segment operating profit                                   |       | 85,522                                                  |       | 92,763 |   |
| Unallocated expenses                                       |       | (13,794                                                 | )          | (15,794 | ) |
| Share-based compensation expense                           |       | (3,468                                                  | )          | (5,447 | ) |
| Operating earnings                                         |       | 68,260                                                  |       | 71,522 |   |
| Interest expense, net of interest income                   |       | (39,673                                                 | )          | (46,483 | ) |
| Earnings before provision for income taxes                 |       | $                                                       | 28,587     |   | $ | 25,039 |   |
| Segment operating profit margin:                           |       |                                                    |       |   |   |
| Sally Beauty Supply                                        |       | 15.9                                                    | %          | 17.5 | % |
| BSG                                                        |       | 8.6                                                     | %          | 8.5 | % |
| Consolidated operating profit margin                       |       | 10.6                                                    | %          | 10.9 | % |
| Number of stores at end-of-period  (including franchises): |       |                                                    |       |   |   |
| Sally Beauty Supply                                        |       | 2,849                                                   |       | 2,726 |   |
| BSG                                                        |       | 920                                                     |       | 905 |   |
|                                                       |       | 3,769                                                   |       | 3,631 |   |
| Same store sales growth (decrease) (b)                     |       |                                                    |       |   |   |
| Sally Beauty Supply                                        |       | (0.21                                                   | )%         | 0.30 | % |
| BSG                                                        |       | 0.76                                                    | %          | 7.51 | % |
| Consolidated                                               |       | 0.04                                                    | %          | 2.08 | % |

 

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| (a) |   | Certain  amounts for prior fiscal year may have been reclassified to conform to the  current year’s presentation.                                                                                                                                                                                                        |
|-----|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (b) |   | Same  stores are defined as company-operated stores that have been open for at  least 14 months as of the last day of a month. Our internet site  has generated sales for at least than 14 months and, accordingly,  internet-based sales are included in same store sales for the period ended  December 31, 2008. |

 

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***Comparison of the Three MonthsEnded December 31, 2008 and 2007***

 

### *The table belowpresents net sales, gross profit and gross profit margin data for eachreportable segment (in thousands of dollars).*

 
| ** **                       | ** ** | **Three Months Ended December 31,** | ** ** |
|----------------------------------|------------|---------------------------------------------------------|------------|
| ** **                       | ** ** | **2008**                                                | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| Net sales:                       |       |                                                    |       |   |   |   |   |   |   |
| Sally Beauty Supply              |       | $                                                       | 410,537    |   | $ | 409,564 |   | $ | 973 |   | 0.2 | % |
| BSG                              |       | 235,039                                                 |       | 246,223 |   | (11,184 | ) | (4.5 | )% |
| Consolidated net sales           |       | $                                                       | 645,576    |   | $ | 655,787 |   | $ | (10,211 | ) | (1.6 | )% |
|                             |       |                                                    |       |   |   |   |   |   |   |
| Gross profit:                    |       |                                                    |       |   |   |   |   |   |   |
| Sally Beauty Supply              |       | $                                                       | 212,927    |   | $ | 211,538 |   | $ | 1,389 |   | 0.7 | % |
| BSG                              |       | 90,617                                                  |       | 94,631 |   | (4,014 | ) | (4.2 | )% |
| Consolidated gross profit        |       | $                                                       | 303,544    |   | $ | 306,169 |   | $ | (2,625 | ) | (0.9 | )% |
|                             |       |                                                    |       |   |   |   |   |   |   |
| Gross profit margin:             |       |                                                    |       |   |   |   |   |   |   |
| Sally Beauty Supply              |       | 51.9                                                    | %          | 51.6 | % | 0.3 | % |   |   |
| BSG                              |       | 38.6                                                    | %          | 38.4 | % | 0.2 | % |   |   |
| Consolidated gross profit margin |       | 47.0                                                    | %          | 46.7 | % | 0.3 | % |   |   |
|                             |       |                                                    |       |   |   |   |   |   |   |

###  

### ***Net Sales***

###  

Consolidated net sales decreased $10.2 million, or 1.6%, for the threemonths ended December 31, 2008, compared to the three months ended December 31,2007. While company-operated stores that have been open for at least 14 monthscontributed an increase of approximately $16.5 million, or 2.5%, and salesthrough certain non-store sales channels contributed an increase of approximately$4.3 million, or 0.7%, to consolidated sales; other sales channels experienceddeclines on a year-over-year basis. Sales through our BSG franchise-basedbusinesses declined by approximately $5.7 million, or 0.9% and sales throughdistributor sales consultants declined approximately $5.3 million, or 0.8%, andsales through new stores declined approximately $6.6 million, or 1.0%. Also,incremental sales from businesses acquired in the preceding 12 monthscontributed $13.3 million, or 2.0%, less to our consolidated net sales for thethree months ended December 31, 2008 compared to the three months ended December 31,2007. These amounts are inclusive of approximately $24.8 million in negativeimpact from changes in foreign exchange rates.

 

*Sally Beauty Supply*.  Net sales for Sally Beauty Supply increased$1.0 million, or 0.2%, for the three months ended December 31, 2008,compared to the three months ended December 31, 2007.  In the Sally Beauty Supply segment,company-operated stores that have been open for at least 14 months contributedan increase of approximately $12.3 million, or 3.0%, while our franchise-basedbusiness and other non-store sales channels contributed an increase ofapproximately $4.3 million, or 1.0%. Sales of businesses acquired in thepreceding 12 months contributed $14.2 million less to the Sally Beauty Supplysegment sales for the three months ended December 31, 2008 compared to thethree months ended December 31, 2007. These amounts are inclusive ofapproximately $17.2 million in negative impact from changes in foreign exchangerates.

 

*BeautySystems Group*.  Net sales for BSG decreased $11.2 million, or4.5%, for the three months ended December 31, 2008, compared to the threemonths ended December 31, 2007. While company-operated stores that havebeen open for at least 14 months contributed an increase of approximately $4.2million, or 1.7%, to net sales, other sales channels experienced declines on ayear-over-year basis. Sales through our franchise-based businesses declined byapproximately $5.7 million, or 2.3%; sales through distributor salesconsultants declined approximately $5.3 

 

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million,or 2.2%, and sales through new stores declined approximately $5.3 million, or2.1%. These amounts are inclusive of approximately $7.6 million in negativeimpact from changes in foreign exchange rates. BSG net sales continued to be positively impacted during the periodended December 31, 2008 by the introduction of new product lines duringfiscal years 2008 and 2009.

 

#### ***GrossProfit***

#### ** **

Consolidated gross profit decreased $2.6 million or 0.9% for the threemonths ended December 31, 2008, compared to the three months ended December 31,2007, principally due to lower consolidated sales volume; partially offset byimproved gross margins in both operating segments as more fully describedbelow.

 

*Sally Beauty Supply*. Sally BeautySupply’s gross profit increased $1.4 million or 0.7% for the three months endedDecember 31, 2008, compared to the three months ended December 31,2007, principally as a result of increased unit sales volume and improvedmargins.  Sally Beauty Supply’s grossprofit as a percent of net sales increased to 51.9% for the three months ended December 31,2008, compared to 51.6% for the three months ended December 31, 2007. Thisincrease was the result of recent marketing efforts, low-cost sourcinginitiatives and a shift in product mix including an increase in sales ofexclusive-label products and other higher-margin products.

 

*Beauty Systems Group*.  BSG’sgross profit decreased $4.0 million or 4.2% for the three months ended December 31,2008, compared to the three months ended December 31, 2007, principally asa result of lower sales volume; partially offset by improved margins.  BSG’s gross profit as a percentage of netsales increased to 38.6% for the three months ended December 31, 2008,compared to 38.4% for the three months ended December 31, 2007. Thisincrease in margins was due primarily to a shift in sales mix during the threemonths ended December 31, 2008, towards higher company-operated storesales volume (with higher gross profit margins as opposed to both franchisestore and distributor sales consultants’ sales).

 

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

#### ** **

Consolidated selling, general and administrative expenses increased$0.6 million, or 0.3%, to $223.5 million for the three months ended December 31,2008, compared to $222.9 million for the three months ended December 31,2007.   Selling, general andadministrative expenses, as a percentage of net sales, were 34.6% for the threemonths ended December 31, 2008, compared to 34.0% for the three monthsended December 31, 2007. This increase was attributable principally toincreased expenses related to the opening of new stores and businesses acquiredin the last twelve months as well as to an increase in advertising expenses ofapproximately $2.4 million; partially offset by lower share-based compensationand other unallocated corporate expenses. Selling, general and administrativeexpense for the three months ended December 31, 2007 includedapproximately $1.7 million for BSG retention incentives for distributor salesconsultants (resulting from the L’Oreal contractual changes reported duringfiscal year 2007) with no similar expenses in the three months ended December 31,2008.

 

#### ***Depreciation and Amortization***

#### ** **

Consolidateddepreciation and amortization decreased slightly to $11.7 million for threemonths ended December 31, 2008, compared to $11.8 million for the threemonths ended December 31, 2007. These amounts reflect the amortization of intangible assets anddepreciation of property and equipment associated with businesses acquired aswell as depreciation related to fiscal year 2008 capital expenditures foradditional store openings in both operating segments.

 

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#### ***OperatingEarnings***

 

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

 
| ** **                       | ** ** | **Three Months Ended December 31,** | ** ** |
|----------------------------------|------------|---------------------------------------------------------|------------|
| ** **                       | ** ** | **2008**                                                | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| Operating Earnings:              |       |                                                    |       |   |   |   |   |   |   |
| Segment operating profit:        |       |                                                    |       |   |   |   |   |   |   |
| Sally Beauty Supply              |       | $                                                       | 65,286     |   | $ | 71,733 |   | $ | (6,447 | ) | (9.0 | )% |
| BSG                              |       | 20,236                                                  |       | 21,030 |   | (794 | ) | (3.8 | )% |
| Segment operating profit         |       | 85,522                                                  |       | 92,763 |   | (7,241 | ) | (7.8 | )% |
| Unallocated expenses             |       | (13,794                                                 | )          | (15,794 | ) | (2,000 | ) | (12.7 | )% |
| Share-based compensation expense |       | (3,468                                                  | )          | (5,447 | ) | (1,979 | ) | (36.3 | )% |
| Operating earnings               |       | $                                                       | 68,260     |   | $ | 71,522 |   | $ | (3,262 | ) | (4.6 | )% |

 

Consolidated operating earnings decreased $3.3 million, or 4.6%, to$68.3 million for three months ended December 31, 2008, compared to $71.5million for the three months ended December 31, 2007. Operating earnings,as a percentage of net sales, were 10.6% for the three months ended December 31,2008 compared to 10.9% for the three months ended December 31, 2007. Thedecrease in consolidated operating earnings was due primarily to a decline inBSG segment sales and gross profits, as discussed above.  Consolidated operating earnings for the threemonths ended December 31, 2008 are inclusive of approximately $0.8 millionin negative impact from changes in foreign exchange rates.

 

*Sally Beauty Supply*.  Sally Beauty Supply’s segment operatingearnings decreased $6.4 million, or 9.0%, to $65.3 million for three monthsended December 31, 2008, compared to $71.7 million for the three monthsended December 31, 2007.  Thedecrease in Sally Beauty Supply’s segment operating earnings was primarily aresult of higher advertising costs of approximately $1.7 million andincremental costs related to additional stores operating during the threemonths ended December 31, 2008 (approximately 123 additional stores).  Segment operating earnings, as a percentageof net sales, were 15.9% for the three months ended December 31, 2008,compared to 17.5% for the three months ended December 31, 2007. Thedecrease in Sally Beauty Supply’s segment operating earnings as a percentage ofsegment net sales was primarily a result of higher advertising costs as apercentage of segment net sales and softness in its business, particularly inthe U.K.

 

*Beauty Systems Group*.  BSG’s segment operating earnings decreased$0.8 million, or 3.8%, to $20.2 million for the three months ended December 31,2008, compared to $21.0 million for the three months ended December 31,2007. Segment operating earnings, as a percentage of net sales, were 8.6% forthe three months ended December 31, 2008 compared to 8.5% for the threemonths ended December 31, 2007. This decrease was due primarily to thedecline in segment sales and gross profit, as discussed above. BSG’s segmentoperating earnings also reflect, for the three months ended December 31,2007, approximately $1.7 million for retention incentives for distributor salesconsultants (resulting from the L’Oreal contractual changes reported duringfiscal year 2007). Segment operating earnings for the three months ended December 31,2008 are inclusive of approximately $0.8 million in negative impact fromchanges in foreign exchange rates.

 

*Unallocatedexpenses.*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 decreased by $2.0 million to $13.8 million for the three months ended December 31,2008, compared to $15.8 million for the three months ended December 31,2007. This decrease was due primarily to lower corporate expenses resultingfrom cost-saving initiatives and to certain currency translation gainsresulting from intercompany notes not permanently invested.

 

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#### ***Share-basedCompensation Expense.***For the threemonths ended December 31, 2008, total compensation cost charged against incomefor share-based compensation arrangements was $3.5 million compared to $5.4million for the three months ended December 31,2007. This decrease was dueto a decline in the fair value per share of options awarded in the period endedDecember 31, 2008 compared to options awarded in the period ended December 31,2007.  For the threemonths ended December 31, 2008 and 2007, share-based compensation expenseincludes $2.0 million and $3.1 million, respectively, of accelerated expenserelated to certain retirement eligible employees who are eligible to continuevesting awards upon retirement under the terms of the 2007 Plan.  Duringthe three months ended December 31, 2008 and 2007, Sally Beauty granted toour employees and consultants approximately 2.7 million and 2.6 million stockoptions, respectively.

 

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

 

Interestexpense, net of interest income of $0.1 million, was $39.7 million for thethree months ended December 31, 2008, compared to $46.5 million, net ofinterest income of $0.2 million, for the three months ended December 31,2007.  The decrease in interest expensewas primarily attributable to lower prevailing interest rates on our ABL andsenior term loans facilities and lower outstanding principal balances on oursenior term loans, partially offset by higher outstanding borrowings under ourABL facility as discussed in “Liquidity and Capital Resources” below. Netinterest expense for the three months ended December 31, 2008 and 2007includes a non-cash expense of $3.0 million and $5.7 million, respectively, ofmarked-to-market adjustments for the interest rate swaps, as described in Note8 of the Condensed Notes to Consolidated Financial Statements.

 

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

 

Provisionfor income taxes was $11.4 million during the three months ended December 31,2008 compared to $9.7 million for the three months ended December 31,2007.  Income taxes for the interimperiods ended December 31, 2008 and December 31, 2007 have beenincluded in the accompanying financial statements on the basis of an estimatedannual effective rate.  The estimatedannual effective tax rate (excluding discrete items) is 36.6% for fiscal year2009 compared to 36.0% for the first quarter of fiscal year 2008.  The increase in the estimated annualeffective tax rate primarily relates to a reduction in earnings in low taxjurisdictions and the reduced impact of favorable permanent items resultingfrom higher earnings.

 

The actual tax rate for thethree months ended December 31, 2008 exceeds the estimated annualeffective tax rate because of losses recorded in the three months ended December 31,2008 for entities for which a valuation allowance is required.

 

#### ***NetEarnings***

 

Asa result of the foregoing, consolidated net earnings increased $1.9 million, or12.1%, to $17.2 million for the three months ended December 31, 2008compared to $15.3 million for the three months ended December 31, 2007.Net earnings, as a percentage of net sales, were 2.7% for the three monthsended December 31, 2008 compared to 2.3% for the three months ended December 31,2007.

 

## **Financial Condition**

 

##### ***December 31, 2008 Compared to September 30,2008***

 

Workingcapital (current assets less current liabilities) at December 31, 2008 was$343.9 million compared to $348.6 million at September 30, 2008,representing a decrease of $4.6 million. The ratio of current assets to currentliabilities was 1.77 to 1.00 at December 31, 2008, compared to 1.76 to1.00 at September 30, 2008. The decrease in working capital reflects adecrease, of $12.4 million, in current assets and a $7.7 million decrease incurrent liabilities.  The decrease incurrent assets as of December 31, 2008 reflects a $26.5 million reductionin inventory levels partially offset by a $12.8 million increase in cash andcash equivalents (please see *Liquidity and CapitalResources* below).  Thedecrease in current liabilities as of December 31, 2008 was primarily theresult of a decrease in accounts payable and accrued expenses.

 

Inventories decreased $26.5 million to $571.7 million at December 31,2008, compared to $598.2 million at September 30, 2008 due primarily tolower purchases in the period ended December 31, 2008 in response to thecurrent economic slowdown and to the effect of currency translationadjustments.

 

Accounts payable decreased by $5.7 million to $166.3 million at December 31,2008 compared to $172.0 million at September 30, 2008 due primarily to thetiming of payments to vendors in connection with purchases of inventory.  Accrued expenses decreased by $9.9 million to$144.6 million at December 31, 2008 from $154.5 million at September 30,2008 due primarily to the timing of interest payments on long-term debt;partially offset by a change

 

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in the fair market value of certain of our interest rate swaps.

 

Other liabilities increased by $9.6 million to $33.3 million at December 31,2008, compared to $23.7 million at September 30, 2008 due primarily to achange in the fair market value of certain of our interest rate swaps.

 

Total member’s deficit increased by $25.9 million as aresult of cumulative translation adjustments of $32.3 million and deferredlosses on interest rate swaps, net of income taxes, of $10.9 million; partiallyoffset by net earnings of $17.2 million.

 

## **Liquidity and CapitalResources**

 

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, 2008 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 30,2008.

 

During the three months ended December 31, 2008,we made scheduled payments on our senior term loans in the aggregate amount of$6.1 million.

 

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 finance capitalexpenditures, excluding acquisitions, over the next 12 months.

 

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 theyear ended September 30, 2008.

 

We utilize ourABL facility for the issuance of letters of credit, as well as to manage normalfluctuations in operational cash flow. In that regard, we may from time to timedraw funds under the revolving credit facility for general corporate purposesincluding acquisitions and interest payments due on our indebtedness.  Thefunds drawn on individual occasions during the three months ended December 31,2008 have varied in amounts of up to $20.0**million,with total amounts outstanding ranging from $75.0 million up to $120.0 million.The amounts drawn are generally paid down with cash provided by our operatingactivities.

 

The senior term loanfacilities may be prepaid at our option at any time without premium or penaltyand are subject to mandatory prepayment in an amount equal to 50% of excesscash flow (as defined in the agreement governing the term loan facilities) forany fiscal year (commencing in fiscal year 2008) unless a specified leverageratio is met. In January 2009, the Company made a mandatory repayment onthe senior term loan facilities in the amount of $16.7 million. Amounts paidpursuant to said provision may be applied, at the option of the Company,against minimum loan repayments otherwise required over the twelve month periodfollowing any such payment, under the terms of the loan agreement.

 

Both in the U.S. and incertain European areas in which we operate, the economic stress and thedislocation of the financial markets that began in late calendar year 2007 hascontinued and substantially increased in the recent months. Recently, concernsover inflation (deflation), energy costs, the availability and cost of credit, theconditions of the U.S. mortgage market and declining real estate prices in theU.S. have contributed to increased market volatility and diminishedexpectations about the U.S. and global economies and the financial marketsgoing forward. These factors, combined with the volatility in oil prices,declining business and consumer confidence and increases in unemployment rateshave precipitated an economic slowdown and fears of a potential recession on aglobal scale.On September 18,2008, we borrowed $75.0 million under our existing $400 million ABL facility toincrease our

 

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cash position in order topreserve its financial flexibility in light of the recent dislocation of thefinancial markets.  We currently intend to repay these funds as economicconditions allow during our 2009 fiscal year.****Asof December 31, 2008, Sally Holdings had $267.4 million available for additionalborrowings under our ABL facility, subject to borrowing base limitations, asreduced by outstanding letters of credit.

 

We may from time to timerepurchase or otherwise retire our debt (through our subsidiaries) and takeother steps to reduce our debt or otherwise improve our balance sheet. Theseactions may include open market repurchases of our Notes or other retirementsof outstanding debt. The amount of debt that may be repurchased or otherwiseretired, if any, would be decided upon at the sole discretion of our Board ofDirectors and will depend on market conditions, trading levels of the Company’sdebt from time to time, the Company’s cash position and other considerations.

 

Our primary source of cash has been from fundsprovided by operating activities and borrowings under our ABL facility for thethree months ended December 31, 2008 and 2007. Historically, the primaryuse of cash has been for acquisitions and capital expenditures. The followingtable shows our sources and uses of funds for the three months ended December 31,2008 and 2007 (in thousands):

 
| ** **                                                     | ** ** | **Three Months Ended December 31,** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                     | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| Net cash provided (used) by operating  activities              |       | $                                                       | 31,286     |   | $ | (17,950 | ) |
| Net cash used by investing activities                          |       | (10,123                                                 | )          | (15,277 | ) |
| Net cash (used) provided by financing  activities              |       | (8,127                                                  | )          | 39,086 |   |
| Effect of foreign exchange rates on cash  and cash equivalents |       | (207                                                    | )          | (984 | ) |
| Net increase in cash and cash equivalents                      |       | $                                                       | 12,829     |   | $ | 4,875 |   |

 

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

 

Net cash provided (used) by operating activities,which excludes the effects of acquisitions, during the three months ended December 31,2008 increased by $49.2 million to cash provided of $31.3 million,compared to net cash used of $18.0 million during the three months ended December 31,2007. The increase was primarily due to a reduction of approximately $38.5million in inventory levels and an improvement of approximately $1.9 million inearnings for the three months ended December 31, 2008 compared to thethree months ended December 31, 2007.

 

### *Net Cash Used byInvesting Activities*

 

Net cash used by investing activities during the threemonths ended December 31, 2008 decreased by $5.2 million to$10.1 million, compared to $15.3 million during the three monthsended December 31, 2007.  Thisincrease was primarily due to lower capital expenditures and a reduction incash used for acquisitions for the three months ended December 31, 2008compared to the three months ended December 31, 2007.

 

### *Net Cash (Used) Providedby Financing Activities*

 

# **Net cash (used)provided by financing activities during the three months ended December 31,2008 decreased by $47.2 million to cash used of $8.1 million, compared tocash provided of $39.1 million during the three months ended December 31,2007.  The decrease was primarily due toincremental borrowings under our ABL facility during the three months ended December 31,2007 with no comparable incremental borrowings during the three months ended December 31,2008.**

 

# **Capital Requirements**

 

For fiscal year 2009, we anticipate total capitalexpenditures in the range of approximately $35.0 million to $40.0 million,excluding acquisitions. Capital expenditures will be primarily for the additionof new stores and the remodeling, expansion and/or relocation of existingstores in the ordinary course of our business as well as certain corporateprojects.

 

## **ContractualObligations**

 

Therehave been no material changes outside the ordinary course of business in any ofour contractual obligations since September 30, 2008.

 

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## **Off-Balance SheetFinancing Arrangements**

 

We had no off-balance sheet financing arrangementsother than operating leases incurred in the ordinary course of business, aswell as outstanding letters of credit related to inventory purchases and selfinsurance programs which totaled $11.6 million and $12.1 million at December 31,2008 and September 30, 2008, respectively.

 

## **Inflation**

 

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

 

## **Critical AccountingPolicies and Estimates**

 

The preparation of financial statements in conformitywith GAAP requires us to make estimates and assumptions that affect thereported amounts of assets, liabilities, revenues and expenses and disclosureof contingent assets and liabilities in the financial statements. Actualresults may differ from these estimates. We believe these estimates andassumptions are reasonable. We consider accounting policies to be critical whenthey require us to make assumptions about matters that are highly uncertain atthe time the accounting estimate is made and when different estimates that ourmanagement reasonably could have used 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 30,2008, include but are not limited to the valuation of inventories, vendorconcessions, retention of risk, income taxes and share-based payments. Therehave been no material changes to our critical accounting policies since September 30,2008.

 

# **Recent Accounting Pronouncements**

# ** **

TheCompany adopted the provisions of SFAS 157, *Fair Value Measurements*,as it relates to its financial instruments, effective as of October 1,2008.  SFAS 157 defines fair value,establishes a framework for measuring fair value and expands disclosures aboutfair value measurements. This statement does not require any new fair valuemeasurements; rather, it amends other accounting pronouncements that require orpermit fair value measurements.  SFAS 157defines “fair value” as the price that would be received to sell an asset orpaid to transfer a liability in the principal or most advantageous market in anorderly transaction between market participants on the measurement date.  SFAS 157 establishes a three-level hierarchyfor measuring fair value and requires an entity to maximize the use ofobservable inputs and minimize the use of unobservable inputs when measuringfair 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:

 

Level1- Unadjusted quoted prices in active markets for identical assets orliabilities

 

Level 2 - Unadjusted quoted prices in active marketsfor similar assets or liabilities; or

Unadjustedquoted prices for identical or similar assets or liabilities in markets thatare not active; or

Inputsother than quoted prices that are observable for the asset and liability

 

Level3 - Unobservable inputs for the asset or liability

 

TheCompany measures certain financial assets and liabilities at fair value on arecurring basis, including interest rate swaps. In accordance with SFAS 157, the Company categorized certain of itsfinancial assets and liabilities based on priority of the inputs to thevaluation technique for the instruments, as follows (in thousands):

 
| ** **                         | ** ** | **As of December 31, 2008** | ** ** |
|------------------------------------|------------|-------------------------------------------------|------------|
| ** **                         | ** ** | **Total**                                       | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Liabilities                        |       |                                            |       |   |   |   |   |   |   |
| Hedged interest rate swaps (1)     |       | $                                               | 16,522     |   |   |   | $ | 16,522 |   |   |   |
| Non-hedged interest rate swaps (1) |       | 10,661                                          |       |   |   | 10,661 |   |   |   |
| Total                              |       | $                                               | 27,183     |   |   |   | $ | 27,183 |   |   |   |

 

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(1) Interestrate swaps are valued using internal models based on market observable inputs,including market interest rates.

 

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InOctober 2008, the FASB issued Staff Position FAS No. 157-3, *Determining the Fair Value of a Financial Asset When the Market forThat Asset Is Not Active*, which clarifies the application of SFAS157. FSP-FAS 157-3 was effective upon issuance and its adoption did not have amaterial impact on the Company’s financial statements.

 

Effectiveas of October 1, 2008, the Company also adopted the provisions of SFAS159, *The Fair Value Option for Financial Assets andFinancial Liabilities - including an amendment of FASB Statement No. 115*,which permits entities to choose to measure certain financial assets andliabilities at fair value, but elected not to measure any additional assets orliabilities at fair value that are not already measured at fair value prior tosuch adoption.  As a result, the adoptionof SFAS 159 did not have an impact on the Company’s consolidated financialposition, results of operations or cash flows.

 

Wehave not yet adopted and are currently assessing any potential effect of thepronouncements discussed below on our consolidated financial statements.

 

InJune 2008, the Emerging Issues Task Force reached consensus onEITF 08-3, *Accounting by Lessees forNonrefundable Maintenance Deposits*. Under EITF 08-3, lessees shouldaccount for nonrefundable maintenance deposits as deposit assets if it isprobable that maintenance activities will occur and the deposit is thereforerealizable. Amounts on deposit that are not probable of being used to fundfuture maintenance activities should be expensed. EITF 08-3 is effective forfiscal years beginning after December 15, 2008. Early application is notpermitted.

 

InApril 2008, the FASB issued Staff Position FAS No. 142-3, *Determination of the Useful Life of Intangible Assets*. FAS142-3 amends the factors that should be considered in developing renewal orextension assumptions used to determine the useful life of a recognizedintangible asset under SFAS No. 142, *Goodwill andOther Intangible Assets*. The objective of the Staff Position is toimprove the consistency between the useful life of a recognized intangibleasset under SFAS 142 and the period of expected cash flows used to measurethe fair value of the asset under SFAS No. 141 (Revised 2007): *Business Combinations* and other GAAP. FAS 142-3 is effectivefor fiscal years beginning after December 15, 2008. Early application isnot permitted.

 

In March 2008, the FASBissued SFAS No. 161, *Disclosures aboutDerivative Instruments and Hedging Activities, an Amendment of FASB Statement No. 133*.SFAS 161 requires companies to provide qualitative disclosures about theobjectives and strategies for using derivatives, quantitative data about thefair value of and gains and losses on derivative contracts, and details ofcredit-risk-related contingent features in their hedged positions.  The statement also requires companies todisclose more information about the location and amounts of derivativeinstruments in financial statements; how derivatives and related hedges areaccounted for under SFAS 133, *Accounting for DerivativeInstruments and Hedging Activities*; and how the hedges affect theentity’s financial position, financial performance and cash flows. SFAS 161 iseffective for fiscal years and interim periods beginning after November 15,2008.

 

In December 2007, the FASB issued SFAS No. 160,*Noncontrolling Interests in Consolidated FinancialStatements, an amendment to ARB No. 51*, which requires, amongother things, that the noncontrolling interest (previously referred to asminority interest) in a consolidated subsidiary’s equity be reported as acomponent of equity separate from the parent’s interest and that net income orloss attributable to the noncontrolling interest be included in consolidatednet income on the face of the income statement. In addition, purchases andsales of equity interest that do not result in a change in control will beaccounted for as equity transactions and, upon a loss of control, the interestsold, as well as any interest retained, will be recorded at fair value with anygain or loss recognized in earnings. SFAS 160 is effective for fiscal years,and interim periods within those fiscal years, beginning on or after December 15,2008.  Early application is notpermitted.

 

In December 2007, the FASB issued SFAS 141R, *Business Combinations*. Among other things, SFAS 141Rgenerally requires that an acquirer recognize the assets acquired andliabilities assumed measured at their “full fair values” on the acquisitiondate. This practice replaces the practice, under predecessor SFAS 141: *Business Combinations,* of allocating the cost of anacquisition to the individual assets acquired and liabilities assumed based ontheir relative estimated fair values. SFAS 141R further requires that acquisition-related costs be recognizedseparately from the related acquisition. SFAS 141R must be appliedprospectively to business combinations consummated on or after the first annualreporting period beginning on or after December 15, 2008.  Early application is not permitted.

 

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# **Item 3. Quantitative and 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.

 

## **Foreign currencyexchange rate risk**

 

We are exposed to potential gains or losses fromforeign currency fluctuations affecting net investments and earningsdenominated in foreign currencies. Our primary exposures are to changes inexchange rates for the U.S. dollar versus the British pound sterling,Canadian dollar, Euro and Mexican peso. Our various currency exposures at timesoffset each other providing a natural hedge against currency risk. Whilefluctuations in the U.S. dollar exchange rates had a negative impact onreported consolidated sales of approximately $24.8 million, for the threemonths ended December 31, 2008, such fluctuations did not have a materialeffect on our financial condition and net earnings for the three months ended December 31,2008 and 2007. Although we may use derivative financial instruments to manageforeign currency exchange rate risk from time to time, none were used as of December 31,2008 and 2007 and for the interim periods then ended.

 

## **Interest rate 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 $1.1 billion of aggregate borrowings under theCompany’s term loans and the ABL facility as of December 31, 2008, achange in the estimated interest rate up or down by 1/8% would increase ordecrease earnings before provision for income taxes by approximately $1.3million on an annual basis, without considering the effect of any interest rateswap agreements we may have from time to time.

 

We 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.

 

Effective in November 2006, we entered into fourinterest rate swap agreements with an aggregate notional amount of $500.0million. Interest rate swap agreements with an aggregate notional amount of$150.0 million expired in November 2008 and interest rate swap agreementswith a notional amount of $350.0 million expire in November 2009. Theagreements outstanding at December 31, 2008 enable us to convert a portionof our variable interest rate obligations to fixed rate obligations withinterest rates ranging from 7.19% to 7.44%. Theseinterest rate swap agreements do not currently qualify as hedges and,therefore, the change in the fair value of these interest rate swap agreements,which are adjusted quarterly, are recorded in net interest expense in theCompany’s results of operations. As discussed in Item 1A “RiskFactors” in our Annual Report on Form 10-Kfor the year ended September 30, 2008, changes in the fair value ofthese interest rate swap agreements are mainly driven by interest rate changesand will increase or decrease our net interest expense and may therefore affectour earnings.

 

Effective in May 2008, we entered into twoadditional interest rate swap agreements with anaggregate notional amount of $300 million (each agreement with anotional amount of $150 million).  Theseagreements expire on May 31, 2012 and enable us to convert a portion ofour variable interest rate obligations to fixed rate obligations with interestranging from 5.818% to 6.090%.  Theseagreements are designated as effective hedges, consistent with SFAS 133, *Accounting for Derivative Instruments and Hedging Activities*.  Adjustments to reflect the change in the fairvalues of these interest rate swap agreements, which are adjusted quarterly, arerecorded in accumulated other comprehensive (loss) income until the hedgedobligation is settled or the swap agreements expire, whichever is earlier.  Any ineffectiveness of these interest rateswaps is recognized in 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 is sufficient to cover customer credit risks.

 

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# **Item 4.  Controls and Procedures.**

 

*Controls Evaluation and Related CEO and CFO Certifications.*  Ourmanagement, with the participation of our principal executive officer (“CEO”)and principal financial officer (“CFO”), conducted an evaluation of theeffectiveness of the design and operation of our disclosure controls andprocedures as of the end of the period covered by this report. The controlsevaluation was conducted by our Disclosure Committee, comprised of seniorrepresentatives 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 Securities Exchange Act of 1934, as amended (“Exchange Act”), areattached as exhibits to this report. This “Controls and Procedures” sectionincludes the information concerning the controls evaluation referred to in thecertifications and it should be read in conjunction with the certifications fora more complete understanding of the topics presented.

 

*Limitations on the Effectiveness of Controls.*  Wedo not expect that our disclosure controls and procedures will prevent allerrors and all fraud. A system of controls and procedures, no matter how wellconceived and operated, can provide only reasonable, not absolute, assurancethat the objectives of the system are met. Because of the limitations in allsuch systems, no evaluation can provide absolute assurance that all controlissues and instances of fraud, if any, have been detected. Furthermore, thedesign of any system of controls and procedures is based in part upon certainassumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions, regardless of how unlikely. Because of theseinherent limitations in a cost-effective system of controls and procedures,misstatements or omissions due to error or fraud may occur and not be detected.

 

*Scope of the Controls Evaluation.*  Theevaluation of our disclosure controls and procedures included a review of theirobjectives and design, our implementation of the controls and procedures and theeffect of the controls and procedures on the information generated for use inthis report. In the course of the evaluation, we sought to identify whether wehad any data errors, control problems or acts of fraud and to confirm thatappropriate corrective action, including process improvements, was beingundertaken if needed. This type of evaluation is performed on a quarterly basisso that conclusions concerning the effectiveness of our disclosure controls andprocedures can be reported in our quarterly reports on Form 10-Q and ourannual reports on Form 10-K. Many of the components of our disclosurecontrols and procedures are also evaluated by our internal audit department,our legal department and by personnel in our finance organization. The overallgoals of these various evaluation activities are to monitor our disclosurecontrols and procedures on an ongoing basis, and to maintain them as dynamicsystems that change as conditions warrant.

 

*Conclusions regarding Disclosure Controls.*  Basedon the required evaluation of our disclosure controls and procedures, our CEOand CFO have concluded that, as of December 31, 2008, we maintaindisclosure controls and procedures that are effective in providing reasonableassurance that information required to be disclosed by us in the reports thatwe file or submit under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and forms,and that such information is accumulated and communicated to our management,including our CEO and CFO, as appropriate to allow timely decisions regardingrequired disclosure.

 

*Changes in Internal Control overFinancial Reporting.*  During our last fiscalquarter, there have been no changes in our internal control over financialreporting identified in connection with the evaluation described above thathave materially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

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**PART II — OTHERINFORMATION**

 

# **Item 1.  Legal Proceedings.**

 

There were no material legal proceedings pendingagainst us or our subsidiaries as of December 31, 2008. 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 circumstances andthat may or may not cover any or all of our liabilities in respect of claimsand lawsuits. We do not believe that the ultimate resolution of these matterswill have a material adverse impact on our consolidated financial position,cash flows or results of operations.

 

We are subject to a number of U.S., federal, state andlocal laws and regulations, as well as the laws and regulations applicable ineach other market 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 believethat we are in material compliance with such laws and regulations, although noassurance can be provided that this will 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”), franchisees ofour subsidiary Armstrong McCall division (“AMLP”) of our BSG business unit, asdefendants.  The suit alleged, among other things, that SD Hair breachedits franchise agreement with AMLP by diverting (selling) Matrix brandedproducts to unauthorized buyers, and that L’Oreal is entitled to make claimsagainst SD Hair under the franchise agreement as a third-party beneficiary ofthat agreement.  The suit also alleged, among other issues, that SD Hairinduced AMLP to breach its agreement to distribute Matrix branded products (the“Matrix Agreement”) in some unspecified manner.  L’Oreal’scomplaint against SD Hair was subsequently amended to delete the reference toAMLP’s breach of the Matrix Agreement as one of the specific contractualrelationships that SD Hair allegedly induced and caused to be breached.  However, the amended complaint does notdesignate which distributors are at issue, and L’Oreal has not stated on therecord whether it continues to allege that SD Hair induced and caused AMLP tobreach the Matrix Agreement.  As of November 10,2008, neither Sally Beauty nor any ofits subsidiaries (including AMLP) were a defendant in the lawsuit filed by L’Oreal.  On March 24, 2008, however, SD Hair filed a cross-complaint inthe same case naming AMLP and BSG as cross-defendants, seeking, among otherthings, i) declaratory relief from BSG and AMLP in the form of a judicialfinding that SD Hair is not inbreach of its franchise agreement and that L’Oreal has no rights as athird-party beneficiary to SD Hair’s franchise agreement, and ii) injunctiverelief in the form of a judicial order compelling AMLP and BSG to takeappropriate legal action against L’Oreal to enforce SD Hair’s claimed rightsunder AMLP’s Matrix distribution agreement.  We have answered thecross-complaint. No monetary relief is being sought by SD Hair.

 

# **Items 1A.  Risk Factors.**

# ** **

## **In addition to the other information set forth in this report, youshould carefully consider the factors contained in Part I, Item 1A. “RiskFactors” in our Annual Report on Form 10-K for the year ended September 30,2008, which could materially affect our business, financial condition or futureresults.  There have been no materialchanges from the risk factors disclosed in our Annual Report.  The risks described in that report are notthe only risks facing our company. Additional risks and uncertainties not currently known to us or that wecurrently deem to be immaterial also may materially adversely affect ourbusiness, financial condition and/or operating results.**

 

# **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

 

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

# ** **

Not applicable

 

# **Item 5.  Other Information.**

 

(a) Not applicable

 

# **(b) Notapplicable**

 

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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. (File  No. 333-136259) filed on October 30, 2006                                                                          |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 2.4                  |       | Separation  Agreement, dated as of June 19, 2006, among Alberto-Culver Company,  Sally Holdings, Inc., New Sally Holdings, Inc. and New Aristotle  Holdings, Inc., which is incorporated herein by reference from  Exhibit 2.3 to Amendment No. 3 to the Registration Statement on  Form S-4 of New Sally Holdings, Inc. (File No. 333-136259)  filed on October 10, 2006                                                                                |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 2.5                  |       | First  Amendment to the Separation Agreement, dated as of October 3, 2006,  among Alberto-Culver Company, Sally Holdings, Inc., New Sally  Holdings, Inc. and New Aristotle Holdings, Inc., which is  incorporated herein by reference from Exhibit 2.4 to Amendment  No. 3 to the Registration Statement on Form S-4 of New Sally  Holdings, Inc. (File No. 333-136259) filed on October 10, 2006                                                       |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 2.6                  |       | Second  Amendment to the Separation Agreement, dated as of October 26, 2006,  among Alberto-Culver Company, Sally Holdings, Inc., New Sally  Holdings, Inc. and New Aristotle Holdings, Inc., which is  incorporated herein by reference from Exhibit 2.01 to the Current Report  on Form 8-K of New Sally Holdings, Inc. (File No. 333-136259)  filed on October 30, 2006                                                                                    |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 3.1                  |       | Certificate  of Formation of Sally Holdings LLC, which is incorporated herein by reference  to Exhibit 3.1 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                                                                                                                                                                                                                                      |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 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                                                                                                                                                                                                                           |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 3.3                  |       | Certificate  of Incorporation of Sally Capital Inc., which is incorporated herein by  reference from Exhibit 3.3 to the Registration Statement on  Form S-4 (File No. 333-144427) of Sally Holdings LLC and Sally  Capital Inc. filed on July 9, 2007                                                                                                                                                                                                                                  |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 3.4                  |       | By-Laws of Sally Capital  Inc., which is incorporated herein by reference from Exhibit 3.4 to the  Registration Statement on Form S-4 (File No. 333-144427) of Sally  Holdings LLC and Sally Capital Inc. filed on July 9, 2007                                                                                                                                                                                                                                                        |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 4.1                  |       | Stockholders Agreement,  dated as of November 16, 2006, by and among the Company, CDRS  Acquisition LLC, CD&R Parallel Fund VII, L.P. and the other stockholders  party thereto, which is incorporated by reference from Exhibit 4.8 to  the Current Report on Form 8-K of Sally Beauty Holdings, Inc. filed  on November 22, 2006                                                                                                                                            |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 4.2                  |       | First  Amendment to the Stockholders Agreement, dated as of December 13, 2006,  between the Company and CDRS Acquisition LLC and Carol L. Bernick, as  representative of the other stockholders, which is incorporated herein by  reference from Exhibit 4.2 to the Annual Report on Form 10-K of  Sally Beauty Holdings, Inc. filed on December 22, 2006                                                                                                                         |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 4.3                  |       | Indenture,  dated as of November 16, 2006, by and among Sally Holdings LLC and Sally  Capital Inc., as Co-Issuers, the Subsidiary Guarantors from time to time  parties thereto, and Wells Fargo Bank, National Association, as Trustee,  governing the 9.25% Senior Notes due 2014, which is incorporated by reference  from Exhibit 4.1 to the Current Report on Form 8-K of Sally Beauty  Holdings, Inc. filed on November 22, 2006                                            |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 4.4                  |       | First  Supplemental Indenture, dated as of May 30, 2007, by and among Sally  Holdings LLC and Sally Capital Inc., as co-Issuers, the Subsidiary Guarantors  named therein, and Wells Fargo Bank, National Association, as trustee,  governing the 9.25% Senior Notes due 2014, which is incorporated herein by  reference from Exhibit 4.2 from the Registration Statement on  Form S-4 (File No. 333-144427) of Sally Holdings LLC and Sally  Capital Inc. filed on July 9, 2007 |

 

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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  by reference from Exhibit 4.2 to the Current Report on Form 8-K of  Sally Beauty Holdings, Inc. filed on November 22, 2006                                                                                                                                                                                                                                                                    |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 4.6    |   | First  Supplemental Indenture, dated as of May 30, 2007, by and among Sally  Holdings LLC and Sally Capital Inc., as co-Issuers, the Subsidiary Guarantors  named therein, and Wells Fargo Bank, National Association, as trustee,  governing the 10.5% Senior Subordinated Notes due 2016, which is incorporated  herein by reference from Exhibit 4.4 from the Registration Statement on  Form S-4 (File No. 333-144427) of Sally Holdings LLC and Sally  Capital Inc. filed on July 9, 2007                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 4.7    |   | Exchange  and Registration Rights Agreement, dated as of November 16, 2006, by and  among Sally Holdings LLC, Sally Capital Inc., the Subsidiary Guarantors  parties thereto, Merrill Lynch, Pierce, Fenner & Smith, Incorporated  and the other financial institutions named therein, relating to the 9.25%  Senior Notes due 2014, which is incorporated by reference from  Exhibit 4.3 to the Current Report on Form 8-K of Sally Beauty  Holdings, Inc. filed on November 22, 2006                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 4.8    |   | Exchange  and Registration Rights Agreement, dated as of November 16, 2006, by and  among Sally Holdings LLC, Sally Capital Inc., the Subsidiary Guarantors  parties thereto, Merrill Lynch, Pierce, Fenner & Smith, Incorporated  and the other financial institutions named therein, relating to the 10.5%  Senior Subordinated Notes due 2016, which is incorporated by reference from  Exhibit 4.4 to the Current Report on Form 8-K of Sally Beauty  Holdings, Inc. filed on November 22, 2006                                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 4.9    |   | Credit  Agreement, dated November 16, 2006, with respect to a Term Loan  Facility, by and among Sally Holdings LLC, the several lenders from time to  time parties thereto, and Merrill Lynch Capital Corporation, as  Administrative Agent and Collateral Agent, which is incorporated by reference  from Exhibit 4.5.1 to the Current Report on Form 8-K of Sally  Beauty Holdings, Inc. filed on November 22, 2006                                                                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 4.10   |   | Guarantee  and Collateral Agreement, dated as of November 16, 2006, made by Sally  Investment Holdings LLC, Sally Holdings LLC and certain subsidiaries of Sally  Holdings LLC in favor of Merrill Lynch Capital Corporation, as Administrative  Agent and Collateral Agent, which is incorporated by reference from  Exhibit 4.5.2 to the Current Report on Form 8-K of Sally Beauty  Holdings, Inc. filed on November 22, 2006                                                                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 4.11   |   | Credit  Agreement, dated November 16, 2006, with respect to an Asset-Based Loan  Facility, among Sally Holdings LLC, Beauty Systems Group LLC, Sally Beauty  Supply LLC, any Canadian Borrower from time to time party thereto, certain  subsidiaries of Sally Holdings LLC, the several lenders from time to time  parties thereto, Merrill Lynch Capital, a division of Merrill Lynch Business  Financial Services Inc., as Administrative Agent and Collateral Agent, and  Merrill Lynch Capital Canada Inc., as Canadian Agent and Canadian Collateral  Agent, which is incorporated by reference from Exhibit 4.6.1 to the  Current Report on Form 8-K of Sally Beauty Holdings, Inc. filed on  November 22, 2006 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 4.12   |   | U.S.  Guarantee and Collateral Agreement, dated as of November 16, 2006, made  by Sally Investment Holdings LLC, Sally Holdings LLC and certain subsidiaries  of Sally Holdings LLC in favor of Merrill Lynch Capital, a division of  Merrill Lynch Business Financial Services Inc., as Administrative Agent and  Collateral Agent, which is incorporated by reference from Exhibit 4.6.2  to the Current Report on Form 8-K of Sally Beauty Holdings, Inc.  filed on November 22, 2006                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 4.13   |   | Canadian  Guarantee and Collateral Agreement, dated as of November 16, 2006, made  by Sally Beauty (Canada) Corporation, Beauty Systems Group  (Canada), Inc., Sally Beauty Canada Holdings Inc. and certain of their  respective subsidiaries in favor of Merrill Lynch Capital Canada Inc., as Canadian  Agent and Canadian Collateral Agent, which is incorporated by reference from  Exhibit 4.6.3 to the Current Report on Form 8-K of Sally Beauty  Holdings, Inc. filed on November 22, 2006                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 4.14   |   | Intercreditor Agreement,  dated as of November 16, 2006, by and between Merrill Lynch Capital, a  division of Merrill Lynch Business Financial Services Inc., as Administrative  Agent and Collateral Agent under the Term Loan Facility, and Merrill Lynch  Capital, a division of Merrill Lynch Business Financial Services Inc., as  Administrative Agent and Collateral Agent under the Asset-Based Loan  Facility, which is incorporated by reference from Exhibit 4.7 to the  Current Report on Form 8-K of Sally Beauty Holdings, Inc. filed on  November 22, 2006                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 31.1   |   | 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

 

PLEASE NOTE: In reviewing the agreements included asexhibits to this quarterly report, please remember they are included to provideyou with information regarding their terms and are not intended to provide anyother factual or disclosure information about the Company or the other partiesto the agreements. The agreements contain representations and warranties byeach of the parties to the applicable agreement. These representations andwarranties have been made solely for the benefit of the other parties to theapplicable agreement and:

 

·                  should not in allinstances be treated as categorical statements of fact, but rather as a way ofallocating the risk to one of the parties if those statements prove to beinaccurate;

·                  have beenqualified by disclosures that were made to the other party in connection withthe negotiation of the applicable agreement, which disclosures are notnecessarily reflected in the agreement;

·                  may applystandards of materiality in a way that is different from what may be viewed asmaterial to you or other investors; and

·                  were made only asof the date of the applicable agreement or such other date or dates as may bespecified in the agreement and are subject to more recent developments.

 

Accordingly,these representations and warranties may not describe the actual state ofaffairs as of the date they were made or at any other time. Additionalinformation about the Company may be found elsewhere in this filing and in theCompany’s other public filings, which are available without charge through theSEC’s website at http://www.sec.gov. Please see “Where You Can Find MoreInformation.”

 

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**SIGNATURE**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
|                        | SALLY HOLDINGS LLC                                  |
|-----------------------------|-----------------------------------------------------|
|                        | (Registrant)                                        |
|                        |                                                |
| Date: February 5, 2009 |                                                |
|                        |                                                |
|                        | By:                                                 | /s/  Mark J. Flaherty |
|                        | Mark  J. Flaherty                                   |
|                        | Senior  Vice President, and Chief Financial Officer |
|                        |                                                |
|                        |                                                |
|                        | SALLY CAPITAL INC.                                  |
|                        | (Registrant)                                        |
|                        |                                                |
| Date: February 5, 2009 |                                                |
|                        |                                                |
|                        | By:                                                 | /s/  Mark J. Flaherty |
|                        | Mark  J. Flaherty                                   |
|                        | Senior  Vice President, and Chief Financial Officer |

 

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